Even if the rental property is moved into a single-member LLC, once the property owner changes, mortgage documents require you to pay the existing loan.
Limited liability companies (LLCs) are becoming popular business entities for investing in real estate. When buying real estate or transferring titles, owners frequently choose to create an LLC so that they will be the legal owner of the property. For some investors it is a good idea, however, for others, it might not be the best option.
Let’s dive into the pros and cons of forming an LLC for real estate investments. But before that, we need to understand what the term means.
What is an LLC?
Forming an LLC for your investment property enables investors to buy and hold real estate while protecting them from personal liability. This means that the investor purchases or sells the real estate and states the LLC company is the owner rather than an individual.
People behind the entity can escape personal responsibility if any outside entities or individuals file a claim. For each separate property, property owners can establish individual LLCs, which means that they can prevent cross-liability across properties. Instead of directly owning real estate under their individual names, investors may have more options when it comes to owning rental property through an LLC.
Let’s examine some common benefits and drawbacks of an LLC for real estate investment properties. But bear in mind that what is beneficial to one investor could be disadvantageous to another. So, before forming an LLC to hold real estate, investors should consult with a legal professional nearby to make the right choice.
Benefits of an LLC
Starting a real estate LLC has several advantages. These advantages may include tax benefits, cost savings, and protection against lawsuits and other dangerous circumstances.
- Not Being Personally Responsible
This is one of the common advantages of a real estate LLC. Let’s say someone was hurt while on the property you own. Even if you don’t live there or know the visitor personally, they could decide to file a lawsuit against you as the property’s owner. Investors can lessen their legal liability in a lawsuit if an LLC controls the property. The LLC would be legally responsible for the case instead of the investor, who would no longer be required to defend their personal assets. Even if you have property insurance for such cases, your homeowner’s insurance policy would give coverage up to a specific financial limit. However, if the injured party requests more compensation than the insurance would cover, your private assets may be at risk.
Real estate, as well as other assets held by LLCs, are secure. One important way rental property investors protect their assets is by getting a mortgage for real estate investment through an LLC. An LLC mortgage does not refer to a specific type of loan, rather, it describes the process for getting financing for investment property through an LLC.
- Pass-through Tax Entity
For taxation reasons, an LLC is considered a pass-through entity, meaning that earnings or losses pass through to each member of the LLC according to their respective ownership percentage. Any revenue received by the LLC is taxed under the individual income tax rather than the corporate income tax. So, they avoid double taxation. As a result, you will be able to properly submit your taxes and distinguish between the holdings of your LLC and your personal holdings.
LLCs are flexible, in contrast to the majority of corporate formations. They provide owners with a lot of flexibility. Membership in an LLC is unlimited. Members have the option of managing the decisions (e.g. selling a property) collectively in an equal manner or selecting a single person with property management experience to be in charge of the day-to-day operations or daily details of the property. If no member accepts the burden of running the business themselves, a third party could be recruited as a manager and placed on the payroll.
The Disadvantages of an LLC
Now it’s time to understand the drawbacks of forming an LLC for real estate investment. Yearly fees, potential self-employment tax, and challenging financing are some of the drawbacks of using an LLC. Let’s learn more about the disadvantages.
- ‘Due on sale’ Clause
In general, ownership can be transferred when the mortgage is fully repaid. Any member whose assistance was used to finance the mortgage will have their name listed on the mortgage documents, proving that they are the true owners of the home. The ‘due on sale’ clause implies that if the property is sold, the owner (the person whose name appears on the mortgage document) will be responsible for paying the remaining money. So, it is strongly advised to seek expert guidance before moving forward with the transfer since it might be a challenging process.
Even if the rental property is moved into a single-member LLC, once the property owner changes, mortgage documents require you to pay the existing loan. A mortgage condition known as a ‘due-on-sale’ clause demands that the borrower fully repays the lender if the property is sold. Homeowners can sell their homes once they have fully paid the debt.
- Challenging Financing
Although it could be possible for an LLC to be approved for a loan to purchase a rental property, most lenders require that each member personally guarantee the loan. The lender can, therefore, hold each member of the LLC accountable for any existing mortgage debt if the LLC fails on the loan.
Most states also demand an annual or biannual filing fee to maintain the company’s activeness once an LLC has been created and registered.
- Potential Property Transfer Tax
Certain towns, counties, and states impose a transfer tax when real estate ownership transfers. Transfer taxes sometimes referred to as deed taxes or stamp taxes, may be equal to the percentage of the property value or sale price of the property.
Now you know the pros and cons of real estate investments through an LLC. Opt for legal professionals to make the right choice!