It is amazing how often I am asked by people starting in real estate investment: “What type of corporate structure is best for owning investment property“. I hear that question more often than I am asked how to find tenants or how to finance the property. Here is some information that I have compiled and learned over the years.
Disclaimer: Right up front I need to remind everyone that I am not an attorney nor do I play one on television. You should seek competent legal advice in your area, regarding this topic. These details are simply what I have learned through reading, executing, and talking with attorneys.
Best entity for Investment Property
Although there are many different business entities (LLC, C-Corporation, S-Corporation, partnership), the easiest to set up and cheapest to maintain, for real estate investments, is an LLC (limited liability company). Additionally, an LLC is very flexible and can have any number of owners (technically called ‘members’). Each member can own any percentage of the company (as long as the total equals 100%). Lastly, members can be other LLCs, corporations, and trusts. This flexibility allows you to customize the configuration to suit your tax situation and liability protection goals.
Tax Implications for the Investment Property LLC
C-Corporations pay taxes on profits generated by the corporation, first. The owners pay taxes again on the profits they receive as dividends. Although, S-Corporations avoid the corporate tax, their corporate structure and number/type of owners is severely limited (S-Corporations can only be owned by individuals, not LLCs or trusts). Fortunately, unlike corporations, LLCs do not pay any corporate tax. All profit and losses “pass through” to the member’s tax returns at the percent that they own the company. This is especially helpful if you own multiple LLCs as the profit and losses from each roll up to your personal taxes (a loss on one can offset a profit on another).
Liability Protection for the Real Estate Investor
As the name implies, an LLC provides limited liability to its members, meaning that any liability created by the company is limited to the company. The members’ personal assets are protected from all claims against the company. Partnerships and unincorporated businesses do NOT provide liability protection. It is critical that you protect your personal assets as a 2005 Congressional study stated: “small businesses bear 68 percent of business tort liability costs”. A properly set-up and maintained LLC can protect the owner’s interests in the assets of an LLC from the owner’s personal creditors.
Setting up an LLC for your Investment Properties
I recommend that you consult with a qualified real estate attorney when you set up your first LLC (or purchase your first investment property). Pay them to establish the LLC on paper and with the state. Have them teach you what should/must be done on an annual basis to maintain both the legal entity of the LLC and the litigation protection of the LLC. This may cost up to $1000 per LLC. Some attorneys may offer a discounted price.
How Many Properties per LLC?
This is where a good attorney can weigh the liability protection versus the costs. Many advisors will tell you to set up one LLC per property. Practically speaking this is easy when you own 2-4 properties, but it will become increasingly cost prohibitive when you own 15 properties. Not only does it cost about $360 (in Minnesota, using BizFilings.com) to set up an LLC initially, but each year your CPA will charge you to prepare and file the tax return for each LLC (this costs me about $400 per LLC-you can imagine your tax bill if you had 15 LLCs!). Most real estate investors will put 3-5 properties in each LLC (grouping them based upon geography, age, liability risk, or equity position).
Moving your Properties into your LLC
A common misconception is that you must buy the investment property in the LLC’s name. Unfortunately, you would need to use commercial financing (with a 20% down payment) to have your LLC buy the property initially. A “Quit Claim deed” is all that is required to legally transfer the property from your personal name to your LLC. The mortgage(s) will stay in your personal name and it will remain on your credit report, but you will gain the liability protection mentioned above. This Quit Claim deed process requires a simple one page document signed and notarized by all owners of the property and it is then mailed with the appropriate filing fees (about $50-75) to the County recorder where the property is located.
Property Management Considerations
Technically, each LLC should have its own checking account, corporate credit card, and Quickbooks file. Again, as above, this may be possible with a limited number of LLCs, but it can be overwhelming to think about 15 checkbooks, 15 corporate credit cards, and 15 LLCs signing leases and performing evictions. Many real estate investors will transfer their properties into “ownership” LLCs which simply hold the properties. They will then set up a “management” LLC that signs all leases, pays all bills (including mortgages), contracts for all repairs, and retains one or two corporate credit cards. To keep the liability protection intact, you should have a management agreement signed by both the “ownership” and “management” LLC.
Using the LLC
All the work and cost of establishing the LLCs can be wasted if a judge agrees with the lawsuit plaintiff, that the LLCs are just shells. Follow your attorney’s advice, but generally, you should hold meetings (and keep written minutes of the meeting) on a bi-annual to annual basis. You should record decisions and “vote” on changes to the company. Lastly, have your attorney review your work annually to insure you are maintaining your legal protection in the event of litigation.
As you can see, an LLC has many benefits over other corporate entities (or no entity at all). Having an LLC for your real estate investment is an important step in providing protection for both your personal and corporate assets. Consider the creation and use of an LLC as important as learning how to find tenants.
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15 comments
#1Jacksonville Real EstateFebruary 11, 2008, 10:31 pm
My investment recommendation to my clients follow along the same line as your article.
However, I advise them that the transfer of title to the LLC may cause the lender to invoke the “due on sale clause”. I have never seen this happen when title has been quick claimed to a LLC, but I believe they should know all the facts.
#2Investment PropertyFebruary 11, 2008, 10:35 pm
Great point. I agree. I have been told by attorneys not to do it because of the “due on sale clause”, but just like you, I have only heard of the bank making a fuss once. The bank simply told him to deed it back to his personal name and that was it.
I figured the banks have enough on their hands these days than to go after us for simply semantics!
