Benefits of starting a LLC

[T. Philip Washington]

Hi, we're working to buy our first multi-family property by July of this year. If there's already a thread addressing this issue, please point me in the right direction. Is it more beneficial to start a LLC and purchase our properties through the company for tax purposes? This is a general question about the pros and cons, as I realize that each person's situation may differ. Thanks.

[Jenni Utz]

As you begin investing one question that pops up- should I get an LLC? Well let's back up, what is an LLC? A limited liability company (LLC) is a type of business entity popular in the US. You register this entity with the State Department of the state in which you wish to do business. When the entity gets created through a series of executed contracts, that entity is legally not you. Even if you own and control the entity, it is treated as a separate “person” under the law. An LLC is similar in many ways to its more famous sister entity, the corporation. But corporations have existed for hundreds of years. Many laws, regulations, and traditions have been enacted over the course of those centuries to govern the actions of corporations. LLCs, by contrast, have only existed since 1977. With less case law and tradition that applies to them, they have a reputation of being flexible, versatile, and affordable compared to corporations, while conferring many of the advantages of corporations.

Pros of an LLC for your investment property- Limited Liability: The main advantage of an LLC is right in the name — limitation of liability. If a tenant gets injured on your property, they can pursue the owner for damages. But if the property is owned by an LLC, the LLC is the owner, not you. Remember, legally you are separate “people.” This means that the tenant cannot pursue you for personal damages, attaching your personal home, car, or wages in a lawsuit. After all, you don’t own the property! You just control the LLC that owns it. The scope of the lawsuit will be limited to the rental property itself — which is usually the only asset the LLC owns. By having separate LLCs for each investment property you own, a mishap on one property won’t put the other properties at risk. You Can Remain Anonymous-Property ownership is a matter of public record. If you don’t want prying eyes to find out about your property holdings, LLCs can be very useful. If a marketer, attorney, or bureaucrat looks at the property record, it will be the name of an anonymous LLC (assuming you give your LLC a generic name!) Pass-Through Taxation-One of the key advantages an LLC shares with corporations is the ability to elect pass-through taxation. This allows you to reap the tax benefits of your real estate investment on your personal tax returns, while still remaining legally separate from your entity. Easier to Maintain Than a Corporation-Corporations have strict rules for maintaining their legitimacy, including regular shareholders meetings, directors meetings, and strict keeping of minutes and financial records. The rules for maintaining an LLC are far less stringent. If you want a low-maintenance entity to shield your real estate investment, an LLC is the way to go.

Cons of an LLC for your investment property-It's Costly to Set Up and Maintain: You will spend at least a few hundred dollars setting up your LLC, including attorney fees and state filing fees. Once the LLC exists, it is a separate entity with a separate tax ID number … which means a separate tax return. If you pay a CPA or tax preparation specialist to do your taxes, expect to pay then for a whole extra return. (In all fairness, though, the tax advantages of a good real estate investment are often well worth the expense.)

Harder to Finance-Holding an investment property in the name of an LLC can present a problem for a mortgage lender. Most lenders do not allow LLCs to guarantee a loan — they require you, personally, to guarantee the loan. Lenders also don’t want the loan guarantor and the property owner to be different people, so you may have to buy the property in your name to get the loan. Many investors try to get around this restriction by buying the property, then immediately transferring title to the name of their LLC. But at that point, the title has technically changed hands — from you to your LLC. Many loans have a “due-on-sale” clause, affording the owner the right to call the loan due in full if the title changes hands. That doesn’t mean they will call the loan … it just means that property owners have to tread lightly when attempting this kind of maneuver. Must Maintain Separation-To enjoy the benefits of limited liability, you have to maintain separation between your personal affairs and the affairs of your LLC. This means using separate bank accounts, credit cards, etc. to keep your personal and business expenses and income separate. If you fail to do this, a plaintiff in a lawsuit could attempt to “pierce the corporate veil” and hold you personally liable for an accident or incident on the property.

Some Jurisdictions Impose Restrictions-Check to make sure that your jurisdiction doesn't impose restrictions on entity-held investments. For example, rental property owned by an entity in Washington DC is automatically subjected to rent control and other restrictions. BOTTOM LINE-Holding your property in the name of an LLC has benefits and drawbacks. However, most real estate investors believe that the benefits take priority, while the cons are manageable or circumventable. To limit your liability, enjoy tax advantages, remain anonymous, and protect your assets, holding that investment property in an LLC is an attractive option — one that many real estate investors elect.