We explain how an LLC for property rentals works and take a close look at the pros and cons of LLC for rental property. Using an LLC to own your property rental business has key advantages when it comes to liability protection, insulating your assets, and ownership flexibility.
The key disadvantages relate to formation costs, paperwork filing, and commercial financing. See below for everything you need to know about using an LLC to run your property rental business.
HOW DOES AN LLC FOR PROPERTY RENTALS WORK?
Forming an LLC to run a property rental business is a popular strategy among landlords. Using an LLC to run your property enterprise comes with many advantages, most notably, limited liability protection for the company owners. An LLC is recognized as a legal entity separate from its owners.
This means if the company is ever sued or runs up debts, the owners’ personal assets are protected and out of reach. Although this is a key advantage, it is not the only benefit of managing a property rental business using an LLC.
Forming an LLC is straightforward. The process varies from state to state but the main step involves completing and filing a document called the – Articles of Organization. You’ll need to submit this form to your local secretary of state and pay a small fee to get your LLC registered.
Once the LLC is up and running you need to transfer property title deeds and mortgages from your name into the name of the company. You can avoid these steps by forming the LLC before you apply for a loan or purchase property. Once the LLC is established it can be used to open a bank account, apply for loans, and purchase property.
JUMP TO CONTENT
- LLC for Rental Property Pros and Cons
- The Advantages
- The Disadvantages
- Should You Get an LLC For Rental Property?
- How To Create an LLC
- LLC Limited Liability vs Liability Insurance
PROS AND CONS OF LLC FOR RENTAL PROPERTY
What are the pros and cons of LLC for a rental property? Forming an LLC to own a property company is an appealing option to many landlords. The LLC entity comes with several advantages but the most notable is limited liability protection.
Using an LLC to own a property rental business helps protect the personal assets of the owner. If you form an LLC to own your property rental business you create a layer of legal protection that shields your personal assets from the debts of the company.
The LLC is recognized as a legal entity separate from its owners and your personal assets such as your bank account and home are out of reach if the company is ever sued or runs into debt.
Limited liability is not the only advantage of forming an LLC. And, to understand if an LLC will work for your business you need to weigh up all the advantages and disadvantages an LLC has to offer for your property rental business – see below.
ADVANTAGES OF LLC FOR RENTAL PROPERTY
What are the benefits of LLC for rental property? The key benefits of forming an LLC for your property rental business are liability protection, pass-through taxation, asset insulation, taxation flexibility, and ownership flexibility. Let’s take a closer look at the advantages of LLC for rental property.
LIABILITY PROTECTION
The greatest advantage of using an LLC to own and manage a rental property is limited liability protection. Forming an LLC to own your rental property creates a layer of legal protection between your personal assets and your business assets.
An LLC is recognized as an independent legal entity, separate from its owner. And, as long as it is managed correctly it prevents someone from pursuing you and your personal assets to cover the debts of the company.
For example, if someone is injured on your rental property and takes a legal case against you for damages, then only the assets owned by the LLC are at stake. Your assets are protected and are out of reach.
Liability protection also applies to situations involving creditors. If the LLC runs into financial difficulty and cannot clear its bills – its creditors can only pursue the assets owned by the LLC. Once again, your personal assets are protected.
PASS-THROUGH TAXATION
Another key advantage of an LLC for rental property is pass-through taxation. When you use an LLC to own and run a rental property you will not have to pay any corporate tax. LLCs benefit from the same tax regime as sole proprietorships and partnerships.
When an LLC generates a profit – it pays no tax on this profit. Instead, all these earnings pass through to the company owner in full. The owner then pays tax on these earnings by declaring them in their personal income tax returns.
This is in contrast to how taxation works for a corporation. For example, when a C Corp generates a profit – it pays corporate tax on these earnings. The money is then distributed to the company shareholders in the form of dividends.
Each shareholder will then pay income tax on these earnings as part of their personal tax return. In effect, the earnings of a corporation are taxed twice – at a corporate level and then again at the individual level. For more, check out the Tax Benefits of LLC.
