Creating a real estate LLC to hold your rental property is a great way to protect yourself (and your assets) from liability. Setting up an LLC — a “limited liability company” — doesn’t have to be difficult. Here, you’ll learn why LLCs are a real estate investor’s best friend.
Advantages of LLCs for Real Estate Investors
Corporations and limited partnerships are good choices for some businesses, but LLCs are one of the most popular ways to hold rental properties. Here’s why:
With an LLC, you get pass-through taxation.
That means you’re only taxed once on your rental property’s income. So, if you’re in the 35% tax bracket, you’d pay $3,500 on a $10,000 profit, leaving you with $6,500.
This is much better than double taxation, which is the norm with corporations. If you own your rental property in a C-corporation, the corporation would need to pay the 21% corporate tax rate.
Then, you’d be taxed as an individual on the distribution from the corporation. So, you’d start with $10,000 in income. Then, the corporation would pay 21% ($2,100) in taxes, leaving you with $7,900.
Finally, you’d have to pay your 35% personal income tax when the corporation distributes the $7,900 profit to you, resulting in a $5,135 profit — $1,365 less than if you’d formed an LLC instead.
If you hold rental property in your personal name, you’re setting yourself up for trouble.
If someone injures themselves on your premises, you could be liable for damages.
Insurance is an essential asset protection tool, but if insurance doesn’t cover all of the losses, you’ll be liable for the rest out of your own pocket. A plaintiff could reach your primary residence, stocks, bonds, checking accounts, and more.
On the other hand, if you have an LLC, your liability is generally limited to the property within the LLC — that’s why it’s called a “limited liability” company. So, while an on-site accident could potentially result in you losing the rental property within the LLC (if insurance doesn’t cover the loss), the damage stops there. Your personal assets remain safe and sound.
A real estate LLC is much more customizable than a corporation. While corporations have relatively fixed structures, LLCs are flexible to fit your needs. An LLC’s operating agreement — the main internal governing document — can have tailor-made rules regarding ownership, voting, management, profits distributions, and more.
Disadvantages of Real Estate LLCs
While LLCs are a great tool for real estate investors, they’re not for everyone. Here are a few drawbacks to keep in mind when forming an LLC for rental properties:
LLCs aren’t free. You’ll have several startup costs like filing the organizational documents with the state, drafting legal documents, and appointing an in-state registered agent. We’ll cover how to form a real estate LLC in an upcoming article.
Real estate investors should be careful to keep their LLC separate from their personal life. Commingling funds and failing to adhere to the rules in your LLC’s operating agreement can lead courts to disregard your limited liability protection, leaving you personally on the hook for your LLC’s debts and lawsuits.
Most lenders won’t loan a new LLC money to purchase residential (1-4 unit) property. As a result, you may need to buy your rental in your own name and then transfer the property to your LLC after closing. However, this can be risky, as many loans have a “due on sale” clause, which allows the lender to accelerate the loan if you transfer your investment to another party, including an LLC. Always make sure to speak with your lender and a real estate attorney before transferring title.
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