Attorneys typically recommend that investors hold rental properties in limited liability companies. A limited liability company (“LLC”), maintained properly as a separate entity, limits the investor’s liability to the assets held in the LLC and protects other assets, such as the investor’s own home and savings. For example, if a tenant’s guest slips and falls in the rental property, the guest’s personal injury attorney will sue the homeowner along with the tenant. The primary protection is homeowner’s insurance, which, for a rental property, the owner must advise the insurance company that it is a rental or coverage may be denied. If the insurance policy denies coverage or the coverage is insufficient, the investor may face liability. However, if the owner is an LLC, the liability is limited to the assets owned by the LLC. That is also the reason it is recommended that each rental property be held in a separate LLC, so that liability arising from one property does not impact the investor’s equity in other properties.
While generally there are no tax benefits to holding the rental property as an LLC over direct ownership, there are tax benefits to holding property as an LLC rather than a corporation, as any income can be passed through to the owners and not subject to corporate taxes, thereby eliminating double taxation.
However, most home loans are packaged and sold to Fannie Mae (Federal National Mortgage Association) or Freddie Mac (Federal Home Loan Mortgage Corporation), which together create the secondary market for home loans to provide local banks with more money to lend to homeowners. Fannie Mae and Freddie Mac are targeted for homeowners rather than investors. Fannie Mae requires a borrower to be a natural person or revocable trust with a beneficiary who is an individual. Freddie Mac also prohibits refinancing a property that has been held in an LLC for the past six months. If a lender cannot package and sell the conventional residential loan to Fannie Mae or Freddie Mac, the loan is less desirable to the lender. Thus, commercial loans generally have higher interest rates and tougher terms.
So, when a homeowner moves and chooses to rent rather than sell and wants to transfer the now-rental property to an LLC, can they do it? Can an investor purchase a rental home as an individual (with lower rates and better terms than for a commercial loan) and then transfer the property to an LLC? The answer to both questions is, if the property is encumbered by a conventional residential loan, the investor does so at his own risk. The terms of the loans specify that the loan is due on sale and a transfer to an LLC may trigger the due on sale clause. In reality, many, many investors do it anyway and figure that, as long as they keep up the payments, the lender will not call the loan. Still, it can happen. The loan servicing company picks up changes in title that result in changes to the homeowner’s insurance policy. Thus, if the investor updates the insurance policy to protect the coverage, the loan servicing company may see the change in title and call the loan due. Some investors take the risk anyway and figure, if the lender questions the transfer, the investor can transfer the property back to himself as an individual. Actually, the lender may consider that a second transfer in violation of the due on sale clause. So, is it worth the risk? Only if you can get away with it!
Owning rental property in an LLC is the best solution from a liability perspective; however, it may only be feasible if you do not need conventional financing.