Mike Stohler

    Are you contemplating the formation of an LLC for your rental property? Learn about the overlooked disadvantages of LLC and explore alternative options you may want to consider instead.

    I use separate LLCs for our properties, but it does have drawbacks. For instance, it leads to additional expenses when filing taxes for each LLC and when applying for loans to buy properties.

    I’ll discuss the disadvantages associated with an LLC for rental property so that you can decide if this is the right path for your business.  Let’s go!

    TL;DR

    • LLCs offer limited personal liability protection, shielding personal assets from business obligations and legal issues.
    • But using an LLC can be complex and costly due to formation processes, ongoing administrative requirements, professional service fees, tax considerations, and annual fees.
    • LLCs may not fully protect personal assets in cases of mortgage payments, illegal activities, and property maintenance negligence.

    What is an LLC?

    An LLC, or Limited Liability Company, is a type of business structure that combines a corporation’s and a partnership’s benefits. It provides owners, known as members, with limited personal liability for the company’s debts and obligations.

    Members are generally not personally responsible for the company’s financial liabilities. LLCs also offer flexibility in terms of management and taxation options. Small businesses and startups commonly use them for their simplicity and protection.

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    Pros and Cons of Setting up An LLC for your rental business

    Are you considering investing in short-term rentals or other real estate investments? Should you set up an LLC for your business? Let’s explore this structure’s pros and cons:

    Pros:

    Limited Liability

    One of the main advantages of forming an LLC is that it provides limited liability protection. As a real estate investor, this means personal liability protection.  Your personal assets are generally protected from any legal or financial obligations of your business. If any legal issues arise or a guest sues your LLC, your personal assets, like your home and savings, are shielded.

    Separate Legal Entity

    Creating an LLC makes your real estate business a separate legal entity. This separation allows you to separate your personal and business finances and obligations, making managing your business expenses, taxes, and liabilities easier.

    Tax Flexibility

    LLCs have flexible tax options. By default, a single-member LLC is treated as a “disregarded entity” for tax purposes, meaning the income and expenses flow through to your personal tax return. Multi-member LLCs can be taxed as a partnership or, if eligible, elect to be taxed as an S Corporation. These tax options provide flexibility in managing the tax implications of your business.

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    Cons

    Formation Process

    To create an LLC, you must file articles of organization with your state, which usually requires paperwork and fees; these steps add complications and costs.

    Ongoing administrative requirements

    Once the LLC starts, you will have administrative obligations, which include keeping records, maintaining separate business bank accounts, and filing annual reports with the state.  Failure to meet these requirements can mean penalties or loss of liability protection.

    Professional services

    Setting up your LLC can include incremental costs like real estate attorney fees.  

    Tax filings

    LLCs have tax considerations, and you may need to file separate tax returns for the business entity. If you have multiple LLCs, this can add complexity and increase your accounting and tax preparation expenses.

    Oh boy, can I second this!!! Tax preparation fees for every individual LLC can get expensive when you own multiple properties. 🏡🏡🏡 Consult with a CPA and attorney to see what options exist for your situation.

    Annual fees

    In addition to possible filing fees during the formation process, some states require LLCs to pay annual fees to maintain their legal status. These fees depend on the condition that will be additional to the overall costs.

    Weigh these factors against the potential benefits that an LLC can provide.

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    Personal liability protection limitations for personal assets

    An LLC offers limited liability protection for property owners – the key word being “limited”. Here are some areas where you don’t have full protection.

    Mortgage payment – Single-family home lenders typically require you to pay the mortgage for your rental properties personally. If the LLC fails on the loan obligation, you will be responsible for repayment as legal action.  You are personally on the hook if you cannot pay the loan.

    Illegal activities – an LLC’s liability protection doesn’t cover illegal activities or fraudulent behavior.

    Regardless of the LLC’s existence, you will be liable for illegal actions like discrimination or intentional tenant harm.

    Maintenance – As a landlord, you are responsible for the property’s maintenance.  If you neglect maintenance work that causes safety hazards and a tenant gets hurt or injured, they can hold you responsible for damages.  

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    Difficulty in obtaining financing

    Sometimes, obtaining financing for rental properties owned by an LLC can take more work than individual ownership.

    Lenders may ask for higher credit scores, larger down payments, and more documentation to assess the financial capability of the LLC. These requirements can make it harder to get a loan because, unlike an individual borrower, an LLC cannot personally guarantee the loan.

    Lenders may see this type of loan as a higher risk because they can’t rely on the LLC’s members’ assets to recover losses, so they charge higher interest rates. This can increase overall borrowing costs and reduce the available capital for other investments or business expenses.

    Another lending issue is that lenders may require a proven track record of successful property ownership. If this cannot be demonstrated under the LLC, the lender may deny the loan. Lenders usually want to see the LLC has a history of generating personal income and managing vacation rental properties.

    You may be able to leverage a DSCR loan for your LLC, which is structured to support an LLC as the borrower.

    Other sources for financing LLC-owned properties you can try include:

    Higher taxes and administrative burdens

    An LLC provides tax flexibility, yet vacation rental property owners may face higher tax liabilities. This is due to the inclusion of self-employment taxes typically applicable to LLCs, ultimately increasing the overall tax burden compared to individual ownership.

    Owners report profits and losses from the rental property on their tax returns as they pass through to them.

