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Many investors have probably heard about holding properties in a limited liability company (LLC) but aren't sure about the details of doing so. For a number of investors, the benefits of ownership through an LLC outweigh the drawbacks.

In today's litigious society, for example, many people worry that they could one day find themselves defendants in a lawsuit. In order to protect themselves from legal issues, real estate investors often choose to hold their real estate in LLCs.

"In today's legal environment, people are scared and they want to…protect their investments," Jonathan Alper, a Florida-based asset protection attorney, said. "Ownership interest in the LLC has better legal protections from any other legal problems a person may have than…ownership in their own name or ownership in a corporation," Alper said.

Many commercial lenders favor LLCs, and either prefer to or will only lend to those who set up LLCs to hold title to properties, Richard Keyt, an Arizona-based real estate attorney, said. "They don't want to increase the risk that their borrower can be sued," he said.

The annual fee for an LLC is 75 to 125 dollars in Florida
Creditors can only get a charging lien against an LLC, not the property itself
Additionally, real estate investors should have each high-risk property they own—such as an apartment building or a project that involves a significant amount of construction—in its own LLC, according to Methven & Associates. This ensures that one property's liability will not affect another and can also allow for more accurate insurance coverage, according to Methven & Associates.

But LLCs can do more for investors than just serve as shields from potential lawsuits.

Owning real estate through an LLC can offer real estate investors far better asset protection than they would have if they owned real estate in their own name. "If you own it in your own name, as a sole proprietor, then [creditors can] just grab the property," Alper said.

"[Through] the Uniform LLC Act, which is adopted state by state…the creditor is limited to getting what's called a charging lien against your LLC interest," Alper said. "A charging lien is essentially a lien on any distributions of cash made by the LLC to the membership owners."

"If the LLC distributes nothing…these collection statutes don't provide any other remedy for the creditor," Alper said. "Absent distributions, a creditor gets zero."

Other entities, such as corporations, offer asset protection that is inferior to that offered by LLCs.

"The LLC offers better protection than do corporations," Alper said. "If you own real estate inside a corporation, you get corporate stock, and the creditor can just grab the stock and thereby immediately take all your interest in the corporation and all your interest in the property."

"The cons are that it's more complex than owning property in your own name, because you have another entity. You have a filing fee, you have a legal fee…to create the entity. I don't think there are too many cons other than the…fees," Alper said.

There are recurring fees on top of the initial fees required to form an LLC, however. The fees themselves vary by state. "In Florida, for example, our annual fee is $75 to $125," Alper said.

The state Capitol of California in Sacramento
California taxes LLCs more heavily than other states
But in California, LLCs are subject to an $800 annual tax, according to Section 17941 of the State of California's Revenue and Taxation Code, and Section 17942 requires an additional annual fee based on the LLC's income.

Investors may also incur further LLC-related fees, such as book keeping and tax preparation expenses. Those interested in LLCs should also be aware that the IRS is more likely to classify those investors who hold properties or run businesses from LLCs as dealers.

Still, LLCs are fairly straightforward and inexpensive to form. They require fewer formalities and expenses than do corporations.

"You don't need officers…and you don't need corporate formalities," for LLCs in most states, Alper said. While corporations are required to have officers, annual meetings and minutes, among other things, LLCs in many states are not required to have them. Some paperwork will be necessary, however, as investors must be able to prove to banks and other lenders that they have the right to purchase property on behalf of the LLC.

In Arizona, LLCs are not required to have their own bank accounts whereas corporations are, Keyt said. With an LLC, investors are spared the hassle of handling all transactions through the separate account and keeping the extra books. Investors should note, however, that keeping separate books, while not required, may in fact be simpler in the long run, especially in the event of a lawsuit.

LLCs are fairly flexible in other ways as well, Alper said. "Even people who are buying stocks and bonds can set up LLCs to own their financial investments," Alper said. "LLCs are not limited to real property, and can be used to buy any investment."