INSULATE ASSETS
Another great advantage of LLC for property rentals is that you can insulate and protect each of your property assets from one another. If you own more than one rental property you can form an individual LLC company for each one.
By doing this you legally insulate each property individually. If a financial headache arises for one of your properties it cannot affect any of your other properties. For example, if a legal case is taken against the LLC that owns one of your properties – only the assets of that LLC are on the line to cover any damages you may incur.
The legal proceedings cannot pursue one of your other properties to cover costs – as they are owned and operated by separate LLCs. And, in the eyes of the law, each LLC is a separate legal entity.
OWNERSHIP FLEXIBILITY
Another of the key benefits of LLC for rental property is that it allows flexibility when it comes to ownership of the company. An LLC allows you to easily manage the company as the sole owner or in partnership with another individual such as a family member or business partner.
They are an excellent option if you intend to form a property rental enterprise with a business partner. When forming an LLC you should create an Operating Agreement that clearly outlines the ownership rights of each member and how the company is to be run.
Additionally, forming an LLC may make it easier to attract outside investment in your property rental company compared to running it as a sole proprietorship. LLCs can have an unlimited number of owners and can even be owned by individuals and entities outside of the US.
TAX CODE FLEXIBILITY
As discussed above an LLC benefits from pass-through taxation meaning the company pays no tax on earnings at a corporate level. If the LLC has one owner the IRS will treat it, by default, as a sole proprietorship for tax. And, if the company has more than one owner it will be treated as a partnership.
However, as the owner of an LLC, you have the option to elect to have your company taxed under different tax codes. If you determine that it is in your interests you can apply to the IRS to have your LLC taxed as an S Corp or a C Corp.
Electing to switch the tax regime of your LLC to either an S Corp or C Corp will come with several advantages and disadvantages. If you want to assess if changing tax regime is in your interest you should hire a tax accountant to examine your company finances and offer professional advice. Check out our How LLCs are Taxed guide for more information.
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TAX DEDUCTIONS
Another pro of forming an LLC for a property rental business is that you may be able to tax deductions against some of your business expenses. Also known as tax write-offs, a tax deduction is a business expense that can be used to reduce the value of your company’s taxable income.
To qualify for a tax deduction the expense must be directly related to the running of the LLC company. Amongst the common tax deductions for a property rental LLC are business start-up expenses, office supplies, advertising, business insurance, banking fees, legal fees, and travel expenses.
PROFESSIONAL IMAGE
Forming an LLC to manage your property rental company creates a professional image for your business. As soon as you choose a company name and add the letters LLC you immediately gain greater public trust and recognition.
Using a company brand name will boost any marketing or advertising campaign you run to promote your properties. It will also have greater appeal to investors if you need to raise some capital. Company names look more professional, are easier to remember, and carry greater legitimacy compared to using your name.
SEPARATION OF PERSONAL & BUSINESS FINANCES
Forming an LLC for your property rental business allows you to separate your personal and business finances. Once you establish your LLC you can open a bank account in the company’s name and use this for all transactions related to the business. Separating your personal and business finances has a number of important advantages including protecting your limited liability status.
If you commingle your personal and company finances you can lose your liability protection in a court of law – more on this below. Additionally, keeping your business and personal finances clearly separated will reduce complications when it comes to assessing your end-of-year accounts and filing tax returns.
DISADVANTAGES OF LLC FOR RENTAL PROPERTY
What are the disadvantages of LLC for rental property? Forming an LLC for rental property also comes with some disadvantages. Forming an LLC involves the completion of paperwork and payment of fees with your local state authority.
There are also issues related to financing and tax you should be aware of. Below, we run you through everything you need to know about the disadvantages of using an LLC to manage a property rental.
COST OF REGISTERING AN LLC
One of the key disadvantages of LLC for property rentals is the cost of forming an LLC. Forming an LLC is a straightforward process and shouldn’t prove overly difficult for most individuals. However, there are a number of fees you will have to pay when registering your company with the state authority.
