Legal Question in Real Estate Law in California

An LLC, properly formed and maintained, will provide a level of protection from INVOLUNTARY liability arising out of the ownership of a rental property. There are two problems with it, however: 1. accounting and taxes; and 2. making sure it is properly formed and maintained.

Re #1: When you have an LLC (or small S Corp), you have to maintain separate accounting for the company. Then when you do your personal taxes you have to do a full profit and loss accounting for the company, and then transfer the profits to your personal taxes as taxable income. When there is only a single owner, the company can be treated as a "disregarded entity" meaning no separate tax return for the company and no K-1 income report, but when you have real estate investments you still have to provide additional schedules with your 1040. In most states you also have to pay some form of franchise taxes on a disregarded LLC that you don't have to pay as an individual. Lastly, as I'll explain below, if you want liability protection that will survive attack, you have to maintain full separate accounting for the LLC. All of this raises your costs of doing business substantially.

Re #2: It is very tempting for small business owners, including small landlords, to set up an LLC or Corporation and then conduct the business no differently than if they were operating as an individual. They don't separately capitalize the entity. They don't separately insure it. They either don't set up a separate banking structure or they freely move funds between the entity and personal accounts as if the owner and business are one. By acting as if you are an individual owner, rather than maintaining clearly separate identities between yourself and your business, you allow a lawyer suing you to claim that the business entity is a fiction that should be disregarded so they can sue you personally. If you have not put and kept enough assets in the company to pay any foreseeable liability that comes up, and have not maintained clear separation between you and your company's finances, that will almost always be successful. So if you have to keep enough assets in the company to answer for liability, there's not really much asset protection there, is there?

The one alternative to placing your assets in an LLC where a lawsuit can reach them, is to minimally capitalize the company, and then carry insurance to cover any foreseeable liability. But then why bother to form the LLC with the disadvantages I have outlined, if you can just obtain the same insurance protection as an individual owner?

Insurance is an absolute must; as to whether the property should be owned and operated by an LLC depends upon the operator's level of comfort and experience in setting up and running entities like LLCs and sub-S corporations (as Mr. McCormick points out). The financial scale of the rental operation may also affect the choice. I'd say for the average gal (or guy) with one rental, no complications and no prior experience in running an LLC that insurance alone is probably the better choice. Finally, if you do use an LLC or corporation, a question may arise as to whether it needs to be qualified to do business (and pay an annual minimum fee) in the state where it isn't organized, i.e., if you use a FL LLC, it may have to register in California if that's where the business is being managed, or if you use a CA LLC it may have to register in FL because it has income property there.