{"id":73354,"date":"2015-06-14T09:30:26","date_gmt":"2015-06-14T15:30:26","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=73354"},"modified":"2021-03-16T11:39:15","modified_gmt":"2021-03-16T17:39:15","slug":"2015-06-14-invest-in-real-estate-using-llc","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/2015-06-14-invest-in-real-estate-using-llc","title":{"rendered":"Yes, You Absolutely SHOULD Use an LLC to Invest in Real Estate: A Counterargument"},"content":{"rendered":"

My initial reaction to Scott\u2019s article “5 Reasons I Do NOT Invest in Real Estate Using an LLC<\/a>” was that his advice is perhaps the worst\/silliest advice EVER.<\/p>\n

Please don’t do this. The disadvantages FAR outweigh the gains (and can be done through an LLC\u00a0anyway). Of course, in hindsight I think I was too harsh, and when limited to the 140 knee-jerk\u00a0characters in my tweet, I didn\u2019t do Scott\u2019s thought process justice.<\/p>\n

Brandon Turner at BiggerPockets asked if I\u2019d like to craft a rebuttal, and now, having had the time to reflect, and after\u00a0speaking with Scott, I think my response is more along the lines of, \u201cI\u2019m jealous of Scott. I wish I had\u00a0purchased my first rental when I was 24. When he acquires more rentals and becomes the family\u00a0guy with more assets that he describes in the last paragraph of his post, he\u2019ll surely conduct his\u00a0business through and LLC.\u201d<\/p>\n

Before I dive in, a few disclosures to connect me to some of the things Scott points out in his article.\u00a0I am a lawyer (real estate). I am, in Scott\u2019s words, close to \u201c50 with three kids to put through college\u00a0and a few million in assets to lose.\u201d Not sure about the \u201cfew millions,\u201d but I do own 8 residential homes.\u00a0I am not thoughtless (unless, perhaps, you ask my wife on occasion). I might be very wrong. But I\u2019m not\u00a0selling you anything. And, again, I am jealous of Scott \u2013 I wish when I was 24 I had started buying real\u00a0estate and not waited until I was close to 40.<\/p>\n

The upshot to my rebuttal is this: If you\u2019re a young first time investor, then perhaps you can get away\u00a0without owning your real estate assets in an LLC. If you don\u2019t fit in this category, use an LLC.<\/p>\n

Financing<\/h2>\n

As you likely know, financing is a major driver when investing in real estate, whether residential or\u00a0commercial. And in the current environment, as cap rates decrease and prices compress, financing\u00a0becomes even more important to the equation to successfully invest in real estate. As Scott points out,\u00a0having the ability to obtain financing as an individual is a major advantage considering that the\u00a0commercial financing terms are not as friendly. So, by all means, finance personally. I agree with Scott.<\/p>\n

… with a twist. At some point your bank will advise you that your debt-to-income ratio exceeds the limit\u00a0that allows you to finance in your own name, and you\u2019ll have no choice but to obtain commercial\u00a0financing. But until that tipping point, finance in your own name for the better terms.<\/p>\n

Allow me to point out, however, that financing personally makes you personally liable to repay the debt.\u00a0This means that if you default and the bank forecloses and the bank has a deficiency, the bank can come\u00a0after you personally for the difference. I have to admit this doesn\u2019t occur very often, but the terms of\u00a0your home mortgage are recourse, making you personally liable.<\/p>\n

If you finance through an entity, only\u00a0the entity is liable for the deficiency. As a person, you are separate and distinct from the entity and\u00a0protected from this repayment liability unless you were required to sign as a guarantor (which may be\u00a0likely). So in that case you\u2019ll be on the hook anyway.<\/p>\n

It would seem that Scott\u2019s argument wins the day. Or does it? Many (most?) lenders, including\u00a0mine, allow you to finance individually while owning the assets through an entity, if the entity is\u00a0owned\/controlled by you. So, until you hit that debt-to-income ratio I discussed above, discuss with\u00a0your bank if you can finance yourself but own the assets through your entity, thus benefitting from the\u00a0advantageous rates\/down payment, while at the same time enjoying the liability protections of owning\u00a0through an entity.<\/p>\n

