An LLC is a limited liability company. It is a hybrid business structure available in the United States which combines the advantages of a partnership with the liability protections offered by a corporation. That is why many landlords look at this business structure when thinking about how they want to structure their finances around a rental property.
About 2.4 million businesses in the United States currently identify themselves as an LLC. The structure was first offered over four decades ago in Wyoming and has grown faster than any other business type since them.
Today’s LLC is permitted to have one member or many, which is the term used to describe the owners of the business. A member can be an individual or another business. Unless otherwise mandated by law, LLCs have no limit to the number of members which are associated with the company.
If you’re thinking about renting a property, or if you’re wanting to explore better financial protections for yourself and your family, then here are the pros and cons of using an LLC for rental properties to review.
List of the Pros of Using an LLC for a Rental Property
1. Forming an LLC will help to protect your personal assets.
If rental properties are part of your investment portfolio, then one of your basic requirements is to provide a property which is up to code. Should that not happen for some reason (even if it is through no fault of your own), then the tenant of the property may be able to sue you for the conditions which are present. Any lawsuit which names you will put your personal assets at risk if you’re not incorporated as a limited liability corporation with your property.
Under the LLC format, only your business assets would be under attack if someone were to sue you.
2. There are tax advantages available to the LLC format.
A limited liability company in the United States is presented with a taxation choice. You can either take the pass-through option or be taxed as a corporation. That means you can set it up where the business doesn’t pay any taxes because the income earned from the rental property becomes yours. Since 1988, the U.S. has taxed LLCs as if they were partnerships, even though they offer personal asset protection against liability.
3. Liability insurance products have policy limits.
Outside of the LLC structure for real estate investments, landlords have the option to purchase liability insurance to protect their personal assets. By purchasing a policy, you do gain an advantage over the business structure because you’ll save time and money since you aren’t required to file formal paperwork with your governing jurisdiction. It is essential to remember, however, that all insurance policies have maximum limits which are paid. If an event is financially damaging to someone beyond those limits, you could still be sued, with your personal assets at risk, for the remainder of the cost.
4. Management flexibility is permitted within the LLC structure.
When you structure your rental property business as an LLC, even if it is only one property, you’re given flexibility with your company’s management structure. You can have all the members share in the daily decision-making for the business or designated managers who make those decisions for you. If you are unfamiliar with the benefits and risks of rental properties, this business structure allows you to hire people who are familiar with the responsibilities without contracting the work to a local property management agency.
In most states, your LLC will be member-managed by default unless you state in your filings that you intend to hire managers.
5. It is cheap and easy to start an LLC.
Although there are more paperwork requirements with an LLC when compared to a partnership or sole proprietorship, it is easier to file for this business structure than it is to create an S-corporation or C-corporation. Many states have the filing fee at $500 or less for the initial startup of the business. In Arizona, the filing fee may be as low as $50. Each state is a little different in their costs and requirements, so be sure to review every step of the company formation process to know what will be expected of you.
6. Payment is not restricted to the owners of the LLC.
When using the LLC structure for a rental property, there are zero restrictions in place regarding how the company will pay each owner. Members can be paid more or less than the equity they own in the company. That structure allows each member to receive additional or fewer write-offs for their expenses or reimbursements based on individual need. The only exception to this advantage is the single-owner LLC, which offers the pass-through feature allowing for all profits to be sent to the owner anyway.
7. You can deduce health insurance premiums under this business structure.
If rental properties are your primary source of income, then you are permitted to deduct all of the health insurance costs you pay for yourself and your family. The amount permitted with this advantage is based on the prorated share of the net profits earned by the company. All profits within the LLC count as earned income. Every member that earns an income through the LLC qualifies to take advantage of this unique benefit.
8. You’re permitted to contribute assets to the company.
Owners are permitted to contribute assets to the LLC, even if the primary reason to form the company was to manage properties. You’re permitted to contribute capital to the company. Personal loans from your account to the LLC account are allowed as well. There are several different ways that individual members can put money into the business, then take it out again as a repayment for the loan. Reasonable interest is even permitted when repaying a personal loan given to your LLC.
9. Owners of an LLC are not always required to be U.S. citizens.
This advantage does not always apply, so check with your governing jurisdiction before including foreign investors in your ownership structure. When it is permitted, your LLC allows foreign owners to be part of your business structure. That makes it easier to receive foreign investment for your rental properties while your investors have fewer barriers to market entry to hop through. Foreign members are given voting rights as active owners of the LLC.
10. There are fewer annual administrative requirements associated with an LLC.
When you form an LLC to manage rental properties, there are some annual paperwork requirements that your governing jurisdiction requires to keep the business open. You’re not tasked with documenting shareholder meetings or offering minutes from the board of directors as part of the renewal or authorization process. As long as your articles of incorporation follow local expectations, you may be able to declare who is permitted voting rights and who is not within your structure.
11. Single-member LLCs are possible.
If you are a solo entrepreneur, then the single-member LLC for your rental properties is an idea to consider. They don’t offer the same business legitimacy as other structures, but they are easier to maintain with the same pros and cons for the most part. The protections afforded to the LLC tend to work in reverse under this structure. The personal obligations of the owner don’t affect the business, but if you don’t keep separate books for the company, a court may rule against protecting your personal assets from business dealings.
12. Property acquisition through the LLC offers advantages to consider.
If you acquire new rental properties through the business, then you may have access to additional ownership protections. It would be the business, not your personal assets, which would control the property. Should something happen, you may be afforded more protection from outside lawsuits or issues. Your company would then be responsible for the care and upkeep of the property, while you’d get to take advantage of the equity gains happening over time with the rental.
