Real Estate Matters: Land owner curious about tax implications of forming LLC to avoid probate

Q: I inherited a parcel of land upon my father’s death. His wishes were for the property to remain in the family for my children. In order to prevent any tedious probate in the event of my death, I formed a limited liability company (LLC) with me and each of the children as members. Are there any tax consequences I should be concerned about?

A: Before we get into the tax consequences, we’re not sure if using the LLC was the best option. You were trying to avoid probate and allow the property to pass from you to your children upon your death.

An LLC is a company structure. You and your children can be members of that LLC. But there are some wrinkles to choosing this structure. First, are your children minors? If so, who will represent their interests in the LLC to make a decision upon your death? If you die, have you addressed and documented the transfer of your membership interest in the LLC to your children?

The LLC wouldn’t automatically answer these issues. We hope you worked through these questions carefully with your attorney; otherwise, your children might still need probate to transfer your LLC membership interest. We hope the operating agreement for the LLC provides a structure to allow the property to transfer from each member to another upon the death of one member. The document will need to have a specific mechanism to allow for the transfer of membership interests without having to go through probate.

For our readers, here’s another reason to think twice before putting real estate into an LLC just to escape probate: Creating the LLC structure costs money. You pay to create it, and then you pay an annual fee to the state in which the LLC is formed. You have to file an annual tax return for the LLC and may have to pay an accountant to file the return.

Frankly, we think a living trust would have been a less expensive option. A living trust allows you to control the property entirely during your lifetime, with automatic transfer of control and ownership interests upon your death.

Which is a nice segue to the topic of taxes. We don’t know how you set up the structure, so we can only guess as to some of the potential issues you might face now and in the future by holding the property in the LLC.

Certainly, when your father died, you inherited the property on a stepped-up basis. That is, the land would be valued at the current market rate at the time of his death. If you kept the property in your name, your kids would inherit the land at the land’s market value at the time of your death. With a stepped-up basis, the heirs get the land at its increased value and the new generation would not have a tax to pay if they immediately sold the land shortly after they were to inherit the property.

Here’s how it might play out: Let’s say the land was worth $1,000 when your dad purchased it. When your dad died, the land was worth $100,000. If you turned around and sold the land shortly after he died, you’d pay no taxes on that sale. For Internal Revenue Service (IRS) purposes, you inherited the land at a value of $100,000 and sold it for $100,000. Hence, you had no profit and no tax to pay.

The same is true in the future, assuming tax laws don’t change. If the land was worth $500,000 at the time of your death, your kids could sell the land and pay no taxes on that sale if they sold shortly after your death.

But if you put your kids on title to the land shortly after your dad died, your kids would not get the full stepped-up basis at the time of your death.

Let’s say, you have three children and the four of you are equal owners in the LLC. Each person has 25% of the LLC. If the property is worth $100,000, each of you would have a basis of $25,000 and, when you die, your kids would inherit your 25% interest.

If they sell the land shortly after you die, your three children might not have a tax to pay on your 25% interest. But, they would have to pay tax on the profit from the sale of the land given that their cost basis is $25,000. So, if the land is worth $500,000 when you die and they sell the land, each kid will have a substantial tax to pay on their share of the LLC, but would likely not have tax to pay on your 25% share that they all would inherit from you.

We’ve simplified our example substantially. And, there are other tax issues that go along with an LLC ownership that require a longer explanation. These issues may depend on whether your kids are minors or not, what other assets everybody owns, who’s paying for any expenses on the ownership of the land, including real estate taxes, insurance and any maintenance, and whether you’re earning revenue from the property.

For these and other reasons, you should talk to an estate attorney, tax expert or other person who can work with you to find the right solution for your situation.

(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, a financial wellness technology company. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through her website, ThinkGlink.com.)