Forming an LLC for a rental property is not always as good as it seems. There is concern over potential lawsuits, difficulties in expanding your portfolio, and the headache of navigating through complex tax filings.
But how important are these disadvantages really? And can an LLC actually provide the protection and benefits you want?
In this article, we discuss whether this should be the next step for your business or whether you should keep your rental property in your personal name.
What defines an LLC?
An LLC, or Limited Liability Company, is a type of business structure in the United States that combines elements of partnerships and corporations. This removes a lot of the responsibility of the business away from the individual as they are now protected with limited liability protection.
This means that members are typically not personally liable for the company if it were to go into debt and lawsuits that may arise may be covered by the state or insurance.
This business structure is therefore popular because of the benefits this provides as well as additional benefits like there being the flexibility to manage a team and allocate topics where you want and distribute money to members of a company legally.
If you don’t form an LLC, you will likely be working by yourself at a smaller scale so your rental property portfolio won’t be that large and you won’t be able to collect as much rental income. An LLC allows you to scale and remove the large amount of debt you’ll take on from the individual.
What other options are available other than an LLC?
If you don’t want to form an LLC, there are other options you can take advantage of. These include things like partnerships and sole proprietorships we will go into below.
A sole proprietorship is the simplest and most common form of business organization. With this structure, profits and losses from the rental property are reported on your personal tax return and you are effectively going into business as an individual.
There are also partnerships, corporations, and trusts which are forms of setting up a company that protects against specific situations. For instance, a trust will protect an owner’s business if they were to pass away
What are the disadvantages of forming an LLC?
While a Limited Liability Company (LLC) can offer may seem like it is more secure and there are benefits to it. There are in fact a lot of negatives to weigh up.
#1 You won’t be able to get a mortgage as easily
First of all, securing a mortgage as an LLC can be more complex than doing it as an individual. This is because many lenders are hesitant to lend to LLCs due to an increase in the perceived risk.
As a result, even those that do might charge someone higher interest rates and fees to cover the increased risk anyway. Hence, one way or another, most lenders will want to be covered in the situation that something can go wrong.
Lenders are always very invested in the property deal just like the person who is taking out a mortgage because if there was anything to go wrong with the property legally like if there was an issue with the LLC. This impacts both the lender and the property owner.
#2 You cannot scale a portfolio as quickly
Because of the complexity of obtaining a mortgage, scaling a property portfolio also becomes slower.
So, establishing each new property as an individual LLC can slow down the process of scaling up your rental property portfolio because the time and effort required for setting up an LLC, combined with the potential challenges in securing financing, can make rapid growth more difficult.
On top of this, you may choose to form different LLCs for different rental properties or different developments to safeguard each investment which can take additional time.
For instance, if you have rental property developments, if one was to go bankrupt, the LLC would perish but the others will still be able to operate without the need for those to spend their cash flow on the failing LLC.
#3 You will have to pay for your certification annually
Unlike individual ownership, maintaining an LLC comes with ongoing costs and most states require an annual or bi-annual report along with a filing fee in order to still call yourself an LLC.
These recurring costs can add up over time and need to be factored into the financial planning of your business. If you were to set up a rental property without an LLC and do it individually, this will certainly not be a cost for you and you can keep some extra profit.
#4 Filing fees vary by state
The initial formation of an LLC often comes with a filing fee, which varies by state. Some states also impose additional fees for tasks such as amending the LLC or dissolving it.
This is hard because if you are a landlord or property owner who has various rental properties, this can get hard to manage and keep on top of and you may have to hire additional help to keep on top of your legal expenses.
Sometimes, a filing fee can be so much that it stops the property from being profitable which is something that all landlords should aim to avoid if they can.
#5 There is additional paperwork with an LLC
Creating an LLC involves drafting an Operating Agreement, which outlines the LLC’s ownership and how things operate. This is on top of the paperwork required to form the LLC so there is this expense as well.
#6 There are complicated tax returns to understand
While LLCs have the advantage that profits and losses are reported without it being attached to the individual, things could get especially complex if the LLC has multiple members, adding to the cost and time burden of tax preparation.
In the worst of situations where these calculations are done wrong, you could face the IRS pursuing you to find out if you have paid the right amount of tax. If you have done wrong, this could carry a fine or a prison sentence.
In the same way, a member of your own LLC can also file a case against you if they believe they have been paid incorrectly, even if you are able to show them that you have paid them in the right way.
Hence, if you have a large board of members in an LLC, it is always best to make sure that you hire an attorney or an accountant who can help you with the legal aspects of your business if things are especially complex. But this will result in another business expense.
