Owning a rental property is a business. Whether you have a single renter or dozens of tenants, you need to make sure you’re making smart decisions when it comes to structuring your business. One of the biggest choices you’ll need to make is whether or not to set up an LLC.
An LLC is a Limited Liability Company. This is a type of business structure. Other common business structures include sole proprietorships and corporations. LLCs offer something of a middle ground between sole proprietorships and corporations.
The IRS says that LLCs can also be owned by partners, corporations, other LLCs or foreign entities. Most states also allow single-member LLCs. An LLC owner is typically called a member, so single member LLCs are LLCs with only one owner.
It’s important to note that many business structure regulations occur at the state level. When deciding on a business structure for your rental property, you need to look at the rules in the state or states where you do business.
The U.S. Small Business Administration (SBA) says that LLCs can be a good option for businesses with a medium to a high level of risk and for owners with significant personal assets that they want to protect. This is because LLCs protect the members from personal liability.
Consider what might happen if your rental property business fails. There may be more debts than the remaining funds. With an LLC, your house, car, savings and other personal assets can be protected.
The same goes for lawsuits. Imagine a guest is injured on your property and decides to sue, or a renter accuses you of discrimination and files a lawsuit. If you have set up your business as an LLC, your personal assets won’t be a risk from the lawsuit in most cases.
Every business structure has its pros and cons, and this includes LLCs. Although an LLC offers significant advantages, it can also have disadvantages when compared to your other business structure options.
Many business owners use a sole proprietorship because, frankly, doing so can be easier. In fact, the SBA says that your business will automatically be considered a sole proprietorship if you engage in business activities but don’t register as another business structure. The fees involved in creating and maintaining an LLC can also be higher compared to the fees involved in running a sole proprietorship.
LLCs also have some disadvantages when compared to corporations. It’s true that LLCs offer some liability protection that you won’t get with a sole proprietorship. However, LLCs do not offer as much liability protection as corporations.
Another disadvantage to LLCs involves what happens to the structure when a member leaves. The SBA says that some states require the LLC to be dissolved and then reformed in this situation. Corporations, on the other hand, have a separate existence and are therefore not as impacted when shareholders leave or come on board.
The business structure you use can have major tax implications.
The SBA says that LLC profits and losses can pass through to personal income without facing corporate taxes. The SBA says that LLCs can appeal to owners who want to pay a lower tax rate than they would with a corporation. Since pretty much everyone wants to limit their tax burden as much as is legally possible, this sounds pretty attractive.
However, business taxes can be complicated. According to the IRS, for the purposes of employment tax and some excise taxes, an LLC with only one member is considered a separate entity. However, for income tax purposes, the IRS says that an LLC with only one member is considered a “disregarded entity” if it is not set up as a corporation. This means that the LLC is not considered to be a separate entity from the owner, and the activities of the LLC will usually be included in Form 1040 schedules.
In other words, you have to pay income taxes on the LLC’s profits. The SBA also warns that LLC members are considered self-employed. This means that they must pay self-employment taxes. According to the IRS, the self-employment tax rate is 15.3%. This amount can be broken down into 12.4% for Social Security taxes and 2.9% for Medicare taxes.
To determine whether you should create an LLC, consult with legal counsel and a tax advisor in your state, and consider the following questions.
You will need to choose a name for your LLC, register your LLC with your state, and pay the required fees. You may also need an operating agreement that shows how the LLC will be operated. Even if your state does not require an operating agreement, it can be a smart idea to have one, especially if your LLC has multiple members or owners. The operating agreement can outline the responsibilities of the owners.
When and why should a real estate investor consider an LLC?