3 Reasons Why I Prefer Buying Investment Property in an LLC
I'm going to fill you in on the 3 biggest reasons I buy all my investment properties in an LLC.
Today, I want to tell you why I don't buy investment properties in my personal name. This isn't necessarily the "right" way to do things, nor is it advice by any means. This is just what works for my personal situation.
Let's dive in.
The first reason I prefer buying rental property in an LLC is technically the ONLY reason I need: Asset Protection!
Now, "Asset Protection" is hard to understand if you've never experienced the benefits of it.
It's kind of like insurance: you don't need it until you REALLY need it.
And if you never needed it before, you might constantly question if it’s actually worth it.
I want to share a quick story about how keeping my investment properties in an LLC helped me with Asset Protection.
Back in October 2014, I opened a franchised restaurant. When you open a franchised business, you sign something called a Franchise Agreement.
There were two major parts to the Franchise Agreement I signed and personally guaranteed.
The first part was keeping the business open for 10 years.
The second part was the weekly royalty fee I owed to the franchisor.
Long story short: that business was a dumpster fire from day one.
Even in the busiest months, we couldn't turn a profit.
It took me 3 years to finally throw in the towel.
In October 2017, I locked the doors, turned around, and never looked back.
I thought I was done with that business. Then a few months later, I received a letter from the Franchisor.
It was a lawsuit.
They were suing me for the remaining 7 years of royalties owed on the Franchise Agreement.
They calculated the net present value of 7 years of royalty payments to be a little over $60,000.
There was absolutely no way I was able or willing to pay that.
So I lawyered up and fought back.
When my lawyer asked me what my assets were, I told him the truth:
I had a small retirement account, a few thousand dollars in my checking account, and a car that was probably worth 2,000 bucks at the time.
He then asked if I owned any property.
I told him I rent where I live and any property I control is owned by an LLC.
His exact words were, "Smart man, this should be an easy case."
After the franchisor's lawyers ran a rather invasive search into my personal assets, they decided to settle my $60,000 debt for just $5,000.
That story could have ended very differently if I had any property with equity in my personal name.
If I did, the franchisor likely would have obtained a judgment lien against me and recorded that lien against any property I owned in my personal name.
Then they would have been able to collect that debt if and when I sold that property.
In an extreme case, they might even be able to force me to sell one of my properties in order to recoup their funds.
Thankfully that wasn't the case and I got away with a settlement that was less than 10% of the original lawsuit claim.
I'm glad I learned this lesson early in my real estate investing career.
From that point forward, I made a commitment to buy all my investment property in an LLC.
The second reason I prefer buying rental property in an LLC is because the financing doesn't depend on my personal income.
It took me 6 months and 6 different banks to realize Traditional Lenders Hate Me.
No matter what I did, I couldn't get a loan in my personal name for any of my investment properties.
From what I gathered, there were two main reasons for this:
First, I was self-employed. Banks prefer borrowers with W-2 jobs that provide a consistent paycheck.
Second, my tax returns looked like I didn't make any money.
Although my top-line gross income was decent, I utilized a lot of write-offs that made my net income negative or as close to zero as possible.
That was a problem because traditional lenders use a metric called Debt To Income Ratio to decide whether or not a borrower can afford a loan. Most banks won't lend to a borrower whose monthly debt service is greater than 40% of their monthly income.
Since my monthly net income was close to zero, I wasn't going to qualify for a loan even though the rental property could be self-sufficient.
Just when I was about to give up, I found a DSCR lender that only funded LLCs.
DSCR stands for Debt Service Coverage Ratio.
The formula my lender uses for DSCR is Rent / PITIA, which stands for Principal, Interset, Taxes, Insurance, and Association Fees.
A DSCR of more than 1.5 is required to get preferred terms.
Anything between 1 and 1.5 gets standard terms.
The lender I use to finance all of my rental properties provides a 30 year fixed rate loan with an interest rate as low as 4%.
That’s comparable to what you’d get financing rental property in your personal name.
I can get up to 10 loans or $4M in combined loan amount as long as the property pays for itself.
The best part is the DSCR lender doesn't require any personal income documentation to make the loan.
Now for the 3rd and final reason I prefer buying investment property in an LLC: Ownership Structure.
One of my favorite quotes is, "If you want to go fast, go alone. If you want to go far, go together."
I try to keep a long-term view when it comes to real estate investing so every property I own is in a Partnership LLC.
I like to operate in my zone of genius and partner with people who are good at the things I suck at.
That allows both parties to go further together than they could individually.
But as you probably already know, things can get hairy in a partnership.
That's why it's best to layout as many expectations as you possibly can before entering into a partnership with ANYONE, especially if it's a close friend or family member.
Those expectations are formalized in something called an Operating Agreement.
The Operating Agreement is the legal document that:
- Identifies the members of the LLC
- Outlines each member's ownership percentage, and;
- Details each member's respective duties within the LLC.
Although it's not mandatory to have an Operating Agreement in states like New Jersey, I can't recommend it highly enough.
While it's fun to plan whose going to do what when the business is up and running, another key component of an Operating Agreement is having a plan in place if things go sideways.
Relationships can be ruined if there isn't a well-thought-out exit strategy.
It's much more difficult to formalize this process when buying a property in your personal name and splitting responsibilities with someone else.
It's also going to be difficult to split equity with a partner if a property is in one person's name.
And it hardly makes sense to put the property in two people's names because anyone who signs for the debt will be negatively impacted on their DTI ratio.
When an LLC takes on debt, it doesn't impact the member's DTI ratio at all.
I buy all of my investment properties in an LLC for 3 main reasons:
- Asset Protection
- The Financing Doesn't Depend on my Personal Income; and,
- Customized Ownership Structure