The cost of forming an LLC varies from state to state. In general, you will have to pay a fee when you file your articles of organization with the secretary of state. This is a once-off formation cost. Then there are maintenance costs that have to be paid annually, in most cases.
The fee for registering an LLC falls somewhere between $100 and $300. However, maintenance costs vary greatly and are sometimes charged as a percentage of the company assets. For more information see – How Much Does an LLC Cost?
LLC FORMATION PAPERWORK & FILING
If you create an LLC for your rental property there’s no getting around the fact that you will have to complete and file the relevant paperwork. The principal document you need to get written up is the LLC Articles of Organization.
Processing and filing the necessary paperwork with the relevant authorities can be a challenging and time-consuming process for some. If you need some assistance with getting your LLC started you can hire an LLC Formation Company. For a small fee, they will handle the formation process on your behalf.
COMMERCIAL FINANCING
Another disadvantage of LLC for property rentals is commercial financing. Financing a mortgage as an LLC can be more difficult and more expensive compared to financing as an individual. When you apply for a loan as an LLC, you will be applying for a commercial loan.
Commercial loans are usually issued at higher rates and can prove more difficult to secure compared to a personal loan. Banks often want to establish a track record with a company or an individual before they approve a loan. Additionally, commercial loans are subject to larger down payments and shorter terms.
TAX OBLIGATIONS
Members of an LLC benefit from pass-through taxation. However, one of the downsides to being a member of an LLC is that you will be liable for tax based on the earnings made by the company regardless of whether or not these earnings have been passed through as dividends. And, this tax must be paid as part of your personal tax returns.
This means that if you need to leave some of the earnings in the LLC to reinvest in the company – for example, to carry out some renovation works – you will still have to pay tax on the earnings at a personal level even though you never actually received the income.
And, if you or another member of the LLC are working for and receiving a salary from the company, you must pay self-employment taxes. Self-employment tax is charged at a rate of 15.3% on dividends received and comprises a 12.4% Social Security and a 2.9% Medicare tax.
COMMINGLING COMPANY & PERSONAL FINANCES
Another one of the key disadvantages of LLC for rental property arises if you commingle your company and personal finances. If you don’t draw a clear distinction between your company and personal bank accounts and fail to keep them completely separate – you could be in for some serious trouble.
If you commingle your LLC and personal finances you could lose your LLC liability protection if you are sued and taken to a court of law. The limited liability protection offered by an LLC can be waived by a judge in court if they decide you did not maintain a clear separation between company and personal accounts.
This means you can never use your LLC bank account to purchase personal items such as food, clothes, or pay bills. Similarly, you must always use the LLC bank account to pay for any expenses associated with the rental property.
MORTGAGE FEES
If you form an LLC to take ownership of a property rental you will have to transfer the title of the mortgage from your name to that of the LLC. This is referred to as a ‘transfer title’ and can incur several additional costs.
Your mortgage provider may insist on closing the existing loan in your name and opening a new loan in the company’s name. Your bank may charge a closing fee to have the original loan shut down. And, the new loan may be issued with less favorable interest rates.
You can avoid this problem by forming the LLC before you apply for a mortgage and having the company’s name on the title from the outset. This way the mortgage will be issued to the LLC and not you personally.
TRANSFER OF TITLE
If you form an LLC to serve as the owner of a property you will have to perform a transfer of title on the property deed. The property deed is a legal document that serves as evidence of ownership. In simple terms, this means changing the owner on the deed from your name to that of the LLC.
You can avoid having to process a transfer of title if you form the LLC before you purchase the property. This way the name of the LLC will be recorded in the property title deed from the outset.
DISTRICT OF COLUMBIA
In the District of Columbia, if you own property using an LLC you will be subject to the Rental Housing Act of 1985 and its associated amendments. This act is a rent control law that regulates how much rent can be charged for residential housing and imposes other restrictions on the property provider.
