Do I need to create an LLC to invest in real estate in California? Do I need an LLC to own commercial or residential real estate? Should I create an LLC for my personal residence? How expensive is it to create an LLC for real estate? Do I need an attorney to create an LLC for real estate in California? Does Prop 13 apply to real estate owned by an LLC?
By James L. Cunningham Jr, Attorney at Law
California real estate can be a great investment: it’s a hedge against inflation, you can get significant tax benefits, and it’s a fine way to ride out volatility in the stock market. But you need to do it right. And, for my money, if you’re investing in residential or commercial property, you need to consider creating an LLC.
When you invest in California real estate using an LLC, or “limited liability company,” you don’t own the property–the company does. This can afford you all sorts of protections and opportunities that are unavailable to those who use another method of holding the title to residential or commercial property. In this article, I’ll cover some of the basics of using an LLC to invest in California real estate, which I hope will be enough to provide clarity on some of your questions and point you in the right direction.
Please bear in mind that these are just the basics. I spent six months on these issues in law school. Investing in real estate using an LLC is not a do-it-yourself project, and no lawyer could properly cover all your relevant questions without a one-on-one meeting to address the specifics of your situation.
You may also wish to watch my webinar on using LLCs for real estate investments, and I encourage you to book a call with us for help with the process.
Is real estate still a good investment in California?
Let’s start by asking a very basic question: “Should I still try to invest in California real estate?” Despite the recent run-ups and interest rate fluctuations, almost certainly yes. California real estate can be less volatile than the stock market (or cryptocurrency!), carries tax benefits, and can dramatically increase its value over time—if you do the right things.
Real estate and development are the largest industries in the United States, representing 13% of our gross domestic product, and home ownership is still an essential facet of the American dream, with 123 million Americans owning their homes, representing about 65% of the population. In other words, the housing market is a pretty solid bet. Although houses in California can be exorbitantly high compared to some other places, they’re often worth it.
What is the difference between “real estate” and “real property”?
“Real property” is just the term that attorneys use to describe the same assets that agents and brokers call “real estate.” It’s designed to clear up confusion in the legal realm but often confuses lay people. For most purposes, you can consider the terms interchangeable.
How does California determine who owns real property?
The ownership of real property in California is determined by who holds the recorded “title” to that property. You must always keep this important fact in mind. Titles are registered (“recorded”) in the County Recorder’s Office within the County where the real property is located. Anyone, at any time, can find out who owns what property. If your living trust owns a property, the LLC you create won’t own it unless you transfer the title by deed and record it at the local County Recorder’s Office.
How can I hold the title to real property in California?
There are various ways to hold the title to real property in California, whether residential or commercial. These include:
- Sole Ownership
- Tenants In Common (TIC)
- Joint Tenancy with Right of Survivorship
- Community Property
- Community Property with Right of Survivorship
- Ownership by a trust
- Ownership through a California real estate LLC
I will briefly cover the other options later on, but let me focus on owning real property through that last choice, ownership through a California real estate LLC. I’ll explain why I think it’s generally your best choice for investment property and outline how to set up an LLC for real estate.
How can I own real estate through an LLC?
In my opinion, LLCs are frequently your best option for owning real property as an investment, as they blend the best aspects of partnerships and corporations. With an LLC, you don’t own the property. The company owns it, and the company has its own Employer Identification Number (EIN), separate from your social security number. The members or shareholders of the LLC could include yourself, other parties, your Living Trust, or a separate holding company.
The advantages are considerable, especially if the California real estate LLC makes the initial purchase of the property—that’s because if you later transfer an existing property into an LLC, your name will not only appear in the chain of title (a permanent record), but also when you pass away the property will likely be reassessed.
How does a real estate LLC protect against personal liability?
As I said, an important reason to use an LLC is to protect yourself against liability. The limited liability company structure was invented by the state of Wyoming in 1977 to allow people to easily form companies to protect themselves from the personal liability of owning a business without the hassle, reporting requirements, and structural formality of a corporation (whether it is a “C” or “S” Corporation) or limited partnership. Other states began to adopt the LLC concept, and eventually, the Uniform Limited Liability Company Act was crafted, which has been amended several times and adopted by many, but not all, states.
