Should you hold investment real estate in a LLC?

Whether you’ve been investing in real estate for years or just starting out, you’ve probably wondered if you should hold your investment real estate in a Limited Liability Company (LLC). A LLC is, in simple terms, a business entity that can own assets like real estate.  It combines the tax advantages of a partnership with the liability protection of a corporation. For a more detailed explanation of LLCs, click here. 

There are some situations where you should hold your investment real estate in a LLC.  We’ll cover those in a separate blog post.  However, there are a few reasons you should think twice before holding residential investment real estate in a LLC.  

#1 – Limited Liability may not be so limited

Most people think about holding their real estate in a LLC to limit their personal liability.  However, there’s one huge caveat to this protection that I don’t think is discussed enough. Just holding your property in a LLC does not guarantee these protections.  You must operate the LLC like a business to have limited liability.  Operating like a business means things like: having a separate business checking account for the LLC, manager/member meetings to make decisions, meeting minutes/resolutions recording those decisions, making sure filings state filings are up-to-date, 1099s to owners to disburse profits etc.   If the property owner doesn’t run the LLC like a business, anyone suing it may be able to sue the owners personally. This is called “piercing the corporate veil.”

Most real estate investors own their properties by themselves or with their spouse. In this situation, it may be tempting to take shortcuts that may allow an adverse party suing to pierce the corporate veil. If you’re under-insured because you thought you were protected, you’ll be in for a rude awakening if you get sued.

So how can you protect yourself from personal liability without a LLC?  Take out a significant umbrella insurance policy that kicks in when/if the liability exceeds your policy limits. You’ll want a large enough policy so that it essentially covers your net worth.  Assuming you use the same company for all your insurance, an umbrella policy will also protect you in the event you’re sued as result of a car accident or something related to your primary residence. 

#2 – LLCs are not free

Creating an LLC should be done by a professional. Proper preparation of Articles of Organization and an operating agreement are vital to ensuring the protections of the LLC.  For most people, this means hiring an attorney which will cost at least $800-1000.  If you have a legal background or are comfortable running the risks of drafting these documents yourself, you’ll still likely spend a few hundred dollars.  Online software that assists in drafting the required documents costs $80-100.  All states have a filing fee ranging from about $70 (CA) to a few hundred dollars.  Some states even require you to talk out an advertisement in the newspaper announcing ownership of the LLC.

If you’re lucky enough to live in California like me, you will pay California an annual $800 franchise fee.  This fee applies to all businesses operating in California even if you don’t make a profit.  Additionally, the fee applies even if your property and LLC are in another state.

#3 –Conventional financing is not available to LLCs, so borrowing money is more expensive.

Fannie May and Freddie Mac back/insure 30-year fixed rate mortgages for 1-4-unit properties bought as investments.  The rates are usually 1-1.5% higher than rates for a primary residence.  Fanny/Freddie currently allow an individual to have up to 10 financed properties.

Fannie/Freddy does not insure/back mortgages to LLCs.  This means in most instances a LLC will have to get a commercial loan.  Commercial loans normally have a higher interest rate than Fannie/Freddy backed mortgages. Banks normally amortize commercial loans over a shorter period of time (usually 20-25 years). Commercial loans normally have a balloon payment of the entire loan due after 5 or 7 years.  This means that your monthly payment will likely be significantly higher. You’ll also have to pay off the loan balance after 5/7 years or refinance the loan at that time.  Most banks will require you to personally guarantee the loan.

You may think you can avoid this disadvantage by purchasing the property initially in your own name using a Freddie/Fannie backed loan and later transferring the property to an LLC.  If you take this course of action, you risk triggering the mortgage’s “due on transfer” clause. This clause basically says if you transfer the property to another owner, the bank can require you to pay the entire balance due.  The bank may not catch you. I’ve only heard of this happening one time, but it’s a big risk.  Right now rates are at historic lows. In 5-10 years rates will almost certainly be higher. I could see banks looking for reasons to call loans due so that they can lend the money out at a higher rate of interest.

Conclusion

Using a LLC to hold investment real estate may be a wise decision in certain circumstances. However, there are at least three large drawbacks to LLCs.  Investors should consider all three before deciding to hold property in a LLC. 

If you are just getting started, consider reviewing our article on entry level investing here.