The Pros and Cons of Forming an LLC to Invest in Indianapolis Rental Real Estate
If you’re reading this blog, it’s probably safe to assume that you’re conducting research to determine whether or not you should form an LLC for real estate investing purposes.
The good news is, there’s a fair amount of information out there, the bad news is, there’s no general consensus. Investors are are pretty torn on this issue and both sides of the argument seem to be passionate about why they’re right.
Out of the hundreds of investors that we represent, around 15% of them have formed LLCs to conduct their rental property business. That may not seem like an overwhelming majority, however, I think it’s a big enough number to warrant further discussion.
We certainly can’t tell you one way or the other what you should do, but there are definitely some pros and cons that you should be aware of when using an LLC for REI.
WHAT IS AN LLC?
First off, just to cover all of our bases, let’s define what an LLC actually is. LLC stands for Limited Liability Companies and it’s simply a business structure that combines aspects of a corporation and a partnership. An LLC is a legal form of a company that provides its owner(s) flexibility and protection in certain cases.
PROS OF FORMING AN LLC TO INVEST IN RENTAL REAL ESTATE:
There are certain benefits that make forming an LLC appealing to Landlords, some of these perks include:
- Asset protection – It’s no secret that owning rental properties can leave you open to lawsuits. No matter how many precautionary steps you take to ensure your properties are safe and secure, there are certain things outside of your control.
An LLC offers protection for personal assets in the event of a judgment from a lawsuit against the business.
For example, if something happens and one of your Tenants decides to sue you, they can only come after the LLC, not your personal assets. Essentially, your LLC forms a wall that separates you from your business.
This also gives you a certain amount of anonymity which some Landlords prefer.
When speaking about asset protection, there is another aspect that we need to discuss.
Some Investors choose to form multiple LLCs, or an LLC for every new rental property. This may sound excessive, but it’s the only way to get the most protection possible.
If you have one LLC and own 8 properties under it, all of those assets are liable in the event of a lawsuit. However, if you have multiple LLCs or one for each property, it minimizes the risk factor greatly.
It’s really up to you to determine how much protection you want.
Here’s what one of our Owners had to say about why he chose to go the LLC route:
“I use LLCs for asset protection. I need my real estate investments to be insulated from the rest of my money so that if a Tenant decided to sue, they could only sue the LLC entity and not me personally. Any of my personal assets would be better protected and isolated from being targeted by a tenant or anyone else.
For example, there was a tenant living in my property who had a dog. She took the dog for a walk and it got away from her and bit a neighbor. I didn’t know anything had happened until I received a letter from an attorney representing the victim. They were suing my Tenant and wanted to go after any homeowner insurances or other assets that they could get.
Ultimately, they didn’t have any grounds for coming after me because the incident didn’t happen on my property, but had it occurred on my property, I could have faced some negative consequences. It was stated in our contract that the property owner was not responsible for the actions of the pets of a Tenant, but had that wording not been in there, or had there been any other problems, I, as the owner, may have been exposed to some very real (and negative) liability. The language of rental agreements and how a real estate entity is structured makes a difference when it comes to legal ramifications.
The down side is that it costs money to set up the LLC entities and there are renewal fees every year that must be paid to maintain them. Over time, those fees add up. But it is my opinion that the legal protection of an asset and insulating personal money/property from the rental property is worth it.”
- Tax advantages – LLCs have what is called “pass-through taxation”, which means that the LLC itself doesn’t have to pay any taxes and eliminates the double taxation penalty that corporations have.
All LLC profits flow through the owner(s) and are taxed at the personal income rate, which, depending on the circumstances, can be quite a bit lower. Business income or loss is reported on each individual members’ tax return and single member LLCs file under their personal tax return while multi-member LLCs would generally file a partnership tax return.
Another perk is that the IRS allows any loss of the LLC to pass through to the individual. This loss can offset other sources of income, in effect, reducing your overall tax liability.
