What are the fundamental mistakes investors make when forming a real estate LLC?
Investing in real estate offers many lucrative advantages compared to other investment vehicles. On the other hand, it can also expose real estate investors to risks and pitfalls they never knew existed. That said, forming a real estate LLC (limited liability company) is one of the more important things investors can do to safeguard themselves from outside interference.
A real estate LLC is a corporate structure that aims to not only shield you from being sued if things go awry but protect your personal assets such as a home, personal bank account, or investments. By forming a real estate LLC, investors and their respected businesses will be viewed as two separate entities in the eyes of the corporate world, helping to protect them from being personally liable in case of debt or lawsuit from the business. Along with protection, a real estate LLC offers unique tax advantages to investors, as well as the flexibility to accommodate their growing business demands.
What Is A Real Estate LLC?
An LLC for real estate is an established legal entity that allows investors to purchase and own real estate in such a way that protects them from personal liability. This means that the investor buys and sells real estate and conducts other business in the name of the LLC rather than as an individual. If any outside entities or individuals make a claim, the individuals behind the entity can avoid personal liability. Also, property owners are allowed to establish individual LLCs for each separate property, meaning that they can avoid cross-liability between properties.
Real Estate LLC vs. Liability Insurance
If investors decide that the process of forming an LLC is not worth the protection it will provide if they were to face a lawsuit, they can choose to rely on liability insurance instead. Liability insurance is an affordable option, but these policies can be risky as they will include exceptions and limits to the protection they offer. Overall, LLCs are becoming increasingly popular due to the benefits they offer real estate investors.
Limit Personal Liability
One of the biggest benefits that LLCs offer investors is a limit to the personal vulnerability they would face if a lawsuit were raised against the property they own. For instance, if an investor personally owns a property, they would be named in the lawsuit, leaving their personal assets vulnerable in the legal proceedings of the case. However, if an LLC owns the property, investors can reduce their personal liability in a lawsuit. Instead of having to defend their personal assets, the liability of the case would fall on the LLC, creating a protective barrier between the investor and their personal property.
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How To Set Up A Real Estate LLC In 6 Steps
Starting a real estate investment LLC has risen in popularity in the past decade, namely due to the unique benefits that cannot be ignored. Forming a real estate LLC is not difficult; rather, it is a matter of doing your research and getting organized. The following is a brief overview of the required steps, which can vary by state.
Research your state’s regulations on forming a LLC.
Pick out a business name and run a search to make sure it doesn’t already exist.
File an “Articles of Organization” document that can be found on your Secretary of State homepage.
Create an Operating Agreement for your LLC, which outlines how your entity will be organized and run.
Find out whether your state requires you to publish an intent to file through your local newspaper.
Obtain any necessary business licenses and permits, as well as apply for a tax identification number through the IRS.
The formation of an LLC will vary slightly from state to state, with fees and regulations being subject to change. Most investors choose to incorporate within the state they conduct business, though some opt for areas with more “relaxed” business laws like Delaware or Nevada. Do note that if you have a physical presence or do business across states, you will have to register a foreign LLC in each of these places. Selecting a state is entirely up to you; be sure to research the process before actually getting started. All of this information will be available on your area’s Secretary of State website.
Choose A Business Name
The right business name is more fundamental than you might think. Not only does it need to attract potential clients, but it must also be unique to register as an LLC. Write out a few potential options before going online to check their availability. One of the best tips to follow as you name your business is to avoid pigeonholing yourself. Starting an LLC is only the beginning of your real estate business, so choose a business name with potential. Once you have some candidates in mind, make sure they are not already taken. The most common reason LLC applications are rejected is because of problems with business names.
[ For more information on choosing the right business name, be sure to watch this video. ]
File Your “Articles Of Organization”
The Articles of Organization for an LLC is essentially the blueprint of a business. It should state the company name, primary address, start date, business owners (called “members”), and a brief description of the business. As I mentioned above, the specificities can vary between states. With that in mind, make sure you include each of the required parts before submitting your Articles of Organization to the Secretary of State’s office. This is also the part of the process where business owners must pay any fees associated with starting an LLC. It may take a few weeks to hear back from their office, but there should be no issues with approval if everything is submitted properly.
Create Your Operating Agreement
Not all states will require an operating agreement, though it is not a bad idea to create one as part of your business plan anyway. The states that do require one include California, Delaware, Maine, Missouri, and New York. While the other states have different rules, an operating agreement can actually come in handy no matter where you live. Essentially, it states how the business is divided among members and how decisions will be made within the company. Further, it can also describe what would happen if one member decided to leave the company. One of the biggest perks of starting an LLC is that it can offer protection from several negative situations. The same logic applies to an operating agreement: it protects business members by anticipating possible scenarios that could harm the business structure.
