In the rental property investment business, investors usually take two common routes—sole proprietorship and limited liability company. Each structure provides its own advantages and disadvantages, but in this article, we will be focusing on the potential downsides of an LLC setup.
When it comes to rental property business structures, LLCs offer a higher level of protection against personal liability and some taxation benefits. As appealing as these benefits might seem, it is still essential to understand the disadvantages of LLC before making a decision to form it. After all, selecting the wrong business structure can put your investment at risk.
What Is a Limited Liability Company
A limited liability company (LLC) is a business structure, owned by one or more persons, which offers the owners limited liability protection for business debts and obligations. This type of entity is especially beneficial to rental property businesses where investors are found liable for any damages incurred on their properties.
With LLCs, owners are not held personally responsible if the business is sued or if it experiences financial issues. This level of protection is not available with sole proprietorships, which leave owners vulnerable to lawsuits and other liabilities.
Also, LLCs have the flexibility to choose how they want to be taxed. Profit and loss can either be reported on the owners’ individual income tax returns or reported as a separate entity. Unlike corporations, LLCs are not subject to double taxation.
Moreover, LLCs are relatively easy to form and operate. Businesses must register with the state, pay filing fees, and typically submit articles of organization that describe the company’s purpose.
Like any other business structure when running a rental property, there are limitations of limited liability company that you should be aware of to ensure your investment is safe and profitable.
How an LLC Works in Rental Properties
When you use an LLC for a rental property business, it means that the company will act as the landlord. This is possible because the LLC is an entity in itself. This entails that the rental income and profits of the business will be recorded in this entity instead of being attributed to individuals, allowing income tax savings for each owner.
The advantages of using an LLC when owning rental property include protecting owners from personal liability in case of tenant lawsuits or other liabilities, as well as being able to take advantage of deductions to reduce taxable income.
These advantages can be appealing to investors who want a more secure business structure. But again, it is important to consider the disadvantages of LLC when owning rental property.
9 Cons of Forming an LLC for a Rental Property
Here are the common disadvantages of LLC when investing in rental properties that you should know about.
1. More Paperwork Required for Setup
Forming an LLC for a rental property requires more paperwork than forming a sole proprietorship. The filing fees with the state, as well as other costs associated with setting up the business, can add up quickly. Additionally, you must file annual reports and adhere to specific regulations that are set by their respective states. Failing to comply with these regulations can result in hefty fines, so keep yourself updated on the matter.
Since LLCs are separate entities from their owners, they must file taxes separately as well. This means that you will need to keep detailed records of all expenses and income within the LLC for tax purposes. The burden of this additional paperwork and regulation can be overwhelming for some, especially if you are already overwhelmed with the responsibility of managing rental properties.
2. Tax Filing Is More Complex
Among the cons of forming an LLC that you need to know is that the company is generally taxed as a partnership, which means that the business must file separate tax returns and pay taxes on any profits generated by your property. This can be a bit more complex compared to sole proprietorships where all profits and losses are reported on an owner’s personal income tax form.
Additionally, owners of LLCs are required to register with the Internal Revenue Service (IRS) for a federal tax ID number, especially if there is more than one owner in the business.
3. Participants Cannot Receive Wages
Since LLCs are not considered employers, participants cannot receive wages from the business. This is one of the consequential LLC disadvantages for small businesses, where owners may need to pay someone to manage the rental property. In this case, LLCs cannot offer such positions and must rely on independent contractors instead.
Generally, owners of LLCs can only take profits from the company as payouts and not as wages or salaries. This means that any participant must be a shareholder.
4. Financing Can Be Challenging
When it comes to financing rental properties, LLCs may face some significant drawbacks. Some banks and traditional lenders may be reluctant to lend you money because they cannot seize personal assets if the property owner fails to pay back the loan. This makes it more difficult for business owners who need additional funding for their investments.
Lenders may also require that all LLC owners have perfect credit ratings to qualify for loans. This can be a challenge since some members may not have such.
Finally, LLCs are usually required to provide collateral for a loan when borrowing money from lenders. Equity in the business is often used as collateral which means that if there is a default on the loan, the lender can take ownership of the business.
