Creating an LLC for Real Estate Investing
Forming an LLC can insulate you from the liabilities and risks associated with a real estate business, while also providing you with tax benefits and other advantages. That said, creating an LLC for real estate purposes isn’t always an automatic win. We go over the pros, cons, and processes for creating an LLC for real estate investing below.
In this article:
What is a Real Estate LLC?
Advantages of a Real Estate LLC
Disadvantages of a Real Estate LLC
Forming a Real Estate LLC
Real Estate LLC FAQ
What is a Real Estate LLC?
A real estate LLC is a business entity distinct from an individual investor, formed for the purpose of purchasing and owning real estate property.
Many kinds of real estate companies can benefit from becoming an LLC, whether you want to buy property for the sake of resale (such as in the case of renovating and “flipping” homes), buy land for a new construction development, lease out unused personal properties, or own real estate for use in a property management firm.
Advantages of a Real Estate LLC
The limited liability protections and tax advantages of an LLC can be especially beneficial for those investing in real estate.
Assets and Liability Protection
LLCs are business entities with assets and liabilities separate from the people who own them. As such, when you run your real estate business through an LLC, your personal assets are better protected in the event of debt collection or legal judgments.
Say someone is injured on a property you own. You might face legal action as the owner—and if you are a sole proprietor, your personal assets might be at risk from a lawsuit. However, if the property is owned by your LLC, only the LLC’s assets could be used to pay damages in a successful lawsuit. An LLC also provides this protection of personal assets from financial disputes and, depending on state law, can help shield real estate from forced sale.
Now, liability protection is not a unique feature of an LLC—a corporation also shields its shareholders from losing personal assets to company debt or legal action. So why choose an LLC over a corporation? Besides being simpler and offering more flexible structures, LLCs also offer potential tax savings on property transfers, as described below.
Tax Savings on Property Transfers
In real estate, capital gains taxes—taxes on the profits of the sale of an asset—can greatly affect your bottom line. While we don’t profess to be tax experts (and we’re not offering tax advice), LLCs generally have more tax flexibility than corporations. And when it comes to capital gains, LLCs tend not to be hit as hard as entities like corporations. Here are some common tax advantage scenarios:
Owners Transferring Property to a Business
For LLCs with default taxation, a member transferring property to an LLC can often avoid the capital gains hit that a typical sale would incur.
For example, let’s assume a pretty straightforward situation. The transfer is a contribution (not a sale or a gift) in exchange for membership interest, and there are no debts on the property. In this case, the value of that contribution will generally be the basis of the property. (IRS Publication 551 goes over “basis of assets,” which is the generally the cost you paid). The value is NOT the current fair market value of the property. So what does that mean for you?
Say you bought the property a few years ago for $250,000. The fair market value is now $400,000. In a regular sale, this would usually incur capital gains taxes on the “gain” ($150K). But in this transfer, your contribution is valued at $250,000. No capital gains. (Note that if the LLC later sells the property, capital gains taxes would apply.)
In a corporation though? Property exchanged for corporate stock is treated very much like a sale—so typical capital gains taxes would apply. Per IRS Publication 542, there is a capital gains exception for owners who own more than 80% of the corporation’s stock—but issues such as mortgages or other liabilities on properties can nullify these exceptions.
Owners Transferring Property out of a Business
Normally when a business sells a property, the fair market value of the property is considered, incurring capital gain or loss. However, in a traditionally taxed LLC, the business could potentially transfer a property to a member as a distribution. A distribution would typically use either the basis of the property or the member’s membership interest as the value—so there is no gain or loss to consider.
(That being said, note that property distributed within seven years of contribution could trigger capital gains or losses—for the contributor. Per IRS Publication 541, the contributing member’s interest would need to be readjusted for the gain or loss between the basis and the fair market value at the time of the contribution.)
But if a corporation wants to transfer property to a shareholder as a normal distribution? You got it—capital gains or losses. Of course, for both LLCs and corporations, there are many factors that can affect transfers and taxation (such as debts against the property). It’s always a good idea to consult a CPA before transferring a property in or out of a business.
Disadvantages of a Real Estate LLC
Any LLC is subject to certain limitations, such as the risk of losing liability protection if personal and business assets are co-mingled. However, other potential issues are unique to real estate LLCs.
LLC Mortgages and Other Financing
One major issue with using LLCs for real estate properties is financing. New LLCs will have little or no income history to inspect for a lender considering a loan application. This means lenders may ask for more documentation and guarantees for a loan—and may need to look at members’ personal credit or income history when deciding whether or not to grant a loan. This can mean the mortgage ends up reported on the members’ credit reports, despite being loaned to the LLC.
Even if an LLC is well-established, there can be financing hurdles. Some conventional lenders will not mortgage properties owned by business entities, or will at least make it very difficult. And alternative financing sources usually charge higher interest rates. You’ll need to build business credit for your LLC to help mitigate these issues. Getting a federal tax ID number and a business bank account are useful steps towards that goal—especially if payments are made on time from that account. If possible, you might also transfer a paid-for property to the LLC to provide it with more assets.
Due On Sale Clause
On the subject of transferring property to the LLC, another potential pitfall real estate LLCs might experience is a “Due on Sale” clause. A mortgage typically includes this clause requiring the property owner of record to pay any remaining mortgage balance in full when transferring ownership. To avoid this situation, try to obtain a waiver from your lender before such a transfer.
