If you’re going to invest in real estate there are many legal entities that you should consider because of the benefits they’ll provide you. No one entity meets every investor’s needs, so research is necessary.
But with enough research, you’ll be able to make the choice that’s best for your business.
What are the main aspects of entity structuring?
Entity structuring has three main components: compliance, legal, and tax. What you want is to find the entity structure that suits your needs best because none of these is one size fits all. Luckily, structures can be changed, giving you some much needed wiggle room. So, what do these categories mean?
- Compliance: This refers to the requirements you have to meet in order to claim the entity in the first place. This includes annual filings, fees, separate tax returns, mandatory meetings, etc.
- Tax liability reduction: this refers to how a given entity will reduce your tax liability.
- Asset Protection: This refers to how the entity structure inoculates you against bottom up and top down creditors.
- Bottom up creditor: This is a creditor who has a claim and/or judgment against the company itself due to an act or omission committed by the company.
- Top down creditor: This a creditor who has a claim and/or judgment against a particular member of the company. If the creditor wins the judgment against the particular member in question, then the company provides no protection for the member.
What are the advantages of incorporation?
- Liability Protection: Liabilities are various responsibilities or obligations.
- Perpetual Existence: this means that the business won’t be affected if one of the owners dies or withdraws
- Tax Advantages: There are tax deductions you can take for many types of operating costs that’ll significantly lower your company’s general tax liability.
- Improved Business Perception: Literally, people think more of a business if “Inc.,” “Co.,” or “LLC” appears after the business’s name.
- Easier Management: When you incorporate your business you centralize it, which tends to mean a board of directors, which makes running things easier.
- Incorporating is Easy: Incorporating isn’t time consuming and can cost you less if you don’t use a lawyer.
What’s some vocabulary you should know?
Limited Liability Company (LLC): An LLC is an unincorporated business filed under state law wherein the owners, who are called “members” or “managers”, have limited legal liability. An LLC is a hybrid entity that provides some of the legal benefits of a corporation and some of the tax benefits of general partnerships.
An LLC can be taxed as a corporation, partnership, or as a sole proprietor. In the arena of real estate, however, an LLC should choose to be taxed as a partnership so that it can take advantage of the tax benefits offered to partnerships.
Partnership: This is an association of two or more legal persons (or entities) joined in a business. It’s affordable and easy to form a general partnership, and there are no state filings to worry about either. Although not advised, partnerships can even be done informally and verbally. General partnerships expose you to a lot of liability, so they’re not recommended for real estate transactions.
LLC-Partnerships: This is both a legal and tax entity with a minimum of two members. These tend to be the ideal entity for real estate ownership. Partnerships receive a lot of tax benefits, and they also have a lower risk of being audited by the IRS.
Limited Partnership (LP): An LP is a legal entity formed under state limited partnership statutes. LPs have at least one general partner and one limited partner. Tax wise, an LP is a pass-through entity, which is an entity through which income passes before finding its way to the LP’s owners and/or investors.
An LP files partnership tax forms and receives almost all the same tax benefits as a partnership. Limited partners are wholly subject to passive loss limits and, as a result, are not entitled to deducting rental property losses against other types of income.
Corporations: Legally, a corporation acquires personhood and exists separately, distinctly, and apart from its owners. There are two relevant types of corporations:
- C Corporation: C-corporations have their own tax rate schedule and pay their own corporate taxes. They’re taxed separately at a tax rate of roughly 40%
- S Corporation: S-corporation do not have their own tax rate schedule. They usually don’t pay their own corporate taxes. Income and losses, within certain limits, pass through to the shareholder’s own tax returns. S-corporations offer limited liability identical to a C-corporation, but don’t have the disadvantage of being double taxed.
S-type corporations are good for short term cash investment strategies with significant profit streams. This way you can pay yourself a salary that’s subject to self-employment taxes while your remaining income will be subjected to regular rather than self-employment taxes.
Series LLC (SLLC): The SLLC includes a master or umbrella LLC and other LLCs that, for liability purposes, are separate from each other. Each LLC has its own separate assets, while the master or umbrella LLC controls all the other LLCs. Each unit has its own members, and each separate LLC is liable only for that LLC’s separate debts and obligations.
Why form an LLC?
If you want to own real estate, then LLC can be very useful. Such LLCs are known as real estate holding companies (REHCs) and they exist for the sole purpose of owning real estate. They are formed so that any contracts and deeds are in the company’s name. If you get financing, the mortgage will be under the LLC’s name as well.
What does it take form an LLC?
An LLC is easy to form. All you need is a certificate of formation, also known as articles of organization, within the state your LLC will function in. You fill out some paperwork and pay a fee, which usually ranges between $50 and $200. In most states, you renew your LLC every yer for a nominal fee. You also need a tax ID number from the IRS. If your LLC has members other than you, then you’ll want an operating agreement that outlines how the company is run.
What are the legal benefits of an LLC?
