First and possibly most importantly, LLCs limit personal vulnerability to potential lawsuits related to the property.
Consider the situation where a tenant has a back yard BBQ and the tenant’s guest falls over the deck railing and is injured. In today’s legal climate, it is quite possible the injured guest would pursue a claim based on the “unsafe condition” of the deck. The Owner will be named in any lawsuit.
If the rental property were owned by an individual, he or she would have to defend his or her personal assets from the plaintiff’s claims. In contrast, if the property were owned by an LLC, the owner’s risk exposure would be insulated by the protection of the company and only the assets owned by the LLC would be exposed to potential lawsuits (as opposed to all the Owner’s personal assets.)
Insurance: Yes, your Insurance policy would kick in and be some protection, however, if the lawsuit were to go beyond your policy limits or exceptions and carve-outs, then your personal assets would be vulnerable. While the chance of a loss that exceeds policy limits may be small, the consequences can be devastating.
An alternative, or for additional protection to forming an LLC in terms of asset protection is an Umbrella Insurance Policy.
Tax Advantages: An LLC can offer options of pass-through taxation or avoidance of double-taxation you can get taxed as a partnership. If you have the LLC taxed as an S-Corp you may be able to use that to reduce self-employment tax or other taxes. The tax advantages must be tailored to your specific structure and situation and not all the options apply to everyone, so you would want to discuss tax advantages with your tax advisor.
LLCs Can Make Business Life Easier, opposed to other entity forms:
When delegating management responsibilities, LLCs have greater flexibility than a corporation or partnership. While corporations are required to have officers and directors, the LLC can be easily managed by its owners or third-party managers.
In the many states that impose increased fees based on the authorized number of shares, LLCs may pay lower state registration and maintenance fees than corporations.
Owners of LLCs have flexibility in distribution of profits, as determined by the LLC’s Operating Agreement. Cash flow distributions do not have to be pro rata according to ownership like an S corporation. This gives owners the ability to financially reward the “sweat equity” effort of select members through distributions of cash flow.
Unlike an S corporation, foreign ownership and investment in U.S. real estate is possible through an LLC.
LLC owners can easily transfer ownership in real estate holding by proactively gifting the company’s membership interest to their heirs each year. Over time, it is entirely possible to pass ownership of real estate owned by an LLC to loved ones without ever having to formally execute and record a new deed. This enables property owners to avoid transfer and recording taxes and fees. These fees can be substantial in many states.
Disadvantages of an LLC:
Cost? In some states, there is a reasonably small fee to form an LLC and no yearly fees. That makes an LLC very affordable. Legal Zoom even offers a form to use. (Not recommending that without some advice from your advisor, but it is an option out there.) For example, in the state of Missouri, forming an LLC is easy and not very costly.
Other states are much more expensive and can have an $800 yearly fee and possible other costs. Get advice regarding the regulations in your state.
Financing: Some lenders won’t lend money to an LLC and if they do, it may still be backed by your personal name. This probably is not a factor if your primary goal is to limit personal liability.
Triggering Due-on-Sale Clauses: If you already own your rental property and want to quit claim it to an LLC, there is a slight risk it could trigger the “due-on-sale” clause in your loan agreement. You could then owe the remainder of the loan immediately or must re-finance. Word is this is a very small chance, but it is thrown out there as a possibility.
To LLC or Not to LLC?
The insulation from personal risk exposure for real estate investors provided by an LLC, the relative ease of administration and potential tax benefits, make ownership of rental property with an LLC a desirable option in most instances.
But, before you make any decisions, consult a licensed professional who specialized in real estate investing to guide you on what is best for your individual situation.