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Should you form an LLC for your rentals?

You’ve found your way here because you are wondering whether or not it’s worth your time going through the (often rather convoluted) process of incorporating your properties. You’ve perhaps heard that other people do this, but you’re not entirely sure what the benefits are or the associated work and costs of doing this.

The answers, unfortunately, isn’t a simple yes or no. It will depend on your rental property strategy, your cash-flow, the risks you are willing to take, and your situation.

We’ve read articles that argue both sides, and some that toe the line, suggesting mediating strategies. And it can be a little confusing, to say the least.

So, we thought we’d do our best to outline both these arguments clearly for you, discuss the external mitigating factors which might influence your decision, and offer our thoughts up for you on what your next steps could be.

The broad and general consensus out there is that incorporating your rental makes sense if you have a reasonably large portfolio but the benefits don’t necessarily outweigh the cons if you’ve only a small number of properties.

First things first, we hope you found this blog interesting! However, do note that it should not be used as a substitute for competent legal and/or other advice from a licensed professional.

It’s also worth noting that the costs and benefits of incorporating your rentals vary greatly dependent on which country you are in, and varies just as much between states in the US. To determine the details of incorporation in your jurisdiction you will need to specific location based research.

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. Which 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. 

As above stated we are going to dive further into the overall benefits and problems of creating an LLC for your rental, however, as they are state specific we strongly recommend doing further state specific research and before making any final decisions and as always, consult with a professional.

Documents for forming an LLC

Benefits

It’s a Question of Protection

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

There are two main ways an LLC can protect you:

Limiting Personal Liability

By forming an LLC with your properties you seperate 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 pertaining to 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

There are (in most states) not as many tax benefits of this as I thought there were going to be, generally the benefits are designed to help out the bigger corporates not individually owned small businesses. However, that slight complaint aside there are a couple of points worth mentioning. 

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 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 can write off all sorts of things 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).

benefits of an LLC

Easily Separate Business and Personal Expenses

When you create an LLC, you should 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 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.

Disadvantages

Fees & Costs

This is where things get a little more complicated. There are a number of applicable fees, and they vary widely state to state.

The registering of an LLC, for example, 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 for incorporating rentals in your specific state.

Getting Financing

As far as I know, 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, or you can try to deed the property to the LLC after purchasing in your own name. 

Alternative Suggestions

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, for example, an LLC currently costs $800 a year. Which is a lot for as small time landlord and it would be ridiculous to set up 20 LLCs for 20 properties and pay out $16k a year for what is essentially insurance.

The Personal Pucker Factor

This is something we came across as we browsed through online 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 a number of 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 when you pucker up, as it were.

Umbrella Insurance Policy

umbrella insurance policy

Landlords often try to mimic the liability protection of an LLC with 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 dollars, 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.

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Summary: Pros vs. Cons

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.

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 cashflow. 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:

InvestingLandlord InsuranceProperty ManagementReal Estate

Ben Luxon

"Ben is an author and real estate enthusiast. His interest in all things entrepreneurial has led him to work with real estate professionals all over the world, distilling their knowledge into articles and Ebooks. His love of travelling has taken him to over 10 countries in the last year, where he has sampled the craft beer of them all."

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