LLCs are a popular option for real estate investors including house flippers. Here’s why.
What is an LLC?
LLC stands for Limited Liability Company. It’s a very common type of business structure especially for individual property investors.
When you create an LLC to hold your real estate investment, you’re creating a separate legal business entity. But you can still pay taxes on your LLC’s income on your personal tax return.
What are the benefits of an LLC for a house flipping business?
There are several benefits to using an LLC to flip houses.
Personal Asset Protection
One of the primary reasons to form an LLC is to receive personal asset protection.
When you don’t have a separate business entity, you have personal liability for almost anything that goes wrong in your business. If you get sued because someone gets hurt on your property or your investment doesn’t work out and you can’t pay your contractors, you might lose your own house.
A limited liability company provides liability protection by separating your personal assets and business assets. Generally, when you operate under an LLC, only your business income and assets are at risk.
If your house flipping business turns south and you owe money you can’t pay, the most your creditors can usually take is the real estate, cash, and other assets held by your LLC. If your LLC can’t pay the debt, you can typically walk away from the LLC.
Another important concern for a house flipping business is privacy. Virtually all real estate transactions are public records.
If you buy and sell real estate under your personal name, anyone can look up where you live. This can include buyers who think they got a bad deal, neighbors who aren’t happy that you’re house flipping in their neighborhood, or general criminals looking for people they think have money.
While LLC owners are also generally public records, there are ways you can protect your identity with an LLC. Options may include having a separate business address, using your lawyer’s address, or having the LLC owned by a trust.
What other options do you have besides an LLC?
An LLC is not the only business entity option you have for your house-flipping business.
Many people stick to an unregistered sole proprietorship for flipping houses.
Note: There are two things people may be referring to when talking about sole proprietorships. Sole proprietorship can refer to any business with a single owner, including a single-member LLC. It can also refer to a business with no separate legal entity.
The benefit of not having a separate business entity is reduced legal costs and hassle of forming an LLC or other entity.
If you’re considering this option, you should consider the risks involved. If you’re flipping houses that need minor cosmetic work and buying them in cash, you might not have much risk of financial loss or getting sued.
If you have a house flipping business as an electrician or other skilled trade and are doing major upgrades like electrical work, there’s a higher potential you can get sued if someone claims your faulty work injured them or caused property damage.
It can also depend on your state’s laws. Some states leave you open to more potential liability than others. You may want to talk to a lawyer before deciding which business entity to use.
S-corporations are another common business entity used by house flipping businesses. Unlike other types of real estate investing that are considered a passive activity, flipping houses is usually considered an active activity.
The difference between passive and active investments is that the money you make from active investments is typically subject to self-employment taxes. The money you make from passive investments generally isn’t.
One of the main tax benefits of S-corporations is the possibility of being able to avoid at least some self-employment taxes by converting some of your income into dividends.
The Internal Revenue Service has very strict rules on when you have to pay self-employment taxes on S-corporation income, and it depends on how your house-flipping business operates.
Talk to a tax accountant about whether you can receive these tax benefits and if they’re worth the cost of forming an S-corporation.
What do you need to create an LLC?
You can form an LLC for a house flipping business by filling out a few forms, but if you want to get the personal liability protection and other benefits, it’s important to do things correctly. Here are some of the things you need to keep in mind.
Business Bank Account
One of the fastest ways to lose the liability protection of your LLC is by not having a separate business bank account.
If you mix personal and business money, the law generally considers that to be a sign that you’re not actually operating as a separate business. If you’re not operating as an LLC, you can’t receive the benefits of an LLC even if you have one on paper.
You can of course pay yourself and generally as much as you want. Instead of using your company card to pay for personal purchases, you should generally pay yourself an owner’s draw.
When you need to spend money on your LLC, move the money into your business account as an owner’s investment. In the alternative, if you have to spend money on a personal credit card, give your LLC the receipt and write out a formal reimbursement form just like you would when working for a corporation.
You generally need a physical address for an LLC. You can use a PO Box as a mailing address, but your LLC needs a physical location.
Your physical address also needs to be a place you can be served legal papers if needed. Many people use a registered agent service to meet this requirement.
Some states require you to run an advertisement that you’re starting an LLC. This is a way of making public who owns the LLC and giving people who may have a trademark a chance to make a claim if they think your chosen name violates their trademark.
This process can be very expensive in some states, so it could be a factor in whether you want to form an LLC for your house flipping business.
LLC Operating Agreement
An LLC operating agreement includes things like how the owners make decisions, how new owners can be brought on, what to do if one owner wants to sell, and other important issues.
If you’re a single owner, you can often skip the operating agreement or use a very broad template that lets you do just about everything. If you’re house flipping with a co-owner, it’s very important to create a thorough operating agreement. You may also want to get help from a lawyer.
Understanding of Your Legal Requirements
LLCs have many legal requirements, such as maintaining separate bank accounts, filing annual reports, and taking other steps to show that you’re truly operating as a separate entity.
If you don’t follow the requirements, you can lose your liability protection. This is known as piercing the corporate veil because it allows someone to bypass the veil of your LLC and sue you directly.
Some of the requirements can be very technical, so you should carefully study your state’s law and consider getting help from a lawyer.
What other legal issues do house flippers need to be aware of?
Your house flipping business may also have other legal obligations.
When you do work on a home, you may need to secure permits. The requirements vary widely, with some places requiring permits for anything more than painting and others only requiring permits for major renovations.
If you don’t get the needed permits, you may be unable to sell the home. You could also have to redo all of the work under a permit to make sure it’s up to code. Government fines are also a possibility.
Check with your local building department to find out what permits you may need.
You may also need a license to operate your house flipping business. Again, the requirements can vary widely, and some real estate activities need a license while others don’t.
You’ll need to check the requirements for both your state and local government.
Factors that can affect whether you need a business license include:
- How many properties you flip
- How extensive of a renovation job you do
- Whether you hire employees or contractors
- Whether you have tenants
Real Estate Disclosure Laws
Another thing to look into is your state’s real estate disclosure laws.
House flipping businesses sometimes have a bad reputation as putting lipstick on a pig. This refers to buying a house with major structural issues, putting on fresh paint and other minor cosmetic work, and selling it to an unsuspecting buyer.
You or your business partner may believe that you don’t need to disclose things because it’s buyer beware, and the buyer can get a home inspector.
Depending on your state, you may be required to disclose all major issues that you know about or issues that may be difficult to uncover during an inspection. You should also be aware of the potential risk of being sued if a buyer believes you failed to disclose something you truly didn’t know about.
Keep in mind that real estate agents aren’t supposed to give you legal advice. They may not fully understand the disclosure laws or may want to leave things out to make a commission.
Talk to a lawyer to learn more about your disclosure laws.
If you decide it’s better to fix up and rent houses than flip to sell, you’ll need to become familiar with your state’s landlord-tenant laws.
This can include things like:
- What you can include in a lease
- Whether a tenant has a right to renew
- Rent control or rent stabilization
- Your duty to make repairs
- Fair housing laws
- Limits on evictions
If you’re worried about making mistakes or don’t want to be on call 24/7 for emergency repairs, you may want to hire a property management company. You can still use a property management company if you have an LLC — you just need to make the property management contract with the LLC.