LLCs are a popular business structure with rental property owners, but do they make sense for you and your rental property? We’ll go through the benefits, drawbacks and possible alternatives.
A Limited Liability Company, or “LLC”, is a business structure that’s best known for shielding the personal assets of owners from the debts and lawsuits of the business. While LLCs have their benefits, alternatives such as Sole Proprietorships or Real Estate Trusts can be better options in certain situations.
Benefits of an LLC for Rental Properties
There are many reasons why property owners may choose to form an LLC to manage their rental properties.
- Personal Liability
- Property Separation
- Pass-Through Taxation
- Separate Expense Logs
- Ownership Flexibility
One of the main reasons that many property owners create an LLC is that it limits their personal liability if something goes wrong. Lawsuits made against the LLC only affect property that the LLC owns, so a member’s personal property is protected.
Say, for example, that a tenant in a rental property calls in a work order to have their balcony fixed. In the time it takes for the landlord or owner to call someone and arrange for it to be fixed, a friend slips and falls off of the balcony. The tenant may be able to sue the owner for a large amount of money.
If the property is managed by an owner without the use of an LLC or other company, the owner may have to give up their own home or car to cover the damages. When the case goes to court, the owner’s personal property (including other rentals) can be seized.
However, if the owner is part of an LLC, only property that the LLC owns can be seized. The owner’s personal funds and property cannot be affected by the lawsuit at all, no matter how much monetary compensation the LLC is required to produce.
Though it may cost exponentially more, some landlords prefer to set up a separate LLC for each rental property. The protections that are inherent to the LLC will then apply to each separate property. If someone sues the LLC that owns the property, only assets and finances tied to that single property are liable for seizure.
On the other hand, if an LLC owns multiple properties under the same umbrella, that same tenant can cost you your other rental properties and assets and finances associated with every property you own.
The ability to separate properties and insulate each of them from each other and from personal assets is attractive, and some landlords choose to go into business this way no matter the fees and costs.
Another of the most popular reasons to create an LLC comes down to tax benefits. Pass-through taxation prevents an LLC from being taxed as a corporation, which can mean a lot to owners when tax time rolls around.
With other types of corporations (such as standard C corporations or S corporations that have special tax status), the company is taxed on whatever it earns throughout the year. Then the owner/owners are taxed on the income they’ve generated from the company. The result is a double taxation situation, and it can be incredibly costly for smaller owners.
On the other hand, LLCs benefit from their model in a major way. There is a slight difference in the way that the IRS classifies multi-member LLCs and LLCs with a single member, but both types of LLCs can benefit from the lack of company taxes.
Either way, taxes pass through the company and fall directly on the member/members of the LLC. This means that there are no taxes at the company level, and the earnings that the LLC generates cannot be double-taxed. Owners with multiple rental properties may find that an LLC is a more cost-effective way of managing those properties.
Single-member LLCs are taxed the same way that sole proprietorship is taxed, and may be subject to self-employment taxes. However, the business owner pays the taxes, and no taxes are levied directly from the company. At this point, LLCs are regarded in the same way as companies with a sole proprietor; they are classified as ‘disregarded entities’.
If an LLC has multiple members, the taxes still pass through. However, each member of the LLC has to complete special tax forms to ensure that only their share of the income is taxed on their personal return.
Separate Expense Logs
LLCs must create separate bank accounts for business expenses. All finances must be kept separate between the company and personal funds, or certain protections offered by the LLC may be void. However, this is actually a benefit.
Keeping your business expenses separate from personal finances is extremely helpful when it comes to doing your taxes, especially if you want some of the special deductions that an LLC offers. Keeping separate bank accounts and separate logs of financial spending makes tracking those deductions so much easier in the long run.
LLCs allow business owners to be that much more flexible when it comes to certain aspects of the company. Taxes are one area that becomes more flexible under an LLC, but ownership is also extremely flexible. There is no upper limit on the number of members your LLC can have, and there is no minimum either.
