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How To Start Investing For Financial Independence, Part 2
Last week, we started a multi-part series about how to go from being a beginning investor to being “financially independent” in a steady and predictable way. Many, many people want to overly complicate this process so let's briefly, let's recap...
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Should You Use an LLC for Your Real Estate Investing? Probably--and Here's Why
Accountants and attorneys love limited liability companies. But
do limited liability companies--LLCs for short--really make
sense for real estate investors. Probably they do for two almost
unknown reasons.
The Big Legal Benefit of an LLC: Limited Liability...
The big legal benefit of an LLC is that limited liability
companies provide all the same liability protection as a
corporation--but with much less red tape. A regular corporation,
for example, requires regular stockholders meetings, a board of
directors, regular board meetings, and of course records of all
these activities and bodies. But a limited liability company
doesn't.
This legal liability protection provided by an LLC can be
extremely valuable. One local attorney I often collaborate with,
for example, tells his clients that an LLC protects real estate
investors from the worst case scenario--which in his mind is a
"slip and fall" accident on the investor's property.
With an LLC as the property owner, so says my attorney friend,
the "worst case scenario" is liquidation of the LLC. That
liquidation means the people who own the LLC wind up with
nothing--which isn't good. But all the owners lose is what
they've invested in the LLC.
In comparison, without an LLC, the real estate investor's
"worst case scenario" if there's a "slip and fall" accident is
that the owner or investor can lose almost everything they own.
In other words, the business owners or investors could lose not
only their investment in the real estate property but many other
assets.
Let me issue a caveat here, however. You may not get as much
legal liability protection from an LLC as you want or hope. Say,
for example, that you're repairing the roof on your apartment
house and that, unfortunately, you happen to drop a hammer onto
the tenant's head during the roofing project. Your LLC probably
won't protect you from that sort of tort liability. In other
words, the tenant can probably look not only to your LLC for
payment of damages related to the dropped hammer but also to you
personally.
And here's another example, which unfortunately makes things
even murkier. What happens if someone working for you, one of
your employees or subcontractors, drops a hammer on the tenant's
head? The LLC may offer you some protection in this case. But
you may still be personally responsible. The tenant might
reasonably argue that you should have done a better job managing
the employee or subcontractor, for example.
If you're extremely concerned about the asset protection
features of setting up and operating an LLC, get an attorney
involved in your real estate investment planning. An attorney
knowledgeable in LLC and real estate law can help you increase
the liability protection that you gain from using an LLC for
your investing. And this consultation doesn't need to be
particularly expensive. You may be able to buy an hour or two of
time from a good local attorney and get all your LLC- and
liability-related questions answers.
The Big Tax Benefit: Enormous Tax Flexibility...
A second benefit of LLCs relates to the income taxes that
investors pay on profits and capital gains. A limited liability
company can be almost whatever tax entity it wants to be for
income tax purposes. A limited liability company that is owned
by one person can be a sole proprietorship, a C corporation, or
an S corporation. A limited liability company that is owned by
two or more persons can be a partnership, a C corporation, or
even an S corporation (if the LLC meets the S corporation
eligibility requirements). This second benefit of the limited
liability company means that an LLC can choose to be taxed in
whatever way is most favorable to the investment or the owners.
For example, a very small real estate business with a single
member (LLC owners are called "members"), might decide to be
treated as a sole proprietorship for federal income tax
purposes. This decision to be treated as sole proprietorship
would
keep the business's accounting very simple--and it would
also mean that unique tax planning opportunities available to
sole proprietorships can be used.
A larger real estate investment fund--perhaps one with several
partners--might decide to operate as a C corporation or as an S
corporation in order to take advantage of some of the unique tax
planning advantages of these entity choices. A C corporation,
for example, often lets businesses provide rich tax-free fringe
benefits to employees including shareholder-employees. And an S
corporation often lets a business dramatically reduce the
self-employment, social security and Medicare taxes paid on the
owner's profits.
Note: While a limited liability company is not difficult to set
up by yourself--you can have the paperwork done less than a
quarter hour from now--you should be aware that paying a few
hundred dollars to an accountant to pick the right taxation for
your new LLC might be the best investment you ever make. It's
common that the right taxation choice for a new LLC can save the
owner or owners of a small business $10,000 to $20,000 annually.
The Drawbacks of the Limited Liability Company Choice
When you consider the two big benefits of a limited liability
company--limited liability but with less red tape and tremendous
tax flexibility--you have almost the perfect investment entity
choice. So an obvious question is "Why wouldn't every investor
use an LLC or limited liability company?"
Perhaps predictably, there are some costs and headaches
associated with operating as an LLC.
An LLC may increase your banking, accounting and insurance
costs. For example, while the bank account for a sole
proprietorship or informal partnership may be free if you keep a
large-enough balance, the bank account for a limited liability
company probably won't be free. The bank may charge $10, $20,
even more each month.
While a sole proprietorship or informal real estate partnership
may be able to keep its bookkeeping and income tax return
preparation very simple, an LLC probably needs to file its own
tax return if the LLC operates as a partnership, a C corporation
or an S corporation. And this LLC tax return may cost anywhere
from a few hundred dollars to a few thousand dollars annually.
Finally, it's worthwhile to note that an LLC may involve
several hundred or even a few thousand dollars of startup
expense. For example, you may spend money on publications like
this. You may buy the services of accountants and attorneys. You
will need to print new letterhead, business cards, and envelopes
(if you use these) that use the new LLC's name in order to show
the world that you're now operating as a limited liability
company.
So where does all this leave you? How should you balance the
big benefits of forming an LLC with all the costs and drawbacks?
Unfortunately, I can't give you a one-size-fits-all answer.
You'll need to carefully consider the benefits and costs as they
add up in your specific situation.
I will share these thoughts, however. In my opinion, an LLC is
uneconomical for very small real estate investments--unless
there is only a single owner. For example, a real estate
investor who owns one single-family home may not want to
shoulder the hundreds of dollars of cost (or more?) incurred in
setting up and operating an LLC. (Remember that this investor
can use liability insurance to reduce his or her risk, too.)
On the other hand, any time you've got a large real estate
investment--say multifamily housing--or any time you've got
substantial wealth, an LLC economically reduces investment risk
and as an added bonus can even save the owners thousands of
dollars a year in income or payroll taxes.
About the author:
Bellevue WA CPA Stephen
L. Nelson is the author of both Quicken for Dummies and
QuickBooks for Dummies and an adjunct tax professor for Golden
Gate University's graduate tax school.
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