Consultant’s Corner: Selecting a Business Entity for Real Estate Investing
Q. I own multiple rental properties. Should I form an LLC to protect our personal assets?
It is common to hold rental properties and other real estate investment activities in an LLC or other business entity. Also, if you plan to have multiple investors in any of your property investments, the Limited Partnership structure is a possible consideration. In addition, it is common to hold multiple investment properties in separate business entities for legal risks, financing, income tax, owner liquidity, or other business reasons.
Real estate investing can potentially have mortgage financing, personal injury, workers’ compensation, debt collection, and other business risks that prompt business owners to form a business entity or entities to hold their properties. While there is no one best business entity structure for acquiring and holding real estate investments (commercial, residential, mobile homes, long-term rental, remodeling, flipping, etc.) in every conceivable scenario, many experts recommend that investors hold their properties through LLCs, but an S corp can also be a viable option. Also, limited partnerships are often used for large rental property investments with multiple investors. In addition, properties are often held in one company and a separate company formed to manage the properties. With multiple properties, it is common to have properties owned by separate entities in order to give the owners flexibility in disposing the properties, bringing different investors into certain properties, avoiding any cross collateralization on mortgage and other debts of the properties, and spreading the business risks. In addition, forming separate business entities in different states is effective in some cases, particularly when multi-state operations are planned.
Corporations (C and S types), LLCs, and limited partnerships all provide protection of the owners’ personal assets from the business obligations. However, it is more common for real estate investments to be owned by an LLC, limited partnership, S Corp or other business entity that provides pass-through income tax treatment rather than a C corporation, which is subject to double taxation. Also, a C Corp’s capital gains are taxed at corporate ordinary income tax rates and are not eligible for the preferential capital gains tax treatment that may apply to gains recognized by individual taxpayers or gains passed through to individual taxpayers from pass-through entities that they own (this tax treatment applies as well to an LLC taxed as a C corp). While experts often recommend LLCs for real estate investing activities, the following are some suggestions when forming business entities for real estate activities:
- Passive or non-passive activity status. With real estate investment operations, owners should consider whether they will be full-time real estate dealers or passive investors which affects taxation. Passive income and losses have special tax treatment and limitations on utilizing losses. You can review information on passive activity losses and limits at the IRS website:
- Type of real estate investing: rental property for long-term investment which may generate losses due to depreciation expense; or buying and reselling properties for a profit. Generally, the IRS defines a “dealer” of real estate properties as someone who actively buys and sells real estate on a regular basis with the intention of reselling properties rather than holding them for investment. This definition typically includes individuals who flip properties. The formula for determining who is an investor and who is a dealer is subjective, but the IRS will consider several factors which you can review at the following websites:
If the IRS determines that you are a dealer your properties are not “investments” but rather “inventory.” Property considered inventory is not eligible for the preferential capital gain tax treatment provided to investment property. Gains on the sale of property considered inventory are taxed at ordinary income tax rates, regardless of the business structure.
- The long-term growth plans including capital requirements and additional partners or investors.
- Income level from your other jobs or businesses. This affects the amount of self-employment taxes and the ability to absorb losses of the real estate operations.
- Other entity comparisons are:
- No corporate double taxation on earnings with an LLC not taxed as a C corp and a corporation taxed as an S corp.
- With an LLC not taxed as a C corp and a corporation taxed as an S corp, elimination of double taxation when the business is eventually sold.
- With an LLC taxed as an S corp and a corporation taxed as an S corp, self-employment tax savings can be achieved in certain situations.
You can review additional discussions on selecting a business entity for real estate investing at the following websites:
Also, you can review general business entity comparisons at the following websites:
- Rental property due on sale considerations. If you have mortgage loans on any of your personally owned rental properties, you will have mortgage loan due on sale clause considerations if you attempt to transfer legal title of these properties to a business entity that you form without first obtaining the permission of the mortgage lenders. Most mortgage loans have an alienation or due on sale clause which prevents the borrower from transferring ownership of the property without the permission of the lender. If the property is transferred without the lender’s permission, and the lender discovers the transfer after-the-fact, the lender could call the loan. Calling the loan would make it immediately due and payable, which would force you to refinance the loan, assuming you couldn’t pay it off, under a revised risk scenario and quite likely a higher interest rate. You can review the following example industry information regarding due on sale clauses:
Due to the various legal and tax implications when evaluating business entities and business reorganizations, business owners generally use local professionals (CPA, lawyer, and business insurance agent) for help in reviewing their business plans and evaluating business entities, tax, licensing, legal, and risk management issues.