One last tax benefit is that in an LLC, members are allowed to add the amount of the mortgage to their basis for the purpose of computing loss.
Take some time to speak with your CPA or tax advisor to determine what your best course of action would be.
- Straightforward and Affordable – If you decide that forming an LLC is for you, then the good news is it’s a relatively straightforward and affordable process in the state of Indiana.
You can fill out all of the necessary paperwork online in about 15 minutes and the fees are under $100. You will file through the Secretary of State which can be done on the Indiana Government website.
CONS OF FORMING AN LLC TO INVEST IN RENTAL REAL ESTATE:
There are also some setbacks to forming an LLC that should be strongly considered.
- Financing – The biggest drawback of using an LLC would definitely be the financing aspect.
There’s a good chance you will no longer be able to obtain a mortgage loan from a residential lender which means you’ll have to go through a commercial lender, and they typically charge higher interest rates.
Since banks and lenders will not grant loans so easily to LLCs, what members often find themselves doing is taking out a home loan as an individual, then transferring the title (usually via a Quit Claim Deed) to the LLC before renting the property.
This is obviously a tedious and frustrating process and can cause problems if you decide to sell or refinance down the road.
- Limited Protection – Forming an LLC isn’t a full-proof protection plan. While it does offer some significant benefits, you could still get burned.
You will still be personally liable if someone sues you for your own negligence or wrongdoing—even if the accusations are related to your business. An LLC does not protect your assets if you personally guarantee a contract or loan, and it won’t protect the business itself from losing everything in a fire, flood, lawsuit, or economic downturn.
Because of these limitations, an LLC is never really your first line of defense against business problems. Insurance is essential to protect you and your business against the unexpected. An LLC then adds an additional element by protecting your personal assets from your business’s creditors.
CAN I TRANSFER A PROPERTY THAT’S UNDER MY NAME TO AN LLC?
Let’s say you already own one or more properties under your personal name, but you want to form an LLC and transfer them over. This is not impossible, but depending on your situation, could have negative consequences.
Any drawbacks really only come into play if you still have a mortgage on the property. In this scenario, transferring a property to your LLC will most likely incur a “Due on Sale” clause which means the lender could force you to pay the remainder of your loan at the time of transfer.
They may also require you to refinance the loan at a higher interest rate.
This, obviously, could be a huge road block for some Investors.
It’s not extremely likely, but some lenders are willing to allow a transfer without acceleration of the loan if you remain personally liable for it, which kind of defeats the purpose of moving it to the LLC in the first place, but it could be an option.
It’s crucial that you speak with your lender, tax adviser, financial adviser, etc., to ensure transferring a property is in your best interest.
IMPORTANT THINGS TO KEEP IN MIND IF YOU FORM AN LLC:
- Keep everything separate – If you decide to form an LLC, you need to take certain steps to ensure everything to do with your company is completely separate from any of your personal affairs.
This means separate bank accounts, credit cards, email addresses, etc. If you co-mingle the two, you run the risk of losing whatever protection you may have under your LLC because a Judge could rule that that the LLC is too close to your personal assets and therefore, not a separate entity.
- File Biennial Reports with the SOS – In order to keep your LLC in good standing, you must file a report every other year following the year it was formed and it must be done within its anniversary month.
The purpose of this report is to keep your business records up to date with the state which allows the government, creditors, and other interested parties to look up your business information should they need to contact you.
They can be filed online and cost $50 per report. If you fail to complete these reports, it could result in the company being dissolved.
ALTERNATIVE TO FORMING AN LLC
Many Investors who don’t want to manage properties under an LLC opt for extra liability insurance.
This is often referred to as an “umbrella policy” and it basically gives you protection beyond your average rental dwelling policy. These policies are typically pretty affordable as well.
Beefing up your liability insurance can be a good option if you feel you need more coverage but don’t want to go the LLC route.
Remember, no plan, whether it be an LLC or Insurance, is a 100% guarantee of protection.