Do you own a second property that you rent out for income? If so, you should know the potential legal issues that may hold you personally liable if you operate the rental property individually, not through an entity structure.
As a rental property owner, consider protecting yourself by transferring your rental property to a limited liability company (LLC) or another type of legal entity.
How can an LLC protect me?
An LLC is a business structure often used to protect an owner's personal assets by allowing legal separation of the business' assets from the owner's assets. An LLC is viewed as an independent legal entity that can file its own lawsuits or be independently named as a party in a lawsuit, make its own contracts and purchases, incur its own debts, pay its own taxes, and conduct its own financial transactions. Therefore, if an LLC is sued and liability is found, then only the LLC's assets can be seized.
Here are three reasons you should create an LLC for your rental property:
- limits personal liability,
- pass-through taxation,
- and allows for asset separation
Limits Personal Liability
As previously discussed, one of the major benefits of forming an LLC is to keep LLC assets and liabilities separate from personal assets. Suppose a property owner is sued and found liable. In that case, all of the property owner's personal assets, including any other properties owned, are at risk of being seized or otherwise liquidated to satisfy the judgment. If an LLC owns the property, the only assets available for seizure or liquidation are those owned solely by the LLC—protecting the owner's personal assets.
Why might I be sued?
People can be sued for many reasons when renting a property to another person or entity. For example, if someone trips and falls on the property because of something in the unit that you should have fixed, they can sue you for damages.
Another popular benefit of forming an LLC is pass-through taxation. Pass-through taxation refers to a business owner paying individual income taxes on profits earned from the business. Unlike corporate taxation, which requires the company to pay for both its own taxes on profit and requires corporation members to pay taxes on any dividend income received from those profits, LLCs allow taxes to pass through to the owners as personal income taxes only.
In addition to double taxation, corporations are generally taxed at higher rates than individuals, starting at 15% versus the minimum individual tax of 10%. With the passing of the recent Tax Cuts and Jobs Act of 2017, LLC members can now deduct up to 20% of their qualified business income before calculating their individual taxes allowing even greater savings.
Asset separation is important for both company organization and potential litigation. Personal liability limitation is not absolute. Owners could still be found liable for the debts of their LLCs when courts have difficulty discerning the difference between the owner's and LLC's assets. Therefore, by naming the LLC as the property owner and opening a separate bank account in the LLC's name, all property expenses can be kept separate from the individual LLC member(s).
Remember, an LLC is considered an independent legal entity and can have its own assets. The bank statements provide clear records of which expenses were paid for by the LLC and which monies were received by the LLC. These records could provide sufficient evidence in a court of law and prevent a judge from “piercing the corporate veil” – when a court disregards the limited liability of a corporation and finds the LLC's members personally liable for the LLC's financial obligations.
A second way an LLC assists with asset separation is if an owner holds more than one property. Forming an LLC for all rental properties to limit liability is a good idea. Having a separate LLC as the owner of each property could protect the owner's other properties (assets) from being seized or liquidated to cover legal judgments or financial obligations. If the properties are listed under one owner, then that owner could be held liable for any legal liability found relating to their other properties.
Should You Consider Different LLCs for Different Rental Properties?
The short answer to this is 'maybe.' As previously mentioned, having different LLCs for different rental properties protects an owner's other properties or assets from seizure or liquidation to satisfy any property's debts or legal judgments.
Additionally, if you live in one of the 17 states or two U.S. territories that allow it, a series LLC could be a great instrument for both separating assets and managing various investments (properties).
What is a series LLC?
A series LLC is an LLC that acts as a "parent company" for sub-LLCs that are legally isolated from one another.
While a series LLC offers the same level of asset separation protection as forming different LLCs, its structure allows for a simpler formation process – you do not have to draft additional Articles of Organization or Operating Agreements for each sub-LLC as they will follow the parent company's LLC rules.
The parent LLC can have unlimited sub-LLCs, and each sub-LLC must usually contain the name of the parent company LLC. Currently, series LLCs are recognized in Alabama, Arkansas, Delaware, Illinois, Indiana, Iowa, Kansas, Missouri, Montana, Nevada, North Dakota, Oklahoma, Puerto Rico, Tennessee, Texas, Utah, Virginia, Washington D.C., or Wyoming. California recognizes series LLCs formed in other states and allows them to do business within the state but does not allow the creation of them within the state.
Should You Choose a Series LLC (if applicable) instead of adding a DBA?
A series LLC differs from a DBA ("doing business as) because a DBA is not a formal business structure or a separate business entity. Therefore, a DBA does not offer separate asset protection and is instead simply an extension of the original company for identification purposes. Like a DBA, a series LLC can make obtaining financing easier because banks may recognize the parent company LLC or have a previous relationship with the parent company LLC versus a new LLC with no assets or insufficient credit history.
