This question that keeps coming up in discussion among new, and not so new, investors. It’s an important question, but unfortunately there is no clear definitive answer. What’s more, the answer requires you to make a choice, which is not the easiest choice to make…
Just yesterday I had lunch with a new investor, who come to town to buy me lunch (since he knows I can’t afford my own), and he posed the question in exactly this way:
“Ben, as a new investor, should I use an LLC to buy my first property? I want to start things off on the “right foot”, so I won’t have to later fix things?”
I offered him some of my thoughts, which I will now offer to you as well. Please do not take this as legal, or accounting advice, as I am neither an attorney nor a CPA. I do, however, make it my business to know enough to speak intelligently to my licensed professional advisors, and thus I have opinions on the and other matters. What follows are some of my opinions, and while I do not want you to rely on anything I say as professional advice, I do think this knowledge will help you to communicate with your professional advisors.
What is an LLC
LLC stand for Limited Liability Company. This in an entity structure which was created to combine the benefits of easy taxation/reporting of a partnership and sole proprietorship, with asset protection attributes of a corporation.
Taxation of LLC
A limited Liability Company is what we call flow through taxation entity. What this means is that none of the income coming into the company gets taxed at the company level. Instead, all of the income flows through to the member’s (owner’s) income statement. Talk to your CPA, but the basic point here is that passing your income through an LLC does absolutely nothing to lower your tax exposure, unless you elect for the LLC to be taxed as an S Corporation, which is a subject for another time…
LLC Taxation and Real Estate Investors
In that LLC, generally speaking, does nothing to alleviate tax burden of the member, this is a non-issue for real estate investors. The reason being that real estate rental income is considered passive, and is not subject to FICA taxes. Additionally, since so many passive losses are available to us real estate investors, most of the cash flow should be off-set, leaving us with very little taxable income to speak of.
With this in mind, our interest in an LLC is strictly from a liability protection standpoint, and the fact that it is a flow-through taxation entity doesn’t bother us at all…
Liability Protection and LLC
If tax relief is not the purpose of an LLC, then what is – Liability Protection. Generally speaking, in our legal system corporations are treated as individuals for the purposes of both taxation and exposure to liability. Thus, a lawsuit against a corporation stays at the level of the corporation, and does not expose the owner’s/shareholder’s, which is the defining feature and benefit of earning money as a corporation.
The problem is that the reporting requirements for a corporation are much more cumbersome than a partnership or a sole proprietorship, and in the case of a C Corporation there is also the issue of double taxation, meaning that the corporation pays income tax on the profits, and the shareholders do as well.
As such, while a corporation offers the benefits of liability protection, the extra reporting and the planning required to avoid the issue of double taxation make it unreasonable for a lot of people.
LLC was created to solve this problem. On hand hand, as I mentioned above, LLC is a flow-through taxation entity, and this there is no issue with double taxation. On the other hand, however, LLC can provide a corporate veil of liability protection. For this reason, given the option, we would always prefer to own property inside an LLC!
LLC and Financing
As much as we always want to own rentals in an LLC, there is a problem, especially if you are a new investor. As a new investor you want the safety of Fannie mae/Freddie mac, 30-year, fulkly amortized, conforming mortgages. While it is impossible to grow big without eventually graduating into commercial financing, in the beginning you should take Fannie mae up on its’ offer of 10 mortgages.
The catch is that these were designed and are intended for owner-occupants, and while they can be used for a certain number of investment property, the qualifying entity has to be a human being. An LLC, or any other entity, is not qualifiable for a conforming mortgage…
The Choice You Have to Make
With all of that being said, the reality comes down to a choice between the lower interest rate, longer amortization, and potentially much lower down-payments via a conforming Fannie Mae/Freddie Mac note, or the liability protection of owning the asset inside an LLC, which forces you to utilize a commercial note, with higher down-payment and interest rate, and shorter amortization.
This is a tough choice to make, but it’s a choice that has to be made if you are new.
I hope this helps a little. Feel free to leave comments and questions below.