By Mark Parkinson
Whether you’re an individual investor with a single rental unit or a group of investors holding many commercial properties, you’re likely to be aware of the advantages of transferring your property to an LLC (Limited Liability Company).
These advantages include:
- Protection: LLCs help protect an owner’s (LLC owners are referred to as members) personal assets, primary residence, cash, and equity in real estate and investment accounts from litigation or debt collection. Furthermore, LLCs can apply for and receive a Federal Employee Identification Number (EIN). This enables a LLC to establish a separate credit rating from its members, whilst not negatively affecting the member’s personal credit status.
- Taxes: Once an investor establishes an LLC, the IRS allows the LLC to pay federal taxes on property revenues as a sole proprietor, partnership, S-corporation, or C-corporation at the federal level. Depending on the size of the holdings and the amount of revenue, this can save the LLC thousands of dollars in federal taxes every year. It should be noted that this is not always true on a state level (i.e., Californian LLC members pay a rate of 8.4 percent or a $800 franchise tax every year).
While putting holdings in an LLC is considered by many a real estate mover and shaker to be a best practice, what is not so obvious is whether a single LLC should hold multiple properties or whether each property should have its own LLC.
I have set up many LLCs for real estate investors and have noticed that many investors automatically set up a new LLC every time they purchase a new property. Conversely, some investors simply amend their existing LLC to add an additional property purchased recently. While there are many reasons to do one or the other, it occurred to me that many investors don’t have a strategy regarding entity and asset allocation.
I set out to poll my real estate friends who are both individual investors and owners of large commercial real estate management companies. I have also drawn on my own past tomfoolery in real estate investing. Our discussions touched on Series LLCs, section 1031 exchanges and related ‘downleg’ and ‘upleg’ properties (to be addressed in a future blog). Although there were many factors affecting their decisions on entity and asset allocation, it became obvious that three factors drove their decision making regarding whether to put multiple assets in a single entity or each property in a single LLC:
1) Lender Driven – If there is a real estate loan on the property, many lending institutions require the property be the sole holding in an LLC. It is not uncommon for lenders to require that the LLC be formed in a specific state (Delaware or Nevada are common). This offers predictability and stability for the lending institution. It enables the lender to protect its asset to the fullest extent and not have ancillary properties, unrelated to the original loan, complicate litigation or debt collection. This is also advantageous to the LLC owner from a standpoint of not co-mingling properties that are owned outright and those, which have a mortgage.
2) Schedule Driven – I found that when an investor had no liens on the property and/or planned to buy and hold the properties for an extended period of time, it was common to have as many as 20 or more real estate holdings in a single LLC. If an owner does decide to buy and sell properties in this single LLC, exercising a 1031 exchange is very common in this scenario.
3) Partner/Investor Driven – When a single LLC has multiple property holdings, it is not uncommon to have multiple members (usually investors) involved in the LLC. If the Operating Agreement of the LLC is not very specific about management of the LLC, it can get complicated when selling or adding a property. Some investors may have brought in a company to the LLC as their contribution, or may have invested money based on the value of a property whose value has changed. Many real estate investors find that when more than one member is involved in the LLC, owning a single property greatly simplifies the sale of that property from an asset allocation standpoint.
The above list is hardly exhaustive or comprehensive. However, considering these 3 factors when purchasing your next investment property or when setting up your next LLC may save you money and stress down the road.
Mark Parkinson works in Incorporation Sales at Rocket Lawyer.