It's a common misconception that LLC is better for a rental property owner than a Sole Proprietor. There are disadvantages to establishing an LLC for rental property.
Have you ever considered the benefits of creating an LLC or corporation for a rental property? You may be surprised that many people are turning to this business structure. However, it is good to remember that every business is different, and some disadvantages come with using this legal entity.
One of the most prevalent justifications for using an LLC for their rental property is that it enables them to enjoy the advantages of being a limited liability company (LLC), including operating under a specific set of rules and regulations that encourage corporate accountability. But as we all know, there are also disadvantages to establishing an LLC for your rental property.
So we're going to talk about the disadvantages you should consider before moving forward with the process. But before we move forward, we'll go through the fundamentals of LLC for rental property.
What is a Rental Property LLC (Limited Liability Company)?
An LLC is a corporate entity that real estate investors frequently create to own rental property.
An LLC's shareholders are referred to as members. And it can have one or more members, depending on the investor's purpose and the LLC's operating agreement.
Creating your own LLC can reduce your responsibility and keep your personal assets separate from your company's. This asset protection can make real estate investors and landlords feel more secure. You cannot lose your private property or incur personal liability if you face legal or financial problems, like a court case or debt.
An LLC enables people to work independently or with other shareholders efficiently and seamlessly. It is fundamentally a hybrid of a corporation and a limited partnership.
Due to their more flexible tax options and uses, LLCs are typically the best option for forming a corporation for a landlord. Additionally, since each state has its regulations governing LLCs, each has its registration requirements.
Fundamentals of an LLC for A Rental Property
There are standard procedures that come with when you form an LLC to manage your investment property's interests.
The LLC will first require a separate bank account to manage all rental income and costs. You should keep your financial affairs distinct from the company's.
The maintenance of accounting transactions and accounting is necessary to ensure that everything complies with the requirements of the jurisdiction of registration. This process is another justification for keeping your firm finances separate.
Being an LLC owner comes with ongoing rental property expenses you must pay each year.
For taxation reasons, the IRS views an LLC as a pass-through corporation. Each shareholder shares in the profits and losses of the LLC. These profits and losses are documented on their tax returns, like in an S corporation, real estate partnership, sole proprietorship, or real estate partnership.
Let's use shareholders A and B to give a clear illustration.
If shareholder A owns 55% of the stock and shareholder B has 45%, Shareholder A would get 55% of the gains or losses, and B would get the remaining.
However, LLC shareholders have the option to choose a "special allocation" that does not consider each member's ownership proportion. Instead, this special allocation allows earnings and losses (or tax write-off such as depreciation) to get transferred to each shareholder.
Therefore, even if shareholder A owns 55% of the LLC, the other LLC members and shareholder A may agree to share profits equally.
There are many ways to profit from owning multiple rental properties, and creating an LLC may or may not be for you. Yes, there are benefits, but sometimes the disadvantages of LLC for rental property outweigh the advantages.
Doing your research before making up your mind is wise. But it may not be enough. It's best to talk to a professional realtor who knows different rental markets and has experience handling all rental properties.
Disadvantages of LLC for Rental Property
When used successfully, an LLC serves the same purpose as a corporation but requires less paperwork and is less expensive. An LLC can be an excellent choice for rental property. But before you jump into this new venture, here are some disadvantages of opening an LLC with rental property in mind.
Taxes May Be Difficult
The tax advantages that attract many owners to form LLCs might be challenging to achieve and interpret in some circumstances. Filing taxes through an LLC may be challenging when it is first formed and registered.
There are numerous forms, and although it is identical to a single proprietor LLC, things can rapidly become complicated if there are many members and numerous account numbers and credit cards with various identities.
Although the LLC offers protections, tax filing might be more complex than an income tax return.
Greater Difficulty in Setup
Be prepared to complete a ton of additional paperwork if you contemplate creating an LLC for each investment property.
If you're seeking a quick approach to forming an LLC, you won't find one because it takes time. The entire process might take a while, including filing documentation, obtaining the necessary licenses, applying for a new loan, and opening new bank accounts. Therefore, be ready for unexpected delays and other potential filing blunders.
