Holding your real estate in a separate legal entity is an important component of investing. If done right, this entity can limit your personal liability, protect the asset from your own financial troubles, and encourage investors and lenders to put money into your venture.
But legal entities are not one size fits all. There are many considerations you will have to make to decide whether to hold real estate in an LLC or Corporation or something else. So even though people hate it, we have to give a typical lawyer answer for the question of what legal entity to use for real estate investments—the answer is “it depends.”
Below are rules of thumb to keep in mind when deciding what legal entity to use for real estate investments.
Rule One: Protect Yourself and Limit Your Liability
In general, a lot of liability can arise from any business, including real estate. The types of liability are numerous, including liability from defaulted loans or legal liability from accidents on the business property.
Limited Liability Entities vs. Partnerships
The default rule is that without some type of separate legal entity, the person running the business will be held fully liable. Some legal entities won’t even help you in this regard. For example, sole proprietorships and general partnerships hold the owner or general partners completely liable for debts.
This is particularly dangerous with real estate because investors typically take out loans to buy the underlying property. If an owner is held liable for the entire amount on a loan default or on some big lawsuit, the creditors could seize the owner’s personal home, bank account, car or other assets. Don’t risk losing the family farm! Be very careful if you’re using a partnership or holding real estate in your own name.
In general it is better to consider using a limited liability entity to help you avoid risks of losing your personal assets in the event of a default or lawsuit. Oftentimes, real estate investments are held under an S-Corp, LLC, or Limited Partnership. These entities offer the legal protection needed to stay safe from most business-related liabilities that normally arise.
Personal Guarantees May Still Be Required
Although these entities protect you from some liability, most banks will not lend to a borrower who does not agree to be personally liable for the loans. This is often just an unavoidable cost of doing business. Under these contracts you will be held liable for the principal of the loan and all accrued interest in the event that there is a default.
That being said, absent some bad acts on your part, these limited liability entities will protect you from other forms of business liability, such as accidents and injuries. If someone slips and falls on your property, they likely couldn’t get to your personal assets, only the assets held by the limited liability entity.
Further, being personally liable for the debt might not be so bad because the debt is secured by the underlying real estate. Usually, the value of the real estate is higher than the amount due on the loan so there would be no need to go after your personal assets—the worst case scenario would likely be a foreclosure where the real estate is sold to satisfy the debt.
But, as was the case in the recent burst of the housing bubble, circumstances that bring the value of the property down can spell trouble.
Rule Two: Take Advantage of Pass Through Taxation
Another good thing about using an LLC or S-Corp to hold real estate is that these entities act as a pass through for tax purposes. Basically, any income derived from the business will be reported to the IRS as personal income. This avoids the “double taxation” problem of C-Corps where the company is taxed on income, and then owners are taxed again for dividends or capital gains.
Not only do these entities avoid double tax, owners can often use losses to offset personal income and reduce their overall tax burden. Although “losses” sound bad, several tax rules, such as depreciation deductions, allow a real estate investment to report losses even though it is making what most people would consider income. If you owned the entity as a C-Corp, you generally couldn’t take advantage of these losses.
Rule Three: Stay Flexible
Everything in law depends on the circumstances of an issue. Despite the burdens of double-taxation, some investors still incorporate their real estate investment through a traditional C-Corp for different reasons.
One reason is privacy. Since there is no pass through tax relationship, people doing business with the C-Corp usually have no right or reason to look into the finances of the owners. This comes into play frequently during the loan application process. Banks want to ensure they know about all the risk associated with issuing a loan.
If you are using an LLC or an S-Corp, lenders often ask for substantial documentation for all your investments, such as tax returns and profit and loss statements for the last two years. This can be costly and drag out the loan process considerably. If you are using a C-Corp, the bank should only ask for documents related to that investment, because a C-corp is considered a separate legal entity unrelated to its owners, or shareholders.
Because the C-Corp can speed things up for financing, it is sometimes recommended as the entity of choice for active real estate investors engaged in fix-and-flips, wholesaling, or other real estate business models aside from long-term buy and hold investments.
All in all, which type of entity you should use to hold real estate will largely depend on the specifics of your situation. This includes, the type of property you are buying, the location of the property, the purpose for which it will be used, and the overall business strategy or reason for buying the property in the first place.
Every city and state has different laws and taxes that affect each type of real estate holding entity in different ways. Further, you want to ensure that the entity is structured and maintained in a way that ensures your ongoing protection.
So don’t let these rules of thumb fool you into thinking there is one straightforward answer to the question of what legal entity to use for real estate investments. The best thing you can do is to seek help from a qualified real estate lawyer to advise you on how to set up your legal entities and which is the best entity for your real estate investments.
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