So, you own a rental property and keep hearing about how maybe you should put your ownership in an LLC. From liability protection and anonymity to more secure for group ownership, an LLC is certainly something to consider creating. This blog will answer your questions about the pros and cons of holding your rental property in an LLC and much more.
What is an LLC?
A Limited Liability Company (LLC) is a business structure you can create by yourself, with a partner, or with a group. Owners of LLC’s are “members” of the LLC. Each state has their own regulations and price structure when it comes to creating and maintaining LLC’s. As we note in nearly every blog we write, please take the time to research the specific laws and information for the state where the rental property is located. Most Secretary of State offices will offer this information.
You’ll be surprised to learn that there’s more benefits than just protection of liability and more headaches than cost and management when creating an LLC.
PRO’s and CON’S
Pro’s of Holding Your Rental Property in an LLC
1.Your Personal Liability is Limited
Should you find yourself in a legal battle, there are protections an LLC provides that holding in your personal name do not. Only the property (or properties) held in that LLC are at risk. If you own a personal residence and your rental properties in your personal name only, then ALL assets under your personal name would be at stake. This is the primary reason rental property owners hold their property in an LLC.
2. Pass Through Taxation
During a recent call with our CPA, we discovered the benefit of pass-through taxation which is allowed for individually owned businesses. Typically, the profits earned by a corporation must be taxed AND then taxed again when the owners draw income. With an LLC you get the benefit of passing the company’s net income through and only paying taxes (and tax prep) once.
3. Ability to Separate Rental Properties Into Their Own LLC’s
It is advisable to create an LLC for each rental property owned. This will limit the liability to that property in the event of a legal battle. Should you own several rental properties under one LLC, ALL those properties are at risk if you must pay a financial award to someone who gets injured (or worse) on your property. Separating the ownership limits the liability to that one property and protects the others.
4. No Comingling of Personal and Business Funds
An LLC will have their own bank account and accounting of income and expenses is separate, making it much cleaner and easier to track. This function will make claiming expenses against income clear and concise. You will have no worries of comingling of funds (primarily security deposits) or questions of using business funds for personal use.
Con’s of Creating an LLC
1 .A lot of Red Tape
The paperwork to create an LLC can be daunting. You should have a rental property business plan in place to which you would need to add an Operating Agreement. This agreement outlines the rights and responsibilities of each member. The legal jargon that should be included in the Operating Agreement can be overwhelming, so you may want to consult a real estate attorney to draw it up and make sure all members are protected in the event of a legal battle.
The members may also have to conduct an annual meeting with notes to show they are actively involved in operations of the rental property business.
2. Getting a Mortgage Is Much More Difficult
If you create an LLC prior to owning the property, when the time comes to purchase said rental property, you might find the mortgage process tougher. You would be applying for the loan in the company name and corporate loans generally include a higher interest rate.
3. Transferring a Personal Loan into An LLC May Not Be Permitted
Let’s say you bought the property in your personal name and now you want to transfer that rental property into the LLC name. Many conventional loan or banking institutions will not allow you to transfer ownership into an LLC. You may want to inquire prior to applying as there are a few companies that allow it for a fee. Many will call the loan (cancel it) and force you to apply for a new loan at a higher interest rate. If they do allow the transfer into the existing loan, usually they will charge assumption fees or have other costly conditions.
Additionally, you may incur a Title Transfer Tax to move from your personal name into an LLC.
4. Operating LLC’s Can Be Expensive
Many states require annual tax filing fees to keep the LLC in good standing. In California, this fee is $800 annually but some states have no annual fee at all. Additionally, California requires a $20 fee every other year to update your statement of filing information. This is the paperwork that states who the members are, where they live, the address of the company, as well as the who the registered agent for process is.
In addition to the state’s annual fees, to create the LLC you’ll have to pay to register the LLC, publish a note of intent, create an operating agreement (lawyer fees), and pay a filing fee. The cost can be well over $1000.
When Is the Best Time To Create An LLC?
If you are unsure as to when the best time to create the LLC is, before or after purchasing a rental property, then here is some information for you to consider.
Creating an LLC and then purchasing the property allows you to buy the property under the LLC ownership. Putting the deed in the name of the LLC immediately removes liability from your personal assets and avoids a Title Transfer Tax that you would pay after the fact.
Additionally, by buying the property under the LLC, you begin the leases and tenancy under the LLC name. This alone saves you (or your property manager) the hassle of creating all new leases and managing the change of to whom the rent payments are paid to.
Lastly, you avoid the chance of your mortgage company forcing a loan cancelation down the line. If your mortgage company forces you to close the loan and reapply, you will be charged closing fees all over again.
As you can see creating an LLC prior to ownership certainly has its perks.
LLC’s For Out of State Properties, Where to Create an LLC?
If you live in one state but your rental property is in another, you will create the LLC in the state of the rental property, not where you reside. Why? The laws will follow the property. If you reside in California but own property in Indiana, you’ll find the landlord-tenant laws are much different in California and tend to be more tenant friendly. Whereas the laws in Indiana are more landlord friendly so you would want to have those laws protect your LLC. California laws are not applicable in Indiana, so you want to create the LLC in the state the property is located to avoid legal issues.
Additionally, the fees to operate an LLC in California are among the highest in the US ($800) and are due annually. That’s a pretty big chunk our of your bottom line, especially if you own multiple properties, each operated under their own LLC. Most other states have more reasonable fees with some being a one-time creation fee and not renewable each year.
One issue you may run into is double taxation depending on the state where you reside. As the member of the LLC, you may have to pay personal taxes in the state realized (out of state property location) AND the state you reside in. This varies and is again, why you should research if an LLC is best for your rental property.
Does an Umbrella Policy Give the Same Liability Coverage?
Bottom line, no. Having an umbrella insurance policy does add coverage to the existing standard policy and cushions the protection but, still has its limits. If the lawsuit exceeds the amount of both the standard and the umbrella policies, then your personal assets are at risk.
Most umbrella policies do not exceed the value of the asset being covered. Let’s say your rental property is worth $350,000. Your personal policy has coverage for $500,000 and the judgement against you is $1 million dollars. If you have an umbrella policy of $350,000 then your personal assets are at risk for $150,000. If you do not have the cash on hand or the equity in your personal home, you likely will have to sell one of your assets to cover the additional amount owed.
Holding the property in an LLC may result in the same outcome, however, your personal assets wouldn’t be at risk or considered as part of the lawsuit.
Additionally, personal insurance policies contain exclusions that may leave a rental property owner unprotected and exposed to significant risks. Even with an umbrella policy in place, these exclusions may create a situation where the lawsuit exceeds the amount of the umbrella policy, again, leaving personal assets at risk. For more information on this, please read our blog: Make Sure Your Rental Property has Proper Insurance.
Final Thoughts
This is all a lot of information to digest. Do we hold our properties in an LLC? Yes. Our personal assets are too great to chance losing in a legal battle from a tenant or guest of one of our rentals. Should you? If The Pro’s and Con’s of Holding Your Rental in an LLC listed above do not clearly identify that answer, have a conversation with your CPA and/or lawyer. They know your risk best and can define liability, the expense, the process, and the benefits (or not) for your specific situation.
You got this landlords!
Please leave us a comment letting us know what you think of our blogs! Questions? Contact us at Stacie@YourLandlordResource.com OR Kevin@YourLandlordResource.com.
Check out our other blogs to guide you on your self-management journey as a landlord:
Why Landlord Inspections Are Essential
The What and Why of Move-In/Move-Out Inspections For Rental Properties
How Landlords Can Help Tenants Stay Cool In A Heatwave
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