The Advantages and Disadvantages of titling your Rental Properties into an LLC.
The main reason investors prefer to have their rental properties in an LLC is for asset protection. For many years, lawyers, financial advisors, and tax accountants have been teaching asset protection to rental property owners. The more novice investors are worried about losing everything if a tenant or someone gets injured on their rental property. Other investors like to think of their rental properties as a business, therefore putting it into an LLC legitimizes a business entity. In most cases rental properties do create a passive income. This income can be funneled through to your 1040 tax returns on schedule E as personal investment properties or through the LLC that set up. Both ways have tax advantages. I
Legal Benefits – The primary reason to form an LLC is for legal protection. Legal counsel generally has a tough time breaking through the LLC wall. Should any tenets, their guest or anyone on the property to sustain any injuries and the property is owned in the investors name only, their personal assets are at risk.
Tax Benefits – From a tax perspective, any LLC formed with two or more members is classified as a “Pass-Through Company”. A “Pass-through” means its income is passed through to its owners and claimed on those owners’ individual tax returns. The LLC is subject only to capital gain rates on the ownership shares of the member, and not to the corporate capital gains taxes, therefore is no double taxation. LLC’s with just one owned-member, however, are taxed as a sole proprietor and no separate tax return is required. Actually tax dollars say’s from holding real estate in an LLC opposed to personal holding the properties is zero. As of 2011, if you own income property and actively participate in the management of the property in your adjusted gross is less than $150,000, you can write off up to $25,000 of rent losses. The amount of the rent losses that you can write off is proportionately phased out between 100,000 and 150,000. Also remember that although the loss is disallowed for that particular tax year it is not completely lost. When you sell your income property, you can write-off any unused rental losses that have accumulated while you have owned the property.
Expense – when setting up an LLC there are costs involved that are generally charged by an attorney or tax accountant for the preparation of your LLC business. Those fees can vary depending on the source but is highly recommended versus doing it yourself online. Depending on which state you live in even if your LLC is set up in Maryland, there could potentially be an annual fee that are paid to the state. Another fee would be the cost of filing separate tax returns for the LLC if you use an account, which I absolutely recommend if you’re dealing with rental properties. In addition, the state franchise fees would also be another cost incurred depending on the gross profit of the LLC. The IRS has certain thresholds that they use for these franchise fees. Many investors starting off, don’t realize the reality of the impact of any fees against their bottom line until it’s too late.
Financing – To me, this is the biggest hurdle for most lenders to overcome. Many investors “Miss the Forest for the Trees” and don’t realize that owning properties in an LLC can create problems for future financing. Most 1 to 4 residential loans are delivered to Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac’s guidelines does not support “Entity Vesting”. Entity vesting is when the rental property is titled in anything other than the individual borrower’s names i.e. LLC’s, S-Corps, or Partnership. First-time investors that have been educated to set up an LLC for their new real estate business don’t realize that this can be a problem. In addition, the same investors will set up individual asset accounts in their LLC names to support future purchase transactions. These funds cannot be honored as personal assets because they are in a business. There are special circumstances that these funds can be honored, but requires a complete 2 year analysis of the LLC’s profit and loss. This is totally an underwriter discretion.
I highly encourage any investor that’s looking real estate investing to keep the bulk of their assets in their personal account for underwriting purposes.
Due on Sale Clause – Most every Fannie Mae and Freddie Mac loans originated today will have a “Due on Sale Clause”. Most due on sale clauses prohibit the note holder to change the entitlement of the real estate property. What does that mean to the investor? It means that if the loan servicer has knowledge of the property being retitled into an LLC, they could potentially call the note do which means you would have to pay the remainder of the loan immediately. Many investors will take the risk of retitling their properties into an LLC. The chances of the servers are finding this information out is quite small but still possible. Please consider this before retitling your property into your personal LLC.
What are my choices if I don’t establish an LLC for my rental properties?
This will strictly depend on your situation and what you want accomplished by forming an LLC. Some investors will title their rental properties into their family trust. This is totally acceptable by all Fannie Mae and Freddie Mac lenders as long as the trust is a revocable trust. Typically the trust will have to be reviewed by each lender and their legal counsel to be able to finance the loan into a family trust. In addition to the normal hazard insurance on the property in addition to the liability insurance, many investors that choose not to put their properties into an LLC will simply protect their assets by getting an umbrella insurance policy. These policies are very inexpensive and have a great coverage in case of any occurrences happen on your property.