Forming a Real Estate LLC
To form an LLC for real estate investing , you’ll file formation paperwork (typically called “articles of organization”) with the state. (For step-by-step instructions, see our Start an LLC page). Once your LLC is formed, you’ll need the following:
- Deed: If you already have property you want transferred to the LLC, you’ll need the deed to the property. Should that deed be misplaced or lost, you will need to get a certified copy of the deed from your county recorder’s office. For a certified copy, you’ll likely need to pay a fee and provide the full name on the deed, the property’s address, and the year it was purchased.
- Deed Forms: Your county recorder’s office will also be able to provide you with the forms to transfer your deed to the LLC. You will use either a warranty deed or a quitclaim deed—both of which are valid for the sake of transferring property, but are distinct documents serving different purposes. Whatever kind of deed form you get for your transfer, fill out those forms using your legal name as the grantor and the full legal name of your LLC as the grantee.
- Signature & Transfer: You will need to provide a signature for the transfer. Some states require this to be done in the presence of a notary or other witness. Depending on state law, you may also need a proxy to sign as proxy grantee on behalf of your LLC.
Submit the deed to the county registrar or another relevant local agency that manages real estate records.
Real Estate LLC Frequently Asked Questions
While it’s usually most beneficial to form your LLC in the state you where you live (or where your business is already located), some states offer particular benefits for LLC formation—for instance, Wyoming, Delaware and Nevada are common choices for LLCs because those states offer lower taxes, easier filing, and fewer business restrictions.
Yes, series LLCs are sometimes used for real estate—but they are not available in every state. A series LLC establishes subsidiary LLCs to a “master” LLC. Each subsidiary LLC has its own liability and can even have its own tax classification, without requiring multiple formation filing fees. This format is popular with real estate businesses that own multiple properties or developments. That said, series LLCs are a fairly new kind of entity—first enacted in 1996—and have yet to receive full legal recognition outside of the states that allow them.
Series LLCs can be formed in the following states and jurisdictions: Alabama, Arkansas, Delaware, Illinois, Indiana, Iowa, Kansas, Missouri, Montana, Nevada, North Dakota, Oklahoma, South Dakota, Tennessee, Texas, Virginia, Utah, Wisconsin, Wyoming, Puerto Rico, and the District of Columbia.
Yes, although doing so comes with certain benefits and drawbacks (see article above). While you gain the privacy and liability protection that an LLC provides, you also cannot take advantage of state homestead exemptions that protect an owner-occupied home from creditors up to a certain dollar value, or special tax abatements that apply to owner-occupied properties or primary residences. Homeowner property taxes also tend to be lower than the taxes on property that doesn’t qualify for homesteading.
For example, California allows for a maximum $7,000 exemption from the full value of a property occupied as the owner’s primary residence. Arkansas provides as much as $375 in property tax credit towards homestead property. However, these benefits do not apply to similar property owned by an LLC.
In general, yes, but such an arrangement may violate rules about co-mingling personal and LLC funds, especially if the home is a single-family space with no area for additional tenants. Even so, you may need to pay reasonable rent for the area to the LLC, and be able to show financial transactions from your personal account to the LLC’s bank account.
Living in your LLC’s property also negates some of your ability to write off business expenses for your property on income taxes as the building is not solely for business use.
Yes, you can sell your home to the LLC, but if you plan to stay in the home, the normal LLC rules about co-mingling business and personal assets apply. You also lose the benefit of the Home Sale Tax Exemption when selling the house in the future—a capital gains exemption of $250,000 for a single person or $500,000 for a married couple—that applies when selling your primary residence.
An LLC is a great solution for a house-flipping business. With limited liability protection, your assets are protected if anything goes wrong when flipping a home, such as property damage or an injury lawsuit. LLCs also require less paperwork in general than other comparable entities like corporations. The tax flexibility available to an LLC is also advantageous for many small house-flipping businesses.
The two types of deed forms you can use to transfer real estate to your LLC differ in how much protection they offer to the grantee.
A quitclaim deed simply transfers interest—including mere partial ownership—in a property from a grantor to the grantee, without creating a warranty on the title. This gives the grantee little legal protection, if any, against the grantor in the event of liens or prior claims on the property, or if any defects on the title exist. You’re most likely to get a quitclaim deed if a mortgage still exists on the property or other debts or liens still apply to the property.
By contrast, a warranty deed is proof the grantor is providing ownership of a clean title with no restrictions or prior claims. With a warranty deed, the grantee is guaranteed the right to sell the property, and can sue the grantor for damages if the title is discovered to have defects. You can only transfer with a warranty deed if all mortgages, liens or other encumbrances are resolved.
While the liability protection granted by an LLC is considerable, maintaining one requires a degree of ongoing expense and regular reporting, beyond the ordinary expectation for a sole proprietorship or partnership. As a result, some property owners might be tempted to stay at their original level, and instead try to offset potential liability by purchasing umbrella insurance policies.
Umbrella insurance is personal liability insurance that picks up where homeowner or general liability insurance leaves off. These supplemental insurance policies can be used when liability costs exceed standard insurance coverage. Umbrella insurance can cover multiple properties in different states, unlike LLCs, which must be formed in each individual state.
Policies like these are relatively versatile, but usually come with caveats and limitations. Umbrella insurance may also require high deductibles and relatively low coverage totals—most policies top out their coverage at $10 million. That’s a lot of money, but if your real estate LLC has multiple pieces of real estate in a high-value area, that $10 million might not go as far as you’d want against a successful lawsuit.
The limits and exclusions of an umbrella policy can still leave a property owner with considerable risk, and the liability protection provided by an LLC is a better long-term choice. Of course, you could always hedge your bets, and double-up your protection with umbrella insurance for your LLC!
Learn more about LLC rentals on our Setting Up an LLC for a Rental Property page.
