This blog post can be divided into really like three general chunks. First, I’m going to explain what an LLC is, and why they’re so popular. Second, I’ll explain the downsides of an LLC and why you might not want one. And third, I’ll walk through some other options you have for protecting your assets. First, let’s talk about what an LLC is, and what it isn’t.
An LLC is not a get out of jail free card. You can be sued with an LLC, and you can lose everything. An LLC is not designed to prevent you from ever being sued, an LLC’s designed to help you manage and contain the fallout from that lawsuit. So, according to the United States, Small Business Administration, SBA, a limited liability company is a hybrid type of legal structure that provides the limited liability features of a corporation, and the tax efficiencies and operational flexibilities of a partnership. According to this definition, an LLC’s benefits are threefold.
If you were to get sued, your liability or the damage to your wallet may be contained to the assets within the LLC, not everything else you own. In other words, if an LLC is set up right and you get sued and lose, the creditors probably won’t be able to come and take your personal house or your car or garnish your W-2 job wages. There are ways a judge might pierce the protection of an LLC and go after those things. If every I was not dotted and every T was not crossed. All right.
The LLC is fairly easy to handle during tax time, especially if it’s a single-member LLC, which basically means you own it or you and your spouse. LLC’s are known as pass-through entities, which means the income and expenses flow magically through the LLC, and are instead reported and paid by each individual member on their personal income statement. There is no corporate tax a corporation may pay. This can definitely make taxes easier and less expensive than let’s say, a big C-corp. That said, while a single-member LLC does not require its own business tax return, a multi-member LLC with partners does. Don’t make that mistake.
An LLC is fairly flexible in terms of running it. You don’t need a thousand documents, you don’t need a bunch of stock issued. It’s fairly easy to set up, barely inexpensive depending on where you’re at. So, it’s easy to see why an LLC might be advantageous to a real estate investor. I mean, let’s just say a tenant slips on the stairs, bam, and broke their hip, right? The tenant decides to sue the landlord for neglect, and the court sides with the tenant. For whatever reason, let’s say, your insurance doesn’t cover all the legal penalties and you as the owner are required to pay $500,000 out of pocket to the tenant. Well, if you own the property without an LLC, the tenant could have your wages garnished and force you to sell all your properties and drive you to bankruptcy. You’ll probably end up eating cold beans out of a can under a bridge while pigeons sit on your shoulder.
It’s not a fun place to be. On the other hand, if the owner of that property was the main street investments LLC, then the LLC is the owner getting sued. The courts could make you sell that property, but they likely won’t going to make you sell the other properties owned by other LLCs. They won’t take your primary residence, you won’t be eating cold beans. Of course, this example is a bit overdramatized and unlikely to happen. And I actually don’t mind eating cold beans. But it does illustrate the fear that drives most investors to want an LLC. However, even though it sounds like I might be encouraging you to go get an LLC right now, hold your horses. There are some other important factors to consider. So, LLC’s can be awesome, but let’s talk about the problems with an LLC and real estate.
LLC’s are great. I’m not going to deny that. However, they might not be great for you. There are some fairly important considerations to make before you jump into the LLC bandwagon that could affect your decision. For example, and maybe most importantly, lending on an LLC is almost impossible for residential properties. That’s right. If you plan on using a loan to acquire an investment property like a single or duplex, triplex, fourplex, it’s unlikely you can have an LLC own the property. Most residential lenders simply will not lend on property inside of an LLC, and that makes you have to go to a commercial lender, has higher fees, higher rates, shorter terms, something you probably don’t want to do. Now, many investors simply transfer the ownership of the property into an LLC after purchasing the property in their own name, but that does present some risks as well.
If the bank finds out, and they probably will, due to insurance reasons, they get updated to that. They might call your note due, because of the due on sale clause. Of course, you didn’t actually sell the property, but you did transfer the title from one entity, your name, to another, your LLC. Now, in the past, this has never really been a problem as banks generally turn a blind eye to this, but it seems it could change in the future. And it’s really only expected to get worse as interest rates go up. So, if you plan to go that route, I recommend, speak with your bank, get permission in writing to transfer the property into an LLC. This is really the only way you’ll be truly protected from that dreaded due on sale clause transferring from you to an LLC. All right. One other issue with an LLC, well, ask yourself, what are you really protecting and spending all this time and energy doing?
