Using a L.L.C to acquire real estate in the United States has become a common practice in recent years. This popularity can be attributed to the preferred tax rate that the use of such companies often enables, the low cost of establishing and managing such companies and the protection the investor can enjoy by purchasing real estate using a L.L.C.
Despite the popularity of this practice, it is necessary to examine before each investment whether in the specific circumstances this is indeed the ultimate way to acquire real estate for investment purposes. An optimal tax planning strategy will not necessarily acquire real estate using a L.L.C but will take into account the specific circumstances of the investor, in order to achieve a minimum tax liability.
In the article here we will list and explain the 4 things you should know before purchasing real estate through a L.L.C, so if you are thinking of investing in real estate in the United States – you should read the article before you.
What is a L.L.C?
The term L.L.C is an abbreviation that refers to a limited liability company. This is a legal entity that is established under American law and its purpose is a commercial activity. Like other companies, this body is a separate legal entity separate from its owners, this means that the owner’s liability is limited only to the amount of his investment. However, unlike a regular company, the rights holders in L.L.C. are not registered as shareholders, but as members, and the company is not defined as an association but as an organization known as a partnership.
In its essence, the main uniqueness of the L.L.C is that the company is transparent for tax purposes. From the tax aspect, even though L.L.C submit an annual income report, the tax liability does not apply to the company itself, but to each of its partners, in accordance with his or her relative share of the company.
The advantages of purchasing real estate using L.L.C
The main advantage of L.L.C is that it is a separate legal entity from its holders. This structure ensures a buffer between the investors and the company, so that their liability is limited solely to the amount of their investment. This ensures that creditors will not be able to be repaid from the capital and private assets of the investors and these remain protected.
This limited responsibility also exists in a regular company, but a combination of limited liability and transparency for tax purposes enables the investor to enjoy these two aspects at the same time. Unlike a regular company, insofar as it is an L.L.C. which is held by private individuals (and not companies), the tax burdens of a company will not apply to it. Thus, its income will not be taxed at the corporate tax rate, and more importantly, the distribution of profits will not be taxed at the dividend tax rate.
Not only that, but the registration and activity mechanism of the L.L.C is flexible and cheaper – registration is simple, there is no limit on the number of partners, no limit on the place of residence of the partners, the cost of tax returns is small due to their relative simplicity, and more. Another significant advantage is the ability to enjoy in certain circumstances better tax rates when selling assets.
The federal tax rates that apply to L.L.C income.
Current income
Current income is the company’s income from rent. These revenues are generally classified as FDAP (Fixed, Determinable Annual or Periodical) revenues, which are taxed at a flat rate of 30% of revenue, without the possibility of deducting expenses. Because the company is transparent for tax purposes, this means that each of the partners will be taxed at this rate.
Another option is to classify the income as income from a trade or a business. Classifying income as ECI will generally reduce the tax rate, and in any place will allow expenses to be deducted.
Since the company is transparent for tax purposes, as long as the holders of the company are private individuals (as appose to companies), the tax levied on rents classified as income from businesses will be at the marginal tax rate applicable to each partner according to his income (tax rate of between 10-37%). However, to the extent that the L.L.C. company is held by a local or foreign company, and not by private individuals, the tax levied on the rent will be at the corporate tax rate – 21%.
In this context it is important to recognize the tax benefit applicable to limited liability companies. Limited liability companies whose joint annual income of the partners is less than $ 350,000 will benefit from a tax deduction at the rate of 20% of their current income. L.L.C. companies whose joint annual income is higher than this amount will benefit from a tax deduction at the lower of the two rates:
1. 50% of the total salary of the partnership’s employees.
2. 25% of the salary paid +2.5% of the base for U.S. taxation.
Capital gains
In cases where the L.L.C. company is held by a local or foreign company, the capital gain from the sale of assets will be taxed at a corporate tax rate of 21%.
Things are different in cases where the L.L.C. company is held by private partners, then the profits will be taxed at the marginal tax rate applicable to each of the partners according to its relative share in the company. If the property is held for more than a year by the L.L.C. company, a reduced tax rate will apply: the gain on the depreciation component will be taxed at a rate of 25%, while the remaining profit will be taxed at a rate of only 15%.
These rates are for the most part lower than the tax rate that applies to companies, a rate of 21%, and therefore L.L.C in this context has a significant advantage over a regular company.
Estate tax
The applicability of an estate tax is the Achilles heel of L.L.C. Since the company is transparent for tax purposes, it does not provide protection from estate tax.
The main disadvantage of using a L.L.C to purchase real estate is the applicability of the estate tax. Because the company is transparent for tax purposes, it does not provide protection against estate tax. This means that in the case of a death of the investor, heaven forbid, if the value of his assets above $ 60,000 it will be taxed at a rate of 35% (unless he is a U.S. citizen, then he will enjoy an exemption up to a value of $ 11.2 million). Therefore, the age of the investor should be taken into account, and options for reducing the burden should be explored using professional counselling services.
Israeli taxation of L.L. C revenues
The income of Israeli citizens, even those produced abroad, is subject to Israeli income tax. The tax treaty between Israel and the United States provides broad protection against double taxation, but in the case of LLC the situation is more complex. Although in the United States a L.L.C is considered a transparent company, the Israeli tax provisions do not recognize it as such and so it is considered as an ordinary company for all intents and purposes.
In other words, while in the United States the partners are taxed as individuals, in Israel the company will be taxed as a regular company. This means that in Israel it is not possible to receive a tax credit for the tax paid, and in addition, a tax must be paid for the distribution of dividends.
After years of unclarity, two constitutive judgments have been given in this regard. The court ruled that a L.L.C is indeed a corporation, but that a taxpayer who has income from a L.L.C. has two options:
Defining the company as an opaque entity
Then the company will be taxed when distributing a dividend, and it will not be possible to obtain a foreign tax credit.
Defining the company as a transparent entity
The taxpayer will pay tax on the company’s income, will receive credit for the foreign tax, and will not be taxed when distributing a dividend.
Closing words
The use of a L.L.C may reduce the tax burden and provide the investor with legal protection. However, this strategy has its own difficulties, especially in light of the provisions of Israeli taxation, and therefore we recommend receiving professional advice on the subject. The professional staff of Mas America are among the best in the field of American taxation and are at your disposal in this matter as well.
