[Editor’s Note: Today’s article is a guest post from Lyle Solomon is a licensed attorney in California. He has been affiliated with the law firms in California, Nevada, and Arizona since 1991. As the principal attorney of Oak View Law Group, he gives advice and writes articles to help people solve their debt problems.]
Do You Need To Form an LLC For Rental Property Investing?
Real estate investing can be extremely profitable (especially for the busy professional), but it also has the potential for danger.
Regardless of why you’re investing, many real estate investors choose to set up a limited liability company (LLC).
When acquiring investment properties, LLCs are now one of the most preferred corporate entities. When buying real estate or transferring a real estate title from a person to an LLC, owners frequently opt to form an LLC. By doing so, the real estate LLC becomes the legal owner of record rather than the person.
The question of whether you need an LLC for rental property or other real estate investment comes up frequently. The answer, like with most interesting questions, is “it depends.”
But one thing is certain. Limited liability companies (LLCs) have a significant impact on your financial asset protection strategy.
What Is a Limited Liability Company (LLC)
So, what exactly is this LLC thing that everyone is talking about?
First, let’s go through some technical concepts.
The Internal Revenue Service defines it as:
“Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a ‘disregarded entity’). Specifically, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.”
A limited liability company, or LLC, is a legal structure that allows you to possess assets or enterprises without tying them to your personal name and/or assets.
This makes it easier to take tax advantages of deductions and lower your personal liability risk if something goes wrong with the LLC.
Related article: Depreciation: The #1 Tax Break For Doctors
When Do You Need a Limited Liability Company (LLC)?
When you don’t want to accept the level of risk associated with your asset, you may consider forming an LLC for rental property and other real estate investments.
Assume you have a tenant who falls down your stairs and breaks a leg. Then proceeds to file a lawsuit, saying that your apartment’s stairs were unsafe, and that you were aware of it.
The judge may decide you owe the renter considerable compensation.
But if you lack the financial means to pay, you could be in serious trouble.
The court may order you to sell your investment property so you can use the proceeds to pay your tenant’s compensation. But, if you have a high mortgage and little equity in your home, it may not be a practical solution.
If you hold any property in your name, a court may order you to sell assets such as your home, automobiles, and other valuables to pay the compensation.
However, if you acquire property through a separate LLC, and the LLC has no other properties, your obligation will be limited, because you have no assets worth selling. The court won’t come after you because the home is owned by an LLC, not you even though you’re the rental property owner.
It’s also easier to keep track of your business’s profits and expenses with an LLC.
It can be difficult to manage your taxes if you own personal assets and run all of your income and expenses through your personal bank account(s).
Taxes become much simpler if you own your assets in an LLC.
You should also have a separate bank account set up for your LLC to handle all of your portfolio’s income and costs.
You’ll file an annual tax return for your limited liability company, including all of its income and expenses. The bottom line from that return will be translated onto your personal tax return as business income or expense.
Your personal tax return will be filed on the backend, and you will be paid or given a refund based on the total tax flow from LLC to your personal tax return.
Related article: 5 Outstanding Tax Strategies For High Income Earners
When an LLC Isn’t Necessary For You
There are times when you don’t need an LLC to start investing.
In reality, there are probably more situations that don’t require an LLC than ones that do.
However, if you want to form an LLC, that’s a different matter, as it’s always more personal and depends on the individual mindset.
For example, while buying personal property such as a primary home, you don’t require (and can’t have) an LLC.
Your lender will not allow you to accept the title in an LLC if you want to house hack a duplex as your first investment.
If you use a VA loan, FHA loan, or any primary home loan, you must take the title in your name.
Many people start their investing career with a house hack; therefore, an LLC isn’t necessary at this stage.
In general, an LLC is usually unnecessary for your initial investment, depending on how pricey it is. So, it’s more important to decide when forming an LLC is necessary.
Instead of deciding whether or not to form one, just make sure you don’t let it stop you from purchasing your first property.
Do You Need To Form an LLC To Invest in Real Estate?
A limited liability company (LLC) is a fantastic way to secure your assets and consider your investments like a business. It’s not really something you should obsess over, though.
You can form an LLC at any time.
Consider the following pros and cons of forming an LLC for real estate investing to help you decide what’s best for you.
1. Personal Liability Limitation
As a real estate owner, you want the best in liability protection. An LLC is one of the best solutions for minimizing your personal liability risks if something goes wrong with your property.
For example, if you’re the owner of the rental property that a visitor gets injured at, even if you don’t live there or know them, it’s not uncommon for them to sue the homeowner for damages.
Your homeowner’s insurance policy might offer coverage up to a specific financial limit. So, purchasing property insurance to cover such situations is wise. If the injured party seeks compensation beyond what your homeowner’s insurance covers, your personal assets may be at risk.
Even if you effectively fight the claim, the simple fact that your property was involved in a lawsuit may increase your insurance premium.
If you put your property deed and title in the name of an LLC, however, only the LLC is identified as a defendant. You’re not.
More significantly, if the injured party’s lawsuit is successful, only the LLC’s assets will be liable for compensatory damages.
As a result, you’ll maintain your identity, and your personal assets will not be compromised.
Another benefit of putting the title of a property in the name of an LLC is that it protects you from legal judgments in the event of a financial dispute. Assume the LLC signs a contract to sell its main office facility to a third party, but then decides not to complete the transaction.
The third-party buyer might sue the LLC for breach of the contract and seek financial penalties, or try to force the sale of assets.
If the third party wins a financial judgment, the judgment creditor cannot compel the selling of real estate owned by an LLC, which is the judgment debtor. Instead, the judgment creditor must often get a charging order from the court, which creates a lien on the property.
