Protecting your Investment Property with an LLC — Pros and Cons
“I own it! It’s mine! Look at my name on the deed!”
If you are in the first stages of your investment journey, you might need to let go of these vestigial sentiments about “pride of ownership.” Seasoned investors know that having your name on deeds is just asking to get sued.
Instead, investors protect themselves with entities — legal fictions, created by lawyers and registered with the state, that are treated as a separate “person” from the owners and members, but without many of the liabilities of actual personhood.
The corporation is probably the most famous entity (see “Inc” at the end of the official name of your favorite companies). The limited partnership (LP) and the trust are also popular.
While any of these entities could be used to hold real estate, easily the entity that gets the most lip service for real estate investment is the limited liability company (LLC). We’re no exception — most MartelTurnkey buyers who hold their turnkey rentals in the name of a corporation, choose the LLC route.
To understand why — and to know what pitfalls to look out for — here are several pros and a short list of cons to holding your investment in the name of an LLC.
Pros of Holding Rental Property in an LLC
1. Limited Liability
It’s right there in the name, but we can’t stress this enough — rental property owners have to limit their liability. We live in a litigious culture. If your tenant slips and falls on your porch, they may sue you for renting them a shoddily-constructed porch.
If the real estate is in your name, your plaintiff tenant can go after your car, your personal residence, your savings account, your brokerage accounts, your personal insurance policies, and any other asset in your name to settle any damages.
They will probably do it without ever losing a night’s sleep, too. After all, you’re a landlord. You’re rich! You can afford to fork over millions of dollars to make the tenant rich … right?
But if the house is in the name of an LLC, they can’t go after your stuff. After all, you don’t own the rental house … the LLC does! Yes, you own the LLC, but that’s not the same thing for legal purposes. The plaintiff can only target assets owned by the LLC – usually just the house itself, with a lot of debt.
There are several considerations to maintain the “corporate veil” and protect yourself (talk to your lawyer), but that’s the basic idea.
2. Tax Advantages
LLCs have several tax advantages compared to either a corporation or to owning the house in your name.
If you own the house in your name, you are taxed as a “sole proprietor,” which means you are on the hook for self-employment taxes. An LLC can shield you from this.
At the other end of the spectrum, corporations are notorious for “double-taxation” — the corporation gets taxed on its revenue, and then the stockholders get taxed on the dividends.
An LLC, on the other hand, can be set up as a “pass-through” entity, where the income passes directly to the owners without the extra taxation. Not only that, but this sets you up to get the “pass-through entity” deduction.
Want to learn more? Check out this article we wrote on the tax advantages of real estate investing.
3. Easy to Use
Corporations are old-school entities, subject to relatively arcane laws. Corporations must adhere to certain set structures and hierarchies. They must comply with complex reporting laws, holding regular meetings with written minutes. Ownership can only be transferred by “stock.” There are a lot of rules there, too.
LLCs, by contrast, are a relatively new form of entity, with relatively few laws, precedents, and formalities to restrict them. The reporting burden is much smaller, and ownership can be transferred easily with a few signatures.
This varies by state, but in general, an investor can use LLCs to obfuscate the public record and make it hard to know how much real estate they own.
For investors who want a low profile — i.e. who don’t want creditors, predators, looky-loos, and the government to know their actual net worth — this is very valuable.
Cons of Holding Rental Property in an LLC
1. Mortgage Due-On-Sale Clause
Banks don’t lend to entities — they lend to people. They want to have a person to go after for collections. If you buy with a mortgage, you will have to personally guarantee the loan — and the lender will want the name on the deed to match the name on the note.
Most investors structure the deal to close with their own name on the title to satisfy the lender but then, at the closing table, they quietly transfer title to the LLC. Now they have a loan in their name, but title to the real estate is in the name of the LLC.
This transfer of ownership technically violates the “due-on-sale clause” found in all mortgages — that the entire loan can be called due if ownership of the property changes.
Mind you, they have to discover that you did this. They might not if you cover your tracks. (Legally, please! Talk to your lawyer.) They also don’t have to call the loan due. They may look the other way, especially if you establish a good relationship with your lender. Lenders are not stupid — the know investors do this, and they understand why. But you should know that it’s a risk and tread carefully.
Feel free to reach out to us to discuss in detail how to manage this risk.
2. Beware of Transfer Taxes
Transferring ownership of real estate is often a taxable event. Many states waive transfer taxes if there is no practical change in ownership interest. For example, if you and a partner own a rental property 50/50, there may be no transfer taxes if you transfer title to an LLC that you and the partner also own 50/50.
However, some states assess the transfer taxes regardless. Check the laws in your target state so you don’t get caught off-guard.
Sound complicated? Don’t panic. MartelTurnkey helps seasoned and beginner investors alike. We’re more than happy to guide you through the nuts and bolts of your first rental property. We want long, mutually profitable relationships with our customers, so we go the extra mile to set you up for success.