How to Form a Real Estate LLC: Benefits and Costs
Is it a good idea to form a real estate limited liability company LLC after buying a property?
After raising capital for real estate, it’s often recommended to protect your investment by forming a real estate limited liability company (LLC).
A real estate LLC offers extraordinary benefits for a real estate business. But does that mean it’s the right choice for your setup? Here's what you need to know before you sign on the dotted line.
Pros and Cons of a Real Estate LLC
The LLC structure is a natural fit for a property investor because it offers easy entry with plenty of room to grow without changing structures. Like any business structure, an LLC offers both benefits and drawbacks for real estate investors.
Let's start with some of the pros and cons of forming an LLC for real estate.
Real Estate LLC Pros:
- Protection of Personal Assets: While a real estate investment that's a rental property can lead to tidy profits, being an investor also exposes your personal assets to risk unless you have liability protection. Forming an LLC limits exposure to personal lawsuits because it shifts legal responsibility from the investor to the real estate business.
- Pass-Through Taxation: This is one of the biggest LLC advantages for business owners because it prevents double taxation. In addition to offering protection against personal legal liability, LLCs also offer protection against double taxation by exempting businesses from paying taxes as "entities." Instead, income is passed to business owners in the form of personal income tax based on their share of the business.
- Easy Management: Unlike corporations, LLCs can be managed by either third-party operators or direct owners. Officers and directors are not required.
- Lower Fees: State-level fees for LLCs tend to be much lower compared to fees imposed on corporations.
- Flexible Ownership Rules: An LLC can legally have anywhere from one member to an unlimited number of members.
- Easy Ownership Transfers: LLC ownership can be easily transferred from person to person. This is helpful when conducting savvy investments, such as purchasing real estate with delinquent taxes.
- Safety in Numbers: Real estate investors are permitted to create a new LLC for each rental property they own as a way to shield the entire portfolio from claims made against a single property.
- Flexible Cash Flow Distribution: Unlike other business structures, an LLC isn't required to be in proportion during cash flow distribution. That means that high performers can be financially rewarded without conflict.
Real Estate LLC Cons:
- Annual Fees: While LLCs are extremely cheap to maintain, owners will still need to pay filing fees to keep their LLCs active in most states.
- Potential Self-Employment Tax: Could you get saddled with self-employment tax for a real estate LLC? It's possible. The workaround is to register as an S corporation with the IRS for tax purposes while staying registered as an LLC at the state level.
- Properties in Different States Can't Share an LLC: If you're investing across multiple states, you'll need to set up individual LLCs for each property. While this isn't a big deal, it does mean paying fees for establishing and maintaining every LLC.
- LLCs Can Be Subject to Lawsuits: LLCs are not legally impenetrable. While LLCs provide strong protection against personality liability, there are situations where individual members can be held responsible if fraud or negligence can be proven.
- Complications When Changing Members: There are several layers to this downside. The first is that transferring a rental property into an LLC could trigger a "due on sale" clause requiring a mortgage to be paid off when property ownership changes. There's also a potential for city, county, or state taxes to kick in when property ownership changes.
Overall, the downsides of forming a real estate LLC don’t outweigh the benefits. In many cases, proper planning can help investors avoid unexpected fees.
Real Estate LLC vs. Liability Insurance
A real estate LLC and liability insurance are not interchangeable. An LLC is a business structure that offers built-in protections against personal liability. Liability insurance is a policy that helps cover the cost of injuries, property damage, and other types of claims.
Investors who own multifamily properties, commercial properties, or industrial properties should strongly consider having both LLC protection and liability insurance because a higher number of tenants means greater liability exposure. In general, all property owners should consider doubling up. However, landlords owning a single-family rental may be safe choosing one option.
Steps to Form a Real Estate LLC
1. Perform Due Diligence
It's important to research state-specific regulations for forming a real estate LLC. Each LLC must be formed in the state where the property is located. This is true even if you live in a different state.
In most cases, filing is handled by the secretary of state for your state.
While having experience with forming an LLC in one state may help the process along, you should expect different rules for each state. Therefore, consider consulting with a lawyer in the state where you're forming a new LLC.
2. Choose a Business Name
Feel free to bring a little creativity into this step. The LLC name designates your company as a legal entity. While every LLC must have a name, the name doesn't have to align with your name, your brand name, or any other category. Some states require LLCs to include the "LLC" designation in the name.
3. Submit Articles of Incorporation
While every state has its own rules, articles of incorporation are typically short. Expect about a page worth of documentation for this one. The general rundown for articles of incorporation includes:
- The name of your LLC.
- The address of your LLC.
- A brief description of your LLC's purpose.
- The "effective date" for your LLC.
- The name and address of the registered agent.
- The signature of the person filing the articles.
The person filing the LLC articles doesn't need to be the owner. In many cases, the filer is the owner's lawyer. However, some states require the names and addresses of all LLC members to be listed within the articles of incorporation.
4. Create an Operating Agreement
An operating agreement is a core document used by LLCs to outline plans for financial and functional decisions, rules, and regulations. According to the U.S. Small Business Administration (SBA), its purpose is to govern the business's internal operations in a way that suits the specific needs of the business owners. The three purposes of the operating agreement are:
- Protecting LLC status.
- Clarifying verbal agreements between members.
- Protecting agreements in the eyes of the state.
The SBA recommends that operating agreements touch on ownership percentages among members, voting rights and responsibilities, powers and duties of members and managers, distribution of profits and losses, meeting schedules, and buyout/buy-sell rules. Specificity is important. Operating agreements can ultimately settle disputes among members.
5. Obtain Proper Permits and Licenses
Most small businesses need licenses and permits from both federal and state agencies. The most universal requirement is a state business license. In addition to obtaining permits and licenses, business owners must keep all credentials current through renewals.
Forming a real estate LLC provides unmatched protection against personal liability. While the LLC shield isn't fully impenetrable, it prevents personal assets from being touched in ordinary cases that don't involve provable fraud or negligence.
While anyone starting a business should investigate all structure options before forming an LLC, the LLC is almost universally the best option when seeking tax benefits and personal liability protection for a rental property.
