The Pros and Cons of Forming an LLC for Real Estate Investments
What is an LLC?
A limited liability company (LLC) is an enterprise structure that assumes the tax advantages and flexibility offered by a partnership, as well as the liability protection provided by a corporation. An LLC is allowed to have one or multiple members, who are entitled to the owners of the company. Members of an LLC can be individuals as well as other businesses. Furthermore, there is no specified limit to the number of members that an LLC can have.
Approximately 2 million businesses in the U.S were 2014 identified as LLCs, according to the IRS latest figures. It is essential to consider the advantages as well as the disadvantages that come with the establishment of an LLC before making the right investment decision for your business.
Limited liability companies (LLCs) have, in recent years, become one of the most popular business enterprises in real estate property holding. LLCs only came into existence in the United States in 1977 after the State of Wyoming passed legislation to bring onboard the needs of oil firms. Before LLCs came into existence, real estate investors were principally limited to using corporations to acquire titles with limited liability protection. That form of business, however, potential drawbacks.
Several years later, Florida followed Wyoming by enacting an LLC law in 1982. Since then, all 50 states have passed legislation allowing some form of LLC enterprise structure. LLCs provide real estate investors with protection from personal risk exposure as well as the relative ease of organization with potential tax benefits, making the ownership of real estate property a very favorable option for most investors.
LLCs vs. Liability Insurance
Although LLCs offer plenty of benefits to real estate investors, limited liability companies are not the best holding enterprise method for every property holder. Most real estate investors do not view the protection from a theoretical lawsuit to be worth the trouble of forming and operating a company. This is especially true with the availability of liability insurance.
While that may be true, real estate investors who rely solely on the protection of liability insurance take quite a significant risk. Typically, liability policies have limits, carve-outs, and exceptions. While the risk of incurring losses exceeding the policy limits is shallow, the penalties can be quite devastating.
Under the current legislation and market laws, LLCs are likely to continue experiencing more popularity as more and more real estate investors look to take advantage of the lucrative benefits offered by LLCs.
LLCs and Personal Liability
LLCs have a multitude of benefits. One of the significant benefits of investing in an LLC company is the limit to personal liability presented by the form of business. If, for instance, an investment property owner leases out his property to a tenant who decides t hold a party on the premises. Consider that one of the guests falls off a balcony on the property. Under the current legislation in most states, the injured guest will likely pursue a lawsuit based on “unsafe conditions” in the dwelling. The owner will more often than not be named in lawsuits resulting from similar incidents.
If the property is held solely by a real estate investor, they would be named liable for the incident in any lawsuit following such an event. Then they would have to defend their assets or properties from the plaintiff’s claims. However, if the same property were under an LLC, the owner’s risk would be reduced by the protection instituted in the law for the company. That leaves only the property held by the LLC exposed to the risk of potential lawsuits.
Single and Multimember LLC Pass-Through Taxation
Another advantage offered by LLCs is the property owner’s ability to enjoy the benefits presented in pass-through taxation. The IRS announced Revenue Riling 88-76 in 1988, declaring that despite providing corporate-like protection against liability, LLCs would be taxed as partnerships. In contrast, corporations are expected to fulfill a double-taxation policy.
While corporation owners have the option to access pass-through taxation through an “S” election, they become subject to many restrictions that limit their benefits to real estate investors. The revenue ruling of 1988 gave real estate investors the option to avoid double taxation when acquiring property through an LLC and still offer a liability shield.
The default tax classification rule stipulates that real estate holding companies are sole proprietorships that should be owned by one individual. The legislation regards the owner as a “disregarded entity.” As a result of the bill, LLC company owners have to pay the tax due from the firm’s capital gains, while still getting the protection offered by the LLC liability protection.
Since there is no other legislated LLC tax, the property owner can safely avoid double taxation from both the income generated by their property and the value appreciation of their property during disposition. In addition, the proprietor of a sole LLC is allowed to deduct the same mortgage interest as a sole proprietor according to the current IRS rules.
