Owning investment properties can be exciting and lucrative. However, investments in real estate, whether vacation rentals, long-term rentals, or properties for resale, can also create liabilities. That’s why it’s critical for real estate investors to wisely choose how they will structure their businesses.
For example, a renter might trip on an unstable staircase. A guest could slip on an uneven sidewalk. Faulty electrical wiring could shock a tenant or cause a fire. Or a slow leak in a building’s plumbing might cause mold that affects a tenant’s health.
Accidents happen and they can potentially lead to lawsuits against the property owner.
Some business structures, such as Sole Proprietorships and General Partnerships, leave property owners personally responsible if someone sues for damages caused at a property. Other business entity types offer some level of personal liability protection. Without personal liability protection, a property owner’s personal bank accounts, stock, home, and other investment properties may become vulnerable to cover legal costs and settlements.
The business structures real estate investors choose also affect taxes, which can have a notable impact on their bottom line!
Because the way real estate investments are structured has legal and financial ramifications, it’s important that owners seek guidance from trusted, licensed professionals in the fields of law, accounting, and tax matters.
Business Entity Options
There are various ways investors might structure their property investments to minimize their personal liability and gain tax flexibility. Let’s take a look at the three most common, which are the Limited Liability Company (LLC), Limited Partnership, and the C Corporation.
Limited Liability Company (LLC)
Here’s a brief overview of some of the advantages of the LLC entity type:
- An LLC is a separate legal entity from its owners, so it limits personal liability.
- By default, an LLC is a pass-through entity. However, if it meets the IRS criteria, an LLC may elect S Corporation tax treatment.
- Forming an LLC is relatively cost-effective and simple. It requires submitting Articles of Organization with the state.
- Most states allow an individual or a company from outside of the United States to own an LLC.
- The LLC structure has minimal ongoing compliance requirements.
- An LLC has flexibility in how it distributes its profits among its owners (members). Distributions do not have to follow the percent of owners’ monetary investment, so members may be compensated according to their involvement in running the business instead of based only the funds they provided.
- LLC members may proactively gift real estate holdings to their heirs each year. Thereby, they can pass their real estate to family members without executing and recording new deeds. This saves money by avoiding the state transfer and recording taxes and fees.
There are several ways to structure real estate using the Limited Liability Company for real estate investments. Let’s explore these options one by one.
1. A Sole LLC for All Properties
With all real estate investments under one entity, this approach offers the perk of simplicity.
- Only one Articles of Organization needs to be filed.
- There’s no business tax return, and each LLC member has just one business that passes its income and losses taxes through to their personal tax return. Also, the owners need only maintain compliance for one entity.
A potential drawback to having all properties under a single LLC is that if a lawsuit targets one property, assets at all of the LLC’s properties will be at risk.
2. Separate LLCs for Each Property
In this approach, each property is under its own LLC. Because they are individual legal entities, properties are protected from the other real estate investments’ liabilities. There are more formation requirements and costs to handle things this way.
- Owners must file Articles of Organization and pay the associated business registration fees for each LLC.
- Filing income taxes will require filing separate tax schedules with members’ personal tax returns for each LLC.
- Ongoing compliance formalities must be maintained for each LLC.
3. Series LLC for Multiple Real Estate Investments
A series LLC (SLLC) refers to an umbrella LLC with separate LLCs for each property structured beneath it. While there’s just one Articles of Organization required to form a series LLC, each LLC in the series operates as a separate entity. Each LLC in the series has its own business name, establishes its own bank accounts, and maintains its own records. The individual series’ assets, liabilities, operations, and membership interests are independent of other series under the umbrella LLC.
Some of the advantages of a series LLC include:
- Owners enjoy limited personal liability, and individual properties’ assets are protected from the others’ liabilities. If one series gets sued, other series aren’t liable.
- Real estate investors pay just a single LLC formation filing fee to the state, no matter how many series are part of the series LLC.
- The structure may help simplify federal income tax reporting. If a series LLC is structured carefully, all of the series under the umbrella entity may be able to be reported on a single tax return.
