Real Estate and the LLC
Most builders and real estate investors understand the importance of protecting personal assets and optimizing their tax situation — especially in this uncertain economic climate. One way to address both concerns is by choosing the right business structure for holding rental properties. Many property developers and investors choose the LLC for their rental properties because of the limited liability company structure’s asset protection and tax flexibility features. Of course, like with any business entity type, there are pros and cons of the real estate LLC. Is it the right structure for your properties? Let’s discuss some of the potential advantages and drawbacks.
What Is a Real Estate LLC?
LLCs are separate legal entities from their owners (called “members”). They can have one member (single-member LLC) or more than one member (multi-member LLC). By setting up individual properties as their own LLCs, investors protect the assets of each property from the debts and liabilities of the other properties.
A real estate LLC is considered a pass-through tax entity, whereby all profit and loss passes through to its owners’ personal tax returns. The LLC does not pay corporate taxes, although some states require an annual franchise tax (or something similar) to maintain the business entity.
Profit and loss allocations per LLC member typically follow each member’s ownership percentage of the business. However, LLC members may state a different distribution in the company’s LLC Operating Agreement to establish a different split of the profits. This can be very helpful for making member compensation fair for all involved. For example, let’s say an LLC has two members — one with a 30% financial investment and the other with a 70% investment. By default, the profits and losses allocation would be 30% and 70%. But if stated in the operating agreement, the members could instead choose a different allocation, such as 50-50, if the member with less financial investment is putting in significantly more hours working in the business than the other LLC member.
Pros of an LLC for Real Estate
- Credibility – Professionalism can go a long way toward establishing trust and confidence in creditors, vendors, lenders, and tenants. Forming an LLC for real estate rental properties demonstrates a sense of responsibility and accountability.
- Personal Asset Protection for Property Owners – By holding a rental property under an LLC, real estate investors can protect their personal assets in the event of a lawsuit or other debt directly associated with the property. For example, suppose an apartment building tenant slips and falls on the stairway outside the building and decides to sue the landlord. If the property is set up as an LLC, only the LLC’s assets (those related to that specific property) would likely be at risk in the lawsuit. The property owner’s personal assets would be protected because the rental property was established as a separate legal entity.
- Asset Protection for Multiple Properties – Real estate investors who own multiple rental properties often create an LLC for each one. With each property its own business entity, all are protected against the claims against any other properties in the investment portfolio. Some states allow an LLC variation called a Series LLC (SLLC). Series LLCs have become popular in the real estate industry because of their layered protection. In an SLLC, there is a parent (umbrella) LLC with other LLCs (“series”) set up beneath it. Each series has its own income, debts, obligations, and rights. The owner’s personal assets, the parent LLC’s assets, and each individual series’ assets are protected from the debts and liabilities of any individual series within the SLLC. Depending on the state’s rules, a Series LLC might save a real estate investor money on initial startup and ongoing filing costs. Typically, just one Articles of Organization form will need to be filed for the series LLC parent company. Likewise, only one annual report filing (if required) is due for the parent company and all series beneath it.
- Pass-Through Tax Simplicity – Treated as a pass-through entity, an LLC avoids corporate tax rates and the complication of filing a corporate business income tax return. Profits or losses flow through to the personal tax returns of each LLC member.
- Flexible Profit and Loss Allocation Structure – Typically, profits and losses get distributed to members of a multi-member LLC based on their percentage of ownership. However, they can instead establish different allocation percentages in the LLC operating agreement. This flexibility opens the opportunity for some potential real estate LLC tax benefits. Namely, individual members may take on more or less of the LLC’s profits or losses to improve their tax situation. For example, an LLC with a loss after factoring its mortgage into the equation might decide to give members that fall into high individual income tax brackets a higher allocation to reduce their personal tax obligations. Real estate investors should discuss their options with an attorney and accountant or tax advisor to ensure all legal and financial considerations get addressed before determining the ideal allocations for LLC members.
- Ownership Flexibility – In most states, foreign individuals or companies may be owners of an LLC. With non-U.S. citizens allowed to be LLC members, investors may find raising funds to finance their real estate purchases and property development easier. Moreover, LLCs may have an unlimited number of owners, which also can expand funding opportunities.
