Living and practicing on Sanibel, I have many clients who come to us when they purchase a condominium or home for investment income. One of the questions that often arises is whether they should hold their investment real estate in a separate legal entity for tax and liability purposes.
Our recommendation for most clients is that they should consider the formation of a Florida limited liability company (LLC). A Florida limited liability company offers the liability protections most often associated with a corporation, while have the tax attributes of holding the property in your individual name.
In an LLC, each owner holds a “membership” interest, often described as “units” or “percentages” that define their individual ownership, much in the way that a corporation is owned by shares of stock. The LLC should have an Operating Agreement setting forth the terms and conditions (think of them as “rules”) of ownership. There are many options in deciding what should go into an Operating Agreement. You should discuss these options with your attorney when creating the LLC.
Protections of an LLC
The limited liability protections of an LLC mean that in the event of a catastrophic claim, your financial exposure is limited to the value of the assets held in the LLC’s name. For example, assume that a tenant holds a beach party and a guest falls off a balcony, suffering a significant loss. The guest can sue the property owner for failing to properly maintain the property. If the property is owned individually, all of the owner’s assets are at risk for the entire judgment.
If the property is held in a limited liability company, however, the owner’s risk of loss is limited to the value of the property. Thus, if a potential judgment is more than the owner’s equity in the property, the judgment holder could only attach assets of the limited liability company (the property itself, plus any other assets, such as furnishings, or cash in the company’s checking account). If the property is mortgaged, that may mean little actual value.
This does not mean, however, that the property owner should not insure the property. Nothing can replace properly insuring your investment real estate. In addition, we recommend to all of our clients that they carry personal liability umbrella policies that provide additional insurance over and above their property insurance.
It is, however, possible that a claim can exceed the limits of a person’s insurance coverage, or even be outside of the limited of insurance coverage. For those reasons, the LLC acts as a financial fortress to protect the owner’s liability exposure.
The tax consequences of an LLC are beneficial and simple. The Internal Revenue Service treats the entity as a “disregarded entity,” meaning that the IRS does not care about the legal structure of the entity, and will tax the owners as if they owned it in their individual names. That means if you form a sole member (one owner) LLC, the gains and losses relating the rental of the property will be reported on your personal 1040 individual income tax return. If there are two or more owners, then the LLC will file a Form 1065, Partnership Return, passing the gains or losses to the partnership in proportion to their membership interests.
Many real estate investors find that a limited liability company provides them with peace of mind of knowing that they have limited their investment risk. Ask your attorney if an LLC is the correct structure for you.