Should you form an LLC to co-buy a home?
At a glance
At CoBuy, we work with all kinds of folks looking to co-buy and co-own homes. You name it—unmarried couples, friends, family members, multiple couples, and every combination—we’ve seen it. Many first-time co-buyers want to know about LLCs. Over the years, we’ve often been asked “should I use an LLC to co-buy a home?”.
There’s a lot out there on the topic of LLCs in real estate, and it’s tough to separate fact from fiction based on information designed to push a business agenda. We believe that co-ownership is a personal decision and that quality information empowers decision making.
In this post, we’ll cover:
- Co-buying basics
- LLCs in real estate
- Challenges with LLCs
- Alternative solution
You certainly do not need an LLC to buy a home with friends, family members, or your partner. In many situations, the costs of creating and managing an LLC outweigh the benefits.
Co-buying is when two or more people who are not married to one another team up to buy a home together. Compared to a conventional home purchase, co-buying is more challenging on multiple levels. Traditional real estate practices and structures, which have developed around the concept of a nuclear household, do a poor job of addressing co-buying and co-ownership.
Before deciding whether you should form an LLC to co-buy a home, it’s helpful to break things down.
We can think of co-buying in terms of three stages:
- The purchase
- The co-ownership period
- The exit (by sale or transfer)
Financially, we need to consider:
Every situation is different, and the right structure for your co-ownership arrangement depends on your circumstances and goals.
Who will be involved?
How will you finance the purchase?
What are your goals?
Answering these questions is a great place to start.
What is an LLC?
A Limited Liability Company is a business structure.
“A limited liability company (LLC) is the US-specific form of a private limited company. It is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation under state law; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. LLCs are well known for the flexibility that they provide to business owners; depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, and, under certain circumstances, LLCs may be organized as not-for-profit.”
From the IRS:
“A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state may use different regulations, you should check with your state if you are interested in starting a Limited Liability Company.
Owners of an LLC are called members. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members.”
How are LLCs used in real estate?
Real estate investors sometimes use LLCs as a vehicle to buy and hold property investments. There are different types of LLCs, uses, and motivations for using them.
Benefits of LLCs can include:
- Financial or legal protection
- Tax minimization
- Flexible membership
Whether these benefits are relevant for you depends on your situation.
When does it make sense to use an LLC?
There are no hard and fast rules here. Generally, using an LLC to buy and own property makes sense for:
- Real estate investors who own/operate multiple cash-flowing properties
- Co-owners who own property with people they don’t know, where all parties are comfortable paying substantial recurring fees to a management company
There are costs and responsibilities attached to forming and operating a limited liability company. There are also periodic tax and accounting reporting requirements. Failure to comply can undermine the intended benefits, incur financial costs and penalties, and carry legal implications.
Challenges with LLCs
Creating an LLC may not make sense if you want to buy a home with your partner, family members, or friends. Depending on your situation, it may not even be a viable option.
Getting a mortgage
Property is expensive, which is why about 90 percent of U.S. homebuyers get a mortgage to finance their purchase. If you and your co-buyer(s) need a mortgage, it’s helpful to understand how lenders operate. Mortgage lenders—banks, credit unions, brokers, and others—look at risk. Their business models depend on accurately predicting and pricing the risk for the loans that they originate.
The U.S. has a defined and regulated mortgage market. Most residential mortgages are secured against the home. This means that if you take out a mortgage and fail to pay on time or violate the terms of your mortgage, your home could be repossessed. Furthermore, borrowers on a mortgage are considered joint and severally liable. If one of the parties listed on the mortgage does not make a scheduled payment, the other parties are still responsible.
Most mortgage lenders won’t lend to a newly-formed LLC created solely to buy and own a primary residence. The same is true for a second home or investment property where no previous income stream exists. By definition, an LLC limits individual liability. This doesn’t sit well with lenders because it increases their risk. We reached out to six loan officers and an attorney from our network of vetted CoBuy-certified™ professionals, and each confirmed this independently.
According to one CoBuy-certified™ mortgage professional:
“There are very limited options for mortgage financing if the LLC will be the borrower.”
