If you are a real estate investor or thinking of becoming one, it is imperative that you understand the legal issues involved in order to protect your assets. One of the most important decisions you have to make is the legal structuring of your real estate business—or what is more commonly known as an LLC. Do landlords need an LLC for rental property?
In short, it depends on your situation and your investing goals. How many properties do you own? What states are they in? Are you wanting an LLC’s legal protection, or would it benefit your financing options… or do you just want to sound cool and say you own a company?
(In all seriousness, that last point can be a big driver for investors. And it’s no way to make a decision.)
“LLC” is short for limited liability company, a newer form of business entity that offers benefits that partnerships and corporations do not guarantee. It protects investors from themselves and others.
What Is an LLC?
A limited liability company is an entity that you can either own solely or partially.
The main objective of forming a real estate LLC is to draw a line between your personal and business assets. This way, in the event that you run into any legal or financial trouble, no one can seize your personal assets to pay off the debts you owe.
Likewise, it is difficult to use the LLC’s assets for your own personal gain.
The main reason to purchase a property in an LLC is to insulate your personal assets from activities that occur at the property. Meaning, when you hold a property in an LLC and run the LLC properly (this is key!), your risk ends at the LLC should anything occur on the property—like a slip, trip, or fall.
Requirements for a Real Estate LLC
Opening a real estate LLC requires you to do three things:
- Keep the property in good repair, which protects you (and your business) from being found negligent should something happen.
- Hold the title of the property in the LLC. If the property is not titled to the LLC, you do not get to benefit from the legal structure of the LLC.
- Run the LLC as a business in order to maintain your corporate veil.
What does “running the LLC as a business” mean? There are a few standards. It must:
- Have its own bank account to receive income and pay expenses.
- Maintain standard bookkeeping records.
- Maintain corporate records (think meetings and minutes) according to the laws of the state of incorporation.
- Remain in good standing with the state of incorporation.
- Not commingle business and personal funds.
How to Purchase Property in an LLC
Using an LLC for rental property requires you to use commercial, not personal, financing since the loan is made to a business rather than an individual. Up until recently, commercial financing received a bad rap—most commercial lending programs did not offer 30-year fixed financing or competitive interest rates, required 25% or more down, and were riddled with high closing costs and prepayment penalties if you sold the asset within three to five years.
Today, there are many commercial lending programs that offer 30-year fixed rates, 20% down payment programs, competitive rates, and reasonable closing costs. In addition, they are oftentimes more competitive than a conventional loan should you do a cash-out refinance, such as when you are doing a BRRRR.
Purchasing a property in an LLC is a straightforward process. Let’s break it down into its integral parts.
Consult with Experts
Discuss your investing strategy with a lawyer and CPA. You’ll want to talk about legal and tax structures that can protect you and your business. Don’t skip this step! If you are flipping, you may need a different legal structure than if you are buying and holding.
Don’t let cost deter you from getting solid legal and tax advice. You can pay a lawyer and a CPA for an hour to put together the strategy and use a reputable incorporation firm to set up the advised structure.
Establish Your LLC
Different states have different requirements for LLCs, and you’ll want to check with your state business office for the details. Most will require you to file articles of incorporation. They may also request you write and sign an operating agreement While there are templates available online, the best option is to consult a lawyer, who can develop an operating agreement specific to you.
Again, don’t skimp here. The operating agreement will determine how assets are structured in the business in the event of a lawsuit.
Once your Articles of Incorporation have been approved, download a Certificate of Good Standing from your state business office website. You should also secure an EIN (employer identification number) from the IRS.
Benefits of an LLC for Rental Property
There’s a good reason LLCs are attractive to real estate investors: They offer both asset protection and tax advantages.
A rental property’s biggest liability is if a tenant slips and falls—or otherwise hurts themselves—and decides to sue you. A properly structured LLC for rental property separates you personally from your company. The only things at risk are the assets that the LLC owns. That means no one can take your personal residence or other assets.
LLCs offer a number of tax benefits. Basically, because it is a business, you can run it and treat it as a business. That means you can write off expenses and minimize taxes—a huge pro of investing through an LLC.
Plus, an LLC allows you to enjoy the benefits of pass-through taxation. Many corporation owners usually pay a double tax: They must file both their business income and personal income tax statements.
This is not the case with a real estate LLC, which excludes you from paying business taxes. This is thanks to pass-through taxation, which allows real estate investors to avoid double taxation by holding property in an LLC. You can report business profits or losses at a lower rate through your individual tax returns.
However, the exact benefits available to each LLC depend on how it is structured. That’s why it is so important to consult with local experts before filing paperwork with the state.
Builds Credit for Your Business
The ability to build credit for your business is an often underrated benefit of establishing a real estate LLC. An EIN allows your business to build credit without affecting or using your personal credit.
