LLCs for Investment Properties
Real estate investors look for ways to separate their business activities from personal finances. They also seek to limit their liability and reduce tax burdens. A popular way to address all these goals is to form a limited liability company (LLC) to hold the investment property.
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What Is an LLC?
A limited liability company is a corporate entity. An LLC offers the personal liability protection of a corporation. However, unlike a corporation, an LLC allows business owners to declare business profits on their individual tax returns, thereby avoiding double-taxation.
To illustrate, Bob wants to buy a rental property but wants to limit his liability. If he incorporates, he enjoys corporate protection. However, the corporation pays taxes on corporate profits. Then Bob pays taxes on income generated by the corporation. Thus, the double-taxation problem.
There are solutions, such as filing IRS Form 2553 to elect Subchapter S status. But forming an LLC is an easier option.
With an LLC, Bob protects personal assets but also benefits from pass-through taxation. Any profits Bob realizes on his investment property will appear on his personal tax return. As a result, the IRS taxes the gains once, not twice.
How To Form an LLC
It is easy to set up an LLC. First, you file Articles of Organization with your Secretary of State or State Division of Corporations. The cost is minimal to file the paperwork, and you can do it yourself.
Then, you draft an operating agreement outlining the interests and responsibilities of the LLC members and the rules for operating the LLC. It is similar to corporate by-laws.
Each year you file an annual report with your state and pay a small renewal fee. Many real estate investors find the LLC requirements easy to manage.
Using an LLC To Hold Investment Properties
Now that you have an LLC, what do you do?
The LLC separates the activities of the investment property from the business owner personally. Therefore the LLC should hold the title to the investment property. So a real estate investor forms an LLC and then purchases the investment property in the name of the LLC. The LLC name appears on the deed.
Of course, a real estate investor can transfer a property they already own into an LLC. They usually file a quitclaim deed transferring the property out of the owner's name into the LLC name.
Investors who own more than one property may set up an LLC for each property to keep their investments separate.
Other Benefits of an LLC
Many investors want to keep their financial interests confidential. Therefore, they like to form LLCs to hold rental properties in a corporate name. So, renters contract with the business entity, not the individual investor.
Protection of Other Real Estate Investments
Real estate investors often prefer to keep their rental properties in separate LLCs to insulate their properties from each other. That way, a lawsuit against one LLC does not affect the assets of another LLC.
Another advantage to having an LLC hold investment property is to keep business transactions separate from personal finances. For example, you open a bank account under the LLC name to receive rent payments and pay business expenses.
A business entity, such as an LLC, conveys a more professional image to your renters, lenders, and investors. Furthermore, you can start building a credit file for your business under your LLC. That way, you can get a corporate credit card or business loan.
Business Expense Deductions
Running all business income and expenses through the LLC will make things much easier at tax time. Because you have one place to find all your business expenses, you will have what you need to get tax deductions.
Transfer of Interest
An LLC is flexible when you sell or transfer shares of the property. An LLC has a member, or members each with shares of the LLC. Therefore, it is easy for a member to sell or transfer membership interests in an LLC.
Suppose two owners hold title to the property, but one owner wants to sell their interest in the property. In that case, the owners will have to sell or transfer the property title, which may involve costly fees. So an LLC provides easier transfer of interests in the property.
There are several advantages to an LLC owning real estate properties. However, there are some pitfalls when transferring titles: title transfer taxes and due-on-sale clauses.
Title Transfer Taxes
When transferring property from an individual to an LLC, it may trigger a title transfer tax. A title transfer tax is a fee a state or local municipality charges when a property changes title. Check if this applies in your state or local jurisdiction.
Additionally, if the property has a mortgage, transfer of title may activate a bank's due-on-sale clause. A due-on-sale clause means the bank wants immediate payment on the loan because the ownership has changed hands.
To avoid these triggers, it is wise to form an LLC before purchasing the investment property. Then, when you buy the property, you do so in the name of the new LLC.
There is another drawback. If you need bank loans for your real estate investments, lenders generally offer less favorable credit terms. In addition, there are fewer low-cost loan programs for companies than for individuals. So banks may charge a higher interest rate or ask for a larger downpayment.
Alternatives to an LLC
An alternative way real estate investors avoid liability is to get an umbrella policy on the property. For example, you may buy an insurance policy to cover you if there is a lawsuit.
Insurance is tricky, however. For example, you receive a lawsuit for $2 million, but your policy only covers $1 million. What if your umbrella policy doesn't cover the claim? Or what if, due to a lawsuit, your insurance premiums skyrocket or insurance companies refuse to insure you?
Real estate investors use limited liability companies to protect them from liability and reduce taxes. There are many other advantages to using an LLC to hold title to your properties. However, there are a few pitfalls to avoid. Therefore it is wise to talk to a real estate attorney to see if an LLC is the best option for your investment properties.
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