One benefit of an LLC is that it protects your business. Imagine you open a small clothing store. You name the store, known as the operating company, “Fine Fashion Inc.” You need property for the store but don’t want to expose Fine Fashions Inc to liability, so you form an LLC, called “Fine Fashion House LLC” and purchase the property in the name of Fine Fashion House LLC. Now if there’s a mishap on the property, it’s Fine Fashion House, LLC that’s liable and it’ll take the hit, but no action can be taken against Fine Fashion Inc.
What are the tax advantages of an LLC?
An REHC with only one owner is treated as a sole proprietorship, which is more commonly known as a “disregarded entity”. The income and capital gains the REHC earns goes straight to the owner, who pays taxes as an individual. Business owners are likely to avoid double taxation thanks to their REHC because their LLC doesn’t pay separate taxes. The owner of the REHC can also deduct their mortgage interest. LLCs get more deductions in addition to being subjected to less taxes.
REHCs owned by multiple people, known as “multi-member” LLCs, are taxed in a way comparable to a partnership. Multi-member LLCs get the same pass-through taxation benefits as LLCs because the positive and negative income flows through the REHC to its members. It’s on each member, then, to report their share of the gains and losses on either a Schedule C, K, or Form 1065 with their individual tax returns.
How do LLCs compare to other legal entities?
There are several advantages that LLCs have over other legal entities in the arena of real estate investment.
- Management: An LLC’s structure makes delegating responsibility and positions easier. Corporations are required to have officers and directors, whereas LLCs can be managed by their owner or a third-party.
- Fees: Many states have additional fees on the authorized number of shares a company may have. Even though LLCs have to pay these fees, corporations may pay more. That makes state registration and maintenance fees less for an LLC.
- Flexibility: S corporations have to be pro rate in the distribution of cash flow. This means that the distribution of income is in proportion to someone’s stake in the company. LLCs, meanwhile, are not bound by this rule, and can, for example, give someone a bonus if their contributions were deemed deserving of it by virtue of their “sweat equity”.
- Versatility: Nonresident aliens aren’t allowed to invest in S corporations. S corporations also tend not to offer any advantages for real estate investors. LLCs don’t suffer from these limitations!
- Transfers: LLCs make it easy to transfer ownership of the company. Real estate holdings can even be gifted to heirs every year without even having to sign a deed. Gifting property even has the benefit of allowing certain taxes to be avoided.
How do other legal entities compare to one another?
C corporations
Corporations are their own legal entity. They protect their owners from personal liability. They are taxed on the corporate and income level. Their other benefits are:
- The amount of an owner’s investment determines their liability.
- Can be managers or only passive investors.
- There’s no limit on the number of shareholders a C corporation can have at any time.
- All an owner has to do to transfer ownership is sell their shares.
- Corporations continue to exist if an owner dies.
S corporations
Unlike a C corporation, an S corporation chooses to be treated as a pass-through entity for tax reasons. S corporations are not subjected to double taxation because they’re pass-through entities. They otherwise enjoy the same benefits as a C corporation.
Sole Proprietorship
This is the simplest type of business. By default, anyone who starts a small business becomes a sole proprietorship. There’s no separation between the sole proprietorship and the individual. The advantages of a sole proprietorship are:
- It requires no paperwork to get going.
- Lowest starting costs of all legal entities
- Owner reports all gains and losses on their own tax returns, so there are no extra filing requirements.
- A sole proprietorship is reliant upon just one person.
How does a real estate holding company compare to liability insurance?
Not everyone who invests in real estate ends up forming an REHC. For some investors, the fear of a potential lawsuit isn’t motivation enough for the commitment an LLC requires. For such investors, liability insurance may be a better route. It’s important to remember, however, that liability insurance, like all insurance, has limitations, exceptions, and addendums that create murky waters. You may think you’re covered and then find out that you’re actually not.
While it’s not likely that a potential lawsuit will land you in a space without coverage, it’s not impossible. If it does happen, such a lawsuit can be tremendous. So, while it takes effort and commitment to form a legal entity, they provide more protection than liability insurance. Plus, you can’t put a price on peace of mind.
What should you do if you want to move a property that has a loan on it into an LLC?
Don Ganguly, founder of HomeUnion®, answers this question in conversation with Brooke Pollard, Attorney at TLD Law.
Should a landlord with only one property form an LLC?
Yes, a multi-member LLC with a solid and detailed operating agreement/umbrella policy has some solid advantages for a landlord:
LLCs are easy to run because they have the least compliance requirements. You don’t have to have meetings, and even the recommended operating agreement is itself optional (although you should have one).
Thanks to the legal protections offered by an LLC, you can significantly minimize your liability–especially with a solid operating agreement.
The form you use for your taxes 8825 (rental property form for a partnership) is audited far less often than a Schedule E (rental property form for an individual/sole proprietorship).
Bottom line
There’s no one size fits all legal entity for your real estate investment endeavours. Luckily, there’s many legal entities for you to choose from and even liability insurance in the event that you don’t want a legal entity at all.
And while an REHC may be the most common legal entity used for real estate investment, it doesn’t mean that you shouldn’t do your due diligence or that your needs won’t change. Luckily, your choices aren’t etched in stone, so you can always adjust accordingly!
