What Is A Rental Property LLC?
A Rental Property LLC is a limited liability company (LLC) formed for the purpose of holding investment real estate, i.e., real property that is used for renting purposes. It is a good way to save the hassle of registering a corporation in any state as is necessary when using that method. To form a Rental Property LLC, the real estate is transferred into the LLC. This will trigger a deed transfer and should be a quitclaim deed or a warranty deed, depending on the closing circumstances . The title company is usually in possession of the appropriate document to fill in and effectuate the change. A quitclaim deed is premised on the LLC having already been formed and is given by the Owner to the new LLC in order to convey the property. An advantage of forming a Rental Property LLC is that it allows for the protection of assets, including personal assets, from creditors of the LLC. Shielding personal assets is an important benefit for those who may be at a greater risk of loss should the Rental Property be involved in litigation.
The Operating Agreement Explained
An operating agreement acts as a set of instructions for the LLC and its members. The operating agreement outlines how the company will be managed and by whom, as well as what percentage each member owns. The operating agreement details important components such as who handles the LLC’s day to day operations, how profits will be distributed, and how to buy or sell ownership interests in the LLC, of which may include death or divorce.
An operating agreement is a legally binding contract, put into effect as soon as the members sign it. If a dispute arises at some point, having a clearly defined operating agreement can help avoid unnecessarily drawn out arguments by being the go-to document to consult. In states that don’t require LLCs to have an operating agreement, a written contract still helps protect the management from decisions or actions, such as undertaking certain financial obligations or transferring a member’s ownership interests, that other members didn’t authorize.
The operating agreement also provides protection from certain state laws and regulations that apply when no operating agreement is in place, such as dissolution of the company or transfer of interests. Further, the operating agreement provides privacy that a public filing has no such provision for. Financial statements and personal information about the LLC’s members do not have to be made public, although this does not mean lending institutions will not require robust documentation proving the income and merits of the LLC for lending purposes.
Essential Elements Of An LLC Operating Agreement
An operating agreement is a document that spells out the relationship between the members of a limited liability company and outlines the essential elements of a new business. While not legally required by the IRS, most small business owners choose to have one. In the case of a rental property LLC, an operating agreement becomes even more essential. Below you’ll find some of the basic components you’ll want to include in your LLC operating agreement:
Members. The operating agreement should outline the roles and responsibilities of each member of the LLC. Specifically, it should define what their duties are, their degree of authority and how compensation is calculated.
Profits and Losses. This section should list how profits and losses are divided among the members. Are they divided equally across the board or do you have one member who will take a larger share due to a disproportionate capital investment? This can also extend to other expenses, such as debt payments, maintenance and property taxes.
Management. An LLC can be managed by its members or members can appoint a manager or management committee. Consulting an expert in landlord-tenant law in your state will help you outline the management structure best for you and your business.
Why You Should Tailor The Document
The universal operating agreement does not fit every business owner’s needs, particularly when it comes to investing in rental property with spouses and other family members, or when owning a single piece of real estate with acquaintances or co-workers. Customizing the provisions to fit your particular investment will ensure they are better drafted to meet your specific needs.
The operating agreement is going to address "what happens if" scenarios. The agreement will address what happens if one person dies, or some type of divorce situation arises among the members. It will speak to what happens if you want to add someone new, or buy someone out, or what is to happen if you want to sell, or transfer, the property. It will not be a good result if you have an auto-generated, approximately 50-75 page generic operating agreement and try to customize it during these important times when very personal situations are arising. If the majority of your operating agreement is auto-generated, it could also make it difficult to locate the exact provisions that are important right away.
As with all business agreements, your operating agreement should be drafted to best serve the interests of your own particular situation.
Legal Requirements To Include
In the United States, the legal requirements for LLC operating agreements can vary from state to state, although most states provide significant flexibility in how these documents are drafted. At a basic level, a rental property LLC operating agreement must meet the requirements outlined by the state in which the LLC is formed. Typically, those requirements can be reduced to four essentials: the members of the LLC, the management structure, how the operating agreement can be amended, and what will happen to the LLC upon the death of a member or the departure of a member from the LLC.
However, there are additional legal considerations that are extremely important for rental property LLCs that go beyond the needs of a simple small business partnership. The first consideration is finding a state in which you can foreseeably reside or do business that is also friendly to real estate investors. One state to avoid is California, where rent control laws make operating small residential or mixed-income rental buildings unprofitable. Other states have rent control laws, such as New York, New Jersey, Oregon, Washington, and Vermont . While some consider these laws to be a good thing, as they protect tenants from abuse, from a real estate investor’s point of view they tend to dissuade investment in such states and are likely a deciding factor when considering where to form an LLC.
The most important legal consideration in drafting the operating agreement for a rental property LLC is to ensure that it: incorporates some protections against liability for rental properties, such as indemnification, to reduce exposure; specifies which member (or members) will manage the property; and allows the LLC to be dissolved in the event of the departure of one of its members. Indemnification is often overlooked, as most people believe that the manager of a limited liability company that is properly formed will not be liable for injuries or accidents that occur on the property. However, that is not true, particularly if members of the LLC take an active role in managing the property. The operating agreement should specify the extent of indemnification from claims that may arise against the LLC members.
Some Common Pitfalls To Watch Out For
Common mistakes can become costly problems. In the case of a rental property LLC operating agreement, a common mistake is preparing an overly simplified agreement. Real estate investing has become more complex. There are many terms and conditions that must be included that were not historically included in rental agreements. An overly simplified agreement may omit terms that are critical to meeting the needs and expectations of the members.
Another mistake is not having the LLC operating agreement drafted by an attorney who specializes in business formations and real estate. I have seen many poorly drafted rental property LLC operating agreements that were drafted by non-attorneys. Rental property deals have become far more complicated than they years past. Failing to consult with an attorney who specializes in these types of transactions can have disastrous consequences in the event a dispute arises between the members.
Another common mistake made by rental property LLCs involves the failure to provide for the removal of a managing or general member. The circumstances of a member, or members, related to the rental property may change over time. You want to ensure that all members of your LLC have adequate remedies if a situation arises where one member can no longer serve in that capacity. This is particularly of critical importance in a multi-member LLC.
Professional Assistance
Regardless of the complexity or simplicity of the LLC owned rental property, when the time comes to draft or make changes to an operating agreement, the best solution is to seek legal representation. Many states have very specific and complex legal requirements regarding these LLC structures . A professional skilled in knowing what is required by a state can save you considerable time and help to minimize the pitfalls of insufficient compliance. Having an attorney well versed in the rules and laws and with experience in working with LLCs will be more experienced at putting together an agreement that will satisfy the state and avoid future problems.