Real Estate LLC: The Pros and Cons

After a temporary slump, the real estate market is back on track. The upward trajectory is driven by experienced investors expanding their portfolios and new investors entering the market. Setting up a real estate limited liability company (LLC) is an option worth considering for both existing developers and those just getting into the industry. In this article, we will explore the benefits of investing through an LLC and the implications of using an LLC as a business structure to own property.

Real Estate LLC: A Primer

As the name implies, a real estate LLC is a business entity formed solely to make real estate investments. Unlike regular limited liability companies that provide a range of services or sell goods, real estate LLCs often have no activities other than owning and managing properties.

Should you get an LLC for real estate?

If you plan to invest in several real estate projects, forming an LLC is a smart decision. An LLC provides more tax flexibility and allows you to pool capital from multiple investors without exposing your personal assets. However, the decision to form an LLC should be made independently after considering all the pros and cons.

Advantages of LLC for Real Estate Investing

There are several practical benefits of using an LLC to purchase real estate:

1. Personal Liability Protection

The most common reason investors use LLCs is to reduce personal liability. By investing through an LLC, your liability is limited to the assets held by the company. Your personal assets will remain off-limits to creditors or legal persecutors in case anything goes wrong on or to the property. This added layer of security protects you against tenant lawsuits and offers extra personal asset protection when your homeowner's insurance policy doesn’t cover accidents.

2. Tax Benefits over a Corporation

Real estate LLCs provide tax benefits depending on the federal tax classification chosen. LLCs can report taxes as a sole proprietorship or partnership, allowing business income and expenses to flow through to the individual investor. This reduces overall tax burden, and LLC members can claim deductions such as depreciation to lower personal tax liability. Alternatively, you can elect to be taxed as an S-corp or C-corporation, which offers better separation of business and personal taxes but may subject you to double taxation.

3. Easy Ownership Transfer

Ownership transfer is simple in an LLC. You can quickly sell interest in your LLC to transfer a property to another investor or transfer a company ownership percentage to family members. Flipping investment properties through an LLC is easy and cost-friendly as you can transfer ownership and sell the interest rather than selling the property itself.

4. Flexible Management Structure

LLCs allow you to outsource property management to professional companies or divide managerial duties between different LLC members. This flexibility frees up your time for other ventures and goals.

5. Fast Access to Good Credit History

LLCs can take out loans like individual investors. Banks determine the credit amount based on the LLC's creditworthiness, down payment, and property performance. LLCs with good credit history can obtain non-recourse loans, limiting personal exposure to liabilities. They can also use one property to secure a loan for a second property or purchase properties with attractive credit records for better offers. Additionally, LLCs can pool money from multiple members, including foreign nationals, making it easier for foreign family or clients to purchase property in the US.

Disadvantages of LLC for Real Estate Investing

While there are many advantages to using an LLC, there are also some downsides:

1. Extra Maintenance Costs

Setting up an LLC involves various operational and maintenance costs, including filing fees, registered agent services, annual report fees, and minimal annual franchise taxes in some states. Business owners must comply with filing rules and requirements and pay applicable state fees.

2. Limitation to One State

LLCs can only buy property in the state they are registered. If you want to build a portfolio across multiple states, you'll need to set up separate LLCs in each state. This increases operating costs due to state registration fees, annual filing requirements, and minimum franchise taxes.

3. State Business Property Taxes

Some states collect taxes on business personal properties (BPP) owned or leased by a company. This is different from real estate property taxes. The LLC may be subject to business property taxes at the state level and property taxes on the real estate at the local level.

4. Automatic LLC Dissolution Clauses

Under certain conditions like the death of the owner or declaring bankruptcy, an LLC can be dissolved automatically. It's important to address these issues in the operating agreement to protect the legal entity against involuntary dissolution.

5. Obtaining Loans can be Challenging

Obtaining a loan through an LLC can be difficult if the company has no credit history. Banks might offer less competitive rates or require personal guarantees from LLC members. LLCs are also not eligible for typical residential loans, such as FHA loans.

How to Set Up a Real Estate LLC Step-by-Step

Creating a real estate LLC is a straightforward process that involves the following steps:

1. Select an incorporation state.
2. Choose an LLC name.
3. Appoint a registered agent.
4. Decide on the management structure.
5. File the articles of organization.
6. Draft an operating agreement.
7. Register the LLC for tax purposes.
8. Obtain business licenses and permits.

Each state has slightly different rules and requirements for company formation. Consult our state-by-state guide for specific details.

Conclusion

Investing in real estate through an LLC comes with benefits such as better asset protection, tax flexibility, ease of pooling money, and flexible transfer of interests. However, there are also downsides, including extra maintenance costs, limitation to one state, state business property taxes, automatic dissolution clauses, and challenges in obtaining loans. Each investor must consider their specific circumstances before deciding whether to pursue real estate investing through an LLC.

FAQs about Real Estate LLCs

Here are some frequently asked questions regarding real estate LLCs:

1. Can an LLC get a residential mortgage? Typically, yes. It’s possible to get a residential mortgage through an LLC. However, financial institutions may ask LLC members to personally guarantee the loan and pledge their personal assets as collateral if the company doesn't have sufficient assets to back the loan.