Should You Form An LLC For Your Rentals?

Deciding whether to form a Limited Liability Company (LLC) for your rental property portfolio depends on various factors such as your investment goals, risk tolerance, and legal and tax considerations.

One of the main advantages of forming an LLC for your rentals is that it can provide personal liability protection for the owners of the LLC. This means that if someone were to sue the LLC, the owners' personal assets would generally be protected. Additionally, an LLC can provide tax benefits, as it can be classified as a pass-through entity, meaning the income and losses are passed through to the owners' personal tax returns.

However, forming an LLC may also requires significant upfront costs and ongoing fees, including state filing fees, attorney fees, and annual maintenance fees. As such, forming an LLC may not be necessary or beneficial for small rental property portfolios, as the costs may outweigh the benefits.

It's important to consult with legal and tax professionals to determine whether forming an LLC is appropriate for your specific situation. They can provide advice on the potential benefits and drawbacks and help you make an informed decision.

In this article, we take a closer look at whether you should form an LLC for your real estate portfolio as well as the pros and cons of both.

Should you form an LLC in the United States for your Rental Properties?

What is an LLC?

LLC stands for Limited Liability Company. This is a business structure that you can create, by oneself, with a partner, or as a group. LLCs are registered with the state. This means that the process of registering an LLC as well as the benefits and disadvantages of incorporation vary quite widely depending on the state that you are in.

The main reason many people seek to incorporate is for the protection that an LLC offers your assets.

Summary: The pros vs. cons of setting up and LLC for your real estate investments

Pros:

• LLCs limit your personal liability, which potentially saves you a lot of money.
• They separate and protect each of your rental properties.
• You get the benefit of pass-through taxation, so your income is not taxed more than once.
• You can easily separate business expenses from personal expenses by having a separate bank account for your LLC.

Cons:

• It’s a headache to do the additional paperwork.
• It’s potentially more difficult to qualify for a mortgage as an LLC and you’ll possibly have a higher interest rate.
• LLCs have annual filings that can be expensive.

How can an LLC be beneficial for your real estate portfolio?

Limiting Personal Liability

By forming an LLC with your properties you separate them from your personal finances. What this means in practicality is that if someone sues you, they are suing the LLC, the company, and it is only assets held by the company that are at risk.

In other words, the rental property is the only asset at stake and not your personal finances.

Keep Your Rental Properties Separate From Each Other

In addition to separating the rental property from your personal assets, you can also separate your rental properties from each other. If you own multiple properties, you can “insulate” each property from liability claims by setting up separate LLCs for each property. If you have all of your properties under separate LLCs, then if someone files a lawsuit about one of your properties, the rest of your properties will not be affected by the lawsuit. This effectively separates and protects each of your properties.

Pass-through Taxation

Pass-through taxation is a benefit of individual-owned businesses. Normally, a corporation is taxed directly on its profits, and the owners are taxed again when they make income from their business. With an LLC, you get the benefit of the company’s income “passing through” to you as the business owner. Essentially, all income made by your LLC (your rental property) will flow through to your individual income tax return. This minimizes the amount of money taken out of your rental income for taxes.

You could also use the property to pay yourself a controlled salary to potentially keep yourself in a lower tax bracket. By having your business collect rent and paying yourself a salary out of that business, you can better control your tax payments.

Furthermore, since you have a business now, you may also be able to deduct additional expenses against your taxable income. For example, you might purchase a vehicle for business use and keep careful track of your mileage (which could generate some big savings).

Easily Separate Business and Personal Expenses

When you create an LLC, you will need to create a separate bank account for your LLC. That way, your personal expenses are separated from business expenses.

This makes it easier to claim business operating expenses when it comes time to do your taxes. It will be visually clear to you when you check your bank statements which expenses are business and personal. Even if you decide not form an LLC for your rentals having a seperate bank account for each of your properties is still a real estate accounting best practice.

What are the disadvantages of forming an LLC for your real estate investments?

Fees & Costs

The cost of setting up an LLC could be prohibitive depending on where your rentals are based. There are several applicable fees, and they vary widely from state to state.

The registering of an LLC can cost anywhere between $50 and $500. In some states, you will need to publish a notice of formation in a newspaper which will cost $40+.

There will be lawyer fees for creating the appropriate documentation which could run into the thousands.

Then in the state of California, you will need to pay the $800 annual franchise tax.

Because the costs vary so widely from state to state and the requirements for forming an LLC dependent on where you are, are so different, we can’t give even a ballpark figure for how much it might cost you.

It could be anywhere between $100 and $3,000 to form an LLC, and some of those associated expenses are recurring.

We advise you to talk to a professional in your state to better understand the associated costs involved in incorporating rentals in your specific state.

Getting Financing

Financing your investments is a major first step, and having an LLC can make it harder. Some lenders don’t like allowing people to borrow in the name of the LLC. 

Instead, they want someone personally liable. This may require you to buy the property entirely in cash, get more creative with your financing options, or you can try to deed the property to the LLC after purchasing it in your own name.

The personal pucker factor

This is something we came across as we browsed through online real estate forums to see what other people have done (and we liked the name). The personal pucker factor is a suggestion that instead of forming an LLC for every single property, you form a selection of LLCs with several properties in each. The number is arbitrary and depends on how much you are willing to risk.

For example, you might have 20 properties. Which you arranged into four LLCs of roughly equal value. If someone gets injured in one of these and decides to sue you it would be roughly ¼ of your assets at risk as opposed to the whole lot. However, for some, this is still too much of a risk.

It depends on when you pucker up, as it were.

Alternatives to setting up and LLC for your rentals

Alright, from what we’ve said, setting up an LLC sounds like it might be a good idea. However, the paperwork can be a pain, it can be confusing, and depending on which state you are in it can be expensive.

In California, as mentioned above, an LLC will set you back as much as $800 a year. This is a lot for a small-time landlord and it would be ridiculous to set up 20 LLCs for 20 properties and payout $16k a year for what is essentially insurance.

So, what are the alternative options to setting up an LLC for your rentals?

Umbrella Insurance Policy

Landlords often try to mimic the liability protection of an LLC with landlord insurance, specifically with an umbrella policy. An umbrella policy can help cover costs that go above your standard insurance policy. For example, let’s say your insurance covers damages and lawsuits up to $250,000, but you’re sued for $1 million. Your standard policy would not be sufficient and your personal assets would be at stake for the remaining balance. However, if you purchase an umbrella policy, it would help cover the remaining balance, adding more protection for your personal assets.

That being said, your umbrella policy will still have a limit. Your personal assets will be vulnerable if the lawsuit exceeds the umbrella policy’s coverage amount. Creating an LLC is a more effective way to protect your personal assets so they are never vulnerable during a lawsuit. Despite the additional work and costs of creating an LLC, this added protection is often worth it for landlords.

Conclusion

Creating an LLC for your rental property can be a smart choice as a property owner but it really depends on the size of your property portfolio, where you are in the country and your current cash flow. It is definitely worth getting your Umbrella Insurance Policy either way though.

If you decide to create an LLC for your rental property, make sure you update your rental leases.

Despite the additional work and costs, the protection LLCs provide is often worth it for landlords but you need to review your own situation carefully.

As always we recommend your talk to a specialist and get a good understanding of your options, the work involved and the costs associated.

Sources and references for further education on the topic:

• Advantages of incorporation for landlords - Rocket Lawyer
• Should you form an LLC for each individual rental property - Bigger Pockets‍

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