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Ultimate Real Estate LLC Guide: Pros, Cons, Tax Benefits & Setup Tips

Real estate LLCs, or Limited Liability Companies, can shield your personal assets while letting you keep control of the profits from your properties. Here’s a complete step by step guide that dives into the pros, cons, and how to set one up.

What Is a Real Estate LLC?

A Real Estate Limited Liability Company (LLC) is a business structure designed for property transactions that separates your personal assets from your business dealings. In the event of legal issues, it limits your personal liability. In other words, the LLC gets sued instead of you. So, you can continue to live your life, your home, your money, your car. Thus you don’t have to worry about losing everything you own and needing to sleep under a bridge drinking wine out of a paper bag.

Furthermore, a Real Estate LLC allows for multiple members, enabling a group of investors to pitch in and buy property together without the individual liability of personal ownership. This flexibility makes it an attractive option for those looking to buy, sell, or lease properties collectively. The benefit is that you can more easily take on investors so you can buy larger and larger properties that are even more profitable and take less of your time than single family homes. Economies of scale kick in because with a large enough multi-unit property, you can hire an on-site property manager that takes care of collecting all the rent and maintaining the property. So, you save time, because instead of unplugging toilets you free up your time to look for the next deal.

How Does It Work?

As the manager of an LLC, you can have 100% of the control with little to no liability. This is true even if you have other members who have pitched in to buy the property with you. You use your business and real estate investing knowledge. Then, you have other people pay your down payment to buy the property.

Think about it. Would you rather buy one single family home where you have to yank the down payment out of your own pocket that you have to manage and maintain yourself? Or would you rather own 50% of a 200-unit apartment complex for no money out of your pocket and hire someone to oversee it?

Naturally, you’ll want to have some real good legal advice and work with accredited investors so you don’t run into securities issues. But using a real estate LLC and other people’s money, you can do this over and over again. That’s how real wealth is built. Think about it. As of this writing, billionaire Jeff Bezos only owns 9% of Amazon. Elon musk only owns 20% of Tesla. So, new business owners need to pay attention to this instead of tightly clutching a nickel saying, “mine, mine, mine.” In other words, you get a lot richer managing a group than by doing everything by yourself.

Comparing Real Estate LLCs and Corporations: Key Differences

Both Real Estate Limited Liability Companies (LLCs) and corporations, such as S corporations (S-corps) and C corporations (C-corps), offer liability protection. However, there are huge differences on how these structures affect your tax bill. LLCs benefit from pass-through taxation. So, by default, profits and deductions flow through the LLC to your personal income tax returns. In contrast, corporations have some detrimental tax disadvantages for owning real estate.  In other words, CPAs say clearly – own real estate in LLCs. Don’t own real estate in corporations. Here are some reasons why:

  1. Limited Tax Deductions: Corporations may not benefit from some tax deductions and credits that are available to individual property owners or other forms of business entities like LLCs. For example, personal deductions for mortgage interest and property taxes are not as readily available at the corporate level.
  2. Higher Capital Gains Taxes: When a corporation sells a property, it may pay higher taxes on capital gains compared to individuals or other entities. Corporations do not benefit from the lower tax rates on long-term capital gains that individuals enjoy.
  3. FIRPTA Withholding: If a foreign entity holds real estate in the U.S. through a corporation, it may be subject to the Foreign Investment in Real Property Tax Act (FIRPTA) withholding requirements, which can complicate the sale of property and affect the liquidity and profitability of the investment.
  4. Inflexibility in Loss Utilization: Corporations cannot pass losses through to their shareholders to offset other personal income. This can be particularly disadvantageous in the early years of real estate investment where depreciation and other costs might exceed rental income.
  5. Complications in Estate Planning: It’s not as easy to transfer Real estate to your kids that you hold in a corporation. Plus, your heirs will likely not qualify for the step-up in basis that individuals receive. This can lead to huge higher estate taxes and more complicated estate planning.

For example, let’s say you bought a house in 1990 for $100,000. Now it’s worth $1 million. You die. For tax purposes, your kids inherit the property as if they bought it for $1 million. So, if they sell it for $1 million today, they pay no taxes. If they sell it and make a $1 profit, they only pay taxes on the $1. That’s what a step-up-in basis means. This is because the basis upon which the profit is calculated steps up to the appraised value of the property on the day they inherited it.

