By: Beth Schroeder
Forming an LLC to hold tangible property assets is a good idea if you are actively investing in real estate. However, LLCs may not serve as the best holding vehicle for every property owner. Just because LLCs offer a multitude of benefits to real estate investors and their particular industry, it does not mean they are the right choice for every investor. Keep in mind that the field of real estate investing is incredibly diverse, and it would be nearly impossible to find one legal entity that protected every business. Having said that, many investors believe the threat of a theoretical lawsuit warrants the minimal commitment required to run and maintain a legitimate LLC.
LLCs Limit Personal Liability
Investing in real estate is a rather lucrative career choice. There is traditionally a lot of money involved in every deal—at least more than the average individual can cover on their own accord. Having said that, it is absolutely imperative for respective investors to protect their personal finances (those outside of the business). First and foremost, LLCs limit personal vulnerability to potential lawsuits related to the property.
Any lawsuit that comes against an LLC is aimed specifically at the company, not the individual responsible for it. If the property in question were owned by an LLC, the owner’s risk exposure would be insulated by the protection of the company, leaving only the assets owned by the LLC (as opposed to all of the owner’s personal assets) exposed to potential lawsuits. In other words, personal finances would not be in jeopardy.
Assuming liability coverage is the most important factor of forming an LLC, taxes are a close second. In fact, some real estate investors consider framing their business structure as an LLC based solely on tax benefits. Liability protection may just be an added bonus to some.
Any income and capital gains generated by the LLC would transcend to the owner, who, as a result, would only have to pay taxes as an individual. However, the respective owner still enjoys the protection against liability.
Seeing as how there is no separate tax accompanying the formation of an LLC, business owners are in a position to avoid double taxation. Neither the rental income generated by a property, nor the appreciation in value upon disposition incurs tax penalties. Additionally, the owners of a single-member LLC can use mortgage interest as a deduction around tax time. In forming an LLC, you are not only subjected to fewer taxes, but you are awarded more deductions.
Real estate companies owned by more than one person, however, are viewed differently in the eyes of the IRS. Otherwise known as “multimember” LLCs, these business entities are taxed similar to that of a partnership. Multimember LLCs also enjoy the benefits of pass-through taxation as the LLC passes its profits and losses through to its members. Each respective owner is then responsible for reporting their share of the profits (or losses) on either a Schedule C, K or Form 1065 with their individual income tax returns.
Unfortunately, for new LLCs with little to no financial history, commercial lenders will likely require the member to sign a personal guarantee before lending any money.
Forming an LLC does not protect you from all threats. For example, a fire can break out and can damage equipment and other business property. This means that while an LLC designation can provide important protection, it does not act as insurance. It is also important to understand a concept called “piercing the corporate veil.” You can think of an LLC as a kind of barrier between your business operations and your personal finances. However, certain errors you make can allow the legal system to break through that barrier. For example, if a limited liability company takes on excessive business debt, a legal team can sometimes hold the business owners accountable for those debts.
The homestead exemption is important to many debtors in bankruptcy who own their own homes. But a debtor whose home is owned by a LLC typically cannot take advantage of the homestead exemption. This is because bankruptcy courts have held that the debtors do not have interest in the home.
However, one possible way around this issue would be to execute a written lease from the LLC to the homeowner, with a definite term and some level of rent payment. If you have a single-member LLC, because there would be no other members in the LLC, the rent would not have to be at market. It is necessary that a signed lease agreement is in place, as the courts have found that an oral lease is nothing more than tenancy at will, which does not provide interest in property. While a written lease with a definite term should normally be construed as creating a real estate interest in the property.
1031 Lifetime Exchange
Partners are not permitted to sell or dispose of their partnership interest and subsequently defer the payment of their capital gain taxes by acquiring like kind replacement property through a 1031 Tax Deferred Exchange transaction.
Partnership interests are specifically excluded from 1031 Exchange treatment under Section 1031 of the Internal Revenue Code. Partnership interests are personal property, and are not considered to be like kind to the acquisition of real estate, even though the underlying assets held within the partnership are in fact real property.
However, with proper advanced tax planning, partners can restructure their ownership position so that they could qualify for a future 1031 Tax Deferred Exchange transaction involving the underlying real estate held in the partnership entity.
Real Estate Ownership
It is important to understand the distinction here. The underlying investment property is owned by the partnership and not by the underlying partners. The underlying partners merely own a partnership interest in the partnership entity. This partnership interest is a personal property interest and not a direct ownership interest in the underlying real estate.
This is a critical distinction to understand when planning and structuring a 1031 Tax Deferred Exchange transaction involving real estate owned through a partnership. Individuals wishing to complete a 1031 Tax Deferred Exchange must sell a direct interest in real estate (fee title) and subsequently acquire a direct interest in replacement real estate (fee title).
There are numerous variations to the types of strategies used to qualify for a future 1031 Tax Deferred Exchange for partners, and it is recommended you speak with a real estate attorney or experienced tax professional.