However, accounting, tax filing, annual fees, and compliance are slightly more complex with a series LLC than a DBA because each sub-LLC has its own yearly fees, accounting, taxes, and compliance requirements. A DBA has no additional fees or tax filing requirements outside of those for the original LLC.
What are the tax Benefits of Using an LLC for your Rental Property?
LLCs are taxed differently than sole proprietorships or partnerships. You can treat LLC profits as self-employment income with an LLC and file that income on your individual tax return. Alternatively, you can choose S-Corporation as the filing status for tax purposes to enjoy corporate tax benefits.
S-Corporations are a good choice if you would like to save on Social Security and Medicare taxes because members and managers are given employee status. Some other common corporate tax deductions S-Corporations enjoy include premiums paid for health or disability insurance, vehicle expenses like lease payments and reimbursement for employee use of company fleet vehicles, and home office expenses like maintenance, cleaning, telephone, utilities, and insurance.
If you choose pass-through taxation, you must file a Schedule C if you are a single-member LLC or a 1065 Partnership Return for multiple-member LLCs. If you want to change your tax status from a single-member LLC or partnership to an S-Corporation, you must complete Form 8832, Entity Classification Election. You should speak with a tax attorney or other tax professional to determine which option would work best for your current situation.
How can you form an LLC for your rental property?
How you can transfer your property to an LLC depends on whether the property is financed or if you own the property free and clear. Regardless, you will need a transfer deed to transfer the property to the LLC.
Property With Financing
Transferring your rental property ownership into LLC ownership is the same process as forming any other LLC, except for a few additional steps. If the property is currently financed, you must contact your mortgage company and advise of the desire to transfer the property in the name of the LLC. The mortgage company will provide additional paperwork and details on transferring the financed property. This is an important step, as changes in ownership without notice could disrupt or terminate finance agreements with your lender.
Property Without Financing
If the property is not financed but is owned free and clear, you must complete and file an updated deed with your local Register of Deeds' office. The new deed must reflect the LLC as the named property owner, and you will have to pay any applicable transfer taxes.
If you have not purchased the property yet but are considering purchasing it as a rental property LLC, then follow the basic steps of forming an LLC and adding the LLC as the property owner on all ownership and title documents. If the property currently has tenants, you must notify the tenants of the ownership change and update any lease or rental agreements.
The basic steps to starting an LLC are as follows:
- Decide on a business name
- Select a Registered Agent
- File your Articles of Organization
- Create an Operating Agreement,
- Register your LLC with the Secretary of State for your jurisdiction,
- Apply for an Employer Identification Number (“EIN”)
Decide on a Business Name
This is self-explanatory, but you have to choose a name so that you and others can identify your LLC. You should check your Secretary of State's website to ensure that your chosen name is not already in use within your state.
Select A Registered Agent
A Registered Agent is also known as an agent for service of process. This party is tasked with receiving official business documents and important government notifications for any businesses that it is registered with. A Registered Agent is a requirement for LLCs in all 50 states. You are welcome to choose any Registered Agent of your choice, but that agent must meet the following criteria:
(1) be at least 18 years of age,
(2) have a physical office within the same state as the LLC,
(3) be available during normal business hours of 9:00 am – 5:00 pm in the same time zone as the LLC,
(4) receive important notifications and official correspondence on behalf of the business that it is registered with, and
(5) provide notification of the receipt of the official correspondence.
Official correspondence can include corporate filing notifications, federal and state notices, tax bills, notification of lawsuits, subpoenas or summons, or wage garnishments.
Draft Articles of Organization
Articles of Organization are part of a formal legal document to identify the business, its location, Registered Agent information, DBA designations, business structure type, and the company's purpose. This legal document is required for LLC formation at the state level and is often not written from scratch. Some states have pre-filled forms that can be completed by filling in the blanks. Your local Secretary of State can offer guidance on the types of forms that may be available. An attorney can also assist with completing this document or offering specific guidance based on your business structure type.
Draft Operating Agreement
The operating agreement is a business contract that LLC members draft outlining how they will handle potential disputes, dissolve the business, transfer ownership, allocate profits, and provide other important instructions regarding the company's operation. An operating agreement is also required for LLC formation at the state level. You should consult an attorney for assistance completing your operating agreement because some industries have specific regulations that should be complied with or noted within your document.
Register Your LLC with your Secretary of State
Once you have completed your Articles of Organization, you should file the documents with the Secretary of State and pay the appropriate filing fees to register your LLC officially.
Apply for an EIN
While this step is not mandatory to form an LLC, it is recommended so that you can separate the LLC's assets from the owner's personal assets. An EIN is required to open a business bank account and start any other financial accounts. You will want a business bank account so that your LLC can cover its own expenses and prevent the commingling of the owner's personal funds and the LLC's funds.
If you have questions about creating an LLC for your rental property, contact our experienced lawyers at Newburn Law today for a free consultation.
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