Contemplating an LLC for your rental property? This overview explains the basics of an LLC including benefits and drawbacks, the value of asset protection, and the flexibility around both taxes and ownership structure that an LLC provides.
What is an LLC?
LLC stands for limited liability company. The United States Small Business Administration describes the limited liability company as “a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.”
There are a number of benefits but also drawbacks to consider when using an LLC. This article provides a high level look at each to give you a quick primer on whether an LLC is right for you and your real estate business.
LLCs help protect the members of the company from the company’s liabilities and business debts. For example, if someone sues you directly and wins, you risk losing private assets since you made no distinction between what legally belongs to the company and what legally belongs to you. However, an LLC limits your liability for a claim against the company to the company’s assets as long as you clearly separate your company and personal finances.
Understand that an LLC is not designed to prevent investors from being sued. Rather, should a lawsuit occur, the LLC is meant to effectively manage and contain the fallout.
Holding each property purchase in its own LLC will separate individual properties from one another. If there is a liability claim against one property, it should not affect any other properties held by you. That being said, you should weigh the cost and benefit of each incremental LLC. Depending on the value of your properties and overall portfolio, it may make more sense to hold multiple properties together.
Flexibility During Tax Time
The IRS does not tax the LLC directly. If you operate using an LLC, there will exist a certain amount of flexibility. Depending on personal circumstances, placing properties in an LLC allows pass-through taxation where all profits and losses pass through to each LLC member. The business will not pay federal income taxes, but some states do apply an annual tax to LLCs.
The IRS allows the LLC to use partnership, sole proprietor, or corporate tax rules. Immediately after the creation of your LLC, the IRS automatically treats your business as a partnership for income tax purposes. If you are the sole owner, however, then you must pay taxes as a sole proprietor. If you prefer filing as a corporation, then you have the option to elect corporate tax treatment by filing Form 8832. Unfortunately, once you decide and act upon this decision, you cannot alter it for five years.
- Partnership filing: LLCs that are subject to these rules are not responsible for paying business earning taxes, but they are responsible for preparing annual partnership tax returns on Form 1065.
- Sole proprietor filing: With this setup, you are essentially responsible for all tax payments and filings. You must now complete a Schedule C attachment, reporting the income and deductions that relate to your business activities.
- Corporate filing: If your LLC qualifies for this set of rules, the IRS will treat your business as a separate taxpayer. The LCC is required to report all income and deduction on Form 1120 each year as well as paying the appropriate tax amounts.
Many individuals choose to invest with partners. Whether friends or limited partners, having an LLC ensures you outline owner roles and responsibilities as well as the percentage of ownership.
Owners of an LLC are referred to as either members or managers. A member is typically the owner of the company, while a manager is appointed by the member to manage the LLC. A manager, however, can also be a member. Depending on the rules of that specific state, LLC members can consist of a single individual (one owner for all the assets), two or more individuals, corporations, or even other LLCs. LLC ownership percentage is expressed in two different ways.
They can either be expressed through percentage or membership units, which are similar to shares of a corporation stock. Both of these scenarios allow the right to vote and the right to share in profits. What’s unique about an LLC’s ownership structure is that it can distribute ownership power according to member preference, regardless of how much money or property a member contributes to the company itself.
If a silent partner contributes $500,000, and the other member contributes absolutely no money but is in charge of day-to-day operation, both parties can still split membership interest by 50-50.
LLCs are not free. Not only will you be paying a fee to set up each LLC, most states also charge an additional fee to file a return every year. This matter will vary depending on where you live and where you register your properties.
For example, if you are residing in California, there is a $800 annual fee that is unavoidable. If you are trying to register a foreign LLC in California, there is a $70 normal processing fee. Expedited 24 hour processing is an additional $350 charge and an additional $500 for 4 hour processing. If you are registered out-of-state and trying to register in California, you will need to hire a local agent for an additional annual payment of $50 to $200 to manage everything from tracking your report due dates to uploading documents into your account for immediate reviewing.
Keep in mind that there is an initial filing fee and a licensing fee for each year the LLC is active. The fees vary from state to state. Below are a few examples from popular states:
- California: There is a $20 reporting fee and a statement of information is required 90 days after formation and then once again every 2 years. There is currently a $70 filing fee and a $800 LLC tax due by the 15th of the fourth month upon completing the formation and every following year. If the income exceeds $250,000, then there is an additional LLC tax based on the income amount.
- Delaware: There is an annual LLC tax of $300 due on June 1st upon the year after formation. No additional state income tax is charged.
- New York: LLCs are required to publish a notice of formation in at least 2 newspapers in the county of which it was established. This fee may run up to $2,000 and the LLC must then submit a certificate of publication to the state. This submission includes an additional $50 fee. For LLCs that want to be treated as a partnership, there will be an annual tax that is collected based on the income.
The implications of financing property in an LLC vary depending on your type of loan. Traditional residential investment property loans are designed for single family homes and buildings with four or less units on the property. These loans more closely follow a typical home mortgage with similar qualifying standards (i.e. Debt to income, credit score, loan to value). Residential loans will extend for up to 30 years. Unfortunately, most residential lenders will not lend money to LLCs.
The lenders that do work with borrowers with properties in LLCs will often offer less compelling terms. For instance, you will most likely not have access to the same 30 year fixed mortgage you might get with a single family home in your name. In addition, the loans will usually be recourse (backed by your personal finances). All this being said, it is possible to bundle a number of residential buildings together into an LLC and get a portfolio loan (but that is a topic for another post).
Commercial investment property loans are designed for properties with five plus units and nonresidential investment properties. Commercial investment loans can be used to purchase or refinance properties such as multifamily residential, mixed use, and office buildings. Commercial investment lenders usually look at the ability for the property to provide cash flow and the investor’s experience when deciding whether or not to lend. Commercial financing is regularly done with LLCs. However, be aware of the terms as the interest rates are usually higher, amortization can be shorter (15 to 20 years), and the loans often have balloon payments at the end of their term.
So should you place your properties in an LLC?
This depends on your personal holdings and needs. Consider the amount of property you own and what state both you and your holdings are located. Determine whether you are simply looking for legal protection or are seeking ways to benefit your financing. Regardless what you decide, remember that it is important to have a safety net.
Should you decide that an LLC is not the best option for you, purchasing an umbrella insurance policy for asset protection is a good alternative. The policy covers you or your business for claims made up to a specific amount of money that isn’t already covered by another insurance policy you maintain.
This option is cheaper than most LLCs and will protect you from injuries, property damages, lawsuits and personal liability situations. Insurance policies also have benefits such as attorneys who the insurance company will appoint and pay to defend you.
Now you have the basics. That being said, there are a lot of considerations when determining how to hold and protect your real estate assets. We recommend consulting with a licensed professional when making your decision.