The LLC (Limited Liability Company) has become a popular type of business in which to hold title to real estate investment properties in San Diego. An LLC is a legal entity, meaning it can obtain a tax identification number, open a bank account, and do business under its own name, but how might this benefit the average landlord?
LLCs Offer Limited Liability
Like corporations, LLCs offer limited liability for their owners (called members) yet are simpler and less complex to manage. Limited liability means an LLC’s members are not personally liable for the LLC’s debts and liabilities, so if the LLC incurs debt creditors can only go after the LLC’s assets to satisfy that debt (unless the debt is for a tax deficiency). As a member in an LLC only the assets you invest are at risk, so as a landlord, your personal exposure is limited to the capital you invested in the property and your portion of the property’s value.
Limited liability is also important when it comes to lawsuits regarding your property. Say someone is injured on your property and sues. As the owner of the property, you would be named in the suit, potentially exposing your personal assets in the case of an excess judgment. However, if an LLC owns the property, only the LLC’s assets are at risk adding a layer of personal protection for you.
LLCs are “pass-through entities” meaning LLCs do not themselves pay federal or state taxes, but instead profits and losses are reported on members’ personal income tax returns. (Although California requires LLCs to pay an $800 annual tax to the state and an additional fee if the LLC’s California total income is equal to or greater than $250,000.). By default, for both federal and California tax purposes, LLCs are treated one of two ways, depending on how many members there are. Single-member LLCs are treated as “disregarded entities,” and are taxed as sole proprietorships, allowing the single member/owner to avoid double taxation on rental income and property appreciation, and deduct mortgage interest. Multi-member LLCs are taxed as partnerships, so members report their proportion of the LLC’s profits and losses on their personal tax returns.
Members can elect to have an LLC treated as an S or C corporation instead of the default, and as with anything, there are benefits and drawbacks to choosing one over another. The main reason you might elect to have your LLC taxed as a corporation is so you won’t have to claim all of the LLC’s income on your personal tax return. However, if you decide to have your LLC taxed as a corporation, you become subject to double taxation on rental income, and subject to corporation tax law and corporation filing requirements. It is important to consult an experienced tax attorney when considering what the best option is for you.
Although an LLC traditionally does not pay its own taxes, as of January 2018 if there is a deficiency the IRS will go after the LLC itself instead of pursuing individual members for payment like it used to do. If the IRS conducts an audit and finds a deficiency, the imputed underpayment is computed based on the highest income tax rate applicable to an individual.
Additionally, the Tax Cuts and Jobs Act established new deductions for businesses owned through pass-through entities, such as LLCs. Starting in 2018, owners of such entities may deduct up to 20% of their net business income from their income taxes if they qualify. You qualify for the 20% deduction only if your total taxable income for the year is less than $157,500 (single) or $315,000 (married, filing jointly). If you don’t qualify, being taxed as an S corporation might help you since when you elect S corporation status, you work as your business’s employee and are paid W2 wages instead of reporting all of the LLC’s profits personally. Of course, there are many nuances to tax laws and you should speak with a competent CPA and tax attorney to determine what option is best for you.
Although members must maintain some formalities to retain limited liability, LLCs have far fewer formalities than corporations do. For instance, LLC members get to choose how profits are distributed, unlike corporations where profits must be distributed in proportion to ownership percentage. There are also no membership restrictions when it comes to LLCs, and members can be individuals, corporations, foreign entities, or even other LLCs. LLCs do not issue stock and are not required to hold annual meetings or keep written minutes, which a corporation must do to preserve the liability shield for its owners.
LLCs do have some formalities that must be observed – members must keep their finances separate, not commingle funds, not pay owners ahead of creditors, and must maintain a registered agent and not doing any one of these can expose members to personal liability. Additionally, either before or after filing its articles of organization, the LLC members must enter into an operating agreement, which can be written or verbal, although a formal, written agreement is advisable.
LLC v. Liability Insurance
Understandably some San Diego real estate investors don’t want to go to the trouble of forming and maintaining an LLC since liability insurance is an affordable and simpler option. However, it is not necessarily smart to rely on insurance as your sole source of liability protection. Liability policies have limits, exceptions, and carve-outs that can affect whether or not a circumstance is even covered. Although it is rare to have a loss that exceeds policy limits, it can happen and can have devastating consequences if it does.
There are many benefits of forming an LLC as a landlord, especially if you plan on investing in multiple properties. An LLC is much easier to manage than a corporation, yet provides limited liability and flexible taxation. If you are interested in learning more about creating an LLC for your investment property, please speak to a qualified tax attorney to explore your options
Disclaimer: This information is provided to give a general knowledge of the subject. I am not a CPA or tax attorney, and I do not give tax or legal advice. Every business situation is unique, and taxes and laws change regularly. You should consult with a tax professional and attorney before making any decisions that could affect your business.