One of the biggest questions RealWealth members ask is whether they should use an LLC for their rental properties and also where they should set up their LLC for the best asset protection. The answer to the first question, which will discuss in detail below, is often a yes for passive investors. The answer to the next question is not that simple, which is why I recently had one of the nation’s preeminent asset protection attorneys on my podcast. He’s also a real estate investor who owns over 200 investment properties, so he really knows what he’s talking about when it comes to asset protection.
He was kind enough to answer a variety of questions asked by Real Wealth Show Podcast listeners and RealWealth members about using LLCs for rental property and other real estate asset protection dos and don’ts. In the article below, I’ve highlighted some of the most important of these questions and their answers.
Is it illegal to have an LLC in another state from where I live?
It’s completely legal to have an LLC in another state from where you live, and it’s actually very necessary. If you’re going to own real estate in another state, take, for example, Florida, then you’re legally required to have an LLC for your rental property set up in Florida or registered to do business there.
For example, if you lived in California, and you own an investment property in Florida, you will need to set-up a California LLC and register it in Florida to conduct business. Your LLC is doing business there. It doesn’t matter where you sit, where you live, and where the entity is located. In the eyes of the IRS, it all flows back to you. You’re going to pay taxes on that money, regardless, so they don’t care where it’s set up.
This line of questioning brings up another frequently asked real estate investor question — what if I wanted to open up a Nevada LLC to save taxes when I really live in California? Is this okay?
Can I set up an LLC in Nevada when I live in another state?
This is a different strategy from the one discussed above. Setting up a Nevada LLC is a tax avoidance strategy which was really popular back in the early 2000s. There was a lot of advertising about setting up entities in Nevada that would allow investors to pay zero tax. People would do this based on the logic that if they owned a Nevada entity they wouldn’t be subject to federal income tax or state income tax on their business that is derived from that particular state.
A lot of Californians set up Nevada entities during this period. They’d run an active business that was actually taking place in California through their Nevada entity to try to avoid all California state tax. Some people even thought that they didn’t have to pay federal tax using this strategy. And the unlucky of those people ended up wearing orange jumpsuits. The lucky ones ended up with huge fines when they were caught.
The moral of the story here is that you don’t want to lie about where you live. At RealWealth, for example, we do business in all kinds of states, but we live in California. No matter what, we have to pay California tax unless we move.
What if I move? Do I have to set-up a new entity?
Yes. If you wanted to change your domicile out of a particular state to a different state, you would have to establish residency in that state. This would typically require that you register to vote there and you get a driver’s license in that state. And most importantly, you’d have to supply utility bills showing that you actually reside in that state for at least six months.
We’ve actually seen issues arise with individuals who claimed residency in Nevada when they were not actually residents there. Nevada would request their utility bills for the six months they said they lived there and they would find there was no water usage and no electricity usage. These people would get in a lot of trouble. A slightly sneaky workaround would be to put your mother-in-law or adult child in your property during that time. This way you’d have a record of the utility.
What does the term entity mean?
An entity is another word for limited liability company, land trust, or corporation. It’s just something that is formed under state law or used for a specific purpose.
We talk about real estate in terms of entities a lot. In this case, we’re looking at a title-holding entity, which is something that is going to hold your real estate for a few different purposes. One of the biggest benefits of holding your rental property in an LLC is for asset protection — if anything happens with the property, you won’t be personally liable. If you get sued individually, for example, your property would be removed from that potential claim. There are also tax motivations for putting your rental property in an entity.
Why do most real estate investors use LLCs for their rental properties?
The reason most real estate investors use LLCs instead of S Corps, C Corps, or other entities is because of the tax benefits the LLC offers an individual who’s a passive real estate investor. This is really important to understand if you want to have proper real estate asset protection.
Basically, you want to have flexibility when moving a rental property so you’re not hit with transfer tax. When you have an S Corp or a C Corp you can be hit by income tax.
Here’s an example:
Let’s say I have three properties in an S Corporation and I decided that I want to pull two of them out and move them to a different company. The properties have appreciated in value over the last 10 years, and there’s $400,000 in gain. Just by deeding that property out to myself, I’ll have to pay tax on that built-in gain even though I didn’t sell it.
With an LLC you don’t have that concern, because you’re typically going to set them up to be either disregarded, which means the IRS just looks through it and you’re considered to be the owner, or a partnership, which, again, the IRS looks through. You’re then going to pay the taxes on the income and you put that income on your 1040. In other words, it’s treated a lot differently than an S or a C Corp because you can move assets in and out without having the built-in gain recognized and taxed.
This is why real estate investors tend to gravitate towards an LLC versus a Corp — it’s one of the best asset protection strategies. They’re also easy to set up and they don’t require a lot of maintenance from you. Basically you can set-up an LLC and a bank account to collect your rents, and then forget about both.
Do the S Corp, C Corp, and LLC offer the same level of asset protection?
When you talk about S and C Corp, what you’re really referring to is federal taxation unless you’re thinking about the actual form of a corporation. From a tax standpoint, an LLC can be treated as a C or an S Corp. From the physical attributes of the entity, if I were to set up an entity in Texas, and I chose to set up a traditional Corporation Inc versus a limited liability company. Let’s say I had an LLC and a corporation and I put one property into each of them. If my Corporation was sued, I’m protected as a shareholder. If my LLC is sued, I’m protected as the member of the LLC.
