This Is the Best Time to Set Up an LLC for Your Investing Business

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[ Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation. ]

If you are a real estate investor and include “buy and hold” as one of your strategies, then protecting your assets should be of utmost importance.

You can buy a level of protection with insurance—homeowner’s insurance for protection against property damage and liability insurance for protection against lawsuits. While insurance is a good first line of defense, many investors add another layer of protection against liability by setting up one or more LLCs.

Real estate investors who buy and hold often turn to LLCs. They do so not only for the protection from personal risk exposure an LLC offers but also for the relative ease of managing and potential tax benefits.

Other investors view LLCs less favorably, concluding the time, money, and resources needed to form and maintain an LLC—or multiple LLCs—isn’t worth the protection from the theoretical threat of a lawsuit, particularly when affordable liability insurance is available.

RELATED: Do Landlords Need an LLC for Rental Property?

When Should You Set Up an LLC?

For buy and hold real estate investors who decide the benefits to be gained from setting up an LLC are worth the effort, the next question is: when should you set up an LLC?

As you might suspect, the answer is “it depends.” This isn’t very helpful, so here are a few things to consider as you determine the right time for you.

Advice for New Investors

If you are a new real estate investor and plan to buy and hold multiple properties, most experts and seasoned real estate investors will tell you it is much easier to do so prior to purchasing the property versus setting up an LLC after the fact. Transferring property to an LLC comes with paperwork and fees, and you may even need an LLC to get your lender to consent to the transfer.

If you set up the LLC first, you will avoid the following;

• The need to notify your mortgage holder you are transferring title to the LLC
• Potential closing costs that would be incurred if your mortgage holder chooses to close the loan
• Potentially higher interest rate if your mortgage holder closes the loan and issues a new one
• The need to notify tenants the property is now owned by the LLC and update your rental agreements
• Potentially triggering new taxes, specifically a title transfer tax (although this may not apply if the beneficial owners of the property don’t change)

Related: 4 Different Types of LLCs and the Ways They Pay Taxes

Advice for Experienced Investors

The ideal timing to set up an LLC will vary for investors who already own one or more investment properties.

Here’s what experienced investors should consider:

• Each investor’s tolerance for risk is different; however, the more properties you acquire, the more likely you are to become party to a lawsuit. Many experts believe the right time is “as soon as possible.”
• A potentially good time to set up an LLC is when you are also doing estate planning, when there are other significant business events (plans to buy or sell multiple properties), or life events occur (inheritance). There is likely to be crossover in the decisions to be made and paperwork required when you take the time to set up appropriate LLCs.
• Another expedient time would be prior to embarking on a significant buying spree. If you own, manage, and keep a close eye on your properties, you may feel your risk of liability is low. But if you are thinking of expanding, by purchasing properties in other regions/states that you will not manage directly and will not be able to keep a close eye on, it could be prudent to setup the LLCs before making the new purchases.

The Perks of Setting Up an LLC

In addition to protecting you and your personal assets from liability, LLCs have other benefits. These additional benefits may come into play as you decide on the right timing.

Pass-Through Taxation for Single & Multi-Member LLCs

• If you are considering LLCs versus a C corporation or S corporation, LLCs offer several advantages. You’ll avoid the double taxation incurred by owners of C corporations. In addition, LLCs have less complex legal filings and regulatory requirements compared to a C-corp or S-corp when it comes to real estate investing.

Simplified Business Administration

• LLCs offer more flexibility and simplicity than a corporation or partnership. An LLC can be easily managed by its owner(s), while corporations are statutorily required to have officers and directors, adding complexity.
• Typically, LLCs will pay lower state registration and maintenance fees versus corporations. Many states impose increased fees on corporations based on the authorized number of shares.
• LLCs offer much more flexibility versus corporations in the distribution of profits. Cash flow distributions are determined by an LLC’s operating agreement. This contrasts with an S corporation that requires cash distributions to be pro rata according to ownership.
• Foreign ownership and investment in U.S. real estate is possible through an LLC. This is not the case with an S corporation.
• LLC owners can easily transfer their ownership in real estate holdings to their heirs by gifting the company’s membership each year. If done consistently over time, it is possible to pass ownership of real estate held by an LLC to heirs without ever having to formally execute and record a new deed. This strategy enables property owners to avoid transfer and recording taxes and fees.

Related: 3 Reasons NOT to Buy an LLC Online

Conclusion

There are many benefits and a few drawbacks to using LLCs to protect you and your real estate investments from liability. Ultimately, determining the right time to set up your LLC will depend on many factors, including your current situation, your long-term strategy, tolerance for risk, and aversion to paperwork and lawyers.

Most agree sooner is better than later, especially if you plan to build a significant portfolio. It will be much easier to setup LLCs in advance or when you still have a small number of properties. The time, effort, and expense of setting up LLCs after you’ve already amassed a portfolio of 10, 20, or 50 properties could end up dissuading you from doing what is ultimately in your best interest.

When considering whether to set up an LLC and the ideal timing for doing so, it is important to remember you can be sued by anyone who enters your property including tenants, delivery people, guests, neighbors, repair people, and even criminals! Also, you can not only be sued for things you are aware of but also for things you “should have been” aware of.

For instance, a court could decide you should have known to repair the property to prevent harm that resulted. Given that anyone can sue anybody at any time for anything, you may prefer to have an added layer of protection between you and your personal assets.

As always, consult your lawyer and accountant if you have any questions on the issues discussed above.

[ Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation. ]

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.