Today's post is very real estate investor specific. I have been writing a lot from my Realtor perspective recently and I wanted to take some time to address something that comes up a lot when talking to people who want to begin their real estate investing career. This is post can hopefully help any one who seems confused about where to start when it comes to setting up a business entity or not.
Disclaimer: I am not a lawyer and am not providing legal advice in this post. However, I would like to give a few examples of different situations that would call for different business structures (if any) and some pros and cons for them.
One of the most contentious questions out there for new real estate investors is how to structure their real estate business or if they should create an entity at all. If you Google "LLC real estate investing" or any combination of similar words, you'll get a plethora of results that argue for and against creating a business entity for investing in real estate. All of the individuals responding to that question have valid points, yet no definitive answer seems present. Most everyone answers this question the same way; "it depends on your situation."
Unfortunately, I agree. I also do not have a real answer for that question. Each and every person's situation, goals, finances and properties are different. For this reason, no one approach applies to all.
Asset protection is one of the most important parts of owning a business that is asset centric, like real estate. Most people own their homes in their own names and they are therefore liable for any litigation that would occur from that property. If a court were to deem any damages caused by the owner of that property or the property in general, that individual would be responsible for that settlement. If that person is unable to cover the costs of the damages, a court might come after their personal property and cease it in order to satisfy that settlement. This is scary if you are a landlord or rehabber. When you are a landlord/rehabber, you are relying upon the presence and activity of other people in order to maintain a healthy business. Another downside of keeping assets in your own name is that you can be sued for negligence because of something that happens at property X. If the liquidation of that property does not satisfy the settlement, then the court can come after properties X, Y, Z if they are also in your personal possession. How do you protect yourself and your assets from litigious tenants, irresponsible employees, etc? You protect your assets by setting up a business entity to hold your assets.
There are many entities that you can form, but the most common is the LLC (Limited Liability Company). When you form an LLC it does cost money. It also continues to cost money. You must maintain your books, accounting, legal aide, etc. These things do cost money, but a very minimal amount in comparison to having assets ceased for menial reasons. An LLC creates what's called a "corporate veil." This veil creates some obscurity between you and your business. This means that your assets between your business and yourself are separate and are not as easy to cease. That does not mean that it is not possible for a court to pierce that veil and cease assets from both. This, of course, would be in an extreme case. An LLC not only creates boundaries and protections for both your and your assets; it also creates a scalable foundation to really grow your business. I absolutely recommend forming some type of entity when you reach a certain point in your investing career, however there are some reasons in which it does make sense to keep your assets/investments in your own name.
I have just recently read an article from Biggerpockets.com by Scott Trench, entitled "5 Reasons I Do NOT Invest in Real Estate Using an LLC." Scott argues against the need to form any business entity in order to successfully invest in real estate. When I was reading this, I initially wanted to disagree entirely. However, as I read further, I began to agree with him. His situation causes his position to make a lot of sense to keep his investments in his own personal name and operate using an umbrella insurance policy to protect his assets. There are a few reasons why this individual chose to keep his investment property in his own name. There are:
It is far easier and favorable to secure financing for properties (especially properties that can create income) if you do so in your own name. For example, the FHA mortgage is a fantastic way to get yourself into your first home. The down payment is really low and the interest rate is about as low as it gets. However, you can not get an FHA in a business name. You can purchase a 1-4 unity home in your name and rent out the additional unity as long as you live in one unit as an owner occupant. There are many loan products that have favorable terms when it pertains to an individual vs. an LLC.
- Tax breaks:
As an owner-occupant, you are entitled to a lower property tax. If you own the same property in the name of an entity, you will not receive that same reduced tax rate. Also, there are many "costs" associated with properties that are more strongly leveraged as personal expenses as opposed to business expenses.
- Capital Gains:
This is an odd one. Generally speaking, if you purchase a property and make a profit while selling it, you can be taxed on capital gains. However, you will not be taxed as long as you have lived in that property for two years prior to selling it (often 2/5 of the previous years). When you buy, rehab and sell properties for a living through an entity, you can be charged capital gains on the profit at the end of every transaction. However, this is all pursuant to your tax assessors. There are some projects that they may say require capital gains taxes and some that you do not. Either way, you are exempt from this if you own the property personally.
In Scott's case, he chose to purchase his first multifamily property in his own name because of his situation. For him, like most young people, he was not able to come up with a very substantial down payment and decided to utilize an FHA. Because he was using an FHA, he had to keep that property in his personal name. He can always refinance it into a business name later, though the terms won't be as good. What he did to minimize his liability was to purchase an "umbrella insurance policy." An umbrella policy covers you from essentially all damages up to a certain amount of money. This means that you make a monthly premium payment and are covered up to an agreed upon amount in the case that you are sued. Umbrella policies are a phenomenal product that I recommend regardless of your situation.
What I see many people doing is to purchase their investments by whatever means necessary and to operate within whatever confines they have. Eventually, they pass those assets off into whatever entity or entities they have formed. All the while, they mitigate their risk by both being good and responsible landlords in conjunction with an umbrella insurance product.
Personally, we handle our active investments (rehabs) through an LLC with an S tax election, which allows my partner and I the same protections and rights of an LLC with the same taxation as a C Corp (big corporation). Eventually I will be forming a second LLC for passive properties (rentals) with the aid of an umbrella policy. The reason for those two entities is because it will make it easier to differentiate the active income and the passive income, because those two things are taxed differently. It will also create a separation of assets between the two. There are many buy and hold investors who will form an LLC for ever property or for every X amount of asset value. This is a fantastic way to protect your assets, but it causes a headache at the end of the fiscal year when taxes need prepared. I don't do well with so many moving objects and prefer to streamline my structure, while protecting myself and my business.
As you can see, there are many, many, many strategies here. None of them are right or wrong. They all depend upon what will serve you the best at whatever time. I would absolutely recommend speaking to a lawyer when you are ready to consider an entity. They will steer you in the correct direction. I also recommend that you do some research online beforehand and try to understand the basics of different entities before considering too heavily. One great place to begin is LegalZoom.com. They also offer LLC and other entity formations for relatively cheap. Do keep in mind that most people on the internet are not certified legal advisors and are just making recommendations; not providing legal advice.
As always, if you have any questions about real estate investing, feel free to let me know! It's an exciting, challenging and rewarding endeavor.
AND if you or anyone you know needs a Realtor, let me know. I would be honored to help you buy or sell your next home!
Troy Franklin Gandee