Real Estate Investing 101: Pros & Cons Of Using an LLC for Rental Biz
Source: Photo by Avel Chuklanov on Unsplash
There are a lot of things to think about when it comes to real estate investing. One of the most important decisions you'll need to make is the kind of business structure you'll use. An LLC (Limited Liability Company) is one popular option due to its protections, tax treatment, and raising investment capital.
But is it the best choice for your rental business?
Here's a look at the pros and cons of using an LLC for rental property investing to help you decide.
What is an LLC for Rental Properties?
An LLC is a business structure to hold your rental properties. Depending on your objectives and the LLC's operating agreement, you can form one with many shareholders or "members" in the structure.
The IRS sees LLCs as a "pass-through entity" for tax purposes. Although certain states might require an annual renewal fee, you don't pay taxes as a corporation does. Instead, it's similar to a sole proprietorship, S corporation, or real estate partnership. The profits and losses "pass-through" to each member and are reported on their personal tax returns.
All profits and losses are given to each member based on their ownership percentage in the LLC. But the members can elect a "special allocation" to allow any other weight distribution for profits and losses or other tax benefits, should they choose to do so.
Pros and Cons of Using an LLC for Rental Properties
With the LLC structure in mind, let’s go through the advantages and disadvantages of using one for investing in rental properties. Ensure that you read each point thoroughly to make the best financial decision for yourself and your family:
Benefits of Using an LLC for Rental Properties
So, if you’re eager to know if this is the right choice for you, here are 10 reasons to use an LLC for your rental properties and why:
Protects Your Personal Assets
Any lawsuits from the tenant will put your personal assets at risk if you're not incorporated as an LLC. With an LLC structure, only your business assets will be under threat if you’re sued.
Tax Advantages
You can choose between taking the pass-through option or being taxed as a corporation. In other words, you can choose to set up where there won't be taxes, as the income earned from the rental becomes yours. LLCs are always taxed as if they were partnerships
Management Flexibility
You have control of the management structure. So, you can have all members contribute to the daily decision-making process or assign property managers for it. You can also hire experts without contracting the work to a local property management agency.
Unrestricted Payments
There are no restrictions regarding how the company will pay its owners. In other words, members can be paid higher or lower than their equity share, so they receive additional or fewer write-offs for their expenses based on personal preference.
Deduct Health Insurance Premiums
If the properties are your primary source of income, then you can deduct all your health insurance costs. The amount is based on the prorated share of the LLC's net profits, which is your earned income.
US Citizenship Not Required
Depending on your governing jurisdictions, you might be able to accept foreign investors in your LLC. This means it's easier for you to receive foreign investments and have foreign investors as owners of your business.
Fewer Annual Administrative Requirements
You won't need documentation of shareholder meetings or the board of directors to renew or authorize processes. Just ensure that your articles of incorporation follow the expectations, and you can declare who has voting rights.
Single-Member LLCs are Possible
Solo entrepreneurs will love having a single-member LLC for rental properties, as they have the same business legitimacy as other structures while being easier to maintain.
Advantageous Property Acquisition
Purchasing rental properties through the business will give you additional ownership protections. The business will also control the property instead of your personal assets. Your company will be responsible for property maintenance, while you get to enjoy the equity gains generated over time
One LLC Per Property is Possible
For higher separation protection, each of your properties can be managed by its own LLC. In doing so, one property will not be affected by whatever happens to another one. Just be ready to handle extensive administrative costs and maintenance requirements of simultaneous LLCs.
Downsides of Using an LLC for Rental Properties
As good as all that sounds, it doesn’t paint the whole picture. On the flip side, here are 10 drawbacks when it comes to using an LLC for your rental business:
Limits to the Protections
Often referred to as "piercing the corporate veil," a judge can rule that the business structure doesn't protect your personal assets in case of a lawsuit. This issue often applies when you combine business books from your personal records
Self-Employment Tax for Pass-Through Income
Given that the tax structure of an LLC is like a partnership, all members have to pay the self-employment tax, responsible for the employer's Medicare/Medicaid and Social Security withholdings with each paycheck. The amount taxed is based on the total net earnings of the business.
Issues with Member Turnover
Continuity might be an issue for landlords. So, if you're the sole owner in the LLC and something happens to you, the state will require the company to dissolve—and your family will have to deal with business debts and lose your accounts before opening a new business to manage the properties
Can't Issue Equity Shares
You can't raise money by issuing equity shares of the business, because the equity is based on your initial articles of incorporation. Each member is assigned a portion based on that document, meaning it cannot be assigned to someone else. You also can't buy someone's shares, sell your own, or trade them.
LLC May Not Pay a Salary
Since LLCs are pass-through organizations to compensate their owners from the profits earned, when payments are sent to owners, the tax structure will see the action as a draw on the account--not counting against the income. You can't deduct the salary cost, so your tax can be higher in some circumstances.
Annual Filing Fees
Most governing authorities will require you to file an annual renewal notice with a fee that's close to the initial incorporation fee. There are exceptions, but most costs might force you deeper into debt (should you have one).
Separate LLCs per State
If you have properties across multiple states, you'll have to file for an LLC formation in each state where you want additional protection. You must also have an office or business address to conduct operations--separate from the actual rental property.
Tax Responsibilities
Both pass-through and corporate tax options require many tax responsibilities. You'll have to use Form 1065 to pass income through to the owners, and distribute K1 forms to each member to declare annual tax responsibilities.
- Struggle to Raise Capital
Since owners cannot buy, sell, or trade equity shares in the company, many investors may be hesitant to put in capital. Outside capital is also rare for the same reason. You'll have to get the funds you need to purchase or maintain the rentals under your care.
- Tax Structures like a Sole Proprietor
A single-member LLC will have the same tax structure as a sole proprietor, which means that even though you'll have reduced liability, the taxes you file will still be on the personal return. It's complicated enough that you might need a tax professional.
Protect Your Personal Assets—Especially if You Have an Extensive Portfolio
Still, remember that what’s advantageous for one investor may not be the same for another. Use your common sense, think through your investment goals, and perhaps even consult with a real estate attorney before creating an LLC for your rental properties.
The bottom line is that an LLC will protect your personal assets in the event of a lawsuit. If you have an extensive portfolio, the small cost of incorporation is well worth the protection you’ll get. If you only own one property, however, then you might want to skip the extra paperwork.
In our opinion, the small cost of incorporation is well worth the protection, given that you have an extensive rental property portfolio. However, if your “portfolio” only consists of a single property, then you might want to skip the extra paperwork and additional headache that comes with an LLC structure.
Do you need more help determining if an LLC structure is right for you? Comment your concerns below or message me directly. I’m more than willing to help you make the best decision for your investments.
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