5. There Is No 100% Assurance of Personal Asset Protection
The personal liability in an LLC is limited, but not absolute. This means that if the business is sued, only the assets of the company can be seized to pay for damages caused by the LLC. However, there are certain cases when personal liabilities may still apply.
For instance, if you fail to perform your due diligence and someone else gets injured or sick because of it, you may still be held personally liable. This is particularly true if you were directly involved in making decisions that led to the injury or illness, even though the liability belongs to the business entity itself.
Also, if an LLC fails to pay taxes on time or comply with other legal requirements, personal assets can be seized as well. LLC benefits are not always guaranteed, and it is wise to keep both personal and business assets separate.
6. Need to Form an LLC for Different States
Remember that when forming an LLC to run a rental property, the company will only be recognized in the state where the property is located. This means that if you own rental properties in multiple states, you would need to form separate LLCs for each one.
Not only can this be tedious and time-consuming, but it also results in additional filing fees and paperwork as well as more complex tax returns.
7. Government Requires Annual Filing Fees
The fees for registering an LLC for a rental property are not a one-time cost. The government requires you to pay an annual fee in order to maintain your company’s status as a separate entity with its own tax structure.
The amount of the filing fee varies from state to state, but it can typically cost hundreds of dollars. This means that you will need to be prepared to pay ongoing fees in order to keep your business in operation.
8. Sale Clause Dues Come with Property Transfers
When transferring a rental property from one LLC to another, there is usually an associated due-on-sale clause. This clause requires the seller to pay taxes on any capital gains or losses that were incurred during the transfer. Depending on how much of a gain or loss was made on the sale, these taxes can be quite expensive.
Furthermore, the buyer may also have to pay a transfer fee when buying the property from an LLC. This is because the company will need to register any changes that have been made and this can result in additional costs for the buyer.
9. Member Turnovers Are Difficult to Handle
Managing member turnovers in a rental property LLC can be a challenge because ownership may change depending on who owns the rental property.
For instance, if a new owner wishes to join, they must first be approved by all existing members. If an existing member wishes to leave, they must also be approved by all other members before their shares can be transferred.
In addition, if a member passes away, their share of the business will need to be transferred to a new owner. This involves updating documents and filing fees with the state as well as possibly notifying tenants about any changes in ownership which can be difficult for remaining members.
It is important to note that, despite its challenges, an LLC can be a great model for rental property owners depending on your needs and goals. By taking the time to learn about the disadvantages of LLC, you will be able to make a more informed decision when building a strategy for your business.
Tips for Navigating Through the Risks of an LLC for Rental Property Businesses
Alt-Text: business partners discussing the risks and disadvantages of LLC when investing in rental properties
While there are LLC drawbacks when using such a business structure for running a rental property, it does not mean that it is a completely ill-advised plan. There are some tips and tricks to help you navigate through the risks of an LLC so that you can make the most out of your real estate investment.
- Take Advantage of Tax Benefits – One advantage of forming an LLC for rental property business is that profits from the business can be taxed differently from personal income. When done correctly, this can result in a significant tax break for owners.
- Document Everything: If you are forming an LLC for your rental property business, make sure that you have all the necessary legal documents drafted and filed properly with the state.
- Educate Yourself: Stay up to date on all rules and regulations pertaining to LLCs as these can change from time to time.
- Keep Separate Accounts: Make sure to keep separate accounts for personal and business expenses. This will help you manage your finances more efficiently and make it easier to track your rental property income and expenses.
Most importantly, always consult with professionals, such as a qualified attorney and an accountant, who can offer advice on the best way to structure your rental property business. They are the best resources to help you understand the ins and outs of LLCs, as well as how to take advantage of their potential benefits.
By getting all the facts, doing your due diligence, and being aware of the disadvantages of LLC, you can make an educated decision about whether or not forming such a company for a rental property business is the right choice for you. With proper knowledge in hand, you will be better equipped to manage the risks and reap the rewards of your venture.
For more tips and information that you can use in managing your rental property business, feel free to check out our other posts!