Let’s start with: Why have an LLC?
There are mainly two reasons why you want any kind of business structure:
Pay less tax, and protect your assets.
Before you jump into creating your LLCs for your real estate holdings, there are a few things to consider. Do NOT make these three mistakes.
Mistake #1: Forming the wrong entity and/or in the wrong state.
Sometimes people get confused about their real estate investments and what the IRS considers them to actually be doing.
You could be a real estate dealer, which means you flip or wholesale properties. You could have a real estate business, which means you rent out property for short stays and provide substantial services, like a motel or some types of vacation rentals. You could be a developer which means you buy property and make changes to it before it is sold or put in service. Or, you could be a regular real estate investor and hold property that has long term renters (commercial or residential).
You first need to know what kind of real estate investor you are. You will use different tax strategies and different types of structures depending on the type of investment. For example, if you’re a real estate dealer, you have a business and that means you want an entity that is taxed like an S Corporation or possibly a C Corporation. Flipping houses or flipping burgers…you have a business.
If you have long term rentals, you will most likely want a single or multi-member LLC. If you are investing from Canada, you’ll want an LP (limited partnership).
Bottom-line, know exactly what you’re going to do first and then decide what the right structure is. If you need to close quickly on a property and want an entity right away, your best bet is to use an LLC. An LLC can decide later what type of taxing structure it should have.
The second part of this is setting up the entity in the wrong state. Make no mistake, one way or another you need to have legal authority in the state in which your property is located. If you buy a property in Ohio, you need an OH LLC or you need to authorize your out-of-state LLC to do business in Ohio. (In effect, you’ll pay twice that way – once to the state that has your LLC and once to Ohio.)
If you don’t get your entity set up or authorized in the state of your property, you won’t have any legal standing for possible tenant issues. One way or another, you have to have an entity in that state.
Mistake #2: REP with wrong structure.
The short answer is that if you want to claim real estate professional status (and all the great tax benefits), you have to be a named manager in a manager-managed LLC.
If you tried to do-it-yourself with an online LLC set-up or used someone to set up your LLC who doesn’t understand real estate tax law, you could have a problem.
Mistake #3: Not set-up or maintained properly.
The #1 mistake when setting up an LLC is failure to prepare the Operating Agreement. Most of the online do-it-yourself websites mention it, but don’t give you the tools to do it. Remember the manager-managed LLC is the type of LLC you need for your real estate investments if you ever want to take the “real estate professional” status.
Once the entity is set up, that’s not the end of it. You need to continue to maintain the LLC with proper state and federal filings. Plus you need to give proper notice in your business dealings. Don’t sign contracts with just your name, use your name plus your title (i.e. Manager of ABC LLC).
Are there only 3 possible mistakes? Of course not, but these are the most common.