Beginning investors often purchase rental property in their own name. While investing in real estate as an individual may be easier to do, owning investment property under an individual name can also create problems down the road.
In this article we’ll explain why many real estate investors hold property in an LLC, the pros and cons of having an LLC, and how to transfer property you already own to an LLC.
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 for rental property?
An LLC is a limited liability company that can have one or more members, including only yourself. Rather than owning rental property as a sole proprietorship under your personal name, the IRS allows you to form a single-member LLC for tax purposes.
While a limited liability company is relatively easy to create, each state has different rules to follow when forming an LLC. The legal resource website Nolo has put together a 50-State Guide to Forming an LLC with links to government agencies, forms, and resources to forming an LLC in the state your rental property is located in.
Pros and cons of transferring property to an LLC
Rental property investors may realize both tax and legal benefits by transferring property into an LLC. However, there are some potential drawbacks to be aware of as well when putting real estate into an LLC.
Pros of moving property to an LLC
- Limit personal liability by using an LLC as a “corporate shield” to protect your other business and personal assets in the event of a lawsuit.
- Keep multiple properties in your portfolio separate from one another to shield one property from potential liability of the other properties and to make tracking financial performance easier on an individual asset level.
- Easier to keep business and personal expenses separate, which can make year-end tax reporting cleaner and less complicated.
- Real estate investment partnerships benefit when property is moved into a multi-member LLC by more clearly defining ownership percentages, management responsibilities, and tax benefits by member.
- Tax advantages of transferring property into an LLC include deducting property operating expenses at the company level with net income “passed through” to each individual LLC member, so that income is taxed on an individual level and not a corporate level.
Cons of moving property to an LLC
- An LLC creates additional paperwork, including creating a separate bank account for each LLC and annual filing and reporting to the state.
- Annual filing fees for an LLC can run several hundred dollars or more each year.
- Mortgage and insurance rates could increase because the property is owned under a corporation that may lack credit history rather than an individual.
- Lenders may still require each LLC member to guarantee a loan taken out under the name of the LLC.
- Moving a property into an LLC may also trigger unintended tax consequences, which is why real estate investors should speak with their financial advisor or CPA when forming an LLC.
How to transfer property to an LLC
There are 6 basic steps to follow to transfer property to an LLC:
1. Contact the lender
If you have a loan on the property being transferred to an LLC, contact the lender to learn if the property title can be transferred to your LLC with the existing loan.
The lender may charge additional one-time fees for transferring the loan, increase the interest rate, and require a personal guarantee. Other lenders may require you, the borrower, to pay off the existing loan if the mortgage has an acceleration clause and obtain a new loan under the LLC.
2. Form your LLC
Complete the formation of your LLC by filing your Articles of Organization and Operating Agreement with the state corporation commission or division.
Articles of Organization for an LLC include basic information such as member contact information, physical address of the company, number of shares issued to each member, and registered agent.
The Operating Agreements describes the rights and responsibilities of each LLC member, how conflicts between members are handled, and what happens if a member wants to sell shares of the LLC to another party.
3. Obtain an EIN
A federal employer identification number (EIN) acts as a social security number for a business. After your LLC has been formed you can file a form with the IRS to obtain an EIN at no charge. You will need an EIN even if your LLC does not have employees.
Your EIN is used for things like opening a bank account for your LLC, filing tax returns for the LLC, paying employee payroll tax, and issuing 1099 forms to independent contractors at the end of each year.
4. Set up an LLC bank account
The bank will ask for your LLC’s EIN, along with a copy of your Articles of Organization that has been filed with and approved by the state, showing that your LLC is in good standing.
Even if your property management company is responsible for collecting the rent and paying your operating expenses, you should still set up an LLC bank account to deposit your monthly distributions and to keep your LLC business funds separated from your personal funds.
5. Transfer property title
File a quitclaim deed or warranty deed to transfer the property from your personal name to the LLC. When you file the deed with the county clerk, remember that you are the grantor and the LLC is the grantee. It’s a good idea to ask your local title company for assistance to transfer title, because the specific process varies based on the state.
6. Update leases, permits, contracts, and utilities
Legal documents such as leases, city permits, the contract with your property manager, and utility accounts should all list your LLC as the owner or responsible party.
Because your LLC is brand new, a utility company may require your LLC to pay a security deposit which is refundable after a certain amount of time, providing all of the bills have been paid on time.
When should you transfer property to an LLC?
You can create an LLC before you purchase property or you can transfer property you already own into a newly created LLC.
Ideally, you will form the LLC to hold the property you are investing in before you buy. That’s because when you transfer real estate from your name into an LLC you will need to:
- Update your existing leases to show the property is owned by an LLC and notify the tenants.
- Give notice to your lender that you are transferring the property into an LLC or refinance the property in the name of the LLC.
- Agree if your current lender wants to close the existing loan and issue a new mortgage in the name of the LLC, creating fees and closing costs and a potentially higher interest rate on the new mortgage.
- Potentially pay more taxes, such as a real estate transfer tax, that can range from a flat fee of $2 in Arizona up to 0.5% or more of the property value in states including Florida and Michigan.
Costs of creating and operating an LLC
The typical costs of creating an LLC can be $1,000 or more depending on the state the LLC is formed in.
Fees paid for forming an LLC may include:
- Name reservation fee
- One-time fee for registering your LLC
- Professional fees paid to an attorney to create an operating agreement for the LLC
- Fee for filing the LLC articles of organization with the state
- Processing fees
- Fee paid for registering an out-of-state business
There are also recurring costs to keep in mind. Recurring annual costs for operating an LLC vary from state to state and may include:
- Annual registration fee
- Yearly fee paid to a registered agent if you are not located in the same state your property is in
- Annual franchise tax fee, depending on the state
Tax consequences of transferring property to an LLC
Generally speaking, transferring property into a single-member LLC that is a disregarded entity for tax purposes will have no tax consequences, although you should always check with your tax advisor. That’s because the LLC is not considered a separate legal entity from its owner.
However, there may be future tax consequences of transferring a piece of property to an LLC if your LLC has more than one member. For example, if your rental property has a current cost basis of $100,000 and a fair market value of $175,000, the value of the property transferred into the LLC is $175,000.
That means you have also transferred a potential tax liability of a $75,000 capital gain ($175,000 market value less $100,000 cost basis) to the LLC and its members.
If the LLC members did not benefit from owning the property prior to joining the LLC, you may want to ask your attorney to add language to your Operating Agreement to make the transfer terms equitable to all of the LLC’s members.
While transferring property to an LLC is relatively easy to do, it’s important to understand all of the benefits and potential disadvantages. Holding rental property in an LLC can help protect your other business and personal assets, and making filing year-end taxes easier.
However, there are one-time costs and annual expenses to form and operate an LLC, and you can’t move your property into an LLC without the consent of your lender.