My initial reaction to Scott’s article “5 Reasons I Do NOT Invest in Real Estate Using an LLC” was that his advice is perhaps the worst/silliest advice EVER.
Please don’t do this. The disadvantages FAR outweigh the gains (and can be done through an LLC anyway). Of course, in hindsight I think I was too harsh, and when limited to the 140 knee-jerk characters in my tweet, I didn’t do Scott’s thought process justice.
Brandon Turner at BiggerPockets asked if I’d like to craft a rebuttal, and now, having had the time to reflect, and after speaking with Scott, I think my response is more along the lines of, “I’m jealous of Scott. I wish I had purchased my first rental when I was 24. When he acquires more rentals and becomes the family guy with more assets that he describes in the last paragraph of his post, he’ll surely conduct his business through and LLC.”
Before I dive in, a few disclosures to connect me to some of the things Scott points out in his article. I am a lawyer (real estate). I am, in Scott’s words, close to “50 with three kids to put through college and a few million in assets to lose.” Not sure about the “few millions,” but I do own 8 residential homes. I am not thoughtless (unless, perhaps, you ask my wife on occasion). I might be very wrong. But I’m not selling you anything. And, again, I am jealous of Scott – I wish when I was 24 I had started buying real estate and not waited until I was close to 40.
The upshot to my rebuttal is this: If you’re a young first time investor, then perhaps you can get away without owning your real estate assets in an LLC. If you don’t fit in this category, use an LLC.
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As you likely know, financing is a major driver when investing in real estate, whether residential or commercial. And in the current environment, as cap rates decrease and prices compress, financing becomes even more important to the equation to successfully invest in real estate. As Scott points out, having the ability to obtain financing as an individual is a major advantage considering that the commercial financing terms are not as friendly. So, by all means, finance personally. I agree with Scott.
… with a twist. At some point your bank will advise you that your debt-to-income ratio exceeds the limit that allows you to finance in your own name, and you’ll have no choice but to obtain commercial financing. But until that tipping point, finance in your own name for the better terms.
Allow me to point out, however, that financing personally makes you personally liable to repay the debt. This means that if you default and the bank forecloses and the bank has a deficiency, the bank can come after you personally for the difference. I have to admit this doesn’t occur very often, but the terms of your home mortgage are recourse, making you personally liable.
If you finance through an entity, only the entity is liable for the deficiency. As a person, you are separate and distinct from the entity and protected from this repayment liability unless you were required to sign as a guarantor (which may be likely). So in that case you’ll be on the hook anyway.
It would seem that Scott’s argument wins the day. Or does it? Many (most?) lenders, including mine, allow you to finance individually while owning the assets through an entity, if the entity is owned/controlled by you. So, until you hit that debt-to-income ratio I discussed above, discuss with your bank if you can finance yourself but own the assets through your entity, thus benefitting from the advantageous rates/down payment, while at the same time enjoying the liability protections of owning through an entity.
The very same tax benefits available to individuals are available if you own your homes through an entity. This is so if the entity is a pass-through for federal tax purposes. You can make this happen by being the sole member of the LLC (or sole members if you own as husband and wife). So, if you form your LLC as a pass-through for tax purposes, you can still claim the deductions that Scott details. And you get the liability protection of using an LLC. Scott: 1, Rob: 1. Tie game.
And a fine point on paying capital gains taxes — the avoidance-of-capital-gains-taxes-on-a-sale applies to the gains from the sale of your primary residence only. Not property used solely for investment. So if you don’t live in the house, you can’t exclude the gains from taxes. If the house is a rental, you can’t exclude the gains from taxes. If you live in half of the duplex, like Scott, you should be in good shape.
But this is still the case if he owned the house in a pass-through entity or individually.
Mixing Business With Personal
Corporate formalities can be a pain in the rear, I admit. As Scott mentions, using separate emails, separate accounting, etc. can be tricky sometimes. And if you own the house in your own name, there is an argument to be made that you don’t need to worry about the separate-ness. So, point to Scott. But if you follow a few basic rules about separation of the entity from your personal life, piercing the corporate veil would be difficult for anyone trying to get to your personal assets.
But I can’t say there is much of an advantage in the spirit of being able to rent to whomever you want if you own personally – unless you want to discriminate. While is it certainly true that federal discrimination laws may not apply to individually owned homes, as Scott mentions, discriminating against someone because of their nationality, handicap, color, religion, etc. is immoral and unethical.
