How to operate a real estate rental property LLC?
With the stock market showing lackluster returns and the collapse of the real estate market well in the rearview mirror, many are turning back to real estate for a nest egg.
Your individual accountant and counsel are best to personally advise you regarding new investments. But a simple method to start your adventure into rental property is by creating a “Limited Liability Company”, or “LLC”. An LLC provides protection to the property owner but there are obstacles to utilizing this mechanism.
The benefits of an LLC are significant. LLCs provide personal asset protection for owners of real estate. This means if a creditor seeks to collect on a personal debt, the real estate covered in the LLC is generally sheltered from that recovery. However, there is no absolute protection. For example, if one of your tenants is exiting your property and is injured, your tenant could very well sue and recover against your rental property to the extent insurance proceeds were deficient. LLCs also provide the benefit of a corporate entity (personal asset protection) with the benefit of a sole proprietorship (income reportable on personal income tax returns). This combination provides protection without the double taxation of a corporation.
What is little known is how significant it can be to maintain the “formality” of your entity. An LLC can be easy to set up using the Ohio Secretary of State portal for small business. But this portal is full of pitfalls causing a simple action to become a chore. For example, personal creditors can and will successfully “pierce” the “corporate veil” of your LLC entity if you manage your LLC in a way which fails to maintain its separate and distinct existence from the owners individually. So how do you ensure this protection? First, make sure you obtain a Tax Identification Number (referred to as an “EIN” or “TIN”) from the IRS and use the same to open a bank account in the LLC name. Then, ensure of your transactions involving your business flow through and are recorded in this LLC account. Be sure not to combine your personal and LLC assets. Meaning, when you get a payment, no matter how great or small, deposit it in the LLC account and track the income. The same goes for expenses. If you spend money for the LLC, write a check from the same account. If need be, open a credit card with a manageable credit limit in the LLC name and charge only LLC expenses to that card. Then pay the card only via the LLC checking account. Last, diligently
keep records of all LLC transactions. It doesn’t matter if you use a simple spreadsheet or a supercharged management software such as Quickbooks, neither
will effectively serve to protect you if you don’t input data regularly. Come tax time you will thank yourself for the ongoing bookkeeping.
Real estate can be particularly tricky working through bank financing when your ownership is through an LLC. With a shiny, new LLC in place banks aren’t exactly eager to lend substantial amounts of money with the lack of credit history. Therefore, with non-owner occupied properties (i.e. rental property) banks expect a larger down payment, higher interest rates and less favorable terms than in the purchase of your own home. You should expect a personal guarantee on the promissory note for the purchase. While this might seem to undermine the goal of personal asset protection of the real estate, bear in mind the bank wants security it will be paid back. What you are primarily protecting is other personal creditors from going after your rental property.
But be careful with banks. Many love to tell you the easiest route is to simply purchase the real property personally and then simply transfer the real estate, post-closing, to an LLC. Bad idea. First, mortgages contain what is a referred to as “due on sale/due on transfer” provisions. That means, if there is ever a transfer of the real estate (i.e. when you transfer it to the LLC) the Bank can at any time call the entirety of the Note due and owing in full immediately. Banks will tell you not to worry – “the bank isn’t going to call the Note due as long as you continue to make the payments…” Wrong! Banks can and will call Notes due particularly with regard to fluctuating property values. Second, what about homeowners insurance on that property. If you buy as an individual, that individual will be the named insured in case of a loss. If you simply transfer the property to the LLC, you have effectively divested the named insured of title to the property – that means no coverage. That means a big problem. Find a bank that can and will lend to you on a commercial loan and do it right from the beginning.
If you follow these steps and for more complicated legal and tax issues take the time to consult with a real estate attorney and CPA you are on track to get the most out of your investment.