- Management Flexibility – A real estate LLC may be member-managed or manager-managed. Most LLCs choose to be member-managed, with the owners actively involved in day-to-day business decisions. However, members may choose to delegate the LLC’s everyday affairs to a manager instead. An LLC manager may be an individual outside the company or select LLC members may serve as managers. In a manager-managed real estate LLC, LLC members typically retain control over major decisions, such as selling the property, securing loans, or refinancing the mortgage.
- Uncomplicated and Cost-Effective to Form and Maintain – In most states, forming an LLC requires minimal paperwork and reasonable filing fees. The costs and requirements vary by state. The registration fees, on average, are approximately $150. Kentucky has the lowest filing fee ($40), and Tennessee has the most potentially expensive filing fee ($50 per member with a minimum charge of $300 and a maximum of $3,000). LLCs must designate a registered agent and retain its services every year to maintain business compliance. Some states have other compliance requirements as well, such as filing annual reports or paying an annual LLC franchise tax. As with any type of LLC, an LLC for real estate must also follow other state and local laws, such as obtaining required licenses and permits to operate legally.
- Opportunity to Borrow from LLC Members – Generally, an LLC may borrow money from individuals, including any of its members. This can be helpful for LLCs that need money to cover their startup costs. An LLC that borrows money as a loan must repay those funds to the individual who provided them. Depending on the state’s laws and tax code, there may be some restrictions on LLCs when borrowing money from members because an LLC’s members have an equity interest in the LLC.
- Simplicity in Transferring Ownership Interests – When a real estate LLC’s operating agreement has provisions for it, the LLC may sell or transfer ownership interests to new members. In other words, ownership of the rental property can be changed without dissolving the LLC under which it’s held.
Cons of an LLC for Real Estate
- Personal Liability Not Guaranteed – While LLC members are generally protected from personal liability for the real estate LLC’s legal and financial issues, there are exceptions. For example, if a member commits fraudulent activity or is determined negligent in a lawsuit, they could be held responsible, therefore putting their personal assets at risk. Likewise, if LLC members failed to follow through with the LLC’s business compliance requirements, a court may determine they pierced the “corporate veil” that separates their personal legal responsibility for the LLC.
- Potential “Adding Up” of Formation and Compliance Costs – Real estate investors with rental properties in multiple states might see their formation and compliance costs add up as they must file and pay for state filings in each state where they hold property. For example, they will have multiple Articles of Organization to file to register the LLCs and multiple annual report filings. Also, they must retain a registered agent in each state where they have an LLC.
- Additional Tax Forms – Although an LLC doesn’t have to pay corporate tax (remember, all profit and loss flows through to the LLC members), multi-member LLCs must file IRS Form 1065, US Return of Partnership Income) to report the income and loss passed through to each LLC member. It must also give each LLC member a Form K-1 (Partner’s Share of Income, Deductions, Credits, etc.) to show that member’s share of the LLC’s profits or losses during the tax year.
- Potential Self-Employment Tax Burden – Typically, income from a rental property is considered passive income and not subject to self-employment tax (i.e., Social Security and Medicare taxes). However, if an LLC member meets the criteria for being considered a real estate professional or actively participates in services to occupants at the rental property, they may be subject to self-employment tax.
- Possible Transfer Tax – Some municipalities, counties, and states charge a transfer tax (called a “deed” or “stamp” tax) when real estate ownership changes hands. This fee is usually calculated according to a percentage of the sale price or a percentage of the property’s fair market value.
- Unassumable Mortgage Issues – Mortgages with a due-on-sale provision (known as “unassumable” mortgages) do not allow a new owner to assume the existing mortgage on a property. If the mortgage on a rental property has a “due on sale” clause, transferring ownership of the real estate LLC may require that the mortgage be paid in full before the LLC (and the property held in it) changes hands. Needless to say, this could create some significant financial headaches, so it’s wise for investors to discuss their options with lenders before signing real estate contracts.
- Personal Liability Risks of Personally Guaranteeing Loans – Lenders may require each member of a real estate LLC to personally guarantee loans taken to fund the purchase or maintenance of a rental property. If the LLC can’t pay its mortgage or other loan debts, the lenders can hold the LLC members responsible. This puts the LLC owners’ personal assets — bank accounts, retirement savings, homes, and more — at risk of being taken to repay what the LLC owes.