Why and How Do LLCs Offer Greater Flexibility to Corporations?

Last week, I spoke about why putting your rentals in a Corporation is not such a good idea after all. This week, we continue with the benefits of having rentals in an LLC.

When it comes to owning rental real estate, partnerships provide a higher degree of flexibility, which is why investors often opt for LLCs when discussing the structure of their entities. Remember that multiple-member LLCs can be termed as partnerships as well.

So Why an LLC or A Partnership?

The process of transferring appreciated real estate into a partnership is straightforward and does not result in tax consequences.

Unlike corporations, where controlling 80% of the corporation immediately after the transfer is necessary to avoid recognizing capital gain, partnerships do not have such a requirement. With a partnership, you can contribute a property with a significant built-in gain, acquire a small 1% interest in the partnership, and not have to worry about taxes now.

Moreover, the treatment of liability relief differs. In a corporation, when a partnership assumes a partner’s liability, any relief exceeding the tax basis becomes taxable.

However, in a partnership, liability relief is only taxable if it surpasses the partner’s basis in the partnership. For instance, if a partner contributes a property worth $250k for a 50% stake, with a tax basis of $100k and a liability of $180k, the partner’s basis would be $190k ($100k + 50% of $180k). In this example, the debt relief of $180k would not incur taxes since it would simply reduce the partner’s basis in the partnership to $10k ($190k – $180k).

What if you need to dispose of the property from the partnership? This can be a cumbersome process in a corporation. However, partnerships have much more favorable rules in this regard.

When a property is distributed to a partner in a partnership, no gain or loss is recognized. Instead, the partner will have a basis in the distributed property equal to the lesser of (1) the partnership’s basis in the distributed property or (2) the partner’s outside basis in the partnership interest. This rule remains intact regardless of whether the property distribution is related to the liquidation of the partnership.

Clearly, partnerships offer a higher level of flexibility when it comes to holding rental real estate. Corporations, on the other hand, penalize you for not planning enough.

It’s hard to predict how your plans might change in the next decade or two. And your corporate structure may no longer be suitable.

By incorporating flexibility into your strategy today, you can better prepare for the future.