If you’re lucky enough to own a vacation home, you might wonder about the optimal ownership structure for the property. For rental real estate properties and real estate held for investment, such as raw land, good choices are single-member and multi-member limited liability companies (LLCs). But the LLC option isn’t always right for vacation homeowners. Here’s important information to help you decide what’s best for your situation.
To illustrate, suppose your family members and friends use your beachfront condo for 90 days. You rent it out to third parties at market rates for 120 days. Personal use exceeds the greater of 1) 14 days, or 2) 10% of the rental days. So the condo is classified for federal income tax purposes as a personal residence for 2022.
Disregarded Single-Member LLCs
Single-member LLCs have only one member (owner). Under the so-called “check-the-box regulations” issued by the IRS years ago, you generally ignore the existence of a single-member LLC for federal tax purposes. There are two exceptions:
- When you elect to treat a single-member LLC as a corporation for federal income tax purposes, and
- For purposes of federal employment taxes and certain excise taxes.
Neither exception should be an issue for a vacation home owned by a single-member LLC. We’ll call a single-member LLC that’s ignored for federal income tax purposes a “disregarded” single-member LLC.
For a disregarded single-member LLC, it’s important to distinguish between rental properties and personal residences. (See “Rental Property vs. Personal Residence” at right.)
Rental properties. When a disregarded single-member LLC is used to own a vacation home that’s rented out enough during the year to be classified as a rental property for federal income tax purposes, you must report the federal income tax results on your personal return. This includes deductible expenses allocable to rental use and allowable itemized deductions allocable to personal use, subject to the limitations on mortgage interest and property tax write-offs. You aren’t required to file a separate federal income tax return for the single-member LLC.
Personal residences. If you use a disregarded single-member LLC to own a vacation home that’s rented out some during the year but also used for personal purposes enough to be classified as a personal residence for federal income tax purposes, you can deduct expenses allocable to rental use to the extent of rental income. Itemized deductions for mortgage interest and property taxes allocable to personal use can be deducted subject to the tax-law limitations. You aren’t required to file a separate federal income tax return for the single-member LLC.
In addition, there doesn’t appear to be any federal income tax reason that would prevent you from using a disregarded single-member LLC to own a vacation home that’s not rented out at all. In this situation, you’d report any allowable itemized deductions for the property on your personal return, subject to the limitations on mortgage interest and property tax write-offs. You aren’t required to file a separate federal income tax return for the single-member LLC.
If a married joint-filing couple uses an LLC to hold a vacation property and there are no other members of the LLC, the entity would apparently be treated as a single-member LLC. If so, the preceding conclusions would apply. However, there doesn’t seem to be any IRS guidance on this issue. Consult your tax advisor about your situation.
Liability Protection for Single-Member LLCs
Although you ignore a disregarded single-member LLC for federal income tax purposes, it’s not ignored for state-law purposes. That’s a good thing. A disregarded single-member LLC will deliver the liability protection benefits specified by the applicable state LLC statute. These liability protection benefits are usually similar to those offered by a corporation.
In general, your personal assets are protected from liabilities related to a vacation home that’s owned by the single-member LLC. However, you’ll probably remain on the hook for any mortgage against the property. The liability protection offered by a single-member LLC is a matter of state law. Consult an attorney for details.
Because a single-member LLC is a separate legal entity for state-law purposes, it should have its own bank account to preserve its liability protection advantages. Keep enough cash in the single-member LLC’s account to pay the bills. You can distribute positive cash flow from rental income to yourself whenever you want.
More Single-Member LLC Tax Advantages
As the sole member (owner) of a disregarded single-member LLC, for federal income tax purposes, you’re considered to be the sole owner of any real estate that’s owned by the single-member LLC. Therefore, if your vacation home can be classified as a rental property or as an investment property that’s eligible for Section 1031 like-kind exchange treatment, you can use your single-member LLC to swap the vacation home for other real property that will be held for rental or investment purposes without owing any current federal income tax. That’s because when you use a single-member LLC to make a swap that’s eligible for Sec. 1031 treatment, it’s treated as a Sec. 1031 exchange conducted by you personally.
Meanwhile, the vacation property that you relinquish in the Sec. 1031 exchange and the replacement real property that you receive in the exchange can be held within the liability-limiting confines of your single-member LLC. The IRS has confirmed this taxpayer-friendly conclusion in several private letter rulings.
Additionally, under Internal Revenue Code Sec. 1014, the federal income tax basis of a vacation property that’s owned by a single-member LLC is stepped up to fair market value when the single-member LLC’s member dies.
Beware if the Home Has Several Owners
Say you own a vacation home with two family members. If you put the property into an LLC, the LLC will have more than one member (owner). As a general rule, a multi-member LLC (one with several owners) that engages in a business or investment activity is classified as a partnership for federal income tax purposes. As a general rule, you shouldn’t put personal-use assets into a multi-member LLC, because that calls into question how the LLC should be treated for tax purposes.
However, if the vacation home is classified as strictly held for investment or as a rental property for tax purposes, it’s probably OK to put it into a multi-member LLC. The LLC will be treated as a partnership for federal income tax purposes, and that’s not a bad result. However, it’s likely that property held by multiple owners will be characterized as a personal residence if there’s more than de minimis personal use by the owners.
Be aware that a multi-member LLC that’s classified as a partnership for tax purposes will create lots of complexities. You’ll need an operating agreement to set forth the rights and obligations of the members and provisions to allocate income and deductions among the members for tax purposes. You’ll also probably need a buy-sell agreement to handle what happens when a member wants to exit the deal. Finally, you’ll need to file an annual partnership federal income tax return and issue annual K-1s to each member. You may have state tax filing obligations, too.
All that said, using a multi-member LLC to own a vacation home will at least give the owners the liability protection offered by the state LLC statute. Of course, co-ownership of a vacation home that’s not put into an LLC can be complicated, too.
Consult an attorney and your tax advisor in the multi-owner scenario. As a general rule, it’s not a great idea to co-own real estate unless it’s held as rental property or strictly for investment.
Ask the Pros
Using an LLC to own a vacation home can make sense in the right circumstances, but it’s certainly not a do-it-yourself project. Before going down that road, consult an attorney about ownership and liability issues. Your tax advisor can help you understand federal and state tax issues.