Holding Vacation Rental Homes in an LLC: Liability, Insurance, and Tax Considerations
Owning a vacation rental home can be a rewarding investment, but it also comes with its own set of challenges, especially when it comes to liability, insurance, and tax implications. Unlike these little turtles who will grow their own protective shell, vacation rental homes titled in your personal name or revocable trust do not have their own protection in Arizona.
As an owner of real estate in Arizona, you assume certain risks associated with such ownership and have a duty to properly repair and maintain the home and comply with applicable laws. Specifically, an owner will be responsible for:
- Injuries on Property: If a guest is injured while staying at a property, they may sue the owner for damages caused by failure to properly maintain the residence such as a loose stairway or railing.
- Property Damage Claims: If your property causes damage to a neighboring property, the owner can be held liable.
These risks are substantially increased when third parties are the primary users of the property. Because the owner is not there on a regular basis, repairs may get deferred. In addition, most vacation rentals are usually near natural hazards such as lakes, oceans, rivers, mountains and other environmental variables that increase the risk exposure to the owner.
One effective way to manage these issues is by holding the residence in a Limited Liability Company (LLC). If the vacation rental home is properly owned by an LLC and someone files a lawsuit against the LLC, only the assets held within the LLC are at risk. Assets held outside of the LLC (like home or other real estate properties, investments, bank accounts) are generally protected.
While there are also some benefits to holding a vacation home used as a secondary residence in an LLC, this article focuses on holding your vacation rental home.
1. Understanding the LLC Structure
An LLC is a business entity that provides personal liability protection to its owners, known as members. This means that, in most cases, assets held outside of the LLC are protected from the liabilities incurred by the LLC and assets held inside the LLC.
Key Advantages of Holding a Vacation Rental in an LLC:
- Liability Protection: Protects assets held outside the LLC from lawsuits or claims arising from accidents or injuries that occur on the property.
- Flexible Management Structure: Members can manage the LLC directly or appoint managers, allowing for flexibility in operations.
- Pass-Through Taxation: Income and losses generated by the LLC can pass through to members’ personal tax returns, avoiding double taxation, by treating the LLC as a disregarded entity or partnership.
- Multiple Owners. The LLC structure allows for multiple owners to own a residence and define the rights and obligations of such ownership and add restrictions on transfers without encumbering title.
- Privacy. Property owned by an LLC will not show up on simple search of county property records and will require a search of Arizona Corporation Commission records to confirm ownership. For larger, high-profile owners, the LLC can be structured to keep the ownership of the property completely off all public records in Arizona using entities formed in other states.
2. Insurance Considerations
Types of Insurance to Consider:
- Property Insurance: Covers damage to the physical structure of the residence. Make sure to include riders or endorsements earthquake and storm damage as appropriate.
- General Liability Insurance: Protects against claims for bodily injury and property damage.
- Umbrella Insurance: Provides additional coverage beyond standard homeowners policy limits, ideal for high-value properties or high net worth owners. We recommend purchasing this extra coverage to all clients as the first step in protecting your wealth.
Property and general liability insurance is your primary defense against claims by third parties and you should make sure the policy is underwritten in the name of the LLC or names the LLC as an additional insured. Otherwise, the insurer may decline coverage if there is a loss.
If you plan on renting your vacation property, obtaining insurance for the LLC recently became more difficult with at least one large carrier refusing to issue new rental policies to LLCs when the owner does not stay in the property at least once during the year.
3. Tax Impact
Holding your vacation rental property in an LLC may have an impact on your tax obligations depending on your circumstances and care must be taken to insure you are not increasing your tax burden by transferring your vacation rental home to an LLC.
- Property Tax Impact. Transferring your residence may cause the property to be re-valued for property tax purposes, increasing your property taxes. If the fair market value of the property is significantly less than the property tax valuation of the property, you will want to make sure the transfer to the LLC will not cause the property to be re-valued.
- Income Tax Impacts.
- An LLC taxed as a disregarded entity typically allows income to flow through to the members, avoiding double taxation.
- An LLC taxed as a partnership files a separate tax return and issues a K-1 to each owner. This maximizes confidentiality and creditor protection but also increases the annual administrative costs of maintaining the structure.
- Entities taxed as C-corporations or S-corporations should not hold real estate.
- Estate and Gift Tax Impact. If the LLC is owned or controlled by you or your revocable trust, there is no estate tax impact. If you transfer minority interests to your family members, the transfer is a gift which may be taxable if it exceeds the annual gift tax exclusion or your applicable unified credit. The gift may be structured to enhance your estate tax objectives, but that is more detailed discussion for another post. If you have questions in the meantime, please give us a call.
4. Setting Up an LLC
Steps to Form an LLC for a Vacation Rental Home:
- Choose a Name: Select a unique name.
- File Articles of Organization: Submit the Articles of Organization with the corporation commission or secretary of state for the state of formation and satisfy any publication or other filing requirements. In Arizona, we recommend using a Manager Managed entity to give greater flexibility when transferring membership interests.
- Obtain an EIN: A separate Employer Identification Number is required for an LLC taxed as a partnership and recommended for an LLC taxed as a disregarded entity.
- Create an Operating Agreement: Although not always required, this document outlines the management structure and operational procedures of the LLC. It also addresses key issues such as fiduciary duties, information rights, transfer restrictions, incapacity, and death.
- Open a Bank Account: Set up a separate bank account in the name of the LLC to keep the entity’s finances organized and make income tax preparation easier.
- Purchase or transfer the vacation to the LLC. To obtain the protection desired, title must be held in the name of the LLC. If transferring a residence you already own, we recommend using a special warranty deed, rather than just a quit claim deed, to preserve your rights to make a claim on your prior title insurance policy.
- Obtain Property and Casualty Insurance and an Umbrella Policy. Obtain property and casualty insurance in the name of the LLC or add the LLC as an additional insured on your insurance policies.
Conclusion
Holding a vacation rental home in an LLC can provide significant benefits in terms of liability protection without losing income tax benefits. However, it’s essential to consult with legal, tax accounting and insurance professionals to ensure that the LLC is structured correctly and that you are fully compliant with local laws and tax regulations. If you want to discuss your vacation rental home, whether it is appropriate to purchase it in, or transfer it to, an LLC and alternatives, please give us a call.