LLC for rental property - FAQ

LLC for rental property

An LLC is a separate business entity formed according to state statute.  While it functions as a legal company and if run correctly has the same asset protection as a regular corporation, it is much less cumbersome to operate in terms of statutory requirements. The individual owners of an LLC are called “members,” and most states do not restrict the type of ownership or the number of members. Members of an LLC can be corporations, other LLCs, foreign entities, and/or individuals. 

One of the most popular reason to form an LLC in Colorado is because you can create an LLC as a “single-member” LLC with just one owner. Many people who own rental property choose to house their investment in this legal structure. Rather than holding rental property as a sole proprietorship as an individual, a real estate investor may consider forming a single-member LLC to hold investment property. LLCs also allow more then one investor to buy or manage a property together with a simple operating agreement ( a must to avoid conflict) delineating the agreement.

The Pros of “housing” your rental property in an LLC structure:

·       LLCs are business entities distinct from the members and are easier and less expensive to create and manage compared to a corporation.

·       An LLC can generally have an unlimited number of members, which may make an LLC a good vehicle to consider for group investing.

·       Members of an LLC may provide equity capital, debt financing in the form of a loan to an LLC, or a combination of both.

·       Single-member LLCs may be formed to hold rental property as an alternative to owning property in a personal name or “doing business as” (DBA) name, thereby protecting the owner’s other assets from liability for the rental property.

·       Income or losses from a rental property held in an LLC are passed through to each member and reported on individual tax returns, with income taxes paid based on each member’s individual rate, avoiding the double taxation of corporate profits.

·       Other business and personal assets of each member are generally protected from legal liability or creditor claims in the event of a lawsuit or bankruptcy.

·       Members of an LLC also may buy and sell their individual shares without having to sell the actual rental property, based on the rules outlined in an LLC’s operating agreement.

The Cons of “housing” your rental property in an LLC structure:

·       LLCs must file annual tax returns (even though LLCs generally do not pay taxes) and provide each member with a Schedule K-1 to report each member’s share of income or losses, deductions, and credits.

·       Member liability protection from an LLC may be limited if an LLC is proven to have done something illegal or if the LLC does not adhere to recommended practices, such as not comingling personal funds.

·       While individual members of an LLC may be able to sell their shares, some states require an existing LLC to be dissolved and a new LLC to be formed if there is a change in membership (not Colorado).

·       Raising additional capital may also be more difficult with an LLC structure, compared to a corporation, such as an S Corporation, which may sell shares of additional stock rather than taking out a bank loan.

I enjoy helping start their businesses and am happy to consult about whether an LLC is a good fit for your business venture. It’s always exciting to hear about new companies and I am happy to discuss the legal requirements and answer questions. You can schedule a quick complimentary consult here.

Real estate trust for rental property

Real estate trusts are a way to house rental properties other then owning them as an company or individual. Trusts usually serve estate planning purposes to avoid estate taxes and probate and keep rental property within the family.

There are 2 types of real estate trusts for rental property: revocable and irrevocable. In both cases, rental property is transferred from the original owner (the grantor) into a trust, but the control that the grantor has is different.

A revocable trust allows the grantor to make changes to the trust during the grantor’s lifetime, to directly control and manage the assets in the trust, and to terminate the trust. However, once the grantor dies, a revocable trust becomes irrevocable.

In an irrevocable trust, the assets are overseen and managed by a trustee, and the grantor no longer has control over the trust assets. Instead, the trustee manages the assets according to the instructions in the trust. Upon the grantor’s death, assets are distributed by the trustee according to the trust instructions.

Pros of Creating a Real Estate Trust

·       After a trust is created, there are no recurring fees to maintain the trust, as there are with an LLC.

·       A real estate trust may be a good estate planning option for investors seeking to avoid estate taxes and pass along property to heirs.

·       A trust avoids a lengthy probate process because it, rather than an individual, has ownership rights to the rental property held in the trust.

·       Real estate trusts also may be used by multiple owners of a rental property as a way to document ownership interests and relationships.

·       Assets held in a trust are not treated as part of the grantor’s personal assets, which may help to lower an individual’s tax liability.

·       Trusts may provide some anonymity, although it is becoming increasingly difficult to do so when deeds and tax information are available online from counties.

Cons of Creating a Real Estate Trust

·       Because a trust is not a business entity like an LLC, a trust does not protect other business and personal assets in the event of a lawsuit or creditor claim.

·       A trust also may be more complicated and expensive to set up compared to a will or an LLC, depending on the grantor’s personal situation and assets being transferred.

·       Creating a will may still be required to address property that is not held in a trust.

Rental Properties and Colorado LLCs

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In Colorado, the Limited Liability Company business structure is popular because it is a hybrid of a corporation and a sole proprietorship/partnership, offering the benefits of both. For a rental property owner, an LLC provides many advantages and protections in legal, tax, and management flexibility. An LLC offers owners, also known as members, limited personal liability for liability created by the entity. One of the biggest benefits an LLC provides is personal property protection. An LLC maximizes asset protection, whether the rental owner has one or multiple properties. Each rental property should have its own LLC, so if the property owner gets sued, only the one property (LLC) will be liable instead of all of the investment properties and the personal assets of the owner. An LLC can be considered an alternate form of insurance because it protects the personal assets of a rental property owner from certain legal claims, such as slip-and-fall cases and contractual tenant disputes. Rental property owners must also be properly insured to protect the property from claims made directly against the LLC.

For tax purposes, an LLC must file a tax return as a sole proprietorship, partnership or corporation because the federal government does not recognize an LLC as a federal tax classification. One tax advantage of a single member LLC is the ability to use pass-through taxation. A single member LLC can choose to be taxed as a sole proprietorship. Income and capital gains from the LLC pass directly to the owner/member, avoiding double taxation. As the legal owner of the property, a single-member LLC can deduct mortgage interest based on IRS rules. An LLC can also choose to be taxed as a corporation. If an LLC has multiple members or opts to be taxed as a corporation, mortgage interest deductions and taxes become more complicated, so a consulting with a good CPA is helpful.

Once the LLC is set up, the owner/member is obligated to follow the guidelines spelled out in the operating agreement rather then the statutory obligations required of a corporation. Additionally, after the LLC is set up the member/members are required to file annually with the secretary of state, hold an annual meeting, keep a separate bank account, and not comingle funds.

If the rental property is mortgaged, retitling it into an LLC is an issue that will need to be addressed with the lender.