Investing in real estate can be a smart move if you approach it wisely. After the housing market crash in 2008, many investors were hesitant to dive back in, but home prices have bounced back significantly since then. However, in many areas, the market has become a bit unbalanced.
These conditions might make some investors nervous, but it doesn’t mean that real estate investment is a bad idea under the right circumstances. It just means that investors need to be extra cautious if they’re considering buying, flipping, or renting out property.
One important thing for any real estate investor to consider is which business structure will suit their investment best. The right choice can vary depending on various factors, and there’s no one-size-fits-all solution.
The Importance of Business Entity Choice for Real Estate Investors
Think of your real estate investment as a business. Once you grasp that concept, you’ll find it easier to navigate the various aspects of the venture. For instance, you not only need to think about protecting your assets when deciding on your business entity, but you should also consider taxes, ways to attract investors for funding, and other fundamental business considerations. Establishing a business entity also helps you build credibility and a positive reputation in the community, which can be valuable for both an investment company and a landlord.
Choosing the right business structure can significantly reduce your liability exposure, but it doesn’t replace the need for insurance. On the flip side, insurance is important, but it can’t do everything that selecting the right business structure can.
Real Estate Investments and Asset Protection
The primary reason people choose to establish a legal structure for their real estate investment is for the asset protection it offers. With a separate legal entity, the assets and liabilities are contained within the company. This is crucial because it shields you from liability if the business can’t cover its debts or meet certain obligations.
Without asset protection, creditors or those with legal judgments against you could potentially seize your personal assets to recover what the business owes them. However, with your real estate investment under a legal structure, only that specific property is at risk. In other words, creditors might access the property, but their influence shouldn’t extend beyond that. This safeguard is often referred to as “corporate veil” protection.
Asset protection also works the other way around. If you have personal liabilities you can’t handle, a separate legal entity can often shield your business assets from personal creditors or those seeking judgments against you. This safeguard is often called “charging order” protection.
An Example of the Importance of Asset Protection: Corporate Veil
Let’s say you’ve bought an apartment building and you’re renting it out to 10 tenants. One of them gets injured in the parking lot and blames you, saying there wasn’t enough lighting. He might decide to sue and if he wins, the judge could award him damages, which could be quite hefty depending on the extent of the injury.
If you have insurance, it might cover this kind of claim, but there’s usually a limit to what it’ll pay out. If your insurance doesn’t apply, you don’t have any, or you’ve hit your coverage limit, you’ll be responsible for paying the rest of the judgment.
Without a separate legal entity offering asset protection, this tenant-turned-judgment-creditor could go after your wages, take your property, and even place liens on your real estate, including your home. But if you’ve set up a separate legal entity providing asset protection, the tenant’s recovery would be limited to the apartment building itself or any income it generates.
An Example of the Importance of Asset Protection: Charging Order Protection
Picture yourself in a motor vehicle accident in your personal car, and it’s your fault. While your insurance might cover a good chunk of the damages, there could be scenarios where it doesn’t apply or doesn’t cover as much as you’d hoped. In those cases, practically everything you own could be on the line, including your investment property if it’s not under a separate legal entity.
But if your real estate is held by a separate legal entity, only the income you get from that property—like wages or dividends—is at risk. The property itself stays safe from your personal creditors, including those with judgments against you.
Which Legal Structure Will Work Best?
Every business structure comes with its pros and cons. But when you’re deciding which one fits your needs best, you should really consider these key factors:
- Asset protection
- Tax advantages
- The ability to attract investors
Sole Proprietorship or Partnership
Sole proprietorships and partnerships are essentially extensions of the individual owners. Along with certain LLCs and S corporations, they’re often known as “pass-through” entities for tax purposes because any income or expenses get reported on personal tax returns. Technically, sole proprietorships and partnerships aren’t separate legal entities because of this pass-through treatment and the fact that they offer no asset protection.
