LLCs for Rental Properties? Here are the basics:
Clients often ask me whether they should put a rental property in the LLC. A rental property can generate passive income, but it can also create risks. For example, if a visitor or tenant slips and falls on the ice on your front steps at your rental property they can potentially come after you for negligence. And, even if the injured person is a friend or is not litigious, their insurance company may still try to recover damages from you as the owner of the rental property.
By setting up a business that owns the property rather than buying it in your own name, some of this risk is shifted.
LLC Basics
LLC stands for Limited Liability Company and is just one type of of business structure you could choose for your rental property. It allows you to be taxed as a partnership while getting the limited liability benefits of a corporation. And, with this structure, you’re less likely to be held personally responsible for claims against the business.
The LLC can be you alone, with a partner, or with a group; and the LLC owns any assets placed in it. It can have its own tax ID number (or taxes can be filed under your social security number), a separate (business) bank account, and conduct business transactions.
Why do people put their rentals in the LLC?
1. Limited Liability
When you own a property as an individual, you are personally liable for any legal actions, which means your personal assets are at stake. By operating through the LLC, only the LLC’s assets would be at stake should there be any lawsuit or claim made. This is one of the primary benefits of the LLC for rental property holdings since your renters could go after the business if they were injured in an accident or incident occurring on the property. Please note: A multi-member LLC has greater liability protection than a single-member LLC.
2. Separate Assets
Because the LLC is easy to set up, creating a new one for each property makes sense. This insulates each property from liability claims made on any others and may provide the same separation protection you get for your personal assets when certain steps are taken to maintain the business formalities showing the separateness of the entity from you as a person.
3. Pass-Through Tax
The LLC allows you to take advantage of what is called pass-through taxation. A business structured as a corporation would typically be taxed on its profits, then you as the owner are taxed again when you take out income.
With the LLC, the company income passes straight through to you, and you claim it on your individual tax return. Your rental income is only taxed once instead of twice.
4. Personal vs. Business
Keeping your personal and business expenses separated is important so that you can claim business expenses on your taxes. You should have separate bank accounts for each LLC you create and never comingle the LLC funds with your personal accounts.
When to create the LLC
While setting up the LLC for a rental property is a fairly easy process, it’s important to understand when the best time is to do it, along with the potential costs in doing so.
The good news is you can have your LLC set up either before or after you buy the property. If you own the property outright, then the LLC can be the title owner from the outset. However, if you plan to finance the purchase, there are definite benefits to having the LLC set up before the closing, because transferring a mortgaged property could result in some additional headaches and costs, such as:
Notifying your mortgage holder and requesting permission to transfer title from your name to the name of the LLC;
Depending on your mortgage contract, the lender may close the loan and issue you a new one, which creates new closing costs and potentially a higher interest rate;
Notifying tenants that the LLC now owns the property;
Updating rental agreements;
The transfer could trigger new taxes like a title transfer tax.
Creating the LLC first means the property deed is in the company name from the start and keeps you from dealing with these issues. However, some lenders don’t want to put the rental into the LLC name because the LLC doesn’t have the credit history that qualified you as the borrower.
So, how do you create the LLC?
Because the LLC is regulated by each state, the rules and regulations for setting up a company may vary. However, the basic process involves the following:
Choose an available business name
Fill out the Articles of Organization
Register your LLC with the state (in Colorado, this is with the Secretary of State’s office)
Create the LLC Operating Agreement
Obtain any necessary licenses and permits
Once you’ve done all that, you can issue leases in the business name and set up your bank account. Costs involved in setting up the LLC can come from registration fees, title transfer fees, and legal fees if you engage an attorney to create the entity, or draft or review your operating agreement. It may sound like a lot of work, but it’s a lot easier than you think.
Is there a downside of the LLC for a rental property?
Overall, the LLC is a good structure for rental property businesses, particularly for short term rentals, and especially if you are going into business with other people or entities. But like everything else in life, there may some drawbacks to be aware of as well.
Pros
It can limit your personal liability
Individual properties can be separated and protected if you create the LLC for each one
Pass-through taxation keeps your income from being taxed twice
Separates business and personal expenses
Cons
Additional paperwork for initial setup and bookkeeping
Can be more difficult to get a mortgage as the LLC
Potentially higher interest rates on your mortgage
Annual filings and fees
Compliance with the Corporate Transparency Act