Owning a piece of commercial or residential property as an investment outside of an LLC can expose you to lots of personal liability. To list just a few examples: What if the old electrical wiring in your apartment building causes a fire that injures your tenants? What if the concrete was not properly reinforced, and it collapses? What if your property manager, without your knowledge, discriminates against a protected class of citizens? The list goes on and on. In theory, unless the LLC is “pierced” legally, the company will be liable, but not you personally. The company may go bankrupt, but your other “outside” assets (outside of the LLC) could be protected.
Do I need an LLC for my personal residence? Can I still get a mortgage deduction on my personal residence through an LLC?
The answer to both of these questions is “probably no.” An LLC is typically not for personal-use assets. You generally cannot get a personal home mortgage deduction for a residence owned through an LLC, and it could also cause unnecessary issues for your protections under Prop 13 and the “good parts” of Prop 19 in California. But if you want to own residential real estate in California as an investment, I highly recommend doing so through the auspices of an LLC. That’s because I’m concerned about liability—and you should be, too.
How hard is it to set up a California real estate LLC?
It’s fairly routine to set up a California real estate LLC, then purchase investment property through that LLC, but it’s still not a do-it-yourself project. The issues are complex and often overwhelming for people who aren’t lawyers, particularly because you should have the right “LLC Operating Agreement” in place.
An LLC Operating Agreement is the document that sets the rules for the management of a limited liability company, establishing who are “members,” who is the “manager,” how the LLC can be expanded and dissolved, how members can be bought out, how members are protected, and many other factors which take significant expertise to get just right. The required agreement provides every member of the LLC with the underlying structure necessary to competently run a partnership or LLC.
Can I write my own LLC Operating Agreement?
Yes, but it’s almost certainly a bad idea. And don’t waste your time (and create booby traps for the future) by simply modifying a sample Operating Agreement downloaded from the internet—get expert advice, because each operating agreement must be carefully crafted to fit your individual circumstances and the eventualities you and your family may face.
The numerous LLC real estate investing issues to be discussed while creating your Operating Agreement include: Should your trust own the LLC? How would you pass the LLC to a child? What if you were to get divorced? Each such issue should be carefully dealt with using a competent attorney.
What if I want to establish an LLC without an Operating Agreement?
It’s a very bad idea to establish an LLC without a clear Operating Agreement, together with a schedule of members. Indeed, much of the power you get from owning an LLC comes from the specifics of the Operating Agreement.
What kind of property can I purchase through an LLC?
You can invest in commercial, industrial, or residential real estate using an LLC. In my view, using an LLC is highly recommended for residential property investments (other than your personal residence) and essential for commercial and industrial properties.
What is the definition of residential real estate in California?
Under the FHA, “residential real estate” is defined as any property designed for people to live in with four units or fewer. Anything larger is “commercial real estate.” The rules regarding financing are different depending on what kind of property it is—whether a unit, a duplex, or a single-family residence—and you must understand them as they relate to your situation.
Can I own multiple properties through the same LLC?
Yes, but it’s typically not recommended. If there’s a problem with your property, your LLC is liable. If you own more than one property through the same LLC, and one of your properties has an issue, it can take the whole entity down with it. The best move is to form separate LLCs for each property.
Can I own property in California through an LLC based in another state?
Yes, but if you manage an LLC located in another state that owns property in California, you must register in California. There are advantages to domiciling LLCs in different states. For example, many of my clients own LLCs based in Wyoming due to some of the specific advantages that state affords.
Likewise, if you have an LLC in Texas that owns Texas real estate and you as a manager live in California, you must register the LLC as a foreign LLC in California because a manager is a resident of the state of California. Complicated? Yup.
Can an LLC be easily pierced in California?
If an LLC is “pierced” by a lawsuit, the owners become personally liable for issues generated by the company. “Piercing the corporate veil” is too common in California, but with proper planning can be avoided here. Much depends on how your LLC is constructed through its Operating Agreement, and whether you strictly maintain a legal and accounting separation between yourself and the company. That’s why you need a lawyer to help you construct and maintain your LLC.
How is an LLC taxed?
