Real estate investors have much to consider when deciding how to structure their businesses. From legal considerations to tax implications, these entrepreneurs face some unique challenges. In this article, I'll share some insights to help you help your clients make an informed decision about which business entity will serve their needs most effectively.
Because the choice of business structure will have legal and financial ramifications, business owners should seek guidance from trusted, licensed professionals in the fields of law, accounting and tax matters.
As an accounting professional, you may provide them with advice in the areas where you are licensed and legally allowed to practice. With your expertise and that of other credentialed professionals, your clients will be better able to decide with confidence which
Key considerations when choosing a business entity type
Many factors influence which business structure may be ideal for real estate investors. Here are several:
- Ease of administration;
- Personal liability protection;
- Tax treatment flexibility;
- Number of investment properties;
- The state where the property or properties are located;
- Number and types of owners;
- Whether the investments will be for the short term or long term.
As your clients discuss their options with you and their legal advisors, the above points of consideration may help them assess what’s right for them.
Business entities and real estate investments
Let’s take a look at some of the possible ways real estate investors might structure their businesses.
Sole proprietorship or general partnership
These are the simplest business structures to operate administratively and from a tax perspective (since all income flows through to the owners' personal income tax returns). However, one drawback for real estate investors is they provide no legal separation between the real estate investor and their business since the business owner and the business are considered the same entity. So, if someone, such as a renter, sues the business, they are suing the property owners, putting those investors’ personal assets (home, car, retirement savings, etc.) at risk.
LLC
Overarching benefits of the LLC entity type include:
- It limits personal liability. An LLC is a separate legal entity from its owners.
- It provides tax treatment flexibility. By default, an LLC is a pass-through entity. Eligible LLCs may elect S corp tax treatment.
- It’s relatively cost-effective and straightforward to establish and maintain. An LLC is formed by submitting Articles of Organization with the state and has few ongoing compliance requirements.
- It offers more flexibility in the distribution of profits. The LLC's operating agreement defines how profits will be divided among LLC members. The distributions do not have to follow the percentage of monetary investment in the LLC.
- It makes it easier to pass real estate investments to owners’ loved ones. With an LLC, the business owner can proactively gift real estate holdings to their heirs each year. By doing so, over time, they can pass their real estate owned through an LLC — without being required to execute and record new deeds. This saves money by avoiding the state transfer and recording taxes and fees.
- In most states, an individual or a company from outside the United States can own an LLC.
Real estate investors can utilize the LLC structure in various ways.
One LLC for all real estate investments
This keeps things relatively simple, with all investments under a single entity. It requires filing just one set of formation documents, filing one income tax return (taxes pass through to LLC members), and maintaining compliance for only one entity. A potential downside is that if something happens at one property that results in a lawsuit, assets at all of the LLC’s properties will be at risk.
Independent LLCs for each investment
By setting up each property as its own LLC, each is an individual entity and therefore protected from the liabilities of the other real estate investments. Each LLC would have its own bank account to keep its assets separate. Potential negatives are that it involves filing formation documents and paying the associated fees for multiple LLCs, filing tax schedules for each LLC, and completing ongoing compliance formalities for each LLC.
Series LLC
A series LLC (or SLLC for short) refers to an umbrella LLC with separate LLCs beneath it. The series LLC formation documents allow for multiple “series” that operate as separate entities under a master LLC. Each series has its own business name, maintains its own bank accounts, and keeps its own records. Each series’ assets, liabilities, operations and membership interests are independent of other series in the umbrella LLC.
Some of the advantages of a series LLC for people with multiple real estate investments include:
- Decreases liability — If one series gets sued, other series aren’t liable. For instance, if someone trips over a broken sidewalk and gets injured at a property, only that series’ assets are at risk.
- Minimizes formation costs — No matter how many series are part of a series LLC, the business pays just a single LLC formation filing fee to the state.
- Consolidates federal income tax reporting — If a series LLC is appropriately structured, all of the series under the umbrella LLC can be reported on a single tax return.
The one downside to the series LLC entity type is that not all states allow businesses to form SLLCs. Currently, the states and U.S. territories that do recognize the SLLC structure include:
- Alabama
- Delaware
- District of Columbia
- Illinois
- Indiana
- Iowa
- Kansas
- Missouri
- Montana
- Nevada
- North Dakota
- Oklahoma
- Puerto Rico
- Tennessee
- Texas
- Utah
- Wisconsin
- Wyoming
California, although it doesn't allow people to form domestic series LLCs in the state, does allow series LLCs from other states to register as foreign entities and do business there.
The other potential drawback of the series LLC structure is that states have no uniform reporting requirements or universally accepted rules for applying taxes to series LLCs. Often, the rules can be confusing. Some states might treat each series as their own separate tax entity, or they might treat the master LLC and all of its series as a single entity.
Limited partnership
A limited partnership (LP) has at least one general partner and a limited partner, and it may have multiple general partners and limited partners. While general partners assume all responsibility for the business’s debts and liabilities, limited partners are only responsible to the extent of their investment in the business. General partners oversee and manage the business’s operations, while limited partners’ control is typically limited to participating in major decisions that require a vote.
This structure might be especially attractive to real estate investors who seek outside investments from people or companies that do not wish to be involved in running the business.
Forming an LP requires registration with the state and creating a partnership agreement to document the ownership interests, rights and responsibilities of the general and limited partners.
C corporation
The C corp structure offers liability protection for business shareholders, directors and officers. Forming a C corp is more involved, and ongoing compliance is more complicated than with the LLC structure. Tax implications of holding real estate in a corporation can become complex and possibly costly with double taxation. If you do a Google search, you’ll find a number of articles that dissuade people from holding real estate investments in a C corporation, primarily due to the tax ramifications.
Real estate investments in multiple states
When investing in properties in multiple states, clients can consider qualifying a domestic entity in their home state as a foreign entity in the other state to keep properties under the same company. Or they may decide to file to form a wholly separate domestic entity in the state where the investment property is located. As I mentioned earlier in the case of a series LLC, some states may require the formation of a separate domestic entity because they don’t recognize certain entity types in other states.
No one size fits all answer
Every client’s situation is different, so it’s important to realize there’s no simple answer to the question, “Which business structure is the best for real estate investors?” Your clients will need to carefully consider all of the pros and cons as they consider the advice they receive from you and their other trusted business advisors.
