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

by | BiggerPockets.com

[ 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.

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.

property-in-LLC

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.

LLC-real-estate-taxes

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. ]

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What other questions do you have about LLCs, S-corps, and C-corps?

Ask away in the comment section below.

 

About Author

M. Ian Colville

Ian Colville is the Managing Partner of CCM Finance. Ian is a native of Minnesota (born in Rochester). He brings both a formal education (BA in Economics and MBA) as well as industry experience to CCM Finance. Ian is passionate about the many opportunities that real estate investments offer for both short-term and long-term financial gains. He is committed to helping local real estate investors turn those opportunities into profits. When not doing real estate deals Ian enjoys – well mostly he enjoys working on real estate deals. But if he does break away he is likely spending time with family or at the gym. Find out more about CCM-Finance and Ian here.

21 Comments

  1. joseph ball

    My attorney advised me that any first year law student can easily crack an LLC. unless it is a big company, with a Board of Directors, Bylaws, Managing Director, etc. The idea of a Mom and Pop LLC offering protection is a myth.
    You also must file a separate income tax return for each LLC.
    I choose liability insurance.

      • M. Ian Colville

        I should have been more clear in the post – Single member LLCs don’t require a tax return. Multi-member LLCs do require a tax return. Apologies for confusion on this. All of our LLCs are multi-member so I didn’t think of the single-member case at the time.

        • Mike Ross

          The author incorrectly says: “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.” In fact, EVERY deed to trust contains a “due on transfer” provision. This allows the lender to call a loan due if the owner transfers title without the lender’s consent. If a loan is made to an individual, the title to the property, the note and the trust deed will be in the name of the individual. Transferring title to the LLC without the lender’s consent breaks the uniformity of title and lien and triggers the due on transfer clause that is designed to protect the lender’s interest and foreclosure rights.

        • M. Ian Colville

          This is reply to @Mike Ross below. I’ll stand by my statement that setting up LLC “first” will allow you to avoid due on sale clause but I’ll clarify what I mean by “first”. What is mean is that you set up LLC, put property in to it and THEN (or at the same time) get a loan so that the bank is aware from day 1 that the borrower is an LLC. This will avoid the due on sale clause and lender will be lending to the LLC right from the beginning. No later transfer of assets required.

        • patrick volpe

          IMHO the LLC is not to prevent you from getting sued, the LLC is to segregate your investment assets, so you may lose equity in one property, not all of them. Virtually every MFR, hotel, restaurant, strip mall, gas station, etc etc, is in an LLC, so they must work. and if the largest RE investors in the country do it, why 2nd guess them, right?

          I bought my first investment real estate (an SFR ) in 1998. In my experience it is much easier to finance 1-4 family as an individual rather than a single member LLC. I have never had a lender call due on transfer on any property.

          as with all things, YMMV, not valid in Utah, and no eating, drinking, smoking or flash photography on this ride…

    • John Woodrich

      You don’t have to file a separate income tax return for each LLC. Single owner LLC generally files no tax return and if you have many LLCs with a partner and common ownership you can structure around having to file multiple returns with a holding company.

      • M. Ian Colville

        Good comment. To be more specific, you can have a multi-member LLC parent company (which WOULD need to file a tax return) that owns a series of subsidiary LLCs and the subsidiary LLCs would not need to file separate tax returns as they would all be considered single-member LLCs (owned by the single parent LLC) and, as such, their tax reporting would be handled on the parent company’s tax return. This does bring up the question of “how much is enough?” however. Having multiple layers of LLCs is a pain to manage so one might decide that having the protection of 1 single LLC layer is enough and skip having multiple LLCs underneath. I usually only see layered LLCs for large investors pools.

  2. John Woodrich

    I don’t think anyone should be taking this post as advice to setup an LLC. Talk to your CPA/Attorney first. Couple of major items this article doesn’t address are the due on transfer/sale clause, loan differences when purchasing a property in an LLC, and insurance considerations.

  3. Grace P.

    Ok We have 4 rentals all in my husband’s and my personal name. Most of them are owned outright We just have HELOC on two of them. We do have an umbrella policy. We are getting ready to renovate and sell one of the rentals. Would an LLC be of benefit for us? And if so, if it is myself and husband would that have to be a multi-partner LLC? What about an LLC with partnership election so we don’t have to do payroll and pay ourselves a 1099 for management? Honestly we just want the easier, tax advantageous route.

  4. Daryl Sielaff

    Don’t quote me either, but I’m pretty sure that varies by state if a husband and wife can be the owners of a single member LLC. Some states require that to be a multi member LLC. I think states with common property laws allow spouses to control a single member LLC.

  5. Franklin Miles

    Great comments by everyone as I am a newbie and I have read so much debate on which approach is better..setting up an LLC or just adding an umbrella policy for coverage for each property. I opted to go LLC so I will see how things progress for the first deal but trying to learn all I can

  6. Vamsi NA

    When you setup an LLC first and then attempt to purchase a property, aren’t there different requirements for the loan to go through? The LLC doesn’t have the same credit history (or income for that matter) as I personally have? Any thoughts on this aspect? Currently I have one rental property that’s in personal name between me and my wife and we have discussed this topic multiple times. We want to expand and buy more properties (even small multi family properties) and we aren’t sure if we should setup an LLC, transfer our current property to that LLC (assuming our bank has no issues) and then build credit for that company and use it to buy further properties.

    • M. Ian Colville

      Vamsi – you raise several issues but I’ll limit my reply to the question you asked directly. Any bank that lends to your LLC at your size will look at the credit score(s) of the LLC owner(s) and will get personal guarantees from the owners on loans to LLC. Building a credit rating for the LLC itself is meaningless until it gets MUCH larger so I would ignore this issue entirely. All you need is your personal credit score.

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