Owning investment properties can be an exciting and lucrative decision. However, if you’re considering an investment in real estate (whether a vacation rental, long-term rental, or for re-sale), be aware that these properties can also create liabilities.
For example, a tenant might trip on a wobbly staircase. A guest could slip on an uneven sidewalk. Faulty electrical wiring causes a fire or shocks a tenant. A clogged chimney leads to a flue fire. Or a slow leak might result in mold that affects a tenant’s health.
Accidents happen. And when tenants or guests are injured on your property, victims can sue the property owner (you) for damages.
I don’t want to scare you off from real estate investment, but I do want to prevent you from falling prey to what could have been so easily avoided in the first place.
How to Protect Yourself: The LLC
To keep your real estate company safe from those potential pitfalls, I highly recommend you form an LLC, as it’s a popular asset protection vehicle for real estate investors. It essentially forms a wall that shields individual owners from personal liability. In addition to this personal liability protection, the LLC can also offer tax advantages and other benefits.
So what is an LLC? It’s a hybrid of a partnership and corporation. It’s considered to be a “Separate Legal Entity.”
Let’s say you set up VacationsRUs LLC that holds title to a vacation rental property. A guest falls from the balcony and the court awards a multi-million dollar judgment to the plaintiff. The defendant, in this case, is VacationsRUs LLC, not you. And the judgment can be collected only from VacationsRUs LLC’s assets, and not from your own personal assets. You may end up losing your investment in the property owned by VacationsRUs LLC, but your other properties, your savings account, and any other investments are all safe.
Setting up an LLC is a relatively easy task. You can either contact your attorney or use a legal document filing service to file the necessary forms with your state’s Secretary of State.
Benefits to the LLC for Real Estate
The LLC (as well as the S Corporation) eliminates the double taxation penalty that you have with the C Corporation. The LLC is considered a pass-through entity. It does not file separate taxes, Business income or loss is reported on each individual owner’s tax return. In the case of a single member LLC, the LLC taxes would be filed under the individual member’s tax return; in the case of a multi-member LLC, the LLC would generally file a partnership tax return.
All LLC profits flow through to the owners and are taxed at the personal income rate – which, depending on circumstances, can be lower than what Corporations pay (check with your CPA or tax advisor regarding your specific situation).
The IRS also allows any loss of the LLC to pass through to individuals. This loss can offset other sources of income – in effect, reducing your overall tax liability. And as an added bonus, in an LLC, members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss.
Drawbacks to the LLC
There are a few situations where the LLC might not be the best fit for your real estate business. If you’re looking for investors, they may prefer to invest in a corporation, so take that into consideration up front.
If, for any other reason, operating as an LLC will disqualify you from getting funding or participating in specific programs for your property, the S Corp is a good alternative.