That’s the distinction between the two. Owners in LLC are members and owners in corporations are shareholders. What’s different is when you yourself get sued. Let’s say you’re driving down the street and you clip somebody that’s on a bicycle, and the bicyclist sues you individually and they obtain a judgment against you for $300,000 for dental work and face reconstruction.
What can they take in that judgment?
What can they do with it?
They can levy on any assets you hold in your own name. Therefore, if you held that rental real estate in your own name, they would just record the judgment in the county where the property is located. It just sits there; it grows its 10% rate of interest. When you sell, they get paid. If you refinance, they get paid.
If you didn’t have any property in your own name, and all you had was a Texas LLC and a Texas Corporation, they have some other ways to recover against you. On your shares of your corporation, they can levy on them and take them because shares are not protected from creditors but they are with an LLC.
They could not levy on your LLC membership interest and take it from you. All they can do is put a charging order, which means that they’re not entitled to anything unless you want to give them something. It’s because of that outside protection that makes the LLC such a unique and favorite entity amongst a lot of real estate investors.
Let's say I buy some rental properties in Florida. Would I want to use a Land Trust in addition to an LLC? What would be the best state to hold the LLC in?
When you’re buying properties you have to look at the state itself to determine the best entity structure for that investment. Using Florida as an example, it would be wise to use land trust as your real estate asset protection strategy rather than an LLC because land trusts in Florida provide protection from what we refer to as inside creditors, meaning your tenants.
If something happens with the property and you have a Florida land trust, they can’t sue you as the owner of the trust. They can only sue the trust. Now where the trust doesn’t protect you is that if you get sued individually. In this case they can take the trust and the property from you. This is why for a Florida investor, it may also be better to have debt on the property, because you also have to worry about doc stamps. If you set up a Florida land trust and transfer the property it can then be exempt from the doc stamp in Florida.
Wondering if you should use an LLC or a Land Trust in your specific state? Click here to become a member of RealWealth and we can connect you with the asset protection attorney who helped me with this article.
Now we can also set-up your Florida land trust to be owned by a separate LLC, maybe a Delaware series, LLC, and create separate cells for each of the land trusts. If you do get sued, they can’t take your land trust from you. If you were to flip that structure and look at Tennessee, then it’s going to be different. Then you would use a series LLC in Tennessee when you’re owning each of the cells, because in Tennessee they have a franchise tax that you have to be aware of.
You also have to apply for the fonts exemption, which is set up in a very specific manner. Tis way you don’t run into a problem.
A friend of mine who’s an attorney explained that a client of his from Florida was working with a CPA and was paying $45,000 a year in taxes that he didn’t have to pay. This happened because the CPA didn’t understand the way taxes worked in Tennessee. Unfortunately, by just creating the structure, you can really screw it up for someone.
In other words, where you set up an entity really depends on where you’re owning the property and what type of structure you’re going to use. This is why people get confused many times. There are also a ton of different strategies. If you’re in California, for example, you might want to use a Wyoming statutory trust to avoid the franchise tax there. If you own 10 single-family rentals you can save around $8,000 a year.
Note: it’s probably not the best idea to try to do this on your own.
At what point do you really need to focus on asset protection using LLCs? What if you’re buying your first property and don’t have a lot of money?
This is a relatively controversial situation, but here’s an example to help you determine the best course of action.
Let’s take two individuals, you and me. I have worked hard, saved up my down payment and now I have my first house. I have about $25,000 in equity in this property and I have a personal residence that has maybe $50,000 in equity. I also have some money in savings. You on the other hand have a hundred properties. Most people are going to look at us and they’re going to say, you need more protection than me because you have more to lose.
Granted, there’s some truth to that. You have 100 properties, I only have one. However, when it comes to protecting your assets, the new investor actually needs asset protection more than the experienced investor. This is counter-intuitive for so many people, but it’s important. If you have one or two properties you really should have each of them in their own LLC. If you own 100 properties, on the other hand, it might be okay to have 5 or 10 properties per LLC.
The reason: well, let’s say you’ve saved for 5 years to buy two properties and you’re planning to use the cash flow from these properties as a large part of your retirement income. If these properties are in your personal name and you get sued… you’re screwed. Assume those two properties generated a combined income of $15,000 each on an annual basis. This means you just lost $30,000.
On the other hand, if you own 100 properties and create an LLC with 10 properties each… so you have 10 limited liability companies, each generating $150,000. If you lose one LLC with 10 properties, you still have nine of the other LLCs producing income for you.
Yes, it would suck to lose $150,000, but your lifestyle isn’t changing because of it. You’re still going to Hawaii. You’re still doing the things that you like to do because that one lawsuit didn’t wipe you out.
Whereas the new investor that’s worked so hard to finally get some purchasing power, and finally grasp the concept of rental real estate, is back to square one or worse yet, they’re behind because they have a judgment that’s been recorded against them that they have to pay off before they’re ever going to be able to qualify for another loan.