Are all LLC’s created equal?
With the ease of forming Limited Liability Companies, (aka LLC’s) through inexpensive legal websites or the advice of different real estate educational programs, many investors think the first step in real estate investing is to set up an LLC. Just because a person forms an LLC, does not mean that it offers protection for all properties purchased using that LLC name. For instance, a properly set up entity should include both the formation document as well as a company agreement or operating agreement. This document lays out the roles of members in the company and contains the contribution or ownership percentage as well. Most importantly, the LLC needs to run just like a real business with separate assets and liabilities. This means setting up a bank account in the name of the LLC with separate accounting. Contract or service agreements should be entered into in the name of the LLC and all documents should be executed in strict compliance with the powers established in the formation documents of the LLC. The creation of the LLC could mean filing a separate tax return with additional expenses involved. The members need to be careful about comingling the LLC funds with their personal funds. A failure to segregate accounting may cause you to lose the asset protection intended by the formation of the LLC, which may be the primary reason you set it up in the first place. In addition, if the goal is to buy multiple properties, then an investor may not shelter their assets if they are holding all real estate assets in one LLC. So it is important to also understand options available as well as the expense of creating multiple LLC’s or using something called a series LLC. Investors are encouraged to speak to a real estate attorney to discuss if forming and maintaining an LLC makes sense in their situation.
Are there other ways to protect my assets with less work involved?
Depending on whether you have a rental or flip property, real estate investors most likely have insurance. Many times a landlord will purchase something called a dwelling policy, which protects the insured based on actual cash value or replacement value coverage if the home is damaged due to a covered occurrence. Some of these policies even contain features that cover loss of rental income during the repair of the damage. In addition to the standard liability coverage, another tool investors utilize is an umbrella policy that protects/defends the insured if they are sued for an incident or accident that occurs on the property. So if your tenant has their clumsy friend over who trips on the sidewalk at your property, and then decides to sue the next morning, the umbrella policy could take care of this problem depending on the coverage purchased. Consult with a licensed insurance professional to discuss all of these options available, and take the time to evaluate the costs. Depending on your goals, insurance products may provide the same or better liability protection as the LLC.
Exit Strategy is important in determining if an LLC is right for you!
Many people jump so quickly into creating that LLC for protection that they don’t stop to come up with their actual real estate strategy first. Investors who want to create a rental portfolio quickly form the LLC, and usually have no problem when it comes to the initial financing with hard money lenders. However, when they go to refinance the property with a long-term lender, they quickly find out the Fannie Mae and Freddie Mac may not allow closing in the name of an LLC for conventional mortgages. Now the investor is left with the huge headache of trying to deed the property out of the name of the LLC and into their own individual name. This creates a whole other set of risks to consider if it is even possible. From title policy implications to taxing ramifications, a solid exit strategy is key to executing a successful real estate investment opportunity. Some investors look for loan products that allow title to be held in the LLC offered by private equity lenders, portfolio lenders, or community banks. These financing options may allow for refinancing in an LLC, but the loan terms may not be as favorable when it comes to the interest rate or loan features.
What entity is best in light of the recent tax reform?
One of the effects of the new 2017 tax legislation revolves around tax treatment of businesses. The new comprehensive changes make it all the more important to consult with a CPA, especially one who specializes in real estate. The default for investors always seemed to be form an LLC in the past based on its hybrid status and ability to choose how it would be taxed. Traditionally real estate investors elected treatment as a partnership or an S-Corp so as to enjoy pass-through taxation where no income taxes are paid at the business level. Since the 20% tax break for small business is phased out if your taxable income is above $157,500 if single, or $315,000 if marred, the pass-through tax status may not be the most favorable going forward. The new tax law provides for a flat 21% corporate tax rate, which seems to give investors another viable option when it comes to considering which type of entity to form. Understanding the nuances of operating an LLC vs. a Corporation are key to the successful use of these powerful vehicles. This simplified explanation only touches on some of the nuances involved in the new reform. Today it is more important than ever that you reach out to a CPA who is well versed in the tax treatment of different entities, and an attorney who can help you understand the best vehicle to hold your real estate assets in from a management perspective. Exercising diligence and planning when executing your real estate investing goals will help your business maximize the distributable income you are generating.
Longhorn III Investments, LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.