When you buy a rental property, you encounter challenges you don't usually face as a homeowner. One of those challenges is protecting yourself from any consequences that arise from incidents or accidents on your property. Your rental property is a business, so you should take the proper precautions to protect yourself and your assets.
What is an LLC for a rental property?
According to the IRS, "a Limited Liability Company (LLC) is a business structure allowed by state statute." LLC owners are called managers or members.
Your rental property LLC has two main functions:
- Protect the owner's assets from legal liability - If an injury occurs on your property and you have liability insurance, the injured party can sue you for damages and medical expenses above your insurance limits. If your LLC owns the property, your personal assets, like your house, car, and bank accounts, would be protected from any lawsuits or creditors attempting to collect debts from the business. Plaintiffs and creditors can only seek compensation from what the LLC owns.
- Protect the owner(s) from double taxation - As an LLC, the business has "pass-through" taxes, meaning that the owner's personal income taxes show any profits or losses from the LLC. The LLC itself is not required to file a separate tax return. The IRS treats LLCs as a sole proprietorship (one owner) or a partnership (two or more owners), and corporate tax regulations generally don't apply.
Do I need an LLC for my rental property?
You do not need an LLC for your rental property. However, you may find that as your portfolio grows, your personal liability insurance won't be enough to cover you in case of a lawsuit or business debt. For example, suppose all of your properties are in your name. In that case, a plaintiff could go after assets from the property in the suit and any other assets and properties you own, including your primary residence, other personal property, and assets.
For this reason, experienced real estate investors recommend forming an LLC for each rental property. This separates the assets from each LLC and gives each LLC a level of protection from legal liability that you would not have otherwise.
Is an LLC necessary for each rental property?
No, you do not need a separate LLC for each rental property. The main reason to do so is to separate properties from one another and thus limit the assets subject to any debt or legal claim.
An LLC can lose its limited liability protection. This is known as "piercing the veil." It can happen when a creditor comes after the LLC for an unpaid debt and asks the court to pierce the veil. When this happens, creditors can use the owners' assets to satisfy business debts and liabilities not paid by the LLC. You'll be off to a great start by setting up the LLC properly for real estate through the steps listed below.
How to set up an LLC for your rental property
Each state has specific requirements for setting up an LLC for rental property.
Here are six standard steps to create an LLC (which may vary per state):
- Choose a business name - Each state has a registry of the LLCs in that state. Every business name needs to be unique in the state where it's registered. For example, in California, you can visit the Secretary of State's business name database and search the name you've selected. If it does not come up in the search, you can reserve your name for up to 60 days with a name reservation form. All 50 states have a database and will follow a similar system for creating an LLC.
- File for an EIN or Tax ID number - If your LLC has more than one member or plans to hire employees, you will need an IRS Employer Identification Number (EIN). You can complete an online application on the IRS website or file form SS-4 to get an EIN.
- File your Articles of Organization - The Articles of Organization include the LLC's name and mailing address, plus the name and address of the registered agent. The articles must also state the purpose of the LLC and how the owners will manage operations. In California, you'll use Form LLC-1 and file it with the California Secretary of State's office. The filing fee is $70.
- Create an Operating Agreement - While an operating agreement for an LLC is not required, it adds credibility to the LLC as a business entity. An operating agreement explains how the financial structure works and outlines the working relationship among your LLC's managers or members. It explains the percentage of ownership, the share of profit and losses, and the rights and responsibilities of each owner. It also explains what happens to the business if an owner leaves the LLC. You can see a sample operating agreement on NOLO.
- File the Statement of Information - In California, you'll need to file Form LLC-12 with the California Secretary of State within 90 days after filing the articles of organization and again every two years after that. In other states, such as Wisconsin, this statement is called an Annual Report, and you file it yearly to inform the state that the business is still active and operating.
- Open a business bank account - Since your LLC is a separate entity, it needs its own bank account to accept money and pay bills. The separate account is crucial in separating personal and business finances. If your property is subject to legal action, the court will need to determine if the business is operating independently; this may involve piercing the LLC's veil to examine how the finances are separated. Experts recommend using a separate business credit card to pay for property-related expenses to keep personal and business transactions separate and help build business credit.
If you plan to invest in rental property outside your home state, it makes sense to set up out-of-state LLCs. The "foreign" LLC will need a registered agent in the state where it's formed, and you'll pay a registered agent fee. This often costs more than setting up an LLC in your home state.
Delaware, Wyoming, and Nevada are considered the friendliest states for foreign LLCs. These states have low filing fees, no state taxes or citizenship requirements, no state or corporate income taxes, and strong privacy protection laws. Florida and Alaska are also relatively friendly as neither have state sales tax or income tax. If you're considering forming an LLC out of state, it's best to talk with your lawyer and accountant to get all of the paperwork completed correctly.
Protect your properties with LLCs and excellent management tools. While setting up an LLC takes a little time and money, the benefits of the flexible business structure, liability protection for each property, and pass-through taxation make it well worth the effort.
In addition to ensuring protection from liability, managing rental property has additional challenges; RentSpree's all-in-one property management platform can simplify many tasks and automate others for greater efficiency. Through RentSpree, you'll have access to comparative analysis to help you buy in the best locations. There are also tools to estimate rent, provide online applications to potential tenants, process tenant screening, and provide online lease signing and rent payment.