Investing in a rental property can be a good way to achieve financial goals. It can be a source of steady income, potentially provide capital appreciation, help diversify your portfolio, and provide tax benefits.
There are a lot of things to plan for. You’ll need to fully understand the costs involved, including purchase price, closing costs, maintenance and upkeep, taxes, utilities, insurance, and the cost of a property manager, if you choose not to take on this responsibility yourself.
You should also consider the financial risks. These aren’t limited to tying up capital, taking on debt, or potential investment risk. The biggest risk may be opening yourself to potential liability. A landlord insurance policy can mitigate some of these risks, such as property damage, loss of rental income, or third-party liability claims. An umbrella policy goes even further and can provide additional protection if the costs of a liability claim exceed a standard policy.
But if you own the property as a sole proprietor, all of your other assets may be at risk. For this reason, and because there are additional benefits, rental property investors may choose to create a limited liability corporation (LLC)
The Basics: Understanding Real Estate LLC(s)
Setting up an LLC for real estate holdings separates you as an individual from the liability incurred by the business of the property. If you are renting out an investment property, and the tenant is injured on the property and brings a lawsuit, your assets can be shielded from the suit and only the company may be liable. If you own multiple properties, setting up an LLC for each property is the most effective way to maximize this benefit. The liability protection is not absolute, however.
The limitation of liability covers more than being sued for damages. If you have a mortgage on the property, the debt is in the name of the business and does not affect your assets. However, if you personally guarantee any debt on the property, your assets will be at risk.
The structure of an LLC allows for more than one person to be a member of the company. This can be beneficial if you own property with someone else, as the LLC permits multiple people to be members, without having to change the deed of the property or name individuals on the deed. Since it’s a company, it’s governed by a legal agreement that specifies the percentage of ownership each member will have, and how any profits or losses will be distributed.
The Tax Advantages of an LLC
The IRS considers a limited liability company as a blend of the benefits of a corporation and a partnership. It limits liability like a corporation but allows for pass-through taxation. LLC profits flow directly through to your personal tax return. This means you avoid the double taxation of being taxed at the corporate level and then taxed again on your personal income.
LLC Considerations
LLC rules and costs are different for each state. There is a setup or registration cost, and some states also require an annual report filing that requires an additional fee.
When you set up your LLC also matters. It’s best to do it before you purchase the property. However, if you do decide to transfer an existing property into an LLC, check with your lender first to see if the change of name of the property owner will trigger a “due on sale” clause. This clause can allow the lender to demand the remaining balance due on the mortgage. If this clause was included in your mortgage documentation, you’ll need to ask the lender to waive it.
The Bottom Line
Real estate rental properties can be an attractive investment that helps you fulfill your long-term goals. Setting up an LLC can limit liability, offer tax benefits, and facilitate investing alongside partners.
