Setting up LLCs Before Getting Started -- Operating AND holding?

Question

Hello everyone,

I am searching for my first buy & hold investment.  I am starting to think that it is in my best interest to set up an LLC to protect my assets and insulate a property from some degree of liability.  So, I wanted to get some of your thoughts on this process, especially on setting up holding and operating LLCs.  Please feel free to answer any one of these questions.

-Q1: Do you recommend that a new investor set up an LLC before acquiring their first property?  I know this is a contested issue and depends on the individual.  While I do not have any personal assets right now (currently a graduate student), I want to avoid having to later assign/transfer/sell the property to a LLC and invoking a due-on-sale clause.

-Q2: While I plan on investing in NJ and PA, do you recommend setting up the LLC in the states where you do business or in Delaware?  From my experience in law school, I assume Delaware is standard because of the pro-LLC laws there.

-Q3: Do most investors have one LLC per property or multiple LLCs (operating AND holding)?

-Q4: If the latter, what is the basic structure of operating and holding LLCs?  Is the operating LLC basically a project management company where all business involving the property is conducted from that LLC?  And the holding company simply holds the asset?  Does the operating or holding LLC acquire and finance the deal?  Is there a way to set up a deal where the operating LLC does all of the groundwork, communication, and negotiation with the seller but holding LLC acquires the property as part of the deal?

-Q5: What are the advantages of having both the operating and holding LLCs?  Are there any disadvantages, such as additional cost?  Does this structure protect your property from legal disputes with the lease because the operating company entered into the lease but still leave the property at risk for accidents that happen on the property as the holding LLC owns the asset?

Thanks,

Ian

Omar Khan · Answer

@Ian Livaich You are putting your lawyer hat on and, technically, doing the right thing. But due to the amount of capital involved (1 property, assuming it's not a multi-million $ one), I would say that you are over complicating the issue. I am prone to doing the exact same thing when it comes to building financial models and valuation (background is in institutional finance).

1) If you plan on acquiring multiple properties in a short period of time, I would suggest setting up an LLC. Alternatively, you can always get a bigger umbrella insurance for the time being.

2) For your particular case, there wouldn't be too big of an advantage going the Delaware route. Again, this is only because of the capital involved. Bigger companies use Delaware due to the complexity of operations and size of invested capital.

3) Some investors have one LLC, but, honestly, if you're buying and holding SFRs, IMO, it's best to throw in a few properties under one LLC to avoid the costs and hassle of accounting for multiple LLCs. Again, you can get a bigger umbrella insurance to avail some of the "asset protection" benefits at the fraction of the cost and headache.

4) Currently, you don't need operating and holding LLCs. Hopefully, you'll become a tycoon and go down the route soon. Save costs, save the hassle and save yourself the inconvenience.

5) Additional cost, hassle, inconvenience. It becomes a PITA  to manage multiple accounts and stay on top of the finances while holding down a full-time job and having a life.

Best of luck!

Lumi Ispas · Answer

@Ian Livaich , great questions. I advise you though to start looking at properties first. If you plan to finance them, talk to your lender and see if they allow you to buy in an LLC.

As you are at the beginning, you might be starting smaller, with a residential property, meaning, most of the time you won't be able to finance in an LLC. If you do start with a commercial property, and the lender is okay with the LLC, then when you write the offer, just write it in your name, or/and assignee and just open up an LLC after you got your offer accepted and close in that company.

There is no benefit to have opened the LLC earlier unless you buy for cash an REO property which requires that you don't change the name of the buyer.

All the answers above from @Omar Khan , @Steve Vaughan and @Eve Mahoney are great answers.

Registering your company in Delaware might not be as helpful as you think.

After you buy your first property, reevaluate your goals and financials and sit down with an attorney to plan the way to buy the next properties.

I will say focus on taking action first and make sure you don't get into analysis paralysis which I see quite often.

Resolve what type of property you want to buy, and start looking and writing offers!

Steve Vaughan · Answer

I have LLCs to hold my commercial assets and an s-corp as mgt co. Mostly for anonymity and retirement plans.

For little houses with debt, I own personally, act above board and carry good insurance.

For little houses without debt and that I never plan to leverage, LLCs are fine.

The biggest questions for me are what asset type? Will debt be involved?

Try getting that awesome Fannie financing for a house inside an  LLC. Insurance co's are also confused by a little house inside a business entity.  Harder to finance and insure. Asset protection?

Eve Mahoney · Answer

Q2: No matter what state you live in and no matter what state you organize an LLC in, you will owe taxes on the income to your home state.  If you buy property in a state you will probably have to register your LLC in that state even if it is organized in Delaware.

I am in California.  If you, as a NJ resident, organized an LLC in Delaware and purchased property in California you'd be considered to be doing business in California, your LLC would have to register in California and file a California tax return. I don't know if this holds true in every state but odds are it does.