LLCs also offer tax flexibility, as they are pass-through entities. The IRS "does not consider an LLC itself to be a taxable entity," according to The Company Corporation, an entity formation and service provider. "Instead, the company's earnings 'pass through' to the owners, who report their share of profits or losses on their individual tax returns."

"For single member LLCs, the IRS disregards the LLC as a taxable entity, so you don't even need a tax return [for the LLC]," Alper said. "If you have two or more members in your LLC…then you have to file a partnership tax return," Alper said. "You have to pay your CPA to file a tax return, and I guess that's a con."

Further, "Two married [people] cannot form a single member LLC, even though they file a joint [tax] return," he said. This can vary by state, though, so investors should be sure to research the laws that pertain to their area.

LLCs can be taxed the same way as other entities; this requires a tax return even if there is no tax to be paid, Keyt said. But some investors could benefit from choosing to have their LLC taxed as another type of entity.

"People don't realize that an LLC could be taxed…as some other type of entity. In other words, they don't understand that the LLC for legal purposes can be different than the LLC for tax purposes," Alper said. "An LLC can file and choose to be taxed as either a partnership or corporation."

There are some benefits for small business owners, for example, in being taxed as a corporation—specifically, an S corporation—rather than as an LLC, Alper said. "You can, in many cases, reduce employment tax liability."

One major hurdle for owning property in an LLC faces those who purchased a property in their own name and would like to transfer it to an LLC.

"One of the potential problems for owning real estate through an LLC…is that, if the property is acquired by borrowing money from a lender, almost all loan documents…contain a clause known as a 'due on sale clause,'" Keyt said. "That's language...that says that if the title of the property transfers to a new owner, then the lender has the option to call that loan."

An LLC is not covered by the same title insurance if the buyer transfers the property
Investors should contact a title insurance agency before moving property into an LLC
Thus, if an investor purchased real estate in his or her own name, but later wished to hold it in an LLC, the lender would be able to call the loan because of the due on sale clause.

Another risk of transferring title from an individual's name to an LLC is that, "If the buyer later transfers title to an LLC created by the buyer, the LLC is not going to be covered by the same title insurance," Keyt said. Thus, he said it was important for investors to contact their title insurance agency before transferring a property into an LLC.

For a nominal fee, a title company can transfer a policy to an LLC; the fee will often be heavily discounted because the title company will not have to perform all new due diligence; they will just have to do research on the time after the policy was first issued, since they will have researched the property when it was initially insured.

This situation is becoming increasingly common as more people decide to form LLCs in which to hold real estate. "Over the last few years, I've formed over 1200 Arizona LLCs, and…I'd say at least half of those are for the purpose of holding real estate," Keyt said. LLCs "are definitely the entity of choice in terms of holding real estate for investment."

"A few years ago, more people would use corporations because people were more familiar with them, but that's no longer the case," Alper said. "I think [LLCs] are probably right now the entity of choice."

"LLCs are relatively easy and cheap to form," he said. "And certainly someone should use an LLC before owning real estate in their own name. There's no reason to own property in your own individual name when you can own it through an entity and control the entity."

The key is that there is no reason for investors to own property in their name, rather than an LLC, when they can afford to do so. Holding property in an LLC limits the leverage investors are able to use. Typically, lenders will not lend more than about 70 percent of the price of the property to an LLC. Someone borrowing money to buy a property in their own name, however, could likely get a loan for 90 to 95 percent of the cost of the property, even in today's market.

For commercial loans, however, lenders focus more on the property itself, and are less concerned about whether the property is being purchased in an indivdual's name or through an LLC. Some commercial lenders, in fact, prefer to lend to LLCs rather than individuals.

Thus, there are many circumstances in which it makes sense to use LLCs to hold property. Real estate investors should evaluate their own situations and goals and talk to someone experienced with entities if they are interested in forming LLCs.