The Advantages of Using LLCs for Rental Properties

by John Cromwell

Owning rental property is a popular means of making money, either as a career or as a second job. However, this line of business is one with significant legal risks that, if not properly addressed, could threaten your personal assets. There are also issues regarding how the business is taxed that are also important to consider. Choosing the correct form of business is crucial for protecting your assets and minimizing your tax liability. One type of business organization that can address these concerns is the limited liability company.

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Personal Liability

One of the chief characteristics of an LLC is its liability protection for its members. This means owners of the LLC are generally not liable for the debts of the business. If the LLC lacks the funds to pay for certain debts, the LLC owners do not have to make up the difference using their personal funds. If someone owns multiple properties, he can place each building in a separate LLC so that a creditor of one property cannot compel him to use the proceeds he receives from another building.

Piercing the Corporate Veil

One important exception to this liability protection is a legal action known as “piercing the corporate veil.” If the owner of an LLC uses the business inappropriately, a court can compel the owner to settle all outstanding obligations using his personal assets. Veil piercing generally applies when the owner misuses the funds associated with the LLC, does not provide enough initial funding to meet the LLC’s obligations, or uses the LLC to perpetrate fraud on a third party.

Ease of Management

An LLC is not the only type of business organization that can protect its owners from being personally liable for business debts. Both C and S corporations provide the same liability protection to their shareholders, subject to the same conditions. However, an LLC is easier to manage. Both types of corporations are subject to very strict, detailed and costly formalities that must be followed when making any decisions. LLCs have fewer operational rules. However, an LLC is generally required to file annual reports with the state where it is located and must keep minutes of meetings where major decisions are made.

Tax Advantages Over C-Corp

LLCs also have a tax advantage over C-Corps. The proceeds of a C-Corp are essentially taxed twice; the business is taxed when it earns money and its shareholders are taxed when the business distributes the money to them. However, an LLC can choose to be taxed as a partnership. This means that an LLC is considered a “disregarded entity.” The LLC’s annual proceeds are divided amongst its owners and each owner pays taxes on his share. When the LLC owner receives funds, he generally does not have to pay any additional tax so the business’s funds are only taxed once.

Tax Advantages Over S-Corp

Like an LLC, an S-Corp can be considered a disregarded entity for tax purposes so its income is only taxed once. However there are certain restrictions on real estate tax transactions with S-Corps that may make an LLC a better choice on a tax basis. Any time a property is sold by an S-Corp, the proceeds minus the original acquisition cost is taxed at a rate of 15 percent. Any deductible losses from the sale of an S-Corp property are limited to your investment in the business. Exchanges of similar property, such as real estate for real estate, are not normally taxed. However, if an S-Corp participates in a like-kind exchange, it must pay taxes on the transaction. In contrast, an LLC faces none of these restrictions.