Investing in real estate can be very lucrative, which is why many entrepreneurs consider it a viable option. For example, suppose you’re considering getting into real estate and forming a limited liability company (LLC). In that case, you should know that it’s a business entity that offers benefits and many potential concerns.
Read on to learn how to form a real estate LLC and whether it’s the best fit for you and your business.
What Is an LLC?
An LLC is a popular business structure for startup companies due to its many benefits. An LLC provides personal liability protection, for example, so your assets are not at risk if your business is sued or cannot pay its debts.
Also, an LLC is a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
Benefits of an LLC for Real Estate Investments
The liability protection provided by an LLC protects you from personal liability if disputes arise over the property itself or if someone is injured on the property.
The LLC can also protect the property to an extent, as a creditor or lawsuit party cannot force the sale of the property to recover their funds. They can, however, place a lien on the property.
A corporation is also an option for your real estate business, but an LLC offers a tax advantage. As stated above, LLCs are pass-through entities, meaning the LLC is not taxed. On the other hand, a corporation is subject to corporate taxes, and dividends paid to shareholders are also taxed, referred to as double taxation.
Drawbacks of an LLC for Real Estate Investments
When you buy properties under your LLC, they will be in the LLC’s name and become assets of the business. However, financing properties in the name of an LLC is not always easy, and some types of loans, such as FHA loans, are only available to individuals.
Also, sometimes lenders charge higher interest rates for properties owned by a business. Finally, if you need to transfer the ownership of a property either from the LLC to you or from you to the LLC, it may trigger a due-on-sale clause in the loan, requiring additional financing.
How to Form a Real Estate LLC
Starting a real estate LLC is nearly the same as setting up an LLC for any other business. You’ll just need to include specific language in the operating agreement about how properties are purchased and how ownership is determined.
1. Name Your Real Estate LLC
Naming your real estate investing business can take time and effort. You need a name that’s unique and easy to remember and conveys what your business does. You also need it to be SEO-friendly so that it can easily be found on Google. To choose a name, you can try a few different methods:
- Ask people you know for suggestions
- Use an online business name generator
- Brainstorm some ideas and ask family and friends for their opinion
Your business name is your business identity, and the first impression people will have of your company, so take care with this step of the LLC formation process.
Once you have a few business name ideas, you’ll want to ensure they’re available. First, do a business name search on your state’s relevant website, usually the Secretary of State’s website. You’ll also need to check your state’s LLC naming regulations to ensure you comply.
Next, you’ll need to make sure the name is not trademarked. Then, check with the US Patent and Trademark Office to ensure the name is available nationally.
You should also check to see if the domain name is available, which you can do on a site like GoDaddy. For example, you’ll want a .com domain name rather than .org or .co to give your business domain more credibility.
Once you know it’s available, you can reserve the name with your state using their name reservation form.
2. Select a Registered Agent
Most states require that you appoint a registered agent for your LLC. A registered agent is a person or company authorized to accept official correspondence for your business, such as legal, tax, or financial documents.
A registered agent ensures your business stays in compliance with state laws. In addition, the registered agent’s job is to ensure no important notices or documents are missed.
In most states, a member of the LLC can be the registered agent, or you can choose an individual that meets your state requirements. Generally, the requirements are that the registered agent:
- Be 18 years or older
- Have a physical address in the state
- Be available during regular business hours
- If the agent is a business, it’s registered to operate in the state
Some states have more specific requirements, so check the rules in your state.
Many business owners hire a registered agent service to ensure all important documents are received and addressed in a timely manner. A registered agent service also offers convenience.
If you choose to be your registered agent, you’ll have to be available at your registered agent’s address during regular business hours. However, a registered agent service will allow you the flexibility to run and grow your business wherever you need to be.
3. Determine Your Management Structure
Members or managers can manage LLCs. In a member-managed LLC, members handle all management duties. In a manager-managed LLC, non-member employees oversee operations and management duties.
Note that with a manager-managed LLC, a member can be a manager, but only in cooperation with another manager who is not a member.
