By now, you either know someone who formed a Limited Liability Company (LLC) as a rental property owner, or you are someone. Either way, you understand how vital an LLC’s role in the real estate world is, especially for property owners interested in real estate investing.
In this article, we will tackle the uprising interest in the real estate investment and property management as a business owner and get to the bottom of:
- What is a Limited Liability Company (LLC)
- What are the benefits and downsides of a Limited Liability Company (LLC)
- How to start a Limited Liability Company (LLC)
- How to effectively use a Limited Liability Company (LLC)
- Alternatives to the Limited Liability Company (LLC).
By the time you finish reading the article, our goal is to help you answer the question ‘Do I Need an LLC for My Rental Property?’
Let’s start and see what you will conclude.
What is a Limited Liability Company (LLC)?
A limited liability company (LLC) is a business structure that, due to its benefits, became one of the top choices when it comes to business entities.
An LLC is a business structure that keeps business owners free of personal liability for the company’s debts or liabilities. To understand it better, it is a hybrid between a corporation and a partnership or sole proprietorship.
An LLC can be formed by an individual, with a partner, or with a group. Once you own an LLC, you become a member of the LLC. Hence, there are two types of a Limited Liability Company:
- Single-member LLC (there is a sole owner)
- Multi-member LLC (there are several members).
Bear in mind that Limited Liability Companies are regulated at the state level, meaning that the process of forming or creating an LLC is regulated by each state individually. We will guide you through the most important things you should be aware of when forming an LLC, but make sure you do additional input collection according to your state’s resources.
Benefits of a Limited Liability Company
There is a reason for a growing trend of forming an LLC – it is becoming so popular that some property owners or real estate investors are forming a separate LLC for each property they own. Here are the main upsides of creating a Limited Liability Company, based on business owners’ and real estate investors’ experience.
Limiting Personal Liability
People choose to work for someone else instead of starting their own business because they are afraid of the potential risks they would have to face. The main concern for those brave enough to start their entrepreneurship journey is ensuring liability protection and securing personal assets.
If you become a real estate owner, you will find yourself looking for asset protection. The best one that you will find is a Limited Liability Company.
LLC protects you from any lawsuits you might face while running a rental business. This means that in case someone gets injured while residing in your real estate and decides to file a lawsuit against the property manager — they will be pursuing a legal claim against the LLC, not personally you.
LLC gives you anonymity – your personal assets stay private to you, while LLC’s assets are obligated to pay out damages if the lawsuit turns to be rightful.
Probably you can see the main difference compared to owning an insurance policy (for example, liability insurance). If you had only an insurance policy — and not an LLC — your personal assets could be exposed if the insurance policy does not provide sufficient coverage. Not to mention the possibility of increasing premium since your investment property was subject to a lawsuit.
An additional reason to consider placing a property title in the name of an LLC is that it gives you liability protection against monetary judgments if a financial dispute involving the LLC arises. This refers to any potential contract breach lawsuits that might arise.
The follow out would be similar – a third party pursuing a lawsuit would not be able to press charges directly against you but against the Limited Liability Company. The worst-case scenario with an LLC would be obtaining a so-called charging order from the court to become a lien on the real estate. On the other hand, without an LLC, you could find yourself in a situation of losing your property and, therefore, a possibility for any rental income in the future.
We believe you can see how owning an LLC can limit your personal liability and provide you additional insurance and security.
As we mentioned before, LLCs are regulated at the state level, so available remedies vary from state to state. However, there are some common benefits, no matter the state you are in.
For example, all members of LLCs who own real estate acquire benefits when it comes to taxes from the Internal Revenue Service (IRS). This applies to any type of LLC:
- Single-member LLC (you as a sole owner)
- Multi-member LLC (there are several members).
This tax benefit is known as pass-through taxation.
Pass-through taxation is a system that enables you to avoid double taxation. Any income earned by the LLC — such as rental income, etc. — will pass through the LLC to its individual members or sole owners. In other words, it would not be taxed at the corporate level, as the traditional corporations are being taxed, but solely on the individual.
Every LLC member is required to report the income on their individual federal income tax returns. This is usually on Schedule C. Avoiding double taxation with a pass-through taxation system is one of the biggest reasons property owners choose to create a Limited Liability Company.
Keeping Rental Properties Separate
If you are lucky enough or you have worked hard enough to own multiple rental properties, you’ll consider setting up separate LLCs for each property.
This is done to further secure personal assets. If a lawsuit is pursued against one of your LLCs, this won’t affect the other ones you own. In other words, your rental properties are not dependant on each other.
An additional benefit is that you can start categorizing and differing business expenses from personal by creating separate LLCs. You can go even one step further and categorize expenses by each property. This can ease your process of filing personal taxes.
Ease of Transferring LLC Interests
In case of realizing that owning a Limited Liability Company is not the best solution for you, you can quite quickly turn to the new one. Transferring LLC interests is possible and done with ease – you can transfer your interests to the new LLC members while LLC keeps running smoothly. Although something you should consider are transfer taxes – depending on the state you are in, you might be required to pay tax transfers in the amount determined by that state.
