BEST WAY TO OWN RESIDENTIAL REAL ESTATE

Key Takeaways:

• Holding residential property in a Revocable Living Trust guarantees immediate wealth transfer to heirs while completely bypassing costly probate court proceedings.
• Standard deeds lack asset protection, leaving real estate exposed to a homeowner’s personal lawsuits, divorces, or catastrophic creditor claims.
• Utilizing a Beneficiary Deed acts as a baseline fallback option, automatically transferring property ownership upon death without requiring active trust administration.

More thought should be given by the purchaser as to how title should be held. Ask yourself these three main questions:

1. Where is the money coming from to purchase the real estate?
2. Will the property be rented out, short term or long term?
3. Are you married?
4. What’s the end game? Long term hold or short term flip?

Where is the money coming from?

If the money is coming from an existing LLC, an existing Trust or some other existing entity, then your answer is generally easy. Take title in the name of the entity where the money is coming from. So, if money comes from your LLC, take title in the name of your LLC.

Is the property going to be held as an Investment?

If you plan to rent out the property (short term or long term) or you plan to develop the property for resale, then you have some potential liability. In such case, you will want the property held in some type of limited liability structure, like a Limited Liability Company or a Sub Chapter S Corp. Absent this layer of protection, a lawsuit against you stemming from an activity on this property could spill over to all of your assets, including real property or personal property such as stocks and bonds and bank accounts. Either structure will limit your liability to the one property causing the liability.

As an estate planning lawyer, I often advise clients on the best ways to hold rental properties based on ensuring tax efficiencies, risk tolerance and long-term plans. The impact to your income tax return will depend on many different factors. Since your CPA is more familiar than your estate lawyers is with your income tax issues, we would encourage you to get them involved to weigh in on this discussion.

Key Considerations for Rental Property Ownership

When deciding how to own rental real estate, consider the following factors:

• Liability Protection: Rental properties expose owners to risks such as tenant lawsuits, property damage, or personal injury claims.
• Tax Implications: The structure affects how rental income, deductions, and capital gains are taxed.
• Management and Control: Some structures allow more operational flexibility, while others impose restrictions.
• Estate Planning: Ownership structure impacts how the property is transferred upon death or incapacity.
• Cost and Complexity: Certain structures require set-up and maintenance costs, such as legal fees or state filings.
• For most rental property owners, the optimal structure is to hold the property in an LLC and transfer the LLC interests to a revocable living trust.

Are you married?

Arizona is a community property state. Under Arizona law (A.R.S. § 25-211), property acquired during marriage is generally considered owned equally by both spouses, regardless of how title is held. However, the way title is actually taken can affect how the property is managed, transferred, or distributed upon death or divorce. If you hold it in an LLC for liability protection, then the Trust that holds the LLC should be a Community Property Trust. If you hold it as individuals, then both spouses should be on the title.

The main options for married couples in Arizona are community property, community property with right of survivorship, joint tenancy with right of survivorship, tenancy in common, and holding title through a trust.

If you want the property to pass to the surviving spouse without a probate, then you want to hold the property in a Trust (best solution) or at least hold it with a “right of survivorship” feature. In either case, title will pass to the surviving spouse without a probate. And, between joint tenancy with right of survivorship or community property with right of survivorship you want to hold it as community property. Upon the death of one spouse, the surviving spouse receives a full step-up in cost basis for the entire property (not just the deceased spouse’s half), reducing capital gains tax when the property is subsequently sold (Internal Revenue Code § 1014(b)(6)).

If you don’t want your community half to pass to your spouse, and you don’t have to, then hold the title as tenants in common. Under this scenario, a spouse dies, and his or her interest filters thru the estate or trust to beneficiaries other than the spouse, i.e. kids of a previous marriage. Community property doesn’t mean you have to give both halves to the survivor. It only means that the survivor must get at least half the property at death.

What’s the end game? 1031 Exchange vs. Outright Sale?

Most dedicated real estate investors understand IRC section 1031 that allows an exchange of real estate for real estate without incurring any capital gains tax. You don’t get a new stepped-up cost basis in the new property, but instead you are stuck with “carry over basis” which means capital gains will be incurred when the new property is sold based upon the cost basis of the old property.

If the end game is going to be a 1031 exchange, it is much easier to do if the property is either held in a single member LLC, with you and your wife as the members, or inside of your revocable trust or held as community property. A 1031 exchange can get real difficult if you have other partners owning the property and only some want to do a 1031 exchange and others don’t. Once again, this is more of an income tax issue for your CPA to weigh in on when the appropriate entity selection is made.

Conclusion

Owning rental real estate through an LLC, paired with a revocable living trust, offers the best combination of liability protection, tax efficiency, and estate planning benefits. While sole proprietorships are simpler, they expose owners to significant risks, and corporations add unnecessary complexity for most investors. By carefully structuring ownership and consulting with legal and tax professionals, you can protect your assets, minimize taxes, and ensure a smooth transfer of wealth to future generations.