Do you need an LLC? Absolutely. There is No Debate About It.

Do you need an LLC? Absolutely. There is No Debate About It.

Rental Property Investor · Brooklyn, NY · Member since 2014 · 722 posts · 1k+ votes

The LLC debate rages on here at BP. Rarely does a day pass without an investor asking whether they should use an LLC or not. Perhaps BP should have a whole forum just devoted to this question . . .

Having an LLC is a no-brainer. Real estate is a business, and if you are in business you should not be operating in your own name -- unless the law requires it, such as for certain professionals like lawyers and doctors who society feels should not have their professional liability limited. My knowledge is not exhaustive here, but I am unaware of any jurisdiction that requires you to own investment real estate in your own name.

People are confused because they get a lot of bad advice about LLCs -- what they can and cannot do. They are told -- wrongly in my view -- that they should not bother with LLCs because an LLC will not protect them from liability to a lender or because insurance does the same thing. I will expose the incorrect thinking below.

But first, let's discuss what an LLC actually is. A Limited Liability Company is a corporate form with a separate legal identity. As the name implies, it limits your liability to the value of the asset. It does not eliminate your liability, so when people say you should not bother with an LLC because it does not eliminate all liability, they are confusing the issue. An LLC provides important liability limitation and risk-management capability, and if you are in business you should be taking advantage.

It is true that lenders won't lend to an LLC with no history. If you are new, and the LLC does not have a proven cash flow, a lender will make you sign on the debt yourself. But you should still organize your business in a corporate form, like an LLC. Why? Because banks are not your only potential creditors. Who else is out there? Practically the entire world is a potential creditor. Tenants, vendors, guests of tenants, the mailman, UPS, the cable guy -- in other words, anyone who ever sells anything to the property or sets foot on it is a potential creditor. (Anyone who sets foot on the property is a potential creditor if they slip and fall on the property -- or if they claim they slipped and fell even if they did not.) If the property is owned by an LLC that you own, the LLC is the debtor. If you own the property directly, YOU are the debtor. If an LLC owns the property, the worst the creditor can do to you is take the property. If you own the property, and the property is not worth enough to satisfy the judgment, then the creditor will take the property AND THEN go after your personal assets -- that means your house, your car, your 401(k), your children's 529 plan, your baseball card collection, your monthly paycheck.

Insurance is another must, but it does not replace an LLC. If you have insurance, that's great. It will cover what's in the insurance contract, up to the coverage limit. But insurance does not cover it when you don't pay a vendor. And what if someone is injured on your property and the court awards more than the insurance coverage? If you have an LLC, they may try to go after your assets, but they won't be successful if you have run the business properly. If you own the property in your own name, then you should re-read the previous paragraph about your house, your car, your 401(k), etc.

A very important note about LLCs is, as I said above, that they are separate legal entities. To get LLC protection against creditors, you must respect the separate legal entity. You must IGNORE the advice that some real estate gurus give, which is to run a whole bunch of personal expenses through the LLC. THIS IS THE ABSOLUTE WORST THING YOU COULD POSSIBLY DO. Will it save you some taxes? Maybe, if you don't get audited. Will it destroy the limited liability protection and expose your personal assets to seizure by creditors? Absolutely.

The biggest complaint against LLCs is that they cost money. Yes, you need to file tax returns for them. Yes, you need to do proper accounting. All this is true. These are all costs of doing business. But, remember, this is a business. You are not in real estate for a hobby. This is where the big boys and girls play. If you are not willing to spend a couple hundred dollars a year on LLC costs, you probably should not be in this business at all. But the real question is: Would you rather have the couple hundred dollars extra each year or the peace of mind knowing that your and your family's personal assets are not exposed because you decided to buy an investment property? That choice is up to you, but to me the answer is obvious.

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Scott TrenchPro Member
Rental Property Investor · Denver, CO · Member since 2014 · 2k+ posts · 6k+ votes
11y

I'm a young investor, and purchased a property via the "house-hacking" method back in November of 2014.  The property is under my name, and I rent out the other side to two wonderful tenants.

The work has been done Do-It -Yourself style, and I have gone a few months now successfully living rent free.  

Make no mistake about it, I consider this Duplex to be a business, and run it as such.  I manage the tenants with a separate email address and have a separate bank account for property related expenses.  I pay rent to the business and take money out of the business.

But the property is under my own name.

