Have you considered buying an LLC that owns real estate, instead of the direct real estate? While many investors we work with still prefer to create their own entity on purchase, there can be good reasons for purchasing an existing LLC instead.
Here we cover what you should know when evaluating whether you should consider purchasing an existing LLC that owns the real estate you want to purchase. In order for this to work smoothly, the real estate must be held by a single-purpose entity, which is usually an LLC.
The Pros of Buying the Entity
1. Reducing Transfer Taxes
Transfer tax rules differ by state, so it is vital to understand the implications in yours.
- In Pennsylvania, a realty transfer tax is generally triggered when you acquire an interest in an LLC (or other entity) that owns real estate if you purchase more than 90% of the company’s ownership interest within a three-year period. This transfer of “beneficial ownership” is treated as a taxable transfer of the underlying real estate.
- In Maryland, transfer tax is generally triggered when you buy more than 80% of an LLC (or other entity) that owns real estate, provided the transfer is considered a change in “controlling interest.” This rule applies when the LLC acts as a “real property entity,” meaning the real estate makes up at least 80% of its total asset value.
- When an investor purchases an entity with a majority transfer of ownership, they are required to file and pay transfer tax. However, the amount is usually based on the current assessed value, adjusted with the Common Level Ratio in PA. This results in investors typically paying less transfer tax than if they paid it on a fair market value transfer rate.
Investors should always consult with their attorney regarding this type of transfer.
2. Smooth Transition of Leases and Vendor Agreements
Since the legal ownership does not change, the existing leases and vendor agreements remain intact, making the transfer a simpler process.
3. Financing
For real estate that has non-bank financing without personal guarantees, assumption of the financing is typical and usually more attractive than obtaining new debt. This often benefits the seller, who avoids prepayment penalties, and benefits the buyer, who obtains financing that may be better than market rate.
Assumption always involves approval of the incoming buyer at the same standards, but can be expedited when the buyer is purchasing the underlying entity for the real estate. For bank financing that involves personal guarantees, assumption can still be discussed with the bank, but in today’s market, most banks are reluctant to permit assumptions when underlying loans are at rates much lower than current market rate. A transfer of majority ownership interest in the LLC can trigger the “due on sale” clause, so make sure you are transparent with the lender to avoid issues.
4. Title
While an entity transfer should always include a title check, whether a new policy is needed should be discussed between the buyer and their attorney, and may save the cost of a new policy. The lender may also require an updated title policy or review.
5. Property Tax Basis
In some states, property taxes are always assessed when a sale takes place. Having an entity-level transaction may help keep the new assessment lower than a direct sale.
While in Pennsylvania it is not standard practice to reassess property taxes at the time of sale, it is starting to become more commonplace. Legally, a tax assessment change cannot take place just because of a sale, but taxing jurisdictions are using sales as an opportunity to adjust “errors” on the assessment and accordingly increase the taxes. Using an entity transfer can help keep a transfer discreet and avoid the prying eyes of the tax assessment offices.
6. Rights and Approvals Transfer
When you purchase an LLC, any approvals transfer as well. A good example would be if a buyer purchases a parcel of land that had full approvals to build. The land development approvals would be in the name of the LLC, and purchasing the LLC interest would ensure that all approvals attached to that entity transfer with the sale.
7. Insurance
Often, if the current ownership has a solid insurance policy at very attractive rates, purchasing the entity can avoid resetting to new rates that could be potentially much higher than a new ownership’s policy.
Cons and What to Watch Out For
1. Liability Exposure
When purchasing an LLC, you can potentially inherit any pending litigation, unpaid bills, and obligations. A buyer should always do proper due diligence — use strong reps and warranties, estoppel letters, UCC and judgment searches, tax certificates, and, when appropriate, escrow holdbacks and seller indemnities. A well-drafted hold-harmless agreement puts pre-closing liabilities on the seller. Solid legal counsel is key here.
2. Depreciation Schedules
When purchasing an LLC, you will also inherit the former tax basis unless proper tax filing is conducted to adjust the basis on the property in conjunction with your transfer of ownership. A Section 754 election, where you step up the basis of the assets of the LLC upon transfer, needs to be filed. Buyers should discuss this with their tax advisor and make sure it is carefully documented.
3. Need for In-Depth Due Diligence
Buyers should be careful to conduct due diligence that will make sure they do not inherit obligations in the LLC that they are not expecting. This can potentially require more in-depth investigation than a typical arm’s-length transaction would.
Buying the Real Estate Directly
Many investors opt to purchase the real estate directly, and while it may involve a higher transaction cost, it makes for a cleaner transaction.
Pros: a fresh start with no concern about past obligations, unpaid bills, liens, or past litigation; financing that matches your risk tolerance and is set to current market value; and a new title policy with clear protection from past liability related to the property or LLC.
Cons: potentially higher costs without any offsetting transfer-tax savings; a longer timeframe, since closing typically takes at least 60 days to process loans, title work, and appraisals; and a change in transition, since tenants, vendor agreements, property management, and utilities can all be disrupted by a known change in ownership.
Summary
When approaching a real estate deal, some of the best transactions happen when investors have a creative mind and take the time to think about the best strategy for each property. Considering when to purchase an LLC interest can be an important option for investors, which should always be done in conjunction with the investor’s trusted advisors.
Many investors we work with appreciate the careful but smart approach to maximizing value and minimizing risk that we balance. If you are working to grow your investments with this type of eye for value, contact us to schedule a consult to ensure your property value is maximized.
