Perhaps the most common question I receive from BiggerPockets members is, “Should I set up an LLC for my real estate business?”
It’s a good question because I’m sure you’ve heard the horror stories of landlords getting sued by tenants and losing everything. You didn’t spend years learning about real estate, growing your portfolio, and figuring out how to be an effective landlord only to lose it all to some deadbeat looking to game the legal system.
However, LLCs are also highly misunderstood in the real estate space because they are just so darn complicated. What works for one person may not work for you, and what works for you might not work for me. While I could give you the simple answer of “talk to an attorney,” I want to dive a little deeper.
Of course, I am neither an attorney nor a CPA, so please take what I’m saying as my own personal opinion and get a qualified person to help you out with these legal discussions.
What is an LLC?
First, let’s talk about what an LLC is and what it isn’t. An LLC is NOT a get-out-of-jail-free card. You can be sued with an LLC, and you can lose everything. An LLC is not designed to prevent you from ever being sued. An LLC is designed to help you manage and contain the fallout from that lawsuit.
According to the United States Small Business Administration (SBA), a limited liability company is “a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.” According to this definition, an LLC’s benefits are three-fold:
- Limited Liability: IF you were to get sued, your liability (the damage to your wallet) can be contained to the assets within the LLC, not everything else you own. In other words, if the LLC is set up right and you get sued (and lose), the creditors probably won’t be able to take your personal house or your car, or garnish your W-2 job wages. Or course, there are ways a judge might “pierce” the protection of an LLC and go after these things IF every “i” was not dotted and every “t” not crossed.
- Tax Efficient: The LLC is fairly easy to handle during tax time, especially if it is a “single-member LLC,” which means an LLC owned by just you or you and your spouse. LLCs are known as “pass through entities,” which means the income and expenses flow magically through the LLC and are reported (and paid) by each individual member on their personal income statement. There is no “corporate tax” like a corporation might pay. This can definitely make taxes easier and less expensive than, let’s say, a corporation. That said, while a “single-member LLC” does not require its own business tax return, a multi-member LLC does. Don’t make this mistake.
- Operationally Flexible: Finally, an LLC is fairly flexible in terms of running it. You don’t need thousands of documents, and there is no need to issue stock. An LLC can be set up fairly easily and inexpensively and requires just a few documents.
It’s easy to see why an LLC might be advantageous to a real estate investor. Let’s say a tenant slipped on the stairs and broke their hip. The tenant decides to sue the landlord for “neglect” and the court sides with the tenant. For whatever reason, let’s say your insurance doesn’t cover all of the legal penalties and you as the owner are required to pay $500,000 out of pocket to the tenant.
If you own the property without an LLC, the tenant could have your wages garnished, force you to sell all your properties, and drive you to bankruptcy. You’ll probably end up eating cold beans out of a can under a bridge while pigeons sit on your shoulder.
It’s not a fun place to be.
On the other hand, if the owner of that property was “Main Street Investments LLC,” then the LLC is the owner getting sued. The courts could make you sell that property, but they likely won’t be able to make you sell other properties owned by other LLCs. They won’t take your primary residence. You won’t be eating cold beans.
Of course, this example is a bit over-dramatized and unlikely to happen. And I don’t actually mind eating cold beans. But it illustrates the fear that drives most investors to want an LLC. However, even though it sounds like I might be encouraging you to go get an LLC, hold your horses. There are some other important factors to consider:
The Problems with an LLC and Real Estate
LLCs are great, I won’t deny. However, they might not be great for you. There are some fairly important considerations to make before you jump onto the LLC bandwagon that could affect your decisions.
Lending on an LLC is Almost Impossible
That’s right, if you plan on using a loan to acquire an investment property, it’s unlikely you’ll be able to have an LLC own the property. Most residential lenders simply will not lend on a property that is inside of an LLC, forcing you to turn to a commercial lender that has higher fees, higher rates, and shorter terms… something you probably don’t want to do.
Now, many investors simply transfer the ownership of the property into an LLC after purchasing the property in their primary name, but that presents some big risks as well. If the bank finds out (and they probably will due to insurance stuff), they might call your note “due” because of the “due on sale” clause.
Of course, you didn’t sell the property, but you did transfer the title from one entity (your name) to another (your LLC). In the past, this has never really been a problem, as banks have generally turned a blind eye.
