There are many things to consider before (1) setting up an LLC to own rental property; or (2) conveying a rental property into an LLC. Here are five topics to consider:
#1 – Financing Terms
Financing terms available to individuals are oftentimes more favorable than financing terms available to LLCs, which can make holding the rental property in an individual’s name more attractive. Financing with an interest rate fixed over a 30-year amortization period is not typically available on commercial loans (which are required when the borrower is an LLC rather than an individual).
#2 – Liability Protection
Regardless of whether a rental property is held in an individual’s name or in the name of an LLC, the first line of defense is a good insurance policy and an umbrella liability policy. An owner of rental property should work with a qualified insurance agent to ensure that the owner is adequately protected in the event of an insurable event, such as a tenant’s slip and fall at the rental property or a kitchen fire caused by a tenant. If a rental property owner is looking for additional comfort in protecting the individual’s assets from potential liabilities arising from the rental property, forming an LLC can be beneficial.
#3 – Due on Sale Clause
If a rental property owner currently owns a rental property individually and that is encumbered by a mortgage and the rental property owner desires to convey that property into an LLC, the owner should be aware of the mortgage’s “due on sale” clause. Most, if not all, mortgages have a provision that allows for the lender to declare a default under the mortgage and accelerate the indebtedness secured by the mortgage if the property is transferred, including a transfer to an LLC owned by the individual. Property owners desiring to transfer a rental property into an LLC should be aware of this risk.
#4 – Additional Costs and Complications
Hiring an attorney to form an LLC is a cost that needs to be weighed against the benefits of forming an LLC. In addition, correctly operating an LLC is more burdensome than owning a property in an individual’s name or in multiple individuals’ names. An LLC requires a bank account separate and distinct from the owner’s bank account, and an LLC may require an additional tax return, resulting in added expenses each year.
#5 – Concerns Regarding Joint Ownership
If a rental property is owned by several individuals, the individuals should know that a creditor of one of the individuals could cause problems for the remaining individuals. For example, if Tom, Joe, and Dave jointly own a property and Tom has a judgment obtained against him by his creditor, that judgment may attach to the entirety of the property (rather than only to Tom’s interest in the property), causing issues for Joe and Dave. Joint owners should seriously consider forming an LLC due to this added risk.
There is no “one size fits all” answer to the question of whether to form an LLC to hold rental property; rather, it is a decision that needs to be made by each individual after consulting with that individual’s attorney and accountant.
Eric practices real estate and business law in South Dakota and Iowa, and he can be reached at (605) 553-4675 or email@example.com.
Disclaimer: This newsletter is for educational and informational purposes only. Nothing in this newsletter is to be considered as the rendering of legal advice. Readers are advised to obtain legal advice from their own legal counsel.