A significant number of our clients (more than) dabble in real estate investing. Why? Because it’s a fantastic way to aggrandize one’s wealth. The tax breaks, even with breakeven rent, and the growth in capital (the value of the house increases) are hard to beat- especially in today’s market.

Invariably, we recommend our clients place the rental property in an LLC. (As a matter of fact, if there are to be multiple rental acquisitions, we recommend a separate LLC for each one- more on that later. (It certainly causes the real estate funds- income and expenses- to be maintained separately from the personal funds of the investor. Moreover, there needs to be an LLC to “house” (own) all the subsidiary LLC’s.)

(Maybe now is a great time to explain that an LLC can operate as a partnership, an S entity (formerly known as a small business entity), or a C entity. LLC’s operating as a partnership also mean that profits and losses, as well as capital gains and losses, can be appropriated among principals on an as-desired basis. An S entity maintains the flow-through aspects of the LLC, but formalizes the arrangement so that profits and capital are allocated based upon ownership percentages. A C entity pays taxes directly to the IRS (and state authorities, as obtains), with no flow through. Only in special cases do we advocate that an LLC operate as a C entity.)

It is always critical for the investor to know (or at least formulate) an exit strategy- how the property will be eventually disposed. Knowing the risks- not finding renters, finding renters that fail to pay rent (like in the current pandemic [I have a blog coming soon about this]), renters not properly caring for the property, or disasters- is also part of the considerations before investing in real estate.

But, why do we advocate for an LLC holding the property? Basically there are two reasons, with a potential third advantage.
The first- having the rental property in an LLC means that one’s personal assets are protected from any problems that may arise with or due to the rental property. There is no potential for losing one’s primary residence or car in the face of rental property calamity. Tenants can only sue the LLC- and not our personal client- with this protection. (Our clients never are involved in fraud or neglect, which would allow corporate/business veil penetrations.) This is also why we recommend separate LLC’s for each property- no other asset is at risk should an issue arise.

The second reason has to do with the vagaries of the IRS rules and regulations. To deduct all the expenses (especially depreciation), the IRS expects the owner to be a real estate professional. A significant portion of one’s time is required to be devoted to the real estate- so that if one has another position (other than real estate) it is highly unlikely that the investor will be able to take advantage of all the tax benefits. But, if the property is an LLC (which by SCOTUS [Supreme Court of the United States] decision), it is deemed to be it’s own person. And, the only business of this “person” is real estate- so it is clearly a real estate professional. Et voila, full tax benefits accrue.

The potential third reason if there will be multiple parties investing in this real estate acquisition. Operating as an LLC sets up the formal structure for multiple owners- and a means for owners to sell their ownership percentage to others.

Of course, this choice does mean one must file a separate tax return for the real estate. (The flow-through is allocated according the K-1 schedules found as part of the 1065 [partnership] or 1120S [S-entity] tax filings.) There also is the cost of forming an LLC. (Our fees run from $ 200 to $ 400 depending upon the state of formation and how many owners; costs from other firms can ring up bills as high as $ 800 or $ 1000. There are also annual fees which can run from $ 50 to $ 400, depending upon the state involved and whether one needs a registered agent.) And, then, there’s the fact that a commercial mortgage (which is what would be obtained when the LLC finances the property) is always at a higher interest rate than one could obtain as an individual- but not much higher than it would be for a second home.

And, don’t forget- the LLC must be formed before one even purchases the property- so that the sale and the mortgage can be properly titled.

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