The main benefit of a Limited Liability Company (LLC) is right in the name. To limit liability. I also discuss minimizing self-employment taxes towards the bottom. Should I form an llc for my real estate business? Let’s find out!
An LLC is Like, Legal Magic
A group of modern day magicians decided to create what is now known as a Limited Liability Company with the power of words. By creating a limited liability company, you are creating an “entity” that is a person that is not you, even if you can control this person. Your personal activities and assets are still yours. Your business activities and assets are now owned by this magic entity.
What Does This Mean?
If you decide to separate yourself from your business activity then your business and personal activities are now two separate entities. Just like you and I are two separate activities. You are not liable for my mistakes because we are two separate entities. You shouldn’t have to go to jail if I harmed someone. This same treatment is applied to my business and personal activities. I shouldn’t have to suffer for my businesses wrongdoing. (We have pretend to ignore the fact that I control the business for this to work. The magicians have made it so people ignore this fact).
So How Does This Apply to Real Estate?
Let’s use an extreme example. Say I flip houses for a living. A house I sold has a dangerous defect that I negligently did not notice, which causes it to burn down and the person I sold the house to dies. The estate of the person I sold the house to now wants to sue me for everything I have. If I was doing business through a business entity I could make the argument that pretty much amounts to, “Hey, I didn’t do it, the business did it, hold him responsible not me!” In practice this is a very strong argument. If this person gets a judgement against my business entity and not against me personally, then he can only take what the business owns and not what I own to satisfy a judgment.
How Likely Is Such an Extreme Example to Happen?
Probably not likely. In fact, there’s plenty of investors that don’t use LLC’s at all. However, it does happen.
Does The Magic of Limited Liability Protection Always Work?
No it does not. It is still possible to be held personally liable for business activity. However, this is very unlikely if you correctly operate your business and separate business and personal activity. Sign business activity in the business’s name, have a separate bank account for the business, etc
How Much Does It Cost To Maintain An LLC?
Not only does it cost to create an LLC but it costs to maintain one. Examples of maintenance fees are CPA’s and/or book keepers, a business bank account, an additional business tax return (if required by your jurisdiction), a registered agent if you choose to have one. For example, let’s say that it costs 1k per year to maintain your LLC (could be more or less depending on your jurisdiction). If you want to use a book keeper, lets bump it up to 2k per year. Is this extra layer of protection worth the maintenance costs? Should I form an LLC to get this extra layer of protection?
Is There Any Magic Business Entities Can Help With Other Than Limited Liability?
Why yes there is young padawan, changing your tax status. LLC’s can choose to be taxed as a Sole Proprietorship, Partnership, S-Corporation, or C-Corporation. For example, if you’re just starting out and not making any money you can choose to be taxed as a sole proprietorship. However, if you’re making 100k per year (in an operational real estate business such as fix and flipping or wholesaling, this does not apply to passive income from rentals. And that’s how the rich stays rich). then you’ll get taxed at the Federal 15.3% self-employment tax (this doesn’t even count state taxes). That’s a 15.3K hit! Yikes! You can reduce that hit by switching to a more favorable tax status. However, this generally causes your LLC maintenance cost to rise, but it could definitely be worth it to minimize taxes.
Another benefit is privacy. Property ownership is public record. There are free and inexpensive public records search companies that can easily find each property that is in your individual name. If the property is not in your personal name people will not be able to find what you own in a free or expensive search. Depending on how your business is structured it can be very difficult to find who the owner of the business is. However, this is no guarantee of absolute privacy. There are people that specialize in locating people and their assets.
Are There Any Alternatives To Protect My Business Activities Than Limited Liability Companies?
Really Good Insurance. Some investors choose to forego Limited Liability Companies and rely solely on insurance policies for their business activities.
Being Highly Leveraged
Here’s an extreme example for an illustration of how it works. Let’s say you buy an investment property for $600,000 with a $5000 down payment and borrow $595,000 to pay the rest from secured lenders. X sues you The worse happens and you get a judgment against you and the sale of the property is forced. The $595,000 from the sale gets paid first to the lenders. Then, the remaining money in the assest will be used to pay off the last creditor, X. Unfortunately for X, there is only $5000 left. By being highly leveraged, it will discourage attorneys from suggesting to their clients to sue you personally. Should I form an llc for my real estate business.
It’s Very Difficult To Get Loans to Purchase Investment Properties for LLCs
For buy and hold investors of investment properties, many residential lenders will not loan to you. Commercial lenders will loan but they charge much higher fees. It could possibly be a better business strategy to acquire properties in your personal name. On the other hand, once you have a proven business you’ll have more people willing to lend to you at better rates.
So Should I Form An LLC For My Real Estate Business?
Read All This and Decided To Form an LLC in Maryland or DC?
Yours truly, legal magician extraordinaire will be happy to help. If you like this post then you’ll like my substantially similar post here!