Forming an LLC for real estate investments: Pros & cons

Real estate investment can be very lucrative, but it also can expose investors to risks that they didn't know enough about to anticipate.

A good way to protect yourself is to form a real estate limited liability company (LLC). Forming an LLC, a legal form of ownership, can help you and other LLC owners survive lawsuits, keep you from double taxation, avoid business debts, and allow you to change limited liability partnerships easily.

Biggest advantages of a real estate LLC

Here are some good reasons to form an LLC.

Liability protection

For many people, the most important advantage of being an LLC owner is liability protection from lawsuits. The business partners who form the limited liability company probably won't be held personally liable for most debts and other liabilities incurred by the real estate entity itself. For example, a tenant slips on ice, falls, and sues the LLC for failure to shovel the walk. Whatever the outcome of the suit, the tenant is unlikely to be able to get their hands on your personal properties or bank accounts that aren't part of the real estate LLC. That alone is a very good reason to form an LLC that is a separate entity from your other financial interests.

Lower taxes

The second valuable advantage to forming a limited liability company is the possibility of paying less federal income tax by sheltering income from the property from double taxation. The LLC can file an information-only tax return with the IRS. This federal tax election shows profits and losses for the tax year and the percentage allocated to each owner. The owners then pay taxes on their portion of the LLC profits as individuals. This is known as pass-through tax treatment or, in some cases, a disregarded entity.

You also can choose to have your real estate LLC taxed as a C or S corporation, which offers two other potential tax and business structures. These structures have different advantages, especially if you are earning more than $40,000 annually on your real estate investment. It's wise to talk to your accountant before making your decision about structure and taxation.

Location

Your real estate LLC doesn't have to be filed in the state where you reside or even where your investment property is. You can shop for the state where you form your limited liability company to ensure that it offers you the best deal for your particular situation and property. Keep in mind, however, that filing in another state can also lead to complications: Here are some downsides to consider. Overall, where you register your business can have many implications for the fees that you pay or the legal benefits you receive.

Loans

If you need to borrow money, many banks are more likely to give you a loan with good terms—even if the LLC involves only a single member. That is compared to the offers you might get borrowing as an individual with a sole proprietorship.

Flexibility

Compared to other forms of incorporation, LLCs have fewer restrictions on ownership, management, and business structure. In comparison to C or S corporations, owners can run the company the way they see fit without much government interference. Members, as LLC owners are known, can be added and removed at will, and the percentage of ownership of each member can be changed along the way. Membership isn't even limited to individuals. Other businesses can be members. That can make it easier to add investors as owners. For federal tax purposes and other reasons, these can be big advantages.

How to form an LLC for real estate investment

It can be easy to form an LLC as a real estate investor and maintain it because, like a sole proprietorship, it doesn't require much LLC paperwork. It also doesn't have the requirements that other corporations like C and S corporations must follow. No board of directors is required to form an LLC, so there are no required regular meetings or meeting records. Most states allow you to form an LLC by registering the business entity on a designated state website and with the Internal Revenue Service (IRS). The initial LLC cost can be $50 to $500 in filing fees, depending on the state.

The fact that setting up an LLC business entity is relatively easy doesn't mean it's a good idea to do it without the help of an attorney. Knowledgeable business attorneys are business formation experts and can save you money by handling things that you don't know about or would find time-consuming to handle on your own. The attorney also will understand the Internal Revenue Code and keep you out of tax trouble.

Some states require that you submit an operating agreement when you register the LLC. The agreement explains the basic who, what, where, and how information about your business. A good operating agreement will include some fundamental company rules, lay out members' rights and responsibilities, and spell out other information that can eliminate confusion and resentment down the road. An attorney's insight can really help make this a useful document.

One of the initial tasks of forming an LLC is choosing a name for the business entity. It's a task on which all members will want and need to have input. Yes, you can do it yourself, but having an attorney involved can give you peace of mind—knowing that you've not usurped some other company's name or violated any trademark agreements.

An LLC also needs a registered agent. The registered agent handles business filings and receives tax forms and other legal information that might come to the LLC. The agent can take responsibility for paying taxes, filing fees, and meeting deadlines for licensing and other legal details that come with costs and penalties for late or improper filing.

Another issue to consider while forming an LLC is how you'll take profits. A common question is: “Should I take a salary for property management?" The answer is likely no. Paying management fees to yourself is income on which you'll owe self-employment tax. Rental income isn't subject to self-employment taxes. So why call it salary and pay more? Properly characterizing profits can be very important in this legal entity.

Where should you file?

There is no requirement that real estate LLCs be filed in the state where the property is or where the owner or owners live. Most property owners choose to file where the property is, where they work, or where they live, but sometimes it can be worth the trouble to file in a different state.

