If you’re interested in limiting your personal assets from the debts and liabilities of your rental properties, your first thought might be using an LLC to operate your real estate investing business. However, there are notable disadvantages of an LLC for a rental property that you should be aware of before you start the registration process.
Depending on the size of your portfolio, the location of your rentals, how you plan to buy your new property, and your personal preferences, you might decide that the LLC structure is ideal for your needs.
That being said, there are definitely some tradeoffs when you use an LLC versus purchasing rentals as an individual investor. On top of that, there are several disadvantages that might create significant obstacles to your ability to build your portfolio and maximize your ROI.
So, without further ado, let’s dive into the drawbacks of LLCs for rental properties to ensure that you are equipped with the information you need to make an informed decision.
One of the primary advantages of starting a Limited Liability Corporation (LLC) is that it allows you to separate your personal assets from your business assets and reduce your personal liability. If you come across financial or legal issues, asset protection can help give you peace of mind. For this reason, sometimes people consider using LLCs to purchase a rental property.
LLCs are hybrid entities that combine the features of a sole proprietorship or partnership with those of a corporation. Basically, this is a corporate structure that helps to protect its owners from having their assets at risk if they are pursued for repayment of the liabilities or debts of the company.
LLCs are regulated at the state level, which means the process of registering an LLC isn’t the same in all 50 states. Except for insurance companies and banks, any individual or entity is allowed to be an LLC member.
The limited liability characteristic of LLCs is similar to the way that corporations are structured. However, LLCs don’t directly pay taxes on their profits. Instead, the members report the profits and losses on their individual tax returns as LLCs are pass-through entities.
There are a number of arguments that are commonly used to support the idea that having an LLC for rental property is a good idea. These include:
However, it’s important to understand that there are also some significant disadvantages to operating an LLC for rental property. Let’s take a look at some of the reasons you might not want to start an LLC as a real estate investor.
One of the primary disadvantages of having an LLC for rental property is that it makes it a lot harder to get a mortgage. If you are planning on building your rental empire with cash alone, this doesn’t apply to you. However, if you are like many real estate investors, you might want to leverage debt in order to maximize your returns.
Are you planning on buying a rental property with a mortgage? If so, you’ll want to learn the ins and outs of amortized loans.
If this is the case, forming an LLC will make it tremendously more difficult to get financing for your property. When you purchase a property with an LLC, it means that the bank is lending money to the business rather than you personally. Typically, banks tend to only make loans to businesses that have a proven track record of income and profit. When you form a new LLC to buy a rental property, you won’t have evidence of this.
At the same time, banks generally only make commercial loans to businesses which tend to have less favorable terms and rates than conventional mortgages. Before you start trying to pivot to another form of financing, unfortunately, the same is usually true for private lenders, hard money lenders, and seller financing options.
If you are committed to having your rental property in an LLC, it is possible to buy the property as an individual and then transfer it into an LLC.
However, this can be an issue if you have a mortgage. Basically, the lender might have the right to call your loan due at the time of this transfer. This means that you would be required to pay back the loan’s full balance when you transferred the property into the LLC.
For the record, it is not a definite that the bank will call upon the due on sale clause. That being said, it’s important to understand that they will have the right to.
The lender might choose to give your LLC an new loan if they do request the full balance of the loan. However, you will be dealing with the same issue listed above where the terms will probably be less favorable.
You also might find that there are new taxes triggered by converting the property to an LLC, such as the Title Transfer Tax.
In short, using conventional mortgages to purchase rental properties has a lot of potential benefits, which is why this method is so common among real estate investors. If you decide to form an LLC for your rental property, you will probably find it incredibly difficult to get conventional financing for any rental property. If you choose to buy a property in your name and then transfer it, you are taking on the risk of a lot of potential problems down the road.
Are you wondering what it takes to qualify for a mortgage? Check out our complete guide here.
While some people talk about the potential tax benefits of LLCs for rentals, there are more tax responsibilities if you choose to use an LLC to purchase and operate property than if you do so as an individual investor.
An LLC will require a separate tax filing for the business. Form 1065 is required when income is passed through an LLC to the owners of the company. It is also required that K1 forms are distributed to each member of the LLC, which declares the annual tax responsibilities of each individual.
There could also be additional taxes including excise taxes and franchise taxes depending on which state you register your LLCs in.
One of the primary reasons that investors typically form LLCs for rental properties is to give them additional asset protection. It’s important, though, to understand that there is not a 100% guarantee that your assets will be protected in the case of a lawsuit.
If you are thinking about starting an LLC for rentals, you’ll want to familiarize yourself with the laws surrounding LLCs in the state where you are planning on registering it.
Even though LLCs are touted as a tool that protects your personal assets, it is still possible to end up personally on the hook for business debt and liabilities. Courts can choose to hold the owners of an LLC or corporation personally liable in a process that is known as piercing the corporate veil.
