rental property investing

Real Estate LLC for Investing Legal Protection

As a new real estate investor, you’re already thinking about legal entities and whether or not you should have one.

This is very common with beginning investors.

It’s certainly okay to think about whether or not you need one but the issue I have with it is that many investors end up using a legal entity as a crutch or excuse as to why they haven’t gotten started investing yet.

The truth: You don’t need a legal entity to invest in real estate.

In fact, most banks won’t lend to your real estate LLC. They only will lend to you personally until your real estate LLC has a track record and shows profits, since it is a business after all ya know.

Instead, just get started. Find a property and inquire with a bank about financing by trying to get pre-approved.

You can purchase the property, fix it up, and place a tenant in it if it’s a rental unit. Later on you can get an LLC set up to hold your property and protect it.

That’s the route I’ve taken and would recommend you take as well so that you aren’t slowing your success by trying to get the real estate LLC figured out.

Why Set Up a Legal Entity for Real Estate?

When you first start out as an investor, you are operating as a sole proprietorship. You are the captain of your own ship and responsible for anything that happens. You’re on the hook for all liabilities incurred in your business. If someone gets hurt on your property and sues, they could potentially come after your personal assets, home, and cars to be reimbursed for damages issued by the court in a lawsuit.

Therefore, many investors consider using one of the entities listed below to protect themselves from their business.

Types of Legal Entities

  • Sole Proprietorship
  • Limited Liability Partnership
  • Limited Liability Company
  • Incorporated

The most common entity chosen by real estate investors is the LLC. I recommend you consult with an attorney and discuss the specifics of your situation to get help and advice on which entity is best for your business.

However, since many people want to learn about the LLC and use the LLC, I’ve created some education content for you to read through but as a disclaimer this is educational content only and should not be considered as advice nor should it be deemed factual or true. The law changes. You should consult with your attorney.

Let’s proceed.

Should You Set Up Your Real Estate Business as an LLC?

Features of a Real Estate LLC:

  • Limited Liability for the owners
  • Pass through of income to the owners, avoiding double taxation (unless corporate tax treatment is elected)
  • Ease of Operation – few filings, forms, formal meetings, record keeping requirements, and start up costs
  • Fewer profit sharing restrictions

Over the last decade, limited liability companies have become one of the most preferred forms of business entities used to hold title to real estate investment properties.

In 1977, Wyoming became the first state to enact an LLC statute followed by Florida a few years later in 1982. Hawaii was the final state to adopt the LLC statute in 1997.

What makes an LLC great compared to other entity options?

Under an LLC, you are shielded from personal risk exposure if the LLC screws up, and the LLC can be shielded from risk exposure from you if you screw up if it is a multiple member LLC.

Wait what? Two forms of protection?

Yes, an LLC has what’s called a charging order that protects the company assets and other members from your personal liabilities if you get sick or get in legal trouble and creditors try coming after your LLC’s assets.

Along with the legal protection that all LLC’s provide, you also get a flexible tax structure compared to other business entities. The IRS lets you decide how you want your LLC to be taxed; whether it be as a sole proprietorship if single person, or a partnership if multiple owners, or an S or C corporation.

Moving over to a LLC really depends on how much equity risk is being exposed. If you don’t have much equity to your name, a sole proprietorship or partnership will be fine to run your investment business as. Once you start acquiring a net worth that needs protected, you’ll want to move assets into an LLC.

Remember, LLC’s guarantee you at least one form of asset protection and can give you two forms of asset protection if it’s a multiple member LLC as we discussed. Plus, an LLC gives you the flexibility to choose how you want it to be taxed. Now let’s jump deeper into the different tax structures and the situations where you’d want to potentially use each type of tax structure.

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How to Determine Your Real Estate LLC’s Tax Structure?

If there is one thing that is certain in life it is paying taxes. When setting up an LLC, it’s important to understand that you get to choose what tax structure you want the LLC to be taxes as. Many people don’t realize this and their LLC gets taxed as the default setting based on how many members there are in the LLC.

