Starting a Real Estate Investment LLC – Pros and Cons - Walsh Banks Law
August 18, 2017by Brandon Banks
One of the most common questions new real estate investors have is what are the pros and cons of holding your real estate investments in an LLC? The information provided in this post is not intended to replace the advice of an attorney. You should speak with a real estate attorney before making any final decisions. While every situation is unique, here are the general pros and cons of forming an LLC as a real estate holding company.
Pro: Shield You From Personal Liability
The most common reason for wanting to use an LLC is for asset protection. When your real estate investments are owned by an LLC, you are shielded from personal liability should something go wrong with one of the properties. The LLC should, if properly setup and maintained, should shield you from liability if you find your self in a dispute with a business partner or are being sued by a tenant, or contractor
More experienced investors often hold properties in several different LLCs to further reduce risk. In complex transactions you may even be able to split the ownership of certain financial instruments into different LLC holding companies.
Unless you signed a personal guarantee, creditors would only have the rights to the assets held by the LLC if you default.
When you hold your investment property in your own name you have much less flexibility for shielding your assets from potential claims.
Pro: Pass Through Taxation
Nobody wants to pay more taxes than they have to. While using a corporation to own real estate investments would give you the same level of asset protection as an LLC, it could increase your tax burden. You may end up having to pay corporate income tax and personal income tax on your profits, depending on how you went about setting up the business entity.
But, LLCs are pass-through structures. That means all of the profits pass-through the company to you. You then only have to pay your taxes on the profits.
The reason LLCs are so popular with real estate investors is because they offer superior asset protection and tax treatment.
Con: Loss of Certain Tax Benefits
However, in certain instances holding property in an LLC can limit your access to certain tax benefits that are only available to individual property owners. When it comes to tax benefits for your personal home, you may still be able to use a pass-through holding company to access some of the tax benefits, but doing so is much more complicated and expensive.
The downside of using LLC holding companies for real estate investments is that sometimes you have to sacrifice access to certain tax benefits in order to keep your liability protection.
Con: Complying With Legal Formalities
If you choose to set up an LLC you will have to comply with all of the legal formalities. This includes paying your fees on time, filing all of the appropriate paperwork, and acting like a real business.
If you fail to fully meet all of the legal obligations of the LLC, you could lose the asset and liability protections that your LLC is supposed to provide. A future plaintiff could ask the court to pierce the corporate veil to get access to the real estate assets inside the LLC by arguing that the business is just a sham.
While meeting all of the legal requirements of running a LLC – also known as corporate maintenance – are not onerous, they do take time and increase your costs.
Many real estate investors don’t want to expense of hiring a lawyer so they setup their own LLCs. Or, they use a low cost alternative like an online incorporation service, their accountant or a paralegal. Setting up an LLC using a low cost service may save you money upfront. But, it could likely cost you more in the long run.
If you have been setting up your own business entities without the guidance of a lawyer you may be surprised to find out that those companies are not actually legally formed or do not provide the type and depth of protection you expected. Often they do not find out until they are involved in a lawsuit or audited by the IRS. By that time its too late to fix the problems. You should have a business lawyer perform legal audit to make sure everything is setup properly.
Pro: Flexible Profit Distribution Options
When you are part of an ownership group you need to find a way to fairly divide the profits from the real estate investments. Your options are limited to using pro rata distribution through share dividends if you hold the real estate in a corporation. If you do not have any type of legal entity acting as a holding company, you can create complicated tax issues when distributing profits.
However, LLCs are extremely versatile. You can distribute profits in any manner you like provided it is described in the LLC operating agreement. This allows for ownership groups to reward the sweat equity that members have put into properties in lieu of financial contributions.
Work with a business formation attorney to make sure the distribution agreement is documented properly. If the agreement is not properly documented the result could have serious legal and tax implications.
Con: Financing Issues
While using an LLC can shield you from liability, it can also make financing more expensive. Banks realize that commercial loans may be riskier than loans where you are personally on the hook precisely because of the LLC.
Unless you sign a personal guarantee, your loans will have higher interest rates on your real estate investments and may require more extensive disclosures when seeking a loan.
Pro: Ease of Asset Transfers
If you want to transfer property it can be a pain. Even if you use a quitclaim deed, there are a lot of steps you need to go through to make sure the person you are transferring the property to receives clean title.
This can be an issue when it comes to doing your estate planning. However, when you use one or more LLCs to hold your investments, you can transfer your ownership shares in the LLC instead of dealing with title documents.
If you are a real estate investor, or are considering investing in real estate, you should discuss your plans with an experienced real estate attorney. An attorney will be able to give you the best advice for your specific situation?