This is my attempt to definitively answer the question – should I form a single member LLC to hold my rental property or should I operate as a sole proprietor?
This is not legal advice. Consult a lawyer licensed to practice in your state.
The primary benefit of forming an LLC is liability protection. If someone obtains a judgment against your LLC (and not against you personally), then your personal property, including other LLCs that you own, is not at risk. If your LLC borrows money, you will not have personal liability for repayment (assuming you have not given a personal guaranty). If your LLC goes bankrupt and defaults on its contracts, there is a good chance you will not be personally liable for the breach of those contracts.
But there are two key areas of liability that an LLC does not adequately protect you from:
1. Liability for any action you personally perform or oversee. If I create an LLC for my dental practice, the LLC does not protect me from a lawsuit if I kill somebody by giving them too much anesthesia. I will be held personally liable. The same is true if I manage my own rental property and my tenant dies of smoke inhalation because my rental property didn't have any smoke detectors. The LLC might protect me if my property is managed by a professional property manager and the contract between the property manager and my LLC makes it clear that the property manager is required to install and maintain smoke detectors on the property. There is a good discussion of this issue earlier in this thread.
Note that this is not the same as "piercing" your LLC – a concept frequently discussed on these boards. There is no requirement that the plaintiff prove your LLC was a sham, or that you didn't maintain it properly. The plaintiff simply needs to prove that you personally were negligent.
2. Judgments against you that are unrelated to your rental property. If someone successfully sues you for hitting them with your car or defaulting on your credit cards, that judgment creditor can come after your LLC. Remedies vary by state, but every state at least allows a judgment creditor (anyone who wins a judgment against you) to obtain a charging order against your single-member LLC. The charging order entitles the judgment creditor to take your LLC distributions to satisfy the judgment. In some states, you can defeat the judgment creditor by not taking any distributions, but I do not consider this to be adequate liability protection.
Another potential benefit of an LLC is to create the appearance of legitimacy for your business. It may make it easier for you to keep your business and personal records separate and organized. An LLC allows you to hide your ownership of a property from the county records. If this is your intent, have a lawyer form your LLC for you to keep your name off of the filing documents.
There are costs involved in forming an LLC. You will have to pay filing fees. Most states require some type of annual filing, including a fee. Most people will need an attorney to draft their organizational documents and advise them on how to operate and maintain their LLC. In the context of the rental property business, an LLC can be a disadvantage because your LLC cannot qualify for government-subsidized financing through Fannie or Freddie. Rates are not as favorable for LLCs, even with a personal guaranty. Some investors will get a loan in their name and then transfer the property to an LLC. I don't like this strategy because it is a breach of your mortgage agreement. I understand anecdotally that lenders do not enforce the "due on sale" clause in this situation, but it would make a lot of sense for them to start enforcing it if mortgage rates increase significantly.
Having laid out the positives and negatives, here is my answer to the question:
If any of the following are true, you should operate as a sole proprietor because the LLC will not be worth the cost:
1. You want to borrow money against the property and you can qualify for financing through Fannie or Freddie. In my opinion, the benefit of government-subsidized financing through Fannie or Freddie outweighs the liability protection and other benefits provided by the LLC;
2. You have little or no assets, income or expectation of future income (in other words, you are judgment-proof); or
3. You don’t have the discipline and/or intelligence to keep the LLC separate from your personal business. This means conducting business pursuant to a valid operating agreement, conducting all of the LLC business through a separate bank account, keeping business records, and always signing contracts in your capacity as a representative of the LLC (and not in your personal capacity).
If all of the following are true, then you should form an LLC for your rental property:
1. You don’t plan to borrow any money against the property, or you can’t qualify for Fannie/Freddie financing anyway;
2. You don't live in California or some other state that charges exorbitant fees to form and/or maintain an LLC; and
3. You have either (i) some equity in the property, (ii) some other valuable assets, or (iii) a decent income or the expectation of a decent income in the future (you are not judgment-proof).
A couple of bonus thoughts:
1. If you are going to enter into any business with partners or multiple owners, then you should almost certainly form an LLC (or perhaps a limited partnership or corporation, depending on the situation). If you do not form an entity, you will be treated as a general partnership, which offers no liability protection.
2. The LLC would be my third line of defense against lawsuits. It can be a valuable tool in an asset protection strategy, but it is not sufficient by itself. The first line of defense would be to operate my business in a safe and responsible manner. The second line of defense would be to carry substantial amounts of liability insurance. If you have assets in excess of your liability coverage, get an umbrella policy.
