Should Rental Property Be in an LLC or Trust? Pros/Cons of Each

The structure chosen for holding rental properties can be the difference between success and failure. With so much at stake, choosing between an LLC or trust for a rental property can be a challenging and critical decision.

This article will clear up the confusion and provide a simple explanation of the differences between these two structures. You’ll learn how each option works as a rental property holder, its advantages and disadvantages, specific factors to consider when choosing which one to use, and common pitfalls to avoid.

Overview: LLCs vs. Trusts

In premises liability cases—when owners and landlords are determined to be at fault for an injury caused by their property's condition—the average award was $90,000, according to Forbes. That's one reason to be aware of the different legal structures you can use to protect your investments if you’re considering investing in a rental property or are already an investor.

Two of the most common structures are a limited liability company (LLC) or a trust. Understanding their similarities and differences can help you make an informed decision about which one is suitable for your investment.

Overview of LLCs

The primary benefit of an LLC is limited liability protection for the owners and investors. Generally speaking, if there's any legal action taken against the business, only assets within the LLC are at risk instead of other personal assets or investments. It also limits personal liability from debts associated with the business as well.

Another advantage of an LLC is flexibility when it comes to taxation. LLCs are treated differently from traditional businesses because they are considered pass-through entities. Taxes pass through to individual members without being taxed at the company level. Owners have more control over how their income gets taxed.

Overview of Trusts

A trust, such as an irrevocable or revocable living trust, can provide similar benefits to those of an LLC in terms of limiting liabilities from disputes or debts associated with real estate investments. However, trusts also come with additional benefits related to estate planning and asset protection planning.

A revocable trust can be altered or terminated by the grantor once created, while an irrevocable trust cannot. The main difference between the two is that a revocable trust allows the grantor to keep control and ownership of the assets, and an irrevocable trust transfers ownership and control to a third-party trustee.

Owners may choose an irrevocable trust structure if they want added protection from creditors. Both trust structures can be used to avoid probate upon death since ownership passes through a trust document rather than through a will or deed transfer.

Advantages and Disadvantages Between The Two Structures

When deciding whether to form an LLC or set up a trust for rental properties, there are several factors to consider. Depending on your specific needs and circumstances, these include financial objectives, long-term estate planning goals, and asset protection strategies.

Sometimes, setting up both an LLC and a trust could be beneficial. Doing so provides extra legal and financial protection, plus they could work together strategically for taxes due to their respective tax benefits. Depending on your situation, this option might make sense.

Rental Properties Held in an LLC

Here are the pros and cons of holding a rental property in an LLC.

Pros

• Limited liability: Owners are generally not personally liable for any debts or liabilities associated with the business.
• ‍Asset protection: An LLC provides added protection against creditors, judgments, and other liabilities.
• ‍Flexibility: They are usually easy to maintain and flexible in how you structure the business.
• ‍Tax benefits: An LLC offers tax savings opportunities and deductions compared to a corporation subject to double taxation.
• ‍Simplicity: There is typically little paperwork involved in creating and setting up an LLC compared to corporations.

Cons

• Complexities in multiple states: The process could be more complex than expected if you operate across multiple states.
• Additional fees: Forming and maintaining an LLC may be more expensive than other ownership options for rental properties.
• Double taxation risk: This risk exists if the owners do not properly structure the business before filing taxes with the IRS.
• Ongoing costs: An LLC requires yearly meetings and filing fees in certain states if you're operating multi-state businesses.
• Possible self-employment taxes: Depending on your situation, you may incur self-employment taxes when running a rental property within an LLC. If you are considered a working member of the LLC instead of just an investor, you may be subject to payroll taxes and additional liability.

Rental Properties Held in a Trust

Owning rental properties through a trust is a popular investment vehicle offering added legal and financial protection and tax benefits. Here are some pros and cons to consider when deciding whether a trust is right for you.

Pros

• Asset protection: An irrevocable trust can offer added protection against creditors, judgments, and other liabilities.
• Estate planning: A trust can help simplify the estate planning process since it allows you to transfer assets upon death without going through probate court.
• Tax benefits: Through trusts, owners can take advantage of certain tax benefits at the time of death that may not be available with other investment vehicles, such as the transfer of real estate assets without paying capital gains tax.
• Privacy: Certain types of trusts allow for additional privacy concerning the ownership of assets held in them
• ‍Flexibility: Owners have control over how the trust is structured and managed, giving them more flexibility than other options for owning rental properties. Revocable living trusts, irrevocable life insurance trusts, and certain charitable remainder trusts can be created with language allowing an owner to remain anonymous.

Cons

• Complexities: Setting up an effective trust structure could be more difficult than some other ownership options for rental properties due to complexities related to taxes and transfers of title deeds upon death or in the case of divorce or separation agreements.
• Increased cost: The costs associated with setting up a trust can be greater than some other ownership structures depending on the business's complexity, size, and scope.
• Expert advice needed: It is essential to get expert advice when setting up a trust to get it right and take advantage of all its potential benefits.
• Liability: Trustees can be held personally liable if they breach their fiduciary duties related to managing and protecting the trust's assets.
• Possible self-employment taxes: Depending on your situation, you may incur self-employment taxes when running a rental property within a trust.

