A limited liability company (LLC) is a popular business structure for all types of entrepreneurs, including rental property owners. One reason is that an LLC offers personal liability protection for owners, who are called members in the case of an LLC.
But before you decide to form an LLC, it’s important to weigh the pros and cons. So read on to learn more about the advantages and disadvantages of choosing this structure for your property rental business.
What Is an LLC?
An LLC is a popular business structure for startup companies due to its many benefits. First, an LLC provides personal liability protection, as mentioned above, 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 members, who report it on their tax returns.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
Know the Risks of Owning a Rental Property
Owning rental property comes with risks, so you should consider forming an LLC to protect your assets. These risks include:
- Injuries to tenants, their visitors, or others
- Disputes regarding rent or security deposits
- Disputes regarding the condition of the property
- Issues with the purchase of a property
Any of these situations could lead to legal action and incur damages. If you run your rental property business as a sole proprietorship, you and the business are legally the same, which puts your assets, including your home, at risk.
An LLC offers personal liability protection, so the only assets at risk are those of the LLC.
Pros of an LLC for Rental Properties
An LLC offers many other benefits that make it a good choice for your rental property business.
1. Simplicity of Administration
LLCs are easier and less expensive to form than a corporation. However, due to their complexity, corporations are best formed with the help of an attorney. Also, unlike corporations, LLCs are not required to have a board of directors or hold annual meetings.
LLCs do, in most states, have to file annual reports. Corporations do as well, but their reporting requirements are more complex.
In an LLC, members do not have to answer to anyone. Instead, they completely control the company and can structure the management in any way they choose. In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power.
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.
For corporations, the business income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions.
However, members are subject to self-employment tax in an LLC 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, with S-Corp status, self-employment taxes do not apply to a member 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.
4. Profit Sharing Flexibility
Most businesses split profits based on owners’ capital contributions, no matter which entity type. Corporations, for instance, pay dividends based on the shareholders’ ownership percentage.
But with an LLC, owners can specify in the operating agreement any profit-sharing plan they choose. As a result, one member can take a share of profits greater than their ownership interest, while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.
If you have a sole proprietorship, your name is the legal business name. However, an LLC allows you to choose your business name, lending greater legitimacy.
Cons of an LLC for Rental Properties
While an LLC certainly has many benefits for rental property owners, there are also some disadvantages to consider.
A business owner might place each rental property in its LLC to get the most liability protection from an LLC. While this approach makes sense, costs can add up quickly. For example, formation services and filing fees can be expensive, as well as attorney consulting and accounting fees during tax time.
Additionally, if you choose to have your LLC taxed as a sole proprietorship or partnership.
While LLCs provide liability coverage for rental properties, homeowner’s insurance also covers liability. In other words, you may obtain liability protection through your insurance policy without the cost and hassle of forming an LLC.
Most homeowner’s insurance plans allow you to add an umbrella policy to increase the amount of coverage. Umbrella policies are usually priced reasonably, adding more to your insurance premium.
3. Due to the Sale Clause
If you have a mortgage on any of your rental properties, transferring the property from individual ownership to an LLC can be risky if not done properly. This type of transfer is considered a sale of the property, so all documentation must display the change in ownership.
Mortgage lenders often have a “due on sale” clause, meaning the mortgage balance is due upon the sale of the property. Transferring an individually owned property to an LLC could violate the terms of this clause and become quite costly.
If you decide to make this transfer, work with your mortgage company to obtain a waiver to protect yourself from violating the due-on-sale clause. Also, consult an attorney to ensure all transfer paperwork and transactions are compliant and error-free.
Deciding which business structure makes the most sense for your property rental business is no small task. An LLC is often a smart choice, but only in some situations. Therefore, it’s essential to take the time to weigh the pros and cons before officially forming your business and consult with an attorney to help you make the best decision.