Real estate holdings with several owners, also known as multimember LLCs, are primarily taxed by the IRS similarly to partnerships. That means that the company files informational tax returns but does not pay taxes itself.
The benefits of tax-through taxation also apply to multimember LLCs. This is principal because LLCs pass their profits and losses to their members who, in turn, report their income or loss portion with their personal income tax returns. Basically, the legislation shields both multimember and single-member LLCs from the risk of double taxation. Through the limited liability clause and the numerous benefits of pass-through taxation, LLC owners and members can access personal protection from lawsuits.
LLCs Make Business Life Straightforward
LLCs offer several benefits to entities that do not necessarily apply to but use LLCs to own and operate real estate investments. While the entity form might not be entirely unique to LLC firms, they certainly apply to their use in real estate investment. Some of these benefits include:
• LLCs enjoy much more flexibility when delegating management roles than both partnerships and corporations. While corporations have statutory requirements to have directors and officers, LLCs can easily be managed by their owners as well as third-party managers.
• Most states that increase fees on firms based on the number of authorized shares force corporations to pay higher registration and maintenance fees than LLCs.
• LLC company owners have the freedom to take advantage of the incredible flexibility in profit distribution, as stated in the LLC operating agreement. Unlike S corporations, Cash flow distributions in LLCs do not have to be pro-rata. This gives the property owner the ability to reward the sweat equity effort from specific members via distributions of the available flow of cash.
• An LLC, unlike an S corporation, allows foreign entrepreneurship and property ownership in the U.S real estate industry.
• U.S LLC owners can also reliably Transfer their company ownership in the form of real estate holdings through the hands-on gifting of company membership interests to the firm’s heirs every year. In the long run, it is entirely possible to pass the ownership of a property held by an LLC to loved ones without formally executing or recording a new title deed. This effectively shields property owners from transfer fees and filing taxes, which can be quite substantial in some states.
Though not every company seeks to enjoy the above-listed benefits, it is a fact that LLCs offer much more appealing benefits to the company or property owners that take advantage of their policies.
Weigh Your Options
Most business owners opt to develop and operate an LLC primarily because they are unfamiliar with the legislation surrounding the different entity choices available. Most of them assume that LLCs offer greater risk protection since it features limited liability in its name.
However, the reality is that properties formed and operated under LLCs actually get protection from personal liability to their owners. The U.S law offers this advantage to LLCs by shielding the investors from personal risk beyond their investments into the firm. However, in most instances, corporations and specific partnerships also get the same advantage.
The integrity of the protection provided by corporate law can be compromised by the failure of the enterprise owner to respect the distinct identity of the firm or to observe the legislative requirements for corporate firms. Such irregularities include the inability to maintain registered agents, paying owners on behalf of creditors, or mingling business funds with personal cash.
However, the necessary requirements to create an LLC under the outlay of corporate statutes do not contain any errors.
Choose the Right Strategy to Minimize Risks
There is no practical way of eliminating all the risks surrounding a real estate business investment. However, you can improve the chances of complying with the legislated policies easily, though the steps can sometimes seem confusing even to experienced real estate lawyers.
If you are looking to invest in the lucrative real estate market, you should consider acquiring the property through an LLC. If it is the right choice for you, it will be much easier for you to purchase the property via an LLC as opposed to having the real estate property being transferred to a sole owner at a different date where the property lender will have to consent to the authenticity of the transaction.
LLCs may offer property owners more protection from outside lawsuits than most corporations or limited liability partnerships. It also offers several other advantages that make it one of the most desirable options in most cases, particularly with regard to real estate companies.
Easy startup and maintenance
The initial fees and paperwork for LLCs are relatively fair, though there is a wide variation in fees and taxes across states. An Arizona-based LLC, for instance, will be required to pay a filing fee of $50 for all its organization’s articles while it will cost $500 to carry out the same process in Illinois.
