What are the advantages of forming an LLC or corporation for my rental property business?
Forming a business entity for your rental property can offer several important advantages.
You are running a business when you rent property to tenants, whether you realize it or not. A business that you run on your own with no formal business structure is known as a sole proprietorship. If you were to own this type of business with one or more additional people, you would be a general partnership.
Sole proprietors and general partners have personal liability for business debts, meaning that business creditors may be able to come after the business owners’ personal assets. In addition to lenders, people who get hurt on the property and file personal injury claims may seek damages that come from the business owners’ personal assets. You could find yourself in serious debt, or even bankrupt, which makes liability protection one of the most important benefits of forming an LLC or corporation. The business structure shields your personal income and assets from business creditors and other claimants. The corporation or LLC would be liable for the debts and other claims – not you.
A corporation or LLC can provide certain tax benefits. For example, the money you earn from collecting rent payments could put you in a higher income tax bracket, leading to you paying more on your personal tax return. You can help mitigate this by having a business collect the rent and pay you a salary.
Most of the expenses associated with operating a rental property are tax-deductible. This may include anything from purchasing a new refrigerator for a unit in your building to making repairs to the front door. Operating as a corporation or LLC can make it easier to claim these expenses as tax deductions.
It is important to choose a business structure carefully if tax benefits are your main goal. The IRS treats each type of business entity differently:
- The default type of corporation is known as a “C corporation” or “C-corp." It pays corporate tax on its income. While corporate tax rates are often lower than personal rates, shareholders are also required to pay tax on the distributions they receive from the business. As a result, the corporation’s income could be taxed twice.
- A corporation that chooses “S-corp” status can avoid double taxation. The income “passes through” to the shareholders, who pay income tax on their share of the profits.
- LLCs typically receive tax treatment that is similar to S-corps. Owners, known as “members,” pay income tax on their share of the profits.
- A single-member LLC is a “disregarded entity” for federal income tax purposes. The LLC member enjoys all of the liability protection of an LLC, but they report all business income and deductions on their personal tax return.
Please note that there might be some negative tax consequences if you form a business entity, depending on your situation. For example, you may have to pay self-employment tax in certain situations. You can reach out to a Rocket Lawyer network attorney for affordable legal advice and answers to questions about your specific situation.
Hiring employees or workers
A separate business entity can be helpful if you want to hire employees. You might want to hire a person who can run the property on-site, for example, instead of a third-party property management company. A corporation or LLC keeps your legal responsibilities as an employer separate from your personal finances.
How does liability protection from business formation differ from liability insurance?
A business structure provides more comprehensive liability protection than an insurance policy, although the best liability protection strategy is to have both. A liability insurance policy covers certain types of losses, such as the cost of legal defense associated with personal injury claims for injuries sustained on the property. If you are a sole proprietor with liability insurance, expect any claim that exceeds your policy limits to affect you personally. A plaintiff whose claim exceeds what your insurance provider has promised to pay may come after your personal assets.
If you operate your rental business as an LLC or corporation, all claims go to the business – not you. A plaintiff who has exhausted your insurance benefits can only go after business assets.
Am I required to transfer my rental property to an LLC or corporation?
After forming a business entity, property owners often transfer the title to the property to the new business. This makes the property a business asset and ensures that the landlord can keep it separate from their personal finances. You are not required to transfer the property to the business entity, but doing so generally provides the most complete liability protection.
Transferring the property to the business entity can be complicated when the property has a mortgage in your name for the following reasons:
- You are personally liable for that debt, and the lender may not let you off the hook just because you formed a corporation or LLC. In all likelihood, you are going to remain personally liable for paying the mortgage.
- Many residential mortgages have “due on sale” clauses that require payment in full when you sell the property. Transferring the title to your new business entity might trigger this clause. Be sure to speak to your lender about this and see if they are willing to allow you to transfer the title without calling in the balance of the loan. One option is to refinance the loan in the new company’s name, although the lender may require you to sign as a guarantor.
As the recipient of the property, the new business is required to agree to take over any payment on an existing mortgage. You can do this rather easily if you are the only business owner. Your Single Member LLC Operating Agreement, for example, could include an agreement to pay the mortgage.
This type of transfer may also have tax implications. If the property has appreciated in value, the IRS might view this as a sale that is subject to capital gains tax in some situations. A tax expert can help advise you of your options in this case.
What happens to my existing leases with tenants after I formalize my business structure?
Typically, a buyer is required to honor current leases after closing on the sale of real estate. If you sold your rental property to someone else, any existing leases would be binding to them. They would not be able to make any changes until the end of those lease terms. The same applies if you transfer your rental property to your new business entity. In that case, the corporation or LLC would become the landlord and would be subject to the same terms as before the transfer. It inherits the right to collect rent but also the obligation to maintain the property in livable condition. You may want to note in your official business documents that any existing contracts are to remain in force.
Each state has its own laws governing landlord-tenant relationships. Most, or perhaps all of them require you to notify your tenants of a change in ownership. While the transfer of the property does not immediately affect their rights as tenants, it could affect them in the future, such as when it is time to renew the lease. It’s also important for them to know because they are going to be required to start making payments to the business entity instead of you.
More questions? Ask a lawyer.
If you’re considering the benefits of forming a legal entity for your rental property business, a good way to get started is to complete an Articles of Incorporation Worksheet or Limited Liability Company Worksheet. If you have questions about how to incorporate your rental property or whether it’s the right move for your business, contact a Rocket Lawyer network attorney today for affordable legal advice, or reach out to our business services experts to get more information about the different entities.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.