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3 Business Structure Mistakes Real Estate Investors Make

Real Estate Investment LLCStarting A Real Estate Investment LLC

Why have an LLC?

There are mainly two reasons why you want any kind of business structure:

Pay less tax, and protect your assets. LLCs can be especially helpful if there are multiple owners of a property. When you create an LLC, you’ll create an operating agreement that outlines the rights and responsibilities of each member of the LLC.

This can help you seamlessly manage your rental property business and also protect each member of the LLC in case of legal trouble.

Before you jump into creating your LLCs for your real estate holdings, there are a few things to consider.  Do NOT make these three mistakes while creating an LLC for your real estate investment company.

1. Forming The Wrong Real Estate Investment Company and/or In The Wrong State

Sometimes people get confused about their real estate investments and what the IRS considers them to actually be doing. You could be a real estate dealer, which means you flip or wholesale properties. You could have a real estate business, which means you rent out property for short stays and provide substantial services, like a motel or some types of vacation rentals. You could be a developer which means you buy property and make changes to it before it is sold or put in service. Or, you could be a regular real estate investor and hold property that has long term renters (commercial or residential).

You first need to know what kind of real estate investor you are.  You will use different tax strategies and different types of structures depending on the type of investment.  For example, if you’re a real estate dealer, you have a business and that means you want an entity that is taxed like an S Corporation or possibly a C Corporation.  Flipping houses or flipping burgers…you have a business.

Forming LLC For Rental Property

If you have long term rentals, you will most likely want a single or multi-member LLC for your rental property business.  If you are investing from Canada, you’ll want an LP (limited partnership).

Bottom-line, know exactly what you’re going to do first and then decide the right structure of your real estate investment comany.  If you need to close quickly on a property and want an entity right away, your best bet is to use an LLC.  An LLC can decide later what type of taxing structure it should have.

The second part of this is setting up the entity in the wrong state. LLC’s are regulated at the state level, so the process of creating an LLC will differ state-by-state. Make no mistake, one way or another you need to have legal authority in the state in which your property is located.  If you buy a property in Ohio, you need an OH LLC or you need to authorize your out-of-state LLC to do business in Ohio.  (In effect, you’ll pay twice that way – once to the state that has your LLC and once to Ohio.)

If you don’t get your entity set up or authorized in the state of your property, you won’t have any legal standing for possible tenant issues.  One way or another, you have to have an entity in that state.

Benefits of LLC For Rental Property

1. If you create an LLC, then the only assets at stake are those owned by the LLC. In other words, your rental property is the only asset at stake and not your personal finances. This is very beneficial in case of you face any law suits.

2. If you create separate LLCs for your rental properties or portfolios, then each property or portfolio becomes a separate legal entity. In this way you can insulate each property from liability claims by setting up separate LLCs for each property. The benefit of setting up separate LLCs is that if someone files a lawsuit pertaining to one of your properties, then the rest of your properties will not be affected by the lawsuit. This effectively separates and protects each of your rental properties from a single lawsuit.

3. Setting up an LLC can lead to paying less taxes. With an LLC, you get the benefit of the company’s income passing through to you as the business owner. Essentially, all income made by the LLC of your rental property will flow through to your individual income tax return. This minimizes the amount of money taken out of your income for taxes.

4. When you create an LLC for your rental property, you should create a separate bank account for your LLC. This makes it easier to claim business expenses when it comes time to do your taxes. It will be very clear to you when you check your bank statements which expenses are business and personal.

2. Real Estate Professional With Wrong Structure

How to become a real estate professional?

The short answer is that if you want to claim real estate professional status (and all the great tax benefits), you have to be a named manager in a manager-managed LLC. If you tried to do-it-yourself with an online LLC set-up or used someone to set up your LLC who doesn’t understand real estate tax law, you could have a problem.

3. Not Setting Up Real Estate LLC Operating Agreement

The #1 mistake when setting up an LLC is failure to prepare the real estate llc operating agreement.  Most of the online do-it-yourself websites mention it, but don’t give you the tools to do it.  Remember the manager-managed LLC is the type of LLC you need for your real estate investments if you ever want to take the “real estate professional” status.

Once the entity is set up, that’s not the end of it.  You need to continue to maintain the LLC with proper state and federal filings.  Plus you need to give proper notice in your business dealings.  Don’t sign contracts with just your name, use your name plus your title (i.e. Manager of ABC LLC).

Are there only 3 possible mistakes?  Of course not, but these are the most common.

  1. Comment by Jennifer
    March 8th at 4:52 pm 

    As to mistake #1. If you have a property management for a rental unit, would it matter if your LLC is held out of state? The property management in that state that is managing property should be represent you in legal issues?

  2. Comment by Marco Santarelli
    March 8th at 5:03 pm 

    Jennifer — Your property manager will only represent you when it comes to tenant/landlord related laws and issues. They are not attorneys and will not represent you on legal issues outside their scope of service. You’d need an attorney for that. When it comes to property related legal issues, you’ll want your LLC in the same state as the property, or registered in that state.

    Continued success!

  3. Comment by Jeremy
    March 9th at 4:44 am 

    Thanks for the information! Should an investor file state taxes in the state where the property is located (and LLC was formed)? Or does everything just pass through to his/her personal return in his/her home state?

  4. Comment by Admin
    March 9th at 1:26 pm 

    Hi Jeremy — if you set everything up properly, you will have disregarded entities and therefore there is no state tax form to file. Income and expenses flow straight through to your personal tax return.

  5. Comment by Rob
    March 10th at 7:49 pm 

    Great article! What entity should an investor use if they own a vacation rental that is being managed by a management company?

  6. Comment by Marco Santarelli
    March 13th at 11:12 pm 

    Hi Rob,

    In almost every case, it’s best to hold title to property in a LLC. Most asset protection attorneys would suggest this. I’m not giving you legal advice, but this is the best way in my opinion and the way I do it too.

    Continued success!

  7. Comment by Wes Thompson
    April 5th at 6:13 pm 

    Hi Team-

    Thanks again for the article. I own rental properties (in my home state) and have a management company managing those. Since the management company “does all the work”, I’ve been told that any liability could “pierce the corporate veil”, because law would identify the LLC as solely existing for liability purposes — so that the actual asset protection does not exist. They are all on my personal return, but I have an umbrella policy which I use for the corresponding asset protection.

    Does anyone have experience with actual liability in an “owner only” LLC where a management company is used? I’m just trying to confirm what a reputable attorney has shared with me in the past.

  8. Comment by Marco Santarelli
    April 5th at 6:25 pm 

    Hi Wes — that’s a very good question. Not one I have an answer to unfortunately. I hate to say it, but I’d check with a competent legal advisor who specializes in asset protection.

    I’d be curious to know what you find out. 🙂

  9. Comment by Jose
    April 18th at 9:24 pm 

    Regarding asset protection … I have several rental properties owned by a few single member LLCs. My accountant does my taxes putting all my properties in the schedule E and not mention any of my LLCs on my taxes. I am not sure if that is correct? And on the asset protection point of view that will be considered co-mingling, correct? What will be the best way to do my taxes as all my LLCs has one member (me) and not do comingling?

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