Saturday, August 11, 2012

The Best Investment Property Holding Entity is the LLC

The Best Investment Property Holding Entity is the LLC


It is amazing how often I am asked by people starting in real estate investment: “What type of corporate structure is best for owning investment property“. I hear that question more often than I am asked how to find tenants or how to finance the property. Here is some information that I have compiled and learned over the years.

Disclaimer: Right up front I need to remind everyone that I am not an attorney nor do I play one on television. You should seek competent legal advice in your area, regarding this topic. These details are simply what I have learned through reading, executing, and talking with attorneys.

Best entity for Investment Property

Although there are many different business entities (LLC, C-Corporation, S-Corporation, partnership), the easiest to set up and cheapest to maintain, for real estate investments, is an LLC (limited liability company). Additionally, an LLC is very flexible and can have any number of owners (technically called ‘members’). Each member can own any percentage of the company (as long as the total equals 100%). Lastly, members can be other LLCs, corporations, and trusts. This flexibility allows you to customize the configuration to suit your tax situation and liability protection goals.

Tax Implications for the Investment Property LLC
C-Corporations pay taxes on profits generated by the corporation, first. The owners pay taxes again on the profits they receive as dividends. Although, S-Corporations avoid the corporate tax, their corporate structure and number/type of owners is severely limited (S-Corporations can only be owned by individuals, not LLCs or trusts). Fortunately, unlike corporations, LLCs do not pay any corporate tax. All profit and losses “pass through” to the member’s tax returns at the percent that they own the company. This is especially helpful if you own multiple LLCs as the profit and losses from each roll up to your personal taxes (a loss on one can offset a profit on another).

Liability Protection for the Real Estate Investor
As the name implies, an LLC provides limited liability to its members, meaning that any liability created by the company is limited to the company. The members’ personal assets are protected from all claims against the company. Partnerships and unincorporated businesses do NOT provide liability protection. It is critical that you protect your personal assets as a 2005 Congressional study stated: “small businesses bear 68 percent of business tort liability costs”. A properly set-up and maintained LLC can protect the owner’s interests in the assets of an LLC from the owner’s personal creditors.

Setting up an LLC for your Investment Properties
I recommend that you consult with a qualified real estate attorney when you set up your first LLC (or purchase your first investment property). Pay them to establish the LLC on paper and with the state. Have them teach you what should/must be done on an annual basis to maintain both the legal entity of the LLC and the litigation protection of the LLC. This may cost up to $1000 per LLC. Some attorneys may offer a discounted price.

How Many Properties per LLC?
This is where a good attorney can weigh the liability protection versus the costs. Many advisors will tell you to set up one LLC per property. Practically speaking this is easy when you own 2-4 properties, but it will become increasingly cost prohibitive when you own 15 properties. Not only does it cost about $360 (in Minnesota, using BizFilings.com) to set up an LLC initially, but each year your CPA will charge you to prepare and file the tax return for each LLC (this costs me about $400 per LLC-you can imagine your tax bill if you had 15 LLCs!). Most real estate investors will put 3-5 properties in each LLC (grouping them based upon geography, age, liability risk, or equity position).


Moving your Properties into your LLC
A common misconception is that you must buy the investment property in the LLC’s name. Unfortunately, you would need to use commercial financing (with a 20% down payment) to have your LLC buy the property initially. A “Quit Claim deed” is all that is required to legally transfer the property from your personal name to your LLC. The mortgage(s) will stay in your personal name and it will remain on your credit report, but you will gain the liability protection mentioned above. This Quit Claim deed process requires a simple one page document signed and notarized by all owners of the property and it is then mailed with the appropriate filing fees (about $50-75) to the County recorder where the property is located.

Property Management Considerations
Technically, each LLC should have its own checking account, corporate credit card, and Quickbooks file. Again, as above, this may be possible with a limited number of LLCs, but it can be overwhelming to think about 15 checkbooks, 15 corporate credit cards, and 15 LLCs signing leases and performing evictions. Many real estate investors will transfer their properties into “ownership” LLCs which simply hold the properties. They will then set up a “management” LLC that signs all leases, pays all bills (including mortgages), contracts for all repairs, and retains one or two corporate credit cards. To keep the liability protection intact, you should have a management agreement signed by both the “ownership” and “management” LLC.


Using the LLC
All the work and cost of establishing the LLCs can be wasted if a judge agrees with the lawsuit plaintiff, that the LLCs are just shells. Follow your attorney’s advice, but generally, you should hold meetings (and keep written minutes of the meeting) on a bi-annual to annual basis. You should record decisions and “vote” on changes to the company. Lastly, have your attorney review your work annually to insure you are maintaining your legal protection in the event of litigation.
As you can see, an LLC has many benefits over other corporate entities (or no entity at all). Having an LLC for your real estate investment is an important step in providing protection for both your personal and corporate assets. Consider the creation and use of an LLC as important as learning how to find tenants.

31 comments:

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