Co-ownership of Real Estate Titled as an LLC Post-Divorce
It is best to manage the co-ownership of income-producing real estate post-divorce by entering into a business relationship or partnership.
This partnership should be formalized with a detailed and legally binding operating agreement which is often associated with placing the real estate into an LLC entity. The title on the property need to be owned by a multi-member LLC that the parties would each be a member of.
Components of an operating agreement include:
· Naming the members of the LLC
· Specifying the percentage of ownership that each member has
· Stipulating how conflicts among members are settled
· Detailing any restrictions on a member’s ability to transfer their membership interest (including transfers to a trust)
· Specifying what happens to each member’s interest if the member dies
· Describing potential exit opportunities and what happens to each member’s interest in each circumstance
Anything that is owned by the LLC either retitled in the name of the LLC during the parties’ lifetimes, bought by the LLC, or transferred by operation of law at one party’s death, will not go through the public, costly, and time-consuming probate process.
However, there are a few pitfalls of placing real estate held into LLCs and these ramifications need to be considered for each specific case. These pitfalls may be categorized as estate and personal tax consequences, mortgage and refinancing issues, additional costs and complexities, title and legal issues as well as other considerations.
A list of issues includes:
Loss of Step-up in basis for gifted interests: Since it is common post-divorce to leave your share of assets to your offspring or others and not to a former spouse, assets in an LLC may not receive a step-up in basis to fair market value upon the grantor’s death, potentially causing a higher income tax burden for heirs when they sell the property.
Due-on-sale Clause: Most mortgages have a due-on-sale clause that springs whenever a title transfer occurs. Transferring the title to that of an LLC may trigger a requirement to pay off the entire loan immediately. Of course, this is lender-dependent and a case can be made that the members of the LLC are the same as the original owners, but in many instances, this will not be considered an exemption by the lender. It will also be important to understand that the shared property will likely remain on both parties’ credit reports potentially impacting future borrowing capability.
Personal Guarantees: Lenders often require a personal guarantee from the LLC members. This has the effect of nullifying the protection generally granted by the Limited Liability Corporation for that debt.
Limited Liability Corporations require filing annual reports with the state, paying state taxes and maintenance of proper records which could be burdensome and expensive. Additional fees may also be required at the time of transfer and recording of title and in some states, transfer fees are assessed upon change of title. In certain jurisdictions, transferring property to an lLC is considered a change in ownership and this may trigger a reassessment of taxes leading to higher property taxes.
Importantly, retitling as an LLC may trigger a change in the homeowner’s insurance policy from a personal policy to a commercial/landlord policy which are not only more costly, but if there is a change, the current property and casualty insurer may no longer writing new policies in the state. This is an especially critical consideration for Florida and California where insurance providers are leaving the state or limiting any new policies.
Title and legal issues may arise since the title insurance policy may not automatically coer the new LLC. This will require a new policy or an endorsement which can also add costs, complications and take additional time and effort.
An LLC is a legal entity which should have its own bank accounts that are commingled with any personal funds. If the LLC is not properly maintained as a separate and distinct entity, there is “veil piercing risk” whereby the court may disregard the entity and hold the members personally liable thus nullifying the protection initially sought with the LLC title.
Alternatively, the title could be held as tenants in common with percentage of ownership listed on the title for each party. This not only distinguishes both parties’ interests but also considers estate planning needs.
The operating agreement, either associated with an LLC or held separately, should detail how expenses will be shared, how maintenance will be addressed (define responsible party, cost-sharing, next steps to mitigate disagreements), the source, amount, timing and execution of income distributions, exit strategies for one or both partners which include “what ifs” and establish a clear timeline for a buyout or sale of the property. Since there may be a plethora of opportunities to exit, parties will need to identify as many as possible and describe how they will reach agreement on purchase offers, mergers, acquisitions, etc.
It is usually best to use a third-party property manager to minimize the personal interaction between parties and in many situations mitigate conflicts between ex-spouses by deferring to the property manager if there is disagreement. The property management firm will be responsible for handling tenants, repairs, rent collection, etc. The property manager may be deferred to if there is a disconnect or disagreement in any decisions that need to be made.
Finally, each member may, if permitted by the operating agreement, assign or gift a minority interest to heirs in a multi-member LLC. While the IRS allows for valuation discounts on minority interests in an LLC thereby reducing gift taxes, the IRS may scrutinize these to ensure that they are not overvalued.
Note: This article is for informational purposes only and is not intended to provide either tax or legal advice. Please contact your attorney or accountant and rely on their independent research and advice for these matters.
