Using LLCs to Purchase and Own Rental Property

By Nathan G. Osborn

Nathan G. Osborn is an equity shareholder with Montgomery Little & Soran, P.C. in Greenwood Village, Colorado.

The number of people owning rental properties has been on the rise. With an increasing demand for rental properties, especially residential properties in urban areas, more people see the advantages of owning and managing rental properties. Similarly, with the soaring costs of homes in the United States, just about anyone with the means to do so is getting into the market of renting real estate to others. According to Redfin, in 2022, only 21 percent of homes for sale were “affordable,” meaning that the “monthly mortgage payment would be no more than 30 percent of the county’s median income.” In light of these economic trends, my clients are more inclined to invest in real estate and take on the role of landlord. Owning rental properties comes with risk, however, so many people turn to limited liability companies (LLCs) to protect

their personal assets and reduce their potential liability. The insulation from personal liability risk, ease of administration, and potential tax benefits make ownership of real estate investment property through an LLC a desirable option.

This article will explore the increasing trend of owning rental properties and the advantages of owning rental properties in LLCs, and explain why owning a rental property in an LLC is an intelligent business decision that attorneys should frequently recommend to their clients.

Increasing Demand for Rental Properties

The rising demand for rental properties is one of the primary reasons for the increase in rental property ownership. With the increasing cost of homeownership, many people are choosing to rent instead of buy. This shift has led to a surge in demand for rental properties, especially in urban areas, where housing is typically expensive and in short supply. The increase in remote work also has led to a growing number of renters looking for affordable housing in which to live and work (or, out of which to work). With the need for rental properties growing, many people have contacted real estate attorneys for advice about their new rental property businesses.

Initial Step—Understanding the Contemplated Business

When an attorney is helping a client determine the best business structure, the attorney should ask several key questions. First, the attorney should inquire about a client’s business goals and plans for growth because different types of structures may be more suitable for businesses with different plans and goals. For example, a client who wants to purchase a single property is ideal for an LLC. In contrast, a multi-jurisdictional real property investment company with plans for significant growth might prefer a corporate structure. The attorney should also ask questions about the client’s personal financial situation. Renters are a liability, and the client should shield themself from liability to the extent possible. Indeed, clients with significant assets should ensure that a slip-andfall judgment from their rental property does not impair their personal wealth. LLCs can protect a real estate client.

The attorney should ask about the client’s tax situation and whether the client has preferences regarding tax treatment. For example, a client may be operating at a loss initially, and the client may want to avoid taking the monetary losses personally. In this situation, a corporate structure may be preferable. A landlord will need to pay taxes on rental profits, and determining how these profits are taxed is critical when selecting the best business structure. Relatedly, the attorney should determine whether the client has foreign investors because foreign-based owners are not legally permitted to hold stock in S corporations. Another helpful initial point of information is where the client intends to operate the rental business. Indeed, for convenience and efficiency, clients should consider establishing an LLC in the state where the real property exists because the client will need to file a tax return there.

After asking the introductory questions and receiving answers, the attorney likely will advise clients to put their rental properties in an LLC and incorporate the LLC in the state where the real property is located. Using LLCs for ownership is an effective way to protect the client’s personal assets from potential liability and a practical way to streamline your client’s rental property business.

Liability Protection

Owning rental properties can be a lucrative investment but it comes with potential liabilities. Landlords can be held liable for accidents or injuries on their properties, which can put their personal assets at risk. This is where LLCs come in. When real property is owned by an LLC, the owner’s risk exposure is insulated by the protection of the company, leaving only the LLC’s assets subject to creditors (as opposed to the owner’s personal assets). In short, this means that the members’ personal assets are protected from the liabilities of the LLC. In the event of a lawsuit against the LLC, the members are not personally responsible for the debts or obligations of the business. Instead, the liability is limited to LLC assets that, in the case of a real estate LLC, would likely include the LLC bank account and the real property owned by the LLC. This protection is one of the main advantages of forming an LLC; the business structure can shield members’ personal assets from legal claims incurred by the real estate company.

Notwithstanding the reduction in exposure that an LLC provides, LLC liability protection is not absolute. There are certain events in which members’ personal assets still could be at risk. For example, the personal assets of an LLC’s members could be at risk when a court “pierces the corporate veil” and holds members of an LLC personally liable for the obligations of the real estate business. “Piercing the corporate veil” can occur if the LLC is perpetrating fraud or its members have co-mingled personal and business funds and affairs. Lenders also may require personal guarantees before funding a loan for the business. This means that if the real estate business cannot repay a loan, the lender may seek repayment from the LLC members personally.

