What to Know about LLCs: Real Estate Investing
Growing a house flipping business, the right way
You’ve likely watched one of the many popular real estate shows and seen people buying a run-down or outdated property, magically sprucing it up with a bit of demolition and a lot of imagination, and earning a quick and easy profit.
But there is a lot more to consider before you embark on this journey. It’s not just a fun hobby, it’s a business! Here’s how to start.
House flipping: not just like on TV
Let’s review how house flipping works. A property investor purchases a home that is in need of repair and updating, and then invests money to update the home with the goal of selling and making a profit. This is called "fix-and-flip" home buying.
But it’s not all fun design tricks and obvious updating. (Out with the shag carpeting!) In order to start a serious business, you will need to ensure you have a thorough understanding of the real costs and other considerations in order to avoid serious financial mistakes.
First and foremost, house flippers must choose a business entity. The entity you choose may determine how much profit you make, how much you pay in taxes, and how exposed you may personally be to liabilities. The most popular types of business entities include corporations, sole proprietorships, and Limited Liability Companies (LLCs).
A Sole Proprietorship
Typically the easiest business to start, sole proprietorships make sense when working in low-risk industries, since the owner is personally responsible for all liabilities.
- All one needs is a business license in order to start a sole proprietorship.
- The Internal Revenue Service (IRS) allows a sole proprietorship owner’s spouse to bypass taxes that he or she would have to pay as an employee elsewhere.
- A sole proprietorship would not be the best choice for anyone needing to receive a large loan, because your own assets would be put at risk.
- A Sole Proprietorship cannot protect you if you were to be sued, meaning that your personal property would be at stake if you needed to settle a debt.
Corporations are designed to raise and make large sums of money and include a large group of stakeholders.
- The owners of a corporation cannot be held personally liable for debts.
- There are several tax advantages to a corporation. Most significantly, corporations can deduct health and life insurance for employees.
- Corporations are complicated and expensive to run.
- The owners have to pay taxes on their personal income from the corporation.
LLCs: The basics
LLCs have long appealed to small business owners and this only increased since the Tax Cuts and Jobs Act went into effect on January 1, 2018. The very first LLC in the United States was formed in Wyoming in 1977. Roughly 20 years later, LLCs took off due to increased flexibility rules from the IRS.
An LLC is the "Goldilocks" of business entities, since it offers the best parts of all other options. Overall, LLCs are the most popular and the most flexible option for real estate investors.
- Founders of an LLC have the option to supply only a small percentage of money when they start their business, while still retaining full authority.
- LLCs do not have to pay federal income taxes, since the owners only pay taxes on their personal income. This is called "pass-through taxation."
- LLCs separate your personal assets from your business assets. Owners have no personal liability for the business debts.
- LLC owners don’t necessarily have to have any employees, nor do they need a board of directors.
- LLCs enable investors to transfer ownership, and oftentimes, business owners will transfer to a family member in order to bypass paying some taxes.
- Since an LLC has the highest degree of flexibility of all the business entity options, the agreement to start one must be precise. Business owners must determine how profits will be distributed, how the management team will function, and several other details on how to manage capital. Lastly, once you choose a name for the LLC, it is set in stone, so try to keep it simple.
What to know before establishing an LLC
A common mistake among house flippers is purchasing the property first, before establishing an LLC. All key documents, such as the purchase contract, agreement of sale, and deed, have to be in the name of the LLC, not of the homebuyer. Make sure to file for your LLC in the state in which you live, even if the property you own is in another state.
You don’t need an attorney when filing for an LLC, but you will need to pay a fee ranging from $40 to $500, depending on the state, and create an LLC operating agreement.
Maintaining an LLC: taxes, fees, and other "gotcha" risks
The first step after legally filing your LLC is to get an EIN, or employer identification number. This is also called a federal tax ID, and will be provided by the IRS. In order to receive one, you just need to clarify the type of entity and the date you founded your business. That’s it!
Depending on where you live, your taxes could be very different, so make sure to get the information you need from a trusted source such as the IRS or Small Business Association. Certain states will charge annual fees, completely outside of taxes. These fees can be up to several hundred dollars.
When tax day arrives, you will file a form called 1065: Partnership Return of Income. This will include a Schedule K-1 for each member of the LLC, which delineates each person’s income and any deductions. Next, you can decide to file as a corporation, if you have more than one member of the LLC, or as a sole proprietorship — the most common option if it’s only you in the business.