Incorporating a rental business may offer legal protection for a landlord’s personal assets along with various tax benefits, including pass-through taxation. Forming a business for rental property also creates a more straightforward structure for managing multiple properties, allowing for easy scaling.
However, this also means the landlord will be subject to laws governing businesses in their jurisdiction, and in some cases, they may have to pay any mortgage balances before incorporating.
This article explains the concept of incorporating for rental businesses, the advantages and disadvantages of incorporating, and the next steps after forming a business so you can make an informed decision for your property.
What Does it Mean to be Incorporated?
When a landlord earns income from rental property, they usually operate as a sole proprietor, meaning there’s no legal separation between owner and business. This setup offers minimal legal protection.
Incorporating creates a distinct legal entity that owns and manages property independently from the landlord. While the landlord maintains control over operations, the business entity has its own tax, financial, and legal responsibilities. This means the entity can enter contracts, buy property, and even face lawsuits, much like an individual.
For landlords with multiple properties or co-owned investments, incorporation provides a formal management structure, helping streamline decisions and growth.
Legal Protection
During incorporation, business owners transfer ownership of some assets to the legal entity formed and leave the rest as personal assets. In the case of a lawsuit or debt collection case against the business, only the assets under its ownership can be used to cover these damages. The owner’s personal assets are safe from business liabilities.
Example
You own a rental property. One tenant reports a worn-out floor section, but before you can fix it, another tenant slips in the same area and suffers serious injuries. If the rental business is incorporated, the tenant can sue the legal entity but not you as the landlord, protecting your personal assets from compensation claims.
Formal Structure
When filing incorporation documents, rental property owners must understand and define the purpose of forming a new business entity. For properties owned by multiple landlords, the incorporation process involves creating an agreement on managing key business procedures such as shareholder or member powers, decision-making, signing contracts, and voting rights.
For sole owners, incorporation streamlines the financial management of multiple properties, making it easy to expand and acquire more rentals.
Steps to Incorporate Your Rental Business
The steps and requirements for registering a rental business vary from state to state but generally include:
- Select a Name for the Entity: Review your state laws and requirements for choosing a business name and conduct a search to ensure the name’s availability.
- Appoint a Registered Agent: Businesses must have a primary person or entity address in the state where the rental properties are incorporated to receive legal documents on behalf of the business.
- Form a Board of Governors or Directors: A board of directors will fill the management knowledge and experience gap among property owners who have not run a business before. Make sure to clearly lay out terms such as length of service, decision-making powers, and compensation.
- File the Articles of Incorporation: File a set of formal documents with the state to form the legal entity that will own and manage your rental business. The filing fees and specific details to include may vary from one state to another, but most must include the business name, its purpose, physical address, board of directors, and a registered agent’s address.
- Draft Bylaws: While this is not mandatory in all states, creating an official document with guidelines on how the board of directors should run the business will encourage smooth operations and prevent conflict, especially when there are multiple owners.
- Obtain an Employer Identification Number (EIN): The Internal Revenue Service (IRS) requires all corporations to obtain an EIN identifier for tax administration and bank account purposes. You can apply for an EIN for your incorporated rental business online, by fax, by mail, or by telephone for international applications [1] .
- Obtain Business Licenses and Permits: Depending on the type of rental property and state laws, you must obtain several licenses and permits that allow you to operate within a particular area. You’ll also need to purchase business insurance in case of general liability or disasters like fire.
- Issue Shares of Business Stock: Incorporation allows a company to sell shares of ownership as a way of raising capital. During the first board meeting, board members will authorize and issue shares to themselves and other interested parties.
Transferring Property to Your Business Entity
The transfer of property is done once the state recognizes an incorporated entity as a legal business. Transferring ownership of rental properties funds the new business entity. This is crucial for liability protection offered by incorporation and when looking for financing.
The steps to transfer a property to a corporation vary from state to state, but most places require business owners to:
- Gather the required documents, including articles of incorporation, bylaws, and rental property titles.
- Speak with your mortgage company to understand how the transfer may affect your terms of repayment.
- Fill out a deed of transfer form, which in this case may be a quitclaim deed or a warranty deed.
- Obtain signatures with a notary.
- Pay the required fee and file the documents with the local county recorder’s office or relevant government authority in your state.
- Update the property’s tax records to reflect the new owner.
Advantages & Disadvantages of Incorporation for a Rental Business
Property owners must understand the benefits and downsides of incorporating a rental business and their implications on processes like taxation, liability, and administration.
