Why would you buy a property under an LLC?
The pros and cons using a legal entity instead of your own name to purchase real estate.
This last weekend I was talking to a buddy about a house he was putting an offer on. I told him to negotiate on a few minor items directly with the seller who was probably a more reasonable person than his stubborn Attorney. But he mentioned that he has no idea who the owner is because the property is owned by an LLC and the Broker and Attorney are handing every detail. I have previously read some articles about Russian Oligarchs and Celebrities that owned home under LLC’s, but I always figured it was useful for some kind of tax loophole. This piqued my curiosity. Why would someone choose to buy a property under an LLC? What are the benefits and drawbacks? I decided to delve into the topic and share my findings with you.
Understanding the Basics of an LLC
An LLC, or Limited Liability Company, is a type of business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. This means that the company's profits and losses pass through to the owners' personal income without facing corporate taxes, while the owners are protected from personal liability for the company's debts and obligations.
When it comes to real estate, buying a property under an LLC has become a common strategy, especially for investors and rental property owners. But why is this the case? Let's explore the advantages and disadvantages of this approach.
Advantages of Buying Property Under an LLC
Privacy
One of the main reasons individuals and businesses opt to buy property under an LLC is for privacy. When a property is purchased under an LLC, the business's name, not the individual's, appears on public records. This can be particularly appealing for public figures or those who value their privacy. It ensures that your personal name is replaced with a corporate name on public records, offering a layer of anonymity.
Limited Liability
Another significant advantage of buying property under an LLC is the limited liability protection it offers. If the LLC faces debts or lawsuits, the owners are typically not personally responsible. This is particularly appealing to real estate investors who may face potential lawsuits related to their properties. This is probably appealing for investment properties and any flip projects you may be taking on where significant work will be done to the property. However, it's important to note that this protection isn't absolute. If you live in the property owned by your LLC, it could potentially weaken the LLC's liability protection. You would need to consult with an attorney to understand the nuances of a single family property vs. living in one of the units of something like a 4-plex.
Estate Planning
Buying a property under an LLC can also offer benefits in terms of estate planning. Instead of having to file a new mortgage or deed of trust, you can transfer your home to your family by adding them as LLC members or increasing their percentage of ownership in the LLC. This can simplify the process of passing down property to the next generation.
One of the key benefits of using an LLC in estate planning is the ability to consolidate assets. By transferring assets such as real estate, stocks, and other investments into an LLC, you can manage these assets under one entity. This can simplify the management of these assets and make the transition smoother upon the owner's death.
Another significant advantage is the potential for tax benefits. When assets are held in an LLC, the profits and losses pass through to the owners and are reported on their personal tax returns. This means that the LLC itself does not pay taxes, avoiding the double taxation that can occur with corporations. Furthermore, when the owner of the LLC passes away, the beneficiaries may benefit from a step-up in basis, which can reduce the capital gains tax if the assets have appreciated in value.
However, it's important to note that using an LLC for estate planning is not without its complexities. For instance, transferring personal assets into an LLC may trigger a taxable event. Additionally, while an LLC can provide liability protection, this protection may not be absolute. For example, if the LLC is sued, the assets within the LLC could be at risk.
Moreover, while an LLC can be an effective tool for estate planning, it's not suitable for everyone. The costs and administrative requirements of setting up and maintaining an LLC may outweigh the benefits for some individuals. Therefore, it's crucial to consult with a financial advisor or attorney to understand the implications and determine if an LLC is the right strategy for your estate planning needs.
Disadvantages of Buying Property Under an LLC
While there are clear advantages to buying property under an LLC, there are also some potential drawbacks to consider.
Higher Costs
Setting up an LLC can be costly due to various fees, including legal fees and the cost of filing the LLC's articles of organization. Additionally, there may be ongoing costs such as annual LLC taxes, yearly report fees, registered agent fees, and business license renewal fees. It's important to factor in these costs when considering whether to set up an LLC for property purchase.
Limited Financing Options
When it comes to financing a property purchase through an LLC, the options are quite different from those available to individual buyers. Traditional mortgages, which are often the go-to for individuals purchasing a home, are typically not available to LLCs. This is because mortgage lenders view loans to LLCs as commercial loans, which carry different risks and terms. If you're in a position to pay for a property in cash, the process is somewhat simpler. The LLC would simply purchase the property outright. However, it's important to note that while this eliminates the need for a loan, it also ties up a significant amount of the LLC's capital in the property. This could limit the LLC's ability to invest in other opportunities or cover operating expenses.
Personal Mortgage vs. LLC Mortgage
A personal mortgage is a loan given to an individual or individuals based on their creditworthiness. The lender considers factors such as personal credit score, income, and debt-to-income ratio. On the other hand, an LLC mortgage is considered a commercial loan. The lender will look at the financial health of the LLC, including its credit history and income. The LLC's members may also need to personally guarantee the loan, meaning they would be responsible for the debt if the LLC defaults.
If you are going to pursue a commercial loan, the Debt Coverage Ratio (DCR), also known as the Debt Service Coverage Ratio (DSCR), is a key metric used by lenders when assessing a commercial mortgage application. It measures the ability of a property's income to cover its debt obligations, including mortgage payments, property taxes, insurance, and maintenance costs.
