Co-Author: Mara B. Peterson, Esq.
Using Revocable Trusts and Limited Liability Companies in Estate Planning
If you are someone who owns real estate, particularly if your properties are used for rental purposes, there are many important legal and tax considerations for these properties in an estate planning context. Without proper estate planning, these assets could be vulnerable to liabilities and leave your beneficiaries with a difficult and expensive mess to deal with upon your death. Proper planning to incorporate your rental properties into your estate plan will ensure their smooth transition and management after you pass away. Three primary considerations for your rental properties in an estate planning context are 1) probate administration avoidance, 2) asset protection, and 3) tax planning.
Probate Administration Avoidance
If you are a resident in the state of Colorado there are considerations for probate when owning rental properties. If you own real estate in Colorado in your individual name (or names, such as if you are a married couple), upon your death(s), those assets will most likely have to go through a probate proceeding with the applicable court in order to get transferred to your intended beneficiaries.
Further, if you own rental real estate outside of Colorado, those assets may need to go through what is known as “ancillary probate” in the applicable court in that state.
Setting up a revocable living trust and placing your rental properties into the trust can help avoid probate, by ensuring the trust controls the disposition of these assets when you pass away. With a revocable trust, you can specify the terms of distribution for each rental property, including your preferences for who should inherit the property and how it should be managed.
While you are living, you can be the trustee of your own trust, meaning you can maintain control over the property just as if it were in your individual name. Any assets held by your revocable trust during your lifetime remain in your control and for your benefit while you are alive and of sound mind. An additional benefit of a revocable trust is that you can name a trusted individual or corporate trust company as a successor trustee in the event of your incapacity or death, ensuring your assets will continue to be properly managed.
Asset Protection
In some cases, if you hold real estate for rental purposes, you should consider setting up an entity such as a Limited Liability Company (“LLC”) and transfer these assets into the name of the LLC. An LLC offers similar benefits to a revocable trust, with the additional benefit of a layer of liability protection.
Generally speaking, setting up an LLC for liability protection safeguards your personal assets from potential lawsuits or creditor claims arising from your rental properties. If someone should get injured on your rental property and sue you, or if a tenant sues you for an issue related to the property, holding that property in an LLC (and respecting the LLC as a separate entity) can result in your personal residence and assets being protected from being used to satisfy any judgments against the LLC. An LLC (if structured and operated properly) creates a separation between the rental property and your personal assets to help shield your personal assets if any legal or financial issues arise with the rental property.
Additionally, an LLC offers a streamlined structure for management of the property so you can keep management, finances, and the operations in one centralized place.
An important consideration when establishing an LLC is who should be the members of the LLC. In an estate planning context, this could result in setting up a revocable trust, listing that trust as a member of the LLC. If you own several rental properties, it might be advisable to set up separate LLCs to hold each individual rental property, to maximize liability protection for each property.
There are also several operational requirements and federal and state law compliance issues to consider when setting up and managing LLCs, so it’s important to discuss these issues with an attorney.
Tax Planning
By default, LLCs are treated as “pass through” entities for tax purposes, meaning an LLC is not taxed itself, rather the profits and losses pass through to the individual owners or members, who report them on their personal tax returns and are subject to the tax. If an LLC has one owner (AKA single member), the LLC would normally be treated as a single member LLC and therefore disregarded for separate income tax reporting purposes. In this case, all tax activity would normally be reported on the individual’s Form 1040 tax return. If an LLC has multiple owners (AKA multi members), the LLC would normally be treated as a Partnership for income tax purposes and the tax activity would normally be reported on a separate partnership Form 1065 tax return and Form K-1s issued to the owners who would report the activity on the individuals individual Form 1040 income tax returns.
Using Revocable Trusts and/or LLCs to hold your rental properties can still allow for the ability to conduct IRC §1031 like-kind changes on the properties. For capital gains tax purposes, if structured properly these properties can still receive an IRC §1014 step-up in income tax basis on death. If the rental property was a primary residence before or after the rental use, there could also be potential capital gains exclusion available under IRC §121 on the sale of the property. It’s always a good idea to speak with your tax advisor when dealing with rental properties to maximize your tax benefits.
Conclusion
The best way to realize the asset transferring benefits of a revocable trust and the liability protection offered by the LLC is to do the following – (1) set up an LLC for your rental property, (2) set up a revocable trust for estate planning purposes, and (3) set up the trust to own the LLC. This ownership structure will allow your rental properties the comprehensive benefits of both being shielded from liabilities and the seamless transition of these assets to your beneficiaries upon your death.
The considerations for estate planning and asset protection are unique to each individual’s circumstances, so it’s important to consult with an attorney and tax advisor to understand your particular circumstances and planning goals. Please contact Jeff Cohen and Mara Peterson to discuss the legal and tax aspects of incorporating LLCs as part of your estate plan.
