One of the first questions I hear from new real estate investors is:
“Should I create an LLC for rental properties, rather than owning them under my personal name?”
It’s a good question, and shows foresight. After all, people love to sue landlords. And love to hate landlords for some reason, despite the fact that rental property owners offer a much-needed service.
As a general rule, the answer is yes: you should use an LLC for investment properties. But that opens the door to a slew of other questions.
As a recovering landlord who has owned dozens of investment properties, here are the questions I’ve heard most often — and their answers.
Key Takeaways:
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- Pros include limiting your legal liability to the LLC’s assets, flexible ownership, easy ownership transfer, and tax benefits.
- Cons include costs, accounting complications, imperfect protection, and financing challenges.
- You can transfer ownership of a rental property from your personal name to an LLC, but you’re better off buying it under the LLC name from the beginning.
Benefits of an LLC for Rental Property
The main reason landlords use a limited liability company (LLC) is, drumroll please… to limit their liability.
When someone sues you personally and wins, they can come after almost all of your personal assets. Your house, your car, your Magic: The Gathering card collection, your prize-winning show goldendoodle. All right, that’s a bit of an exaggeration, but you get the idea.
When someone sues a business, they can only go after the assets owned by that business. So, by using an LLC for real estate investments, you add an extra layer of protection between your rental properties and your personal assets. Litigious tenants or neighbors can theoretically only seize your rental property — not your life savings.
Granted, LLCs aren’t bulletproof. Most ambulance-chasing attorneys will name you personally in their lawsuits, even if you own the property under an LLC name. But assuming you’ve dotted all your I’s and crossed all your T’s, you can petition the judge to remove your personal name from the list of defendants. That dotting and crossing mostly involves keeping the LLC in good standing and clean accounting.
Which raises another benefit of LLCs for rental property: separate accounting and deductions. More on the tax benefits of an LLC for rental properties shortly.
You can also use LLCs to create a modicum of privacy. Determined sleuths will figure out who owns the LLC, but again, it provides another barrier.
As a final note, LLCs provide flexible ownership. You can add multiple owners easily, and change ownership shares at any time with the stroke of a pen on the operating agreement. If you want to sell ownership of your investment property to your daughter, you can simply change the ownership of the LLC. That saves you thousands of dollars on closing costs, as you don’t need to do a formal settlement.
Disadvantages of an LLC for Rental Properties
To begin with, LLCs cost money. It costs money to create them in the first place, and in most states, it costs money to renew them each year.
It also costs money (or your precious time) to prepare a separate tax return for the LLC. Plan on at least an extra $500 each year, perhaps thousands.
State laws and taxation can get tricky if the LLC is filed in a different state than the property. For example, if you live in California but invest in Kansas, do you open the LLC in California or Kansas? Or somewhere else entirely, such as Nevada or Delaware, for their business-friendly laws? Those are wrinkles you have to iron out with an attorney or accountant.
As touched on above, LLCs don’t provide perfect protection. You have to use separate bank accounts and keep your accounting squeaky clean. All rental income and other business income must go into the business bank account. If you mix personal and business funds even once — known as commingling funds — it can invalidate your personal liability protection.
It’s often harder to get a mortgage for an LLC-owned property. If you borrow a conventional mortgage rather than a portfolio loan, expect extra headaches and hoops to jump through.
Tax Benefits of an LLC for Rental Property
The IRS treats LLCs as “pass-through entities,” meaning they aren’t subject to double taxation from both corporate taxes and personal taxes. The income passes through to members for tax purposes. You then pay taxes on that income based on your personal income tax rate.
If you prefer, you can usually opt to have your LLC taxed as an S corporation or C corporation. Speak with a tax specialist about the pros and cons of doing so.
Limited liability companies also allow flexibility in the proportion of tax benefits. While the income and expenses are typically attributed based on ownership percentage, you can write into the operating agreement that one member gets a disproportionate share of a property depreciation write-off, for example.
All rental property tax deductions apply, of course. These appear on a separate schedule (Schedule E) on your tax return, and don’t require you to itemize your personal deductions. You can also deduct some business expenses that ordinary workers can’t on their personal income tax return, such as a home office expense. Again, all while still taking the standard deduction.
