Eventually, every rental property owner considers whether to set up an LLC for their real estate investments. An LLC is a great option for many landlords—but maybe not for the reasons you’re thinking. Many people believe an LLC is an invincible shield that will protect their businesses and properties from all liability and legal actions. Sadly, that’s not the case. Let’s look at this misconception and six other myths about LLCs and rental properties to uncover what the true purpose of an LLC really is.
What Is an LLC?
First, let’s be clear about what an LLC is.
A limited liability company (LLC) is a type of business entity that combines elements of a corporation, partnership, and sole proprietorship. In this organizational structure, all the earnings pass through the business and go to the members. Members then report the income on their personal taxes. The LLC does not pay taxes.
The point of an LLC is to protect your personal assets both financially and legally. So if your tenant or a tenant’s guest was injured while at your rental unit and they sued your LLC, only the LLC is financially at risk. Your personal assets have protection from the lawsuit.
And that brings us to the first LLC myth.
Myth 1: An LLC Eliminates All Personal Liability.
The key is in the name—limited liability company. Having your rental properties in an LLC can limit, but doesn’t eliminate, your personal liability. When used properly, you may have protection for your personal assets. But you’re not immune to all risks.
In some circumstances, you may still be held personally liable:
- If you pay company expenses out of a personal account, you weaken the shield of protection your LLC provides.
- If you don’t maintain your business registration, you’re at risk.
- If you are personally responsible for a neglected task (debris removal, maintenance) leading to tenant injury, you’re still liable as an individual.
Note: Single-member LLCs are at more risk of claimants “piercing the veil” of an LLC. That means the plaintiff can claim there isn’t a difference between the LLC’s assets and the owner’s. The laws for this situation vary from state to state, but it’s further proof that your LLC cannot guarantee total protection.
Myth 2: You’re Shielded from All Legal Actions.
Similarly, an LLC doesn’t make you invulnerable to legal actions. Your tenants, creditors, vendors, and others can still sue you, even if you have an LLC.
- If you break a law or take part in deceptive business practices, you are at risk whether or not you have an LLC.
- If multiple properties are all part of one LLC, all company assets are at risk regardless of which property or tenant led to the initial suit.
Myth 3: LLCs Provide Tax Benefits Automatically.
Many people tout the pass-through aspect of LLCs, claiming that the owner is saving money by only paying taxes once on their rental income. However, using a sole proprietor structure results in the same amount of tax paid, so the pass-through income isn’t really a tax benefit. The type of LLC you choose (S Corp, partnership, single member, etc.) can affect the way you prepare your taxes, though.
Now, if your rental property business was structured as a corporation, you would pay tax at the entity level, then again on your personal income from the corporation. That’s where the double-taxation idea comes from. But it’s not as common to use corporations for residential rental property, so this isn’t an issue.
Some landlords expect to receive the 20% pass-through deduction that was introduced as part of the Tax Cuts and Jobs Act of 2017. This deduction allows qualified businesses to deduct up to 20% of their net income from their taxes. Unfortunately, passive investments do not qualify, and merely forming an LLC doesn’t automatically grant you the deduction.
Myth 4: It Separates Personal and Business Finances.
Setting up an LLC doesn’t automatically separate your personal and business finances. When you form an LLC (or any other business entity), the best practice is to set up bank accounts and account books solely for that entity.
To truly separate your business and personal finances, take these steps.
- Have a bank account and credit card in the business’s name.
- Set up and maintain separate account books for tracking the business’s income and expenses.
- Put contracts in the company’s name.
- Do not run personal expenses through the company’s books or accounts.
The goal here is to show that the company acts as a separate entity from you, the owner. Without separate business accounts, you damage the shield of protection your LLC could provide.
Myth 5: Forming an LLC Is Too Expensive and Complicated.
Setting up an LLC requires an investment of both time and money, and the start-up process varies from state to state. However, many states provide online resources to help you through the procedures, and the setup isn’t as complicated as it was in the past.
The costs associated with forming and maintaining an LLC depend on your state. Be prepared to pay the following fees:
- Setup costs
- Filing and incorporation fees
- Annual fees
- Tax return preparation fees
- Bank account or credit card fees
Any business requires organization, structure, and administrative work—your rental property business and LLC are no different.
Myth 6: An LLC Can Only Have One Member.
It’s true that an LLC can have one member, and single-member LLCs are common. But depending on how you set up your LLC, you may have several members. In fact, having an LLC for your real estate investment business actually ensures the clear and fair distribution of profits because the payments are based on the partner’s ownership percentages.
Multimember LLCs can have different rules, though, so check with your lawyer about the requirements for your state.
Myth 7: Your LLC Guarantees Anonymity.
An LLC may provide some privacy, but ownership information is often required during the formation process or when the LLC participates in any legal proceedings. Some states make it easier to track down ownership information. Right now, New Mexico provides the strongest privacy and confidentiality for LLC owners. All other states require identification of the LLC’s owners to the state.
Takeaways
The point of an LLC is to reduce your liability. Limited liability companies do not guarantee tax breaks, anonymity, or elimination of liability or legal actions. Consult with your attorney and tax preparer to determine whether setting up an LLC is the best way to protect your real estate investments.