A benefit to be considered — especially if you are just starting a rental business — is that owning and holding real estate in the name of an LLC appears to be more professional and businesslike. This could give you an additional boost when it comes to renting a piece of real estate, as the LLC name can either build trust or put a massive setback in your business.
Downsides of a Limited Liability Company
As in everything in life, owning a Limited Liability Company has some downsides as well. We went through them all and highlighted the most important ones you should be aware of.
The “Due on Sale” Clause
The “Due on Sale” clause is a regular provision in a mortgage that obliges the borrower — in this case, the named property owner — to pay the mortgage balance in full at the time of a sale.
This complicates the process of transferring real estate to an LLC a bit. If you decide to place a property title in the name of the LLC, make sure that you check whether there is a mortgage for that real estate. If there is — and you are the one qualified for a mortgage — your name will be the one that appears on the mortgage documents, and that needs to match the grantee on the deed.
A transfer of real estate from an individual owner to an LLC is officially recognized as the sale of the property, meaning that the LLC owner is the one ensuring that the insurance documents match the guarantee on the deed.
In some cases — if not being careful — this could lead to a situation of the mortgage lender claiming that the transfer violates the terms of the mortgage’s “due on sale clause” if they learn about the transfer once the property insurance bill comes due (if insurance is escrowed).
To prevent facing this downside, you might consider cooperating with a waiver from the mortgage lender before transferring real estate from an individual’s name into the LLC.
Possibility of Transfer Tax Obligations
We already mentioned the transfer tax obligations that might appear when transferring a real estate property from an individual to LLC. The crucial element that determines this is the actual state you are in.
There are states — such as Delaware — where no transfer taxes exist, in the case of individual transferring ownership to an LLC, as long as the ownership interests remain the same before and after the transfer. On the other hand, in some states — such as Pennsylvania or Nevada — transfer taxes apply regardless.
Even though you still probably see more benefits than the downsides, make sure to consult your lawyer for legal advice about your state’s laws before moving forward with forming a Limited Liability Company.
Capital Gains Taxes
Unless you choose to utilize a 1031 exchange, you could get hit with state and federal capital gains taxes when you sell your rental property. If you’ve rented the property out for several years and an LLC holds it, it’s been utilized as a rental/income property.
Capital Gains Taxes
Bear in mind that you might find yourself in a situation to pay state and federal capital gains taxes in the case of deciding to sell your rental property. If you formed an LLC for your rental property, it’s been utilized as a rental/income property.
Not eligible for Homestead Exemption
State offers different benefits for individual property owners. One of them is the homestead exemption, which shields a portion of a home’s value from property taxes. However, this is only available to people, not to LLCs, so in case you formed an LLC as a rental property owner – you wouldn’t be eligible for homestead exemption.
Mixing business and personal
The aim is to run the business at the highest level of professionalism. However, there are many challenges in that way when we’re mixing business and personal.
Setting separate email addresses, bank accounts, and credit cards for property-related expenses is just the first step. Since it is your house, you have overall power over it. It has happened to many people to start mixing personal and business assets, intending to have more flexibility in moving them around and finishing all the work related to the property.
This could lead to losing the distinction between personal and professional and finding yourself risking your personal assets, even though you started forming an LLC with the idea of protecting your personal liabilities.
When you should use a Limited Liability Company
So far, you understand what an LLC represents, which different types exist, and what various upsides and downsides forming an LLC could bring. Now it’s time to go even further and help you understand when you should use a Limited Liability Company as the best solution for your real estate property.
Should I create an LLC before or after buying a rental property?
The answer to this is simple – you can do it both ways, whatever fits your possibilities better. However, it is our recommendation to create an LLC before buying a rental property. There are the main reasons:
- You can notify your mortgage or loan holder upfront about transferring title to an LLC so that you can avoid any problems related to this.
- You can prevent your mortgage holder from deciding to close your loan and issue you a new one – with an increased interest rate.
- You won’t have to disturb your tenants with changes related to transferring title to an LLC, such as updated rental leases.
- You can avoid title transfer taxes that might appear once you decide to transfer your title to an LLC.
If you form an LLC first, you can buy the property under the LLC’s ownership, meaning that the property deed will be in your LLC’s name.
The best ways to use LLCs in a property rental business
If you’re still following this path, you should learn how to use the LLC in a property rental business, so you get the most of it. These are the main points we highlighted for you.
Protecting Your Assets
We talked about this a lot – if you form an LLC, your personal assets will be safe. In any case of a misalignment that could result in filing a lawsuit against you, your personal assets won’t be reached.
To further the protection, you can create a new LLC for each property you own. By creating separate LLCs, you make them independent – so in case one of them suffers, others won’t be affected.
Managing your money
Once you transfer your real estate title to the LLC, managing your money becomes more straightforward. This applies when having separate LLCs as well. A significant contribution is that it prevents you from co-mingling money, meaning that you won’t be using money earned through LLC for your everyday personal expenses and vice versa. This will help you balance your money and manage any unexpected costs that might appear.
