Why You Should Consider Forming an LLC for Real Estate Investing

April 27th, 2008

In my “Why I Still Love Real Estate Investing: Being a Landlord” post, I mentioned that one of the drawbacks of this investment opportunity was that as the property owner, you’re liable for the safety of the tenants and/or visitors. You will be held responsible if something happens to them due to your negligence. Even with adequate insurance coverage, you as the property owner could be exposed to legal judgments resulting from tenant slip and falls or visitor injuries to environmental contamination. Even worse, landlords have been successfully sued by victims of crimes–such as robberies, rape, and even murder–that occurred on their property on the theory that the landlord provided inadequate security.

What are your legal structure options?

As an investor, the law provides you with several options for the structure of the legal entity that holds the real estate, including corporations, partnerships, and limited liability companies.

A corporation provides liability protection but is not typically used to hold real estate because of unfavorable tax consequences, namely the double taxation of profits: to the IRS, the company is a separate entity and pays taxes on its profits (first taxation); then, whatever dividends are paid out to the shareholders gets taxed on a personal level (second taxation).

On the other hand, a partnership does offer tax advantages: to the IRS, the partnership is not a taxpayer; profits “pass through” to the partners and each owner reports his or her share of the partnership’s income, losses and other items on his/her personal tax return. But there’s no protection from personal liability.

An LLC is a combination of a corporation and a partnership and offers the best qualities of each.

Which one is the best choice for your real estate investments?

Do limited liability companies really make sense for real estate investors? Probably they do for the two aforementioned reasons, plus several others.

Limited liability

The big legal benefit of an LLC is that limited liability companies provide all the same liability protection as a corporation–but with much less red tape. A regular corporation, for example, requires regular stockholders meetings, a board of directors, regular board meetings, and of course records of all these activities and bodies. But a limited liability company doesn’t.

Your primary concern in real estate investing is your vulnerability. Owning property as an individual creates unlimited liability. Tenants, guest, and, in some cases, trespassers may sue you for real or imagined reasons. If they prevail, they may seek to use your bank account, home, and personal possessions to satisfy the court’s judgments. By using an LLC for a real estate investment, you may be able to avoid personal liability for accidents that occur on the property. Liability will be limited to the extent of the LLC’s assets.

With an LLC as the property owner, the “worst case scenario” is liquidation. That liquidation means the people who own the LLC wind up with nothing (which isn’t good), but all the owners lose is what they’ve invested in the company.

Important: You have to actually sign a deed conveying the real estate to the limited liability company and record the deed in the county in which the real property is located. It is a waste of time and money to form an LLC to hold title and never deed the property to the company because you continue to own it and will be the defendant in a lawsuit.

Of course, in the case of negligence on your part, it would be theoretically possible for a court to pierce the LLC shield; barring that, however, that legal structure can provide valuable asset protection that an individual would not otherwise be afforded.

Favorable tax consequences

For federal income tax purposes, the LLC doesn’t exist (it’s even referred to as a “disregarded entity”) and is merely a conduit to pass income, gains, losses, expenses, and tax credits to its members. Each member reports his or her share of the company’s income, losses and other items on a personal tax return. Income or loss is simply reported on the owner’s personal income tax return–he or she completes Schedule C, which is attached to Form 1040.

If you hold real estate in a LLC and later decide to sell the property to some third party, the tax benefits are also substantial. The profit from the sale of a property by a corporation would be subject to a capital gains tax at the corporate level. Once the capital gains tax had been deducted, the remaining profits would be distributed to the corporation’s shareholders in the form of dividends, which would then also be taxed. Because an LLC is a pass-through entity, it is not subject to capital gains tax at the corporate level. As a member, the profit from the sale of a property would be passed through to you. You would simply pay the capital gains tax on your share, thereby avoiding double taxation and potentially saving thousands of dollars.

Estate planning benefits

LLCs offer unique estate planning benefits for parents wishing to pass ownership of their property to their children. One benefit is the ease of transfer of ownership. The ownership of real estate held by an LLC is represented proportionately by a member’s shares of an LLC (referred to as “interest”). Rather than filing a new deed, members can transfer ownership of the property to their children by simply issuing them membership interest in the LLC.

Best of all, current tax laws allow up to $12,000 (2007 limit) worth of such interest per year to be transferred to children in the form of a tax-free gift! (Ownership of the property is essentially transferred in increments, and parents can continue to have control of the property for as long as they are managers of the LLC.) Moreover, parents effectively mitigate future estate taxes by having conveyed a good part of the LLC to their children.

Advanced Strategies

Multiple entities for multiple properties

If you have several properties, should you form one LLC and hold all your real estate under it, or should you create a new LLC for each property?

There are several reasons why you should consider having multiple LLC’s–one for each property.

If you own three rental houses and transfer them all to your newly formed single member LLC. One of your tenants’ guest is injured at house A, wins a lawsuit and obtains a judgment against the LLC. The guest records his judgment as liens against houses A, B and C. Under this scenario, until you clear the liens, you cannot sell house B or C and give clear title to the buyer.

On the other hand, if each property had its own LLC, then the lien could only be put on the property where the guest was injured (assuming that they cannot pierce the corporate veil).

Many banks and lenders require separate LLC’s for each property. They want the property they’re lending against to be “bankruptcy remote”. What this means is that the lender doesn’t want a problem at a separate property to jeopardize their security interest in the property that they’re lending on. If they are lending money to you to buy the building on 123 Main Street, they only want exposure to risks from 123 Main Street, and not from a bunch of other properties that you own elsewhere. Therefore, lenders often insist on a new entity for the property they are lending on.

Multiple LLCs for a single property

You can also use multiple LLCs for a single property. In this case, you would have one LLC own title to the property, while a separate LLC managed the property–i.e. handled repairs, collected rent, paid taxes, etc. For example, if you owned the building at 123 Main Street, you could form an LLC called 123 Main Street Partners, LLC and a second entity to manage the property called Main Street Management, LLC.

Of course, to every set of pros, there’s a corresponding set of cons, and LLC’s are no exception. Here are some of the costs and headaches associated with operating as one.

Drawbacks to forming an LLC

An LLC may increase your accounting and insurance costs. While a relatively basic LLC may be able to keep its bookkeeping and income tax return preparation very simple, an more complex setup (as described in the advanced strategies) may cost anywhere from a few hundred dollars to a few thousand dollars annually in tax preparation fees.

An LLC may involve several hundred or even a few thousand dollars of startup expense. You may buy the services of accountants and attorneys. You will need to print new letterhead, business cards, and envelopes (if you use these) that use the new LLC’s name in order to show the world that you’re now operating as a limited liability company.

Bottom line: Consider the one time cost to form an LLC as an alternate form of insurance that you should not go without if you’re serious about real estate investing. The cost to form an LLC is peanuts compared to what you stand to lose by not taking advantage of this option.

I am NOT AN ATTORNEY… This information is provided for educational purposes only. Consult a professional before making investment decisions.

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