But any valid reason you might want to refuse to rent to someone when you own as a business is allowed. Criminal background, bad credit, poor references, insufficient income, prior lease defaults/evictions, unemployment, etc. These all qualify as valid non-discriminatory reasons not to lease to a potential tenant. You don’t need to own the rental personally to rely on one of these reasons.
Limited Liability and Umbrella Insurance
The benefit to owning properties through an entity rather than individually is limited liability protection. That is, only the entity is subject to any liabilities, lawsuits, judgments, etc., not the owners. The owner’s liability is limited to the amount of equity in the entity. This means that any additional liability above and beyond that amount is the responsibility of an entity with no additional assets.
Let me give you an example (ignoring liability insurance for now). Let’s say you have owned a house for a few years. You have benefitted from amortization and a rising housing market. The house is now worth $200,000, and the outstanding mortgage is $140,000. The amount of your equity is $60,000. You fail to fix a faulty rafter that should have been repaired. It falls. It hits someone on the head. They sue for damages. They get a judgment for $600,000.
This is a simplification, but if you own the house through an entity, the entity is on the hook for the judgment. Your $60,000 equity is also lost. That’s it. The entity is on the hook for the remaining $540,000. The entity has no other assets, so the injured party is stuck with a judgment against an entity with no assets. You walk away. If you had owned the house personally, you owe the injured party the full $600,000. While certain of your assets are creditor protected by law, you now personally owe someone $600,000.
And it’s not quite as simple as Scott points out as starting over. That judgment sticks with you for years and years (depending on jurisdictions). Of course, liability insurance will cover a good chunk of this, so now let’s talk insurance. Let’s say your liability coverage is $250,000. Insurance should cover that amount of the judgment, which means you personally are left holding the bag for $350,000 — a judgment that sticks with you for years and years.
For a couple hundred dollars a year, you can increase your liability protection to $1 million by obtaining an umbrella policy, as Scott mentions – that is one of the smartest insurance products you can obtain. I have a $2 million umbrella policy because, as Scott mentions, I’m older with more assets and want more protection. My umbrella premium is around $330 per year. Money well spent. In the example above, you don’t come out of pocket anything because the remaining claim is under the amount of your umbrella policy.
As Scott points out, “a $1M+ mistake on [his]little rental would be an extraordinarily unlikely event.” I agree. But what if you own your own residence (possible slip and fall on your sidewalk), own 8 rentals (a faulty rafter injures someone), perhaps you run your own business (and injure someone), own a car (which contains the possibility of hitting someone, the damages for which exceed your auto liability coverage), etc.? Is it possible that with all this going on, the potential damages could exceed the liability coverage amount and the umbrella limit? It sure is.
But if you own all your rentals through an entity, the maximum amount of your out-of-pocket loss is the equity you have in the entity – after exhausting both types of liability coverages. You don’t have to worry about any slip and fall, and rotting wood, any work accident, and auto accident, etc.
Do not put your personal assets at risk. Simply use an entity to own and operate your properties.
Note that while a separate entity for each property you owns further isolates liability (in that the potential loss is only the amount of equity in each individual property), it can be expensive. Some states allow entities to create “series” (sort of like different shares) that can further isolate each property from all others. If so, form just one entity, but create a separate series for each property separating the debts and liabilities from one property from the others.
Negotiate With a Higher Authority
No, this isn’t an article about religion. The higher authority to whom I’m referring is anyone other than yourself. What I mean is that you lose negotiating leverage any time the counterparty knows you can make the final decision. So don’t let them know that you make all the decisions. You are much better off if your tenants think you can not make any decisions. But oftentimes when someone owns his/her rental personally, pride and hubris lead them to tell the tenant that they are the owner. And they make all the decisions. They don’t need to listen to someone else.
But owners are much better off if their tenants think that they just manage the property for the “owner group.” That way they can’t be cornered into making decisions. They can work with the tenants (or pretend to be on their side) and always defer to a higher authority that makes decisions regarding the property. They can listen, then take the time they need to consider other options. The tenants feel that they are on their side.
Then, if they want, they can return with an answer (after having had time to think about the issue) and say, “Hey, I discussed with the owners, but they aren’t willing to spend the money to fix _____ right now. I tried to make your case for you. But they offered the following alternative that I think will work…” In this sense, you can still remain an anonymous owner.
Most of the advantages of owning property personally can still be enjoyed by owning through a limited liability company of which you are the sole member (a so-called “single member LLC”), with the very important added protection of limited liability.
Oh, and as always, consult your accountant, tax professional and attorney.
Investors: You’ve heard both sides. What do YOU think? Do you believe an LLC is the wisest way to invest in real estate?
Leave your opinions below!