Reading the OP, I am committing a basic fail against common sense as a real estate investor. But I disagree completely. I had several immense advantages in putting this property under my own name that would have been forfeited were the property under an LLC:

1) I used FHA financing. Try putting down less than 5% on a property within an LLC, especially as a first-time buyer.

2) I am the occupant of the home.  I can rent to whoever I want, and for any reason whatsoever.  It's MY house, not a rental property, and the laws governing it are as such.

3) I had much better interest rates on my mortgage than the LLC would have had access to.

4) My mortgage interest is tax deductible.  In the first few years, where the bulk of my mortgage payments are comprised of interest, this is more advantageous than depreciation.

5) Assuming I live in the property for more than two years, and the property appreciates, I can sell for a tax-free capital gain.

The disadvantages are as follows:

1) Limited protection.  I'm 24 years old and this property is basically the grand total of my worldly assets.  I don't have much to protect.  I also have an umbrella insurance policy.  
This type of protection is good enough for millions of landlords with far more to lose than I. 

2) I'm obviously the owner of the property. I can't hide ownership behind an LLC. In my case, this advantage to the LLC is totally moot. The tenants live next door! I'm obviously the owner.

Conclusion:

Investing through an LLC would have been extremely expensive for me, setup and legal costs set aside. Furthermore, it would have delayed my first purchase significantly, and taken away subjective advantages in running my business as a personal asset.

I think that it is shallow to claim that having an LLC is a "no-brainer". I think that at the very least, my argument here shows that it is a debatable topic and that a reasonable person could conclude that there are indeed strong advantages to operating real estate assets under your own name.

See this reply in the discussion

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  • Lender · Los Angeles, CA · Member since 2015 · 399 posts · 174 votes
    10y
    Originally posted by @Jeffrey S. Breglio:

    @Account Closed and @Matthew Kreitzer. same in Utah as VA.

    And as for title and in Utah, I wouldn't insure the transaction if the party to transaction and/or the grantor/trustee of a revocable trust has judgements against them, even though technically the trustee holds legal title and the grantor holds equitable, for the very reason Matt said. I'd have to clear those judgments first.

     In CA, title insurance companies don't know who the beneficiary of the trust is, they are only entitled by law to a certification of trust which doesn't identify the beneficiary, having said that, not all title company's will insure a title holding trust.  Nevertheless, I was more speaking of a trust that came into existence with title insurance prior to the judgment.  I doubt I would attempt to take title to real property in any form if I already had a judgment against me.

  • Attorney · Winchester, VA · Member since 2015 · 726 posts · 387 votes
    10y
    Originally posted by @Account Closed:

     Same in CA, Revocable trust = creditors can get to any trust assets.  However, a creditor would have to go through the judicial system to even know who the beneficiary of the trust was, and as we have seen from this post in CA that can take multiple years and many thousands of dollars, not everybody is able or willing to do that ... you can have as much justice as you can afford, as the attorneys say.

     Unless you hire a debt collection law firm. I can probably find a list of beneficiaries within five minutes for most estates (even if they haven't been probated or recorded). You do have a point though, will the average joe landlord know how to reach trust assets? Probably not. 

    NOTE: May be seen as legal advertising by the VSB.

  • Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    10y
    Originally posted by @Scott Trench:

    4) My mortgage interest is tax deductible.  In the first few years, where the bulk of my mortgage payments are comprised of interest, this is more advantageous than depreciation.

    5) Assuming I live in the property for more than two years, and the property appreciates, I can sell for a tax-free capital gain.

    Your mortgage interest is still deductible with an LLC. Just to be clear, the mortgage interest should be prorated between the rental unit and the residential unit. If the LLC is a sole proprietorship (also called a disregarded entity) of if you own the property in your own name, the portion of the mortgage interest allocated to the residential unit is deducted on Schedule A (if you itemize). The portion of the mortgage interest allocated to the rental unit is deducted on Schedule E.

    If you sell for a profit and meet the 2 of the prior 5 years ownership and occupancy rules, you can exclude up to $250K per taxpayer from the portion of the capital gains attributed to your residential unit.  This exclusion is not abvailable to the portion of the capital gains allocated to the rental unit.  You can defer the capital gains taxes with a 1031 exchange, otherwise the sale profit is taxable.