Publish An Intent To File
There are only three states that require an intent to file: Arizona, Nebraska, and New York. This means that if you are forming an LLC in one of these three states, you are required to publish an ad in your local newspaper stating your intention to create an LLC in that state. Generally, investors will publish ads over three to six weeks in a newspaper. The newspaper will then send back an Affidavit of Publication, which will need to be submitted to the Secretary of State’s office.
Obtain Licenses And Permits
A real estate investment LLC is typically not the only designation you will need to open your doors for business. Almost all states will have separate licenses and permits that are required before conducting business. These can include a general business license, sales tax permit, professional license, and more. Again, your questions on this part of the process can typically be answered with a little online research. I recommend starting with the U.S. Small Business Administration’s website and going from there.
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6 Fundamental Mistakes To Avoid When Starting A Real Estate Investment LLC
While forming a real estate LLC is immensely important for protection, the beginning stages of setting it up can also be massively intimidating for beginners. Also, there are several common mistakes that investors make along the way. To better assist in understanding the complexity of a real estate LLC, the following outlines the biggest mistakes people need to avoid when forming an LLC:
Not starting the process of forming your LLC before pursuing new deals.
Selecting the wrong LLC structure for your business.
Commingling personal and business funds, or engaging in unethical practices.
Not consulting a professional on the best corporate and tax structures for your business.
Omitting the proper steps and due diligence recommended when forming an LLC.
Underestimating ongoing costs and maintenance to keep the LLC up and running.
1. Waiting To Form Your LLC
The purpose of a real estate LLC is to legally separate yourself from the business. When first getting started, even if you haven’t completed a deal yet, it’s imperative you begin the necessary steps of forming a real estate LLC. This investment umbrella will supply investors with the real estate LLC benefits of asset protection and allow them to immediately reduce their taxable income with business-related expenses. The addition of a real estate LLC can also help to legitimize an investor’s business credibility, as this corporate structure will provide an element of professionalism and trust that other competitors won’t have.
Along with pulling the trigger early on an LLC, it’s also important for beginner investors to understand that individual state laws govern LLCs. This means that, depending on the state you registered your LLC in, the filing requirements and protection they offer will differ from state to state. For example, Nevada is a popular destination to establish a business LLC, as the state offers optimal asset protection laws.
2. Ignoring Corporate Layers
Another mistake that investors commonly make when forming a real estate LLC is choosing the wrong LLC structure. As a result, investors may not be taking full advantage of all tax breaks available to them.
Generally speaking, LLCs are “pass-through” entities, which means owners pay taxes on the company’s profits through their own income tax filings. This basically allows investors to bypass corporate taxes, including double taxation. However, because there are many different investment options in real estate, from buy and hold, rentals, rehabs to wholesale, it’s important to note there are also subsidiaries of LLCs.
A real estate LLC subsidiary allows investors with diverse investments to spread their company’s assets across different business entities, helping to further reduce risk. This practice is pretty straightforward and similar to forming a real estate LLC. For more information, including rules for starting an LLC, investors are recommended to visit SBA.Org.
3. Piercing The Corporate Veil
The primary benefit of forming a real estate LLC is the entity’s ability to provide distance between you and the business while not relinquishing control.
Although forming a real estate LLC can provide an assortment of benefits, including liability protection, it can also be denied if mishandled. An LLC is simply the shell of a corporate structure, which means it will not be enough to avoid personal liability. This corporate shield can be shattered for those who engage in fraudulent activity or, most commonly, co-mingling personal and business funds—leaving you vulnerable to liability. By co-mingling funds, it makes it extremely hard to prove that your LLC is, in fact, a separate entity from you. That said, the importance of separating business and personal finances is second to none, as this small side-step can breach the conditions of a real estate LLC.
4. Not Hiring A Professional
There’s a time and place to do everything yourself as an investor, but not when it comes to the legal or tax segment of your business. The importance of consulting an attorney and a tax advisor is undeniable, as these experienced professionals will provide the best advice moving forward.
As a real estate entrepreneur, it’s important to remember that your skillset lies somewhere else. Although learning information on corporate structures and tax loopholes has its place, your time and effort are better spent in other departments of the business. Leaving it to a professional will allow you more time to concentrate on taking your business to the next level. With the right team and people in place, your real estate LLC will not only cement your position as a business, including full protection but put it in a position to achieve every tax benefit available.