    Managing a property through an LLC company requires maintaining detailed financial records. This practice ensures effective organization, accountability, and transparency for each entity’s financial status. Monitor taxable income, expenses, and LLC-specific transactions and maintain accurate records.

    LLCs can choose various tax classifications, such as partnerships or informal businesses like sole proprietorships. Each type has different requirements, so consult with tax and legal advisors to make the right choice for your business.

    Potential transfer and estate planning challenges

    Opting for an LLC to hold rental properties may not align with your ownership transfer and estate planning needs. Challenges arise when distributing assets post-mortem or transferring ownership.

    The structure of LLC operating agreements adds a layer of complexity when transferring ownership of properties held within an LLC, as opposed to those owned by an individual.

    LLC operating agreements may require obtaining approval from other members to transfer ownership. Assessing the value of the property and a member’s share can pose challenges during the sale or transfer of ownership interest in the LLC. Disputes and delays may arise when determining the valuation of the business structure and establishing acquisition plans.

    Identify potential successors, establish decision-making protocols, and create a smooth management and ownership transition when you structure an LLC for property ownership. Seek professional advice relating to LLC ownership transfer and estate planning.

    Recommended professionals include a business lawyer, professional registered agent service, accountant, and experts in estate planning and business law.  These roles help you develop an effective plan for transferring and planning the estate of your property under an LLC.

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    How much does an LLC cost?

    The fee to form an LLC depends on your chosen options and the service provided. Limited liability company formation services, including IncFile, Zen Business, and Northwest, are available.

    IncFile

    The IncFile basic service is free, providing fast and reliable assistance. This service has a year of registered agent support and offers top-notch customer service. IncFile has many positive reviews from satisfied customers.

    IncFile

    Zen business

    The Zen business base package is $39. Users have given the company high ratings, as it has helped create many companies with unique names. This service also includes other packages with additional service options.

    Zen Business

    Northwest

    Northwest Registered Agent charges $225 for its LLC formation services, including one year of registered agent services. Northwest stands out with its higher pricing because the company oversees every received document as your registered agent.

    Northwest

    Other business structures

    You can consider other business structures that might suit your real estate business. Let’s take a look at some alternative options and their advantages.

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    Sole Proprietorship

    The sole proprietorship is the simplest and easiest business structure. It’s perfect for individuals starting in real estate investing as it requires minimal paperwork and has low operating costs.

    But, as a sole proprietor, you’re personally liable for accidents, damages, or legal claims related to your Airbnb property.

    This means your personal assets could be at risk. This drawback is significant and can outweigh the advantages of the sole proprietorship.

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    Partnership

    Starting an Airbnb business with partners can be a great option. There are different types of partnerships, like general or limited partnerships, each with pros and cons.

    In a general partnership, all partners share equal responsibility and liability for the business. This spreads the risks among multiple people, which can be beneficial. However, it can also lead to complications when making decisions and conflicts if partners have different opinions or goals.

    Limited partnerships, on the other hand, have a differentiation between general partners and limited partners. General partners have control and personal liability, while limited partners have limited control and liability.

    This structure allows for investment partnerships where limited partners provide funding without actively participating in day-to-day operations. It’s a way to attract passive investors while maintaining control over the Airbnb business.

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    Corporation

    Creating a corporation, like an S corporation or a C corporation, can benefit some businesses.

    It helps protect the owners (called shareholders) by keeping their personal belongings separate from any debts or problems the business may encounter. This is especially helpful in a risky industry like a short-term rental business.

    Corporations also have more flexibility to raise money by selling stocks and attracting investors. They can also provide some tax benefits and let you smartly plan your taxes.

    However, corporations have more rules to follow and more paperwork to do, and they can be more expensive than other types of businesses.

    Seek guidance from legal and tax professionals to comply with regulations in your jurisdiction.

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    Conclusion

    Forming an LLC can have benefits, but you should consider the possible downsides, too.

    Forming a limited liability company can make things more complicated and expensive. It might protect your assets less than you’d like, and getting financing might be more complex, with higher taxes and problems when planning your estate.

    Before you decide how to structure your property ownership for your real estate investing business, consult legal counsel and talk to financial experts so you can understand everything and make the best choice.

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    Disadvantages of LLC for Rental Property FAQs

    What is S Corporation?

    An S Corporation is a formal structure that offers a tax advantage compared to an LLC when you have employees and co-owners.

    This tax structure helps lower the self-employment tax for owners by paying them a reasonable salary as if they were employees.

    If you have people working for you and also own the business, being an S Corp is a smart choice for saving on taxes.

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    How to start an Airbnb LLC?

    When starting an Airbnb LLC, there are several steps to follow. Choose a unique and business-promoting name that complies with state requirements. File the necessary documents with the appropriate state agency.

    Designate a registered agent and create an operating agreement. Ensure compliance with local regulations by getting the necessary permits and licenses. Apply for an EIN with the IRS for tax and banking purposes.

    Keep personal and business finances separate by opening a dedicated business bank account. Lastly, understand and fulfill your tax obligations.

    Does using an LLC for rental property make it harder to get a mortgage?

    Using an LLC for rental property may make it more challenging to obtain a mortgage, but it is not impossible. While some lenders have stricter loan requirements for LLCs, options are still available.

    Check out DSCR loans and see if your property and LLC will meet the requirements to use this funding mechanism.

    Note that most lenders will still require a personal guarantee, meaning the individual is responsible for the loan.