Structuring an LLC provides significant tax advantages and other benefits to rental property owners and other rental real estate investors.
Yet, it also comes with disadvantages. For instance, there are limits to the protection that such a business structure provides. If you want to learn more about these disadvantages, then you’ve come to the right place.
But before learning what these downsides to LLC are, let’s first learn the fundamentals of an LLC for rental property.
What is an LLC (Limited Liability Company)?
A Limited Liability Company (LLC) is a business structure that combines the elements of sole proprietorship, partnership, and corporation. It is less complex than a corporation and provides many benefits unavailable in other business types.
This business structure is allowed by state statute, and most states do not restrict ownership. It means that owners may include individuals, corporations, other LLCs, and foreign entities. Owners of an LLC are called members.
Some businesses that cannot be LLCs are banks and insurance companies.
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Why is an LLC a Popular Choice for a Rental Property?
Easy Startup
Initial paperwork and payment for an LLC are light, although it varies in each state. Some states charge taxes and fees.
Yet, one thing is common – the initial process is simple enough that owners can handle it without special expertise. Of course, it’s a good idea to consult an accountant or lawyer for help, especially since there will be ongoing requirements later on that come on a yearly basis.
Personal Assets Are Not at Stake
One of the reasons why an LLC is a popular choice for a rental property is because it can isolate you, as the rental property owner, from personal liability.
You may be liable for insurance, but if someone is seriously injured on your rental property, your personal assets will be protected in case of a lawsuit.
It can happen when the lessee sues you personally for damages or medical expenses.
Pass-through Taxation
Another reason why an LLC is a popular choice is pass-through taxation. This tax structure is where the profits and losses of the LCC or business entity are not taxed at the entity level but “pass-through” to the business owners or shareholders who pay and report taxes on individual tax returns.
Even the income earned by the LCC, including rental income from leasing the LLC-owned property, passes through the LLC to the LLC members.
LLC is treated as a sole proprietorship or partnership to corporate regulations, and taxes generally don’t apply.
Management Flexibility
Members of all LLC owners can share in the business’ daily decision-making. Even professional managers, who are either outsiders or members, can manage the business.
This setup is beneficial if members want to hire more experienced people to run a business. An LLC is member-managed by default in most states, except stated otherwise in their filings.
Still, forming an LLC for your investment property isn’t always appealing. It also comes with a few drawbacks. Here are some of the disadvantages of LLC for rental property that you may have to consider.
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The 8 Disadvantages of LLC for Rental Property
1. Cost of Formation
The setup cost associated with forming an LLC can be significant. It may reach up to $500 plus yearly regulatory and administrative fees needed to maintain your LLC records.
The cost includes payment for registering your LLC, publishing a Notice of Intent, creating an Operating Agreement, the title transfer tax, and the filing fee if you want to transfer the title.
So, before registering your rental property as an LLC, it’s wise to check your state’s Secretary of State website to know the fees you need to prepare when filing for your LLC.
2. Complexity of Maintenance
Maintaining an LLC for a rental property isn’t always easy. Among the many things you must consider are the maintenance of accounting transactions, which are necessary to ensure that your business complies with the registration requirements.
For instance, you have to file your annual report or sometimes called a statement of information (SOI). If you’re registered in Pennsylvania, however, you may only need to file it once every 10 years. In other states, you have to file your SOI every two years and in some, once a year.
Maintaining detailed records is also necessary, so you can prove your LLC is a separate entity from the owners in case of a lawsuit or bankruptcy.
In addition, you have to operate your LLC activities as a separate entity by having separate bank accounts. One that is separate from contracts, leases, and the owner’s personal expenses.
3. Asset Protection Is Not Guaranteed
LLC offers limited liability protection, meaning LLC owners will be protected from personal liability for business claims and debts. But this does not mean that LLCs will be immune from legal action.
The plaintiff may still penetrate the corporate veil if the business or one of the LLC’s members has been negligent in their dealings or has engaged in third-party fraud.
In this situation, they may hold your shareholder or LLC liable for losses that may, consequently, impact your personal assets.
Another disadvantage relating to the limited liability protection of the LLC is when you create LLC for multiple rental properties. If a lawsuit is brought against the LLC, all properties will be at stake in a single lawsuit.
4. Difficulty in Obtaining Financing
It is possible for an LLC to obtain a rental property loan. Yet, most lenders will still ask for members to personally guarantee the loan.
So, when the LCC defaults on the loan, the members can still be jointly and severally liable for the outstanding mortgage debt when the lender files suit.
You may also have to be responsible for the funds needed to maintain or purchase the rental properties in your care.
The reason being investors are usually unsure whether to put any capital into an LLC business structure because owners are not permitted to sell, buy, or trade equity in the company.
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5. Taxation Considerations
The federal government considers LLCs as a “disregarded” entity. As the name implies, it will be disregarded or ignored for income tax purposes.
The taxing authority won’t tax your LLC as an entity separate from you as the owner or LLC member. Yet, despite considering you as a pass-through entity for tax purposes, the LLC will still have to file an annual tax return.
And as the owner of the LLC, you are required to file Form 1065 to report your income and expenses passed through to each member.
You also need to provide each member with a Schedule K-1, indicating the profit or loss distributed for the tax year for each member.
