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LLCs and FLPs It is absolutely amazing how many advisors recommend that their clients transfer their personal residence to an LLC or FLP for asset protection purposes. Why use an LLC or FLP? Many advisors these days have at least read about why people use LLCs or FLPs for asset protection, i.e., the charging order protection. While it is true if a client has a properly set up LLC or FLP in the a state with a good statute that the “sole” remedy a judge can give to a creditor is a charging order; does that automatically mean that using an LLC or FLP is a good idea for the personal residence? The simple answer is no. Why? There are three potentially significant downsides to putting a personal residence in an LLC or FLP depending on which state you live in. 1) The client can lose the capital gains tax exemption upon the sale of the residence. Each spouse has a $250,000 capital gains tax exemption on the sale of the personal residence (which renews itself every two years). In order to take advantage of this exemption, the spouse(s) must live in the house and own it personally for two years out of five. Therefore, if a client transfers the personal residence to an LLC or FLP and then suddenly wants to sell it, the client would lose the capital gains tax exemptions if he/she had not lived in it for the last two years out of five. In the event the client did not want to lose this exemption, he/she could transfer the house back to him/herself personally and live in it for two years and then sell the house. 2) The client will lose the home mortgage deduction if it is owned by a multi-member LLC or FLP. This is huge for most clients who have a mortgage. One of the biggest itemized deductions for clients is the home mortgage deduction, and most clients will not want to forego that deduction to asset protect the personal residence. To the extent the client had no home mortgage, this would not be an issue. 3) In some states (like Michigan), if the marital residence is not owned individually, the client would lose the ability to claim it as their “homestead.” The consequences in Michigan for not being able to claim a home as the homestead is an increase in property taxes that is over 50%. For example, if a client had a $500,000 house and claimed it as his/her homestead, the property taxes would be $5,000. If the client’s personal residence was owned by an LLC, thereby not giving the client the ability to claim it as his/her homestead, the taxes would be $13,000. Again, most clients will not want to pay extra for their property taxes just so they can protect the value of their personal residence. Like with any asset protection strategy, the decision for a client to implement comes down to the fear of losing the asset and the cost and headache of asset protecting it. Conclusion on LLCs and FLPs Unless a client has no home mortgage and no problems with having to live in the residence two years out of five before selling the residence, we do not recommend LLCs or FLPs as good asset protection tools for the personal residence.
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