5. Lacking Due Diligence
Far and away, the biggest mistake investors make when forming a real estate LLC is failing to conduct the necessary due diligence. While starting a business takes time, effort, and motivation to successfully achieve, it can all be erased (and more) without the appropriate legal structure in place. Taking the proper steps, including planning and precaution, is vital when starting your real estate career, especially when forming a real estate LLC. Remember, this important step encompasses both how you and your business will be taxed and how it will be protected in the case of legal issues. Taking the time now to understand the fundamentals of an LLC and how it applies to you and your business will put investors in the best position to succeed, both now and in the future.
6. Underestimating The Cost And Commitment
Whether they realize it or not, aspiring entrepreneurs will be required to make a lengthy commitment to simply keeping the LLC up and running; it’s not a one-time deal. Following the initial creation of an LLC, business owners will need to spend time and money each year to keep it operational. That said, far too many new entrepreneurs underestimate just how much the commitment is.
According to James Gilmer with Harbor Compliance, entrepreneurs need to know what they are getting into before they register for an LLC.
“We encourage entrepreneurs to look into the ongoing requirements for keeping their LLC in good standing. For example, franchise tax obligations can be costly, such as in California where it’s $800 per year per LLC. Most states also require an annual report filing, which while fairly straightforward, can cause fees and penalties if not filed on time. While these are necessary costs of doing business, entrepreneurs should factor this into their budgets and plan ahead,” says Gilmer.
Real Estate LLC FAQs
Due largely to their complex nature, only seasoned business owners tend to understand the “ins and outs” of what LLCs are and how they are formed. Prospective investors, on the other hand, are often clueless about how these legal entities work. New investors aren’t awarded the luxury of years of experience, nor are the concepts at play easy for them to digest. As a result, far too many of today’s real estate investors learn about the legal structure of their own companies through trial and error, which is risky, to say the least.
Instead of subjecting one of the most important aspects of any real estate business to unnecessary risk, investors are better off learning from their predecessors. Specifically, investors could benefit immensely from asking the right questions, not the least of which are outlined below:
Can You Buy Real Estate With An LLC?
Real estate companies structured under an LLC are allowed to buy real estate. In fact, LLCs afford investors one of the most versatile vehicles to shelter their taxes and protect their assets. With the help of an LLC, savvy business owners may even be allowed to keep more of the money they make when it comes time to file their taxes.
Why Should You Put Rental Property In An LLC?
Not only should rental properties be placed under an LLC, but each property in a respective portfolio should have its own separate LLC. Not only will filing as an LLC award investors with great tax benefits and asset protection, but each subsequent LLC will provide another layer of protection. In addition, setting up an LLC for each property will “insulate” them from each other, effectively reducing risk.
What Is The Best State To Form A Real Estate LLC?
While the best state to form a real estate LLC is subjective and dependent on an investor’s personal aspirations, Nevada is a great place to set up a real estate LLC. In addition to awarding business owners the many benefits associated with today’s LLCs, those formed in Nevada are awarded an extra layer of protection. Specifically, Nevada allows LLCs to form what’s known as a “Series LLC.” According to LegalZoom, “The Series LLC allows for the erection of limited liability shields within the LLC. For example, a real estate LLC might hold several properties and set up a series LLC in a manner that prevents one property from being foreclosed upon to satisfy the debts of another property.”
Do You Have To Live In The Same State As Your LLC?
Real estate companies are pretty much free to set up an LLC in any state they choose, with a few exceptions. It is common for business owners to file in the state they currently work in to avoid confusing tax requirements, but sometimes it may be worth it to file in a different state. Take the state’s tax laws into consideration when deciding for yourself.
How Much Does It Cost To Form A Real Estate LLC?
The cost of forming a real estate LLC is contingent on the state it is filed in and the steps taken to form the entity. Individual state filing fees can vary dramatically but tend to range anywhere from $50 to $500. That price, however, is just the filing fee. Additional fees may be required for your own federal tax ID number or if you hire a lawyer or use an online incorporation website.
What Is The Due On Sale Clause?
The due on sale clause of a mortgage typically requires that the property owner listed on the mortgage documents pay the remaining mortgage balance in full when transferring ownership. Therefore, transferring ownership from an individual to an LLC may violate the due on sale clause, but it is possible to obtain a waiver from your lender before doing so.
Forming a real estate LLC is one of the most important steps an investor can undertake when getting started. It not only protects you and your personal assets but it allows you to reap the tax benefits that you rightfully deserve. While the ability to generate sales and build your business is crucial to success, it is equally (if not more) important to keep it protected at all costs. Investors should remember this act pertains to not just your business but your livelihood as well.
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The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only.