Summit Law Blog

When owning a rental property, protecting your personal assets and streamlining estate planning can be crucial for long-term success. One strategy that property owners often consider is transferring their rental property into a Limited Liability Company ("LLC").

An LLC offers a range of benefits, from legal protection to potential tax advantages, and serves as an effective vehicle for protecting you against unexpected legal issues. However, an LLC also comes with costs and important considerations. In this blog post, we will explore the pros and cons of transferring a rental property into an LLC to help you decide whether an LLC would be right for your rental business. 

What is an LLC? 

A Limited Liability Company is a legal entity that combines elements of both corporations and partnerships. It offers personal liability protection for its owners while allowing more flexible taxation options compared to a traditional corporation. 

What Happens When You Transfer a Rental Property into an LLC? 

When you transfer a rental property into an LLC, you create a legal separation between your personal assets and business assets. If done correctly, and with adherence to the necessary formalities and applicable laws (which may vary by jurisdiction), the LLC acts as a protective shield. In the event of a lawsuit, injury claim, or other legal action related to the property, only the assets held within the LLC are at risk, while your personal assets typically remain protected. 

Pros of Transferring a Rental Property into an LLC

• Reduced Personal Liability.

A significant advantage of holding rental property in an LLC is liability protection. When your property is under an LLC, your other assets are shielded from lawsuits or claims related to that property. Thus, if a tenant or visitor sues over an accident or injury that occurs on the property, the lawsuit would be directed at the LLC and the assets within the LLC, not your personal assets or other business assets outside of the LLC in question. 

This protection can give property owners peace of mind, especially in today's litigious environment. However, this protection is only effective if you maintain proper corporate formalities. Failing to follow formalities can result in "piercing the corporate veil", allowing plaintiffs to access your personal assets. 

• Excellent Asset Protection.

Transferring your rental property into an LLC is an excellent asset protection strategy. Ideally, each property should be held in its own LLC. This creates a "firewall" between the properties, so if one LLC faces a lawsuit or debt, the other LLCs (and their assets) remain protected. (e.g., if you own three rental properties and each is in a separate LLC, a lawsuit involving one property will typically not jeopardize the others). 

• Separation of Personal and Business Finances.

Placing the property in an LLC separates personal and business expenses, simplifying accounting and tax reporting. Clear separation makes it easier to track rental income, business deductions, and expenses.

• No Real Estate Excise Tax (REET) on Transfers. 

A common concern with transferring property is the potential tax burden, particularly if the property appreciates in value. However, in many states, transferring a property into an LLC does not trigger real estate excise tax (REET) as long as the beneficial ownership does not change. 

• Tax Flexibility. 

LLCs offer flexibility when it comes to taxation elections. A single-member LLC is a disregarded entity and can be reported on your individual tax return. A multi-member LLC will typically be taxed as a partnership (pass-through taxation), where profits and losses are passed directly to the owners.

Another option is to elect to be taxed as an S-corporation, which may make sense in some situations, including when owners wish to be paid via W2 employment instead of K1s. For many small property owners, pass-through taxation is the most advantageous because it avoids corporate tax rates. 

• Advantageous Estate Planning Tactic. 

LLCs can be a part of an effective estate planning strategy by streamlining ownership transfers and making it easier to bring on new partners, sell partial interests in the property, or transfer ownership to heirs. Instead of transferring the property deed, you can simply transfer membership interests in the LLC. Note that any transfer of a real estate interest is still subject to a real estate excise tax (REET), unless an exemption is met. 

• Professional Image and Credibility. 

Holding rental properties in an LLC can increase the professionalism of your business. Potential tenants, investors, or partners may view an LLC as a more credible, legitimate business entity, which can improve your chances of attracting business partners. 

Cons of Transferring a Rental Property into an LLC

• Transfer Taxes and Title Issues. 

Transferring a property into an LLC may be treated as a sale, which could trigger transfer taxes depending on your state's tax laws. You will also have to pay county recording fees. Additionally, your title insurer may need to approve the transfer to ensure that the title insurance policy remains valid after the transfer, which could result in extra costs or complications. 

• Lender Approval Required for Mortgage Properties. 

Transferring a mortgaged property into an LLC can present challenges. Many standard mortgages contain a "due-on-sale" clause, allowing lender to demand full repayment if the property is transferred to another individual or entity. This means that transferring the property into an LLC could trigger the requirement to pay off the loan immediately, unless you obtain prior approval from the lender. 

1. When requesting consent, explain to your lender that there is "no change in beneficial ownership", meaning that you are still the owner, but simply holding the property under the LLC for liability protection. 
2. Also, before attempting the transfer, ask your lender about their process for approving such transfers! Many lenders are familiar with these requests and may provide guidance on how to proceed without issues. 
3. We must obtain lender consent before proceeding with the title transfer. 

• Formation and Maintenance Costs. 

While an LLC offers benefits, it comes with setup costs and ongoing expenses. You will need to form the LLC with the secretary of state, pay formation fees, and renew the LLC registration annually. Additionally, maintaining proper accounting records and following the required formalities may increase bookkeeping or legal costs. 

• The Need to Properly Maintain Corporate Formalities. 

Maintaining the LLC's liability protection requires keeping separate books for the business and keeping accurate records of all transactions, income, and expenses related to the property. Failing to stay on top of these corporate formalities may result in the loss of the liability protection an LLC provides, a legal concept known as "piercing the corporate veil", which essentially eliminates the LLC's liability shield. 

1. Some key steps to maintain LLC protection include keeping separate financial records for the LLC, ensuring the LLC has its own bank account, and signing contracts in the name of the LLC, not your personal name. (See: Piercing the Corporate Veil).
2. Even with proper formalities, it is still advisable to have a strong umbrella insurance policy in place as an additional layer of protection.

• Limited Financing Options.

Financing options may be more limited for LLC-owned properties. Some traditional mortgage lenders may not issue loans directly to LLCs, viewing them as riskier borrowers. As a result, if you need financing, you may have to seek a commercial loan, which tend to have higher interest rates, shorter terms, and more stringent qualifications. This could impact your ability to purchase additional properties or refinance existing loans in the future. 

• Legal Requirements

You will need to form the LLC with the secretary of state, pay formation fees, renew the LLC registration annually, and comply with any applicable federal regulations (which may include Corporate Transparency Act compliance). 

Is an LLC Right for Your Rental Property?

Whether you should transfer your rental property into an LLC depends on your personal situation, financial goals, and risk tolerance. If you prioritize protecting your personal assets from lawsuits and have a relatively stable cash flow, the benefits of an LLC may outweigh the costs. On the other hand, if you are just starting out or financing the property primarily with a mortgage, the lender implications and additional costs may be more a concern. 

If you do decide to transfer your property into an LLC, it is essential to ensure you use legally compliant residential leases. The lease agreements should be updated so that they are made between the tenant and the LLC, not you personally. We can provide guidance on the best forms of residential leases and resources for landlords.

Summary 

Transferring a rental property into an LLC can be a smart asset protection and estate planning move, but it is not without its challenges. The liability protection, tax flexibility, and estate planning advantages offered by an LLC can be significant, particularly for property owners with multiple properties. However, lender consent, ongoing costs, and the critical need to maintain corporate formalities should not be overlooked. 

If you are unsure whether an LLC is the right choice for your rental property, or if you need help navigating the process, we are here to advise to ensure that your business is protected. We recommend working with your estate planning counsel to ensure any LLC transfers comply with your overarching estate goals. 

If you have any questions, please contact Ada Danelo at adad@summitlaw.com.