Tax Benefits<\/h2>\n

The very same tax benefits available to individuals are available if you own your homes through an\u00a0entity. This is so if the entity is a pass-through for federal tax purposes. You can make this happen by\u00a0being the sole member of the LLC (or sole members if you own as husband and wife). So, if you form\u00a0your LLC as a pass-through for tax purposes, you can still claim the deductions that Scott details. And\u00a0you get the liability protection of using an LLC. Scott: 1, Rob: 1. Tie game.<\/p>\n

Related:<\/strong> Should You Get an LLC For Your Real Estate Business?<\/a><\/em><\/p>\n

And a fine point on paying capital gains taxes — the avoidance-of-capital-gains-taxes-on-a-sale applies\u00a0to the gains from the sale of your primary residence only. Not property used solely for investment. So if\u00a0you don\u2019t live in the house, you can\u2019t exclude the gains from taxes. If the house is a rental, you can\u2019t\u00a0exclude the gains from taxes. If you live in half of the duplex, like Scott, you should be in good shape.<\/p>\n

But this is still the case if he owned the house in a pass-through entity or individually.<\/p>\n

Mixing Business With Personal<\/h2>\n

Corporate formalities can be a pain in the rear, I admit. As Scott mentions, using separate emails,\u00a0separate accounting, etc. can be tricky sometimes. And if you own the house in your own name, there is\u00a0an argument to be made that you don\u2019t need to worry about the separate-ness. So, point to Scott.\u00a0But if\u00a0you follow a few basic rules about separation of the entity from your personal life, piercing the\u00a0corporate veil would be difficult for anyone trying to get to your personal assets.<\/p>\n

But I can\u2019t say there is much of an advantage in the spirit of being able to rent to whomever you want if\u00a0you own personally \u2013 unless you want to discriminate. While is it certainly true that federal\u00a0discrimination laws may not apply to individually owned homes, as Scott mentions, discriminating\u00a0against someone because of their nationality, handicap, color, religion, etc. is immoral and unethical.<\/p>\n

But any valid reason you might want to refuse to rent to someone when you own as a business is\u00a0allowed. Criminal background, bad credit, poor references, insufficient income, prior lease\u00a0defaults\/evictions, unemployment, etc. These all qualify as valid non-discriminatory reasons not to\u00a0lease to a potential tenant. You don\u2019t need to own the rental personally to rely on one of these reasons.<\/p>\n

Limited Liability and Umbrella Insurance<\/h2>\n

The benefit to owning properties through an entity rather than individually is limited liability protection.\u00a0That is, only the entity is subject to any liabilities, lawsuits, judgments, etc., not the owners. The\u00a0owner\u2019s liability is limited to the amount of equity in the entity. This means that any additional liability\u00a0above and beyond that amount is the responsibility of an entity with no additional assets.<\/p>\n

Let me give you an example (ignoring liability insurance for now). Let\u2019s say you have owned a house for\u00a0a few years. You have benefitted from amortization and a rising housing market. The house is now\u00a0worth $200,000, and the outstanding mortgage is $140,000. The amount of your equity is $60,000. You\u00a0fail to fix a faulty rafter that should have been repaired. It falls. It hits someone on the head. They sue\u00a0for damages. They get a judgment for $600,000.<\/p>\n

This is a simplification, but if you own the house through an entity, the entity is on the hook for the\u00a0judgment. Your $60,000 equity is also lost. That\u2019s it. The entity is on the hook for the remaining\u00a0$540,000. The entity has no other assets, so the injured party is stuck with a judgment against an entity\u00a0with no assets. You walk away. If you had owned the house personally, you owe the injured party the\u00a0full $600,000. While certain of your assets are creditor protected by law, you now personally owe someone $600,000.<\/p>\n

And it\u2019s not quite as simple as Scott points out as starting over. That judgment\u00a0sticks with you for years and years (depending on jurisdictions). Of course, liability insurance will cover a\u00a0good chunk of this, so now let\u2019s talk insurance.\u00a0Let\u2019s say your liability coverage is $250,000. Insurance should cover that amount of the judgment,\u00a0which means you personally are left holding the bag for $350,000 — a judgment that sticks with you for\u00a0years and years.<\/p>\n