13. Each property could be managed by its own LLC.
For owners looking to have the highest level of separation protection possible, you could incorporate each rental property as its own LLC. By doing this, you’d be able to insulate each property from potential liability claims generated at another property. The lawsuit would affect the one property only.
Of course, the administrative costs and requirements of maintaining several LLCs simultaneously would be extensive. That is why most landlords choose not to pursue this specific advantage when using an LLC for their rental properties.
List of the Cons of Using an LLC for a Rental Property
1. There are limits to the protections an LLC provides.
If your LLC is named in a lawsuit involving your property, the judge does have the capacity to rule that the business structure doesn’t protect your personal assets. Although this issue applies when you don’t keep separate business books from your personal records, or you’ve conducted business in a fraudulent manner, it isn’t 100% protective. This disadvantage is often referred to as “piercing the corporate veil.”
2. You must pay the self-employment tax for pass-through income.
Because the default tax structure for an LLC is similar to that of a partnership, your members who work for the business must pay the self-employment tax in the United States. That means each member is personally responsible for the employer’s share of the Medicare/Medicaid and Social Security withholdings that are required with each paycheck. The amount taxed would be based on the total net earnings of the business.
Owners do have the option to be taxed as a corporation, which would limit this issue because you’d be taxed on actual compensation instead of your pre-tax profits.
3. There are issues with member turnover to consider.
An LLC is like a partnership or sole proprietorship in the fact that continuity can be an issue for some landlords. If you’re the only owner in the LLC and something happens to you, then the state where your business resides will require the company to dissolve. That means your family would be required to resolve business debts and close your accounts before they could start a new business to manage your properties.
You can avoid some continuity issues as a married couple by being co-owners of the LLC. Even then, however, you may still be required to dissolve the first company before starting a second one to keep doing business.
4. You are not permitted to issue equity shares for your business.
Under the structure of a limited liability company, you’re not permitted to raise money by issuing equity shares of your business. The equity which is available in the company is based on your initial articles of incorporation. Each member is assigned a portion of the company based on that document. It cannot be assigned to someone else because it doesn’t hold the same value that a corporate share holds. You are not permitted to buy someone’s equity shares, sell yours, or trade them.
5. The LLC is not required to pay a salary.
Most LLCs are designed as pass-through organizations to compensate their owners, especially single-owner companies, from the net profits earned. That eliminates this disadvantage for most landlords who use the structure to manage rental properties. When payments are sent to owners, the tax structure treats this action as a draw on the account. That means it doesn’t count against the income of the company like it would for an S-corporation or C-corporation. Because you’re not permitted to deduct the salary cost, your tax obligations could be higher in specific circumstances.
6. An annual filing fees is usually required to maintain the status of your business.
Most governing entities require operational LLCs to file an annual renewal notice as part of their administrative maintenance responsibilities. Most states in the U.S. keep the renewal fee to a cost that is close to the initial incorporation fee. There are some exceptions, however, as some states charge $1,000 or more to keep the business open. If you’ve had a tough year with your rental properties and money is tight, this annual responsibility could force you deeper into debt.
7. You will need a separate LLC for each state you own a rental property.
An LLC incorporation is only good for the home state of your primary residence. If you own properties in multiple states, then you must file for a limited liability company formation in each state where you wish to protect yourself. Without multiple filings, anyone from other than your home state could potentially access your personal finances and assets if they become a creditor.
You must also establish a business address for your LLC in each state where you’re conducting operations. The rental property address does not count unless you have an office at that location. As part of the articles of incorporation, you’ll be asked to designate a specific party who receives communications on your behalf to conduct business. For a multi-state operation, a corporation might be a better structure to consider if you wish to avoid some of these logistical issues.
8. There are more tax responsibilities to consider.
Whether you choose a pass-through or corporate tax option, the administrative requirements of an LLC are higher than other business structures. You might gain the same benefit as a sole proprietor or a partnership, but it does still require a separate tax filing for the business which is not always necessary in other structures. In the United States, an LLC uses Form 1065 when passing income through to its owners. Then K1 forms must be distributed to each member, declaring individual tax responsibilities for the year.
Depending on where you register the LLC to manage properties, there may be franchise taxes, excises taxes, or both which apply to this business too.
9. LLCs struggle to raise capital, just like partnerships and sole proprietors.
Because owners are not permitted to buy, sell, or trade equity in the company, investors are hesitant to put any capital into this business structure. You will be responsible for the funds needed to purchase or maintain the rental properties under your care. Although lending products have more availability since the legal structure of this business is recognized, outside capital is rare.
In the unlikely event that you should have more than a handful of owners associated with your company, an S-corp filing will give you better access to capital. Should you reach more than 100 members, a C-corp filing will provide more opportunities to raise capital compared to the LLC.
10. A single-member LLC faces the same tax structures as a sole proprietor.
A single-member LLC can choose to be taxed like an organization if they wish. They can also choose to tax themselves like a sole proprietor. On the second option, even though you’re keeping separate books to reduce your liability, the taxes you file are still on the personal return. That structure creates enough complication when rental properties are also involved that a tax professional is likely required.
The pros and cons of using an LLC for a rental property are often not worth the hassle compared to the risks the average landlord faces. An LLC provides one key benefit: the likely protection of personal assets when the company is named in a lawsuit. For someone with extensive assets, the small cost of incorporation is worth the protections provided. If you only own one property, then the headache of the extra paperwork may not be worthwhile.
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