Should Rental Property Be in an LLC or Trust?
Should rental property be in an LLC or trust? Unfortunately, the answer is not as straightforward as you might think.
Whether you’re planning your will or setting up a company to manage your growing real estate portfolio, you need to know exactly what type of entity you should use to shield your properties from legal trouble. If you make the wrong decision, you could potentially expose your holdings to unnecessary risk, costing you hundreds of thousands of dollars down the road (or, at the very least, giving you a big headache).
So, first, let’s start with a basic definition of "LLC" and "Trust" as they apply to real estate investing.
(If you just want the pros and cons of each option, feel free to scroll down to the bottom of this article).
Why Use an LLC to Hold Your Rental Properties?
An LLC is a limited liability company.
It’s one of the most popular legal entities that a person can set up to operate their business. You don’t need any employees or a board of directors, and you can use it to separate your business assets from your personal finances. That way, if you ever find yourself on the losing side of a lawsuit, the only assets you’ll be forced to give up are those assets held within the LLC (in this case, your rental properties).
If someone sues you and wins, they can’t take away your personally-owned assets (like your car, primary residence, and your kid’s college fund).
Sounds like a pretty sweet deal, right? You could theoretically make some risky moves with the assets you put under an LLC and then dissolve that LLC in case you get into any trouble. The only risk is the asset, right?
Well, not so fast. There are some instances when your personal assets might be at risk, and you definitely shouldn’t start an LLC for the sole purpose of doing something nefarious.
When Does an LLC Fail to Protect Your Personal Assets from Lawsuits?
There are a few instances when, if you use an LLC to hold your rental properties, you’d be putting both your rental properties and personal belongings at risk. Those instances include:
- You make a personal guarantee on a debt. When you sign a contract for certain loans, including, in some cases, mortgages and home equity loans, you might have to make a personal guarantee to pay it back. That means that you’re on the hook to pay down the debt even if your business doesn’t perform. Lenders will often require you to make a personal guarantee if your LLC doesn’t have a long-established credit history or cash flow.
- You sign a contract with your name, rather than your title with the LLC. Always sign contracts as “John Doe, CEO of Rental Properties LLC,” never just “John Doe.”
- You mix up your personal finances with your business finances, or you fail to observe the requirements of your LLC in your state. Keep separate bank accounts and credit cards for your business and personal finances. As soon as you use your business credit card to buy groceries, a lawyer is going to make the argument that you’re using your LLC to protect your personal assets.
Furthermore, an LLC can create a kind of avalanche effect. As soon as one property is attacked under an LLC that holds multiple rental properties, your entire portfolio can take a hit.
Why Use a Trust to Hold Your Rental Properties?
You’ve probably heard about trusts as they relate to estate planning. By putting certain assets in a trust, you can guarantee exactly how and when they’re distributed. This way you can avoid a solid chunk of estate taxes, since the assets in a trust aren’t considered your personal property, or even protect your assets from heirs that are likely to mismanage them.
One solution is putting all of your properties under separate trusts. There are a few different types of trusts: revocable, irrevocable, pay-on-death (POD), and living trusts. For our purposes, we’re just going to focus on revocable and irrevocable trusts.
- Revocable trusts allow you to control the assets during your lifetime. These are still considered personal assets, and they’ll be included in your estate taxes.
- Irrevocable trusts transfer legal ownership to a trustee, who then oversees the exact details of how the asset should be treated according to the trustors’ will. Since this is no longer technically part of the trustor’s property, it isn’t considered in estate taxes.
What are the Benefits to Using a Trust Versus an LLC?
What are the benefits to putting your rental properties in a trust rather than an LLC?
- Just like an LLC, putting your property in a trust can separate your personal assets from your business, so that if you run into legal trouble, you won’t have to forfeit your personal belongings.
- It can cut down on estate taxes.
- It can distribute liability. If you set up an LLC, you’ll definitely need to buy liability insurance on top of it. Even then, you could potentially lose all of your properties in a single lawsuit. If you put the properties in individual trusts, you spread out that liability.
Should You Put Rental Property in an LLC or Trust?
So, to review, what are the pros and cons of each option?
Putting Rental Property in an LLC Pros
- One of the most popular ways to form a corporation. Therefore, it should be easy to file the requisite paperwork and even find guides online to help you with the specifics.
- Separates your personal assets from your business assets.
Putting Rental Property in an LLC Cons
- You could potentially lose all of your properties in a single lawsuit.
- If you don’t follow the requirements for incorporating an LLC (like holding annual meetings and keeping your personal finances completely separate from your business finances), you could open up a lawyer to “pierce the corporate veil.” If this happens, they’ll be able to prove that you’re just using the LLC as a protection from liability while treating it like personal property.
- In short, you could open up not only your rental property to potential issues, but your personal property as well.
Putting Rental Property in a Trust Pros
- Effectively separate your personal property from your business assets.
- By putting each property in its own trust, you can disperse liability.
Putting Rental Property in a Trust Cons
- Might require more time and resources.
- Less straightforward than simply setting up an LLC.