A common question among beginning real estate investors is whether or not they should have an LLC in another state. The answer is that you can, and there are definitely some very good reasons for forming an LLC.
Because some states and municipalities are more landlord-friendly and others are more tenant-friendly, having an LLC for rental property in another state is useful for long-distance real estate investors. Some tenants may think that because an investor lives in a ‘wealthy’ state, they will be an easy target for a frivolous lawsuit.
There are also other advantages to having an LLC besides legal protection. Here’s how LLCs work and why it’s always a good idea to have an LLC for a rental property in another state.
What is an LLC?
An LLC (or limited liability company) is a legal business structure that is created to help protect both the business and personal assets of the real estate investor. LLCs can have a single-member, multiple members, or even own and operate other LLCs.
Benefits of having an LLC for rental property
As they scale up and grow their business, many real estate investors form a different LLC for each rental property owned.
Doing this helps create a "clean" record of income and expenses of each investment for tax purposes, and also helps protect a creditor or claimant from attempting to go after all of an owner’s assets in a bankruptcy or lawsuit.
There are four major benefits to forming an LLC when you have a rental property in another state (or even in the same state where you live):
- Limits personal liability claims from disgruntled tenants and their guests, vendors, and lenders
- Separates your business assets from your personal assets, and can also separate one rental property from another when you create multiple LLCs
- Keeps personal and business expenses separated by having unique bank and credit card accounts for each LLC
- Pass-through taxation passes through the LLC income (or losses) to your individual tax return, eliminating the requirement to pay a potentially higher corporate tax rate
How to form an LLC
While the exact rules to form an LLC vary from state to state, most follow the same general guidelines:
- File articles of organization with the secretary of state’s office
- Pay the state filing fee, usually less than $200
- Many states also charge an annual renewal fee, and require an LLC to hold an annual meeting in order to preserve the LLC status
It’s also a good idea to create an operating agreement, even if the state you’re registering the LLC in doesn’t require one and even if you’re initially forming just a single-member LLC.
Having an operating agreement already drawn up that explains how the LLC does business, member ownership percentages, and who is responsible for doing what makes it easier to add other investors to your LLC if you require more capital or experience to grow.
An operating agreement can also help protect the LLC structure if there’s a challenge in court. If the judge decides that you don’t really have an LLC, your personal assets could suddenly become at-risk.
Are there business-friendly states for LLCs?
If you’re planning on investing in rental property in several states, it can make sense to shop around for the best state to form an LLC in. When you create an LLC outside of the state you live in, the LLC is considered to be a “foreign” LLC and you’ll be required to have a registered agent in each state where you form an LLC.
Registered agent fees start at around $100 per year, but that small extra expense can be more than offset if you live in a high-tax state such as California or New York.
Also keep in mind that some states are more business-friendly than others.
Factors that can make a state more friendly to real estate investors include low filing fees, no state taxes or citizenship requirements, no state or corporate income taxes, and strong privacy protection laws.
States considered to be the most business-friendly for foreign LLCs are:
- Delaware is known as a haven for incorporations
- Wyoming has low start-up costs
- Nevada offers strong privacy protection for owners of foreign LLCs
Things to know about foreign LLCs
An LLC can be either “foreign” or “domestic.” The difference between the two is based on the home state of the LLC – or the state where the LLC was formed – and the state where the LLC does business.
For example, if ABC Real Estate LLC is formed in California and holds property in California, it is considered a domestic LLC. On the other hand, if ABC Real Estate is formed in Arizona and owns property in California, the company is a foreign LLC in California and a domestic LLC in Arizona.
Whether an LLC is foreign or domestic also determines how the LLC pays taxes and the rules and regulations the LLC operates under. Setting up a foreign LLC is normally easy, but you’ll be required to have a local registered agent in the state the LLC operates in.
Tax laws also vary from state to state. Usually, a foreign LLC is required to pay taxes based on the law of the state the LLC operates in. Sometimes, states have double taxation, which means that in addition to a foreign LLC paying taxes in the state where the rental property is, taxes may also have to be paid in the LLC’s home state.
If you form an LLC in the same state where you live:
- The process is relatively straightforward when you are a resident of the state
- Only need to comply with one set of state laws
- Registering the LLC may be more expensive depending on the state you live in
- Taxes are paid in only one state
If you form an LLC in a different state from where you live:
- The process may be more complicated because you are not a resident of the state
- Need to comply with the state law where the LLC is formed and the state law where the company holds property
- Registering the LLC may cost less depending on the state of registration
- Potential for double taxation depending on the laws of both states
How does a Series LLC work?
As the name suggests, a Series LLC is a group of LLCs linked together under one umbrella or master LLC. The articles of formation of the series LLC allow the company to segregate assets and interests into an independent series.
For example, an investor holding property in several states could form an umbrella LLC, named Global LLC. Within the Global LLC, there would be multiple LLCs for each property owned in different states.
The process for forming a series LLC is similar to a single LLC and can be a flexible option for investors planning to geographically diversify their investment property holdings. However, a registered agent is required in each LLC in each state, and not all states allow series LLCs.
States where a Series LLC can be formed include Illinois, Kansas, Missouri, Tennessee, and Texas. Other states such as California have laws that do not allow a series LLC to be formed, but investors may form a series LLC in another state, then register to do business in states that do not allow series LLCs.
Is an umbrella policy a good alternative to an LLC?
An umbrella policy is extra liability insurance that helps protect property owners against the risk of being sued for damages or personal injury by tenants or their guests, and also protects against claims of libel, slander, or invasion of privacy (such as a landlord entering without giving the tenant proper notice).
Sometimes investors try to use an umbrella insurance policy as a substitute for forming an LLC. While umbrella policies do provide extra insurance, they’re not a substitute for having an LLC.
That’s because insurance policies contain exclusions and “carve outs” that may leave a property owner unprotected and exposed to significant risks. For example, if the claim against the owner exceeds the umbrella policy’s coverage, personal and business assets of the insured will be up for grabs in the event of a lawsuit.
Creating an LLC for a rental property in another state can be one of the smartest moves a real estate investor makes.
Liability is reduced and assets are kept separate. Paying taxes is simplified, and the LLC’s business expenses can be used to reduce income before it’s passed through to the investor.
When you’re ready to form an LLC, you can learn about the rules and fees online at the website for each secretary of state’s office or use the State Guide to Corporations Offices from FindLaw.