Should You Form a Real Estate LLC?

A limited liability company (LLC) is a popular business structure for real estate companies involved in the business of buying, selling, or renting commercial or residential real estate. Most real estate company owners want to make sure they take appropriate steps to limit their liability because of the numerous risks involved with running a real estate business. These risks include depreciation in the value of property, lawsuits arising out of construction accidents, and issues with tenants. One way to reduce the risk of personal liability is to create a separate entity for your business like an LLC.

LLCs Versus Other Business Entities

An LLC is a business entity, which means it is separate from its members—the term used for people who own the LLC. The LLC, not the members, owns and manages the business and real estate. One advantage of an LLC is that you have a great deal of flexibility in deciding how to manage the company and how to split profits among co-owners.

Another option is a corporation, which—like an LLC—provides liability protection for its owners. However, a corporation is generally more complicated to form, operate, and maintain than an LLC. Additionally, depending on your situation, corporations may not provide as many tax benefits for your business as an LLC.

If you decide you don't want to create a separate legal structure, you can operate your business as a sole proprietor, or as a partnership if you are in business with others. While both a sole proprietorship and partnership are the easiest businesses to own and operate, they don't provide owners with personal protection from the debts and liabilities of the business. Business insurance provides some protection, but many real estate company owners want more because of the level of risk involved with owning and operating a real estate company.

Limiting Your Personal Liability

One of the main reasons to form an LLC or a corporation is to limit your personal liability. In the absence of a business structure, your personal assets could be on the line if the business is sued, or if money is needed to satisfy the debts of the business. With an LLC and a corporation, personal assets—like your home or individual bank account—are not at risk and business creditors can only go after the business entity and its holdings and assets.

The only exception would be if there was some type of wrongdoing or a real lack of separation between the business and its owners. In those situations, a court can "pierce the corporate veil" and hold the LLC or corporation owners personally responsible for the debts of the business.

Tax Benefits of LLCs

One benefit of LLCs for many businesses is pass-through taxation. With LLCs, profits "pass through" the business to the members who report their individual share of earnings on their personal income tax returns. The LLC itself does not pay any tax on those earnings. Moreover, owners of LLCs may benefit from the new qualified business income (QBI) deduction, which allows taxpayers to deduct 20% of LLC income from their personal taxes.

Corporations, on the other hand, face two layers of taxation. The business pays a tax on earnings at the corporate level, and then the same earnings are taxed again when distributed as income or dividends to the owners or shareholders. Income from regular corporations does not qualify for the QBI deduction.

Another potential benefit of an LLC is that there are no tax consequences when you transfer property into the LLC. This is unlike a corporation where you have to pay a corporate tax when you transfer property into the corporation. The amount taxed is the difference between the value of the property when you originally purchased it and the value at the time of the transfer to the corporation.

When and Where to File for an LLC

To gain all the protections and tax benefits of an LLC for your real estate investment business, it is best to legally form the company before acquiring your first piece of property. The benefits of limited liability begin once the business is legally formed. If you already have property, it is possible to form the LLC and then transfer the property to the business. However, this is more complicated and you should consult with an attorney if you are in this situation.

You will also have to decide where to form your LLC, particularly if you plan to invest in real estate located in different states. It is common to form the LLC in the state where you live or where your business is located, but there can be benefits to forming your LLC in a different state. Delaware, Nevada, and Wyoming, for example, are known for lower taxes, reduced business formalities, and simpler filing processes. Registering your LLC in a different state from where you live complicates the process though so it is best to consult with an attorney in the state where you want to file.