New investors automatically think they need an LLC to protect themselves, but when you’re first starting out, how much wealth do you really need to protect right then? Think about it, you’ve got a property or maybe two with very little equity. You got car payments, you don’t have six figures in the bank, you want to go through all the trouble to protect your wealth? Now finally, there are also a lot of additional documents and paperwork and hassle when working inside of an LLC. Just something to consider. While LLC’s are definitely easier than corporations when it comes to paperwork and taxes. They still add a lot of complications to the mix. This is especially true if the LLC contains several different unmarried members, as individual tax returns are not enough. You’re going to have to do business tax returns. It’s a mess. Setting up the LLC takes money as well. Maintaining it takes money. Filing taxes takes money. And that property, you’re probably not making that much cash flow anyway.
Think of this, imagine spending two grand a year on this LLC, and the house’s only cashflow is 1200 a year. Yeah, the LLCs can turn a good investment into a bad one. Right? Okay. So, now that you know some of the pros and the cons of LLCs, let me dish out some cold hard truth here to all the new investors. Here’s the thing that I’ve noticed. People like to set up LLCs because it makes them feel like they’re taking action, but in reality, they aren’t. In fact, the idea of an LLC is probably the number one excuse people have for not taking action. I see it almost every day on BiggerPockets. I want to invest in real estate, but I don’t know what to do about an LLC. So, I’m going to sit on the couch and eat cold beans. Now, help sir. Right? The truth is, people, use the concept of an LLC as an excuse so they don’t have to take action. Because it’s easier to say, I don’t have an LLC yet so I can’t go and invest than it is to say, I’m scared.
However, LLCs are no substitution for taking action. If you don’t have any wealth to protect, maybe you don’t need an LLC. And when you find yourself building wealth and creating a sizable business, well then maybe that’s when an LLC will come in most handy for you. By that time you’ll be able to afford the proper attorneys and CPAs who can handle setting the LLC upright. And maybe at that time they’ll tell you that you really don’t need one, or maybe you do need one, or maybe they’re going to set you up with something completely different. You’re not going to know unless you ask. All right. Finally, let’s talk about some of the other options besides LLC’s.
How do you protect your assets if you decide not to get one? Right? What should you do instead of an LLC? Looking back at the three main benefits of an LLC, there’s the tax efficiency, limited liability, and operational flexibility. So, what other legal structure can help you protect yourself from losing personal money if you get sued? And it’s easy to manage and pay taxes? I’ll suggest two things. Insurance and leverage. Let’s talk about both. Number one, insurance. That’s right. Good insurance can help you avoid eating cold beans under a bridge with the pigeon, right? Get the right insurance and get enough of it. Talk to a good insurance agent about your options, and let them know your fears. They’ll be more than happy to sell you the best policy possible. Two, leverage.
When someone is going to go sue you, what is their goal? To get as much money from you as possible, of course. That’s why leverage can actually be a large help in protecting your assets. By leverage, I mean, having little equity, low down payments. For example, if you owe 100 K on a property and the property is only worth 110 K, you are likely leveraged pretty high, right? People often look at that like it’s a bad thing, but asset protection is actually a huge benefit. What kind of lawyer is going to go after someone, spend hundreds of hours litigating and force them to sell their rental, only to have no blood to be squeezed from that turnip?
On the other hand, if you own a rental property free and clear, and it’s worth 110 K, suddenly the idea of suing you becomes much more exciting for an attorney, because they know there’s a ton of money for them to take. I’m not saying you should go up there increase the leverage on every property you own, right? That’s why we have insurance. But, what I am saying is that when you’re first starting out, you’re likely going to be highly leveraged. Thus, you’re not a very big target for lawyers to come after. The question still remains, should you get an LLC? Well, you’re not required to have one general, but I want to end this section with an answer that everyone hates. I don’t know. Talk to an attorney and a CPA.
CPA because only they are going to be able to tell you if you’re ready for an LLC. It’s a powerful legal entity, but only if it’s set up correctly, and only if it actually benefits you. And there is no easy way for me on this video to tell you what the case is in your life. However, I would encourage you not to let the LLC question stop you from moving forward with your real estate ambitions. Don’t let it be an excuse. Don’t let the fear of a lawsuit stop you from achieving your dreams. If you want an LLC, go get one. Go ask the right person.