Starting LLCs (for the purpose of investing in real estate) has become a time-honored tradition of today’s most prolific entrepreneurs. If for nothing else, there are few vehicles capable of protecting a new business owner from both themselves and the malicious intents of others. But I digress, starting LLCs (or even one for that matter) doesn’t necessarily coincide with common sense, nor does the average small business owner know everything there is to know about these protective entities. Truth be told, LLCs can be intimidating to the first-time business owner, and for good reason: they are the legal foundation on which your entire company is built.
It’s worth noting, however, that starting a real estate investment LLC doesn’t need to be as daunting as a task as many make it out to be. Yes, they are integral to the start of a new business, but that doesn’t mean you have to be scared of them. Instead, mind due diligence and embrace the advantages LLCs can provide for you and your company.
For the better part of a decade, real estate investors have favored the protection offered by limited liability companies (LLCs), as opposed to other similar legal entities. While they are not the only option for consideration, most real estate investors find the benefits offered by LLCs to be the most accommodating. In other words, if you want to learn how to start your own business, it couldn’t hurt looking into LLCs for your own protection. The following highlights the benefits of structuring your real estate business under an LLC:
According to Legalzoom:
“A limited liability company is a separate and distinct legal entity. This means that an LLC can obtain a tax identification number, open a bank account and do business, all under its own name. The primary advantage of an LLC is that its owners, known as members, have “limited liability,” meaning that, under most circumstances, they are not personally liable for the debts and liabilities of the LLC.”
LLCs were not introduced in the United States until the second half of the 20th century—1977 to be exact. As far as legal entities go, they are relatively new. In fact, the sole purpose of their existence, at the time of conception, was to accommodate the demanding needs of oil companies. Today, every state has enacted legislation to create some variation of the LLC business structure. It wasn’t until about 10 years ago that individual real estate investors really started taking a keen interest in the real estate LLC benefits. Prior to LLCs, real estate investors seeking limited liability protection were largely limited to using corporations to acquire title. For all intents and purposes, investors made the transition to LLCs to reduce their exposure to personal risk. However, the ownership of investment property through an LLC is also accompanied by significant tax benefits and an ease of administration not witnessed by other legal entities.
Forming an LLC to hold tangible property assets is a good idea if you are actively investing in real estate. However, forming an LLC may not serve as the best holding vehicle for every property owner. Did I lose you yet? Just because LLCs offer a multitude of benefits to real estate investors and their particular industry, it does not mean they are the right choice for every investor. Keep in mind that the field of real estate investing is incredibly diverse, and it would be nearly impossible to find one legal entity that protected every business. Having said that, many investors believe the threat of a theoretical lawsuit does not warrant the commitment required to start an LLC. Those of this school of thought may be more inclined to inquire about affordable liability insurance.
With that in mind, entrepreneurs that rely solely on insurance as a means of protection take on ill-advised risks. It is not uncommon for the average liability insurance policy to have limits, exceptions and addendums that convolute coverage. Essentially, liability insurance does not cover all your corners. While the chances of a lawsuit being filed that exceed the limitations of your policy are remote, they are by no means impossible. Of particular concern, however, are the devastating effects that can result from a lawsuit that is not covered by your policy. On the off chance your policy does not cover a situation, the consequences can be devastating to a real estate investor’s business.
Current laws make the prospect of forming a real estate LLC very intriguing to real estate business owners. While they may require more effort on your part, there is no denying the positive impact they can have on a business. They provide a lot more protection for business owners than liability insurance. But the real benefit is the peace of mind. Investors can sleep comfortably knowing they are safe.
Investing in real estate is a rather lucrative career choice. There is traditionally a lot of money involved in every deal—at least more than the average individual can cover on their own accord. Having said that, it is absolutely imperative for respective investors to protect their personal finances (those outside of their business finances). First and foremost, LLCs limit personal vulnerability to potential lawsuits related to the property, which is perhaps the most intriguing aspect of starting an LLC.
Any lawsuit that comes against an LLC is aimed specifically at the company, not the individual responsible for it. If the property in question were owned by an LLC, the owner’s risk exposure would be insulated by the protection of the company, leaving only the assets owned by the LLC (as opposed to all of the owner’s personal assets) exposed to potential lawsuits. In other words, personal finances would not be in jeopardy.
Assuming liability coverage is the most important factor of forming a real estate LLC, taxes are a close second. In fact, some real estate investors consider framing their business structure as an LLC based solely on tax benefits. Liability protection may just be an added bonus to some.
A 1988 court ruling enabled real estate investors to avoid double taxation by acquiring property through LLCs. As defined by the default tax classification rules, the Internal Revenue Service (IRS) classifies a real estate holding company with one owner in the same way they would a sole proprietorship, otherwise more commonly referred to as a “disregarded entity.” Accordingly, any income and capital gains generated by the LLC would transcend to the owner, who, as a result, would only have to pay taxes as an individual. However, the respective owner still enjoys the protection against liability. It really is the best of both worlds.
Seeing as how there is no separate tax accompanying the formation of an LLC, business owners are in a position to avoid double taxation. Neither the rental income generated by a property, nor the appreciation in value upon disposition incurs tax penalties. Additionally, the owners of a single-member LLC can use mortgage interest as a deduction around tax time. In forming an LLC, you are not only subjected to fewer taxes, but you are awarded more deductions.
Real estate companies owned by more than one person, however, are viewed differently in the eyes of the IRS. Otherwise known as “multimember” LLCs, these business entities are taxed similar to that of a partnership. Multimember LLCs also enjoy the benefits of pass-through taxation as the LLC passes its profits and losses through to its members. Each respective owner is then responsible for reporting their share of the profits (or losses) on either a Schedule C, K or Form 1065 with their individual income tax returns.
As the owner of an LLC, single-member or multimember, you are entitled to the benefits of pass-through taxation. Again, all of these tax benefits are in addition to the liability protection shield that was previously discussed.
For more information on Forming a real estate LLC:
If after reading, you’ve realized that forming a real estate LLC is the best option for your business, check out the next part in our series: A Beginner’s Guide To Forming A Real Estate LLC Part 2. Part 2 compares LLCs to other legal entities like a C corporation, an S corporation, and a sole proprietorship. It also goes into greater detail about the lesser known benefits LLCs offer. You will also learn how to mitigate your risk if you do choose to move forward with a real estate investment LLC.
If you’ve already filed an LLC and are curious about what you need to do next, read part 3 of our series: A Beginner’s Guide To Forming A Real Estate LLC Part 3 | The Next Step. Follow our 4 simple steps – obtain an employee identification number, get your business licensed and permitted, open a separate bank account for your business, and finally, apply for a business credit – and your business will be up and running, and protected, in no time.