The DCR is calculated by dividing the property's Net Operating Income (NOI) by its total debt service. The NOI is the income generated by the property (such as rent) minus operating expenses (excluding debt service). The total debt service includes all annual debt obligations, such as mortgage payments.
For example, if a property has an NOI of $120,000 and a total debt service of $100,000, the DCR would be 1.2 ($120,000 / $100,000 = 1.2).
Lenders typically look for a DCR of at least 1.2 to 1.25, meaning the property's income covers its debt service by 20% to 25%. A DCR below 1 indicates that the property's income is not sufficient to cover its debt obligations, which would be a red flag for lenders.
In the context of an LLC purchasing a property, the lender would calculate the DCR based on the property's income and expenses, rather than the personal income and expenses of the LLC's members. This is another reason why commercial loans often have stricter requirements and less favorable terms than personal mortgages. The lender is relying on the property itself to generate sufficient income to repay the loan, rather than the borrower's personal income. Now you need to build out a business plan for your property if you are going to use it as a rental and include market rates for rents or Airbnb fees.
It's important to note that while the DCR is a critical factor in a lender's decision, it's not the only one. Lenders will also consider the property's location, condition, and market trends, as well as the LLC's credit history and the financial strength of its members.
The terms and interest rates for commercial loans are often less favorable than those for personal mortgages. Commercial loans typically have higher interest rates, require larger down payments, and have shorter terms. This means the monthly payments will be higher, and the loan will need to be refinanced or paid off sooner.
Multi-unit Property vs. Single Family Home
The implications of buying a property through an LLC can also vary depending on the type of property. For example, if you're purchasing a multi-unit property, the income generated from renting out multiple units could potentially offset the higher costs associated with a commercial loan. Additionally, multi-unit properties are often viewed as commercial properties, even when purchased by an individual, so buying through an LLC may not change the financing options significantly. The clear cutoff between individual financing and commercial financing is anything larger than a 4-plex.
On the other hand, if you're purchasing a single-family home through an LLC, the higher costs of a commercial loan could be more of a burden, as there's only one unit to generate rental income. This would be the case if you are using the home as a vacation rental or Airbnb. However, purchasing a single-family home through an LLC could still offer significant liability protection and potential tax benefits.
Tax Implications
Buying property under an LLC can have various tax implications. One of the main benefits is the pass-through taxation, which allows the LLC's profits and losses to pass through to the owners' personal income, avoiding double taxation. However, this can also lead to higher personal income taxes if the property is profitable.
On the downside, buying property under an LLC can potentially limit your ability to take advantage of certain tax benefits available to individual homeowners. For example, you may not be able to deduct mortgage interest or property taxes in the same way you could if the property was in your personal name.
Piercing the Corporate Veil
One potential pitfall of buying property under an LLC is the risk of "piercing the corporate veil." This term refers to a situation where a court determines that a business and its owners are not truly separate entities. This could occur if the owner of an LLC mixes personal and business affairs, potentially resulting in the owner being held personally responsible for business debt. To avoid this, it's crucial to keep finances strictly separate, which includes having separate bank accounts and separate recordkeeping.
Additionally, The IRS has a rule known as the "14-day or 10% rule" for determining whether a property is considered a personal residence or a rental property for tax purposes. According to this rule, if you use the property for more than 14 days in a year, or more than 10% of the total days it is rented to others at a fair rental price, it is considered a personal residence.
So, if you stay in the property for more than 14 days in a year, or more than 10% of the total days it is rented out (whichever is greater), it would be considered your personal home for tax purposes. This could have implications for how you report rental income and expenses on your tax return, and it could also affect your ability to claim certain tax deductions.
However, it's important to note that this is a tax rule and may not necessarily apply to other areas of law. For example, local zoning laws or homeowners association rules may have different definitions of what constitutes a primary residence versus a rental property. NYC is particularly strict about primary residence for the purposes of local city income tax. It's always a good idea to consult with a tax professional or real estate attorney to understand the specific rules that apply to your situation.
Buying a House with an LLC: The Process
The process of buying a house with an LLC isn't too different from purchasing one under your name. However, there are some differences you'll want to know. For example, you'll likely need to open a business bank account, which may require obtaining an EIN (Employer Identification Number).
Once you find a home, your LLC will make a formal offer. Although you will be acting as a representative of your business, it's crucial to make it clear to the sellers that the LLC will ultimately be making the purchase. So, instead of listing your personal information in the offer letter, you would include your LLC’s name and address.
When the seller accepts your offer, you'll write a check (using your business bank account) and sign the sales contract as the owner of the LLC and not the actual purchaser. So, any related documents should list the LLC (not you) as the official homeowner.
Conclusion
Buying a home with an LLC can be great for privacy, liability protection, and estate planning—especially if you're looking into real estate investments or rental properties. However, keep in mind, that costs can be high, and living in the home can significantly reduce your LLC’s liability protection.
So, if you only have one home, living in a house owned by your LLC will probably create more of a headache than real perks for the average person. But, if you have a significant need for privacy or asset protection, then jumping through the maze of hoops might be worth it for you.
While buying a property through an LLC can limit your financing options and potentially increase your costs, it can also offer significant benefits. It's important to carefully consider these factors and consult with a financial advisor or real estate attorney to determine the best approach for your specific situation.
Have you ever purchased a property through an LLC? If so - what was your rationale? Please leave your feedback in the comments below.