The 4 Tax Structures:

  1. Sole Proprietorship – in a single member LLC, this will be the default tax setting if you decide to do nothing or didn’t realize you could choose. It’s a pass through tax structure meaning any profits will pass through the LLC to the owner’s (meaning you) personal tax statement. You’ll report the income from the LLC on a Schedule C to submit with your usual 1040. You may be subject to self-employment tax.
  2. Partnership – in a multiple member LLC, the default tax structure is a partnership where the business’s income passes through to the partners personal income tax statements just as it did in the sole proprietorship. You’ll fill out a 1065 form and may be subject to self-employment tax.
  3. S Corporation – depending on the type of business and income method, you may elect to have your LLC taxed as an S Corporation. If your real estate business is earning passive rental income, you may choose to have it taxed as a sole proprietorship or partnership to allow the passive income to pass through to your personal income tax statement. With an S Corporation, you may elect to pay yourself a reasonable salary rather than receive the income as a distribution. S Corporations are often used when the LLC is performing services and earning income other than passive income. For example, if you ran a property management business as well.
  4. C Corporation – most real estate investors will avoid this tax structure unless they plan to have a huge company that goes public to the stock market such as REIT’s. The C corporation gets double taxed which hinders return on investment for real estate investors. Your LLC’s profits will get taxed at the corporate level and then when you distribute the remaining profits to the LLC members and investors it will be taxed as a dividend (capital gain).

So now we’ve covered why you may want to form as LLC for your real estate investing business and we covered the different tax structures.

The next section below will outline the basic steps to forming an LLC if you decide to create one for your business. I want to reiterate that you DO NOT NEED an LLC to be a real estate investor. Do not let it hold you back from getting started. When I bought my first property I did not have an LLC. We later set one up and transferred the property into it using a quit claim deed. My first LLC was taxed as a pass through partnership so the income earned went to my personal tax return. In my newest multiple member LLC that was formed in Miami, we decided to set it up as an S corp and pay ourselves a reasonable salary.

5 Easy Steps to Setting Up a Real Estate LLC

We’re going to walk through the simple 5 step process to getting an LLC set up.

Step 1: Choose a Name for Your LLC

It must comply with your state’s LLC division and make sure it hasn’t already been taken by another company. It will have to end with the designation “LLC” or Limited Liability Corporation, for example “Mike’s Property Group LLC” and often the state’s will disbar certain words from being used such as bank, insurance, and others. Each state differs so check where you live.

Step 2: File Articles of Organization

You’ll have to download a form from your state that is known as the Articles of Organization. Fill it out and submit it to your state’s LLC filing office with the fee it requests depending on your state. Read this article for more on what’s usually required in the Files of Organization

Step 3: Create an LLC Operating Agreement

The LLC Operating Agreement will outline how your business is set up and will function. In other words what is the percentage ownership of each member, the members rights and responsibilities, the members voting power, how profits and losses will be allocated, how the LLC will be managed, rules for holding meetings and taking votes, and buy or sell provisions for members of the LLC who want to enter or leave the entity. An attorney can draft the operating agreement for $300 to $500 usually.

Step 4: Publish a Notice

Some states may require you to post in the local newspaper a notice your intent to form an LLC and then require you to file an affidavit of publication to the LLC filing office. Again, this varies by state and it’s unlikely most states require this but some do so check with your attorney.

Step 5: Get Licenses and Permits

Your LLC is now official but before you start operating as a business, you should check with your local city and state to ensure whether or not you need to get any business licenses and permits. Usually you’ll be required to get an Employer Identification Number (EIN) which is basically like a social security number for your business.

That wraps up the 5 simple steps to setting up an LLC. It may seem intimidating creating an LLC, but it’s really pretty simple and fairly cheap. Your expenses will be the state filing fee with the articles of organization and then you may have attorney fees for helping you set it up or for drafting your operating agreement.

