By Russell Barneson
By Russell Barneson
LLC stands for Limited Liability Company.
It’s a business structure that has the ability to pass-through income to a sole proprietorship or partnership while enjoying the limited liability of a corporation.
The owners of an LLC are referred to as members and there is no cap on their number.
LLCs can also be owned by other LLCs, corporations, individuals and foreign entities.
An LLC is NOT a corporation under state law.
It’s a legal form of a company that provides limited liability protection to its owners in many jurisdictions.
LLC’s are subject to the laws of the state they reside in.
In this article we review 3 Pros and Cons of using an LLC for real estate investing.
Anyone searching public records needs to know the name of the LLC in order to determine the location of a property and purchase price.
Celebrities and other high profile individuals often utilize LLCs for this very reason.
It affords them a level of privacy they otherwise would not enjoy.
The second benefit of using an LLC to buy real estate is protection of your personal assets.
In the event of a lawsuit, it’s possible your liability insurance would not completely protect you.
If someone is severely injured on your property they could sue you and possibly obtain a large settlement.
If they win the judgement and the LLC owns the property, then the LLC is legally liable for the settlement.
This means all of your personal assets outside of the LLC are protected and only the assets in the LLC are under threat.
Thus, the structure of an LLC provides considerable peace of mind.
The Multiple LLC Strategy
Investors with multiple properties of substantial value sometimes choose to put each individual property into its’ own LLC to reduce the overall risk to their whole portfolio.
Should one property have problems with a judgement against it, the other properties would be shielded in the event of a settlement.
If you own many properties and are engaged in numerous purchases, sales and leases, the attractiveness of multiple LLCs is evident.
For many real estate investors the tax treatment of income generated within an LLC is the primary motivation for forming an LLC.
In the case of a corporation, income is taxed and then passed onto shareholders at which point it’s taxed a second time.
In the case of an LLC, income is not taxed.
Instead, it's "passed through" to its’ owners.
In the eyes of the IRS, LLCs are classified as either sole proprietorships or partnerships depending on the number of owners.
The income of a sole proprietorship is passed onto the owner and the appropriate tax is paid on their personal tax return.
If the LLC is a partnership, (NOT a sole proprietorship) the individual owners are required to file a K-1 with their personal return, listing their profits and losses.
For more information about K-1s read What Are Schedule K-1 Documents Used For?
First, there are costs involved in setting up and maintaining an LLC.
These costs differ from state to state (you can find a list of LLC costs for each state here).
It is not advisable to set up as an LLC using standard templates found on the internet, as there are costs and penalties imposed by the IRS for errors and omissions.
A registered agent must also be appointed and it is prudent to enlist the help of qualified legal counsel when setting up an LLC.
Once the LLC has been formed it must comply with state and federal tax regulatory statutes.
If co-ownership is involved, the LLC is considered to be a partnership.
By March 15th of each year the partnership must file Form 1065.
The LLC itself is not subject to federal tax.
Instead, in April of each year the owners report their share of income or loss on the K-1 form and include the amount on Schedule E of their 1040 tax return.
In addition, other state laws and local taxes may come into play.
Additional Tax Implications
Keep in mind anyone using an LLC to purchase a property they’ll use as their primary residence, may lose both the ability to deduct mortgage interest and utilize the capital gain exclusion on their tax return.
Under current law in 2021, upon the sale of a residence, a single person can exempt up to $250,000 of capital gain, provided they have resided in the home for at least two of the last five years.
For married couples the exemption jumps to $500,000.
Obtaining financing through a new LLC can be more difficult than obtaining a traditional loan as an individual.
The majority of lenders will not approve a loan if the property is purchased using a new LLC.
Banks and lenders want to see established credit and income history, which a new LLC won’t be able to provide.
Therefore, banks and lenders will often ask the owner of a new LLC to personally guarantee the loan.
To circumvent this, some buyers will purchase a home in their own name and upon closing transfer the property to an LLC.
Unfortunately, such a move can activate a due on sale clause.
A due on sale clause states a lender can force a mortgage to be repaid in full upon the sale of the property or a transfer of ownership.
These clauses are found in most residential mortgage contracts.
Consequently, upon the creation of an LLC, you must obtain commercial financing rather than residential financing.
This commercial financing comes with higher interest rates.
In deciding whether or not to form an LLC to purchase a property, one should carefully weigh the benefits versus the drawbacks.
The LLC provides privacy, protection of personal assets and certain tax benefits.
Drawbacks include costs, ongoing compliance and difficulty obtaining financing.
If you’re curious about setting up an LLC, we recommend you seek out competent legal advice.
Disclaimer: Crescent Lenders, DBA CrescentLenders.com ("CL") is a California licensed broker under California Bureau of Real Estate License No. #01792267. Regardless of this license, CL considers itself a “finder” for purposes of applicable laws and regulations (California Business & Professions Code § 10130, et. seq.).