However, not all states allow the formation of a series LLC. Presently, only the following 18 states and U.S. territories recognize the SLLC:
- Alabama
- Delaware
- District of Columbia
- Illinois
- Indiana
- Iowa
- Kansas
- Missouri
- Montana
- Nevada
- North Dakota
- Oklahoma
- Puerto Rico
- Tennessee
- Texas
- Utah
- Wisconsin
- Wyoming
A note about my home state of California: The Golden State doesn’t allow people to form domestic series LLCs. However, series LLCs from other states may register as foreign entities to do business there.
Another possible disadvantage of the series LLC structure is that states have no uniform reporting requirements or consistent rules for how income tax is applied to series LLCs. Investors are wise to find out a state’s stance on SLLCs before moving forward. Does the state treat each series as its own separate tax entity? Does it treat the master LLC and all of its series as a single entity? These are essential questions to answer!
Limited Partnership
Another structure that real estate investors might choose is a Limited Partnership (LP). Real estate investors who seek outside investments from people or companies that do not wish to run the business may find this an attractive option.
An LP has at least one general partner and a limited partner. There may be multiple general partners and limited partners. General partners oversee and manage the business day-to-day, and they assume all responsibility for the business’s debts and liabilities. Limited partners invest money in the business but are typically not involved otherwise, except for partaking in major decisions that require partners to vote. Because of their limited involvement, limited partners are only liable for the business to the extent of their monetary investments.
Forming an LP requires filing business registration paperwork with the state. Real estate investors in the LP should also create a Partnership Agreement to detail the rights and responsibilities of general and limited partners and document ownership interests.
C Corporation
A C Corporation provides personal liability protection for key stakeholders in the business, including shareholders, directors, and officers. Incorporating as a C Corp requires filing Articles of Incorporation, creating bylaws, establishing a board of directors, and possibly other tasks. Ongoing compliance also is more extensive than for the LLC structure.
Realize that tax implications of holding real estate in a corporation may become complicated, and possibly costly, with double taxation on some company profits. Do a Google search, and you’ll see articles that warn against incorporation as a way to hold real estate investments because of the tax ramifications.
Business Structure Wizard
This free, online tool helps small business owners navigate the process of picking the right business structure for their new business.
Owning Properties in Multiple States
Suppose investors want to keep properties in multiple states under one company. In that case, they can consider registering the entity they formed in their home state as a foreign entity in the other states. This is referred to as foreign qualification. The pre-requisite is that the other states will recognize the entity type registered in the investors’ home state.
Another option is to form wholly separate domestic entities in the states where the individual investment properties are located.
Common Mistakes Investors Should Avoid
As I mentioned earlier, getting legal, accounting, and tax advice from experienced professionals will help ensure property investors make an informed decision about how to structure their businesses. Those experts can provide wisdom about what to do and not do. They can also help avoid mistakes that can cost investors precious time and money.
1. Not Transferring an Existing Property Deed to the Business Entity
Although this may seem like I’m stating the obvious, some real estate investors who have a property in their personal name forget to do this! After forming a business entity, the investor needs to sign a deed transferring the property to the business. Also, the deed must be recorded with the county where the property is located. Failure to do this may mean that the investor will legally remain the property owner personally and, therefore, be the defendant in any lawsuit associated with it.
If a business entity purchases the property directly, investors won’t have to worry about transferring the property deed because it will be in the business’s name from the start.
2. Not Insuring the Property Under the Business Entity
To protect property from liability and damage, investors should consider a comprehensive landlord’s property insurance policy in the business name. It’s critical to have written proof showing the business name as the entity insured, so the insurance company won’t have reason to deny coverage in the event of a claim. Investors who have registered separate entities for individual properties would likely need separate coverage for each one.
3. Not Keeping the Business Entity in Compliance
Suppose investors don’t maintain their business entities as required legally. That can put their personal assets at risk in a lawsuit against the business. Noncompliance pokes a hole through a business’s corporate veil, the protective shield that maintains legal separation between a business entity and its owners. Different states have different requirements. Regardless of where a business entity is located, real estate investors should keep their personal funds separate from those of their companies.
4. Wasting Money on an Expensive Lawyer
I strongly recommend that real estate investors consult their lawyers to determine the business entity type that will serve them best. However, it may not be necessary to incur the costs of having a lawyer complete the business registration paperwork. A reputable legal document filing service, like CorXec, can handle the forms and filings quickly and more affordably.