  • Rental Property Investor · Brooklyn, NY · Member since 2014 · 722 posts · 1k+ votes
    10y
    Originally posted by @Ekaterina Gelashvili:

    @Jonathan Twombly

    thank you for your post.

    if investing out of state should you have LLC from that state or the state you are from?

    thanks

    sincerely

    Ekaterina

    It all depends. Depending on what state the property is in, that state might require an out of state LLC to register as a foreign LLC, with a separate bunch of fees attached. Or, if you are doing a syndication, and have investors other than yourself, you might want the LLC to be registered in Delaware, because the laws there are most friendly to corporate sponsors and make it slightly harder for shareholders to sue successfully. (Slightly, not a lot.) Most people doing syndications with investors use a Delaware LLC. Finally, if you have a promotion or management company (distinct from the ownership LLC of any given property), you might want to have that be from the state where you live. In all cases, it is best to consult an attorney about the appropriate structure. I'm an attorney myself, and I consult attorneys on matters like this, because this is not my specialty and it is theirs. So I make sure to get expert help and save myself a headache later.

  • Investor · Charleston, SC · Member since 2013 · 106 posts · 18 votes
    10y

    @Jonathan Twombly

    I agree with most of what you said, and thanks for taking the time to write it out.

    However, there's one important aspect in which I think you were incorrect: 401(k)s and IRAs are typically protected from creditors, although each state has different protection levels.  Also, personal residences may be protected, depending on the state.  I'm not sure about 529s, although it's reasonable to assume that would be protected because 1) they are so similar to IRAs, and 2) the beneficiary is someone other than the RE investor (typically).  I haven't seen specific information on 529 protection though.

    One important caveat, most states will re-consider the protected status if there is gross negligence.

  • Investor · Charleston, SC · Member since 2013 · 106 posts · 18 votes
    10y
    Originally posted by @Dmitriy Fomichenko:
    Originally posted by @Thomas Coburn:
    @Dmitriy Fomichenko:
    2) Make new contribution. Unfortunately traditional and Roth IRA contributions are only $5,500 per year so it would be difficult to do some serious investing with that amount. If you are self-employed or a small business owner however, you can start Individual (also known as Owner-only) 401k and contribute as much as $53,000 per year! With this amount you have a lot more investment choices to self-directed your account.

    Dmitry - Your answer helps A LOT. Thank you.

    We are self-employed. Our business attorney set us up with SIMPLE IRA's about 7 years ago. So, my wife and I are both contributing whatever the maximum is. I think it's about $12K/year each.

    HOWEVER... a few of my mentors have personally drained all of their retirement accounts. They've paid the gains just to be done with them, and then used the cash to invest in real estate, betting on themselves rather than being tied to the stock market. 

    I've seriously been considering this. I'd be very interested in hearing your investing opinion on this.

    Thomas, did I understand you correctly: are you saying that some of your mentors took early distributions from their retirement accounts, paid taxes and penalties and used what's left to invest in real estate?

    In my opinion this is a poor financial choice for most people. Taxes and penalties could wipe out 35-50% of your retirement savings if you take early distribution. 

    I agree that investing in the stock market that most of us have no control over is not a good choice, but that is where self-directed IRA or Solo 401k comes in. It allows you to have total control over investment choices and gives you the ability to invest in something that you understand and have more control over (real estate, trust deeds, tax liens, private lending, private businesses, etc).

     Actually, there is a hug body of research suggesting (proving) that not having control is THE BEST way to earn good returns.  

    Looking at your title, I'm sure you are aware of the work of John Bogle, William Bernstein, and other advocates of low cost, long term investing. Meaning that you keep buying, no matter what, into low cost index funds (or if you are capable of security analysis, individual securities emphasizing low turnover) and over a period of 20-30 years you will wake up rich - especially if the investment was in a tax-advantaged account (401k, Roth, T-IRA).

    I am not saying stocks are better than RE, or vice versa.  Both have a place in a portfolio for building wealth, but psychology is probably the most important factor to earn decent (~10%) annual returns over long periods in the stock market.  Doing less is definitely more in this case.  

    Just my $.02!

  • Scott SmithPro Member
    Attorney · Austin, TX · Member since 2014 · 1k+ posts · 932 votes
    10y

    California charges $800 per year per entity that does business in their state as a Franchise Tax. If you are doing business in California you should be using a properly structure DST to get the compartmentalized asset protection, tax savings, and anonymity.

  • Investor · Round Rock, TX · Member since 2010 · 8k+ posts · 4k+ votes
    10y

    I only skimmed this thread so take this post as one partially informed of the debate.  

