As you establish yourself as a real estate investor, you’ll start to delve into some of the ins and outs of protecting yourself from liability and maximizing the value of your investment.
One of the tools you may consider is the formation of a Limited Liability Company or LLC. There are a variety of different types of LLCs, and each have their pros and cons, tax implications, and other specific considerations.Please Note: The information contained within this article is not designed to offer legal or tax advice. It is to be used for informational purposes only. Professional legal advice should be obtained prior to forming or holding a legal entity.
What is an LLC?
An LLC is a separate legal entity that can be formed in order to hold ownership of some or all of your assets, and potentially limiting your liability in regards to ownership. An LLC can have its own tax identification number, open a bank account, and conduct a variety of business transactions under its name.
There are two general types of LLCs: single-member and multi-member. As the names imply, these give you the same type of potential benefits, but differ according to the number of people registered as owners of the LLC.
The Main Benefit: Protection of Personal Assets
An LLC is often set up to offer asset and liability protection. In the event of a lawsuit resulting from damages in or on a property, the property owner is likely going to be named in the suit. If the property is owned by an LLC, the LLC is the entity that's most likely to be named in the lawsuit.
In the event of a suit brought against the property owner, the plaintiff won't typically have direct access to sue the individual investor. He or she would have to sue the LLC, thus any assets within the LLC would be at risk; but, this limits the liability of the individual owner(s) and protect non-LLC owned assets from an award to the plaintiff in the event that the lawsuit is decided in their favor.
This means that your personal retirement accounts, primary residence, and other investments owned outside of the LLC are generally protected. This can be an important way of ensuring that you, your family, and your long-term financial health are protected in the event of legal action against one of your properties.
The Main Drawbacks: Cost and Time
States require LLCs to pay a fee simply for their existence. For example, in addition to the initial California Secretary of State filing fees, there is a periodic filing fee of $20 and annual state business tax of at least $800 per LLC.
Some of the other "cons" that investors face with an LLC are:
- Costly setup fees (i.e. lawyer fees)
- Each LLC requires a separate tax return
- Each LLC requires a separate bank account
- Many banks will not lend to LLCs, or they may require a personal guarantee
Do LLCs Have Any Tax Benefits?
The tax benefits of LLCs can vary from state to state, so it is important to consult with your local tax professional about how having an LLC may affect your personal tax situation. There are misconceptions about the effect of LLCs, including the notion that an LLC gives you the ability to write off additional expenses on your tax return.
There are misconceptions about the effect of LLCs, including the notion that an LLC gives you the ability to write off additional expenses on your tax return. Because a single-member LLC is taxed as a pass-through entity, meaning that it is considered income for personal taxation purposes, there is little tax benefit to obtaining an LLC for some investors. Add the expenses involved and the LLC may amount to virtually no money savings over simple individual ownership year after year.
Remember, however, that the benefit of an LLC is not limited to potential tax savings. You may find that the limitation on liability is worth the additional expense. It is important to discuss all of the possibilities with your legal and tax professionals.
Insurance - Can it Replace The Need for an LLC?
Many investors feel that having a high liability limit on their dwelling policy provides the same liability protection without the tax and accounting headaches of an LLC. Many also feel that having a big umbrella insurance policy can supplement the liability protection that you need for an investment property.
An umbrella policy can provide extra liability insurance coverage that goes beyond the limits of what's included on your home, auto, or watercraft insurance.
Setting up an umbrella insurance policy with a high liability limit may be quicker and more affordable than setting up and maintaining an LLC with all of the associated bank accounts and management. This may reduce overhead and time spent on management.
Now that we've looked at some of the pros and cons of LLCs, let's dive into the nitty-gritty of actually creating one for your rental properties...
Formation of an LLC
The formation of an LLC varies depending on the state that you're forming it in, but they can usually be formed online or with the assistance of a lawyer. It is helpful to work with a lawyer, especially on your first LLC formation.
Depending on the state of formation, you may need an operating agreement, which designates the rules that operate the company what each manager and member of the LLC can do; you will likely need to designate a manager to run the day-to-day operations of the LLC.
