I recently received a question from someone who had put their primary residence into an LLC with a rental property. That wasn’t what their question covered. It was just one of the facts that were given as background.
First of all, that’s a big problem and in a minute, I’ll tell you why. But first I want to cover why asking questions with background is so important.
You don’t know what you don’t know.
Your Advisor Needs to Ask You More Questions Than You Ask
In this case, the question didn’t have anything to do with the primary residence being in the same LLC as a rental property. If the coaching client hadn’t given me background, I wouldn’t have even known about this. And because the member didn’t understand the significance of their actions, they wouldn’t know there was an issue.
It’s always best to have an advisor who asks you more questions than you ask him or her. Otherwise, you don’t now what to tell your advisor and your advisor doesn’t know how best to advise you.
That’s just a side note. Now let’s get to issue that was behind the question.
Inadvertently Changing Your Primary Residence Status Can Cost You Big Time
There are several differences between a primary residence and a rental property when it comes to taxes. Mortgage interest and property taxes (up to the limitations of SALT) are deductible on Schedule A of your tax return. SALT is comprised or real estate property taxes and state income taxes. You can deduct up to $10,000 per year.
Mortgage interest and property taxes are deductible against your real estate income, along with other expenses such as HOA dues, utilities, repairs, depreciation, insurance and other real estate expenses. If there is an over all loss when you take the deductions against your income, you may or may not be able to take that deduction against other income. If your adjusted gross income (AGI) is under $100,000, you can take deductions up to $25,000 of the real estate expenses. If your adjusted gross income is over $150,000, you can’t take any of the loss against other income. If your income is between $100,000 and $150,000, the amount of loss you can take will phase out.
The other big difference between a primary residence and a rental property is that a primary residence has a capital gain exclusion when the property is sold. A single taxpayer can exclude up to $250,000 of gain, provided he or she has lived in the property for 2 of the previous 5 years. Married, filing jointly taxpayers can exclude up to $500,000 of gain, with the same proviso. There are some special rules if the property was rented and then converted to a primary residence and it gets even more complicated if there was a marriage or divorce.
There is no such exclusion for a rental property.
This is What You Have to Watch with a Primary Residence LLC
You may want to put your primary residence into an LLC for asset protection. As long as it is the only asset in an LLC that uses default taxation, this is a good strategy. Default taxation means that the LLC hasn’t elected another business structure.
If you put it in a business structure with a rental property, you lose the benefits of a primary residence. In other words, it’s treated, for tax purposes, like a rental property. There is no capital gains exclusion.
Check with your CPA before you move assets around in your LLCs. It can have unintended consequences, if you’re not careful.
We meet the 1st – 4th Wednesdays at 5 pm for coaching classes. That’s a great place to ask about strategies like this.
It’s simple to make a mistake and not so simple to undo the problem.