When not to use an LLC to own real estate.

• Author: Packard, Pamela
• Position: Limited liability companies

Over the last several years, many tax practitioners have concluded that limited liability companies (LLCs) are the entity of choice for clients desiring passthrough treatment for new business activities. This is because they can be treated as partnerships for U.S. income tax purposes, while generally being treated as corporations for purposes of providing the owners with protection from business liabilities.

The perceived advantage of an LLC over a limited partnership is that, in a limited partnership, the general partner does not receive protection from liabilities. Accordingly, S corporations are often established to act as general partners of limited partnerships, adding complexity and cost to the structure. However, in certain circumstances involving real estate, the additional tax benefits of using a limited partnership may be worth the cost.

A limited partnership is more advantageous than an LLC for real estate professionals expected to devote between 100 and 500 hours a year to a rental real estate activity. Under Sec. 469(c)(7), special rules apply to taxpayers who qualify as real estate professionals. These rules modify the general definition of passive activities and provide that rental activities are not treated as passive for a real estate professional if he materially participates in the activity. Thus, a professional can use a rental activity's losses to offset nonpassive as well as passive income, without applying the passive loss limits.

The determination of whether an individual materially participates in an activity may be different for an LLC member and a partner. An individual generally is treated as materially participating in an activity in which he has a limited partnership interest only if one of the following tests is met:

1. The individual participates in the activity for more than 500 hours during the tax year (Temp. Regs. Sec. 1.469-5T(a)(1));

2. The individual materially participated in the activity for any five tax years during the 10 tax years preceding the tax year in issue (Temp. Regs. Sec. 1.469-5T(a)(5)); or

3. The activity is it personal service activity and the individual materially participated for any three tax years preceding the tax year in issue (Temp. Regs. Sec. 1.469-5T(a)(6)). Under Temp. Regs. Sec. 1.469-5T(e)(3)(i)(B), an individual is treated as a limited partner if his liability is limited to a determinable amount by state law. In Gregg, DC OR (11/29/00), the IRS argued that, under this...