Similarly, members of an LLC could be personally liable for unpaid taxes, especially if the members engaged in tax evasion. LLC protection might also be circumvented if, for example, a sole owner member files for bankruptcy.. In the Colorado case In re Ashley Albright, 21 B.R. 538 (Bankr. D. Colo. 2003), the debtor was an individual and a sole member of an LLC. The LLC did not petition for bankruptcy. During the bankruptcy proceeding, a trustee took over the LLC, and the court found that the trustee held all rights to the governance of the LLC (including rights to sell real estate to pay off creditors) over the debtor’s objection. Here, despite the perceived protections of the LLC, the trustee was still able to, essentially, collect a corporate debt from an individual.

While certain specific events could place member assets at risk, members can still help shield their personal assets from most types of business-related liability by forming an LLC and owning real estate in the LLC structure .

Tax Advantages

Owning real estate in an LLC can offer several tax advantages for the LLC members. The most significant tax advantage of an LLC is the owner’s ability to have pass-through taxation. C corporations are subject to double taxation—once at the corporate level and then again when dividends are distributed to shareholders. Income and capital gains from a real estate LLC pass through directly to the owner, who has to pay taxes only as an individual. Hence, real estate LLCs can avoid double taxation on rental income and appreciation in value. Also, rental income is considered passive income, subject to a lower tax rate than ordinary income. Multimember LLCs also enjoy pass-through taxation because the LLC passes profits and losses through to its members, who report and pay taxes on only their portion of the profits and losses.

Real estate investors who own property in an LLC may make numerous tax deductions as part of their real estate business, including mortgage interest, insurance, property taxes, maintenance costs, property management fees, advertising expenses, legal fees, travel and mileage expenses, and software, tools, or other real estate support expenses. These expense deductions can help reduce the taxable income of the LLC members. LLCs also have great flexibility in how to allocate revenue. Indeed, through the operating agreement, members can allocate income to minimize their personal tax liability.

The LLC member can use depreciation to reduce taxes. The IRS sets a lifespan of a residential structure at 27.5 years. To that end, owners can deduct 1/27.5 of their property’s building value each year. The member can also depreciate capital improvements to the property.

Likewise, if the operating agreement of the LLC correctly specifies how the member interest is conveyed upon death, when the client dies the property will pass to their heirs. Hence, the first $12.92 million of the client’s estate is tax-free. Accordingly, an LLC member’s heirs typically can sell the property and keep the proceeds tax-free.

A client who owns property in an LLC should take advantage of like-kind exchanges, meaning an investment property exchanged for other investment property of “like-kind.” The IRS does not recognize like-kind exchanges as a gain or loss under the Revenue Code Section 1031. Properties are “likekind” if they are of the same nature or character, even if they differ in grade or quality. Real property is generally “like-kind,” though real property in the United States is not “like-kind” to international real property.

When selling LLC real estate as part of a 1031 exchange, the proceeds from the sale must go to a qualified intermediary rather than to the seller. The qualified intermediary holds the funds until the funds can be transferred to the seller for the replacement property.

A 1031 exchange of an LLC property also allows the members to take advantage of depreciation. Depreciation is the percentage of the cost of an investment property that the LLC can write off , recognizing the effects of wear and tear. When a property is sold, capital gains taxes are calculated on a “net-adjusted basis,” which includes the original purchase price plus capital improvements minus depreciation. Section 1031 allows the client to “re-set” depreciation because, if a property sells for more than its depreciated value, the client may need to recapture the depreciation. The amount of depreciation will be included in the client’s taxable income. Because the amount of depreciation increases over time, the client can avoid a significant increase in taxable income via recapture if the LLC conducts a 1031 exchange. These tax savings, once again, would be passed along to the individual members.

Operating Agreements and the LLC

A limited liability operating agreement is a legal document that outlines the ownership structure, management, and operating procedures of an LLC. Under applicable law, the members typically have great flexibility when deciding upon the terms of the operating agreement. Indeed, one of the great advantages of a real estate LLC is the immense amount of freedom of contract.

By way of example, when delegating management responsibilities, LLCs have greater flexibility than most other business entities. Indeed, through an operating agreement, an LLC can easily be managed by owners or third parties—whereas corporations must have officers and directors. There is also flexibility in the distribution of profits, unlike in a corporation, which requires pro rata distribution to the shareholders. The LLC provides an opportunity to reward someone for sweat equity, such as real estate promoters who do not have investment cash. The LLC can also be a great estate planning device for family-owned property. For example, the owner of a family ranch could instead have an LLC own the ranch, and the LLC could eventually pass along to a member’s children in a pro-rata fashion.

