Real estate investing opens you up to risks and potential liability, such as a tenant or guest getting hurt on your property and suing. One of the ways real estate investors protect themselves is to form a limited liability company.
LLCs are a popular strategy to reduce risk without creating a major tax burden. In this article, we'll cover the pros and cons of pursuing this strategy for your rental properties and share steps to take if you do choose to form an LLC.
What is a real estate LLC?
A limited liability company is one of the legal entities that can be formed to own and operate a business. An LLC combines the best attributes of several types of businesses. It offers the limited liability of a C-corporation, the flexible management structure of a partnership, and the taxation of a sole proprietorship.
LLCs can be owned by a single person, or they can have many owners. Owners are referred to as members of the LLC. Managing members are the owners that run the day-to-day operations of the company, although you can also have a single-member LLC if it's just you running the business.
A real estate LLC is a business entity created to buy, sell, or rent real estate investment properties. These entities are formed to reduce an investor's liability due to the risks of running a real estate business.
Properties are transferred into the LLC and all income and expenses are included in its financials. LLCs file tax returns, but because the income "passes through" to its members, the LLC does not pay federal income taxes. Instead, the members (the investors) claim the income on their personal tax returns.
The pros of forming an LLC for real estate
Limits personal liability
One of the main benefits of an LLC is the personal liability protection for its members. With this business structure, the maximum you have to lose is the money or assets you've contributed to the LLC.
Homeowners insurance and umbrella policies provide some protection against lawsuits. However, you're still personally liable for any judgments above their protection limits and your insurance company may decline to cover the claim. If there is a claim, your premiums may go up on all your properties and future insurance applications may be denied.
Because an LLC is a separate legal entity, the LLC would be the one sued for damages in the event of an accident, and this could provide asset protection for you personally. The exception is when someone is able to "pierce the corporate veil" because you have not kept your personal and business lives separate. When this happens, the plaintiff and their attorney can sue you personally as well. This is one of the main reasons it’s critically important to keep your personal and business money separated.
Although LLCs are required to file taxes, they are not required to pay federal taxes. Instead, the profits are passed on to the LLC members through Form K-1. The members then pay taxes on the profits on their personal income tax returns.
This pass-through taxation is one reason many investors choose LLCs over C-corporations. C-corps pay taxes on their profits before distributing dividends to shareholders, who then pay taxes on the dividends. This is commonly referred to as "double taxation."
An LLC's profits are taxed only at the personal level, which reduces the tax burden on investors and is understandably considered a tax benefit of this business structure.
Right or wrong, many people look at LLCs and corporations as being more legitimate than someone operating as a sole proprietorship. People often assume an LLC represents a larger, more established organization, even if you're the only person involved.
Investors can use this perception to their advantage when opening a business bank account, applying for business credit cards, negotiating deals, and bidding on properties.
Easier transfer of assets
If you are investing money in real estate, it usually involves a real estate agent and other professionals in order to complete the transaction. Each of these professionals charges a fee and there may be local taxes and fees as well. Overall, the process can take a few days to several weeks to complete. These costs are typically multiplied when you own several properties as an individual.
However, when your properties are held in an LLC, you can simply sell all or a portion of the LLC to another investor. When ownership transfers, all the assets within the LLC automatically go along with it. This process costs much less because you can choose to do it yourself or pay an attorney to amend your LLC papers or craft a sale agreement.
Plus, if the LLC has outstanding loans associated with the property, those loans are transferred as well. If you personally borrowed against your real estate, the buyer would need to take out all new loans, as with a regular home sale.
The cons of forming an LLC for real estate
Costs and complexity
When forming your LLC, there are costs associated with creating the paperwork, filing annual reports, and paying yearly taxes. Because the paperwork can be complex and requirements vary by state, most investors hire an attorney or pay an online service to create the LLC formation documents.
Additionally, most states require an annual statement of LLC members and an annual fee to keep your LLC active. These annual statements are fairly simple and quick to complete, so many real estate investors handle this report themselves.
Here are examples of the requirements from a handful of states:
- California charges a $70 fee to file your articles of organization. An annual fee of $800 is due on the 15th day of the fourth month from the date you create your LLC. The $800 fee is then due the 15th day of the fourth month each tax year after that. An additional fee is due on the 15th day of the sixth month of the tax year for LLCs with income over $250,000. A statement of information must be filed within 90 days of formation and every two years after that with a fee of $20.
- Delaware LLCs must pay an annual tax of $300 that is due by June 1. There is no requirement to file an annual report.
- Nevada charges $75 to file your articles of organization. The filing fee for the LLC annual list of officers and members is $150. This list must be submitted when filing your LLC papers and once a year by the end of the month in which your LLC was formed. No additional state income is charged.
If you're learning how to invest in real estate, it is important to know that getting approved for a loan can be more difficult with an LLC. The rates are often higher and the terms are not as generous as applying for a loan personally.
That’s because the LLC can only generate income from the assets it holds, whereas an investor often has other income sources and assets that a lender can consider when underwriting the loan. These secondary repayment sources reduce the risk to the lender, which allows them to offer lower interest rates and more attractive terms to individual borrowers over an LLC.
Plus, many banks will not lend to an LLC until it has been operating for multiple years and can provide the past two years of tax returns to be analyzed. Many banks will also require a personal guarantee (that you'll pay the loan if the LLC cannot), which negates one of the reasons why you created the LLC in the first place.
Due on sale clause
In most mortgage documents, the lender requires that the borrower repay the loan immediately upon transferring the asset to anyone else. This is known as the "due on sale clause." This clause makes sense because once the borrower no longer owns the property, they now owe a debt that isn't backed by an asset. If the borrower defaults, it is harder for the bank to foreclose on the property.