How to Set Up an LLC for Your Rental Properties

Setting up an LLC for your rental properties is a great way to protect yourself from personal liability and ensure your business runs smoothly. Here are the general steps for a real estate investor to follow when setting up an LLC.

1. Choose a name for the LLC and register it with the secretary of state or other appropriate agency within the state where you are forming it.
2. Create an operating agreement outlining how the LLC will function, including ownership, management structure, decision-making processes, and more.
3. Obtain the necessary permits and licenses required by federal, state, and local law to operate your business legally.
4. Open a business bank account and keep your personal finances separate from your LLC.
5. Secure any necessary insurance coverage to protect you and your business from the risks and liabilities of owning rental property.
6. File all required paperwork with the state, local, and federal taxing authorities so you can accurately track revenue generated by each property owned by the LLC.
7. Create an asset protection plan to ensure that any assets the LLC holds are properly secured should something unforeseen happen with one of its properties or investors involved in its operations. This plan could include creating multiple LLCs in different states or establishing trusts to hold the LLC's assets.

How to Set Up a Trust for Your Rental Properties

Setting up a trust for your rental properties is a vital step in protecting yourself from financial and legal liabilities associated with owning rental property. Here are the general steps for a real estate investor to follow when setting up a trust.

1. Choose the appropriate type of trust for your situation and the assets it will hold, such as an irrevocable or revocable living trust.
2. Create a written trust agreement that outlines how the trust will be operated, including its name, purpose, and rules for managing assets and distributions.
3. Identify and appoint trustees who will be responsible for administering the trust according to the terms of the trust agreement.
4. Fund the trust by transferring all relevant assets into it, such as cash, stocks, bonds, or real estate investments.
5. Obtain any necessary permits or licenses required by federal, state, and local law to operate your business legally.
6. Determine whether you will need to pay taxes on income generated by trust assets. If so, obtain an Employer Identification Number (EIN) from the Internal Revenue Service.
7. Establish accounting procedures to ensure that all financial activities related to the trust are tracked and accurately reported when required by law or requested by trustees or beneficiaries.

What to Consider When Deciding Between an LLC and Trust

When deciding between an LLC and a trust for your rental property, there are several factors you should take into account.

First, consider the tax implications of each option. An LLC offers pass-through taxation, meaning profits and losses flow directly to members’ individual tax returns, and can be beneficial if you want to avoid double taxation on corporate profits. On the other hand, trusts may offer more flexibility in distributing income among beneficiaries and estate planning options.

Next, consider asset protection when choosing between an LLC or trust for your rental property.

An LLC protects against certain creditors. However, a trust may provide better overall asset protection in some cases by allowing the trustee to manage assets for the benefit of its beneficiaries. The trustee can choose what assets to protect, how to manage them, what investments to make with them, who benefits from them, and how to distribute them.

Finally, consider state laws when selecting an LLC or trust for your rental property. Different states have different regulations governing LLCs and trusts, so be sure to research the requirements in your area before making a decision.

In addition, some states may require additional paperwork or filings depending on which option you choose. Knowing the applicable laws in advance can help you make an informed choice that best suits your needs.

Common Pitfalls When Using an LLC or Trust to Hold Rental Properties

Using an LLC or trust to hold rental properties can provide several benefits, but they also come with some risks.

One common pitfall is failing to properly register the LLC or trust in the state where the property is located. Each state has its own laws regarding LLCs and trusts, so ensure your LLC or trust is registered and complies with all applicable legal requirements.

Additionally, if you choose to use a single-member LLC for rental properties, be sure it is classified as a disregarded entity by the IRS. Otherwise, you may end up paying additional taxes.

Another potential problem is not maintaining and documenting transactions related to the property. This documentation includes repairs and maintenance, rental payments, and changes in ownership or structure of the LLC or trust. Failing to keep accurate records can lead to significant financial losses if a dispute arises between you and your tenant.

Lastly, consult an experienced attorney about forming an LLC or trust for your rental property. Their expertise will help ensure you follow all applicable laws and that there is clarity surrounding the ownership structure of the asset.

Conclusion

By taking the appropriate steps and remaining vigilant when setting up an LLC or trust for your rental properties, you can enjoy the security and protection offered by these structures without putting yourself at undue risk. Following all legal requirements and carefully documenting transactions will also help ensure any disputes get handled quickly and effectively.

In addition to holding your rental property in an LLC or trust, landlord insurance is another significant way to protect yourself and your asset. Obie offers comprehensive coverage in all 50 states and allows landlords to customize their policy based on the size of their property, number of units, location, and more.

With Obie's easy-to-use online platform and helpful customer service team, you can easily purchase the right landlord insurance plan for your needs without ever having to leave the comfort of your home. Get a quote from Obie today and enjoy the peace of mind comprehensive insurance coverage brings.