Before we explore what LLCs can do for real estate investors, it is important to understand what an entity is. Legal entities are used throughout the business world for good reason, as we’ll see below.
What is a Legal Entity?
A legal entity is a fictional barrier of sorts encapsulating a business. There are many different types of entities. Certain types of entities are given different legal bonuses and tax treatment. Some entities are restricted to specific types of businesses.
Entities are formed at the state level. You may have noticed that many corporations are formed in Delaware; this is due to a robust legal history in the state regarding corporations, bringing more predictability to business owners. This is just one common example. Every state offers very similar types of entities, although the same type of entity in one state can differ slightly if formed in another.
Entities offer their own benefits and completely depend on a business owner’s preference. LLCs are a type of legal entity that carry a unique amount of flexibility and strong tax benefits. This makes them quite popular with real estate investors. Let’s go over LLCs in greater detail:
What is an LLC?
“LLC” is short for Limited Liability Company. Like all entities, LLCs are regulated at the state level.
Regardless, LLCs combine elements of a partnership with a corporation. LLCs offer pass-through taxation as an option for its members. This means they do not have the infamous double taxation of corporations. LLCs also limit the personal liability of its members from business obligations. This is unlike a partnership or a sole proprietorship where each person is subject to unlimited personal liability.
How are LLCs Formed?
To form an LLC, you need to file with your state’s Secretary of State office, often using a specific form document called an Articles of Organization or Certificate. You will also need to designate an authorized agent who can be contacted in the event that someone wants to sue your business.
If you are unsure on where to start in forming an LLC in your state, contact a licensed attorney that specializes in entity setups (and ideally real estate).
Once you have filed the Articles of Organization with the state, you should draft an Operating Agreement for your new entity. This is like a corporation’s bylaws, and it outlines how an LLC will operate and what powers members may have. It should also detail voting structures and any other potentially relevant issues, especially in multi-member LLCs.
After that, most states have an annual reporting fee for each LLC. Thankfully, fees for forming and maintaining LLCs have been greatly reduced over the past couple of decades due to their popularity.
When Should a Real Estate Investor Use an LLC?
This, ultimately, depends on your situation. You should always consult with a licensed attorney to determine what benefits having an LLC would add to your business. Each state has different nuances, and a specialist in your area can give you the best advice.
LLCs offer pass-through taxation, meaning that they are not subject to additional corporate taxes like a C-Corp. This is a significant advantage since there is no double taxation like corporations.
That said, LLCs greatest advantage is in the name; they protect an owner from all sorts of liability that could arise from the business. For example, if your business under an LLC is sued and loses the case, the winning party will only be able to foreclose on the business’s assets, not your personal assets.
This means that, most of the time, if your business under an LLC fails, your home, car, retirement accounts, and other assets should not be on the hook. That said, this is not a guarantee.
Does an LLC Make You Legally Untouchable?
In many cases, yes. However, entities do not shield owners from the consequences of personally breaking the law. If an owner of an LLC commits fraud, for example, the other party can still sue them personally for damages and will not just be limited to the LLC’s assets.
Another way to “pierce the corporate veil” is when an LLC owner co-mingles his or her personal money with the business’s money. When forming a business entity, you will have to make sure that business and personal assets are clearly separated. Using a business bank account for personal expenditures or non-business expenses could subject the owner to personal liability should he or she face a lawsuit against the business.
A common way that creditors can get around your LLC wall is by forcing your newer, less credit-worthy business to have you personally guarantee the loan. This means that, even if your business fails, you will still be personally on the hook for your loan. Be especially careful when signing mortgage agreements and other loans for your business and understand your obligations under any personal guarantees!
Be sure to check your state’s laws for other ways in which an LLC’s protections can be nullified. Personal liability is a nasty thing, and one of the biggest benefits of an LLC is protecting a business owner from it in many cases. Best not to squander this excellent perk!
Do Investors Have Other Options?
Yes. Real estate investors have several options for setting up their business entities. LLCs just happen to be a very popular option as they are usually cheap to form and offer great benefits.
To figure out the strategy that is best for you, it is highly recommended that you reach out to a licensed attorney and potentially a certified public accountant as well. An attorney will be able to explain liability issues that an entity may protect you from. A CPA can help to determine your optimal strategy from a tax perspective. With both opinions, you can find a sweet spot (it just so happens that it is usually forming an LLC).
Of course, an investor can choose to keep their investments in his or her personal name if so desired. This obviously can carry huge risk, but it can be mitigated with certain umbrella insurance policies to protect other assets. However, this is probably very expensive and not an indestructible strategy. One step too far would potentially be enough to both destroy an investment business and lose personal assets that might be crucial for providing for an investor’s family, housing, or retirement, just to name a few key areas.
Whatever strategy you use, always tread carefully.
LLCs are an unusually flexible tool that investors can take advantage of. A real estate investor should do what they can to limit their potential for personal liability. An LLC is a great way to do that for many.
Relatively cheap to form with great benefits, LLCs can be a big step for giving an investor peace of mind by limiting the threat to his or her personal assets. Not only will the investor’s personal assets be far more protected, but he or she will not have to sacrifice any profits to corporate taxes and can choose to have pass-through taxation. This can allow an investor to enjoy the benefits of real estate investing with far less risk.
Once again, be sure to consult with a licensed attorney to go about setting up your entities properly and in a way that makes the most sense for your needs!