If you have multiple LLCs under the same business name, it will be easier for you to start building a brand. People tend to remember company names more than people’, and also – in case you find yourself negotiating with the investors, you will have better chances looking professional.
Using an LLC to Structure a Trust
In the case of any accident or medical incapability, using an LLC to structure a trust can bring additional security to your family, especially to your heirs. Certain types of trusts allow assets to go to your children automatically. You may then set up a trust, and the trust owns your interest in the LLC. Ensure to double-check this with your lawyer so you understand all the possibilities and implications that might arise.
How to form a Limited Liability Company
This is probably the most crucial question. We know why we want to start an LLC; we know how valuable it could be, but we still – don’t know where to start.
The truth is that the process is not over-complicated, and if you are determined – you will be able to form an LLC successfully.
Ten steps you should follow when forming an LLC
- If you already have a loan for your property under your name, the first step should be contacting your lender to find out if they allow a title transfer to your LLC. Find out if they have requirements for allowing the transfer (they may increase your interest rate, charge an assumption fee, etc.) and understand how these conditions fit your possibilities.
- Choose an available business name, so you can start working on your brand and market positioning from the beginning.
- Fill out the Articles of Organization for your LLC that provide general information about your LLC.
- Make sure to create an LLC Operating Agreement – a document that determines the rights and responsibilities of the LLC members (even if that’s only you).
- Check the regulations in your state – you might be asked to publish a “notice of intent” to form an LLC (this is only required in a few states). This notice has to be published in an official newspaper and states your intention to incorporate it in your county. Additional publishing fees might be charged.
- Check the regulations in your state – obtain licenses and permits needed for your business.
- Check the regulations in your state – register your LLC with your state. You need to turn in all the required formal documents to the state, so they can start the process of registering your business. Additional filling fees might be charged.
- Transfer title to the LLC. There are two steps to follow here. First, you should create a Quit Claim Deed. The deed will list you as the “Grantor” and the LLC as the “Grantee.” Second, you should go to your county clerk’s website and search for instructions for how to file a deed.
- Set up a bank account for your LLC and keep funds separate.
- Update your rental leases moving forward. Your lease should state the LLC as the owner, and rent payments should be deposited in your LLC’s bank account.
Bear in mind that you will need an investment to create an LLC. This investment will differ from state to state. These are the general expenses you could expect.
Alternatives to creating an LLC in a property rental business
There are a couple of other options (Liability Insurance, Umbrella Insurance, Umbrella policy, etc.) you should research because forming an LLC might sound appealing, but that doesn’t necessarily mean it is the best solution for you.
Some people claim that liability insurance is a way better solution. However, there are some disadvantages we would like to highlight:
- policy limitations
- addendums that might convolute the insurance coverage
- additional insurance required, such as hurricane insurance.
The insurance policy has its limits, and it can’t cover all the possible damages or expenses that might appear. From our perspective, the best solution here would be to put a rental property in an LLC and then insure the property.
Infinite Banking concept
We could teach you many things about Infinite banking, but for these purposes, we’ve summarized the essential facts you should know.
The concept of infinite banking is about strategically using your whole life insurance policy from a mutual insurance company as a personal endless banking system. In other words, Infinite Banking is essentially being your own banker.
One of the many benefits of a whole life insurance policy is that policyholders can borrow money using their policy’s cash value.
Using this borrowing setup, you would never have to borrow money from a bank again and instead would borrow for yourself (your whole life insurance policy) and pay yourself back over time. Thus, being your own bank.
The goal of Infinite banking is to duplicate the process as much as possible to build the value of your own bank. The duplication process happens by lending and repayment of money typically held in the cash value of a permanent life insurance policy.
Infinite banking allows you to better work towards your individual and unique financial goals for yourself and your family and control your finances without dealing with banking fees or interest rates on loans.
The way infinite banking works allows you to mimic the way a bank operates and borrows money. Instead of borrowing from a bank, you borrow from yourself while still allowing your whole life insurance policy to earn dividends (money) even though you are using that money elsewhere.
Infinite Banking involves:
- Overfunding (with after-tax funds) a high cash value whole life insurance policy from a life insurance company
- Accumulation of Cash Value(tax-free) throughout the years you are a policyholder of your Whole Life insurance policy
- Tax-Free Loans taken out against your whole life insurance policy’s cash value to use for your financial expenses.
If you want to learn more about becoming your own bank, you can check our YouTube video — How To Start Infinite Banking — to learn about steps you need to follow to start with infinite banking.
You should consider the option of becoming your own bank due to the many benefits that could follow. If your goal is to protect your liabilities, you could achieve that with a whole life insurance policy and lower fees and interest rates. If you plan on using your rental property for rental income, consider infinite banking as a concept, as it brings many benefits related to taxes.
We have come to the end of this blog – bravo! So far, you understand a Limited Liability Company, what benefits it brings, and how to start one.
You have also learned about the Infinite banking concept and its benefits to your whole finances. If you want to learn more about how we make money through infinite banking and how you can, too – you can sign up for our premium membership. Looking forward to seeing you in the Wealth Nation community!