An LLC Is a Great Investment Tool…Done Right.
There are a lot of excellent reasons why people talk about LLCs in terms of real estate investment “pluses”: tax savings, shelters for your assets, etc. And it’s true; you’ll reap a fair share of benefits from using an LLC…if you do it right. Getting the best results from this process, however, depends on a number of factors:
…when the LLC is set up
…how the LLC is set up
…how the LLC conducts financial business
Myriad issues concerning LLCs are important; each of them can prove to be a stumbling block toward getting the tax benefit (and asset protection) from your real estate investing. Better to take a little time to do things right than spend time (and money) regretting that you didn’t!
So let’s look at these issues one by one.
Timing Is Everything.
First, let’s talk about when you set up your LLC.
Optimally, you should set up the LLC prior to acquiring the property in question; that way, the LLC is immediately available to take title to the intended real estate. If you don’t set up the LLC beforehand, set it up as soon as possible afterward. Once title has been taken in the investors’ names, the property can be deeded to the LLC for asset protection.
CAVEAT: You need to take special care when moving encumbered property from your name into your LLC. If the property still has a mortgage on it, the lender could accelerate that loan, and that can be a costly situation in which to find yourself!
How do you sidestep that pitfall? When we see an encumbered property in that kind of jeopardy, we recommend you use a land trust. Elsewhere on the site, you’ll find more information about how land trusts can be used to protect your assets in the case of investing in real estate encumbered by debt.
If you don’t need to use a land trust — if the property is unencumbered in any way and your tax status is sure — then simply deed the property from your name to the name of your Limited Liability Company. Title then vests in the name of the entity, rather than you as an individual.
What’s Your Type?
Next, let’s examine which kind of LLC you’re setting up. You can set up your LLC as one of two types:
- manager-managed. In this type, a manager is appointed to handle all business affairs of the LLC.
- member-managed. In this type, members serve as responsible parties in operating the LLC.
Knowing what type of LLC you’ve set up is extremely important, because this will govern who will sign documents on behalf of the LLC, and how.
Let’s look at an example.
Say one of your properties, held by an LLC, needs a new roof. You search around and get a good estimate from Rudolph’s Roofing Company, and you and Rudy are ready to sign the papers.
- If your LLC is manager-managed, and you’re the manager, you’ll sign the contract as manager on behalf of the limited liability company: John Doe, manager of Blue Horizon Limited Liability Company.
- If your LLC is member-managed, however, you’ll sign as John Doe, managing member of Blue Horizon Limited Liability Company.
In other words, you’re putting Rudy the Roofer (and the rest of the world) on notice that whomever deals with Blue Horizon LLC is dealing strictly with the company and not the individual signer of the agreement. Any binding agreement into which your LLC enters should be signed in this representative capacity. If you fail to sign in this manner, you run the risk of being held personally liable for any breaches in any agreement entered into by the LLC. Protecting yourself and your individual assets needs to be done correctly, however, your LLC is managed…or it can get VERY expensive in the future.
Get Thee to the Banker!
Speaking of expenses…
Don’t overlook the next step in setting up your LLC: getting it its own bank account. Your LLC will need to “sign off on” financial transactions, such as collecting rents and paying expenses. Therefore, it needs a bank account designated for it alone — and every one of your LLCs needs one.
There’s a simple rationale for this. In essence, what you’re doing with this limited liability company (which also happens to own real estate) is that you’re effectively substituting the LLC for you as an individual. It’s “walking the mile in your shoes.” That means anything on which your name would normally appear — such as bank and deposit accounts, utility bills, and rental agreements — now transfers over to the LLC’s name. All dealings, from that point on, take place under the name of that LLC.
I cannot overstress the importance of creating this bank account, and creating an individual account for each LLC. Otherwise, you may find out its importance the hard — and costly — way.
Recently, I was consulting with a client who has three rental LLCs, managed and held by a holding LLC. He directed his tenants to pay rents to the holding LLC, however, not the individual ones; he wanted to avoid having multiple bank accounts if he could, and so he asked if that structure was all right.
In fact, however, it was not — as I informed him. If he continued to “funnel” everything through a holding LLC, instead of having individual bank accounts that handled the income and expense for each LLC in turn, he ran a very real risk of a court looking at it as one common enterprise. If all the LLCs were, in fact, treated that way, then if a lawsuit ever happened, EVERYTHING was at risk.
“Come on,” he answered, still skeptical. “Has that ever actually happened?”
“Unfortunately,” I replied, “yes, it has. I’ve seen it myself.”
I went on to explain that another of my clients ignored this advice — she failed to treat each LLC as a distinct entity. Sure enough, when a lawsuit was brought against her LLCs, the court saw no separate bank accounts. It lumped everything together, and she lost all her properties.
Then How Do I Sign the Checks?
Being conscientious about indicating your manager role in terms of signing agreements on behalf of your LLC is good. But this in turn, raises concern from some clients, who then ask, “Do I have to sign my checks this way, too?”
Nope! (Isn’t it nice when at least one thing is simpler than you expect?)
When you sign a check for LLC business, you don’t have to designate your manager role; the check itself indicates that anyone negotiating or accepting it knows that his/her ability to seek recovery is limited to the issuing company itself, not the individual signer. You can go ahead and sign the check as “John Doe” without worries. As long as the LLC has a properly set up bank account, banking law recognizes this limitation.
Spreading the Word
So now, you’ve got the LLC set up, you’ve got its bank account squared away, and you know how to sign documents legally on its behalf. Next, make sure your LLC is the responsible “name” to contact on anything to do with that property.
This means changing your property insurance policies to list the LLC as the insured. It also means switching all utilities to be listed under the LLC’s name as well. And, most of all, it means you’ll need to inform some very key people who have dealings with that property: your tenants.
Typically, I recommend my clients send a letter to tenants in which they instruct them to make rent payments to the name of the limited liability company. The benefits of this are twofold:
- It reduces harassing phone calls from unhappy tenants. You can say, “I’m only the property manager, so don’t hold me at fault.” (Of course, if there’s truly an issue, you’ll address it; this is more a way of dealing with nuisance calls from tenants who are chronic complainers.)
It removes any personal responsibility from you with respect to that property. Your tenants are now on notice that they’re dealing strictly with an LLC, not an individual, and they have to proceed accordingly.
- Once rents are collected in the name of the LLC, you’ll pay all bills out of that LLC; then, any profits can then be distributed to you as the owner of your limited liability company. You can, of course, also create a holding LLC to own the various rental LLCs; this can be an additional layer of protection for your assets. Just make sure the bank accounts are still all separate for each entity: this provides you the best of both worlds.
Bottom Line? It’s About Limiting Your Liability.
That’s what an LLC, at its heart — and by name — is about: protecting your assets, no matter how deep your “toe” is dipped in the investment sea. Following a few simple procedures to the letter makes sure your liability shield stays in place — and your real estate investment strategy remains on a prudent and profitable course. Good luck!