SHOULD YOU GET AN LLC FOR RENTAL PROPERTY?
If your property rental business is generating a regular profit and you want to protect yourself with limited liability protection then forming an LLC may be a very wise move. Other advantages of forming an LLC include pass-through taxation, ownership flexibility, insulating assets individually, and the ability to elect a tax regime.
You’ll need to weigh up the advantages of forming an LLC against the potential disadvantages. The main drawbacks to forming an LLC are the fees and paperwork involved in getting the company registered. Other cons include having to transfer title deeds and names on mortgages with your financial lender. If the potential advantages outweigh the disadvantages then it is in your interests to form an LLC for your property rental business.
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HOW TO CREATE AN LLC
If you decide to create an LLC for your property rental business, you’ll be pleased to know the formation process is straightforward and inexpensive. Many people choose to hire an LLC formation service to complete the process for them. See below for the steps involved in forming an LLC.
TRANSFER OF LOANS
Contact your lender to find out how to transfer any existing property loans from your name into the name of your LLC. Do they allow a title transfer to an LLC? What fees are involved? Transfer the loan to the LLC once it is established.
CHOOSE A NAME FOR YOUR BUSINESS
Choose a unique name for your LLC. The company name cannot have been previously registered and you can not choose a name that can be easily confused with an already existing company or government agency.
ARTICLES OF ORGANIZATION
Get your Articles of Organization written up. This is a document that records all the important details of the company you are about to form and will be held on file by the state authorities.
OPERATING AGREEMENT
This step is not mandatory – but is highly recommended. This document details how the company will be managed and operated. If there is more than own owner it must be signed by each owner.
PUBLIC NOTICE
Some states require you to publish a “notice of intent” about the planned formation of your LLC in an approved newspaper. This step will involve payment of a small fee.
LICENSES & PERMITS
Determine and apply for all the necessary business licenses and permits you need to run a property rental business in your state.
SUBMIT YOUR ARTICLES OF ORGANIZATION
File your Articles of Organization document with your local secretary of state and pay a filing fee.
TRANSFER OF TITLE TO LLC
Once your LLC is formed you need to complete the transfer of title of ownership on the property deed to the name of the LLC. You can do this by submitting a Quit Claim Deed.
OPEN A BANK ACCOUNT FOR THE LLC
Open a bank account for the LLC and use it to conduct all company business.
INFORM TENANTS & UPDATE RENTAL AGREEMENTS
Inform any tenants of the change of ownership and update your rental agreements to reflect the LLC as the property owner.
For more information on setting up an LLC see – How To Form an LLC.
LLC LIABILITY PROTECTION vs LIABILITY INSURANCE
Some business owners choose to protect themselves by taking out a liability insurance policy instead of forming an LLC. While liability insurance is a good starting point, it does not offer the same level of protection as establishing an LLC.
Liability insurance has several shortcomings, including policy limitations, policy exceptions, addendums that affect coverage, and requirements for additional insurance policies to cover adverse events that can be reasonably expected for a property rental business.
Additionally, insurance policies have upper limits. Whether you take out a standard liability insurance policy with a limit of $250,000 or an umbrella policy with a limit of $1 million – once the limit has been reached your assets can be seized to cover the remainder of the claim.
Forming an LLC creates a stronger protective shield for your personal assets. There is no upper limit. Your assets are separate from the LLC and only the assets belonging to the LLC can be pursued in a claim against your company. Ideally, you could form an LLC and invest in liability insurance to protect the business.
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About the Author
Erik Chambers: Senior Editor
Erik is a 30-year industry veteran with a wealth of experience in cross-functional areas ranging from business consulting to business education. He has worked in the private sector where he has advised start-up enterprises on early formation, capital acquisition, and tax issues.
While he specializes in business formation he has also held roles in several academic institutions where he teaches organizational decision-making, business strategy, and operations management. Erik is a graduate of the McCombs School of Business at the University of Texas at Austin.