LLCs are fast becoming a preferred entity type for investing in and holding real estate. Here are the advantages they confer—and the disadvantages.
Limited liability companies have become one of the most popular business entities for acquiring real estate. Owners often prefer to form an LLC when purchasing real estate—or when transferring titles—so that the LLC becomes the legal owner of record, rather than the individual members.
Here are the pros and cons of forming an LLC for real estate investments.
1. Avoiding personal liability
This is the major advantage of an LLC. You want the best option for limiting your personal liability should an unforeseen circumstance arise relating to your property. LLCs provide that protection.
For example, if someone is injured while visiting a property you own, even if you do not reside there or have any connection to the guest, they could potentially pursue a legal claim against you, the owner, for their injuries.
Assuming you acquired property insurance to cover such incidents, your homeowner’s insurance policy would provide coverage up to a particular monetary limit. But if the amount of damages the injured party seeks exceeds the policy limit, your personal assets could be exposed.
If, on the other hand, you placed the deed and title to the property in the name of an LLC, only the LLC (and not you) would be named as a defendant. More importantly, only the LLC’s assets would be obligated to pay an award of monetary damages if the injured party’s suit is successful. Hence you are provided anonymity, and your personal assets are not exposed.
Another reason to place a property title in the name of an LLC is that it gives you liability protection against monetary judgments if a financial dispute involving the LLC arises.
If a third-party succeeds in obtaining a monetary judgment, it—the judgment creditor—can’t force the sale of real estate held by an LLC—the judgment debtor. Instead, the judgment creditor is typically required to obtain a “charging order” from the court that, in turn, becomes a lien on the real estate. While this is by no means cause for celebration, it’s better than losing the property altogether.
Members of LLCs who own real estate as part of their investment portfolio also derive favorable tax treatment from the Internal Revenue Service.
Whether you are the sole owner of the LLC (single-member LLC) or one of several members (multimember LLC), you benefit from so-called pass-through taxation.
For federal income tax purposes, pass-through taxation refers to the fact that any income earned by the LLC—including profits generated through real estate (such as rental income from leasing an LLC-owned property)—will pass through the LLC to its individual members.
Any income earned by the LLC is not taxed at the corporate level (as would be the case with a traditional corporation) but only at the individual level. Each LLC member reports the income on their individual federal income tax returns—usually on Schedule C. These pass-through rules help members of an LLC avoid double taxation.
2. Professional appearance
An intangible benefit of owning and holding real estate in the name of an LLC is that it appears to the public to be more professional, especially when advertising a property for lease to commercial or residential tenants.
An individual or business looking to lease property may be more comfortable renting a piece of real estate from “Smith Properties LLC” than from “Joe Smith.”
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3. Simple transfers
An LLC can be sold through a relatively simple transfer of membership interests. The LLC’s real estate will continue to be owned by the LLC but with new LLC members. Continuity is preserved, and the transfer is seamless.
1. The ‘due on sale’ clause
Be careful about transferring any real estate that is held in an individual’s name to an LLC. If an individual initially secured financing and qualified for a mortgage for the real estate, the individual’s name will appear on the mortgage documents as the legal owner of record.
In the event of a transfer of real estate from an individual owner to an LLC—which is treated as a sale of property—the owner of the LLC must make certain that the name in the property insurance documents matches the grantee on the deed. The mortgage lender will often learn of the transfer when the property insurance bill comes due (if insurance is escrowed) and may claim that the transfer violates the terms of the mortgage’s “due on sale” clause.
The due on sale clause is a standard provision in a mortgage that requires that the borrower (that is, the named property owner) pay the mortgage balance in full at the time of a sale. You may want to seek a waiver from the mortgage lender before transferring real estate from an individual’s name into the LLC.
2. Transfer tax obligations
LLCs may also raise transfer tax issues, depending on the state. In Delaware, for instance, no transfer taxes apply if an individual transfers ownership to an LLC so long as the ownership interests remain the same before and after the transfer. The percentage membership interests in the LLC must be the same as the ownership percentage interests before the transfer. Be aware that some states—such as Pennsylvania—tax the transfer regardless. Be sure to consult your state’s laws before moving forward with an LLC.