Theoretically, all landlords in a certain area could join the LLC. Though it might get messy at that level, there is no law that states that can’t be the case. Whether an LLC is owned by one person or a thousand people, the benefits are substantial.
LLCs are also much less complicated than other corporations, even companies with a sole proprietor. Since it is a special type of company set up specifically for this purpose, an LLC can provide more protection than a traditional company, but with even fewer legal hoops to jump through.
Further, an LLC may even be able to transfer ownership of its properties to individual owners over time without the formality of transferring a deed. An LLC has the ability to be so much more flexible than standard corporations.
If an owner operates without an LLC, the tenant will always know exactly who owns the property. This may not seem like a bad thing, but it can be catastrophic if a tenant has bad intentions.
A tenant who is interested in finding any possible lawsuit might try to sue for more if they know you are a doctor, for instance. Even if they find out from another source, knowing exactly who you are and what your economic status is can be terrible if they want to sue you badly enough.
An LLC gives the owner of the property a certain amount of anonymity. The property will be listed under the ownership of the LLC instead of a name that may divulge personal information. Though it is a small benefit, it is invaluable for those who want to be cautious about their personal information.
Drawbacks of an LLC for Rental Properties
While there are many benefits to creating an LLC, there are also quite a few drawbacks that make it a less advantageous option for some property owners.
- Financing Problems
- Fees and Costs
- Taxes Can Be Tricky
- Money Must Be Kept Separate
- Transferring a Property You Already Own
- Unclear Asset Protection
While it can be difficult to transfer a property you already own to an LLC, it can be just as difficult to purchase a property in the name of your LLC. Lenders and financing companies want to make sure that someone is personally responsible for repaying a property loan. It may be difficult to find a lending company that will allow a purchase in the name of an LLC, because the benefits that work in your favor work against theirs.
Single-family rental properties, especially, create a difficult situation for lenders. Since the LLC protects the owner’s personal property, what will they seize to pay the loan if it defaults? Who is responsible for making payments? While it isn’t impossible, it can make buying new properties more difficult than purchasing them under your name.
Fees and Costs
Setting up an LLC is not free. Between lawyer fees, creation fees, filing costs, and annual costs, creating an LLC can be expensive. Plus, there are fees that must be paid in order to maintain the LLC. These fees vary by state.
Taxes Can Be Tricky
Many owners choose to create LLCs for the tax benefits, but these can be tricky to obtain and difficult to parse in certain situations. When the LLC is first created and registered, filing taxes through it may be daunting. There are a lot of forms, and while it is similar to sole proprietor LLC, it can get tricky very quickly when there are multiple members and a lot of different bank accounts and credit cards.
There are protections afforded by the LLC, but filing taxes will never be as simple as a personal tax return. It’s worth keeping in mind that it’s not going to be as easy as most lawyers may make it out to be.
Money Must Be Kept Separate
This can be a benefit, but it can also be tricky. Bank accounts and credit cards for the LLC and your personal funds have to be kept separate. If you use LLC funds to make personal purposes or use personal funds to make purchases for the property, you can open yourself up to lawsuits. This is known commingling assets.
If someone can find evidence of these transactions, it could spell trouble if there ever is a lawsuit. In an instance like this, your personal property may not be protected at all.
Essentially, the LLC provides plenty of protection when used correctly. It’s up to the member/members to observe the boundaries that maintain those protections.
Transferring a Property You Already Own
It can be difficult to transfer a property you already own into an LLC. It is especially difficult to transfer a property into an LLC if you have an open mortgage on it. Transferring ownership to your LLC may be considered a formal ownership transfer, and you could lose your lower interest rates and more.
Unclear Asset Protection
The protections offered by an LLC may not be as far-reaching as one might think. When it comes down to it, the legal language surrounding LLCs can be broad and unspecific, leaving room for interpretation in a court of law. This can be a good thing, but it can also turn against an owner.