Transferred Tax Obligations
Some states may transfer tax liability when a property's ownership changes, though this is not mandatory in all states. As a result, you might have to make a larger payment if you decide to sell any of your properties or have customers come in and out of your business.
An equivalent amount to the appraised worth of the asset you are trying to sell usually constitutes a stamp tax.
Protection of Personal Assets Is Not Assured
As we previously stated, an LLC is a corporate entity that enables owners to safeguard their personal assets if their company is sued or goes bankrupt.
Note that this does not imply that LLCs are immune from legal action. The plaintiff may be successful in penetrating the corporate veil if your LLC or one of its members is determined to have engaged in third-party fraud or negligence.
In this case, they might successfully hold your LLC or shareholder liable for losses, and this could affect your personal assets.
Having an LLC for your rental properties in real estate has the drawback that most lenders will demand all shareholders to guarantee the mortgage to secure financing.
In other words, each group member will be held accountable for any unpaid debts related to the property's mortgage and have to put their signature on the loan. So, if everyone doesn't have a strong credit score, getting authorized can be more challenging.
Expenses Increase With Time
Being a vacation rental owner and manager is challenging. Owners should anticipate paying fees throughout the year, including extra insurance costs and other facilities and building maintenance charges that may not favor business owners seeking a more passive income.
The advantages and disadvantages of this venture are very evenly balanced. But before deciding to incorporate your rental property as an LLC, it's crucial to consider the advantages and disadvantages of your overall business goals.
You should also ensure your personal finances are stable enough to acquire a loan, pay for all necessary permits and filing fees, and cover maintenance expenditures.
Rental Property LLC Tax Benefits
Limited liability companies do not pay taxes directly like corporations because they are pass-through taxation entities. Nevertheless, some regions may charge an annual renewal fee for LLCs.
Forming an LLC for multiple rental properties can have advantages, including favorable tax treatment. An LLC enables you to treat a significant portion of rental property costs as tax-deductible businesses. This benefit can impact the profit margin of your real estate investments significantly.
Although it is reasonably clear that being able to write off expenses has tax benefits, there are other factors to consider when registering a new LLC.
Does Your Rental Property Need An LLC?
While not all of your rental properties will require their own LLCs, it's still a good idea to consider how much equity would be at risk in case of a lawsuit. Distributing your personal assets across different LLCs ensures that all the properties in your investment portfolio aren't under one LLC, which can put your entire asset base in danger.
You must isolate rental property from house flipping operations within the LLC's legal protection. If the property is in a different state than yours, you must decide whether to register the LLC.
A registered LLC from another state is called a "foreign LLC." Before it can be permitted to operate in the new state, it must register as such.
Foreign LLCs must also keep a designated person in each state where they conduct business and comply with all regulatory and disclosure requirements.
The significant tax advantages and reductions obtained for LLC company activities are among the notable advantages of forming an LLC. To deduct expenses, you can create an LLC. Most of the activities you engage in with your asset can get deducted even if you don't create a formal entity.
The best course of action is to learn more about forming an LLC in your state and be attentive to the entity fees, maintenance expenditures, and other costs incurred from creation to termination.
The Bottom Line
While there are many disadvantages of LLCs for rental property, there are also many benefits. They offer flexibility and options where there were none before, allowing you to tailor your property ownership to fit your business needs. However, the disadvantages may only sometimes fit well with your business. If this applies to you, you might be better off pursuing other legal options.
The need for rental property owners to create an Limited Liability Company is only sometimes necessary, but the benefits outweigh the disadvantages for some. Plus, there are other legal benefits to LLCs that go beyond insurance.
The information above should help you determine if this business structure is appropriate for you and your situation. It's something to consider to be sure that you're adequately covered in case the unthinkable occurs.
Take Advantage of Different Rental Properties
You may create an LLC for your investment property (or not). In any case, the rental market offers various lucrative real estate investments. And the short-term market presents an excellent opportunity to invest in the rental market.
Want to discover top rentals in different markets? The Short Term Shop makes it easy. We can connect you with top short-term rental agents and help you find the best rental property for sale across the United States.