Member-managed LLCs generally work best for LLCs with few members, all of whom can take an active role in day-to-day operations. Conversely, manager-managed LLCs are best for LLCs with multiple members, some of whom want to be “silent” or passive members and not involved in day-to-day operations.
Most LLCs are member-managed, as they are small businesses that cannot afford a management team.
Some states require that when you register your LLC with the state, you declare whether your LLC will be a member- or manager-managed, so be aware that you may need to make this decision before you file.
4. File Necessary Documents with Your State
In most states, the document you need to file to make your LLC official is the articles of organization. In some states, it’s called a certificate of organization or formation.
Generally, you can file the document online, usually on the Secretary of State’s website. The document requires your business name, address, registered agent information, and sometimes member or manager information.
Filing fees vary by state and range from $40 to $500. Depending on the state, your LLC should be approved within a few weeks of filing.
Some entrepreneurs use an LLC formation service like ZenBusiness to handle this step. It saves time and ensures the process is done correctly.
5. Determine Your Tax Status
As mentioned above, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who are members in the case of an LLC – must also pay taxes on their distributions. This is called double taxation.
However, members are subject to self-employment tax in an LLC that is taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses.
6. Draft an Operating Agreement
Most states do not require an operating agreement, but it’s a very important document. It defines the ownership percentages of members and how profits and losses are distributed. Those are the most important elements of the operating agreement, but it should also include the following:
- Each member’s rights and responsibilities
- Management structure and roles
- Voting rights of each member
- Rules for meetings and voting
- What happens when a member sells their interest, becomes disabled, or dies
If your LLC has more than one member, or if you plan to bring on a partner at some point, it’s also important to include provisions about how purchases and sales are decided upon, who’s responsible for making the purchases, and how the value of the properties are allocated to members.
You can find operating agreement templates online, but it’s best to have them drawn up or reviewed by an attorney. The language of an operating agreement is crucial and can often help determine how member disputes will be resolved.
7. Get Your Employer Identification Number (EIN)
The IRS uses an EIN to identify your company. It’s used for tax filing purposes. An EIN is required if your LLC has more than one member or hiring employees. Obtaining an EIN requires applying on the IRS website.
The IRS rules for obtaining an EIN are as follows:
All EIN applications (mail, fax, electronic) must disclose the name and Taxpayer Identification Number (SSN, ITIN, or EIN) of the true principal officer, general partner, grantor, owner or trustor. This individual or entity, which the IRS will call the ‘responsible party,’ controls, manages, or directs the applicant entity and the disposition of its funds and assets. Unless the applicant is a government entity, the responsible party must be an individual (i.e., a natural person), not an entity.
8. Open Your Business Bank Account
When you have an LLC, it’s important to keep your business and personal finances separate for accounting and tax purposes. Co-mingling your business and personal funds can threaten your liability protection since the line between business and personal assets will not be clear.
Most banks offer business bank accounts, so check with your local bank. You’ll need your EIN and a copy of your articles of organization. Your bank may require other documents as well.
9. Get Business Insurance
Insurance is the right choice to protect the investment you’ve made in your business. There are several different types of insurance you may need.
- General liability: A comprehensive type of insurance covering many business elements. It includes coverage against bodily injury and property damage.
- Professional liability: Protects against claims from a customer who suffered a loss due to an error or omission in your work. It’s also known as errors and omissions (E&O) insurance.
- Workers’ compensation: Provides compensation to employees injured on the job.
- Property: Covers your physical business space.
- Business Property: Covers equipment and supplies.
- Equipment Breakdown Insurance: Covers the repair or replacement of broken equipment due to mechanical issues.
- Commercial auto: Covers your company-owned vehicles.
- Business owner’s policy (BOP): This option combines the above insurance types.
10. Annual Reporting
Most states require that you file an annual or biennial report with the state to verify you’re still doing business. These can generally be filed online. A small fee usually applies and varies by state.
Many real estate investors choose to form an LLC because of the many benefits, particularly personal liability protection. But before you take the plunge, it’s best to consult with your tax advisor and attorney to help you make the choice that will give your real estate LLC the best chance of success.