If you’re a real estate investor or if you are considering purchasing a rental property, then you should probably explore your options when it comes to the type of entity under which you want to own the rental property.
One of the main reasons why you should consider forming an LLC for rental property investments is to protect your personal assets in case of a lawsuit between you as the landlord and your tenant.
While this is the number one reason why real estate investors and landlords might consider forming an LLC for rental property ownership, there are some other benefits to forming an LLC as well as some complications that you should take into consideration.
What Is an LLC for Rental Property Owners?
Before we get into more details on the benefits and aspects that are related to forming an LLC for rental property investments, we will briefly explain what an LLC is when owning a rental property.
LLC is short for Limited Liability Company – as the name suggests, this is a type of entity that can protect the owner’s personal assets and separate them from the assets related to owning and running a rental property investment. LLCs are among the most common types of legal entities under which landlords own and run rental properties as a form of business. This is because LLCs have considerable benefits, mainly in protecting the owner’s personal assets, which is an advantage that can also be achieved by forming a corporate entity.
However, unlike corporates, LLCs do not go through double taxation.
LLC for Rental Property – Protect Your Assets
The main benefit of forming an LCC for rental property ownership is, as we repeatedly said, to protect your personal assets.
But what does that mean?
To give you an example, imagine that you own a rental property that you’re renting out to a tenant. That tenant decides to throw a party in your rental property, and during the party one of the guests gets drunk, slips, and falls, hitting his head and breaking some bones. Following the gruesome incident, the tenant renting the place finally sobers up and decides to take advantage of the situation to sue you for a lot of money.
In this case, if you’re a normal owner of the property, if the tenant wins the case, he could be compensated from your own personal assets and belongings. If you own the rental property under an LLC, however, the tenant could only be compensated from the assets that are tied to the rental property that you own. In other words, your personal assets become untouchable, and only the assets that are used for running the rental property would be vulnerable.
Related: The Most Common Reasons for Lawsuits Between Landlord and Tenant
LLC for Rental Property – Tax Benefits
While forming a corporate entity could provide you with the same asset protection benefits, a corporate entity would have to go through double taxation on the rental income and the capital gains of the property. What this means is that a corporation’s profits would be taxed twice – once at the corporate level, and once when the profits are distributed or moved to you as the owner, even if you’re the sole owner of the property.
An LLC that is owned by a single person, which is you, will be treated as a person when it comes to taxation. This means that an LLC can act as a shield or an extra layer against lawsuits, but will still let taxation go through it without any extra penalties.
LLC for Rental Property – Things to Keep in Mind
Naturally, forming an LLC for rental property investments is not that simple. There are some considerations that you have to keep in mind, and it might result in a more daunting task when running the rental property. Before forming any type of a legal entity, you should always consult a legal advisor and a tax advisor to see if the move is worth it or not.
Related: Forming an LLC for Your Real Estate Investment Business
Some of the things that you should take into consideration include:
Consider Your Insurance Options
An LLC is not the only way for you to protect your personal assets. Alternatively, you can use a landlord insurance, which is also known as a dwelling insurance, to protect your personal assets. This insurance can protect your rental property and might pay cash value or replacement costs in case of a catastrophe hitting the property.
You can also use an umbrella insurance to protect your personal assets against a lawsuit. But an umbrella insurance might not cover the total costs you incur and will have a limit on the amount that it could cover.
Consider Your Mortgage Implications
Another aspect that you should consider is that if you already own a rental property that you have a mortgage on and you decide to form an LLC, this might affect your mortgage and your lender might not like it.
Basically, a lender might consider moving the ownership of the property from you as an individual to you as an LLC as a sale, which might lead them to call in your mortgage under a due-on-sale clause. This might lead to you losing a low interest rate that you had on the mortgage, which might cost you a lot of money.
Consider Your Money
Speaking of money, you should also keep in mind that in order for your LLC to be considered a separate entity and protect your personal assets, you should never mix your personal money with the money of your LLC. What this means is that you should not use your LLC money to buy personal belongings or spend it on personal assets, and you should not spend your personal money on your LLC.
If your tenant is smart, he.she might use this against you in court by claiming that you and your LLC are not separate entities, which might put your personal assets at risk.
Related: 1031 Exchange – The 9 Basic Rules That You Need to Know
Bottom Line
While forming an LLC for rental property ownership is generally considered a good idea and can protect your personal assets while avoiding any tax penalties, there are numerous other legal entities and types of companies and corporates that each have their own advantages and disadvantages. So, before forming an LLC, make sure to consider your options and consult a legal advisor to find the perfect match for you, or you can simply forego the whole ordeal and be a traditional landlord and rental property owner as an individual and hope that your tenants are not throwing any wild parties in your property.
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