LLCs (limited liability companies) have been popular for real estate investments for 30 or more years. Prior to that, real estate investors used limited partnerships (LP), with one or more general partners and one or more limited partners. The general partner wouldn’t have asset protection, so that spot was usually filled by an S Corporation. That meant the LP needed at least two entities. It was more expensive and complicated to run.
Once proven in court, the asset protection from LLCs seemed to be the perfect answer. But then a few things started happening.
In this article, we’re going to look at the pros and cons of LLCs for real estate investments and what some other alternative structures could be.
How an LLC Works
An LLC (limited liability company) is set up at the state level. The asset protection, cost and state annual filing requirements vary from state to state. Make sure you check on your own circumstances and don’t assume that what works in one state will be the same in your state.
There are two main reasons why people use LLCs:
Asset protection, and
In most states, an LLC has “charging order protection”. That means that if the LLC has been set up and run properly, it can offer special protection that protects the business from personal debts or judgements of individual owners and it protects the owners from business debts or judgements.
However, not all states have the same level of protection. The worst state of all for LLCs is Florida. There is NO protection for single member LLCs. And in most cases, they will not allow a married couple to have a multi-member LLCs. They consider those single member LLCs as well. If you form a business structure that you own or control, it counts as you too. So it’s difficult to get around the singe member LLC issue for Florida. A true multi member LLC will work in Florida, in fact charging order protection for multi-member LLCs is written into their state revised statutes.
Arizona and Colorado have also each had a troubling case that didn’t allow protection for single member LLCs. However, there were significant other factors that might make these unusual cases.
LLCs and Tax Treatment
There is no such thing as an LLC tax return.
LLCs can elect how to be taxed. So they can be an S Corp or C Corp, or simply use the default tax status. Without election, a single member LLC will file either as a Schedule C (Sole Proprietorship) or Schedule E (for rental properties). Without election, a multi-member LLC will file as a partnership.
The Drawbacks of an LLC for Real Estate Investments
Before you jump into an LLC, there are a few challenges you may run into when you use an LLC for your real estate investments. Check these things out first!
Are you in a state that has good asset protection for LLCs? You will need to use an LLC in the state in which you have property. What are the costs, annual filing requirements and most importantly, what asset protection will you get?
How will you handle the due-on-sale clause with a mortgage? This has been a concern for a number of investors when they move a property they purchased with a mortgage into an LLC. Call your mortgage company and ask for the legal department. Ask the lawyer for permission to move your property into an LLC for estate planning purposes. (This seems to be the magic phrase that makes the legal department happy.) You will undoubtedly get permission. Make a note of who you talked to and when, send a confirmation email for the conversation and save it for your files.
Will you have to pay a transfer tax? Some local jurisdictions charge a transfer tax on each title change, even if you move from your name to an LLC that you own. Check that out first. What is the cost? And is it worth it?
The Alternative to an LLC for Your Real Estate
There are a few alternatives to using an LLC for your real estate. One is to keep the property in your name and just take out a lot of insurance. That may work, but it also can be a problem like one of my clients discovered.
He was being sued by a tenant on a frivolous charge. He had a good insurance policy, including an umbrella policy to cover his own possible acts. He went into the first meeting with the tenant’s lawyers who had dollar signs in his eyes. His insurance company had two lawyers in the meeting as well, so he felt well covered.
That’s when he discovered that the insurance company’s lawyers had one purpose. To figure out what he’d done to invalidate the insurance policy so that they didn’t have to pay. They left him twisting in the wind.
It was an expensive lesson. After that, he always used LLCs that had been properly set up and maintained.
I do believe in having insurance, but I also realize it’s not the ultimate solution to everything. You need something else.
Another popular solution is to set up a trust. Is a trust a good asset protection device? It depends.
There are a lot of different types of trusts, so it’s important to first understand whether it’s a simple or complex trust. (These are specific terms applicable to trusts.) Is it a revokable or irrevocable trust?
It’s impossible to give a blanket statement as to whether a trust is a good idea for you or not.
Most likely, though, the trust most discussed is a grantor type trust, commonly called a land trust. These provide no asset protection, but are useful in some states for privacy. They are best used as part of an estate plan and not for asset protection.
Some people use land trusts in conjunction with an LLC. That could be a better solution, but you now have two different entities to set up and manage.
Asset protection is especially important as you grow your assets. Don’t lose everything you’ve worked so hard for to a silly lawsuit!
We discuss asset protection and tax saving plans as part of our Wednesday Coaching sessions. They are held at 5 pm Pacific on the 1st – 4th Wednesdays. Join us!