Are you wondering if you should form an LLC for a rental property? This is a tactic with a long list of pros and cons that you’ll want to weigh out before making a decision.
As far as benefits go, using an LLC to purchase and own your rentals can reduce your personal liability, offer pass-through taxation, and create privacy and anonymity, to name a few. On the flip side, it can make it much more difficult to get financing, complicate your tax filings, create additional annual fees, and cause problems when you want to transfer a property you already own into your newly formed LLC.
There are many reasons why you might choose to create an LLC to purchase rental properties. Let’s take a look at some of the primary advantages before diving into the drawbacks of this strategy.
The IRS treats LLCs as pass-through entities when tax season rolls around.
This means that the profits or losses of the LLCs “pass-through” to the members of the LLC. In a nutshell, the benefit of this is that you don’t have to deal with double taxation.
One of the primary reasons that people use LLCs for rental properties is to help protect their personal assets. For example, if you own a rental as an individual and are sued by a tenant, your own assets are at risk. If an LLC is sued by a tenant, usually only the LLC’s assets are at risk.
That being said, there are some scenarios where the corporate veil can be pierced. We talk about this a bit more in the disadvantages section entitled “You Still Might Not Be Completely Protected.”
While you could have an LLC that owns a number of different properties, some investors choose to make a new LLC for every property they buy. Because it’s relatively affordable and simple to form and register an LLC, investors can provide additional protection by ensuring that their other properties aren’t at risk when a lawsuit threatens one particular rental property.
If you are looking to have a more business-like appearance when building your rental property empire, an LLC can help provide this. You’ll obviously want to weigh this out with the other advantages and drawbacks of owning an LLC, but many investors find that owning their properties with an LLC helps to give them more credibility with lenders, tenants, contractors, and vendors.
In many U.S. states, forming and registering an LLC is relatively affordable. That being said, there’s a huge range when it comes to both the filing fees and the ongoing fees, depending on which state your property is in.
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Another benefit to using an LLC for rental property is that members are allowed to contribute funding, real property, or other personal assets. On top of that, reasonable interest can be paid from the LLC to its members if the members loan money to the LLC.
You can choose to either have a single-member LLC, or you can have a multi-member LLC with an unlimited number of members. That being said, it’s worth knowing that there’s a 100-member limit if your LLC is structured as an S-Corp for the purposes of taxes.
If you are interested in raising capital outside of the U.S. to fund the purchase of rental properties, you might be interested in using an LLC.
Whether or not foreign members that aren’t U.S. citizens are allowed as members of an LLC depends on the state laws, but in some circumstances, it can be a win-win for both you and foreign investors that want to get a foot in the U.S. real estate market.
There are two sides to every coin, and there is a disadvantage for every advantage when it comes to using an LLC for rental property. If you’re interested in learning more about the downsides of using an LLC for this purpose, be sure to check out our post on the disadvantages of using an LLC for real estate investing.
This is one of the major disadvantages of using an LLC for rental property. While it isn’t impossible to get a loan using an LLC, it’s a lot harder than it is to obtain a loan as an individual– even when you’re an individual buying an investment property.
You might find that most lenders ask that the loan is guaranteed by each member of the LLC. This means that they will be able to hold every LLC member jointly and severally liable if the LLC ends up defaulting on the loan.
Obtaining financing is difficult enough as an individual, so you might want to consider whether the additional obstacle is worth it when you are thinking about using LLCs to buy rentals.
In order to keep your LLC active, you might have to pay a fee annually or bi-annually. Some states, like New Mexico and Missouri, don't have ongoing fees. Others, though, might charge you hundreds of dollars (or more) every single year that the LLC is active.
Check out this guide to buying a rental property out of state if you're thinking of operating investment properties remotely.
Your LLC will have to file a tax return every year, even though it’s considered to be a pass-through entity for the purposes of taxes. You’ll need to file Form 1065 in order to report expenses and income in addition to reporting K-1 distributions to each of the members during the tax year.
If you’re reading into the pros and cons of using LLCs for your rental properties, there’s a good chance you got the idea in the first place because it could help to protect your personal assets. While this is true, it’s important to realize that this isn’t completely bombproof.
Laws vary by state, but it’s possible that the corporate veil could be pierced if a member of the LLC or the LLC itself is found guilty of negligence or fraud. This means that individual LLC members could still be held liable for damages or debts.
If you already own rentals that you want to put in an LLC, you might have to pay a transfer tax to your city, county, or state. This is typically a percentage of either the property sale price or appraised value of the property. In some places, this tax is known as a stamp or deed tax.
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Every LLC member might have to pay self-employment taxes on any income they earn for Medicare and Social Security. If you set up the LLC so that it’s taxed as an S-Corp, you might be able to avoid this. However, you’ll want to talk with a tax professional in order to make sure the structure you’re creating fits your needs.
If your interest is in transferring property you already own with a mortgage into an LLC, it’s important to understand that this could trigger the due on sale clause.
Most mortgages require that you pay off the loan in full when the owner of the property changes. Even if you are the sole member of the LLC, you might find that you are required to pay the full balance of the loan when you transfer the property into your LLC.
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