As an owner or potential owner of investment real estate, you may have been warned not to take title to real estate in your own name. The reason is to protect your personal assets outside the entity from liability in the event of a lawsuit against you, or in case someone is injured on a property you or your company own.
When an entity (rather than you, personally) holds title to, or owns, a property, only the assets of the entity are subject to attachment in the event of a judgment involving the property. The primary exception is where a principal of the entity has engaged in a wrongful act such as fraud, misrepresentation, deceit, etc., in which case that principal’s outside/personal assets could become subject to liability.
How does this apply to you?
First, for residential purposes, one or more of the entities discussed here could be used to take direct title or to serve as a trustee or beneficiary in a title-holding trust.
Second, when a group of investors pools funds to acquire a property in a group investment, the individuals will usually form an entity such as a limited liability company (LLC) with which to take title on behalf of the group.
Third, in a commercial property acquisition, a lender may require formation of a single-asset entity to take title to the property as a condition of the loan.
So how do you know which entity is the appropriate one for your situation? Ultimately, that is up to you and your attorney to determine.
Pros and cons of commonly used entities
As a starting point for your discussions, here is a look at the key advantages and disadvantages of entities commonly used to take title to real estate.
A Limited Partnership (LP) may take title to real estate in its own name. Its members consist of limited partners (passive investors) and a general partner (who manages the LP on behalf of the limited partners). The general partner, who may be an individual or another entity, has unlimited liability, and its earnings may be taxed as ordinary income. The limited partners (cash investors) buy limited partnership interests. They have limited liability up to the amount of their interest in the LP and enjoy passive investment tax benefits. Limited partners are prohibited from participating in day-to-day decisions of the LP or else risk being reclassified as a “general” partner.
An LP is a pass-through entity for tax purposes, so the earnings of the LP are passed through to its partners, each of whom reports the proportionate share of the LP’s earnings on his or her own tax returns. Of note, however, LP interests are considered personal property and are thus ineligible for a 1031 exchange. Because the limited partners rely on the general partner to generate a profit on their behalf, compliance with securities laws is required for if you exchange LP interests for a cash investment.
LIMITED LIABILITY COMPANY
A Limited Liability Company (LLC) is a hybrid entity that combines the benefits of a corporation (i.e., the “corporate veil”) with the benefits of an LP (passive investor liability protection and tax benefits) without the formalities of a corporation. Like an LP, the LLC may take title to real property in its own name and is considered a pass-through entity for tax purposes. The investors in an LLC are called “Members.” They buy “Units” or “Interests.” Also like an LP, however, LLC interests are considered personal property and as such are ineligible for a 1031 exchange.
An LLC can be member-managed or manager-managed, while still affording limited liability protection to all of its members and the manager.
In a member-managed LLC, securities issues may be avoided as long as each major decision is determined by unanimous or majority vote of all members. This is the type of entity most commonly used by Joint Ventures.
In a manager-managed LLC, the members are considered passive investors and may have limited or no voting rights. The manager (who may be an individual or another entity with multiple members) generally makes decisions on behalf of the LLC Members. Thus, in a manager-managed LLC, compliance with securities laws is required for the sale of LLC interests.
A Delaware Statutory Trust (DST) is another entity that can accommodate a group real estate investment. The DST is the only group investment structure (other than a tenant-in-common, or TIC) that can accommodate 1031 exchange investors in a group ownership structure. There are severe limitations (e.g., the “seven deadly sins”) that restrict the authority of the beneficiaries (investors) and the trustee (manager) and essentially, tie their hands with respect to such things as negotiating loans, leases, and certain other major decisions regarding the property. A DST structure is most useful for triple net leased (NNN) properties with long-term leases and tenants who take full responsibility for maintenance and repairs, although there are some fairly complex structures involving master leases and springing LLCs that can make them workable for other property types.
CORPORATION (S-CORP OR C-CORP)
An S-Corporation or C-Corporation may be a suitable entity for acting as the general partner of an LP, the manager of an LLC or as a trustee of a title holding trust. However, a C-Corp is not the preferred entity for taking title to real estate, primarily due to double-taxation and inventory issues.
While an S-Corp is a pass-through entity for tax purposes, only 20 percent of its earnings may be from passive investments, which could subject any passive real estate earnings exceeding 20 percent of the total to ordinary income tax rates.
Where several properties are held for less than a year, such as in a fix-and-flip rehab business, the IRS may classify the entity as a real estate “dealer” and the properties as “dealer inventory” such that all of the entity’s earnings may be taxed at ordinary income tax rates. As such, a corporation (S or C) may be a viable entity for a rehab business, particularly if the business has employees and/or wishes to provide company benefits.
Before you form an entity, you need to get the advice of an attorney and/or CPA, because if you select the wrong entity (as many investors do), or you bury yourself in too many entities, you may end up paying formation costs, accounting fees and taxes for companies that are not suitable for your intended purpose, or that don’t meet your objectives.
NOTE: This information is of a general, educational nature and may not be construed as legal advice pertaining to your specific offering, exemption or situation. Any such advice must be sought from your own attorney pursuant to an attorney-client relationship, after consideration of your specific facts or questions. At Syndication Attorneys, PLLC, we will be happy to discuss your investing goals with you. You can schedule a free, 30-minute consultation by clicking this link.