For instance, some states don't have an income tax, while neighboring states have top income tax rates greater than 9% in 2023. If you find it easy to drive across the state line, it might be particularly worthwhile to figure out what you'd save by filing in the no-tax state.

Another factor is the cost of filing. Some states charge as much as $500 in filing fees and renewal costs. Other states don't charge anything at all.

About half of states allow you to set up a series of LLCs, known as an SLLC. There is one "parent" or "umbrella" LLC with related LLCs operating beneath it. If you are a real estate investor with several properties, this can be a good choice because the financial or legal troubles you encounter with one property won't affect your other properties.

States that allow SLLCs are Alabama, Arkansas, Delaware, District of Columbia, Illinois, Indiana, Iowa, Kansas, Minnesota, Missouri, Montana, Nevada, North Dakota, Oklahoma, South Dakota, Tennessee, Texas, Utah, Virginia, Wisconsin, and Wyoming.

There are a handful of states that are considered particularly good choices for real estate investors who want to start an LLC. Here are three of the cheapest and most hassle free.

Wyoming

This state has the least LLC regulation. There is no state income tax and the cost to file is just $100 with a $60 annual report cost. Out-of-state LLC filers don't pay any more than residents who start an LLC.

Nevada

There is no state income tax and no state business tax unless you earn more than $4 million. It costs just $75 to file for an LLC, although you'll be charged $200 for business licenses and $150 annually to file the required list of members.

South Dakota

There is no state income tax, and the LLC formation fee is only $150 for both residents and non-residents. It costs just $50 a year to file an annual report.

How to file in popular states

Despite the financial advantages of filing in these Western states, most people start an LLC in other states, including Texas, Florida, New York, and California, because so many people live and do business in these states. Other people choose Delaware because of its sophisticated court system. Here's what you need to know to start an LLC for real estate investment in these popular states.

How to start an LLC in New York

• Choose a business name. In New York, your LLC's business name must contain the words "Limited Liability Company" or the abbreviations "LLC" or "L.L.C." Your business name can't be too similar to other New York businesses. Check if the LLC name you want is available in the Division of Corporations business name database. Reserve your preferred LLC name for 60 days by filing an Application for Reservation of Name. The application must be filed by mail. The address is One Commerce Plaza, 99 Washington Avenue, Albany, NY 12231-0002. The filing fee is $20.

• You can be your own registered agent, but because you have to be available from 9 a.m. to 5 p.m. on all business days, many new business owners prefer to use registered agent services. A New York registered agent service typically costs between $100 and $300 per year.

• File your LLC's articles of organization with the New York Secretary of State. Include a $200 filing fee.

• New York requires that all LLCs publish a copy of their LLC articles of organization or a notice related to the formation of the LLC in two newspapers (one weekly and one daily) within 120 days of formation. The newspapers must be approved by the county clerk of the county you designate in your articles of organization. After publication, the printer or publisher of each newspaper will provide you with an affidavit of publication. Submit your affidavit of publication to the New York Department of State.

The whole process of setting up an LLC in New York State can take up to nine months, but you can hasten it if you do as much online as the state will allow.

How to start an LLC in California

• Start by naming your California LLC. Check for availability by searching the California Secretary of State's business name database. An available name may be reserved for up to 60 days by filing a name reservation request form. The form must be mailed or hand-delivered to the California Secretary of State's office.

• An LLC in California must end with limited liability company or the abbreviations LLC or L.L.C. The words "limited" and "company" may be abbreviated to Ltd. and Co. The name can't contain these words—bank, trust, trustee, incorporated, inc., corporation, corp., insurer, insurance company, or any other words suggesting that it is in the insurance business.

• File your articles of organization using Form LLC-1 with the California Secretary of State's office. The articles must contain the LLC's name, physical address, purpose, how it will be managed, and the name and physical street address of its registered agent.

• Either complete Form LLC-1 online or mail or hand-deliver the form to the nearest Secretary of State's office. The filing fee is $70. If you hand deliver your filing to the Sacramento Secretary of State's office, you can request expedited filing for a small additional fee. But it might not be worth it since approval of LLCs in California only takes about eight business days.

• Here are a couple of common issues that sometimes arise with California LLCs. According to the California Department of Real Estate, the state doesn't allow an LLC itself to hold a real estate license, but individual members can act as real estate brokers on behalf of the LLC. Understanding this detail about business licenses is important.

• Filing and holding a real estate LLC in California isn't cheap. Filing costs a basic fee of $1,040, plus another $70 to file your articles of organization. There are some additional fees that vary by location and property value. They can include the California state fee, statement of information, annual franchise taxes, registered agent fee, and gross receipts tax. There is also an $800 per year renewal fee, due for the first time in the fourth month after the approval of your LLC. You'll be charged another $800 in annual tax on April 15 every year.

