A limited liability company, or LLC, is one of the most common corporate forms in American business. It is relatively easy to establish and allows individuals or small groups to do business under a corporate name. Investment LLCs, in which you form a company that does nothing but hold and move assets, are particularly popular. An LLC can also protect you from personal liability if the investment goes badly. When it comes to the high risk/high reward world of real estate investment, that’s an extremely valuable quality.
Consider working with a financial advisor as you invest in real estate.
What Is a Limited Liability Company (LLC)?
An LLC is a corporate entity that can legally own assets, take on debt, pay taxes and otherwise financially operate in the same way as an individual (an idea known as “corporate personhood”). When someone does business as an LLC, or any other corporate entity, it’s the organization which makes and spends money, executes business decisions and otherwise takes all corporate actions.
Corporate entities exist for several reasons, but the two most important are debt and shared enterprise. Working as an LLC allows multiple people to operate a business together.
For example, many law firms operate as an LLC. This means that the lawyers involved can share revenue, costs, clients, cases and all other business operations jointly through the company that they created. They don’t need to negotiate over depositing checks into personal accounts or splitting the bills among individuals. Instead, the company can collect and make payments, then share out the profits to its members.
Perhaps more importantly, like most corporate forms, an LLC also allows you to separate the business’s liabilities from its leadership. An LLC acts, essentially, as a barrier between the individuals who run the business and the business itself. This means that when the company takes on debt, leases, contracts, lawsuits, risk and other liabilities, only the LLC itself owes any payments. The LLC’s creditors can pursue anything that the company owns in order to collect a debt, but they can’t pursue anyone’s personal assets.
This becomes particularly important if the business goes bad. If an LLC owes more money than it can pay, often it will have to wind up operations and make whatever payments it can with the money it has left. Once that process is finished, though, that’s the end of it. No creditor can chase those payments through to the individuals who started or ran the company.
Readers should note that this is how debt and LLCs ordinarily works. However, in some cases, such as when the individuals use an LLC to conduct their personal finances or in cases of fraud, creditors can sue the individuals behind the company. The details of this process are beyond the scope of this article.
Debt protection is one of the main reasons that people use an LLC. It protects you, personally, from being sued in case the business goes badly. Liability is limited to the company’s assets only.
Using an LLC for Real Estate Investing
For individuals, an LLC is particularly valuable when it comes to investing in real estate. Property is one of the most popular forms of major asset investment for individuals. Whether you want to flip houses, lease apartments or just rent out a vacation home, it’s common for people to put their money into real estate holdings.
The trouble, however, is that real estate is often a speculative and risky market, though return potentials are quite high. So when real estate goes well, you can make a lot of money. When it goes badly, however, you could be holding a mortgage worth more than the market will pay for that house.
This is where an LLC comes in. When you form a real estate LLC, the company buys each property, not you. In quite literal terms, the LLC will own the property.
This also means that the company also owns all of the property’s liabilities and debt. If someone gets injured and sues on the property, for example, they cannot touch your personal assets. If the LLC ends up holding an underwater mortgage, the bank cannot come after your personal accounts. In short, your money is entirely separate from the LLC’s liabilities. However, this is also why many banks will not directly lend to a newly formed LLC.
The most your real estate LLC can ever pay is the cash it holds. If it owes more than that, a creditor can get a lien on the company’s property. In rare cases, creditors can force the LLC to liquidate and sell the property to pay its debts. But what they can’t do is collect your cash, place a lien on your home or liquidate your assets.
For investors who hold more than one piece of real estate, it is common to form a separate LLC for each piece of property. This separates liability even further. If someone gets hurt at Property A, they can’t sue for any income from Property B. Liability is limited to the specific property involved, while all the rest of your properties stay insulated.
So long as each piece of investment property you hold is in an LLC, you can keep your personal assets safe from creditors and prevent liability from crossing between properties. This does not, however, generally work for your primary residence. For several reasons, putting your primary residence in an LLC rarely protects you from liability and debt on that asset.
How to Create a Real Estate LLC
Forming a real estate LLC is not difficult, but it is location specific. Starting a new company of any kind is heavily dependent on the local laws of every state. Each jurisdiction has its own process. While the broad strokes are usually the same, the specific rules in each location are different. If you want to start an LLC, take the following steps.
Most importantly, just like when you make any legal decision, look up the rules in your individual state. We cannot guide you on exactly what steps to take in every state and territory, so make sure you check your rights and responsibilities for yourself. Given the scale and consequence of real estate investments, ideally consult an attorney.
If you have multiple members of your LLC, draft a written operating agreement between parties. Among other things this should specify each member’s role in the organization, it’s leadership structure, how the LLC will divide its net income and how it will divide any financial obligations.
Start with the agency in your state which handles corporate formation. This is often handled by the Department of State, the Secretary of State, or a similar office. With your state’s relevant agency, research the necessary paperwork. This paperwork is generally called your “articles of incorporation.” Once you have these forms you will know the specific information necessary to form your corporation. Most states will require you to have information such as the initial members of the LLC, their addresses, their role in the company, the LLC’s structure, any agents for service of legal process and any addresses from which the LLC will operate.
Also with your state’s relevant agency, look up available company names. Select a name for your company based on what’s available. Once you have a name for you LLC, go to the IRS and file for an Employer Identification Number (EIN). Your LLC will use this EIN to pay its taxes. Fill out the paperwork necessary for your state’s articles of incorporation. File it with the relevant agency. Pay any filing fees associated with these forms. This is typically several hundred dollars.
Bottom Line
Using an LLC allows you to separate your professional and personal liabilities. When it comes to real estate investing, this means that you can buy and operate real estate investments without putting your personal money at risk. It’s a smart approach, and one that many professionals use themselves.
Tips for Investing
- Investing in real estate can be one of the most lucrative long-term investments you can make, but it’s generally the most expensive. That’s why it can make a lot of sense to work with a financial advisor if you want to get involved in it. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re making investments for your future, you may want to determine how much you could earn over time. SmartAsset’s investment calculator can help you get there.
Photo credit: ©iStock.com/Funtap, ©iStock.com/cnythzl, ©iStock.com/Bet_Noire