Use Liability Insurance or Use an LLC?
Although there are many benefits to holding real property assets through an LLC, a limited liability company may not be the best holding vehicle for every property owner. For many real estate investors, the trouble of forming and maintaining a company isn’t worth protection from the theoretical threat of a lawsuit, particularly when affordable liability insurance is available.
That said, real estate investors that rely solely on insurance as a means of protection from personal liability take a significant risk. Liability policies typically have limits, exceptions and carve-outs. While the chance of a loss that exceeds policy limits may be remote, if it happens, the consequences can be devastating. If one is evaluating the difference, you have to carefully examine what an insurance policy will and will not pay.
Limit Your Personal Liability
LLCs will limit personal vulnerability to potential lawsuits related to the property. When an owner of an investment property leases it to a tenant who decides to throw a big party, what happens if one of the tenant’s guests falls over a balcony? In today’s legal climate, it is quite possible that the injured guest would pursue a claim based on the “unsafe condition” of the rental dwelling. More often than not, the owner would be named in any lawsuit resulting from the incident.
If that rental property were owned by a real estate investor individually, he or she would be named in the lawsuit and would have to defend his or her personal assets from the plaintiff’s claims. In contrast, if that property were owned by an LLC, the owner’s risk exposure would be insulated by the protection of the company, leaving only the assets owned by the LLC (as opposed to all of the owner’s personal assets) exposed to potential lawsuits.
Under the default tax classification rules, the IRS classifies a real estate holding company with one owner as they would a sole proprietorship, namely as a “disregarded entity.” As a result, income and capital gains from the LLC pass through directly to the owner, who would only have to pay taxes as an individual, while still enjoying the protections offered by the LLC liability shield.
Since there is no separate LLC tax, the owner can avoid double taxation on both the rental income generated by the property and the appreciation in value of the property upon disposition. Moreover, the owner of a single-member LLC can deduct mortgage interest similar to a sole proprietor based on current IRS rules.
Real estate holding companies that have several owners are known as “multimember” LLCs and are generally taxed by the IRS like partnerships, meaning that the LLC files an “informational” tax return, but does not actually pay taxes itself.
Multimember LLCs also enjoy the benefits of pass-through taxation as the LLC passes its profits and losses through to its members, who report their portion of the LLC’s business income or losses on either a Schedule C, K or Form 1065 with their individual income tax returns. This means that both single member and multimember LLCs offer the benefits of pass-through taxation of profits and losses and limited liability and personal protection for the owners.
The Right Entity Can Make Things Easier
The correct entity offers benefits relative to other forms that aren’t necessarily unique t0 the use of LLCs to hold real estate investments.
- They have much greater flexibility delegating responsibility than either a corporation or partnership. Corporations are statutorily required to have officers and directors; LLCs can be managed by owners or third-party managers.
- LLCs may pay lower state registration and maintenance fees than corporations.
- LLCs can take advantage of flexibility in distribution of profits, per the LLC’s operating agreement. Cash flow distributions do not have to be pro rata according to ownership like an S corporation; Owners may reward “sweat equity” effort of select members through appropriate distributions of available cash flow.
- Unlike an S corporation, foreign ownership and investment in U.S. real estate is possible through an LLC.
- LLC owners may transfer their ownership in real estate holdings by proactively gifting the company’s membership interests to their heirs each year. Over time, it is entirely possible to effectively pass ownership of real estate owned by an LLC to loved ones without ever having to formally execute and record a new deed. This enables property owners to avoid transfer and recording taxes and fees, which can be substantial in many states.
Don’t Rush; Explore Your Options
A properly formed and operated LLC does limit the personal liability of the owners, as much as U.S. law allows, by affording the owners no personal risk above and beyond their investment in the company—but, in many instances, so do corporations and certain partnerships. There is simply no way to eliminate all the risks associated with starting a real estate investment business, but you can easily improve your chances of success by complying with the corporate formalities required by applicable laws, even though these steps may seem tedious and somewhat confusing.
It is much easier to purchase the property through the LLC to begin with, as opposed to trying to transfer the real estate to an entity at a later date where a lender might have to consent to the transaction. An LLC may not offer any more or less protection from outside lawsuits than a properly formed and operated corporation or limited liability partnership, but it does offer many other advantages that make it the most desirable form of entity in many cases, particularly with respect to real estate holding companies.
There are a lot of great lawyers that can help you with these decisions. If you live near us, give us a call. We would love a chance to work with you. If you don’t live near us, give us a call anyway and we will route you to some very good people.
Until then, good luck and good hunting.
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The Fisher Law Office is known for its experience in estate planning, probate administration, asset protection, and business development. Annapolis attorney Randall D. Fisher has practiced for over 20 years, maintains the highest peer review rating for ethics (AV Preeminent) by Martindale-Hubbell, and is a sucker for long walks on the fairways.