Real estate investors often ask, “should I hold my real estate in an LLC?” The primary purpose for doing so is asset protection through limited liability. As with so many personal finance questions, the answer is: it depends.
When done properly, holding rental properties in an LLC can limit the owner’s liability to the equity held within that entity. In other words, this serves to protect the owner’s outside assets from liability stemming from the business.
For example, say you own a mountain cabin vacation rental, and someone incurs significant medical expenses after slipping on ice in the driveway. If you own that property in your personal name, then you could be held personally liable. On the other hand, if the property is titled in an LLC and the corporate veil is upheld, then the LLC is solely liable.
That’s where things get a little murkier.
Observing the Fiction
“It’s easy to establish an LLC on the Secretary of State website,” says Denver business attorney Josh Fitch, Esq., of Troxel Fitch, LLC, “but merely having articles of organization doesn’t, by itself, limit an owner’s liability.”
Limited liability is important to economic stability and progress. Without limited liability, entrepreneurship and innovation would be stifled.
“In order to grant limited liability,” says Mr. Fitch, “the law has established the fiction that a business entity is totally independent and freestanding from it’s owner. To warrant the protection of limited liability, you have to observe that fiction.”
Assets and expenses shouldn’t be comingled between the business and its owner. The business should have its own bank accounts, credit or debit cards, and bookkeeping. The business itself should be named in contracts and agreements, not the owner. Personal expenses should not be run through the business.
“Honoring these corporate formalities is key to preventing a plaintiff from piercing your corporate veil,” notes Mr. Fitch.
LLC as the Mortgagee
Ideally, the LLC would be the debtor on the mortgage. If you’ve already got a mortgage in place, check to see if you can assign it to the LLC.
Unfortunately, obtaining or assigning a mortgage to a business isn’t always feasible. In such a case, you may have to obtain or keep the mortgage in your name even while you set up an LLC and follow all the other corporate formalities to limit third party liability. Such an arrangement doesn’t necessarily constitute commingling that would jeopardize the corporate veil.
“In the case of an owner personally guaranteeing business debts, the owner is acting in the business’ best interest,” notes Mr. Fitch. “Because the owner doesn’t personally benefit, and the business doesn’t take on additional or unnecessary risk, this is generally acceptable.”
Even if the mortgage stays in your name, payments should be made from the corporate bank account.
Due on Sale Clause
Another hurdle to this approach is the due on sale clause found in most mortgage contracts. Essentially, this clause gives the lender the right to demand immediate payment of the full mortgage balance if the property’s title changes hands. When you transfer a property from your name into an LLC, there is potential that the lender could call the loan.
You should carefully review your mortgage document and contact your lender to determine what they will and will not allow you to do. Obtain permission in writing if at all possible.
Homeowners and Umbrella Insurance
If all the above sounds like a lot of time and effort, don’t fret! Insurance is here for you.
Liability coverage in your homeowners and umbrella policies are cheap, low maintenance, and effective. Be generous with your liability coverage. You may find it costs very little to obtain an extra million dollars or more in coverage.
Tax treatment is another often overlooked consideration in this decision. Placing rental property into an LLC could change the reporting requirements. In most states, if spouses co-own an LLC, the entity would be treated as a partnership. In such a case, they would be forced to file a partnership return (Form 1065) and issue themselves Schedule K-1s from the business. This additional requirement can be burdensome and costly. Corporate tax prep often costs $750 - $1,000+ even in very simple cases, and adding K-1s would raise the tax prep cost for your personal returns as well.
Personal Finance is Personal
So – should you hold your real estate in an LLC?
It depends on many factors:
- How much of your net worth is outside of the property?
- What is your capacity and tolerance for risk?
- How much time and money are you willing to spend observing corporate formalities?
- Can the mortgage be assigned to an LLC?
- Will your lender call the loan under the due on sale clause if you transfer the property into an LLC?
- What is the risk profile of the property itself? High-rise downtown condos have a very different risk profile than mountain cabin vacation rentals.
- How many properties do you own, and of what types? Owning one rental house in the suburbs is very different from owning several retail or commercial properties in multiple markets.
“An ounce of prevention is worth a pound of cure,” concludes Mr. Fitch. “Everybody hopes they’ll never get sued. The question is, how much are you willing to bet on it?”
Important Legal Junk
This content is not intended as tax, accounting, legal, or financial advice. This information should not be relied upon as the sole factor in an investment or legal decision. The information on this site is provided “AS IS” and without warranties of any kind either express or implied. You should consult your attorney about how this or any other information is pertinent to your personal situation. Downshift Financial is not affiliated with and does not receive compensation from Troxel Fitch, LLC.