A secret many wealthy U.S. real estate investors use is the practice of holding properties within an LLC.
Using an LLC to hold real estate for investments has almost become a given with many tax benefits, liability protection, and acceptance by lenders. If you think about it, any company earns revenue, and in this case, LLC’s revenue comes from the rental income of the property. Also, like any company, you have operating expenses related to running the company (your company-related tax deductions) - more on this later.
In this article, we'll break down how an LLC operates and dive into the advantages of opting for an LLC when dealing with rental properties.
Opening an LLC
An LLC not only shields you from liabilities but also brings in tax advantages. This offers a seamless and flexible approach to handling your investment efficiently.
- Choose a State:
Decide in which U.S. state you want to establish your LLC. Each state has its own rules and regulations regarding LLC formation.
- Name Your LLC:
Choose a unique and compliant name for your LLC. It should comply with the naming rules of the state.
- File Articles of Organization:
Submit the required paperwork, usually called the Articles of Organization, to the appropriate state agency. This is often the Secretary of State's office.
- Operating Agreement:
While not always required, it's advisable to create an operating agreement that outlines the structure and operation of your LLC.
- Obtain an EIN:
Apply for an Employer Identification Number (EIN) from the IRS. This is like a Social Security Number for your LLC and is necessary for tax purposes.
- Bank Account:
Once your LLC is approved, you can open a business bank account. While banks do not help in the formation of the LLC, they are crucial for managing your LLC's finances.
The benefits of using an LLC to hold a rental property
- Single or Multiple Members Allowed
An LLC allows for flexibility in membership, accommodating either a single member or an unlimited number in a multi-member LLC. This flexibility enables individual investors to enjoy an LLC's benefits and protections. However, if the LLC is treated as an S-Corporation for tax purposes, there is a 100-member limit.
- Pass-Through Entity for Tax Purposes
An LLC is treated as a pass-through entity for tax purposes, meaning profits or losses flow through to each member based on their ownership percentage. Members report income or loss on individual tax returns and pay taxes based on personal income tax rates.
- Flexible Pass-Through Structure
While LLC profits and losses are generally distributed based on ownership percentages, members can agree to a different allocation in the operating agreement. For instance, a member in a higher tax bracket might seek a larger percentage of the depreciation expense for a more substantial tax write-off.
- Management Flexibility
The operating agreement of an LLC can be tailored to allow management flexibility. For example, one member with property management expertise may handle daily property details, or the operating agreement may mandate that all members vote on significant decisions like refinancing or sale of the property.
- One LLC for Each Rental Property
Many investors opt to establish a separate LLC for each rental property they own. This adds an extra layer of protection by isolating potential claims against one property from the entire real estate portfolio for those with multiple rental properties.
- Contribution of Personal Assets
Members have the option to contribute personal assets, such as real property or funding, to an LLC. The LLC can also pay reasonable interest to members for loans until the borrowed money is fully repaid.
- Easy Transfer of LLC Interests
Shares in an LLC may be sold or transferred to new members based on the terms outlined in the operating agreement. Real estate held under an LLC can remain within the LLC's control even when under new members.
- Professional and Business-Like Image
Holding rental property under an LLC provides real estate investors with a more professional business appearance. This could enhance credibility with tenants, lenders, and vendors.
- Inexpensive and Straightforward Formation
Depending on the state forming an LLC can be a relatively simple and cost-effective process, from $50 to a few thousand, depending on the state.
Certain states impose a minimum annual LLC tax, require annual reporting fees, and may necessitate payment of registered agent fees to an agent for service of process in the state where the property is located.
Choosing an LLC to hold a rental property can shield an investor's personal assets in case of a lawsuit. Typically, in a legal dispute, only the business assets would be at risk, offering a protective barrier for personal belongings.
What is the best state to form an LLC in?
While forming an LLC in your home state is typically advantageous, there are exceptions for non-residents and specific LLCs. Non-U.S. residents have the flexibility to choose any state, with Wyoming and Delaware being recommended options. For real estate LLCs, the "home state rule" doesn't apply. According to doola.com, Delaware provides business owner anonymity, as it doesn't require the owner's name on entity formation documents. Wyoming allows listing a "nominee" as the LLC owner for added privacy.
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