There is a lot to consider and figure out when getting started with rental properties. Most people expect to spend a good amount of time finding the right property, negotiating the right price, and finding the right tenants- and you should! But also make sure to consider the advantages and disadvantages to owning that property in an LLC. Your choice influences how you handle some of the ongoing realities of owning rental property: taxes, accounting, and potential liability.
An LLC, or limited liability company, is a kind of legal entity. LLCs are used by rental property and real estate investors to isolate specific business activities and assets (such as owning and operating a rental) from personal or other business assets. This separation, if properly maintained, can provide numerous benefits, but it does come with some drawbacks and restrictions.
Does an LLC make sense for your rentals? Read on for a quick rundown of what you need to consider as you make that decision for your own unique situation.
As always, we recommend that you consult with an expert in your locality with any questions and to ensure that your LLC is properly set up and structured.
Advantages to owning rental property in an LLC:
So why do so many rental property owners choose to use LLCs? There are a few key benefits to consider.
Liability reduction and asset protection
LLCs limit your liability because of the legal separation they create between your assets. The owner of a property can be sued for various reasons. If the owner of that property is an LLC, then only the assets owned by that LLC are at risk; personal assets and those in other businesses are protected. If that property is owned by a person directly, then all of their assets, including all ownership stakes in LLC’s, are at risk.
LLCs can hold as many properties as you wish. You can choose to optimize for risk reduction and hold every property in a unique LLC. However, there is a financial and operational cost associated with every new LLC, so you may find it more practical to hold multiple properties together. It depends on your needs and perspective; there is no objectively right answer.
It is worth noting that your needs may also change over time. Your real estate assets are defined as the equity in your properties, or their market value minus outstanding loans. Your assets (whether held in or out of an LLC) will grow over time if your property appreciates or as you pay down your mortgage. This potentially creates a situation where one or more properties are small assets immediately following their purchase, but become substantial assets after a holding period of several years.
Pass-through taxation
Holding rental property in an LLC also provides some options and flexibility when it comes time to pay taxes. The IRS allows LLCs to elect how they would like to be taxed- as a sole proprietorships, partnerships, s-corporations, or c-corporations.
Most rental property owners choose to have their LLCs taxed as sole proprietorships (for one owner) or partnerships (for multiple owners). Both allow for ‘pass-through taxation’. Pass-through taxation means that income is not taxed at the business level, but instead flows through to your individual tax return. Losses also flow through and can frequently be used to offset income from other sources.
Holding properties in an LLC with pass-through taxation results in the same tax bill as owning properties in your own name. This is often the most tax efficient structure for real estate investing. The tax flexibility of LLCs allow for their other benefits while avoiding the burden of extra layers of business taxes that come with some corporations and optimizing for an efficient tax structure.
Simplicity and flexibility
An LLC is one of the easiest and most flexible kinds of corporate structures to set up and operate. While you do need Articles of Organization and an Operating Agreement, there is less paperwork than with a corporation. For a sole proprietorship LLC you won’t even need to file an additional tax return.
LLCs also offer a great deal of flexibility with ownership structure. While there are benefits for single member LLCs and wholly owned properties, LLCs are also the go-to solution for partnerships and joint ventures. When there are multiple owners, the Operating Agreement governs everyone’s rights, responsibilities, and financial participation.
Disadvantages to owning rental property in an LLC:
While owning rental property in an LLC offers some notable benefits, there are also drawbacks.
Organizational cost
LLCs do cost money. There is a fee to create an LLC, and most states charge an annual registration fee. These costs are heavily dependent on your location and that of your properties. These can be relatively low ($10 annually in Colorado) or high ($800 annually in California) depending on states that the LLC was formed and operates. If a lawyer assists you with your filings or acts as your registered agent, you will also pay their service fee.
Financing
Utilizing LLCs can impact your financing. Most traditional residential loans and mortgages for rental property investment are designed and offered to individuals, not LLCs. Even if the lender is willing to lend to an LLC, they may charge more or require personal assets as collateral (which can limit their asset protection if you default with your bank).
Commercial loans are better set up to lend to LLCs, but again they often have higher requirements and cost more than traditional residential loans.
Complexity
Even though LLCs are simple by legal entity standards, every LLC you own and operate increases the overall complexity of your real estate investing activities. Each needs to be properly set up and maintained correctly in order to reap the above benefits. There is already so much to keep track of with rental property investing- adding LLCs and their requirements further magnifies the need for careful financial and legal record-keeping.
Conclusion (and a note on bookkeeping)
Owning rental property in an LLC offers several important advantages. Unfortunately, for some investors, obtaining financing or other realities may make holding properties in them prohibitive.
If you do choose to use an LLC, please remember that LLCs can only protect your assets, operate tax efficiently, and remain simple if they are properly set up and maintained. In order to maintain an LLC, you need to comply with the registration requirements of the appropriate state and file a tax return (unless it is a sole proprietorship). You must also keep the LLC independent of your other financial activities by making sure that there is no intermingling of personal or other business funds. In practice, this means you need a separate bank account per LLC and good bookkeeping practices.
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