Capital Contribution Provisions

Essential provisions in a real estaterelated LLC operating agreement include carefully drafted capital contribution provisions, among others. Capital contributions are the money and assets given to the business by members. Members are often required to contribute capital to an LLC. The operating agreement should set forth the amount of required capital contributions, if any, and the timing of payments. Members should set forth which capital contributions will be used and which will be paid back. Operating agreements often provide that members contributing extra amounts will get a “preferred return.” This “preferred return” can be distributed before any pro-rata distribution to non-contributing members.

The client should also address provisions that deal with situations in which the LLC needs future capital in addition to the initial capital contributions, as this is a common situation in real estate deals. One option is for the LLC to obtain a loan, so clients should set forth the loan application process in the operating agreement. The operating agreement should outline requirements, such as who has the right to obtain a loan, the loan amount, and for what purposes a loan may be permitted.

An operating agreement can require an additional capital contribution if, for example, amounts are needed to pay construction loans, to eliminate safety hazards via alterations or repairs on the property, or to pay off mechanic’s liens. One way to make capital contributions mandatory is to allow for a “preferred return” on the required contributions.

An operating agreement should outline how to pay construction-related fees if the client’s real estate venture involves construction. If the cash flow cannot cover the construction costs, the operating agreement must make clear whether the LLC must pay these costs through a capital contribution or a new loan or by decreasing the members’ distributions to assist with the construction payments. Mandatory additional capital contributions are especially important if the investment is premised on improvements. An operating agreement also may make the additional capital contributions non-mandatory.

Usually, the manager decides whether the LLC needs an additional capital contribution. If there is more than one manager, the operating agreement should provide for dispute resolution when the managers disagree. This dispute resolution should provide quick resolution because additional capital calls need to be made and agreed upon quickly. A good idea is to assign a third-party arbiter who can decide quickly for the LLC.

The operating agreement should provide for penalties in the event a member cannot make a mandatory

additional capital contribution. Initially, the paying members could pay the non-paying member’s share. Then, the LLC could make a loan to the nonpaying member at a high interest rate. The loan can be satisfied by the next round of member distributions. Another option is to dilute the interest of the non-paying member then to recalculate each member’s share based on the total capital contributed previously and under the capital call.

Crafting Distribution Provisions to Share Real Estate Profits

The goal of forming an LLC is for it to become profitable. A return can be made on this investment via a salary for employees of the LLC, capital gains from a sale, or, very frequently, from distributions. Distribution provisions should be outlined in the operating agreement. The LLC can distribute pro rata by capital invested, by membership interest, or by a more complicated formula. In a real estate deal, equity investors and managers may receive distributions based on the performance of the LLC. It is common to have project promoters receive large distributions if the project succeeds. These distributions encourage “sweat equity.” “Waterfall” distributions are standard in real estate deals—a formula where there are tiered distributions. The first people get paid, then the distributions pour over into the second level, and so on. A minority member would want mandatory distributions on a set basis (i.e., quarterly). Sometimes, however, it is better for the real estate LLC if the timing of distributions is discretionary (i.e., when the client has cash available to distribute). The client can cause the manager to make discretionary distributions, which allows for distributions when the LLC has cash flow instead of mandating distributions when there is little money to distribute.

Member-Managed or ManagerManaged?

The operating agreement should address whether the entity is member-managed or manager-managed. As described, member-managed LLCs are managed by their members. All members typically are involved in the operation and management of the business. All members then can also bind the entity and make decisions on behalf of the entity, often without a vote (subject to the terms of the operating agreement).

Manager-managed LLCs grant the power to make decisions to an appointed manager (sometimes a third party). The manager is defined by agreement and typically set forth within the operating agreement. A manager can be another entity. The applicable law often will default the entity to being member-managed if the client does not appoint a manager or the operating agreement is silent on the issue.

A member-managed LLC is best if all the members want to be involved in the decision-making process, the client does not have an operating agreement, or there are few members. A managermanaged LLC is generally more suitable if the client wants only specific individuals making decisions, some members want to be passive owners, some members do not have the requisite expertise, or there are so many members that the management would become too complicated.

An advantage of owning rental properties in LLCs is that it can simplify the management of the properties. An LLC can have multiple members, each with distinct property management responsibilities. This can help distribute the workload and reduce the stress and time commitment of managing rental properties.

Conclusion

Rental property ownership is an increasingly popular investment choice, driven by the rising demand for rental properties. Owning rental properties in LLCs offers numerous advantages and risk protections, such as liability protection, tax benefits, and, if provided by a well-written operating agreement, a flexible management vehicle. Indeed, the LLC is a good idea for anyone considering owner rental properties and should be recommended to real estate clients accordingly.