Pros and Cons of Creating an LLC as a Rental Property Owner
Whether you’re a current owner of a rental property or considering purchasing one, you may want to own the property in an LLC. It’s not always a cut and dry decision, though. We’ve compiled a list of pros and cons to help you make a more informed decision.
What is an LLC?
First, let’s cover the basics. An LLC (Limited Liability Company) is a business that combines elements of a corporation, partnership and sole proprietorship. An LLC is generally a less complex business entity than a corporation and offers owners a variety of benefits they may not be available to other types of businesses.
Benefits of Creating an LLC
The biggest benefit of creating an LLC for your rental property is that it can insulate you from personal liability. Yes, you may have liability insurance, but if someone is seriously injured on your property, they can sue you personally for medical expenses and damages above and beyond the limits of your policy. If your property is owned by an LLC, your personal assets are protected in the case of an extreme loss or lawsuit.
Another benefit of setting up an LLC for your investment property is pass-through taxation. This means that the business does not have to file a separate tax return. Rather, any profits or losses will be reported on the owner’s (or owners’) personal income taxes. This is because the LLC is treated like a sole proprietorship or partnership and corporate taxes and regulations generally don’t apply.
The same protection is true if, as an owner, you are unable to pay contractors for work completed. Let’s say some unexpected renovations become necessary and you significantly underestimated the financial burden. Rather than continue at a loss, you choose to forgo development of the rental property and abandon the project. If your property is owned by an LLC, unpaid contractors can sue the LLC for compensation, but your personal assets are protected.
Setting up an LLC for real estate investment has benefits if you would like to purchase the rental with a business partner. Real estate LLCs make it possible for foreign ownership and investment options that are not available to corporations. So if you’re looking to partner with another domestic or foreign investor, you would be wise to consider setting up an LLC and having an Operating Agreement.
Drawbacks of Creating an LLC
While forming an LLC for your investment property might seem appealing based on what we’ve shared so far, there are a few drawbacks to consider.
There are setup costs associated with creating an LLC that can be significant (sometimes as much as $500). In addition, there are yearly administrative and regulatory fees required to maintain your LLC records. Before deciding to register your property as an LLC, we suggest you check your state’s Secretary of the State website to determine what fees you’ll need to pay to file for your LLC, as well as how much you’ll be spending yearly to maintain it.
In addition, if the LLC is a single member (one owner) then to secure a stronger position for any future legal challenges, you will need to operate the LLC activities as a separate entity by maintaining separate bank accounts, an accounting system that is separate from the owner’s personal expenses, leases and contracts always in the LLC name, etc. The more the owner can demonstrate the LLC does act as an entity separate from the owner, the more reliable the limitation on liability is. And that adds administrative costs.
We mentioned above the benefit of creating an LLC if you’re planning to partner with other investors. In the case of an LLC, all owners pay taxes on the company’s annual profits, whether or not they receive an actual distribution of those profits. Investors into corporations only pay taxes on the distributions.
In the District of Columbia, owning a property in an entity rather than as an individual makes the rental automatically subject to the Rental Housing Act of 1985 and its subsequent revisions. These regulations enforce rent control in residential housing and impose other restrictions on the housing provider.
One significant consideration is that financing a property as an LLC can be challenging and more costly than financing as an individual. Financing a real estate purchase as an LLC often requires building up a development track record with a bank. Loans are usually issued at higher interest rates. In addition you would likely be required to get a commercial loan which has less favorable financing terms such as a much larger down payment and a shorter term (no 30-year fixed terms). These factors combined could mean significantly higher mortgage payments.
Other Things To Consider
Creating an LLC before you purchase a rental property has benefits, but can also be done after the property has been purchased. You’ll simply need to transfer the deed to the LLC.
In some jurisdictions it is a simple and the transfer of title only requires a nominal fee (Virginia). In other areas, such as in the District of Columbia, such a transfer would require the payment of transfer taxes which can be a significant cost. If your property purchase was financed, the lender may not permit ownership of the property by any other person or entity than the borrower.
If you’re relying on an LLC to limit your personal liability, there are circumstances where it may not. In cases where business and personal funds are not kept entirely separate or you fail to maintain your business registration.Therefore, it’s important not only to set up the LLC properly, but to run and maintain it within the bounds of corporate law. A solid umbrella policy with your insurance carrier will provide another type of liability protection.
Lastly, if you have or plan to have more than one rental property, it’s beneficial to set up a separate LLC for each one. This is because all assets of an LLC are at stake if a lawsuit should arise. Therefore, if multiple properties are held by one LLC, all the properties owned by that LLC are at stake, even though the owner’s personal assets are not. If you have an LLC for each property, only that single property is at stake should a lawsuit involving that LLC be filed.
If you have any other questions about the benefits and drawbacks of real estate LLCs, please don’t hesitate to reach out to Columbia Property Management. We’re happy to help you find the best solution for your situation.