The way your assets are protected may vary depending on the circumstance, which may lead to a lot of confusion and uncertainty if a problem does arise. Creating an LLC may be worth it, but it may also work against you.
Alternatives to an LLC for Rental Properties
An LLC is not the only type of company you can form to help manage rental properties. There are a lot of alternatives and different business models, and you can always choose to not form an LLC at all. There are no alternatives that do exactly what an LLC does, but these options may be better suited to certain property owners.
- Sole Proprietorship
- Real Estate Trust
- S Corporation
- C Corporation
- General Partnership
- Limited Partnership
- Insurance Alternatives
LLC vs Sole Proprietorship for Rental Properties
Aside from an LLC, a sole proprietorship is one of the most popular options for property owners. A sole proprietorship is essentially a one-person business. These types of businesses handle taxes the same way as self-employed people do, and they don’t require the same types of fees that setting up an LLC does.
There are certain benefits to using a sole proprietorship business model instead of an LLC.
- Lower start-up costs. Sole proprietorships usually only require permits and/or licenses to get started.
- Fewer name regulations. Sole proprietorships can choose almost any name for their company, as long as there isn’t already a company with that name in your state.
- No separation needed. There’s no reason to separate personal and business funds with this type of business, as they are considered one and the same.
- Very few regulations. While LLCs are heavily regulated, sole proprietorships aren’t subject to a lot of state laws. It’s not the Wild West, but you can forgo annual fees, registrations, and diligent record keeping.
On the other hand, this may not be the best option for you.
- No liability protections. Here is where the LLC becomes a great idea. The sole proprietorship model and structure does not offer any protection from lawsuits. Your personal property can and will go to cover damages from any lawsuits that may be brought against you.
- No difference in taxes. LLCs are taxed just like sole proprietorships most of the time, unless there are a lot of members or they have been set up with different circumstances. Taxes will pass through to the member/s either way.
For these reasons, a sole proprietorship is probably best for a single property owner who doesn’t do much renting, or who has insurance to cover liability concerns. For managing just a few single-family homes (or even a single rental home), a sole proprietorship can be a more useful tool.
LLC vs Real Estate Trust for Rental Properties
A real estate trust, or realty trust, is often used as a way to allow multiple owners to invest in the same property. Though it is widely used for investment properties, it can be used in much the same way an LLC can – only the LLC offers more liability protection. The trust holds the properties and collects rent as trust income.
There are a few benefits to using this type of business entity instead of an LLC.
- Building an estate. If you plan on passing rental properties on to heirs after your death, leaving behind an estate for them, a real estate trust is the best option. You can avoid probate court and clearly determine who the property transfers to if you are incapacitated.
- Better for multiple owners. If multiple owners have claim to the same property (whether they are related or each own a part of the property), a realty trust can make sure that they both get what they’re owned and all of their interests are represented.
However, there are also quite a few drawbacks when it comes to using a real estate trust instead of an LLC.
- Higher taxes. Trusts traditionally have high tax rates, because they aren’t taxed on income. Rather, taxes are assessed based on the value of the property the trust owns. The result can be a much more expensive tax, especially if you own more than one rental property.
- No liability protection. A realty trust does not provide any additional liability protection of its own. To get any type of liability protection, you’ll have to purchase additional insurance.
Essentially, trusts are a good idea for your personal home, or if you have an estate to pass on to your heirs. When it comes to multiple owners with multiple properties, multi-family rentals like apartments, and even a large number of single-family properties, a trust can be expensive and troublesome to maintain.
LLC vs S Corporation for Rental Properties
An S corporation is a business model that elects to use a pass-through taxation method. The shareholders (equivalent to an LLC’s members) are responsible for reporting their own corporate income, deductions, and losses. This alternative is most similar to an LLC because of tax similarities and liability protection.
There are some differences, as well as benefits for choosing an S corporation over an LLC.
