Do you have investment properties and are you thinking about placing one or even all of them in an LLC (limited liability company)? Did you know that one of the main reasons an LLC is formed is to protect your assets? In order to decide whether an LLC is for you or not, we need to briefly explore what is an LLC and why investors choose it. Although this article will guide you in weighing the pros and cons of establishing an LLC, before you make any final decision, my recommendation is to first consult with an expert.
An LLC has its pros and cons where each case should be considered separately and weighed properly in comparison to a corporation and a partnership. Placing your real estate properties in an LLC depends on your situation as an investor and what you would like to accomplish as a result of having an LLC. Do you own one property and are thinking of buying another or do you own several properties scattered across different states and you prefer the legal protection of an LLC? Is it about receiving the benefits an LLC has to offer despite the costs it may take in establishing it? Let’s explore LLCs further.
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Advantages of an LLC
Protecting the Assets
This is one of the main reasons why investors turn to LLCs. When buying a real estate investment property and deciding to rent it, there is liability involved. If the tenant is injured on the property, the tenant will most likely want to collect damages by suing you, the owner. By forming an LLC, you are protecting your personal assets since LLCs limit personal liability to the amount of equity being held in the entity. Any additional liability above and beyond that amount is the responsibility of the LLC with no additional assets being affected.
Protection in the Case of a Lawsuit
If you’re involved in a lawsuit related to a rental property, where the property is owned by you, an individual real estate investor, you most likely would be named in the lawsuit. This means that you would have to defend your personal assets from being taken. On the other hand, if that same property is owned by an LLC, your risk as an investor would be shielded by the protection of the company. Your personal assets would not be exposed. Worst-case scenario, the most you can lose are the assets being held by the LLC.
If you establish an LLC, this provides a channel of “pass-through” taxation, which means you are not required to pay taxes on a business level. “Pass-through” taxation allows you to report the company’s profits or losses on individual tax returns at a lower rate. This is a definite plus. Since there is no LLC tax, as the real estate owner you would avoid double taxation.
As an LLC owner, you would have the ability to transfer you ownership shares in the LLC through gifting or inheritance without the need for executing a new deed. What does this mean for you? Less paperwork and less fees and flexibility when it comes to transferring your shares. Although this is a perk, it is recommended that if you want to set up a real estate holding company as an LLC, you should do this sooner rather than later. Why may you ask? Because if you want to transfer existing real estate investments into the LLC, this may require the thumbs up from your lender, which is easier said than done.
Disadvantages of an LLC
Although this factor depends on a lot of variables such as where you live and the lawyer you hire, if you decide to establish an LLC, you will be forking out money no matter what. Since you are establishing a company, you will be required to pay the setup cost of the LLC. In addition to that, you will be required to pay the yearly fees associated with it, which are different for each state. There will also be costs associated with filing a separate tax return for the LLC, requiring the assistance of an accountant. Even if the deals online look tempting and you feel you can take on the task alone, I strongly recommend not doing it. One of the biggest financial benefits of placing rental properties in an LLC is to reap the tax benefits. But if the LLC is not set up correctly, then you will simply miss out on the benefits provided. Before taking the leap into establishing an LLC, research the fees so there are no surprises along the way. If you want to learn more about fees and how to set up an LLC, be sure to check out rocketlawyer.com.
If you are looking to receive funding from a lender, don’t have very high expectations since most lenders are not too forthcoming to lend to LLCs. Even if they do decide to go against the norm, you will still need to be supported by your own name and credit history. Although it may not be completely impossible, it is not an easy road when it comes to lenders.
Asset Protection is not 100% guaranteed
There are some situations when lawsuits can actually pierce the corporate veil of an LLC, i.e. your assets are not fully protected and can be seized. It is important to know what these situations are before forming an LLC. Also, although lawsuits do not signal happy times, sometimes by having an LLC, the situation becomes even more complicated since resolutions cannot be easily reached. The LLC acts like a roadblock and may lengthen the process further.
Trigger of the “Due On Sale Clause”
This is only relevant for those real estate investors who already own a financed property. The investors I am talking about are the ones who buy properties under their name and then want to transfer the ownership right to an LLC. By doing so, this could trigger the “due on sale” clause, which means you are required to pay the remaining balance of the loan immediately. If this is the case, you will be required to come up with a lot of money upfront. Not an ideal situation if you are for some reason strapped for cash or planning vacation time.
One LLC v. Several LLCs
It all depends on what your current situation is. If you have more than one property, you have the option to hold each of the properties you own in a separate LLC, since this will limit your liability to that specific investment. In turn, this will help you implement a beneficial diversification strategy. Let us assume your real estate portfolio includes a single-family home in Albany, a multifamily property in Milwaukee and a duplex in San Dieg0. A tenant slips and falls at your San Diego rental property and chooses to sue you for damages. Not a good situation to be in, but these things happen.
The good news is that the liability ends with your LLC for the San Diego rental property. You’re other investments and personal assets are protected because they are held in different LLCs. If each property is held by a separate LLC, then the lawsuit at the San Diego property will leave the other properties in your portfolio unburdened. Despite the unfortunate situation, you are free to refinance or restructure your other properties and can take whatever actions are necessary to maximize the return on your portfolio.
Umbrella Insurance Policy
Also, if you decide an LLC is not the option for you, you should still have some asset protection of some sort. A good alternative is also getting an umbrella insurance policy. These policies are not that expensive and will provide the same protection against lawsuits as LLC’s will. If money is an issue, then this is a good option to take since it offers the same protection benefits and usually entails a much easier litigation process in the case of a lawsuit.
After having read the above, don’t make any rash decisions until you consult with a professional who specializes in real estate investing and LLC’s. Since I am only giving advice and recommendations, such an expert will need to review your own personal situation to guide you in the proper way.
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Have you formed an LLC for your properties? What has your experience been? Would you recommend it to others?