What is an LLC?
As one grows their rental property business, there are many ways that one may want to consider to shield themselves from liability and maximize the value of their investments. One of the ways of doing both is through the formation of an LLC. There are organizations such as LegalShield that assist individuals in forming an LLC.
An LLC is a corporate structure and legal entity designed to limit liability of owners and serves as a taxation pass through entity. LLC’s offer the owner flexibility to treat their business as either a partnership or a corporate tax structure. Because of this an LLC is considered a hybrid entity that has characteristics of partnerships or corporations.
When an LLC is formed, it has articles of organization, which are designed to serve as the founding document. The internal operations of the LLC are governed by a document called the operating agreement. The owners of the LLC are referred to as members and there can be single-member LLC’s or multi-member LLC’s.
Because an LLC is considered a legal entity, it has the benefits of having its own tax identification number, bank account, and can conduct business under its own name.
Limited Liability Protection
The main benefit to the LLC is that it can protect an owner’s personal assets from legal liability. This includes a home, vehicles, or other personal assets. In the event that an investor’s property is subject to legal liability, their personal assets are shielded from a lawsuit.
One caveat to remember is that if one is operating an LLC, it is important to keep an accounting of all the LLC transactions separate from personal business. One way of doing this is to acquire software such as Intuit Quickbooks so that business transactions under the LLC are not being commingled with personal expenses.
One can also keep personal and business expenses separate by using a bank account for the LLC. In this manner, the LLC can pay for all the business expenses for the LLC.
Anonymity
Another benefit to the LLC, is that members on the deed will remain anonymous. Normally, the deed will list the names of the individuals that own the property. With the LLC, only the name of the organization will be listed and all partners in the LLC will not be named.
Just because someone has their property listed under the LLC, does not mean that an investor’s personal liability will be completely shielded. There are times when an investor’s personal liability attaches to a lawsuit. In these situations, it is best to consult with an attorney.
Drawbacks to LLC
Setting up an LLC can also be extremely costly. In many cases, there are filing fees associated with setting up a legal entity. There are also annual fees in some states to maintain the status of the LLC.
There are difficulties in getting a mortgage under the LLC. Mortgages under the VA loan program, Fanny Mae, and Freddie Mac usually require that a borrower be an individual and not an LLC.
There are some lenders that will lend directly to the LLC. The lenders will take into consideration the value and rental income to the property. The caveat to this is that the interest rate charged on the note will be several points higher than mortgages that are borrowed by an individual.
Of course, one way of avoiding borrowing as an LLC is to pay cash for the property or transfer the property to the LLC if there are no encumbrances. When the LLC pays cash for the property, the LLC members assume all the risk. When the property is transferred to an LLC, it is best to work with a real estate attorney.
Due On Sale Clause
One thing to consider when buying a property with a mortgage under an individual’s name and transferring it to an LLC, is that the “due on sale” clause prevents this type of transfer. The moment that the transfer occurs, the entire mortgage is due right away.
The alternative to this is to use the LLC to receive rents and pay for expenses on the property, while the mortgage remains in the name of the individual. In this event, the investor receives the benefits of having legal protection without the difficulties of legal entanglements in transferring the property.
Should you use an LLC for your rental property business?
There are benefits of legal protection in using an LLC, but it is best to be cautious and ensure that you are operating the LLC as a business. If there are questions about any possible liability issues, it is best to consult with an attorney.