LLCs are good for owning investment real estate, but what about a primary residence?

Posted by David Kanne on Thursday, July 31st, 2014 at 6:54pm.

In today’s litigious society, the threat of being sued is an increasing reality.  As a result, individuals go to great lengths to protect their real estate assets by utilizing insurance policies and limited liability companies.  For most Austinites, their primary residence represents their greatest real estate asset.  As a result, the question is often asked: Should an individual transfer their primary residence into a LLC for asset protection purposes?  Surprisingly, the answer is likely no and here are some of the reasons why: 

1)   Capital Gain Exclusion – Section 121 of the Internal Revenue Code provides that an individual can generally exclude up to $250,000 (if you are not married) and $500,000 (if you are married) of capital gain upon the sale of their primary residence.  Consider the following simplified example:  An unmarried person bought a house for $100,000 and utilized the property as their primary residence for two years.  The person sells the property for $300,000 realizing a $200,000 gain.   Under Section 121, no capital gains taxes would be owed on the $200,000.  However, if the property was placed within a LLC, the $200,000 gain could be subject to capital gains taxes. 

2)   Homestead Exemption – A homestead exemption is a safeguard that is used to protect the equity in an individual’s home from creditors.  However, in Texas, homestead protections are only available to individuals and not business entities, like LLCs.  As a result, transferring a primary residence into a LLC could result in the loss of the property owner’s homestead protections.

3)   Due on Sale/Transfer Clause – A Due on Sale or Due on Transfer clause is a clause within a mortgage which states, in relevant part, if the property is ever sold or transferred, the mortgage becomes immediately due and payable.  While this issue can be resolved by obtaining the lender's consent, transferring the property from the owner's name into the name of a LLC, could trigger the Due on Sale/Transfer clause within a mortgage.

4)   Administrative Requirements – A LLC needs to have a business purpose.  Further, a LLC’s members must maintain certain business formalities (ie: not mixing business and personal assets) or else the existence of the LLC could be disregarded.  In the context of a primary residence being transferred into a LLC, satisfaction of the business purpose / business formalities requirements would likely require the property owners to pay rent to the LLC.  As most people don’t enjoy paying rent (when not required), the administrative requirements associated with owning a primary residence within a LLC are not always justified. 

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