Although real estate investors may directly own property as sole proprietors, rental property is often held in a limited liability company (LLC) or trust. Both entities are vehicles that may help investors protect assets and reduce potential risk, although an LLC and a trust are used for different purposes.
In this article, we’ll explain the difference between an LLC and a trust and review the pros and cons of holding rental property in an LLC versus a real estate trust.
- An LLC and a real estate trust are 2 vehicles used to hold investment property but are formed by investors for different purposes.
- While both an LLC and a trust are formed at the state level, an LLC is usually more expensive to create and maintain compared to a trust.
- LLCs can usually have an unlimited number of members and ownership types, such as individuals or other LLCs.
- Holding rental property in an LLC generally protects investors from creditor claims on other business and personal assets in the event of a lawsuit.
- A real estate trust is generally formed to avoid probate and reduce estate taxes, and to pass real property from one family member to the next.
- Although trusts can help investors avoid taxation, they do not protect other business or personal assets from creditor claims.
- Both LLCs and real estate trusts are pass-through entities for tax purposes and avoid the double taxation found in other corporate structures, such as a C corporation.
LLC vs. real estate trust
An LLC and a real estate trust can both be used for asset protection. While LLCs and trusts are created at the state level, the entities are used for slightly different purposes.
An LLC is a distinct business entity, similar to an S corporation, that is formed to help protect investors from potential legal liability and separate other business and personal assets from those held in an LLC. On the other hand, a real estate trust is formed to avoid tax liability when real property is transferred from one family member to another or from one generation to the next.
Before continuing, keep in mind that when deciding whether to hold rental property in an LLC or a trust, you may wish to speak with a financial advisor or attorney.
LLC for rental property
An LLC is a separate business entity formed according to the statutes for the state in which a rental property is located.
The individual owners of an LLC are called “members,” and most states do not restrict the type of ownership or the number of members. As the Internal Revenue Service (IRS) explains, members of an LLC can be corporations, other LLCs, foreign entities, and individuals.
In most cases, states also allow “single-member” LLCs with one owner. Rather than holding rental property as a sole proprietorship as an individual, a real estate investor may consider forming a single-member LLC to hold investment property.
- LLCs are business entities distinct from the members and may be easier and less expensive to create and manage compared to a corporation.
- An LLC can generally have an unlimited number of members, which may make an LLC a good vehicle to consider for group investing.
- Members of an LLC may provide equity capital, debt financing in the form of a loan to an LLC, or a combination of both.
- Single-member LLCs may be formed to hold rental property as an alternative to owning property in a personal name or “doing business as” (DBA) name, where state laws allow.
- Income or losses from a rental property held in an LLC are passed through to each member and reported on individual tax returns, with income taxes paid based on each member’s individual rate, avoiding the double taxation of corporate profits.
- Other business and personal assets of each member are generally protected from legal liability or creditor claims in the event of a lawsuit or bankruptcy.
- Members of an LLC also may buy and sell their individual shares without having to sell the actual rental property, based on the rules outlined in an LLC’s operating agreement.
- Many states charge an annual LLC renewal fee and require members to hold annual meetings.
- LLCs must file annual tax returns (even though LLCs generally do not pay taxes) and provide each member with a Schedule K-1 to report each member’s share of income or losses, deductions, and credits.
- Member liability protection from an LLC may be limited if an LLC is proven to have done something illegal.
- While individual members of an LLC may be able to sell their shares, some states require an existing LLC to be dissolved and a new LLC to be formed if there is a change in membership.
- Raising additional capital may also be more difficult with an LLC structure, compared to a corporation, such as an S corp, which may sell shares of additional stock rather than taking out a bank loan.
Real estate trust for rental property
Real estate trusts are formed at the state level, although trusts are not business entities like LLCs. Trusts usually serve estate planning purposes to avoid estate taxes and probate and keep rental property within the family.
There are 2 types of real estate trusts for rental property: revocable and irrevocable. In both cases, rental property is transferred from the original owner (the grantor) into a trust, but the control that the grantor has is different.
A revocable trust allows the grantor to make changes to the trust during the grantor’s lifetime, to directly control and manage the assets in the trust, and to terminate the trust. However, once the grantor dies, a revocable trust becomes irrevocable.
In an irrevocable trust, the assets are overseen and managed by a trustee, and the grantor no longer has control over the trust assets. Instead, the trustee manages the assets according to the instructions in the trust. Upon the grantor’s death, assets are distributed by the trustee according to the trust instructions.
- After a trust is created, there are no recurring fees to maintain the trust, as there are with an LLC.
- A real estate trust may be a good estate planning option for investors seeking to avoid estate taxes and pass along property to heirs.
- A trust avoids a lengthy probate process because it, rather than an individual, has ownership rights to the rental property held in the trust.
- Real estate trusts also may be used by multiple owners of a rental property as a way to document ownership interests and relationships.
- Assets held in a trust are not treated as part of the grantor’s personal assets, which may help to lower an individual’s tax liability.
- Trusts may provide some anonymity, although it is becoming increasingly difficult to do so when deeds and tax information are available online from counties.
- Because a trust is not a business entity like an LLC, a trust does not protect other business and personal assets in the event of a lawsuit or creditor claim.
- A trust also may be more complicated and expensive to set up compared to a will or an LLC, depending on the grantor’s personal situation and assets being transferred.
- Creating a will may still be required to address property that is not held in a trust.
LLC vs. trust: How to choose?
As with most other financial and tax planning strategies, the choice between holding rental property in an LLC or a trust depends on an investor’s unique situations, needs, and goals.
An LLC for rental property may be a good way to protect other business and personal assets from creditor claims and to raise funds for group investing. By comparison, a real estate trust may be a good vehicle for investors seeking to avoid probate, reduce estate taxes, and pass real property to another family member.
Both an LLC and a trust are pass-through entities for tax purposes. They will collect rental income and pay expenses, with any income or losses passed through to the individual members or owners and reported on personal tax returns. Investors also may defer capital gains when rental property held by an LLC or a trust is sold and a replacement property is purchased within a specific period of time.