- Self-employment taxation. When your LLC is taxed as a sole proprietorship (the default tax situation), members still have to pay a self-employment tax. With an S corporation, owners are allowed a “reasonable salary”. Any corporate earnings over this salary amount are considered “unearned” and won’t be subject to the self-employment tax. This is one of the most important benefits to choosing an S corporation.
- Good for multiple owners. S corporations can prove beneficial for multiple owners overall, though there are some limits to how many members or shareholders an S corp can have. The business model works better for multiple people than an LLC, because there is a clear hierarchy with leaders and managers.
On the other hand, some drawbacks may apply.
- Fewer members. An S corporation cannot have more than 100 shareholders at any time. LLCs can have as many members as they want or need to have, and their numbers aren’t regulated.
- Citizenship. For someone to be a shareholder in an S corporation, they must be a US citizen or a US resident. This is not the case with LLC members.
While S corporations and LLCs may seem functionally the same, they are different in a variety of ways. Regardless, an S corporation is very similar to an LLC, and one of the most popular alternatives. If you make a lot of rental income or plan on making a lot of investments, an S corp may be preferable for the tax benefits. Realty businesses with multiple owners or even multiple apartment-type rentals could also benefit from an S corporation.
LLC vs C Corporation for Rental Properties
C corporations are the standard business model (so far as there can be a standard business model). This means it’s the business type widely used for most larger companies and retailers. This is the type of company that is heavily taxed, but there are divisive benefits to choosing this business model over an LLC.
A C corporation is beneficial in the following ways.
- Lower audit risk. LLCs and sole proprietorships are much more likely to be audited, because they are in the hands of one or more property owners who must keep their own records. Due to the nature of a C corporation, it’s less likely to be audited.
- Business debt liability. The liability of a C corporation is a bit more than an LLC covers. Here, there is some measure of business debt liability as well as general liability. It provides more protection for your personal assets.
- Great for bigger incomes. If you have a lot of rental income or plan on expanding your business, a C corporation is a good option despite the tax issues because of the way it handles shareholders and investments.
However, there are substantial drawbacks that LLCs help mitigate.
- Double taxation. C corporations will be taxed at the corporate level, and then shareholders and members will be taxed again at the personal level. This means that for the owner and other important shareholders, a C corporation is much more expensive.
- Tighter regulations. C corporations must follow strict guidelines, such as holding regular meetings, updating business records consistently, and issuing stocks to shareholders. There is also a certain unspoken threshold of income required to maintain a C corporation.
- Shareholders are not equal. One of the benefits to an LLC is the ability to make all members equal and member-manage the company. This is not true of C corporations, where shareholders have parts of the company, but there is a clear and strict hierarchy of directors and managers that must be adhered to.
C corporations are not set up to be a single-member or single-owner business. Multiple owners or owners with multiple properties may get some benefit from a C corporation, but overall it isn’t ideal for the average landlord.
LLC vs General Partnership for Rental Properties
A general partnership offers the same level of shared expense and control as an LLC, but without the liability protection. Workload is shared between members of the partnership, much like it would be in an LLC. A general partnership is a bit less formal.
There are some benefits to choose a general partnership instead of an LLC.
- Less formal structure. There are fewer guidelines to adhere to in the creation of a general partnership. While it is still a business structure, there are fewer restrictions and qualifications than with LLCs or corporations.
- Lower startup cost. LLCs can have expensive startup fees, as well as yearly fees to keep the LLC running. General partnerships can start without a substantial cost, and any cost is shared between partners.
Compared to LLCs, however, there are some drawbacks to a general partnership.
- Shared liability protection. This is the biggest reason why someone might want to choose an LLC instead. General partnerships don’t offer an umbrella liability that protects personal assets. Instead, the liability for any lawsuits or damages is split between the partners.
- Needs more than one member. LLCs and sole proprietorships can exist with just one member or owner. General partnerships need at least two individuals to be part of the company.
General partnerships may be a valid option for a handful of property owners with only a few properties each, but the lack of liability protection may be an issue when it comes down to it. The shared income also makes individual taxing a bit more difficult, but it can be a viable option over an LLC in certain cases.