If the corporate veil is pierced by a court, it means that creditors can go after your home, investments, bank account, and other assets in order to satisfy the debt. This can occur if the company’s actions were fraudulent or wrongful, if there isn’t any real separation between the owners and the company, and if the creditors suffered an unjust cost.
According to the Cornell Law School Legal Information Institute, though, “courts typically require corporations to engage in fairly egregious actions in order to justify piercing the corporate veil.”
As you can likely tell, the whole thing is pretty complicated. If you are serious about starting an LLC to protect your personal assets from the debts and liabilities of your rental property business, you’ll want to become familiar with the causes and potential outcomes of the corporate veil being pierced.
If you get a mortgage for a property and then transfer it to an LLC, you might have to pay a transfer tax. Whether or not this will be true in your case will depend on your city, county, and state. In some places, the transfer tax is referred to as a stamp tax or a deed tax.
Usually, the amount owed in the form of a transfer tax is a percentage of the property sale price or the appraised value of the property.
We mentioned this above in the section about how much more difficult it is to get a mortgage with an LLC, but it’s worth repeating.
If you choose to finance a property as a individual in order to make the process easier and then transfer the property into an LLC, it could trigger the due on sale clause.
This clause is found in most mortgage documents. It states that it is required for the existing loan to be paid off if ownership of the property changes. This means that even if you transfer property from yourself to the LLC that you operate solely, you could be required to pay the full loan amount upon transfer.
Again, lenders might not always choose to exercise their right to call the loan balance due, but the point is that they do have that right. If you feel like the benefits of putting rentals in an LLC outweigh the costs but you want to purchase the home with a conventional mortgage in your own name, you will definitely want to talk to some lenders and discuss what it would mean to transfer your property after purchase. Otherwise, you could get stuck with an unexpected and enormous bill for the entire amount of the loan.
A lender might also choose to give your LLC a loan when you transfer the property, but there is no guarantee. This would also leave you in the situation listed above, where business loans are harder to get and tend to have less appealing rates and terms.
How much it costs to register an LLC varies quite a bit between states. The most expensive places to start an LLC are:
On the other hand, the cheapest states to start an LLC are:
In most states, you are also required to file an annual renewal notice in order to keep your LLC operational. While it differs between states, it is common for this fee to be similar to the cost of the initial fee for incorporation.
In a handful of states, there is a $0 fee for renewal. These are:
In other states, though, it might cost quite a bit more to renew your LLC each year. The most expensive state when it comes to renewing your LLC is California, which charges $800 each year that your LLC is operational and an additional $20 every two years.
Depending on where you live, the cost of registering and renewing your LLC might not cost-prohibitive. However, in some places like California or Massachusetts, you might find that the costs outweigh the benefits.
On top of that, there could be additional fees due to needing to have separate credit cards for your LLC. Filing separate tax returns will also cost additional money, whether it’s in the form of hiring a CPA or taking your own time to navigate the process.
If you are considering having each property you own in its own LLC, this is particularly disadvantageous. While a few hundred dollars upfront and each year might not seem like much, it can really start to add up if you are operating multiple LLCs for multiple properties.
One of the metrics that real estate investors use to determine whether a rental property is a good investment is known as return on investment (ROI). Check out this article to learn how to calculate ROI on rental property.
Forming an LLC is definitely more complicated than purchasing a rental property as an individual investor. If you go through the process properly, having an LLC for rental property will require:
If you are planning on building a healthy portfolio of rental properties, you will need to put even more attention towards maintaining and managing each aspect of each LLC. The short story is that using LLCs for rental property can require a more complex system than taking another route.
Some real estate investors might choose that starting an LLC for rental property is worth the downsides. However, it’s important to not assume that it is the best strategy for you, as there certainly are significant costs, risks, and disadvantages. Knowledge is power when it comes to real estate investing, so it’s a good idea to have a thorough understanding of the playing field before you hop into waters you’re unfamiliar with.
Regardless of the business structure you choose when operating your rental property business, one of the most important things that will support your ability to succeed as an investor and landlord is the property you choose to purchase.
There are definitely some subjective aspects to determining whether a rental property will be lucrative, and you might find that you have a knack for feeling out which properties will be profitable.
However, that doesn’t mean you shouldn’t run the numbers very carefully before making an offer on a property. And, in a competitive market, determining where the end of your budget lies in order to make sure you don’t get caught up in the frenzy and pay more for your property than you initially planned.
In order to help new and seasoned investors streamline their property selection process, we’ve created the best rental property calculator available on the internet. You can input detailed information about your property and instantly receive priceless information about your total return, your IRR per year, your depreciation, and more.
You can even use this tool to test out different scenarios in order to make sure that this property will be the best path toward reaching your financial goals. For example, you can see the real impact that different vacancy rates will have on your rental income or you can take a look at how your mortgage payment is impacted by how much you choose to put down in the form of a down payment.
Are you ready to see if the numbers add up for your prospective rental property? Check out our advanced rental property calculator today.