Once you have filed the required legal documents to form the LLC, you can apply for and receive a Federal Employer Identification Number (FEIN) from the IRS for the LLC. You use the FEIN for tax returns and for opening accounts with local municipalities, utility providers, or for bank accounts.
The purpose of an LLC operating agreement is to define the structure of your LLC and head off problems before they occur. At its best, an LLC operating agreement gives you the ability to think through a variety of scenarios related to the management and ownership of the properties contained within the LLC.
For single member LLCs, you will be responsible for all aspects of the operations of the entity (although you can designate a manager to run the day-to-day operations of the company).
For multiple member LLCs, an operating agreement allows you to formalize profit-sharing, the decision-making process, and the process for dealing with the admission of additional members or the departure of existing members. If there are disagreements or mistakes regarding finances and management, an operating agreement will help you to properly settle these issues.
While many states do not require you to draft an operating agreement, it is typically important to have one in order to protect your limited personal liability in the event of legal action. For a single member LLC, the lack of an operating agreement can mean that you are treated as a sole proprietor even with an LLC and lose the protection that an LLC may provide.
Additionally, an operating agreement can help you to chart your own course when it comes to the operation of your legal entity. Without one, your LLC will be subject to the operating rules instituted by the laws of the state where your LLC is formed, which may or may not result in the outcome you want.
For example, many states require you to divide up losses and profits equally. This may not make sense if you and your partners invested different amounts initially or have contributed differently over time. Thus your operating agreement should spell out the differing shares and profit or loss each of the members should hold.
Filing and Management Fees
Costs associated with the setup of an LLC can include legal fees and initial filing fees. Some states require that you pay an annual fee of hundreds of dollars just for the existence of an LLC. For this reason, it is important to ensure that you plan to use your LLC before setting it up.
You should have separate and well-defined bookkeeping processes for each LLC. This may require additional expenses for bookkeeping and accounting services.
In addition, each LLC requires its own separate tax return, so there are additional accounting costs associated with the financial management and tax filing for each entity. Because each LLC requires its own separate bank account, you may also have bank fees associated with each LLC.
Holding properties under an LLC can also affect your ability to borrow from a bank. Many banks require a personal guarantee and will not lend to an LLC. Check with your financial advisor to better understand strategies for financing properties owned by an LLC.
Having Separate LLCs For Each Property or Group
You may want to hold separate LLCs in order to limit liability to smaller groups of properties and their values rather than putting your entire portfolio at risk under one entity. Here are a couple of ways to divide your properties:
- LLCs by Geographic Location: Some investors divide ownership of their properties by state or region with a separate LLC for each. This allows you to group a number of properties under one LLC while still protecting those properties in other areas. It also allows you to differentiate the management of your properties according to the different laws of each state.
- LLCs by Number of Properties: You may want to set up LLCs according to the number of properties in a group. For example, each group of 50 properties might be owned by a different LLC. This creates a potential firewall between groups of assets, so that if there are problems with one property in a group, it won’t effect the whole portfolio.
In order to avoid commingling of funds among various LLCs, it is important to ensure that you have adequate division among various LLCs and that banking and accounting is kept separate and well-defined. This is especially important if you or someone in your company holds a real estate brokers license.
Moving From Individual Ownership to LLC
Early in your real estate investing career, the overhead involved in an LLC can seriously undermine cashflow. In order to save, you can put your first few properties in your own name and obtain high liability limits on the properties’ insurance policies.
Once your portfolio begins growing, you might choose to set up an LLC and execute deeds transfer those properties from your individual name to the LLC. This allows you to put the properties under the ownership of the LLC with minimal difficulty.
Many people write about LLCs, making it one of the most hotly debated topics in the real estate investing world. Some feel that you should always hold ownership under an LLC while others believe they are a waste of time and money.
In reality, every individual has a different financial picture and there's really no one-size-fits-all approach. Each investor should decide what makes sense financially and in terms of potential risk after consultation with their legal and tax advisors.
While you might not currently feel that you need an LLC, as the size of your portfolio grows, it may make more sense to set one up. For beginner investors, an LLC is not a “must have” requirement, but investors should keep it in mind as a strategy for the future as the continue to scale their portfolio.