Sometimes I encounter a client who wants, for asset protection reasons, to store their principal residence inside of a limited liability company.
Now, let me say right off the start, that I’m sure that a good attorney can make a strong case for the asset protection benefits of owning a principal residence inside a limited liability company. Accordingly, if you have confirmed with a local attorney that you should, for asset protection reasons, put your principal residence inside a limited liability company, I of course defer to your attorney. He or she knows your specific situation. He or she knows the local laws.
However, as just a general point here, I want to identify a potential tax problem related to placing your principal residence inside of a limited liability company: In order to receive the Section 121 “Exclusion of Gain on Sale of Principal Residence” tax benefit, you need to own your residence.
Let me review the Section 121 tax loophole, just so we’re clear on this. Section 121 of the Internal Revenue Code allows you to exclude up to $250,000 of gain if you’re single or up to $500,000 of gain if you’re married, on the sale of your principal residence as long as you’ve lived in and owned the home for at least two of the preceding five years.
Here’s where Section 121 and the use of a limited liability company may trip things up. A potential problem with owning your principal residence through a limited liability company is that the limited liability company may cause you or your spouse to fail the ownership test.
If you’re single and you own your principle residence through a single-member, or “one owner,” limited liability company, the single member limited liability company gets disregarded for tax accounting reasons. This disregarding should mean that the limited liability company doesn’t cause you to lose the Section 121 exclusion benefit.
If you’re married and you and your spouse together own a limited liability company that, in turn, owns your residence, you may find that your husband-and-wife multiple member limited liability company gets treated for tax accounting purposes as a partnership. Because a partnership owns your principle residence, you presumably will lose your ability to use the Section 121 exclusion.
But let me say that this area of tax law is a little murky. If you live in community property state, for example, you may be able to treat even a multiple-member limited liability company owned by two spouses as a disregarded entity. And in that case, the “dis-regardization” should mean that the spouses own the house–not the partnership created by the LLC.
Note, too, that even if you are married you may still be able to work your way around the Section 121 ownership requirement. For example, if you are married but both you and your spouse own your individual shares of your principal residence through single member limited liability companies, the single member limited liability companies should be disregarded. In this case, the LLCs essentially “disappear” and that should mean that you salvage your Section 121 exclusion.
Finally, let me just acknowledge this point: Even if you do lose the Section 121 exclusion, you may gain more important asset protection benefits by holding your principal residence in an LLC. Accordingly, even if I was your personal accountant (which I’m not of course), I would absolutely defer to a local lawyer well-versed in the facts and circumstances of your specific situation.