When you transfer your property to your LLC, technically this triggers the due on sale clause — even though you may be transferring to an LLC that you are 100% owner of.
In reality, most mortgage lenders will never find out the asset changed ownership. And if they do, many will not act as long as you continue making the payments on time. If you start missing payments or default on the loan, that is when the mortgage company will act swiftly to protect their interest in the property.
May incur additional state income taxes
Each state has its own tax laws that affect how real estate investors do business. In some states, you may be taxed differently when you incorporate your business into an LLC. For example, Tennessee imposes a franchise tax and an excise tax on most LLCs. In California, LLCs must pay a minimum tax of $800 per year.
How to start your own LLC
If you decide an LLC is right for you, here are some tips to get you started.
1. Create the LLC
Traditionally, most people hired an attorney to create the formation papers for their LLC. On average, an attorney charges $1,000 to $3,000 to create LLC documents. The cost can rise based on your location, the number of LLC members, and the complexity of your documents.
Now, there are online services, like ZenBusiness and LegalZoom, that make it quick and easy to create LLC documents by yourself. These services also tend to dramatically reduce the cost compared with using an attorney.
2. Choose a Registered Agent for your LLC
LLCs must have an "agent for service of process" in the state where your business is formed. This person or entity is responsible for accepting legal documents served upon your business.
You can choose an owner or employee of your business to be your LLC's registered agent if your LLC is formed in the same state as where your business has an office. If you are an out-of-state investor or your LLC is formed in a different state, then you need to hire someone to provide registered agent services.
Many companies, like LegalZoom, offer registered agent services for an annual fee.
3. Obtain a Tax ID for your LLC
Just as you received a Social Security number when you were young, your LLC needs its own tax ID number now that it has been created. Your business will receive an employer identification number (EIN) that will be used in place of your Social Security number for tax purposes.
Requesting an EIN is quick, simple to do, and free. You can apply for an EIN online at the IRS website. At the end of your application, you'll receive your number.
Print out the confirmation page for your records and keep your EIN in a safe spot that is easily accessible. You'll need this number frequently as you establish your LLC.
4. Apply for a business credit card
To keep your personal and business expenses separate, you should have a business credit card to pay for your LLC expenses. In addition to making your taxes easier, this is an excellent opportunity to earn more welcome bonuses from the credit cards associated with your favorite rewards programs.
Additionally, business credit cards often offer bonus points and miles in different categories than personal credit cards. This opens up another avenue to maximize the rewards you can earn on your spending.
To get you started, we've compiled a list of the best credit cards for LLC owners.
5. Open a business bank account
If you haven't already, once you form an LLC, you'll need to open a business bank account. Many landlords deposit rent checks into their personal accounts, which makes tracking business income more of a challenge.
Because an LLC is a separate, legal entity, it must have its own checking account. Not following these rules could "pierce the corporate veil" and impact the legal protections that LLCs offer.
6. Transfer ownership of your rentals to the LLC
After your LLC has been created, you can transfer your rental properties into the LLC. Depending on your lender, this may cause the mortgage's "due on sale" clause to kick in. If that were to happen, the lender could demand immediate repayment of your mortgage balance in full. Because of this risk, some investors choose to keep their existing real estate holdings in their personal name.
7. Insert LLC name into leases and other business documents
The name of your LLC should be inserted into all lease agreements and other business documents. This will formalize the transition of your business to the LLC. It will also provide further evidence that you are running a legitimate business separate from your personal life.
Incorporating your LLC name into these documents also provides some secrecy for your private life because your personal name isn't listed across every document.
8. Create an email account for your business
Your business should be professional across every facet of your operations. When people contact you, they should be emailing Joe@MyRentalLLC.com instead of JohnDoe1234@aol.com. Even if you're the only one involved in your business, having a business email address makes outsiders feel your business is more legitimate.
Some small business owners set up "alias" email addresses. This makes their business seem larger or makes it easier to organize emails. You may create ap@MyRentalLLC.com for accounts payable, rent@MyRentalLLC.com for questions about rent checks, or repairs@MyRentalLLC.com for service requests. All of these email addresses can have separate inboxes or forward to your primary email account. It can both look more professional and keep you more organized.
Can you buy real estate under an LLC?
Yes, you can buy real estate through an LLC. If you have enough cash, you can buy the property outright. For investors who need to borrow money, you may need to work with a broker who can find financing options for you. Depending on the size of your LLC and how long it has been established, you may not qualify for some bank lending programs.
How do I pay myself if I own an LLC?
As the owner of an LLC, you have two ways to make money from your business. The first is to receive a regular paycheck like a traditional employee. The second is to receive a distribution from the profits at the end of the year. Many LLC owners choose to do a combination of the two options. They'll receive a reasonable salary based on the fair market value of their work, then pay a year-end distribution of the company's profits.
Can I live in a house owned by my real estate company?
Yes, you can live in one of the properties owned by your real estate company. Many people who "house hack" or own multi-unit buildings live in the buildings they own through their LLC. If you choose to make a rental property your primary residence, it would be smart to consult with your tax advisor about whether you should pay the LLC rent and how that might affect your tax planning for personal and business tax returns.
As a property owner and real estate investor, creating an LLC for your real estate business could offer a more professional appearance and protection for your personal assets. In addition, LLCs are not taxed separately, so all income is passed through to your personal tax returns.
Although there are many benefits to forming an LLC, the annual fees and reporting requirements can be cumbersome depending on which state your LLC is formed and does business.
It is best to consult with your tax advisor to understand how this strategy may affect your real estate business. How you handle these assets might be part of something you wish to include in your estate planning as well.