An LLC in California can be taxed as a corporation (“S” or “C”), a partnership, or a “disregarded entity.” If a single-member, single-owner LLC is taxed as a disregarded entity, it means that, in the eyes of the IRS, for income taxation purposes, the LLC is not considered separate from you, the owner. A Disregarded Entity LLC does not file a separate Federal return but it does file its own State income tax return. This could also be true if you own an LLC together with your spouse. With multiple owners, an LLC is likely to be taxed as a partnership. This requires federal form 1065 as well as a state income tax filing. There are other options, such as being taxed as an S Corporation, but if you own real property through an LLC in California, it’s likely to be taxed as either a disregarded entity or a partnership. It’s important to discuss issues regarding California LLC taxes with a good tax-planning attorney and CPA before going forward.
When is the property owned by an LLC reassessed in California? What is the “original owner” of a property?
Under California’s Prop 13, there’s a limit to how much your property taxes can increase year over year. But that goes out the window if the value of the property is reassessed. Importantly, if 50% of the shares in your LLC change hands or control changes hands, the whole property is reassessed, after which it will be taxed at its new, presumably much higher value. On the other hand, if you buy shares of your LLC, your LLC buys a property, and your kids inherit it, the value may not be reassessed, and they’ll likely have a much lower tax bill. This will help offset the cost of their $99 Starbucks Grande Lattes in 2050.
As long as the proportional interest remains the same, there’s no reassessment when you put property into an LLC. But once more than 50% of those LLC shares change hands, the whole property is reassessed. This last fact requires complex strategies to avoid reassessment which I detail in my article on strategies for families to potentially circumvent Prop 19 reassessment through daisy-chained LLC ownership. Not a DIY project!
If the property is owned by an LLC, does it get a step-up valuation at my death?
When a property is owned by an individual, and that individual dies, their heirs can generally avoid paying capital gains from the years of the original owner’s lifetime by the establishment of a new, “step-up” value. Does the same apply to properties owned by LLCs? This can be a complex question. Generally yes, if the LLC is taxed as a partnership, as the deceased partner’s ownership interest or share. If it’s taxed as a disregarded entity, maybe. This is yet another reason to work with a good lawyer in establishing your real estate LLC.
How much does it cost to form an LLC for real estate?
Forming an LLC in California is not prohibitively expensive for most people looking to invest in real estate. The state does currently charge an $800 per year minimum fee to each LLC, regardless of its tax structure, but the administrative overhead is far lower than most corporate structures. Remember, it’s a company, not a corporation! You can expect to have some legal and accounting overhead, but you should find that relatively modest.
If I have good real estate insurance, do I need an LLC?
You need both. They do different things. Neither is too expensive.
Will I Still Have to Give Personal Guarantees for Real Estate Loans to my LLC?
If you are buying property through an LLC, it’s likely that your bank will still insist on a personal guarantee for the loan. If the loan is not repaid, you will still be personally on the hook to pay the loan or mortgage, despite the “limited liability” offered by your LLC structure. In essence, you have waived your limited liability in the case of this loan. In most cases, however, this will not impact the overall protection afforded by the LLC, and you will likely not have waived your limited liability for other issues. If the LLC is later sued by, say, a tenant, you will likely still be personally protected by the LLC shield.
What is a “drop and swap” in California and how can my LLC avoid it?
This is a complex subject related to 1031s, an advanced strategy in real estate investing which I haven’t the space to detail here. In brief, real estate investors attempting to execute complex maneuvers to avoid taxation must avoid performing what’s known as a “drop and swap” in California. If the owners of a property transfer it from an LLC to, for instance, Tenants in Common ownership, and then multiple owners try to “split the sheets” and effectuate their own respective 1031 exchanges in hopes of deferring capital gains taxes, California will likely dub this a “drop and swap.” If this happens within the same tax year or so, they’ll probably deny the 1031 and subject owners to California income tax. If you are considering any 1031 exchange, consult a qualified attorney. To learn more about 1031 exchanges and this issue, please see my webinar on the topic.
Do I need a real estate agent to buy or sell property with an LLC?
