What is an LLC?
An LLC is a business structure that is usually easy to form and can protect you from certain financial issues down the road if you are running a business, such as managing a rental property. Setting up an LLC for real estate protects the property owner from personal liability in the event of a lawsuit or other costs that aren’t covered by simple liability insurance. Personal bank accounts and other assets not included in the LLC are protected, and since forming an LLC is fairly simple, such business structures are very popular.
How to form an LLC
Requirements for forming an LLC vary from state to state, but generally you will file paperwork with your secretary of state and pay a filing fee. You may also have to apply for a business license or obtain other permits, like a certificate of occupancy. Every state and municipality will have different rules and requirements, so it may be in your best interest to hire an accountant or lawyer who is knowledgeable about the process and can help you do everything correctly.
Advantages of creating an LLC for a rental property
There are benefits and drawbacks to LLC’s though, and it’s important to understand those before deciding one is right for your business. Here are the significant advantages: Protection for personal liability As stated above, the main benefit of forming an LLC is personal liability protection. If you operate rental properties with only liability insurance and do not form a business, your personal assets, including your bank account, your own home, and other belongings become subject to lawsuits and other costs incurred that land outside the scope of your insurance. However, if you create an LLC, your personal assets are protected in such cases, and only the assets associated with the business are relevant. You can even form an LLC for each rental property you own, ensuring that each is held as a separate asset from the other. Separate personal and business expenses When you set up an LLC, you’ll want to have a separate bank account and credit card associated with it. This way your business and personal expenses are clearly delineated, and come tax time, sorting and claiming your business expenses will be much easier than if you were using one account for every single transaction. This also helps establish the LLC as totally separate from the owner’s personal accounts, which will be very important to show in the case of legal issues. Pass-through taxation Although LLCs include some facets of a corporation, they are not corporations and are treated as a sole proprietorship. And this is important because it means there are tax benefits for the business owner. Corporations pay tax on their business income, and then individuals also pay tax on their income from that business—meaning they’re taxed twice on what the company brings in. With an LLC, the earnings for the business “pass-through” to you, which means you only pay tax on the income once and avoid double taxation on your personal tax return. You may also get to take advantage of the 20% “pass-through deduction,” which allows most business owners to deduct up to 20% of business income. In the end, this can mean quite a bit of savings for you.
Disadvantages of starting an LLC
Although there are many advantages to setting up an LLC, it’s important to understand the disadvantages as well. Here are the top disadvantages: Setup costs While starting an LLC can be a relatively simple process, it is not free. At the very least you will pay a filing fee, and there may be other fees incurred along the way, too, especially if you need additional permits. Every state and municipality will have its own rules, fees, and permit requirements, so it’s important to explore these and decide if the cost is worth the savings you may enjoy later. If you want to be extra careful, you will also have to pay an accountant or lawyer fee, as well. Additional paperwork Keeping an LLC running smoothly means making sure you file any required paperwork on time, and that you keep careful documentation that everything has been done so that a record exists in case you should need to show it to officials, or for use during legal matters. Again, you may want an expert to handle this for you, in which case you will incur the fee of the professional you chose to help you manage the LLC. Higher interest rates Property purchased by an LLC, or a mortgage transferred into an LLC, typically has higher interest rates than those purchased by an individual. There is also a chance that transferring property you already own into an LLC will register with your lender as a sale as the deed may be transferred from your name to the LLC’s name, and trigger a “due on sale clause” that requires the mortgage be paid in full upon sale. It is worth exploring this possibility, and how to avoid it, prior to the transfer. Again, you may need to consult an expert to better understand your options and the risks associated. Additional taxes Forming an LLC may cause you to incur additional taxes, depending on where you live. An example of one such fee is the franchise tax, which is charged by some states to businesses that operate within their borders—it’s essentially the price you pay for the privilege of doing business where you are. Depending on where you live, you may pay a flat fee or a percentage of the business’s net worth. You may also end up paying a title transfer tax, which is charged—as the name suggests—for transferring the property title from one name (yours) to another (the business). Title transfer tax is charged by a state or local government and is usually based on the value of the property and its classification.
If you decide to create an LLC for your rental property, make sure you update your rental leases. You’ll list the LLC as the property owner. And be sure to separate personal money from rental property money. For example, all rent payments should be stored in your LLC’s bank account.
Owning and managing rental property can involve a number of “moving parts.” So, if you would like to delegate some (or all) of these responsibilities, working with an experienced property management team can be beneficial. Contact Overland Management today and let us help you!