• It isn't recommended that you put your personal residence in California in an LLC. If you do so, you'll pay a lot of fees, and you may not be able to claim a mortgage tax deduction. Also, putting personal property in an LLC may disqualify you from some or all of the advantages of property ownership interests under California Props 13 and 19, which contain complex rules on property taxes and inheritance. Talk to your attorney about your personal liability and other situations if you are intent on doing this.

How to start an LLC in Florida for real estate investment

• Starting a real estate LLC in Florida is simple—and cheap. There is no state income tax in Florida. Start by choosing a name. In Florida, your company name must include the phrase “limited liability company," LLC, or L.L.C. It can't include words suggesting your LLC is a government agency. The words "FBI," "Treasury" and "State Department" are forbidden.

• File your articles of organization. The easiest way is online through Florida SunBiz, the state's online directory for companies. There is a $125 fee, which includes $25 to register an agent—you or someone else. Once your LLC is approved, there's an annual renewal fee of $138.75.

• Florida SunBiz approves online applications in two or three days. It takes longer if you apply by mail.

How to start an LLC in Texas as a real estate investor

• Start by naming your Texas LLC. The name must include: “limited liability company," "Ltd. Co.," "L.L.C.," "L.C.," or “limited company." To make sure your name is unique, you'll have to open a Texas Secretary of State Direct (SOSDirect) account. It takes about 15 minutes to get registered, and then there is a $1 fee per search.

• Every Texas LLC needs a registered agent with a physical address in Texas. You or an employee of the LLC can be the registered agent, but the LLC can't be its own agent.

• Next, file Form 205, Certificate of Formation-Limited Liability Company. You can download it and mail it, or complete it on SOSDirect. The filing fee is $300.

• Getting an LLC in Texas takes five to seven business days. Expedited service is available the next business day for an additional $25.

• Texas doesn't have a state income tax, but it does charge LLCs an annual franchise fee. It's based on 70% of total revenue, although you can subtract any compensation you pay yourself. A good accountant who understands the ins and outs of this can save you money.

How to start an LLC in Delaware

• Delaware is often considered one of the best states in which to form an LLC because its sophisticated Court of Chancery expediently handles any kind of legal situation that might affect a business. There is also an element of privacy that most other states don't have. The names of LLC members don't have to be disclosed when the LLC is formed, and members can choose not to have their information in any public record. There is no requirement to file an annual report. Foreign property is permitted. If you buy a rental in the Bahamas, it can be put in a Delaware LLC.

• Start by choosing a name. Names for Delaware LLCs must end with “Limited Liability Company," “LLC," or “L.L.C." You can't use the word “bank" or any variation of it. You can reserve a name for 120 days for $75.

• Delaware requires that you use a registered agent and provides a list to help you find a registered agent service. But the agent actually can be almost anyone as long as that person has an address in Delaware.

• File a certificate of formation. To file LLC formation documents, access a PDF on the Division of Corporations website and pay the $90 filing fee. It takes a maximum of three or four days to process the certificate of formation.

• After your LLC is approved, you must create an LLC operating agreement. Delaware is one of only five states to require an LLC operating agreement. While it is a good idea to do it—you'll need it if you have to go to court—Delaware doesn't require that you actually file the operating agreement.

• Delaware LLCs are required to pay a $300 annual fee each June 1.

Downsides to real estate LLCs

While LLCs are a good idea for real estate investment, they aren't perfect. For instance, real estate LLCs aren't impenetrable liability protection. They won't save you from prosecution or losing a lawsuit if you are found guilty of fraud or negligence.

Here is another drawback. If you already have a mortgage when you put the property into an LLC—even a single-member one—you may trigger the due-on-sale clause and your mortgage holder will want to collect immediately. Talk to your lender before you pursue an LLC and understand his position on this issue.

It is also wise to make it clear in your operating agreement how a member can get out of the ownership agreement, either because they want out or you want them out. This is particularly important in the case of LLCs held by spouses. You don't want a divorce hanging up the sale of your jointly held rental property. Nor do you want to be responsible for someone else's business debts.

Real estate LLCs will need care and feeding

Thoughtfully launching a small business is key to making a multimember LLC work. It requires organization and cooperation to do even the basics to get an employer identification number (EIN), open a bank business account with that employer identification number, obtain necessary business licenses, and make fundamental business decisions about the business model.

Some of these requisite small business decisions include calculating business expenses, deciding whether the small business owners will operate as a limited partnership or general partnership, and whether the entity will be manager-managed or managed cooperatively.

Only after these fundamentals are decided can a small business consider the more sophisticated things like limited liability protection, LLC laws, necessary legal documents, required business filings, personal tax returns, paying any required sales tax, and where to file legal documents.

Forming an LLC is smart. It can provide liability protection and help you make more from your real estate investment, including paying less in taxes. It also can protect you from legal jeopardy, including bad tenants. But you can't just set it and forget it. Meeting renewal dates and paying fees in full and on time is vital.