Holding an investment property in a Limited Liability Company (LLC) is a common strategy among real estate investors. This approach can offer several benefits, but it also comes with potential drawbacks. Understanding these advantages and disadvantages can help you make an informed decision about whether an LLC is the right structure for your investment property.
What is a Limited Liability Company?
A Limited Liability Company or "LLC" is a business entity created by Massachusetts law by drafting and filing Articles of organization with the Massachusetts Secretary of the Commonwealth. It is also recommended that you contact an experienced attorney to draft an operating agreement, which will serve as a guide for future acquisitions, voting rights, succession plans, and potential disputes. In Massachusetts, an LLC can be formed by one, single member, or have multiple members. When creating an LLC, you do not need to specify the exact legal purpose of the new entity, but pursuant to M. G. L. c. 156C § 6(a), an LLC may be formed “for any lawful purpose" which provides flexibility for the managing members.
Advantages of Holding an Investment Property in an LLC
1. Limited Liability Protection
One of the primary benefits of an LLC is the protection it offers to its owners (called members). If the property is involved in a lawsuit or incurs significant debt, the personal assets of the LLC members are protected. This means that only the assets owned by the LLC (including the investment property) are at risk, but not the members' personal assets.
To illustrate this benefit with an example, let’s say that you own an investment property that you rent out to one single tenant. You setup a single member LLC that is the title holder of this property. If your tenant slips and falls and suffers a serious injury as a result of an issue with the property, they will likely attempt to sue you as the landlord to recover the damages suffered. However, because this property is held in an LLC, the tenant only has legal standing to sue the LLC directly. If the tenant wins the suit, any liability is only incurred by the LLC, and not you personally, as the sole member. This means that when the judgment is rendered, your personal assets, such as your primary residence or your car, are protected from being used to satisfy the judgment. Only the assets of the LLC can be subject to the judgment because the LLC that holds the property is treated by the state of Massachusetts as its own unique, standalone entity. That said, as the managing member of the LLC, you will of course be obligated to satisfy the judgment. But the protection of the LLC does not force you to use your personal assets to satisfy the judgment or any subsequent judgment lien.
2. Pass-Through Taxation
LLCs benefit from pass-through taxation, where the income and losses of the LLC are passed through to the members and reported on their personal tax returns. This avoids the double taxation that corporations face, where profits are taxed at the corporate level and again when distributions are made to the shareholders as dividends. LLC profits typically flow through to each member based on the percentage of ownership in the LLC itself; however, the operating agreement can outline the profit-sharing arrangement, and be set at whatever allocation the members agree to.
3. Operational Flexibility
LLCs offer flexibility in management and operations. Unlike corporations, which have strict requirements for governance (such as a board of directors and formal meetings), LLCs can be managed by the members or by appointed managers, offering a simpler structure. LLC’s can even be formed and managed with one, single member. These types of LLC’s are typically created for the sole purpose of holding and managing real estate investment properties. Due to this flexibility, many real estate investors opt for creating a unique LLC for each individual investment property that they own, rather than one single LLC that owns several properties. This creates an added layer of protection by insulting any potential legal claims brought against a single property from the entire real estate portfolio as a whole. However, members, especially single-member LLC's, must be very careful not to use the LLC as a mere facade for their own personal dealings or abuse the overall LLC structure, otherwise the limited liability advantage previously outlined can be lost (known as piercing the corporate veil).
4. Estate Planning Benefits
An LLC can be incorporated into your overall estate plan. By holding property in an LLC, you can transfer ownership interests to heirs in a structured manner, potentially avoiding some of the complications and taxes associated with probate. Just like with a Will or a Trust, in your LLC operating agreement you can name successor members or managing members. In this way, you do not own the real estate in your own name, so the property will not be subject to Massachusetts Probate or Intestacy laws. For more information about the Massachusetts Probate process, click here to read our legal blog. Instead, the managing member that is named as the successor in the operating agreement will automatically take over the LLC upon your death.
For non-Massachusetts residents, there can be additional benefits to placing your Massachusetts investment property into an LLC for estate tax purposes. If you own Massachusetts property but are a resident of another state that does not have state-level estate taxes (such as New Hampshire or Florida), placing your property into an LLC makes that property an "intangible" asset pursuant to M.G.L c.156C § 38. which states in full: "The limited liability company interest is personal property. A member has no interest in specific limited liability property.”
