Investing in real estate can be profitable. It also comes with potential risks. Whatever your reason for snatching up real estate, many individuals—particularly investors—choose to form a limited liability company (LLC).
LLCs have become one of the most popular business entity types for acquiring real estate. Owners often prefer to form an LLC when purchasing real estate—or when transferring title to real estate from an individual to the LLC—so that the LLC becomes the legal owner of record and not the individuals.
To help you choose what's best for you, consider the following pros and cons of forming an LLC for real estate investments.
Pro No. 1: Limitation on Personal Liability
As an owner of real estate, you want the best option for limiting your exposure to personal liability should an unforeseen circumstance arise relating to your property. LLCs provide that protection.
For example, if someone is injured while a guest at a property you own, even if you do not reside there or have any connection to the guest, it is not uncommon for the guest to pursue a legal claim against the property owner for their injuries.
Assuming you acquired property insurance to cover such incidents, your homeowner's insurance policy would provide coverage up to a particular monetary limit. However, if the amount of damages the injured party seeks exceeds the policy limit, your personal assets could be exposed.
Even if you successfully defend the claim, your insurance premium could increase simply because your property was subject to a lawsuit.
If, on the other hand, you placed the deed and title to the property in the name of an LLC, only the LLC (and not you) would be named as a defendant. More importantly, only the LLC's assets would be obligated to pay an award of monetary damages if the injured party's suit is successful. Hence you are provided anonymity—and your personal assets are not exposed.
Another reason to place a property title in the name of an LLC is that it gives you liability protection against monetary judgments if a financial dispute involving the LLC arises. For instance, assume the LLC enters into a contract to sell its principal office building to a third party but later decides not to consummate the sale. The third-party purchaser might file a breach of contract lawsuit against the LLC and seek money damages or attempt to force a sale of the property.
If the third-party succeeds in obtaining a monetary judgment, it—as the judgment creditor—can't force the sale of real estate held by an LLC—as the judgment debtor. Instead, the judgment creditor is typically required to obtain a "charging order" from the court that, in turn, becomes a lien on the real estate. While this is by no means cause for celebration, it's better than losing the property altogether.
Remedies available to creditors vary from state to state, so be sure you review the applicable state law. Members of LLCs who own real estate as part of their investment portfolio derive favorable tax treatment from the Internal Revenue Service.
Whether you are the sole owner of the LLC (single-member LLC) or one of several members (multi-member LLC), you benefit from so-called pass-through taxation.
For federal income tax purposes, pass-through taxation refers to the fact that any income earned by the LLC—including profits generated through real estate (such as rental income from leasing an LLC-owned property)—will pass through the LLC to its individual members.
Any income earned by the LLC is not taxed at the corporate level (as would be the case with a traditional corporation) but only at the individual level. Each LLC member reports the income on their individual federal income tax returns—usually on Schedule C. These pass-through rules help members of an LLC avoid double taxation.
Pro No. 2: Businesslike Appearance
An intangible benefit of owning and holding real estate in the name of an LLC is that it appears to the public to be more "businesslike," especially when advertising a property for lease to commercial or residential tenants.
An individual or business looking to lease property may be more comfortable renting a piece of real estate from "Smith Properties LLC" than from "Joe Smith" individually.
Pro No. 3: Ease of Transferring LLC Interests
An LLC can be sold through a relatively simple transfer of membership interests. The LLC's real estate will continue to be owned by the LLC but with new LLC members crewing the ship. Therefore, continuity is preserved, and the transfer is seamless.
Con No. 1: The "Due on Sale" Clause
Be careful about transferring to an LLC any real estate that is held in an individual's name. If an individual initially secured financing and qualified for a mortgage for the real estate, the individual's name will appear on the mortgage documents as the legal owner of record.
In the event of a transfer of real estate from an individual owner to an LLC—which is treated as a sale of property—the owner of the LLC must make certain that the name in the property insurance documents matches the grantee on the deed. The mortgage lender will often learn of the transfer when the property insurance bill comes due (if insurance is escrowed) and may claim that the transfer violates the terms of the mortgage's "due on sale clause."
The due on sale clause is a standard provision in a mortgage that requires that the borrower (that is, the named property owner) pay the mortgage balance in full at the time of a sale. You may want to seek a waiver from the mortgage lender before transferring real estate from an individual's name into the LLC.
Con No. 2: Potential for Transfer Tax Obligations
Also, transfer taxes may become an issue, depending on the state. In Delaware, for instance, no transfer taxes apply if an individual transfers ownership to an LLC so long as the ownership interests remain the same before and after the transfer. The percentage membership interests in the LLC must be the same as the ownership percentage interests before the transfer. Be aware that some states, such as Pennsylvania, tax the transfer regardless.
In the end, as LLCs are becoming more popular for real estate transactions, the pros appear to outweigh the cons—but be sure to consult your state's laws before moving forward.