As you become more established as a real estate investor, you’ll need to start learning more about how to protect yourself from legal issues and how to get the most value out of your investment.
One tool you may consider for your business is an LLC, or Limited Liability Company. There are many different types of LLCs, each with their own benefits and drawbacks, tax consequences, and other unique details to consider.
While it may on the surface seem like a boring topic, it’s extremely necessary nonetheless.
What is An LLC?
An LLC is a legal entity that can be formed to hold ownership of assets, and potentially limiting liability in regards to ownership. An LLC can have its own tax identification number, open a bank account, and conduct a variety of business transactions under its name. This includes hiring employees, entering into contracts, and leasing property.
There are two main types of LLC: those with one owner (known as “single-member LLCs”) and those with multiple owners (known as “multi-member LLCs”). A single-member LLC is owned and operated by one person, while a multi-member LLC can have any number of owners A single-member LLC is owned and operated by one person, while a multi-member LLC can have any number of owners. As the names imply, these give you the same type of potential benefits, but differ according to the number of people registered as owners of the LLC.
Forming an LLC for Real Estate Investments: Pros & Cons
LLCs are being used more often than before to invest in and hold real estate. Here are the advantages they confer—and the disadvantages.
More and more people are choosing to set up limited liability companies to buy real estate, as this offers several advantages. Owners often prefer to form an LLC when purchasing real estate—or when transferring titles—so that the LLC becomes the legal owner of record, rather than the individual members.
An LLC can offer investors personal asset protection and pass-through taxation. However, LLCs can be expensive to set up and require ongoing maintenance.
Pros:
1. Avoiding personal liability.
This is the major advantage of an LLC. The best way to limit your liability is to have insurance in case something happens to your property. LLCs provide that protection.
For example, if you own a property and someone visiting gets injured, they could pursue a legal claim against you even if you don’t live there or have any connection to the guest.
If your home was damaged in a storm and you have insurance to cover such incidents, your homeowner’s insurance policy would provide coverage up to a particular monetary limit. This means that if you are being sued for more money than what your insurance policy covers, the other party could go after your personal assets.
If you were to place the deed and title to the property in the name of an LLC, the LLC would be the only one named as a defendant, as opposed to you. This means that if the suit is successful, the LLC’s assets would be the only ones responsible for paying the awarded damages. Since you are anonymous and your personal belongings are not at risk.
If an LLC’s property is titled in the LLC’s name, the LLC’s owners will have limited liability protection against any monetary judgments that result from financial disputes involving the LLC.
If a company obtains a monetary judgment against another company, it cannot force the sale of real estate owned by the other company. If someone owes you money and you want to collect, you can’t just go after their real estate. You first have to get a “charging order” from the court, which then becomes a lien on the property. Although this is not something to be happy about, it is better than losing the property completely.
LLC members who own real estate as part of their investment portfolio receive favorable tax treatment from the Internal Revenue Service.
Whether you are the sole owner of the LLC (single-member LLC) or one of several members (multimember LLC), you benefit from so-called pass-through taxation.
The LLC’s members will then pay taxes on that income on their personal federal income tax returns. For federal income tax purposes, the fact that income earned by the LLC will pass through the LLC to its individual members means that the members will pay taxes on that income on their personal federal income tax returns.
The income earned by the LLC is not taxed at the corporate level, but only at the individual level. Each LLC member reports the income from the LLC on their individual federal income tax returns, typically on Schedule C. The pass-through rules help members of an LLC avoid being taxed twice on the same income.
2. Professional appearance.
An advantage of owning real estate through an LLC is that it looks more professional to the public, which can be helpful when trying to lease the property to commercial or residential tenants.
An individual or business looking to lease property may be more comfortable renting a piece of real estate from a company called “Smith Properties LLC” than from an individual called “Joe Smith.”
3. Simple transfers.
An LLC can be sold by transferring membership interests. The real estate owned by the LLC will continue to be owned by the LLC, but with new LLC members. Continuity is preserved, and the transfer is seamless.
Cons:
1. The ‘due on sale’ clause.
Be cautious when transferring real estate that is held under an individual’s name to an LLC. If someone gets a mortgage for a piece of real estate, their name will appear on the mortgage documents as the legal owner of the property.
If an individual transfers real estate to an LLC, which is considered a sale of the property, the owner of the LLC must make sure that the name in the property insurance documents matches the grantee on the deed. The mortgage lender might find out about the transfer when the property insurance bill arrives (if insurance is being held in an account for payment at a later date). The lender could then claim that the transfer goes against the terms of the mortgage’s “due on sale” clause.
If the borrower sells the property, they are required to pay the mortgage balance in full. Before transferring your property into your LLC, you should check with your mortgage lender to see if you need a waiver.
