What Are the Tax Consequences of Transferring Property to a Limited Liability Company?

Deeding a rental into an LLC you own usually triggers no federal income tax. If you are the only member, the IRS ignores the LLC, so nothing is sold for tax purposes and your basis and depreciation carry on unchanged. A contribution to an LLC with two or more members is also generally tax-free, unless the mortgage that shifts to the other members is larger than your basis. The costs that do show up are usually state and local: a deed transfer tax in some states, and property tax reassessment rules in others, such as California.

Single-member LLC: no federal tax event

The IRS treats an LLC with one owner as a disregarded entity unless it elects to be taxed as a corporation. Its income and expenses go on your own return, on Schedule E for a rental, as before. Because the LLC does not exist for income tax, moving the property into it is not a sale, and there is no gain to report.

That defers tax; it does not erase it. Example: you bought a rental for $430,000, have claimed $60,000 of depreciation, and it is worth $630,000 when you deed it to your LLC. Your adjusted basis, meaning cost minus depreciation, is $430,000 minus $60,000, or $370,000. The transfer owes nothing. Assume no further depreciation, improvements, other basis adjustments, or selling expenses. If the LLC later sells for $630,000, the gain is $630,000 minus $370,000, or $260,000, taxed on your return just as if you had sold it in your own name.

An LLC owned by you and your spouse has two members. It generally files as a partnership, but spouses who wholly own the LLC as community property under state law can choose disregarded treatment for federal income tax if it is not taxed as a corporation.

Multi-member LLC: usually tax-free, but check the mortgage

An LLC with two or more members is taxed as a partnership by default. IRS Publication 541 says that usually neither a partner nor the partnership recognizes gain or loss when property is contributed in exchange for an ownership interest. Your starting basis in your LLC interest is the adjusted basis of the property you contributed, and the LLC takes over your adjusted basis in the property.

The exception is debt. When the LLC takes over your mortgage, the part of that debt now treated as owed by the other members counts as cash paid to you. If that amount is more than your basis, the excess is taxable gain.

Worked example, following the method in Publication 541: assume no part of the property contribution is treated as a sale under the disguised-sale rules. You contribute a rental with a $120,000 adjusted basis and a $300,000 mortgage (after a cash-out refinance) for a 50% interest. If the other member is allocated half the debt, $150,000, your basis drops by $150,000. That is $30,000 more than your $120,000 basis, so your basis goes to zero and you report $30,000 of capital gain. For a cash-out refinance, a tax preparer must check the timing and use of proceeds: borrowing in anticipation of the contribution can trigger those rules and change the gain calculation.

How the LLC's debt is divided among members depends on the loan terms and the operating agreement, and the allocation rules can shift more of it back to you. When the mortgage is larger than your basis, have a tax preparer run the numbers before you record the deed.

Partnership rules can also tax the deferred gain later. For example, if the LLC distributes the property to another member within seven years of your contribution, you recognize the gain that was deferred.

What happens to basis and depreciation

The federal depreciation statute treats a partnership that receives property in a tax-free contribution as stepping into the contributor's shoes for the carried-over basis (26 U.S.C. section 168(i)(7)). You do not restart a new 27.5-year schedule on the property's current value. For how the recovery period works, see how long the depreciation period lasts.

State and local costs: transfer tax and reassessment

A deed to an LLC is a recorded transfer, so state and county rules apply even when federal tax does not. Three examples show the range:

In California, the people who own the LLC right after an excluded transfer become its "original co-owners," and the reassessment test in the table tracks their later transfers. A separate change-in-control rule triggers reassessment when a person or entity obtains more than 50% of the LLC's capital and profits, such as an increase from 50% to 51%, unless an exclusion applies. When LLC interests change hands, the LLC must file form BOE-100-B with the State Board of Equalization within 90 days of a change in control or ownership, even when an exclusion applies, or face a penalty. Other states and many cities set their own transfer tax rates and exemptions, so ask the county recorder or a local real estate attorney which exemption form, if any, goes with your deed.

Before you record the deed

1. Confirm how the LLC will be taxed: one member (disregarded) or two or more (partnership).
2. Compare the mortgage balance with your adjusted basis. If the mortgage is larger and the LLC has other members, get a tax preparer's calculation first.
3. Check your state and county transfer tax and claim any exemption on the deed or transfer return.
4. In California, claim the proportional interest exclusion with the county assessor when you record the deed.
5. Keep your original purchase records and depreciation schedule; the LLC uses them.

The mortgage itself raises separate issues, covered in transferring a mortgaged property to an LLC. Whether the LLC is worth forming at all is in whether to create a separate legal entity for your rentals, and insurance after the deed is in whether you need landlord insurance.