Business Formation for Real Estate Investments

Real estate can be a great investment if you plan it correctly. Since the housing market bust in 2008, investors have been wary of starting back up in real estate, but home prices have made a significant recovery since then. Nonetheless, the market has become a bit lopsided in many parts of the country.

These conditions can scare away investors, but that does not mean that investing in real estate under the right conditions is a bad idea. Instead, investors just need to take extra precautions if they plan on owning, flipping, or renting property.

One planning item that should be on any real estate investor’s list is which business entity will work best for their investment. The answer may vary depending on several factors, and there is no “one size fits all” solution.

An Example of the Importance of Asset Protection: Corporate Veil

Imagine that you have purchased an apartment building that you are currently renting to 10 tenants. One tenant hurts himself in the parking lot and claims that you are at fault because you did not provide proper lighting in that area. He may initiate a lawsuit and obtain a judgment in his favor. The judge will then award him damages related to any injuries or losses that he may have suffered. These damages could be in the thousands of dollars, depending on the type of harm.

If you have insurance, your insurance company will likely help you with this type of claim, but there are limits to every coverage. If your insurance does not apply, you do not have insurance, or you have hit your coverage limit, you will be on the hook for the remaining amount of the judgment.

If you do not have a separate legal entity that provides asset protection, this tenant-turned-judgment-creditor can garnish your wages, repossess your property, and put liens on your real estate, including your home. On the other hand, if you have established a separate legal entity that provides asset protection, the tenant's recovery will be limited to the apartment building itself or income that is derived from it.

An Example of the Importance of Asset Protection: Charging Order Protection

Imagine that you are involved in a motor vehicle accident in your personal vehicle that is your fault. While your insurance may cover a significant portion of any damages that result from the crash, there are situations where your insurance may not apply or where your coverage does not extend as far as you had hoped. In those situations, virtually everything you own may be at risk, including your investment property if it is not a separate legal entity.

If a separate legal entity holds (or owns) your real estate, then only the income that you receive from that property is at risk (such as wages or dividends). The asset itself will remain intact and safe from your personal creditors, including judgment creditors.

Sole Proprietorship or Partnership

Sole proprietorships and partnerships are considered extensions of the individual owners. They, along with some LLCs and S corporations, are often referred to as “pass-through” entities for tax purposes because any income or expenses from these business types will end up on a personal tax return. Technically speaking, sole proprietorships and partnerships are not separate legal entities because of this pass-through treatment and complete lack of asset protection.

Sole proprietorships and partnerships can still take advantage of tax savings by deducting their business expenses on Schedule C of their tax return. However, the tax savings are often not as extensive as they would be for larger companies, and there is no asset protection available in either of these types of structures. This is even true for general partnerships that may have a partnership agreement.

Simplicity is a huge selling point for sole proprietorships and partnerships, however. There are no formal requirements to form either of these types of business entities, which makes them extremely popular as they are considered the “default” business structure. That is, real estate investors and other small business owners do not have to do anything to create these entities—they simply come into existence when the venture starts to have income.

Limited Liability Companies (LLCs)

LLCs are extremely popular business structures because they offer the simplicity of a sole proprietorship or partnership and the asset protection of more complicated structures like corporations. In fact, many experts will always recommend that real estate investors use LLCs for their real estate investments. However, whether an LLC is appropriate for your investment is still a personal decision.

Real estate investors must file the necessary formation documents to create an LLC in the state of their choosing. The owners of the LLC are called “members,” and there can be as few as one member or as many members as you would like. An LLC has some very specific benefits when it is used as a means to own rental property. In many situations, these include the ability to:

• sell property at favorable capital gains tax rates;
• generate housing credits;
• exchange on a tax-free basis;
• pay for tax on the sale of real estate in installments, in some cases; and
• create depreciation deductions.

Unlike corporations, LLCs do not generally need to conform to the very particular requirements set out by state law for corporations, including having annual shareholder meetings and keeping meeting minutes.

It is sometimes harder to attract investors in an LLC because potential investors must become full-fledged members as opposed to more passive stockholders in a corporation. However, if you are interested in selling your entire investment, an LLC is easily transferable.

An LLC can be taxed as either a partnership or a corporation, which means that investors can have the benefit of pass-through taxation associated with those entities. However, in an LLC you must still pay self-employment tax, which can be significant for some members.

S and C Corporations

Corporations are entirely separate legal entities. They offer the strongest vehicle for asset protection. However, they are also the most difficult to form and are costly to maintain.

There are two types of corporations: S corporations and C corporations. A C corporation is the “traditional” type of corporation. It has its own separate tax rate, and stockholders or owners are taxed individually on their dividends or salaries as well. This “double taxation” often scares off real estate investors from this particular structure as the investment may not be large enough to offset the increase in taxes.

In an S corporation, shareholders elect to be treated as a partnership from a tax standpoint, which means they are only taxed once, and the business becomes a pass-through entity. Nonetheless, S corporations must still meet their corporate formalities and compliance requirements as set out by state law.

S corporations are much more commonly used for real estate investments compared to C corporations because of their favorable tax treatment. However, S corporations have some limitations on who can be a shareholder that may cause some problems. Shareholders in an S corporation must be U.S. individual investors; certain estates and trusts are also permitted to be shareholders. They cannot be foreign persons or corporations. This limitation can be troublesome for real estate investment companies that are large or operate throughout the United States. Nonetheless, shares in an S corporation are simpler to transfer than membership in an LLC. That means that if you are trying to attract outside investors, an S corporation may make it easier to accomplish that goal.