If you’re starting an LLC, the business entity formation process is one of the first and most important hurdles. This step can be terribly complex ...
Should You Form an LLC for Your Rental Property?
Written by: Carolyn Young
Carolyn Young is a business writer who focuses on entrepreneurial concepts and the business formation. She has over 25 years of experience in business roles, and has authored several entrepreneurship textbooks.
Edited by: David Lepeska
David has been writing and learning about business, finance and globalization for a quarter-century, starting with a small New York consulting firm in the 1990s.
Updated on April 29, 2023
Should You Form an LLC for Your Rental Property?
If you own rental properties, hopefully you’re making steady income from rent payments! If you’re running your business as a sole proprietorship, you may be wondering if you should instead form a limited liability company (LLC). LLCs have many benefits that it may be worth taking advantage of, particularly in terms of personal liability protection.
Risks in a Rental Property Business
Unfortunately, there are many scenarios in which you could be sued with a rental property business, including:
- Injuries to tenants, their guests or others
- Disputes regarding rent or security deposits
- Disputes regarding the condition of the property
- Issues with the purchase of a property
As a sole proprietor, if you’re sued for any reason and you lose, your personal assets are at risk, including your home. If you have an LLC and the same scenario occurs, only your LLC assets are at risk, not your personal assets, because you and the LLC are separate entities and your LLC offers liability protection.
What is an LLC?
An LLC is an increasingly popular business structure for startups, offering liability protection for ownership and greater flexibility than a corporation, particularly in terms of taxes. The LLC itself does not pay taxes. As a “pass-through” entity, income passes through the business to the owner or owners, who report it on their personal tax returns. An LLC is created by filing paperwork with your state, and nominal fees are involved.
An LLC offers its owner or owners, who are called members, considerable flexibility in terms of management. You can choose your management and operational structure and decide how you want to be taxed. Your LLC can have a single member or multiple members, all of whom have personal liability protection, meaning your personal assets are not at risk if you cannot pay business debts or are involved in a lawsuit.
Benefits of Forming an LLC for Your Rental Property
An LLC is simple to form, requiring much less paperwork than a corporation. You only need to file articles of organization and have an operating agreement to define ownership and roles and responsibilities. There are no annual meeting or reporting requirements, as with a corporation, and you don’t need a board of directors. In some states, however, you do have to file an annual report for an LLC. It’s also less expensive to form an LLC. Corporations and partnerships are best formed with the assistance of an attorney, which is expensive. It is a good idea, however, to have your LLC’s operating agreement reviewed by an attorney. Corporations also pay fees for their required annual filings.
In an LLC, you can be the only owner just like a sole proprietorship so that you have full control of the business. If you have more than one owner, you can structure the management any way you choose with your operating agreement. You don’t have to answer to a board of directors or anyone else. You have more freedom to make decisions than you do in another type of business structure, other than a sole proprietorship.
Limited Personal Liability
Unlike a sole proprietorship, an LLC is considered a legal entity that is separate from you, as the owner. Just as in a corporation, your personal assets are protected because you’re not personally liable for the company’s debts or legal liabilities. In a sole proprietorship or general partnership, your personal assets such as your home are at risk if there are unpaid debts or legal liabilities. There are some instances in which an LLC owner, however, could have personal risk. For example, if you’re asked to personally guarantee a business loan, you’re personally liable for the debt.
An LLC is considered a “pass-through” entity, meaning income passes through the business to the owners for tax purposes. The LLC is not a taxable entity, so all income is reported on the tax return of the owner or owners and taxed at their personal income tax rate. In the case of corporations, the corporation is taxed as well as the dividends shareholders receive, which is sometimes referred to as double taxation. LLC owners also may be eligible for the 20% pass-through deduction that was part of the Tax Cuts and Jobs Act, meaning they can deduct up to 20% of business income. An LLC, however, can choose to be taxed as a corporation or partnership if it is deemed to be beneficial for the company.
Most businesses split profits based on the capital contributions of owners. In a partnership, profits are generally divided equally. Corporations pay dividends based on the ownership percentage of the shareholders. In an LLC, in the operating agreement, the owners can specify any profit-sharing plan that they choose. One owner can take a percentage share of profits greater than their ownership interest, while other owners take less. This may be done when one owner is more involved in the operations of the business than others.
An LLC has the advantage of having more credibility to customers and vendors than a sole proprietorship. As a matter of perception, people tend to see an LLC as a more established company, as opposed to a one-person show.
In short, a rental property business has risks, and without personal liability protection, your personal assets could be threatened. While having an LLC is a choice and not a requirement, it offers many benefits to you as a business owner. To make sure that an LLC is right for you, it’s recommended that you consult your attorney and tax advisor.
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