When we fail to consider the variation in prices, the process of creation for LLCs is simple enough for any real estate investor to handle. It is, however, advisable to consult the help of a lawyer or a professional accountant when starting an LLC.
The cons of LLCs
The self-employment tax
For tax purposes, the IRS considers all LLCs the same as all partnerships by default, unless the members opt to be taxed by the government as a corporation. The government considers all the members of the LLC t be self-employed. In turn, all the members of the firm are liable to Medicare and social security taxes. Medicare and social security taxes are collectively known as self-employment taxes and are based on the total earnings of the enterprise.
Comparatively, for property owners whose file forms are taxed as S corporations, the owners that work for the firm are required to only pay taxes for social security and Medicare and not the pretax profits of the entire firm.
Since no strict guidelines are governing the business, this could cause problems in the long run unless a detailed operating agreement is put into place. The contract should demand additional upfront costs from the members, including attorney fees.
While most advisors will recommend starting your business as a limited liability company, LLCs also carry with them a few disadvantages. However, LLCs do offer lucrative tax and legal advantages to the owners as well as the members. The problems of an LLC are mostly in terms of the means of payment and the record-keeping method. The legal protections you enjoy, basically determine the amount of profit that ends up in the investor’s pocket.
Whether you or any other member of the LLC receives any payments from the LLC, you will be considered responsible for the taxes on your share of the LLC’s profits. If you serve the LLC as a managing member or operate a single-member LLC, you must also file returns on your self-employment taxes on your profit share. In most states, you are required to make quarterly self-employment taxes. While federal law exempts some property owners from tax payments, most state governments need LLCs to pay taxes.
An LLC is not able to provide you with a wage equivalent to regular employers. TO get payments on a regular basis, you are required to establish a system of guaranteed payments.
LLC Protection Preservation
An LLC can only protect you, as a member of the firm, if you take the necessary steps to keep you and your firm separate from different claims. If you are running a sole LLC, it should have an individual bank account. A court could decide that your firm is a sole proprietorship with no access to liability protection if you choose to pay the bills and deposits the firm’s precedes into your personal account.
If your lender or vendor insists that you personally warrant the LLC’s debts, the personal assets in your name are at risk. No protection will be offered to your firm if there is evidence to show that you defrauded or cheated the creditor for personal gain.
The Control of the LLC
A creditor cannot achieve an ownership stake in the firm from a charging order. However, state laws allow creditors to foreclose ownership of an LLC. This offers the firm’s owner and his partners a greater spur to engage in a settlement. A creditor is not entitled by a foreclosing to go to court and foreclose your ownership of the firm.
Furthermore, foreclosing does not entitle the creditor to assume a manager role in the business. This requirement protects the members of the firm that are co-owners from being forced into taking up a new partner. If you are the sole owner of the firm, the state laws may not offer sufficient protection.
For instance, in the state of Florida, very little asset protection is offered for sloe-proprietor LLCs, according to Jonathan Alper’s website.
LLCs and bankruptcy
During liquidation, according to chapter 7, LLCs have to go out of business for bankruptcy court to sell off their assets. Chapter 11 quotes how an LLC should recognize paying debts and piping out others. While the requirement keeps the firm alive. It is usually more costly than chapter 7. Though the stipulations state that the LLC structure should protect your personal assets from creditors’ claims, there are certain exceptions. For instance, if you have personally guaranteed any debts, the creditors of the LLC may have a few ways to sue you in a court of law.
In personal bankruptcy, creditors will be able to make a claim on your financial stake in the LLC firm. This fact diverts your company’s share to your creditors. Most state laws, however, prevent creditors and partners from obtaining administrative rights in the firm. That basically prevents your partners from going into business with an individual or firm that did not ask to join the LLC. Most operating industry agreements also block individuals from entering into a transaction with other firms without the owner’s approval.