Massachusetts has its own state-level estate tax exemption, which is currently set at $2 Million Dollars. The estate tax still applies for non-residents that own Massachusetts real estate. This means the Massachusetts property held in an LLC would not be includable in the calculation when determining estate taxes due for non-residents owning Massachusetts property, which could otherwise be as high as 16%. This arrangement is highly complex and we strongly recommend reaching out to the attorneys at Lane, Lane & Kelly to learn more if you are a non-resident that owns Masschusetts real estate.
5. Enhanced Credibility
Operating an investment property through an LLC can enhance your credibility with lenders, tenants, and other business partners. It shows that you are serious about your investment and have taken steps to protect and manage it professionally.
Disadvantages of Holding an Investment Property in an LLC
1. Formation and Maintenance Costs
Forming an LLC involves initial setup costs, which can include state filing fees, legal fees, and other related expenses. In Massachusetts it costs $500 to file an LLC Certificate of Organization. Additionally, there are ongoing costs for maintaining the LLC, such as filing the annual report each year which also costs $500. The annual report must be filed online each year to maintain the LLC’s legal status and good standing, and to avoid any potential penalties. Additionally, an LLC is still required to file an annual tax return despite its pass-through structure. Once filed, each member is then given a K-1 indicating how much profit or loss they are directly responsible for, which is attributable to them on their own personal tax return.
2. Financing Challenges
Securing a mortgage for a property held in an LLC can be more challenging than obtaining a personal mortgage. Lenders often require personal guarantees from the LLC members, which can negate some of the liability protection benefits. This means that if the LLC defaults on the loan, the lender can hold each member jointly and severally liable for the outstanding mortgage debt. Interest rates and loan terms may also be less favorable for LLCs compared to individuals.
If there is a mortgage already on the property, transferring title into the name of the LLC can also be difficult as it may violate the loan’s “due-on-sale” clause. This clause allows the lender to demand full repayment of the loan if title is transferred to an individual or entity that is not explicitly referenced on the loan document itself. The applicable statute that outlines exceptions to when a due-on-sale clause may be triggered is the Garn-St. Germain Depository Institutions Act of 1982 (12 U.S.C. §1701j-3). For a full overview of the Garn-St. Germain Act, you can read our legal blog here. Before transferring your property into an LLC, be sure to consult with your lender directly to obtain their consent.
3. Potential Tax Disadvantages
While pass-through taxation can be a benefit, it can also be a disadvantage if the LLC generates significant income. Members may face higher personal tax rates than they would if the income were taxed at the corporate level. Additionally, certain tax deductions and benefits available to corporations may not be accessible to LLCs. Members of the LLC will likely be required to pay self-employment tax on any income earned from the LLC. This can be avoided, however, if the LLC elects S-Corp status with the IRS.
4. Complexity in Ownership Transfer
While LLCs can simplify estate planning, they can also complicate ownership transfer if not structured properly. Adding or removing members requires updating the operating agreement and may involve legal assistance to ensure compliance with state laws and the LLC's governing documents. In a multi-member LLC, you also need to be sure that the operating agreement addresses member turnover in the event that a member wishes to leave and cash out their shares. The agreement will also govern whether the member has the right to sell their shares and ownership interest to anyone they wish, family members only, or if they have to grant the LLC itself the opportunity to buy back their shares.
The real estate attorneys at Lane, Lane & Kelly can provide you ongoing legal assistance with not only the creation of the LLC, but also with any updates or changes that need to be made down the road. Lane, Lane & Kelly has aided countless businesses with a consultative approach to helping you choose the right type of business, and can create your LLC operating agreement for you.
Final Considerations
Holding an investment property in an LLC can offer substantial benefits, particularly in terms of liability protection and tax flexibility. However, it's important to weigh these benefits against the potential costs and challenges, such as higher formation and maintenance expenses, financing difficulties, and Massachusetts-specific regulations. Consulting with legal and financial professionals can help you determine if an LLC is the right choice for your real estate investment strategy.
By carefully considering both the advantages and disadvantages, you can make an informed decision that aligns with your financial goals and risk tolerance. If you are contemplating holding your investment properties in an LLC and have any questions at all, please contact the attorneys at Lane, Lane & Kelly, LLP today.
This blog is made available for educational purposes only as well as to give you general information and a general understanding of the law, not to provide specific legal advice. By reading this blog you understand that there is no attorney client relationship between you and Lane, Lane & Kelly, LLP.
Please be advised that nothing in this article is intended to be used as specific tax advice. Lane, Lane & Kelly, LLP is not a certified Tax Specialist. For specific questions, please contact a qualified tax expert or accountant. The information in this article is intended for educational purposes only.