2. Transfer tax obligations.
LLCs that are transferring ownership may have to pay taxes, depending on the state. An individual in Delaware can transfer ownership of property to an LLC without incurring any transfer taxes, as long as the ownership interests in the property remain the same before and after the transfer. This means that if, before the transfer, one person owned 50% of the LLC, that person would still own 50% after the transfer. Some states, such as Pennsylvania, have a transfer tax, which is a tax on the sale of property. You should check your state’s laws before continuing if you want to create an LLC.
Insurance – Can it Replace The Need for an LLC?
Many investors believe that having a high liability limit on their home insurance policy provides the same level of protection against liability claims as creating a limited liability company (LLC), but without the tax and accounting complications that come with an LLC. Many people believe that having a large umbrella insurance policy can provide the extra liability protection that you need when investing in property.
An umbrella policy provides extra liability insurance coverage that is not included in your home, auto, or watercraft insurance.
An umbrella insurance policy with a high liability limit may be quicker and more affordable to set up than an LLC with all of the associated bank accounts and management. This may reduce overhead and time spent on management.
Now that we’ve reviewed some of the benefits and drawbacks of LLCs, let’s look at the process of creating one for your rental properties.
For us, we do both. An LLC & an umbrella policy.
Formation of An LLC
The process of forming an LLC differs in each state, but it can normally be done online or with the help of an attorney. A lawyer can help you with the LLC formation process, especially if you’re doing it for the first time.
The rules that operate the company, as well as what each manager and member of the LLC can do, need to be designated in an operating agreement. A manager is likely going to need to be designated to run the LLC’s day-to-day operations.
If you want to form an LLC, you need to file some legal documents first. After that, you can go to the IRS and get an FEIN for your LLC. For tax returns and to open accounts with local municipalities, utility providers, or banks, you’ll need to use your business’ FEIN.
Operating Agreement
The purpose of an LLC operating agreement is to establish the rules for how your LLC will be run and to prevent disagreements between members from happening. An LLC operating agreement is best when it allows you to consider a variety of potential scenarios related to managing and owning the properties included in the LLC.
As the owner of a single-member LLC, you are responsible for all aspects of the company’s operations, although you can delegate day-to-day management to another individual.
An operating agreement for a multiple member LLC allows you to set up how profits will be shared, who gets to make decisions, and what will happen when members join or leave the LLC. If there are disagreements or mistakes about money or how the business is run, an operating agreement will help you solve these problems.
An operating agreement is a legal document that outlines the ownership and operating procedures of an LLC. While many states do not require LLCs to have an operating agreement, it is typically important to have one in order to protect your limited personal liability in the event of legal action. If you are a single member LLC and don’t have an operating agreement, you might be treated as a sole proprietor even though you have an LLC. This could cause you to lose the protection that an LLC may provide.
An operating agreement can help you set your own policies and procedures for your business. If you don’t have one, your LLC will have to follow the operating rules set by the state where it’s located, which may not give you the results you want.
Filing and Management Fees
An LLC can cost money to set up, which may include legal fees and filing fees. Some states require that you pay an annual fees of hundreds of dollars just for the existence of an LLC. It is important to have a plan for your LLC before setting it up.
There should be separate and well-defined bookkeeping processes for each LLC. This may mean that you have to spend more money on bookkeeping and accounting services.
Each LLC requires its own tax return, so there are additional accounting costs associated with the financial management and tax filing for each entity. Each LLC requires its own bank account, which may incur associated fees.
If you own a property under an LLC, it may affect your ability to get a loan from a bank. Many banks will not lend to an LLC without a personal guarantee. It is advisable to speak to a financial advisor to get advice on the best way to finance properties that are owned by an LLC.
Moving From Individual Ownership to LLC
If you’re just starting out in real estate investing, the costs of setting up and maintaining an LLC can take a big chunk out of your profits. If you want to start saving, you can put your first few properties in your own name and get high liability limits on the properties’ insurance policies.
As your portfolio expands, you may decide to establish an LLC and convey ownership of the properties from your individual name to the LLC through a deed. Purchasing property under an LLC can be difficult, but with this method it can be much easier.
Final Thoughts
Many people write about LLCs, making it one of the most hotly debated topics in the real estate investing world. Some people think that you should always own a business under an LLC. Other people think that LLCs are a waste of time and money.
There is not one financial situation that is the same for every person, so there cannot be a single approach to solving financial problems. After speaking to their legal and tax advisors, each investor should make a decision about what is financially sensible and what level of risk they are comfortable with.
An LLC may make more sense for you as your portfolio size grows. An LLC is not a “must have” requirement for beginner investors, but it is something to keep in mind for the future as they continue to scale their portfolio.
Kurt has gone from the financial lows of the ’08 financial crisis to personal financial success. He is a professional real estate investor, media buyer, faithful Red Sox Fan.
One of his passions is financial education and the pursuit of financial freedom.
You can learn more about Kurt here, or get a hold of him on Facebook or Twitter.
