One of the most asked questions I asked of me, or I see on other forums, is how to hold rental property. Should it be an LLC, S-Corp, sole proprietorship, etc. I cannot speak to all the benefits of each method, but I can speak to what I have done with my properties. You may want to consult an expert (i.e. not me) to determine what is best for yourself.
Here is the way I hold rental property, and the reasons behind it.
How to Hold Rental Property for Personal Protection
Many real estate investors hold property in various entities for personal protection reasons. Make no mistake, personal protection is important. It is also important to do the right things so you avoid needing protection in the first place. You should have enough insurance so you can cover the most anticipated issues. Have an umbrella insurance policy that protects your personal assets and your business entities as a firewall.
Setting up a business entity to avoid disclosing ownership is OK, but a sharp attorney will find your assets, or compel you to disclose them. And they can pierce the corporate veil if they really try. Or cause you to go broke defending yourself. People can find out who owns what property, and where that person(s) lives, if they really want to.
Where to Form the Business Entity
There are Delaware corporations, Nevada LLCs, South Dakota entities, Irish corporations, Virgin Island business, etc. Unless you are very large, you may find it is best just to incorporate in your own state. All mine are Minnesota entities, all are pass through entities, and none are large enough to pay any extra taxes, such as apportionment taxes, due to their size.
There is a strategy that you name your LLC after a company that exists far away. Like naming the “123 Oak Street LLC” property, to “Nevada Mortgage Corporation, LLC” instead. This may throw potential lawsuits to look out-of-state to Nevada when they are actually trying to find a Minnesota LLC. It also may cause you to forget what LLC name goes to what property when you have several properties. And if you are too slick for your own good, a jury may think so too.
All my properties are in their own LLC. Each one has a unique name, which corresponds to the address for the property. Like an LLC for a property on “123 Oak Street”, is named “123 Oak Street, LLC”. It’s non-creative, but I can remember what LLC goes to which property easily. If I buy a property that a previous investor owned and they also used this naming strategy, I may need a slightly different name. I have never had an issue with someone already using the LLC name I wanted.
Expenses with Setting Up Business Entities
Each one of my business entities had to be filed with the Minnesota Secretary of State. It costs $155.00 for my most recent organization. I needed to get a Federal EIN, and a Minnesota taxpayer ID for each one. Those tax numbers are free, but it still needs to be done.
Each property files their own income taxes and has a lengthy partnership tax form. There are annual registration filing requirements with the Minnesota secretary of State, which is free, but is a time burden that must be completed.
Each Property in an LLC
Each one of my properties is in its own LLC. I am not sure if I actually need the separate LLCs, but it is what I do. They are all multi-member LLCs, with a token allocation percentage to a non-related,non-spouse person.
I have heard that multi-member LLCs are safer in a lawsuit, as the plaintiff cannot get 100% of the LLC, I am not sure. I do know that I can potentially lose my allocation, but the other member’s allocation that is not mine would not likely be ‘lost’. It may create a dis-incentive to be sued?
Since each property is in a separate LLC, if I was to get sued and lost the suit, I could jettison that single property and move on. It would sting, but I would likely not loose the entire enterprise. A different property in a different LLC may be exempt from that lawsuit. In any case, it would have to be named separately in the court action. Hopefully this helps my asset protection.
Each LLC needs to file their own taxes, something I do myself with TurboTax. I have eight rental properties, so I need to file and mail eight returns. It keeps me busy at tax time, but it is very repetitive work, not hard work.
If you can complete a Profit and Loss Statement (P&L), you can use TurboTax. Meet with an accountant once a year, or ask a lot of questions, and you can avoid paying for any tax preparation.
A Holding Company for the LLCs
I have a pass through LLC entity, or a holding company, that conducts business for all the individual properties. To be honest, I am not 100% sure I need it, but it makes sense. 100% of the income is distributed to the individual LLCs through this ‘master’ LLC. There are no expenses to this LLC, other than “Distributions to Owners”. That expense is identical to the income it takes in. The holding company, is really more of a consolidation company. It really doesn’t hold anything, and has no assets. It helps with income and expense allocation.
The holding company distributes the various income and expenses to each property LLC using an allocation strategy based on the revenue the individual property received. That way, when I go to Home Depot, I do not have to figure out what item went to what property. The expenses are all allocated across all the properties. I only need one checking account, one credit card, and one bank account. If I had a checking account for each property, I would likely be overdrawn all the time as I would forget where I wrote check from…
The holding company does not have any accounts though. It merely receives income and expenses and passes them on. It does not retain any assets. The value of this company is $0.
The holding company also needs its own tax return.
An S-Corporation to Manage Properties
I use an S-Corp as a property manager entity. It is the only entity that has a credit card, or a bank account. It is the only name that tenants write checks out to. I can deposit all checks, from all my renters, into one account, in one transaction.
The S-Corp coordinates with contractors and purchases any supplies. The S-Corp holds the business liability insurance and any Workers Compensation insurance. The S-Corp signs all the leases.
The S-Corp leases any equipment and vehicles and puts the CEO (i.e. me) as a personal guarantor. It does pass through the income and expenses to the holding LLCs at the end of each year. It gets paid by the holding LLC to manage the properties.
The S-Corp also needs its own tax return.
Mortgages and Property Holding Names
All the mortgages for my properties are held in non-business entity names. The mortgages are in my personal name. It is easier to get a 30-year residential mortgage in your own name, than an LLC name. It is difficult, or impossible to refinance it, unless you reverse the name change. And then, the mortgage bank will expect you to keep it in your own name.
Using a commercial lender will help if you have an LLC, and want to refinance using that LLC. They will be loaning funds on the property value, not your good name and credit, so you may need more money down. Loan origination expenses will likely be higher, and the interest rate may change every few years.
Due on Sale Clause
After a LLC is set up, I transfer the property to an LLC name. I have been told that banks with call a loan due when the property ownership changes from who they loaned money original to, to an LLC. I have never experienced that, and if it does, I would pay off the mortgages. It would be painful, but could be done. Or reverse the LLC to my own name again. Or punt.
Here is what it All looks like
How do you like the above strategy? What do you do with your own investment properties? Would you go crazy having to file so many tax returns? Am I missing something I should be concerned about?