#7 There aren’t many benefits to tax that impact you personally
An LLC offers the benefit of being able to deduct business expenses through a company that isn’t able to be taxed. However, most of the tax advantages are related to business expenses and do not really benefit the individual.
For instance, if you have a mortgage payment as a business, you will have to be able to take this away from the revenue of the business and then pay yourself a salary or take money out of the business through dividends. However, if you did it as an individual, the expense can be written off straight away.
If you find this complicated, there are many online tools that you can use such as property management software, lofti for instance that will track a business’s expenses and income.
#8 You will no longer qualify for the homestead exemption
If the rental property is also your primary residence, transferring the title to an LLC could make you ineligible for the homestead exemption, a tax benefit available to homeowners in many states.
In this way, it is important to find a business that suits your lifestyle and if you would prefer to keep your homestead exemption then an LLC may not be for you.
#9 Transferring property can get complicated
Transferring property into an LLC can potentially trigger a due-on-sale clause in your mortgage agreement.
It can also have tax implications, depending on the value of the property and how the transfer is structured.
#10 The impact on JV partners
If you’re involved in a joint venture (JV), moving properties into an LLC could complicate relationships with your partners. This might impact the distribution of profits, decision-making, and the overall dynamics of the partnership.
Sometimes, it is best to keep things simple and keep things as an individual and then pay out the rest of the people who are involved in the deal later on.
However, in this case, be sure to still have contracts and agreements in place whether that be online or offline. Learn more about how to do this offline by reading our article on DocuSign here.
#11 You will have to learn new management structures
Managing an LLC can be different from managing properties as an individual. This includes keeping separate finances for the LLC, understanding state laws that govern LLCs, and possibly dealing with additional regulatory requirements.
#12 Tenants may not want to rent from a corporation
Some tenants might feel more comfortable renting from an individual than a business entity. They might perceive an LLC as more impersonal or assume it will be less responsive to their needs compared to a private landlord.
This is shown to be the case because the data on real estate shows that those who have the best experience in their rental property are in regular contact with their landlord.
#13 You are not 100% exempt from being personally responsible
While an LLC provides a level of personal liability protection, it does not provide complete immunity. Under certain circumstances, like fraud or illegal activities, courts can “pierce the corporate veil,” holding members personally responsible.
#14 There is limited protection
While an LLC does provide liability protection, this protection is limited. If your LLC is sued, the assets of the LLC might be at risk, which could include your rental property. Furthermore, LLC protection generally doesn’t cover personal acts of negligence or wrongful acts committed by the members.
What are the advantages of forming an LLC?
There are a few advantages of an LLC that you can learn from including the fact that there are tax advantages and you can also benefit from the peace of mind of having your personal finances and business expenses separate.
#1 Have Access to Tax Advantages
While forming an LLC for a rental property does provide certain tax benefits, such as the ability to deduct business expenses and potentially avoid double taxation, it’s important to note that not all tax advantages are beneficial to the individual member.
For instance, personal tax benefits, like the mortgage interest deduction, may be more limited under an LLC compared to personal ownership. Furthermore, although LLCs enjoy pass-through taxation, they could still require a separate, more complex tax return, especially if there are multiple members involved
#2 Separate Business and Personal Finances
One of the primary reasons for forming an LLC is to separate personal finances from business finances. This is certainly a benefit in terms of protecting personal assets from business-related lawsuits or debts. However, this separation also introduces additional administrative responsibilities.
You’ll need to maintain separate bank accounts for the LLC and ensure all business transactions are made through the business account. Failure to maintain this clear separation can potentially jeopardize the liability protection an LLC provides.
#3 You Can Remain Anonymous
Establishing an LLC for a rental property can provide a certain degree of anonymity, as the property would be officially owned by the business entity, not you personally. While this can add a layer of privacy protection, it’s worth noting that the level of anonymity largely depends on the state where your LLC is registered.
Some states require LLC members to be listed in public records. Additionally, complete anonymity might not always be desirable, as some tenants could be wary of renting from a faceless corporation rather than an individual landlord.
All in all, forming a Limited Liability Company (LLC) offers distinct advantages for managing a business, such as providing personal liability protection, facilitating tax benefits, allowing more flexible management structures, and the potential for scaling a business.
In particular, when it comes to rental properties, an LLC can offer a shield against personal liability in debt situations and lawsuits.
The choice of forming an LLC should therefore be based on individual circumstances, factoring in potential risks and benefits while considering one’s personal goals and the nature of the business being operated.
Using this understanding, you should be able to find the best scenario for your situation whether that be within an LLC or other options.