The Real Estate CPA Blog
The Real Estate CPA Blog is the most up-to-date resource for real estate investors looking for tax, accounting, business operations, and investing advice.
Our experts have real-world experience that they share through their writing. 
 
Subscribe to our blog below for automatic updates!

Investors: Should You Use an LLC for Rental Property?

Posted by Brandon Hall on May 24, 2016
Brandon Hall

Time and time again I am asked questions pertaining to entity structuring for a portfolio of rental properties. Should a landlord have an LLC? Multiple LLCs? A property management LLC? Is insurance adequate? 

It's likely you've asked these questions too. While I'm not an attorney and cannot speak to the liability aspect of entity structuring, I can speak to the tax aspect. The following is not to be taken as legal advice and is based on my experience and observations of how my clients are structuring their portfolios.

Before we launch into this, let's define what an LLC is. An LLC is a Limited Liability Company. There are variations of LLCs, such as Professional Limited Liability Companies which is how my company Hall CPA PLLC is structured. But the key aspect to note here is that an LLC is not a Corporation.

Plenty of investors mistakenly think an LLC is a Corporation. This misunderstanding can lead to negative tax and legal implications.

Tax Impact of Using an LLC for Rental Property

Many new investors believe that using an entity will allow them to shelter their income from taxes. They have likely picked this up from a course or a book and believe that they must set up an LLC before they even begin.

But are there really tax advantages to using an LLC for rental property?

Not really.

An LLC is primarily used for asset protection as that's where the real benefits come into play. Placing rental property in an LLC will not grant you any more tax deductions than you could have had otherwise. Many entrepreneurs operate as a sole proprietor, meaning they do business in their own name rather than through an entity. They are still able to claim legitimate business expenses even though an entity is not involved.

The same goes for landlords when they decide to use an LLC for rental property. All of your normal business expenses that you could have used without the LLC will remain the same. Deductions will not change by simply using an LLC unless we are now factoring in the legal fees to set up the LLC and the ongoing administrative fees the LLC requires.

The case could be made that an LLC taxed as an S or C-Corp can provide tax advantages, and depending on the situation I'd be inclined to agree. But then we'd be talking about an S or C-Corp which will be a post for another day.

Financing Impact of Using an LLC for Rental Property

Have you ever heard investors complain that their new LLC can't obtain financing? It's true, generally a bank will shoo away an investor who wants the LLC to qualify for financing unless the investor personally guarantees the mortgage.

For an LLC to obtain financing, it must generally "season" for a period of two years. On a high level, this means that it must show growing net income for 24 months before a bank will consider lending money to the LLC. There are exceptions to this when the LLC can contain a high amount of equity or cash reserves. But for the average investor, it will be difficult to obtain financing.

The "brilliant" way to get around this financing issue is to simply buy the property in your own name and then deed the property over into the LLC. Problem solved, right?

Not necessarily. This type of transaction will more than likely trigger the "due on sale" clause contained in the majority of today's mortgage agreements. The due on sale clause allows a bank to call the note when the deed changes hands. While a bank may not call a performing note today, what happens when interest rates increase? If I'm a bank manager looking for an easy way to re-apply capital locked into a low interest rate, do you think I'll be looking for "easy to call" mortgage violations? You betchya.

Other financial issues that may arise will include an increase in insurance costs. Legal problems may also persist, so contact a real estate attorney prior to engaging in any sort of transaction.

What Are My Clients Doing?

My clients are using a variety of products that largely depend on their net worth and risk tolerance. A client with a small net worth may not necessarily need a multi-million dollar asset protection strategy, and therefore may resort to solely using insurance as a means of liability protection.

Some of my clients use a multi-layer LLC structure. They will have a parent entity that owns subsidiary, or child, entities. The sub entities will own the asset and pass income up and through the parent entity. The idea is that you can pass liability down to a subsidiary entity, but a subsidiary entity cannot pass liability up to a parent. Confirm with your attorney on that one.

Related: Hiring a CPA is Key to Your Success

Another common usage of LLCs with rental property is forming a property management LLC that then manages the rentals or contracts with the LLCs that own the rentals. The idea here is that in a tenant dispute, the property management LLC will be sued rather than the LLC owning the asset. I'm honestly not 100% sure how this works out in the court of law as agency rules can get complicated. For instance, the property management LLC is arguably acting on behalf of the LLC that owns the rental. My thinking is that a competent lawyer would sue every entity involved and let the courts work it out. Again, confirm with an attorney.

A more interesting structure I've seen lately is using a combination of LPs and LLCs. The LP holds a majority stake in the title to the property and the LLC owns the minority stake. You will then own 100% of the LLC. The idea is to dissuade creditors and make it harder to attack the asset held jointly by the LLC and LP. This strategy is being utilized by a handful of my clients at the moment. Again confirm with your attorney (a good one at that!).

My Thoughts on Using an LLC for Rental Property

Using an LLC for rental property is a good way to limit liability that may be caused from your rentals, no doubt about it. However, a lesser known benefit is that an LLC is also a good way to protect your equity from negligence caused by you or your family.

I heard somewhat of a tragic story recently. An investor owned a multi-million dollar portfolio and all properties were in his own name. He was content with "being a good landlord" and maintaining a large umbrella insurance policy covering his properties. His thinking was that as long as he treated people fairly, he too would be treated fairly.

And then his teenage son, under the influence of alcohol, smashed into another car and critically injured a young woman.

That woman is not suing the father, the real estate investor. Because his assets are under his own name, they are being wrapped up in the lawsuit. What a nightmare.

Spending some time Googling court cases, I found that this type of case has precedence. There are many cases where the parents lose millions in assets simply because their child made a dumb decision.

If you would have asked my thoughts on using an LLC for rental property prior to this story, I would have said "in my non-legal opinion, be a good landlord and have great insurance." But that's simply not adequate. That can't protect you from the one off, highly rare occurrence that can wipe out literally decades of your hard work.

My opinion now is: "in my non-legal opinion, meaning you need to seek out an attorney's guidance, I suggest you seriously consider using an LLC for your rental property."

 

Topics: Business Advice, LLC, LLC rental property, rental property in LLC, Tax Strategies

Opportunity Fund White Paper

Posts by Topic

see all