However, if that property was in a corporation the kids would have to pay taxes on the whole $1 million. If they sold it right away and distributed to proceeds, they could get hit with, for example, a $370,000 tax bill. But if they inherit the property in an LLC, since the taxes and deductions flow through the LLC to the individual owners, the step-up-in basis benefit flows through to them, too.

Bottom line? Owning real estate in an LLC has tremendous tax advantages compared to owning real estate in a corporation.

Real Estate LLC vs. Sole Proprietorship: Choosing the Right Business Structure

Operating as a sole proprietorship is often called the simplest business form, requiring no formal registration or paperwork to start. That is, until a lawsuit strikes. This simplicity, however, comes with significant risks.

Unlike a Limited Liability Company (LLC), a sole proprietorship does not separate personal and business assets. This means if legal issues arise, such as claims against your property, your personal assets could be at risk. In other words, without an LLC, a lawsuit on your rental property could jump over to you personally. That is, the lawsuit could take your personal residence and empty your personal bank account.  An LLC, on the other hand, offers a layer of liability protection by distinguishing between personal and business assets, providing a safeguard that a sole proprietorship lacks. So, when someone sues the LLC, the lawsuit stays inside of that LLC and you don’t need to bring the pain home.

Advantages of Forming a Real Estate LLC

1. Enhanced Liability Protection

Establishing a Real Estate LLC is primarily aimed at minimizing your personal liability. Consider a scenario where an injury occurs on your property, leading to a lawsuit. Ownership through an LLC means that any legal action targets the company, not your personal assets. This structure confines potential financial losses to the business’s assets. Similarly, if the LLC fails to meet property loan payments, unless you personally guaranteed the loan, your personal assets remain shielded from creditors.

2. Tax Benefits

While an LLC doesn’t remove your tax obligations, it does offer advantages that can reduce your tax liability. As we’ve stated, real estate LLCs benefit from pass-through taxation, where the income is taxed once at your personal rate on Schedule D, avoiding tax at the company level then more tax at the personal level as seen in other business entities. Additionally, managing rental properties through your LLC, our tax attorney said that some of you might qualify you for a 20% deduction on business income on your personal taxes, leveraging more savings. In the U.S. tax code, there’s a provision known as the Qualified Business Income Deduction (QBID), or Section 199A deduction, which allows owners of sole proprietorships, partnerships, S corporations, and LLCs to deduct up to 20% of their qualified business income on their personal tax returns. We are not tax experts. So, check with your CPA for details.

3. Simplified Partnership Investments

Incorporating partners into your real estate venture is more straightforward with an LLC. Instead of the complex process of changing property deeds, which also involves lenders, you can adjust the LLC’s operating agreement. This document will outline each partner’s ownership stake and detail how profits and losses are divided, streamlining the process of collaboration and investment management.

The Downsides of Forming a Real Estate LLC

1. Risk of Triggering the Due on Sale Clause

Transferring existing properties into an LLC carries the risk of activating the “due on sale” clause in your mortgage agreement. This clause allows lenders to demand full repayment of the outstanding loan when property ownership is transferred. If you are unable to meet this demand, it could lead to foreclosure. It may be possible to negotiate with your lender to waive this clause, particularly as you retain ownership through the LLC, but success is not guaranteed.

Loans on properties that you put into LLCs that Fannie Mae and Freddie Mac have purchased from your lender may not trigger a due-on-sale. This is because their regulations seem to allow transfer to LLCs. However, these institutions do not own all loans. That’s one reason why we set up land trusts, naming you as the initial beneficiary, which don’t trigger the due-on-sale clause. Then we have a separate piece of paper that assigns the ownership of the land trust, or more technically speaking, the beneficial interest in the land trust over to an LLC.

So, as long as it’s between a one and four-unit residential property, the bank can’t call the loan due as long as you remain a beneficiary of the land trust. And you are. There you are on the trust. But if a lawsuit comes knocking, you can show that extra piece of paper where you’ve assigned your beneficial interest to your LLC, so you have the liability protection.

