Those individuals who currently own or are contemplating the purchase of rental or commercial real estate may be well advised to consider forming a “hub and spoke” entity limited liability company (“LLC”) structure. Owning rental or commercial real estate in an LLC as opposed to individual ownership helps insulate the owner from personal liability, streamlines the ownership of the real estate and administrative expenses and provides a great opportunity to remove significant value out of the owner’s estate which can create significant estate tax savings.
The plan would begin with the creation of a limited liability company (“LLC”) or S corporation. For purposes of this article, we will assume that an LLC is used. This LLC will be the hub entity (the “Hub LLC”) from which the owner(s) can invest in multiple real estate ventures. This Hub LLC would in turn own 100% of various other LLCs. The individual LLCs (the “Spoke LLCs”) owned by the Hub LLC would each own a separate piece of property. The Spoke LLCs will not need to file their own income tax returns as they are disregarded entities for tax purposes. Their income will flow through to their owner (the Hub LLC). The Spoke LLCs will protect each property from liabilities associated with the other properties. As long as the form of ownership is respected (e.g., with each LLC having its own bank account to which rental payments are deposited and from which expenses associated with the property owned by that particular LLC are paid), liabilities associated with one property should not attach to the other properties.
For properties already owned by the client, it will be important to assess whether there are environmental issues associated with a transfer of the properties. For example, the transfer of commercial manufacturing facilities in New Jersey could trigger ISRA compliance issues. An owner should obtain lender consent to the transfer of any property secured by a mortgage to avoid an acceleration of the mortgage. Additionally, as to any existing real estate, the owner must change the property and casualty insurance covering the property to reflect the new owner to maintain insurance protection.
For federal tax purposes, the Hub LLC will be taxed as a partnership if there are two or more owners, unless it makes an election to be treated otherwise. As a partnership, all of the Hub LLC’s income and losses would flow through to its members to be reported on their individual tax returns. A single member Hub LLC will be taxed as a sole proprietorship unless it elects to be treated otherwise. The Spoke LLCs will be disregarded entities for tax purposes.
The Hub LLC and Spoke LLCs would be created by filing a Certificate of Formation with the Secretary of State’s office. An operating agreement could be prepared for each entity with the LLC’s internal rules of governance. With respect to the Hub LLC, this could incorporate buyout provisions which would deal with what happens in the event a member dies or transfers an interest, voluntarily or involuntarily.
The structure can be used in connection with estate planning as well. Interests in the hub entity can be gifted to children, grandchildren or trusts for these individuals. Discounts for lack of marketability and lack of control would apply in valuing the interests gifted. This would be a mechanism to remove an interest in the real estate from the owner’s taxable estate, together with future appreciation and the income associated with the interest, substantially reducing estate taxes.
For properties to be purchased currently, when the Hub LLC is established, an interest in this entity can be owned by designated family members or trusts for their benefit from the inception. To avoid a gift on the purchase of the property, monies could be loaned to the Spoke LLC to allow this entity to purchase the new property.
The structure allows for additional objectives as well such as shifting income associated with the real property to family members who are in lower income tax brackets (such as children or grandchildren), asset protection planning and avoiding ancillary administrations of estates (if real property is in a state other than where the owner resides, at the owner’s death, the property must pass through ancillary administration in the state where the property is located unless the property is owned by an entity).
The structure described above minimizes administration costs and streamlines the ownership of real estate, while maximizing the liability protection afforded a taxpayer and accomplishing income and estate tax planning.
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