LLC vs Limited Partnership for Rental Properties
A limited partnership only differs from a general partnership in that each partner has limited responsibilities. In a general partnership, all partners are “in it” together. In a limited partnership, each partner can only earn a set amount, and contributions are likewise restricted.
The benefits of a limited partnership are much the same as a general partnership.
- Unlimited investors. The more investors you take on in a limited partnership, the less profit each member will make. While this is a gamble, it means that you can ultimately set up the business exactly the way you want, with each member only in control of their own assets and contributions.
- Limited liability. Not every partner in a limited partnership gets the same level of liability. Liability is restricted to the initial investment that the partner makes when joining the business. This means that people technically only get back as much as they can offer, taking the strain off of the other partners.
The drawbacks are a bit difficult to come to terms with, though.
- Limited benefit. Because of the way a limited partnership is structured, each member’s benefits from the business will also be restricted. Partners are all equal, but not in the same way that they are in an LLC. For multiple owners, an LLC seems more beneficial when it comes to liability protection and tax options.
- Unhelpful for larger partnerships. While you can have an unlimited number of partners in this structure, each one cuts down profits. Unlike a general partnership, a limited partnership is not recommended for more than a few partners.
For smaller businesses or partnerships, this can be a viable option. The low cost of starting a limited partnership may make it more attractive, but ultimately an LLC has more freedoms and equality.
LLC vs Insurance Alternatives for Rental Properties
Insurance can be an additional protection for LLC members, or it can replace the need for an LLC. There are certain benefits to choosing an insurance policy over formally starting a business, including:
- Less expensive. Insurance may get pricey, but it usually isn’t as expensive as the fees and costs for starting an LLC. Besides filing fees, you’re looking at lawyer fees, annual fees, and perhaps even publication fees associated with starting an LLC. Insurance is a once-monthly or once-yearly expense, but you don’t have to look after it like you would an LLC.
- Already required. Chances are, you’re already going to want insurance on your properties. The benefit to using this as an alternative to an LLC is that you won’t have any further costs. Since you probably already have insurance, this is a simple fix.
But LLCs look more attractive for certain conditions, including the following.
- Expensive lawsuits. Insurance can only protect you up to a certain amount. If something goes wrong on a larger scale, your personal property may still be at risk if you rely on an insurance policy alone.
- Policy limitations. Some policies will only protect against certain types of damages, or certain types of lawsuits. The limitations across insurance policies make them less attractive and riskier to deal with alone.
- Exceptions. Policies may have exceptions for certain events that aren’t covered. Most of the time this isn’t a big deal, but if you happen to come across one of these issues, it may be catastrophic.
Liability Insurance for Rental Properties
Liability insurance can be purchased even without an LLC, and it can help protect you and your properties in case of a bodily injury lawsuit. It is generally less costly than LLC formation, and it’s generally recommended to have some sort of insurance for your rental properties.
The limitations to liability insurance may not make it an attractive option to owners with multiple properties, however. Sometimes there are stringent policy limitations, additional insurance requirements, exceptions, and other consequences. Additionally, liability insurance may not cover the entire amount of a lawsuit, especially if it is particularly expensive.
This means that your personal property may be in danger in the event of a more expensive ruling. Liability insurance will take off a portion of the amount owed, but the property owner would be responsible for any amount not covered by the insurance.
These policies are sometimes referred to as umbrella insurance.
Dwelling Policy (Landlord Insurance) for Rental Properties
Dwelling Policy is a type of insurance that covers costs associated with property damage, usually due to natural disasters, fires, hail, vandalism, and theft. This type of policy is not held by landlords alone; in fact, it is common for most homeowners to have some type of dwelling policy insurance.
While this type of policy can help cover certain events and situations, it doesn’t really work the same way as an LLC would. It is umbrella insurance, and only really covers property damage lawsuits. If a tenant sues for an issue unrelated to property damage, your personal assets can still very much be at risk.