Even though sole proprietorships and partnerships can deduct business expenses on Schedule C of their tax return, the tax savings aren’t usually as significant as they are for larger companies. Plus, neither of these structures provides asset protection, not even for general partnerships that might have a partnership agreement.
The big draw for sole proprietorships and partnerships is their simplicity. There are no formal requirements to set them up, which makes them incredibly popular—they’re considered the default business structure. In other words, real estate investors and other small business owners don’t have to do anything special to establish these entities; they just naturally come into existence when the venture starts generating income.
Limited Liability Companies (Llcs)
LLCs are super popular business structures because they blend the simplicity of a sole proprietorship or partnership with the asset protection you’d find in more complex setups like corporations. Many experts swear by LLCs for real estate investments, but whether it’s the right fit for you depends on your personal situation.
To set up an LLC for your real estate investment, you’ll need to file the necessary paperwork in the state of your choice. The folks who own the LLC are called “members,” and you can have as few or as many as you want. Using an LLC to own rental property comes with some neat perks, including the ability to:
- Sell property at favorable capital gains tax rates
- Generate housing credits
- Exchange property on a tax-free basis
- Pay taxes on real estate sales in installments, in certain cases
- Claim depreciation deductions
Unlike corporations, LLCs usually don’t have to follow strict state laws regarding things like annual shareholder meetings and keeping meeting minutes.
One downside of LLCs is that it can be trickier to attract investors because they have to become full-fledged members instead of just passive stockholders like in a corporation. However, if you’re looking to sell your entire investment, transferring ownership in an LLC is usually pretty straightforward.
In an LLC, you get to choose whether you want it taxed like a partnership or a corporation. This gives investors the advantage of pass-through taxation that comes with those entities. However, keep in mind that in an LLC, you still have to pay self-employment tax, and for some members, that can add up to a significant amount.
S and C Corporations
Corporations stand as their own legal entities, providing the strongest level of asset protection. However, they’re also the most challenging to set up and come with hefty maintenance costs.
There are two kinds of corporations: S corporations and C corporations. A C corporation follows the traditional corporate structure. It has its own tax rate, and shareholders are taxed individually on their dividends or salaries—a phenomenon often dubbed “double taxation.” This aspect might deter real estate investors, especially if their investment isn’t large enough to offset the increased taxes.
In an S corporation, shareholders opt for partnership-style taxation, which means they’re only taxed once, and the business becomes a pass-through entity. However, S corporations still need to meet corporate formalities and comply with state laws.
S corporations are more commonly favored for real estate investments due to their favorable tax treatment. However, they do have limitations on who can be a shareholder, which might pose issues. Shareholders must be U.S. individuals, and certain estates and trusts are also allowed. They can’t be foreign individuals or corporations. This restriction could be problematic for large real estate investment companies operating nationwide. Nonetheless, transferring shares in an S corporation is easier than transferring membership in an LLC. So, if you’re aiming to attract external investors, an S corporation might facilitate that process.
Combining Business Entity Types
Some real estate investors might opt to blend various business entity options. By doing so, they can maximize asset protection and minimize overall taxes. While these arrangements can get intricate, keeping a practical mindset can help you craft a system that suits your needs and financial situation.
Since LLCs offer numerous perks for real estate investors, many experts default to recommending this entity. However, in some states, single-member LLCs don’t get charging order protection, which can be a significant issue given how many real estate investment opportunities individuals own. Combining different business entity types can help tackle this problem.
Imagine you own two rental properties. You could, for instance, place each property in its own LLC. This way, any liabilities tied to that property won’t extend beyond it. Then, you could place both properties into a newly established corporation. The corporation would offer charging order protection, giving you two layers of corporate veil protection, even if your state doesn’t allow charging order protection for single-member LLCs.
Being creative can lead to finding the perfect blend of business entity types for your real estate investment company.
Getting Help with Business Formation
No matter which business entity you pick for your real estate investment company, we’re here to assist you in finding the appropriate forms and drafting them in compliance with your state laws. Take a look at our business formation documents to see what we can provide.