LLC or LP? Which Entity is Best to Protect my Rentals?

As an investor in long term holds I know the importance of making sure that I am protected from any liability exposure associated with my investment property.  The question becomes should I use a Limited Liability Company or a Limited Partnership for asset protection purposes with my rental properties?

Having consulted and educated thousands of investors across the country I have seen both LLCs and LPs used to hold rental properties.  Both entities are extremely well situated to protect properties from unrelated liability exposure (called outside liability).  However, there are two distinctions that make LLCs better suited to hold rentals and lease options.

 The first benefit deals with inside liability exposure.  This type of harm occurs within the entity itself and is associated with the property.  In a Limited Partnership with have two classes of partners: General Partners and Limited Partners.  Limited Partners are able to contain their risk exposure to what they have invested in the business because they are completely passive investors.  As passive investors, the Limited Partners are not able to participate in the management or running of the business.  The General Partner is in total control of how the business is to be run.  In exchange for the control, the General Partner is subject to unlimited liability exposure.  Therefore, if a tenant is injured not only can the General Partner lose his or her investment in the business, but the General Partner can have all of his or her personal assets at risk  as well.  The way to avoid personal unlimited liability is to use an entity such as a corporation to serve as the General Partner.  Conversely, an LLC has Members and Managers who are both protected from unlimited liability exposure if an injury occurs within the LLC.

 The next distinction is directly related to our tax benefits of holding long term properties.  As investors, we are able to capture the depreciation of our long term holds on our 1040 returns (subject to income thresholds).  In order to be eligible to capture the depreciation we must have some participation in the operation of the investment property.   Unfortunately, I encounter many people who have gone to their local attorneys and those attorneys completely ignored tax consequences and placed the rental properties in LPs for asset protection.  If you place your rental property in a LP and you are the Limited Partner, you lose your ability to capture your depreciation on an annual basis because a Limited Partner cannot participate in the operation of the business.  This is a huge mistake when it comes to tax planning.  However, if you use an LLC for your investment, you do not lose the ability to capture your annual depreciation because even a passive Member within the LLC can participate in the operation to an extent that would allow for the full capture of the annual depreciation. 

When it comes to proper planning for asset protection, be diligent to ensure that you will not only receive the best level of protection but that your plan does not hinder proper tax planning.  In almost all circumstances, LLCs are the preferred entity to provide not only asset protection for your investments but also solid tax planning.