When it comes to property, there’s a lot that can get in the way of your investment’s success.
One often overlooked element is protecting your business from the inevitability of lawsuits and legal trouble of all kinds.
It’s not fun to think about, but it is the kind of thing that can leave you crippled if you go in within the right kind of protection.
One of the best tools for guarding yourself from that uncertainty is an LLC, which is an effective vehicle for protecting you against many of those unexpected events.
Below, we’ll cover what an LLC is, why you should consider putting your rental property under an LLC, the pros and cons of doing so, and much more.
What is an LLC?
LLC stands for ‘limited liability corporation’, and it’s one of 3 types of corporations or business structures.
An LLC differs from other types of corporations in that it’s generally much easier to create and manage while offering many of the same protections.
Creating an LLC differs based on what state you operate in, but the process is typically much the same.
And if you’re unclear about why you’d use an LLC vs. insurance, and what the difference is, don’t worry.
We’ll cover those points below, as well as a deep-dive into the pros and cons so that you have clarity about why you might consider an LLC to protect your property.
What are the benefits of an LLC for rental property?
Next, let’s cover the benefits– as well as the drawbacks– of putting your rental property under an LLC.
There’s no better way to understand whether something is a good decision for your business or not than seeing the pros and cons clearly outlined.
Pros of using an LLC for rental property
First, let’s start with the benefits of using an LLC for rental property.
Pro: Reduce your personal liability
Owning property as an individual means that any lawsuit filed regarding that property comes back to you.
If the property is under an LLC, however, your personal assets are protected because the LLC owns the property. Therefore,
Pro: Pass-through taxation
A lesser-known benefit of using an LLC for property is that you can take advantage of pass-through taxation.
Typically, a corporation pays taxes on its earnings then an owner pays taxes on their income from the business. Especially if you’re running a 1-person operation, you’re essentially having to pay taxes twice.
However, pass-through taxation means that your LLC’s earnings can pass directly to you, so the LLC isn’t taxed on your earnings through the rental property.
The result is potentially big tax savings.
Pro: Keep your properties separate and protected
Similar to the first point, if you go a step further and protect each of your properties under its own LLC, you’re able to protect them from one another.
Typically, if all of your properties are under you– or even under the same LLC– and you’re hit with a liability suit, your other unrelated properties could be put in jeopardy.
However, if your properties are protected under their own LLC then you won’t have anything to worry about. That’s because each LLC– like person– is considered a separate entity.
Cons of using an LLC for rental property
Now, let’s touch on the cons. These are the main cons of using an LLC for rental property:
Con: Corporations– including LLCs– require additional paperwork
While it’s nothing the average business owner can’t handle, it is important to know in advance that starting a corporation of any kind isn’t like being a sole proprietor.
An LLC is much easier to manage than an S or C corporation, but it still requires some paperwork and maintenance to keep going each year.
However, it is pretty minimal and generally just involves an annual report and fee of some kind depending on the state.
Con: LLCs come with setup and maintenance fees
LLCs typically have startup fees in most states, so it’s worth checking with your state to see how much it will cost you.
It’s also important to note that some states have an annual fee for maintaining an LLC moving forward.
Again here the fee will differ depending on the state, though it’s usually pretty low and easy to manage.
Con: You may pay additional taxes
Remember how we mentioned that an LLC benefits from pass-through taxation?
That reduces your personal tax bill, or at least keeps it roughly the same as when you’re a sole proprietor.
That’s a boon, but on the flip side, having an LLC can in some cases result in additional taxes.
For example, some states have a title transfer fee. That means you’d pay when moving ownership from yourself to your new LLC.
Also, other states require you to pay franchise tax, which will either be a percentage of the net worth of the LLC or a flat fee.
Neither of these apply in every case, but they are additional taxes and fees you may have to pay depending on your location and situation, so they’re worth being aware of.
How to set up an LLC for rental property
Beyond that, you’ll also need to:
Obtain an EIN
First, you need an EIN or Employer Identification Number (also known as a TIN or Tax Identification Number).
Think of your EIN as your business’ form of identification, much the same way that you might use your driver’s license to identify you in an official capacity.
Open a business bank account in the LLC’s name
You might have already learned the virtues– and necessity– of having a separate business bank account for all your business activity.
However, you’ll also need a separate business bank account for all of the LLC’s dealings.
And file the deed to transfer ownership of the property to the LLC
Depending on your state and situation what type of deed this is will vary, though it’s usually a quit claim deed.
It’s important to speak with your lender to understand clearly what your options are here as there are a few ways you can go about it.
For example, you may be able to refinance the property to change the name to the LLC’s, though you might not.
Does an LLC offer the same protection as an umbrella insurance policy?
One common question is whether to set up an LLC for protection or use an umbrella insurance policy.
For landlords, an umbrella insurance policy is a type of insurance typically used in addition to liability protection.
Liability protection doesn’t cover everything. Likewise, neither does an LLC.
For complete protection, landlords will often protect their properties in LLCs while using liability protection and an umbrella insurance policy overlayed on top of that.
However, it’s worth stressing that what is best for you may differ depending on your state, situation, etc.
Check with your insurance rep to see what your liability policy covers and to see how an LLC and umbrella insurance can work together to offer maximum protection.
And to learn more about how umbrella insurance works, check out our guide: Umbrella Insurance for Rental Properties: The Complete Guide.
On forming an LLC out of state
One last note: some choose to form an additional LLC outside the state that their property resides for additional protection.
To be clear– that’s in addition to an LLC within the state that your property resides.
The purpose of this is to protect from what are called “charging orders”.
Charging orders allow many states to claim against disbursements you made to yourself from the LLC when in a lawsuit.
Whether you may need this depends on what state your property resides in, so be sure to check with an attorney to see whether they’d advise this route or note based on your location and other information.
Protect your property– and yourself
Forming an LLC for your rental property is a sound move if you’re at all concerned about protecting yourself from claims against you and your property.
An LLC offers valuable liability protection that forms part of a sound business strategy to guard you against legal issues.