However, this seems to be changing lately and is expected to only get worse as interest rates begin to rise. If you plan to go this route, I would recommend speaking with your bank and getting permission in writing to transfer the properties into an LLC.
This is the only way you’ll be truly protected from that dreaded “due on sale” clause.
What Are You Protecting?
New investors automatically think they need an LLC to protect themselves, but when you are first starting out, how much wealth do you really need to protect? Think about it. You have a property or two with very little equity. You have car payments.
You don’t have six figures in the bank, yet you want to go through all this trouble to protect your “wealth?”
Additional Paperwork and Hassle Furthermore
While LLCs are definitely easier than corporations when it comes to paperwork and taxes, they still add a lot of complications to the mix. This is especially true if that LLC contains multiple members who are not married, as an individual business tax return will be required. Setting up the LLC takes money, maintaining it takes money, and filing taxes takes money… on a property that you probably are not making much on in the first place. Imagine spending $2,000 per year on asset protection on a house that only cash flows $1,200 per year. Yes, an LLC can turn a good investment into a bad one.
The Truth About New Investors and LLCs
Here’s the thing I’ve noticed: people like to set up LLCs because it makes them feel like they are taking action.
In fact, the idea of an LLC is probably the number one excuse people have for NOT taking action.
I see it almost every day on BiggerPockets. “I want to invest in real estate, but I don’t know what to do about an LLC.” How absurd! The truth is: people use the concept of an LLC as an excuse so they don’t have to get out there and take action.
It’s easier to say, “I don’t have an LLC yet, so I can’t buy a property” than it is to say, “I’m scared.”
But this is often the truth.
Yes, LLCs are valuable.
Yes, I have them.
Yes, I recommend talking with someone about setting one up, sometime.
However, LLCs are no substitution for taking action. If you don’t have any wealth to protect, maybe you don’t need an LLC. When you find yourself building wealth and creating a sizable business, that’s when an LLC will come in most handy for you. By that time, you’ll be able to afford the proper attorneys and CPAs who can handle setting the LLC up right.
And maybe at that time they’ll tell you that you really don’t need an LLC. Maybe they’ll set you up with something different. You won’t know unless you ask.
What Should You Use Instead of an LLC?
Let’s look back at the three benefits of an LLC:
- Limited Liability
- Tax Efficient
- Operationally Flexible
What other legal structure can help you protect yourself from losing personal money if you get sued and is easy to manage and pay taxes?
I’ll suggest two things: insurance and leverage. Let’s talk about both, briefly.
That’s right, good insurance can help you avoid eating beans under a bridge. Get the right insurance, and get enough of it. Talk to a good insurance agent about your options and let them know your fears. They’ll be more than happy to sell you the best policy possible.
When someone is going to sue you, what is their goal?
To get as much money from you as possible, of course. This is why leverage can actually be a large help in protecting your assets.
By “leverage,” I mean the low down payment you use on your purchase. For example, if you owe $100,000 on a property and the property was worth $110,000… you are highly leveraged.
People often look at this like it’s a bad thing, but in asset protection, it’s a huge benefit.
What kind of lawyer is going to go after someone, spend hundreds of hours litigating, and force them to sell their rental — only to find there is NO blood to be squeezed from that turnip?
On the other hand, if you own a rental property free and clear and it’s worth $110,000, suddenly the idea of suing you becomes much more exciting for an attorney because they know there is a ton of money for them to take.
I’m not saying you should go increase the leverage on every property you own. But what I am saying is: when you are first starting out, you’ll likely be very highly leveraged, thus not a big target for lawyers to come after.
So, Should You Get an LLC?
Finally, I need to end this section with the dreaded answer everyone hates: I don’t know. Talk to an attorney and CPA.
Only they’ll be able to truly help you know if you are ready for an LLC. An LLC is a powerful legal entity, but only if it’s set up correctly and actually beneficial to you.
And there is no easy way for me to tell you if that’s the case in your life.
However, I would encourage you NOT to let the LLC question stop you from moving forward with your real estate ambitions.
Don’t let it be an excuse, and don’t let the fear of a lawsuit stop you from achieving your dreams.
Investors: Have you set up an LLC for your real estate business? What has your experience been?
Leave your comments below!