In real estate transactions involving an LLC, it may often be the case that the buyer is already known. In such cases, you may not need a real estate agent to buy or sell property with an LLC. At CunninghamLegal, we offer a private real estate transaction service that can save you a lot of money on commissions and make sure the legalities of buying and selling are handled properly.
If I own a duplex where one unit is my home and the other unit is a rental unit, should the duplex be put into an LLC?
Maybe or maybe not. LLCs typically aren’t for personal-use assets, but can the case be made for using an LLC in this situation? Perhaps. In such cases, you should definitely talk to a qualified tax planning lawyer to discuss your specific situation.
OTHER WAYS OF OWNING PROPERTY OTHER THAN AN LLC
Generally speaking, owning the title to investment property in California through an LLC is best, but it’s not the only path. Below, I’ll outline some other ways of holding a title—just remember that none of these other options offer the same liability protections as an LLC.
What is Sole Ownership of real estate?
Under Sole Ownership or exclusive ownership, a property has exactly one owner: you. It’s pretty much what it sounds like, and one of the simplest types of real estate ownership. I rarely recommend sole ownership, however, because of the difficulties in passing the property on to heirs (ownership through a Living Trust is generally better, see below) and the lack of protection against liability.
What Is “Tenants In Common” (TIC) ownership of property?
Tenants In Common (TIC) is an arrangement in which two or more people have a shared interest in a property. Under TIC, different owners can own different percentages; for instance, you might own 65% of a property, your friend Allison might own 30%, and her friend Greg might own 5%. If Allison dies, she can leave her share to her beneficiaries, which may or may not include you and Greg.
What is Joint Tenancy ownership of property in California?
In California, joint tenancy means that two or more people fully share ownership of a piece of property and, importantly, when one of them dies, that person’s stake passes to the other owner(s).
What is Community Property in California?
In California, “community property” means that all assets acquired by spouses are considered to be owned by both of them. The laws around this vary significantly state-to-state. California is a community property state and so are eight others, including most of the states that used to be part of Mexico. On the death of one spouse, a probate will likely be required to clear title.
What is Community Property with Right of Survivorship in California?
This is the same “Community Property,” above, but on the death of one spouse, the other spouse inherits the property. Using this method means the deceased spouse cannot leave their half of the community property to whomever they want.
Does California offer Tenancy by the Entirety (TBE) ownership of property?
In some states, “tenancy by the entirety” allows spouses to own property together as a single legal entity. California does not offer this legal option.
What is a Limited Partnership (LP) ownership of property?
An LP is an old-fashioned way to own property, and it has become obsolete for several important reasons. If you own property through an LP, or you’re considering buying property through an LP, you should speak to a qualified attorney about why this is often an antiquated, inefficient approach.
Should my Living Trust own my property in California through an LLC?
If you have a revocable Living Trust in California, you should, in most cases, retitle all your property to that trust. But a revocable Living Trust generally offers no protections against personal liability related to properties. That means it may be your best move to title the property to a limited liability company (LLC), and then make your Trust the owner of the LLC. Remember, however, that this may trigger a reassessment, and you should consult a lawyer before making this move.
Key takeaways
- In California, investing in property through LLCs is smart for residential and mandatory for commercial. Do not own commercial property in your own name!
- LLCs are generally not for your personal residence.
- Use one California real estate LLC for each property.
- Get legal advice. This is not a DIY project. You need a solid Operating Agreement and the right ownership and tax strategies.
At a minimum, you need the services of what I call your “A-team” to create and maintain a proper Real Estate LLC:
- Real Estate Professional
- Qualified Attorney
- Certified Public Accountant
- Financial Advisor
What Do We Do as California Estate Attorney Specialists?
The lawyers and staff at Cunningham Legal help people plan for some of the worst and best times in their lives; then we guide them when those times come.
Make an appointment to meet with CunninghamLegal for California Estate Planning. We have offices throughout California, and we offer in-person, phone, and Zoom appointments. Just call (866) 988-3956, schedule a free call, or contact one of our offices throughout California.
Please also consider joining one of our free online legal webinars.
We look forward to working with you!
Best, Jim
James Cunningham Jr., Esq.
Founder, CunninghamLegal
We guide savvy, caring families in the protection and transfer of multi-generational wealth.