2. Partial Liability Protection

While an LLC generally protects personal assets from business liabilities, there are exceptions where personal liability can still arise. For instance, if you personally guarantee a business loan for your LLC and the business fails to meet its obligations, creditors can pursue your personal assets. Additionally, personal negligence or misconduct in managing property can also lead to direct legal accountability, bypassing the LLC’s protective barrier.

3. Additional Operational Costs

Setting up and maintaining an LLC involves initial and ongoing expenses that can impact your financial planning. The initial formation of an LLC typically requires a fee, plus there are annual fees to keep the entity in good standing. Usually, it’s only about $50 to $100 or so as it s in Wyoming. However, these annual fees vary by state and can be particularly high in places like California, where they reach up to $800 a year. These costs need to be factored into your budgeting decisions when considering an LLC for your real estate investments.

How to Set Everything Up

Here’s how we like to do things.

1. Set Up One LLC Per Property

Set up one LLC per property and title the property in the name of that LLC. That way when there’s a lawsuit on one property it doesn’t take all the rest of your properties. So, cubbyhole your labiality with one LLC per investment.

2. Set Up Another LLC to Collect Rent

Then, you set up another LLC that collects all your rents for all of your properties. So, if you have 30 properties, you don’t have to open 30 bank accounts, one for each LLC. That’s too much work. An LLC doesn’t need to have a bank account at all. 

We like setting up one LLC that collects all the rents and pays all the expenses. You can use accounting software to separate the expense for each property. That one LLC doesn’t own any property. So, when it gets sued it doesn’t own anything and there’s nothing to take. That is, you just shut down the bank account, set up another LLC and use the new LLC to manage your properties.

So, you have one master LLC up to manage all your properties. Then you have all these LLCs without bank accounts that own each property. For more info, see our video on real estate asset protection.

Steps to Establishing a Real Estate LLC

Forming a Real Estate LLC Made Simple

Creating a real estate LLC follows a similar process to forming any standard LLC. If you’re serious about forming an LLC, feel free fill out a strategy session on this page. If you want us to do the work for you, call us or fill out the form. Now, if you’re just curious browse our website and watch videos on The Business Guy YouTube channel. So go on our website and see out videos for free info. But if you want to hire us to do the work for you, reach out.

 

  1. Select Your Business Name Choose a name that reflects your business. We like using the address of the property such as “123 Main Street LLC. You can, if you want, include terms like “real estate” or “properties.” Ensure your name ends with “LLC” and complies with state regulations. Certain terms like “mortgage” or “investment” may require special permissions in states like New York, and terms like “urban development” might be prohibited. Verify your chosen name’s availability through your state’s secretary of state office database.
  2. Appoint a Registered Agent A registered agent handles legal correspondence for the LLC. This agent must reside in the state where the LLC is formed. We provide this service in all 50 states
  3. Draft and File Articles of Organization The articles of organization, or certificate of formation, detail your LLC’s name, purpose, and management structure. Complete the state-specific articles of organization, have it signed by all business owners, and submit it to your state. States like New York and Nebraska may require publishing a notice in a local newspaper before filing your documents.
  4. Develop an Operating Agreement An operating agreement is crucial for defining the internal workings of your LLC. It covers aspects such as:

     

    Profit distribution

    Procedures for member exit

     

    Business funding strategies

     

    Creating this agreement helps prevent future disputes among partners. When we set up LLCs for clients we provide an operating agreement.  

     

     

  5. Comply with Additional State and Federal Requirements After filing your LLC documents, you must fulfill other legal requirements to operate your real estate business. These may include obtaining a general business license, applying for an Employer Identification Number (EIN) from the IRS, and submitting annual business reports. Requirements vary by state.

Final Thoughts

In summary, forming a real estate LLC is a smart move for those committed to serious real estate investing. It provides robust liability protection compared to individual or sole proprietorship ownership and offers more favorable tax advantages than S-corporations or C-corporations. While the process of establishing an LLC is generally straightforward, state-specific regulations can add complexity. For additional guidance, consider reaching out to our professional LLC services by filling out the free strategy session on this page. We can you to streamline your setup and help you to ensure compliance with legal requirements.

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