Should You Create An LLC For Your Rental Property – Pros & Cons
Are you planning to create an LLC for your rental property?
Are you sure about the decision or are you just following the herd?
In the past, the only option for real estate investors looking for limited liability protection was to form a corporation for acquiring title. But for real estate property owners, the business structure of a corporation has a few potential drawbacks.
Since the introduction of LLC (Limited Liability Company) structure, most rental property owners now prefer creating an LLC for their properties. Popularly known as a hybrid business structure, LLC combines the tax benefits of a partnership and limited liability advantage of a corporation.
So, should you go ahead with your decision? The only way to know is by understanding the pros and cons of creating an LLC for your rental property. As no single answer is applicable to all the landlords, understanding the benefits and drawbacks will make you more confident.
So, let us start with the pros first, followed by the drawbacks.
Pros of Creating an LLC for Your Rental Property
- Limited Liability Protection
Needless to say, the most significant advantage of creating an LLC is the limited liability protection it offers. The business structure protects your financial assets in case a lawsuit is filed against you. For instance, let us assume that your tenant throws a party at your property and one of the guests falls over the balcony and hurts himself.
It is very much possible that the guest might file an “unsafe condition” claim against your property and as the owner, your name will appear in the lawsuit. If the rental property belongs to an LLC, only the assets that the LLC owns would be at risk. All of your personal assets would remain protected.
Sepate LLC for Each Rental Property?
In this regard, if you have multiple rental properties, it is recommended that you create a separate LLC for each of the properties. If a single LLC owns all of your rental properties, in case of a lawsuit on any one of the properties, all of your properties would be at risk. With separate LLCs, just the assets of the LLC which owns the property on which the lawsuit is filed would be at risk.
- Pass-Through Tax Benefits
An LLC is a pass-through business entity. This means that the profits and losses of your LLC are passed through the LLC members (owners), and they then report the same on their personal tax return. However, this is not the case with corporations like C corporations which are subject to double taxation.
Moreover, by creating an LLC, the owner can also avoid the double taxation on the rental income as well as the appreciation in the cost of the property when it is sold. Also, if you are a single-member LLC, the interest of your mortgage can also be deducted just like a sole proprietorship.
In case if it is a multi-member LLC, each of the members will only be required to report a portion (corresponding to their investment they put in the LLC) of the profits and losses on the personal tax returns they file.
- Other Important Benefits
There are a few other essential benefits of creating an LLC for your rental properties. For instance, it is easier to keep your personal expenses separate from the business expenses by forming an LLC. Moreover, as compared to partnerships and corporations, LLCs offer greater flexibility in terms of profit distribution and transfer of interest rights.
Also, as compared to corporations, LLCs are generally required to pay lower state registration fees in most of the states. As far as delegating management responsibilities is concerned, LLCs have more flexibility as compared to a corporation or a partnership.
With a corporation, it is mandatory to have directors and officers in your company. But with an LLC, the owner(s) or 3rd party managers can handle the business operations.
Cons of Creating an LLC for Your Rental Property
- Cost of Forming and Maintaining an LLC
Talking about the cons, the most important one is related to the cost of forming and maintaining an LLC. You will be required to pay fees for setting up your LLC. If you have multiple properties in multiple states and you want to create a separate LLC for each of them, you will be required to pay fees for setting up each of them.
Apart from setting up the LLC, you will also need a lawyer for tax preparation and filing taxes every year. The fees for setting up an LLC and their ongoing and annual fees vary between states. So, ensure that you check the same on your Secretary of State’s website.
- Personal Asset Protection is Not Guaranteed
While personal asset protection is the most significant benefit of forming an LLC, the protection has its limitations. There are several situations or circumstances in which a plaintiff can bypass this corporate veil to hold LLC member(s) liable for obligations and debts.
For instance, if you fail to do a job that was your personal liability such as pool maintenance or snow removal and it resulted in an injury to the tenant, you can be individually liable for the same. Deceptive business practices or frauds can also hold your personally responsible.
Is Buying an Insurance a Good Option?
A lot of property owners rather than forming an LLC prefer purchasing a liability and umbrella insurance. While the coverage will not prevent your tenants from filing a personal lawsuit against you, the insurance cover might be able to pay for the damages.
However, if at all the insurance coverage is not adequate to pay for the lawsuit, you will have to pay the remaining amount from your pockets. Also, insurance policies generally have a lot of exclusions too which can get you in trouble in case of a lawsuit. So, check the exclusions if you are going with this option.
Now that you have the most important pros and cons of forming an LLC as a rental property owner mentioned above, you might probably have a fair idea about what you should do. With LLC, you will get personal asset protection, tax benefits and a host of other benefits. However, personal asset protection is limited, and there are costs for forming and maintaining an LLC.
As the decision is a complicated one, it is better to consult with a financial advisor, attorney or CPA as their expertise would help you know if creating an LLC is beneficial to you.