This is preferable instead of losing the property entirely.
Creditor options differ from state to state, so make sure you check your state’s laws.
The Internal Revenue Service provides favorable tax treatment to LLC members who hold real estate as part of their investment portfolio.
You’ll make a profit from pass-through taxation, whether you are the sole owner of the LLC (single-member LLCs) or one of total membership (multi-member LLCs).
Pass-through taxation states that any income made by the LLC, including profits from real estate (such as rental income from leasing an LLC-owned property), will pass through the LLC to its individual members for federal income tax purposes.
Any revenue made by the LLC is taxed at the individual level rather than the corporate level (as it would be with a typical corporation). The income is reported on Schedule C by each LLC member on their individual federal income tax filings. These pass through regulations enable LLC members to avoid double taxation.
2. It becomes simple to transfer LLC Interests
An LLC can be sold by transferring membership interests, which is a fairly straightforward process. The LLC’s real estate will remain in its possession, but the LLC will have new members.
As a result, the transfer will be smooth, and the LLC will work flawlessly.
So, if you’re thinking about creating an LLC for rental property, you are thinking wisely.
3. Appearance Is Quite Similar To Business
When offering property for lease to residential or business tenants, one intangible benefit of acquiring and managing real estate in the name of the LLC is that it looks more “businesslike” to the public.
It creates a trustworthy business entity that helps earn revenue.
Renting a piece of real estate from an “LLC” is much more comfortable for an individual, rather than getting it from somebody called “Lyle Solomon.”
1. Mind the Clause “Due on Sale”
If you buy rental properties or any other real estate investment, and you own the properties in your name, be cautious when transferring those assets to an LLC. If an individual received funding and qualified for a mortgage for the properties, the individual’s name will appear as the legal owner of record on the mortgage documents.
When transferring real estate from an individual owner to an LLC, which is treated as a sale of property, the LLC’s owner should verify that the grantee on the deed matches the name on the property insurance paperwork.
In other words, ownership of the properties in insurance papers should match the LLC owner after the transfer.
When the property insurance bill (if insurance is escrowed) is due, the mortgage lender will often find out about the transfer and may claim that it breaches the rules of the mortgage’s “due on sale clause.”
The due on sale clause is a conventional mortgage condition that compels the borrower to pay the entire mortgage sum at the time of the sale. Before transferring real estate from an individual’s name to the LLC, you should get permission from the mortgage lender.
2. Problems of Transfer Tax Liabilities
Depending on the state, transfer taxes could become a problem. If a person transfers possession to an LLC in Delaware, there are no transfer taxes if the ownership interests stay the same pre and post-transfer.
Before the transfer, the percentage membership interests in the LLC should match the percentage of ownership interests.
Some states, such as Pennsylvania, impose a tax on the transfer, anyway.
Finally, as LLCs become more popular for real estate investments, the pros outweigh the cons. But be careful to check your state’s rules first before using an LLC for rental property.
Do Passive Investors (Syndications) Need an LLC?
For a variety of reasons, real estate syndication is now a powerful strategy of passive investing.
Syndications offer a low-stress alternative to invest in real estate for people having limited time. They also work for investors with limited investment budgets, and they provide significant tax benefits.
The initial investment and due investigation might pay off in the form of cash flow both during the process and when the asset is sold. The structure is one of the essential aspects of passive investment in a syndicate.
Syndications can be structured in a variety of ways. A limited partnership (LLP) or a limited liability company (LLC) are two prevalent entities (LLC). The entity type is the most prevalent element determining your prospective tax savings, whether you share in the revenues, the capital, or both, and whether you acquired equity or debt investment.
The majority of syndicates are structured as limited liability companies (LLCs). An LLC can be governed by its members or its manager, but it must provide limited liability protection to all its members and the manager. LLCs are exceptionally adaptable business structures that allow investors to possess a variety of share classes. Varying share classes often have different holdings in the profits and capital of the company.
An LLC that is a limited partner in the syndication and a company that manages the LLC are two options for a passive investor. One entity for the syndication investment and one entity to manage the investment process will cover all possible business deductions. It is also a smart tax mitigation and asset protection strategy.
Every LLC member must be accredited for the LLC to be accredited.
You will earn a pro-rata share of the entity’s profits and losses if you are an equity holder in an LLC with a profits interest. This means that you’ll be entitled to a part of whatever tax approach the company is using.
An LLC will claim all income and deductions on its tax return and then send you a Form K-1. That K-1 will be used to fill out your tax return and record your portion of the company’s profits and losses.
You will receive interest income from the entity if you are a debt holder. You will not benefit from any tax tactics used by the entity because you will not participate in its gains and losses.
It’s important to know that unless the funds distributed by the LLC exceed your basis in the LLC, you won’t have to pay taxes on them.
For example, clients will get $50k in dividends, but their Form K-1 will indicate a passive loss. Even though they got $50k in distributions, the investor would not pay tax because of the loss declared on the K-1. Instead of increasing the investor’s basis in the entity, these payouts would be regarded as a return of capital.
You should consult an attorney and/or a CPA before forming an entity such as an LLC. It is because if you choose the wrong entity (as many investors do) or dump yourself in too many entities, you could end up paying formation costs, accounting fees, and taxes for companies that aren’t suitable for your intended purpose or that fail to meet your objectives.
The answer to the question “do you need an LLC to invest in real estate?” is… yes. It could be beneficial if you want to avoid the risks.
Author Bio: Lyle Solomon is a licensed attorney in California. He has been affiliated with the law firms in California, Nevada, and Arizona since 1991. As the principal attorney of Oak View Law Group, he gives advice and writes articles to help people solve their debt problems.
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