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House Hackers: Here’s Why You Shouldn’t Use an LLC for Rental Property

Matt Faircloth
5 min read
House Hackers: Here’s Why You Shouldn’t Use an LLC for Rental Property

LLCs are a hot topic with new investors. If you’ve been investing for a while, you probably invest with an LLC. But is an LLC (or “limited liability company”) worth it for a new investor?

Maybe you haven’t done a deal yet, and you’re about to do one. Should you be using an LLC for rental property?

Or maybe you have a few deals already. Then, the question might be when should you start your LLC?

This article will address when to start an LLC and if it’s even worth it at all.

Out of the gate, it’s important to note that an LLC is not a one-size-fits-all approach. If your goal is to build net worth into the hundreds of thousands or millions of dollars, then set up the LLC. If you plan to keep your portfolio small (or are house hacking), an LLC may not be right for you.

Related: Do Landlords Need an LLC for Real Estate?

LLC written in blue marker on a spiral notebook laying on desk with small potted plant and other desk decor

Why You Should Skip the LLC When You’re House Hacking

Don’t use an LLC when house hacking, because it may prevent you from getting the financing you want. For instance, low-money-down, Fannie Mae, or FHA-backed mortgages can’t be held under an LLC. As a first-time home buyer, you’re able to put down as little 3.5 percent with an FHA loan. But this type of loan is available only to people purchasing primary residences under your personal name.

The same bank that would allow you to purchase a property for just five percent down may require 20 percent down for you to buy using your LLC. Plus, you might be able to get lower interest rates when purchasing a property as yourself, not an LLC.

That’s why you want to think about the type of investing you want to do before starting an LLC.

Special tax breaks

Interest on a mortgage for a primary residence is tax-deductible on your personal income. And if you opted for an FHA loan with a low down payment, your mortgage insurance is also tax-deductible.

You might not be able to claim either of these tax breaks on your personal tax return were you to move the property into an LLC. These tax breaks are especially important to highly leveraged owner-occupiers—like house-hackers—who pay lots of interest and mortgage insurance each month in the first few years of ownership. Even in pass-through entities, like single-member LLCs, these tax breaks are minimized because investors can’t leverage as much. Putting down 5 percent or less through an LLC is a rare feat.

Tax-free capital gains

Assuming that you live in the property for at least two years—and assuming that the property appreciates over that timeframe—you can sell your investment for a tax-free capital gain. This gain caps at $250,000 for a single person and is limited to primary residences only. Unlike a 1031 exchange, the money is truly tax-free and can be spent on your next vacation, manicure, or other non-real estate assets.

Assuming that my property appreciates 10 percent over the next two years, I’m looking at a cool $20,000, instead of perhaps $13,000 after taxes. That’s a meaningful difference to me.

Mixing business and personal

Of course, a good real estate investor runs their property as professionally as they can, with separate email addresses, bank accounts, and credit cards for property-related expenses. But because this is your house, at the end of the day, you have the option to cheat when necessary by mixing personal and business assets. I have no corporate veil to defend, and thus have more flexibility in moving assets around, managing tenants, doing work on the property, etc.

Reasons to Use an LLC

But not all investors house hack—and even if you are opting for this method, you may prefer the veil of an LLC. There are a number of good reasons to elect for an LLC.

Related: How Does an LLC Owner Get Paid?

Protection from liabilities

LLCs protect you from liability claims. For anything that’s a claim against a property—like, “Hey, I slipped and fell!”—an LLC is an entity that can stand between you and that. Whoever makes the claim will come after the LLC, not you personally.

Full transparency: There are ways around this. The most important one to mention is liability insurance. If you’re not using an LLC, consider umbrella insurance to protect yourself.

It makes sense to want to distance yourself from your properties for liability reasons. But for many first-time investors who are owner-occupiers or owner-managers, this advantage is likely forfeited from day one. Your tenants will see if you put the work in or not: getting that leak fixed, mowing the lawn, installing that new carbon monoxide detector, etc. Your presence on-site may expose you to legal risk regardless of your LLC status.

Tax write-offs

Because it’s an entity with its own tax return, LLCs allow you to write things off (e.g., business-related expenses like your cell phone bill). You can try to write them off on your personal tax return, but it looks a little suspect to the IRS that a person, not a company, is claiming business expenses. It makes things cleaner from a financing and tax perspective to write them off under an LLC.

If you don’t plan to use an LLC, do whatever you can to keep your investments separate from your personal account. Use a separate email, get a credit card only for business expenses, and have a separate account for your real estate investments.

Selling company shares

An LLC operates as a business entity. As long as it’s registered properly with the SEC, you can sell shares—or in the instance of LLCs, what’s called “interests”—of the company to other investors who want to invest with you. Or you can sell the LLC altogether as a business that owns things.

Related: 9 Steps to Take BEFORE Setting Up a Real Estate Investing Business Entity

More LLC Pro Tips

Here are a few final thoughts on the topic.

Avoid setting up your LLC online (unless you’ve been doing it for a while). Instead, have a lawyer help you.

Also, have a lawyer help you create an operating agreement with the LLC. You can do this online, too, but strongly consider NOT going that route—especially if you have partners. A good lawyer can set up an operating agreement for you for less than $1,000. It’s worth it.

Bottom line, if you’re going to build a business around real estate investing, run it as a business. An LLC is a company. If you’re looking to make this a side hustle or just something you do a little bit, then do it in your personal name and own one or two properties—that’s OK.

But if in the future you intend to build a big portfolio, set up an LLC. Operate as a business. Do it now—five years before you get to that point. Moving properties out of your personal name and into an LLC is not easy. It’s doable but difficult.

Where should I set up my LLC?

One last thing: set up the LLC where the property is. Don’t favor Nevada or some other state simply because of favorable tax policies. The LLCs owning certain properties should be set up in the state the property physically exists in. You’re going to have to pay a tax return in that state. So just set it up there.

The reason people talk about state-based LLCs is because they believe specific types of LLCs will prevent certain claims from jumping over the LLC and getting to you personally. However, it’s unlikely that an LLC will prevent anyone from getting a hold of a person specifically if that’s what they’re trying to do. Plus, that’s what insurance is for. Avoid the tax headache of setting up an LLC outside of the state the property is actually in.

Please consult a lawyer or CPA about this subject. A lot of the information in this article is my opinion, so it’s important to consult a professional.

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What do you think about LLCs? Do you favor a certain state over others? 

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