Pros
- Liability Protection: Incorporation safeguards an owner’s assets, ensuring lawsuit plaintiffs and debtors can’t use them as compensation. For instance, a water leak at your rental property that isn’t fixed quickly can lead to a costly lawsuit. Incorporating separates your personal assets from such claims.
- Pass-Through Taxation: This prevents double taxation on business and personal income for rental business owners. Your incorporated rental business could also be eligible for various benefits that reduce your tax burden.
- Streamlined Business Operations: A board of directors and corporate bylaws ease the stress of managing multiple properties, encouraging further investments and business expansion.
Cons
- Incorporation Costs: The incorporation process may be costly, especially for owners who have just purchased their property. Ongoing and one-time costs include filing fees, finding a professional registered agent, property transfer fees, and compensating the board of directors.
- Due-on-Sale Clause Activation: Incorporating a rental business may trigger its due-on-sale clause during transfer if the property has a mortgage balance [2] . Owners may have to pay the balance in full or revise borrowing terms and obtain written permission to transfer ownership.
Managing Your Incorporated Rental Business
Your incorporated rental business will have an operating agreement or corporate bylaws outlining how to manage the business entity formed. The board of directors will draft these rules at their first meeting to oversee business processes such as voting, holding meetings, the number of shares available, profit and loss distribution, and key decision-making. Board members may also draft additional guidelines on property management issues like evictions, lease agreements, tenant screenings, and property repairs.
Like other property owners, incorporated rental businesses are expected to follow federal and local property management laws. Examples include anti-discriminatory laws like the Fair Housing Amendments Act (FHAA), safety standards and maintenance laws, and lease agreement laws [3] .
Corporation vs. LLC for a Rental Business
The most common types of business entities rental businesses can choose from when getting incorporated are a limited liability company (LLC) and a corporation. Both offer nearly the same legal protection but are distinct in several ways, including who they’re ideal for.
An LLC is easier to start and manage because it doesn’t require many steps or complicated accounting requirements, especially if you’re the sole property owner. To start an LLC for rental properties, owners file the articles of organization with the secretary of state for official incorporation.
A corporation is owned by shareholders as opposed to members of an LLC. It’s more suitable for rental properties with multiple owners who may not all want to take active management roles. Corporations for rental properties tend to own many properties, such as luxury apartments or a chain of vacation homes. To start a corporation, owners file the articles of incorporation with the relevant state agency.
Feature | LLC | Corporation |
---|---|---|
Ideal For | Single property owners or small groups seeking simplified management | Multiple owners or investors, especially when some prefer a passive role |
Ownership Structure | Members (individuals or groups who actively manage the property) | Shareholders (may include passive investors who don’t manage property directly) |
Management Requirements | Minimal formalities; flexible structure | Requires a formal management structure (e.g., board of directors, officers) |
Ease of Setup | Easier setup and management; articles of organization filed with the state | More complex setup; requires filing articles of incorporation and more regulatory compliance |
Accounting Requirements | Simpler accounting and tax flexibility (pass-through taxation available) | More structured accounting; separate tax return for the corporation |
Typical Uses | Single-family homes, small portfolios, or beginner rental investments | Larger portfolios, luxury apartments, or chains of vacation homes |
Umbrella Insurance for a Rental Business
Landlords who are not ready to incorporate their rental businesses but still want to protect their personal assets may benefit from an umbrella policy instead. Umbrella insurance is an additional liability policy that provides coverage beyond the limits of your other business liability insurance.
For instance, consider a rental property owner with $15 million in liability insurance and a $10 million umbrella policy. If a swimming accident lawsuit in a rental property results in a $20 million settlement, the umbrella policy will pay the $5 million difference after exhausting liability insurance.
However, an umbrella policy doesn’t provide limited liability protection and the potential tax benefits available after incorporating a rental business.
Final Thoughts and Next Steps for Your Incorporated Rental Business
Incorporating a rental business protects a landlord’s assets from debtors and lawsuits, offers various tax benefits, and streamlines property management. An LLC or corporation are two of the most common business structures landlords can choose from to reap the most legal and organizational benefits.
After incorporation, corporation owners must create a shareholder agreement to agree on matters such as shareholder powers, profit and loss distribution, and management.
New lease agreements may not be necessary if you already had one in place before incorporating. However, consider asking existing tenants to sign a lease amendment that acknowledges the change in ownership.
Next Steps for Incorporating a Rental Business
- Finalize Bylaws: Draft bylaws for management and legal compliance.
- Update Lease Agreements (If Necessary): Ask tenants to acknowledge the ownership change with a lease amendment.
- Secure Appropriate Licenses and Permits: Check local requirements to ensure compliance.