For a couple hundred dollars a year, you can increase your liability protection to $1\u00a0million by obtaining an umbrella policy, as Scott mentions \u2013 that is one of the smartest insurance\u00a0products you can obtain. I have a $2 million umbrella policy because, as Scott mentions, I\u2019m older with\u00a0more assets and want more protection. My umbrella premium is around $330 per year. Money well\u00a0spent. In the example above, you don\u2019t come out of pocket anything because the remaining claim is\u00a0under the amount of your umbrella policy.<\/p>\n

As Scott points out, \u201ca $1M+ mistake on [his] little rental would be an extraordinarily unlikely event.\u201d I\u00a0agree. But what if you own your own residence (possible slip and fall on your sidewalk), own 8 rentals (a\u00a0faulty rafter injures someone), perhaps you run your own business (and injure someone), own a car\u00a0(which contains the possibility of hitting someone, the damages for which exceed your auto liability\u00a0coverage), etc.? Is it possible that with all this going on, the potential damages could exceed the liability\u00a0coverage amount and the umbrella limit? It sure is.<\/p>\n

But if you own all your rentals through an entity,\u00a0the maximum amount of your out-of-pocket loss is the equity you have in the entity \u2013 after exhausting\u00a0both types of liability coverages. You don\u2019t have to worry about any slip and fall, and rotting wood, any\u00a0work accident, and auto accident, etc.<\/p>\n

Do not put your personal assets at risk. Simply use an entity to own and operate your properties.<\/p>\n

Note that while a separate entity for each property you owns further isolates liability (in that the\u00a0potential loss is only the amount of equity in each individual property), it can be expensive. Some states\u00a0allow entities to create \u201cseries\u201d (sort of like different shares) that can further isolate each property from\u00a0all others. If so, form just one entity, but create a separate series for each property separating the debts\u00a0and liabilities from one property from the others.<\/p>\n

Related:<\/strong> #AskBP 013: Should I Have Several LLCS For My Real Estate Business?<\/a><\/em><\/p>\n

Negotiate With a Higher Authority<\/h2>\n

No, this isn\u2019t an article about religion. The higher authority to whom I\u2019m referring is anyone other than\u00a0yourself. What I mean is that you lose negotiating leverage any time the counterparty knows you can\u00a0make the final decision. So don\u2019t let them know that you make all the decisions. You are much better\u00a0off if your tenants think you can not make any decisions. But oftentimes when someone owns his\/her\u00a0rental personally, pride and hubris lead them to tell the tenant that they are the owner. And they make\u00a0all the decisions. They don\u2019t need to listen to someone else.<\/p>\n

But owners are much better off if their tenants think that they just manage the property for the \u201cowner\u00a0group.\u201d That way they can\u2019t be cornered into making decisions. They can work with the tenants (or\u00a0pretend to be on their side) and always defer to a higher authority that makes decisions regarding the\u00a0property. They can listen, then take the time they need to consider other options. The tenants feel that\u00a0they are on their side.<\/p>\n

Then, if they want, they can return with an answer (after having had time to\u00a0think about the issue) and say, \u201cHey, I discussed with the owners, but they aren\u2019t willing to spend the\u00a0money to fix _____ right now. I tried to make your case for you. But they offered the following\u00a0alternative that I think will work…\u201d In this sense, you can still remain an anonymous owner.<\/p>\n

Upshot<\/h2>\n

Most of the advantages of owning property personally can still be enjoyed by owning through a limited\u00a0liability company of which you are the sole member (a so-called \u201csingle member LLC\u201d), with the very\u00a0important added protection of limited liability.<\/p>\n

Oh, and as always, consult your accountant, tax professional and attorney.<\/p>\n

Investors: You’ve heard both sides. What do YOU think? Do you believe an LLC is the wisest way to invest in real estate?<\/em><\/p>\n

Leave your opinions below!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"

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