What advantage do you get/hope to get by organizing in Delaware?

Jay Helms · Answer

@Ian Livaich - congrats on taking the plunge!

Q1 - as you said , this depends. Thing to note about titling a property to an LLC is the loan type. You’ll have to go with a commercial loan, which has different terms than a conventional.

Q2 - personal preference, but mine are in the states in which the properties are located. I have heard Delaware and NV are really LLC friendly though.

Q3 - also depends. The advice I receive the most is to limit my exposure per LLC, either per units or by overall value.

Q4 & Q5 - not sure, I haven’t heard this one before, especially for just starting out.

Depending on the type of property you buy, you can always title in your name and grab an umbrella insurance policy to enhance your liability coverage.

Costin I. · Answer

Ian, your Q1-Q4 are more like Q1-Q20 questions and no good answers will not open another 10 questions each for you. You just entered the Wonderland of asset protection and you need to understand how the LLCs play along with land trusts, insurance, property management, estate planning, etc. to form together a toolbox to use in your investment journey and in the minefield of financing, DOS, leases, tenants, litigation, etc. I went down these rabbit holes and I can send you my notes gathered after many hours of research.

My advice on JV/partnership with a family member is: don't. Get a loan from them and treat it like any other mortgage. Or at least, understand what is involved in a partnership and how to protect yourself/them in a JV. I can send you a checklist for JV.

Omar Khan · Answer

@Ian Livaich Without knowing more details or the extent of the involvement of your family member, I will offer my surface-based opinion. You should sign a promissory note backed by the property i.e. they are the "bank" offering you a mortgage. Hopefully, you will also buy umbrella insurance.

In this case, regardless of the actions of the tenant against you, you still owe your family member a promissory note.

You can write whatever terms 2 parties agree into a contract. Hence, you agree to pay back the promissory note (at certain terms) plus a percentage of free cash flow generated from the property.

I would advise to not start paying additional free cash flow from Year 1. You want to build reserves for the bad times.

You can PM me and we can discuss this in detail.

Ian Livaich · Answer

@Mike Taddy Thanks for your suggestions, Mike.  I did comb through the forms and blog posts, which were helpful but did not directly fit with my situation so I decided to make my own forum post.  Great tip about connecting with a local RE mentor who can point me in the direction of a lawyer specializing in these fields.  I am planning on attending my local REIA meetings this month.

@Eve Mahoney Definitely sounds like forming the LLC in the state that I will be doing business is a better option to save on costs.  Appreciate it!

@Steve Vaughan Thanks for your advice, Steve.  The asset type would be SFR and possibly small multifamily.  The first deal or two would likely be all cash but a conventional loan is always an option.

@Lumi Ispas Great insight, Lumi!  To confirm your inclination, I am looking at residential properties exclusively, mainly SFRs and possibly small multis.  Have you had any problems with the due-on-sale clause when transferring properties into an LLC?  Also, what are the typical terms for commercial loans for LLCs?  I have heard to expect a 5% interest rate and a 15 or 20 year amortization period.  Also, thanks for the actionable advice on just getting started.  I will make it my goal this week to start analyzing X number of properties per day and start making offers soon!

Ian Livaich · Answer

@Omar Khan Thanks for hitting all of the questions!  Your answers are extremely helpful.  I think your conclusion is spot on: have 1 LLC that holds a few properties to save on costs (Brandon Turner mentioned on the podcasts that this is what he does for each partnership structure) and perhaps change this structure if I have a sizable portfolio in the future.

Taking it one step further, I have a family member that is looking to fully finance my first property (and possibly more after that) while I would do most of the groundwork for the property.  We are looking to split profits 50/50.  However, he has assets that he wants to protect.  Because I have little-to-no assets to protect as a graduate student, what are your thoughts on this alternate structure (hopefully I got the mechanics right):

My name is on the deed of the property and my family member becomes more like a private lender with a promissory note and deed of trust being executed.  That way, if there was an issue with the property, the tenant could only come after me but not my family member.  Also, if the "mortgage" is recorded, any lawyer will realize that I have little to no equity in the property.

I am trying to eliminate any risk to my family member's assets.  Is there a way to structure private lender deals where the lender receives a percentage of the profits rather than interest only payments?  Or should I look more into forming a JV or LLC at that point?

I am thinking about making this question its own forum post but wanted to get your take first.

Thomas S. · Answer

Until the point in time that you have actual employees it is not usually necessary to have a LLC. One would have more than enough protection with adequate insurance coverage.

The prevailing opinions on the value of having a LLC is split and statistical about 50% of investors will go the LLC route. It may depending on the state you operate in but primarily is physiological protection.

Talk to your accountant before you proceed.

Setting up LLCs Before Getting Started -- Operating AND holding?

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