Summarizing an LLC by Components

Legal Pieces of the LLC:

  • Articles of Organization – filing fee varies in each state
  • Operating Agreement –  $250 to $1,000 drafted by attorney
  • Copies of Operating Agreement – for members and partners to keep on file
  • Bank Account – keeps business funds separate from partner’s personal funds
  • Record Book – maintains records in case of lawsuit

Articles of Organization Filed with the State

  • Name of LLC – must include LLC or L.L.C or Limited Liability Company as part of the name. Make sure to check with your state and ensure the name you want to select for your business doesn’t conflict with another business that’s already registered.
  • Name and Address of Registered Agent & Office (this can be a home or business location) – the registered agent is the person who will receive the official papers and documents for the LLC.
  • Statement of Purpose – a brief and simple statement of your business
  • Duration of LLC – how long will your business exist. If you don’t have to provide an answer it’s because it is assumed your business will last forever
  • Place of Business – where is the location your business will operate
  • Type of Management – will it be member managed or will someone else manage your business for you.
  • Signatures of the people forming the LLC
  • Additional Criteria – your state may or may not include the points above and they may also ask for additional information not listed

Operating Agreement

This document sets the rules for how you’ll run business. It can be completed in the presence of an attorney or by an attorney if needed.

Things you should include:

  • How ownership interest % is determined
  • Capital Contributions/Provisions
  • Membership Voting
  • Type of Management
  • Percentage of Profit/Loss Allocation
  • Distribution of money/timeline – when will profits be returned if any exist
  • Tax preference (partnership or corporation)
  • How will a membership interest transfer
  • How will new members be added and what happens to existing members percent share when new members join
  • Buy & Sell Ownership Provisions
  • Non-compete clauses

Bank Account:

  • Checking Account
  • ACH transfer ability with no or low fees
  • Check scanner for the office

LLC Record Book

An LLC should create and maintain a record book to help in the event of court cases. In the business world, there are always lawsuits as one or more parties aren’t happy with the way business was conducted. To protect your LLC as well as your personal assets, you should have an LLC Record Book.

This consists of the following:

  • Articles of Organization
  • Operating Agreement
  • Membership Register (names & addresses)
  • Membership Transfer Ledger
  • Membership Certificates and Stubs
  • Minutes of LLC Meetings and Written Consent Forms

You should also document the following:

  • Authorizations of bank accounts
  • Who can sign checks and withdraw funds
  • Borrowing money procedures & policies
  • Procedures for amending the Articles of Organization
  • Procedures for entering into contracts
  • Procedures for buying, selling, or leasing real estate/land
  • Who is authorized to distribute profits to members
  • Procedures for admitting new members to the LLC
  • Procedures for buying out an existing member of the LLC

The 10 Things You May Not Have Known About LLC’s

1. An LLC allows for an unlimited number of members

2. If an LLC only has one member, it will be taxed as a sole proprietorship

3. The members of an LLC enjoy limited liability (personal assets are protected)

4. The managing member can deduct health insurance premiums as an expense against their share/ownership interest of the net profit because the managing members income is considered earned income

5. The managing member’s share of net income is considered earned income and is subject to self-employment tax

6. The LLC’s “members” share of net income is not considered earned income and therefor is NOT subject to self-employment tax

7. As a member of an LLC, you are not allowed to pay yourself wages

8. If any members die, the LLC can continue to exist

9. A corporation can be a member of an LLC

10. The “members” of an LLC do not get to enjoy fringe benefits because they are considered to be inactive owners

Brief Explanation: The managing member of the LLC is someone who runs the company. The other members of an LLC may not be involved with the operations and may just be investors who contributed capital or other assets to the LLC. Therefore, they are considered members only and not managing members. Each party gets to enjoy different positives and negatives.

Overall, consult your attorney and determine the best entity for protecting your real estate assets as well as your personal liability. Paying a few thousand dollars to set up an entity could save you thousands of dollars should something happen.

For those of you who are super cheap and save every penny, then another resource I recommend checking out is LegalZoom.com. Check out their tools and resources if you’re looking to draft your documents online to save some money.

What to Do Next?

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