Most of our borrowers set up a Limited Liability Company (LLC) to purchase their investment property. An LLC is a type of business structure that may include individuals, corporations, other LLCs, and foreign entities.
Why do our borrowers tend to operate through an LLC?
- Operating through an LLC provides protection for the investor’s personal assets should anything go awry. For example, if a tenant at a rental property slips and falls and brings suit against the investor, the investor’s personal assets will be protected if the investor is operating through an LLC. This does not mean that there are not loopholes, but the chances of the investor’s personal assets being at risk are lessened. (Remember that you will need a separate bank account for your LLC to isolate business from personal funds.)
- In some cases, real estate investors set up individual LLCs for each property that they purchase with the name of the LLC corresponding to the address of the property. In other cases, real estate investors use one LLC to purchase multiple properties. The benefit of doing so is that just like an LLC structure offers personal asset protection, having individual properties in individual LLCs also means that LLCs for unrelated properties are protected to some extent from legal claims. Naming a specific LLC after the specific property address offers the best protection in terms of shielding other assets from liabilities associated with one particular property.
- Operating through an LLC enables an investor to write off business expenses.
- Using an LLC means that company shares can be sold to other investors—though that may require that the entity be registered with the SEC.
- Using an LLC allows an investor to build credit for her business, without affecting/using her personal credit.
- Using an LLC offers the investor some anonymity with respect to their purchase of property. With that said, if the property purchase is being financed, the mortgage documents will identify the signatory for the LLC, and that information may be publicly accessible (it can be accessed in Maryland through MDLANDREC).
- There may be significant tax benefits to operating through an LLC in the form of pass-through taxation. This is a topic that an investor would need to address with his/her accountant/tax advisor.
If there are so many benefits to operating through an LLC, why don’t all real estate investors choose this route?
- One reason that investors may shy away from operating through an LLC is a reluctance to go through the administrative process of setting up their LLC. The administrative process in Maryland includes filing Articles of Organization and naming a resident agent. In addition, all business entities registered to do business in Maryland are required to file an Annual Report each year. A Personal Property Tax Return must accompany the annual report if the business owns, leases, or uses personal property in Maryland. These requirements may necessitate the hiring of a professional (business advisor, attorney, and/or CPA). Failure to adhere to the requirements can result in the determination that the company is “Not in Good Standing,” which will eventually result in forfeiture. If the entity has been forfeited, then it cannot legally conduct business in Maryland.
- Another reason that investors may choose not to operate through an LLC is the fees involved in doing so—beyond the professional fees that may need to be paid to attorneys, CPAs, etc. There are fees associated with both the initial setup of the business entity in addition to annual maintenance fees, and fees associated with any changes that may be necessary along the way, such as changing an address, changing the resident agent, etc. The fees associated with the various charter filings and filing to change or amend an existing business in Maryland can be found here.
- Another reason is that generally, interest rates and costs to finance your purchase are lower for a residential loan versus a commercial loan. A borrower may also be able to borrow more against the property on the residential side than on the commercial side. Some lenders will not even lend to LLCs—or if they do, they will require a personal guarantee.
Whether it is the administrative time or costs associated with setting up and operating an LLC, some investors will forgo that option and simply increase their liability and umbrella insurance instead. These investors may be somewhat less risk averse than those who opt for individual LLCs for each property held, named for the address of each individual property.
Please note that the information provided in this blog post does not, and is not intended to, constitute legal advice. Instead, all information in this post is for general informational purposes only. Those individuals contemplating entity formation should seek advice from a professional (CPA, attorney) before proceeding with entity formation.