Furthermore, some states or cities charge transfer tax when real estate ownership changes. Transfer taxes, also called deed tax stamp tax, often equal the percentage of the property sale price or appraised value.
The IRS constantly revises its regulations, and tax laws can be very complex to handle alone. Consulting with an accounting professional is essential to kickstart your new business.
6. Difficulty Transfering Ownership
Although members of the LLC can transfer their rental property into the LLC, there are unintended consequences of doing so. One is that it may trigger a due on the sale clause.
Even if the rental property is transferred as a single-member LLC, most mortgage documents demand the previous loan to be paid off if the owner changes.
Thus, it’s important for investors to consult with their lenders about the options for transferring ownership of the rental property to an LLC.
In relation to this, an LLC may restrict the ease of transferring or selling a rental property because it often requires the approval of all members to make such a business decision.
This makes it more challenging to take advantage of immediate market opportunities or make quick decisions.
7. State-Specific Requirements
Registering an LLC is only good for the home state of the business’s primary residence.
If you have other rental properties in other states and you want to protect yourself and your personal asset, you must file a limited liability company formation in these states too.
Furthermore, an LLC does not pay taxes as an entity, but it passes the tax burden to the owner. However, you may have to consider other tax responsibilities. These include franchise and excise taxes or both, depending on where you register your LLC.
If you don’t do multiple filings on your other properties in the other states, anyone other than the LLC incorporation home state may access your personal assets and finances if they become a creditor.
8. Consequences of Member Turnover
If a member leaves the LLC, goes bankrupt, or passes away, the LLC must be dissolved while the remaining members will be responsible for the financial and legal obligations left by that member. This rule applies in many states.
Of course, the members may still do business. However, they may have to start a new LLC from scratch.
How To Form an LLC for a Rental Property
If you own multiple rental properties and decide to form an LLC to cover each of these properties from liability claims, here are steps to do it:
Choose a name - You’ll use this business name in the state where you plan to do business. To ensure others are not using your chosen business name, search through the secretary of the state’s website in your state, online directories and the country clerks’ offices.
Many states allow applicants to reserve an LLC name for a fee, which will be valid for a certain period before filing the articles of organization.
Choose a registered agent - This person you designate as a registered agent will be the one to receive official letters or messages for the LLC.
It’s best to choose this person first before filing your articles of organization, as most states require you to list the agent’s name and address.
Some states have a list of third-party companies that provide registered-agent services, although people in your LLC can serve in this role.
File articles of organization - This very important step brings your business into existence. State laws require basic information about your business, which should not be difficult to provide, especially if you have a thorough business plan.
Some details that you need to provide are your business name, management type, and principal place of business.
Get an EIN - If you’re a single-member LLC or a multi-member LLC, you must obtain an employer identification number. It’s a nine-digit number assigned to your LLC for tax purposes.
The fastest way to get an EIN online, although you can still apply throug fax or mail using Form SS-4. Obtaining an EIN is free of charge in the United States.
Have a separate business checking account - Make sure to keep business and personal finances separate. This is important if you want to lessen any potential risks to your personal asset in case a lawsuit questions your business practice later on.
Update preexisting leases - Lastly, you must update any pre-existing leases under your name to indicate that the LLC has become the official landlord. Relay this change to your tenants, so they’ll know that rent needs to be paid to the LLC and not your personal account.
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Alternative to an LLC for Rental Owners: Trust
There’s an alternative to an LLC for rental property, and that is trust.
It’s a business structure of holding assets for someone else (the beneficiary) on behalf of the person who created the trust (grantor).
When a property title is transferred to a trust, the name/s of the owner/s cannot generally be revealed without a court order. Thus, it offers more privacy and is cheaper than an LLC.
Revocable and Irrevocable Living Trusts
A revocable living trust is one where the trustee, grantor, and beneficiary are all the same person, and the entity uses a person’s social security number for tax reporting. Protection in this form of business structure comes in avoiding probate court in case the grantor/trustor dies.
Meanwhile, an irrevocable trust will be inaccessible to creditors during the grantor's life. It cannot be dissolved or changed without third-party approval. Irrevocable trusts cannot be canceled or changed after they are created.
Another benefit of putting a rental property in an irrevocable trust is restricting assets to the assets regarding inheritance. Beneficiaries must go through the trustee or the disbursement of assets.
Nevertheless, many people still decide that LLC is the better choice because there’s limited control over the rental property in trust. With LLC, there’s broader asset protection while granting greater control.
Final Thoughts on Forming an LLC for Rental Property
Owning investment property through an LLC is an attractive option for most people because of the tax benefits and limited liability. Yet, it also comes with several disadvantages.
The cost of registering the rental property to be an LLC is generally worth the protections provided by LLC for someone with extensive assets. However, the extra paperwork may not be worth the hassle for someone with only one rental property.
Whether you still prefer to form an LLC for rental property, the data above should help you decide if the LLC business structure is right for you, especially if the benefits outweigh the disadvantages.
We wish you the best in building your business.
If you have an LLC for rental property, the nuances of taxes and liability can sometimes be a headache. But don’t worry.
Consulting a tax advisory or accounting team about your situation makes a difference.
Their expertise ensures compliant and accurate financial and tax records that ease your burden and move you closer to your business goals.
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