#3Jacksonville Real EstaeFebruary 12, 2008, 10:50 am
I totally agree banks are way to busy right now. I am waiting for answers on short sales for 3 – 4 weeks. A lot of buyers are not waiting around and go on to another home.
On a side note, I have heard people name their LLC after their own name in order to past a quick glance of the title by the lender. Joe Blow names his LLC … Joe Blow LLC.
#4Investment PropertyFebruary 12, 2008, 11:04 am
Interesting idea.
I actually have always been advised to never have any LLC with your personal name. It makes it easier for people that are suing you to find your assets. Ultimately, even though you have the LLC to protect the asset, you still have to defend yourself in court.
#5Jacksonville Real EstaeFebruary 12, 2008, 11:36 am
I have read the same thing.
However, you can easily search and see who are the registered agents and officers in the LLC with all the paperwork being filed electronically. So if you were trying to protect your identity you wouldn’t be an officer in your LLC.
I have seen people who only list their attorney as the officer and registered agent of the LLC. I don’t know the ramifications of this.
Also you would want to have your tax notices mailed to your attorney’s address so there is no personal connection with the property whatsoever.
I am sure there are more ways to try to protect your assets and an attorney would best be consulted to advise.
And while we are talking about protecting your assets, I would recommend umbrella insurance.
Lastly, let me give the same disclaimer I give my clients when we start getting into these subject areas: I am not an accountant or an attorney. I do not give legal or accounting advice. Should you have any questions please consult your attorney or CPA.
Sorry Scott. Didn’t mean to take your post off subject.
#6Investment PropertyFebruary 12, 2008, 11:41 am
No problem. All great additions to the topic!
#7Jeff BrownMarch 3, 2008, 1:35 am
Though there are plenty of supporting IRS ‘letters’ — there is a problem that pops up from time to time. My attorney says not to worry, as the problem has more or less disappeared in the last several years. Still, it crops up now and again. Here’s the deal.
You close the front part of your exchange, selling a property owned by one of your LLCs. You ID an upleg. However, the lender requires you to relinquish the property to yourself (as Scott indicates), because they won’t lend to your LLC and won’t allow it to take title to your upleg.
In many cases that’s a taxable event and goodbye tax deferred exchange. This nearly happened to a referral, sent to me a couple years ago, AFTER they’d closed the escrow on the front end of an exchange. They owned the property in a formal general partnership. We solved it, but it took a few grand to do it.
Bottom line? The IRS is pretty much looking at the spirit more than the function now — but beware. Scott’s warning to see your attorney wasn’t just for show — he knows what he’s talking about.
Great stuff, Scott.
#8Johnbeck SeminarMarch 28, 2008, 12:41 am
Now who are these sources and why are they using “housing” and “real estate” interchangeably when addressing the bubble?
#9John From CaliApril 13, 2008, 2:22 pm
Scott,
I appreciate your economical insight into “How Many Properties per LLC ?”
The common response is to set up an LLC for each property. This is usually based on advice from individuals who are charging you to set the entities up for you.
I also got some insight into how much it cost to have my CPA file a tax return for each entity. When you add it all up, I agree their needs to be a balance of costs vs. protection and 3-5 properties per LLC sounds like a good starting point.
#10Investment Property in TunisiaFebruary 20, 2009, 10:50 am
Hi Scott, thanks for this post, it’s certainly food for thought. We’ve always worked on the premise of more than one property per LLC, however John from Cali raises an interested different angle of having one per propery.
#11Minnesota House RentalSeptember 13, 2011, 9:21 pm
I think the one thing that rings true in all this discussion is to use the LLC but also to carry a good property insurance policy on each investment property, and add to that an umbrella policy. Then I also require each tenant to purchase renters insurance with $300k of liability insurance so HOPEFULLY you can burn through all those layers before needing the protection of the LLC.
#12janetelayneDecember 23, 2011, 8:27 pm
I have $25,000 worth of credit card debt that I am in the process of settling. To protect my investment property I was advised to set up a LLC with this property’s address, which I have done. However, as this property is occupied by family there is no income from it so I will have none to claim on my taxes for the LLC. Also the LLC is listed as a theatrical one with me as the only member and performer. I was also advised to open a LLC bank account to deposit my income from my job and from my security benefits to protect it from my creditors while I resolve the debt. After reading your post, I am considering the quitclaim deed if my lender will allow it. Is there anything else I should do to protect this home? And will not having an income to report for the LLC be a problem for me should I be sued?
#13Scott FicekDecember 23, 2011, 8:42 pm
I’m not an attorney. You should get advice from an attorney or credit counselor.
Here is my thoughts: What are you trying to protect? Only in bankruptcy can a creditor ask for a property to be liquidated to pay off debts. Also, if the home has a mortgage on it, that bank would get paid off first. In this market, I assume there is no equity in the property if you have a mortgage. Plus, if you are not taking income, what could they go after?
#14Scotty1February 1, 2012, 7:23 pm
Thank you for the discussion, but I have a lingering question. The Feds don’t recognize the LLC as a tax entity. The LLC is simply a State tool. Once you’ve set up the LLC, what entity do you want for federal taxes – S-Corp or the default Partnership? Thank you for the input.
#15Scott FicekFebruary 1, 2012, 9:25 pm
I am not an accountant, but correct. If you don’t do anything, most accountants will file as a C corp. You can save some self-employment tax if you change and file as an S corp (which I did).
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