“You can find financing for LLC’s for residential purchases but not through standard financing channels. You often need a commercial lender or specialty lender. Using an LLC limits the financing options and typically results in a less desirable loan.”
For many co-buyers, a higher interest rate and/or requirement for a personal guarantee negates the benefit of using an LLC.
So is it possible to transfer ownership to an LLC after getting a mortgage and closing on a purchase? Not without consequences. Tactics designed to circumvent the rules can wind up backfiring. Attorney Shane Yelish explains:
“Most lenders will not lend to an LLC on the run-of-the-mill residential purchase transaction. In an effort to get around this, some borrowers decide to purchase the property in their individual names and then convey the property to an LLC after closing. This can create other significant issues, like triggering the due on sale clause.”
DefinitionA due on sale clause is a common feature of residential mortgages. It allows a lender to demand immediate repayment of the mortgage in full if there is a sale or transfer of ownership.
Forming an LLC involves time, cost, and complication—after all, you’re setting up a business. “There are costs to form the LLC and annual fees to maintain the LLC,” says Yelish. Requirements include filing Articles of Organization, securing a Registered Agent, and creating an Operating Agreement. Using online cookie-cutter templates to form an LLC isn’t advisable: errors or omissions can be costly and carry penalties (see the list of possible repercussions from IRS.gov).
LLCs are also subject to reporting. LLC members need to ensure ongoing compliance with tax and regulatory requirements at the state and federal levels.
“Generally an LLC is meant for a profit-seeking business entity.
Using an LLC to co-own real estate generally makes it a partnership for federal income tax purposes. That means you’d have to file a Form 1065, due March 15th.
The LLC is a flow-through entity for federal income tax purposes, which means it doesn’t pay federal income tax, but you do on your personal return. This would then be reported on a K-1 and carried to schedule E on your personal return due in April.
You may have other state and local tax obligations as well.”
Luke Frye, CPA & Co-founder of Timber Tax
Staying on top of periodic filings, fees, and obligations requires hiring attorneys and tax professionals. Alternatively, you can hire a management company to handle all LLC-related matters. All-in costs can total thousands of dollars annually.
Risks and implications
If you’re buying a home as a primary residence, using an LLC can eliminate tax benefits such as mortgage interest tax deductions, capital gains exclusion, and 1031 exchange eligibility.
Capital Gains ExclusionWhen you sell your home, you may be able to exclude capital gains from taxation at the federal level if you've resided at the property for at least two years. Current guidelines exempt up to $250,000 for a single person or $500,000 for a married couple.
For example, consider three co-owners who purchased a primary residence five years ago in Seattle or San Francisco. Our imaginary co-owners are median earners. They sell their home today. Assuming a 15% capital gains tax rate, forfeiting the capital gains exclusion could easily cost each party $20,000 upon sale.
Other considerations arise on a state-by-state basis. If you are committed to going the LLC route, you should engage a licensed real estate attorney in the state you intend to purchase.
Many co-buyers choose to structure co-ownership as Tenants in Common (TIC). TICs are popular because they’re flexible and cost-effective. They’re frequently used when at least one of the co-buyers will live in the home, but they are also suited to second homes and investment properties. Key features of the TIC structure include the ability to divide ownership equally or unequally between co-owners, the preservation of tax advantages, and compatibility with residential mortgage standards.
A TIC does not require forming a business entity, but co-buyers should create a co-ownership agreement to define the terms of co-ownership and address various risk scenarios. When combined with other tools such as tailored insurance, many of the benefits associated with LLCs can be achieved—often more efficiently and effectively.
The co-buying process and co-ownership are dynamic. Co-buyers should think about structuring co-ownership early and start by getting clear around circumstances and goals. These inputs aren’t just useful to guide decision making: they’re essential.
There’s no one-size-fits-all answer to the LLC question. That said, you don’t need an LLC to co-buy a home.
Key takeawaysYou may want to steer clear of using an LLC to co-buy if you:
CoBuy is not a law firm, and we do not provide legal services. The content on this site should not be treated as legal advice. You should always consult a licensed attorney for questions and advice related to co-buying and co-owning real estate.
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