Beware of Single-Member LLC’s Holding Title to Your Home in Bankruptcy

When your LLC owns your primary home and you declare bankruptcy, your home may lose its precious Homestead exemption, as a recent court decision illustrates (Breece 6th Cir. )

Generally, when you file for bankruptcy, there is a presumption – as many bankruptcy attorneys and advisors indicate – that you are likely to keep your primary residence away from the reach of creditors under what is known as the homestead exemption.  The exemption reduces the value of assets available for potential creditors’ claims.  However, many homeowners and business owners, subject to various sources of advice, prefer to own real estate through interests in various entities, such as Limited Partnerships (LPs), Limited Liability Companies (LLC’s), Limited Liability Limited Partnership (LLP’s), and some even venture to hold real property via interest in a corporation.

In recent years ownership of real estate through Limited Liability Companies (LLC’s) has increased drastically. It is a general consensus among California tax advisors and attorneys that LLC is the preferred vehicle to hold real estate because it affords  liability protection, is comparatively inexpensive to organize and setup, and because it allows a very flexible ownership structure. The latter reason is probably the most significant as any entity or individual can become an LLC member-owner.  This includes nonresident aliens, partnerships, trusts, corporations, other LLC’s, LP’s etc.

It has also become quite common for individuals who form LLC’s to have the LLC’s own their homes by either talking title to a new residence or transferring title of an existing residence to a newly formed LLC. Single-member LLC exists when only one member-owner owns a 100 percent interest in the entity.

In one Appeals Court bankruptcy case, an individual had LLC hold title to her primary residence. The person later filed for bankruptcy claiming the Homestead exemption.  The exemption presumes you own your primary home. The Appeals Court dismissed the argument that the home qualified under the Homestead exemption rules because the taxpayer did not directly own the real estate.

We should note the interesting view that a single-member LLC is disregarded for tax purposes, namely by the federal income tax rules, but treated as a separate entity distinct from its owner in this case.  Of course, the court considered the relevant state law and case history basing its decision on the strict interpretation of property ownership statutes in the state.  It concluded that the taxpayer could qualify for the homestead exemption only if she had interest in the home. The taxpayer claimed she had interest in the property through her membership interest in the LLC. The court held that  the taxpayer held no specific interest in property owned by LLC and because the exemption statute allowed the taxpayer  to exempt her  interest in property used as a primary residence, and because she had no direct interest in the Real Property, she could not claim an exemption.  In addition, a homestead exemption was denied because neither the property nor any interests in the property were property of the taxpayer’s estate.

Therefore, before taking ownership in primary home via LLC interest we should consider the likelihood and implication of bankruptcy. Moreover, given that the tax code affords additional tax benefits to homeowners, claiming ownership of primary residence though an LLC becomes even less attractive.

I recommend that you consult a tax specialist before engaging in such transactions.

Breece 6th Cir.