If you own a rental property, you may be considering the pros and cons of forming an LLC.
A limited liability company (LLC) is a popular choice for a business entity structure due to the limited liability protection and pass-through taxation advantages it provides.
In this article, we explore common LLC business structures for rental property owners, the advantages and disadvantages of LLCs, and how to form an LLC.
LLC business structures for rental properties
There are several options when choosing an LLC business structure for your rental property. Choosing the best one for you depends on your business needs and the state where you’re located.
1. LLC
An LLC is a business entity that is separate and distinct from its owners. An LLC shields the owners from the company’s debts and liabilities by separating the business from the personal assets of the owner(s).
By law, the owners (or members) of the LLC have options for managing the LLC. You can elect to manage the LLC yourself, or you can elect a manager or managers to run it for you. These roles and responsibilities are defined in the LLC operating agreement (which may be amended over time).
2. Series LLC
A series LLC (SLLC) is a variation of a traditional LLC. It can be used to operate several lines of business or investments and insulates each from any owner debt or liabilities.
Think of an SLLC as a group of LLCs owned in a tiered structure. At the top of the tier is the overarching LLC which owns and controls the lower tier LLCs, each of which has independent assets from the others. Each LLC has its own owners (members) and is liable for its own debts and obligations.
Without a series LLC, these businesses would need to establish separate LLCs for each aspect of their operations to achieve equivalent liability protection.
Not every state allows businesses to establish a series LLC. Certain states, like California, prohibit the formation of SLLCs but recognize series LLCs established in other jurisdictions to operate within their borders.
Also, the tax treatment of SLLCs is fuzzy. Guidelines across states are not uniform or consistent. In some states, an SLLC is a single taxable entity, in others they are viewed as multiple taxable entities.
Advantages of using an LLC for a rental property
Below is a list of advantages to using an LLC for your rental property.
Separate legal entity
Because an LLC is a separate entity from its owners with its own rights, responsibilities, and liabilities, it can file a lawsuit or sue another entity in its own name. An LLC can also buy, own, and use its own property, create its own contracts and guarantees, lend money, and invest funds.
Limits personal liability
Creating an LLC for your rental property allows you to oversee property management while protecting your personal assets from any legal action. With an LLC, only the company bears responsibility for such liabilities, not its owners or managers.
However, forming an LLC doesn’t absolve you from personal liability for your own negligence, malpractice, or other wrongdoing related to your business.
Nevertheless, having an LLC offers protection to owners against personal liability for any misconduct by fellow owners or employees during business. If the LLC faces legal action and is deemed liable for the negligence or misconduct of its owner or employee, the LLC's assets may be seized by creditors to settle the judgment against the LLC. Yet, the LLC's owners would not be personally responsible for that debt. While the individual who committed the wrongdoing may still be personally liable for their actions, a co-owner of the LLC who was not involved in the wrongdoing would be shielded from personal liability.
Pass-through taxation
The income of an LLC is taxed as pass-through income to the LLC’s owners/members. This means that no tax filing is required by the business. Pass-through taxation avoids the predicament of double taxation that often impacts corporate companies.
A single-member LLC can also deduct mortgage interest on the property. However, this deduction becomes more complex in multi-member LLCs, partnerships, and corporations. Check with your tax attorney or CPA to understand your tax situation.
Investing with partners
LLCs can be single-member or multi-member. If you partner with investors to purchase rental properties, it’s advisable to form a multi-member LLC. This structure provides protection for all investors’ personal assets. Be sure to have a robust LLC operating agreement in place, this will ensure that financial decisions are made ahead of time and simplify any transactions.
Challenges when using an LLC for a rental property
Below is a list of disadvantages to using an LLC for your rental property.
Entity costs and obligations
LLCs are subject to certain fees and regulatory requirements. These include state formation fees, registered agent requirements, and recurring annual report fees and franchise taxes. These fees and requirements apply in all states in which the LLC is registered to do business – and costs can quickly mount up.
Failure to keep up with these obligations can result in the loss of the LLC’s right to do business as a statutory entity and associated advantages (including limited liability).
An LLC for a rental property may also be required to file a Beneficial Ownership Information (BOI) report with the U.S. Department of Treasury’s Financial Crimes Enforcement Network (FinCEN).
Other tax and legal implications
Depending on the jurisdiction of your rental property, transferring the property to an LLC may trigger tax and/or legal requirements, such as capital gains and transfer taxes.
Another step you’ll need to take is updating your insurance policies. Personal insurance policies may not provide coverage once the property is under the control of an LLC.
Due on sale
Operating a rental property as an LLC may also activate the due-on-sale clause of your real estate loan and mean payment is due in full. Consult with your lender to ensure you understand the ins and outs of your loan terms.
Financing difficulties
Obtaining mortgage financing for a rental property that has been structured as an LLC may be challenging. Lenders generally view an LLC as an independent legal entity distinct from its owners (members) that protects them from personal liability relating to the company's affairs. When an LLC seeks a mortgage, lenders assess the entity as a business rather than an individual borrower. Consequently, the lender scrutinizes the LLC's creditworthiness, financial track record, and business operations.
Furthermore, to offset the risk to the lender, LLC mortgages have stringent eligibility requirements and high borrowing costs.
How to form an LLC for a rental property
The steps for forming an LLC vary by state. Here are the basic steps.
- Decide on a formation state: Most LLC owners form their company in the state in which they plan to operate, but there may be times when you should consider forming your LLC in another state.
- Select a name for your LLC: Follow state laws about which names are acceptable for your LLC.
- Appoint a registered agent: An LLC must have a registered agent to receive important legal notices and tax documents on behalf of an LLC.
- Prepare an operating agreement: An LLC operating agreement (or LLC agreement) is a key document that establishes the rules and structure for your LLC and can help address any issues that arise during business operations.
- File LLC formation documents: These must be filed with your formation state.
- Obtain an EIN: An EIN or Employer Identification Number can be obtained from the IRS.
- File BOI report. Unless your business is exempt, you will need to file a beneficial ownership information report through FinCEN’s BOI E-Filing System.
- Open a business bank account: Having a separate account to your personal bank account can help avoid piercing the corporate veil and losing your limited liability.
- Foreign qualification: Register to do business in other state if needed.
For more information on LLCs see, How to form an LLC.
Ready to form an LLC for your rental property?
BizFilings can help you create your LLC online in three easy steps. We’ve helped many small businesses start an LLC. We guide you through the steps and make sure the process is done right. But we don’t stop there, our experienced team, comprehensive services, and exceptional value is with you through the life of your business, whatever your LLC needs. Learn more.