This can be a powerful tool for you as a real estate investor. And assuming your personal credit profile is in good standing as well, that business credit essentially doubles your borrowing power.
An LLC is fairly flexible. You don’t need thousands of documents or to issue stock. An LLC can be set up fairly easily and inexpensively and requires just a few documents—making it an ideal business strategy for real estate investors.
Disadvantages of an LLC for Rental Property
Whoa, wait—there are disadvantages? Yes! If LLCs were always the best choice, every investor would elect to file. But that’s not the case. Here’s what to consider.
An LLC can dig into your cash flow. For instance, California requires all LLCs to pay an $800-per-year fee—even if they’re registered in another state.
Additionally, some accountants charge more for filing LLC returns. (And yes, you need an accountant.) That can ring up to another $800 per year. Don’t use one of those cheap online do-it-yourself tax programs—one of the biggest financial benefits of rental properties are the tax advantages. If you aren’t set up correctly, you’ll miss out on a lot of those.
LLCs can get complex. There are many ways to set up the business, and there are many things that can go wrong. You’ll need to do separate bookkeeping for each LLC—which can be expensive and time-consuming. You could make mistakes, do the wrong things, and compromise the business or the accounts. Then, your personal assets are no longer protected.
Many lenders won’t lend to LLCs. And even if they do, the funds will be backed by your personal name anyway. In general, getting financing for properties under an LLC name can be very difficult.
Non-Foolproof Asset Protection
An LLC for rental property doesn’t always protect you from lawsuits. Consult with your lawyer to have a full understanding of any vulnerabilities your LLC might have. Also, if a lawsuit does happen, sometimes having an LLC can actually complicate the process.
Triggering Due-on-Sale Clauses
This one only matters if you already own a financed property. Oftentimes, investors will buy properties under their personal name and then quitclaim it to an LLC. Doing so could trigger the “due-on-sale” clause in your loan agreement. That means you would owe the remainder of the mortgage immediately.
Considerations When Using an LLC for Rental Property
While the list of drawbacks is considerable, many investors believe the asset protection and tax advantages alone are major reasons to set up an LLC. Ready to start? Here are questions to ask your lawyer or accountant beforehand.
- Should you use an umbrella LLC? You don’t have to have each property in its own LLC. But consider how much equity you can afford to lose if there is a lawsuit. Having all your property under one LLC might put your entire portfolio at risk. However, individual LLCs are expensive to form and maintain.
- What state should I file in? Discuss if you should file the LLC in the state the property is in rather than your home state. (This assumes you’re buying property out-of-state.) This can help keep costs down, as well, as the LLC won’t be transacting as a foreign business.
- Should I have a separate LLC for flipping? Work with your CPA to determine how to keep rental real estate activities separate from your flipping activities. The two types of income are treated differently.
- Should I file in Wyoming or Nevada? You will find many posts on BiggerPockets regarding holding companies in Wyoming and Nevada, or any state with strong charging order protection. This means that if something happens on a property, it’s harder for a lawyer to unravel all of your LLCs or get to your personal property. This may be overkill for many LLCs, but it’s worthy of consideration.
LLCs for Rental Property: Frequently Asked Questions
We asked CPA (and BiggerPockets expert) Amanda Han to answer readers’ most-common questions about establishing LLCs for rental property. Here’s what you need to know.
Do I Need an LLC to Write Off My Expenses?
Not necessarily. Let’s say you attend a business conference in Las Vegas. Even if you don’t have an LLC, you should be able to write off expenses like your flight and the hotel. As long as the expenses are ordinary and necessary as they relate to your real estate business, chances are they will be tax deductible.
Can I Write Off Every Penny I Spend?
Having an LLC does not automatically make all your expenses tax deductible. You would still need to be able to show that the expenses are business-related. For example, your cousin is getting married in Las Vegas and you are one of the attendees. You fly there, stay in a hotel, and celebrate the weekend with friends and family. No real estate or other business was conducted while you were there.
It just so happened that you opened a new LLC for rental property a few months ago. You might think, “If I pay for the cost of these trips with my LLC bank account, I should be able to write off my Vegas trip.” Unfortunately, you would be wrong. Neither the trip nor any of the expenses are related to your real estate or business activities.
How Much Will I Need to Pay?
All entities are not created equal. Certain states have high entity fees, and others have high maintenance costs. Before forming a legal entity, make sure that you have a clear understanding of what the formation and annual maintenance costs will be.
As with anything in investing and business, it is always a good idea to do a cost-benefit analysis prior to forming a legal entity such as an LLC. Only form a legal entity for your real estate business after you have a clear understanding of what benefit you will be receiving and after you ensure that it makes sense for your specific situation.
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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