    Regarding whether or not a LLC is absolutely needed this is an unwinnable argument similar to whether to invest in cashflowing properties or appreciation properties. The same argument is carried on and on about whether or not one should invest in publicly-traded securities or real estate. The same argument is made about whether or not to invest in private offerings or public offerings.

    So what does this whole argument boil down to and why is it unwinnable?  It all boils down to RISK.  Some people can tolerate more risk given their circumstances and lack of need to worry about long-tail risk.  Some people are not willing to take any long-tail risk because they're trying to protect vast fortunes.  Some people have the ability to rebuild even if they go bust through innate abilities or perceived superiority in skills.  Some people are purposefully very cautious and would have a hard time rebuilding if things go really really wrong by trying to scrape by on the bare minimum.  

    Thus you are never going to win this argument.  The answer is that it depends.  One would need to know a ton about the facts and circumstances of any given investor's situation to be able to advise them properly.  Debating this in the abstract on a message board is entertaining, but not very fruitful past most of what has already been hashed out hundreds of times on BP.

    Regarding the post above about active control producing above average returns I would challenge how the studies accounted for the time requirements active participation carries with it.  Absent someone actively managing vast sums of money the time they invest in the project is generally poorly compensated based on my experience.  Most of the investors in the industry would be better-served investing that time in other pursuits and that is why the majority of small-time real estate investors keep their day jobs while using real estate as "an investment."   You need to account for how hard the money is working and also how hard YOU are working to make the money work.  Time spent on BP counts.  Time spent reading real estate books instead of enjoying time with your family counts.  Time spent procuring new investments, chasing contractors around, negotiating exits, dealing with tenant workouts, etc. all counts.  Make sure you do an apples-to-apples when comparing any form of active investing to passive investing and you will probably find that the money really consumes 80% of the value in the situation most times and the labor consumes the remaining 20%.  The money is in the money.  

  • Staten Island, NY · Member since 2016 · 36 posts · 12 votes
    10y
  • Rental Property Investor · Brooklyn, NY · Member since 2014 · 722 posts · 1k+ votes
    10y
    Originally posted by @Johnny Aloha:

    @Jonathan Twombly

    I agree with most of what you said, and thanks for taking the time to write it out.

    However, there's one important aspect in which I think you were incorrect: 401(k)s and IRAs are typically protected from creditors, although each state has different protection levels.  Also, personal residences may be protected, depending on the state.  I'm not sure about 529s, although it's reasonable to assume that would be protected because 1) they are so similar to IRAs, and 2) the beneficiary is someone other than the RE investor (typically).  I haven't seen specific information on 529 protection though.

    One important caveat, most states will re-consider the protected status if there is gross negligence.

     Thanks for adding that in.  It's a good point.

  • Investor · Panama City, FL · Member since 2015 · 378 posts · 183 votes
    10y

    @Jonathan Twombly

    Nice post but I would like to add that IRS allows you to treat a single member LLC or and in some cases multi with a spouse, as a "disregarded entity" for federal tax purposes so you would not have to file in a separate return. This helps keep the compliance cost down

  • Real Estate Investor · Sandy Springs, GA · Member since 2017 · 25 posts · 3 votes
    9y

    Just reading a more recent thread and came across Mr. Twombly's careful post. Have to say, I strongly agree. I spent about 30 years defending homeowners, business people, real estate developers, contractors, law enforcement individuals, and others, in lawsuits brought here in the wilds of California, and have to agree with his cautions--and not just here.   I've had literally thousands of clients who never thought it would happen to them, but lawsuits do, and given the predatory ilk who file them (read, lawyers, and especially here), they can be very ugly and extremely frightening, including to good people like the BP audience.  It doesn't take much--a simple dog bite (e.g., to the face of someone who leaned down to pet it), a slice from broken glass, or a freak accident which renders someone quadriplegic, can and has, resulted in claims in excess of many insurance policies, and in the last example, led to a claim of close to fifty million.  Sure, most of the cases settle for less, or can be won at trial, but you may spend years at the business end of a lawsuit, having to answer questions under oath, or, if they don't settle, with the whites of jurors' eyes staring at you.  Even in those cases where we were successful--which was fortunately in almost all--our clients were terrified, and not just for a little while.  So for what it's worth, I second Mr. Twombly's advice, and strongly suggest you all protect yourselves with as many corporate shields and as much insurance, as you possibly can. No, I don't sell the stuff, but I buy it, and will follow JT's advice when we move to Atlanta.

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