If you’re in the residential real estate investment business, and have worked with a hard money lender or used other private investor money, the lender is likely to require you to set up an LLC. You may wonder why this is the case? First let’s take a look at what an LLC is and why it’s important to have one.
According to the United States Small Business Administration (SBA), an LLC is a “hybrid type of legal structure that provides the limited-liability features of a corporation and the tax efficiencies and operational flexibility of a partnership.”
Let’s take a quick look at a few advantages and disadvantages of forming an LLC for your fix-and-flip business.
Limited Liability: It protects owners from personal liability in the case of judgements or debts against the business. Only your LLC would take the hit and your personal assets will be protected. In this situation, the members’ personal assets are protected, similar to the protection offered to the shareholders of a corporation. (Caveat here is that some hard money lenders will require that you provide a personal guarantee which gives them some recourse to your personal assets.)
Tax Options: An LLC is taxed as a sole proprietorship, partnership, S corporation, or Corporation based on who or what owns the LLC. For example, if the LLC is held by a person then income and losses flow into the owner’s personal taxes; if the LLC is held by an C-Corp, net earnings will flow into the C-Corp’s taxes and so forth.
Pro Tip: Set-up one master LLC that holds individual LLC's for each property. The earnings of each property flow into the one master LLC.
Perpetual Existence: Depending on your State’s laws, an LLC has a life of its own regardless of its owner and can continue to exist after the owners sell their shares or pass away. If you’re looking to pass along your portfolio to your family, this is a benefit to take into account.
Cost and Administration: There is a cost to set up new LLC's. These are typically nominal, but it is an additional expense. Further, you'll need to set up bank accounts and accounting systems for the entity.
Additional Taxes: Some states, for example, Texas, New York, and California obligate LLC’s to pay a capital values tax. Essentially, the Capital Values tax on LLC’s is the fee paid to the state for the administration of the limited liability. It can be based on revenue, profits, number of owners, and amount of capital employed in the state.
LLC’s help protect your personal assets from liabilities incurred by your business. There are some tax advantages but there are also some additional costs.
If you're serious about being a professional real estate investor, setting up an LLC is highly recommended, and usually required to get a hard money loan. While there are additional costs, the benefits of protecting your assets likely outweigh the downside of additional nominal costs.