Forming An LLC To Purchase Real Estate
Because of the inherent risks of owning real property, owners limit that risk by holding property in entities, such as LLCs, rather than their personal names. In this article, we will focus our attention on: Entity selection strategies, Minimizing risk, and Critical tax considerations
ENTITY SELECTION STRATEGIESSeries LLCs: Although series LLCs are flexible and hold promise, they have not yet been widely used in real estate transactions. Series LLC's cannot be formed in California, but California recognizes series LLC's formed in other states (e.g., Delaware). However, California treats each unit of a master LLC as a separate entity for filing and tax purposes, essentially eliminating the utility of a series LLC in California. There are also uncertainties as to how series LLCs will be treated under federal tax law, questions about how bankruptcy courts will treat bankruptcy of one series of a series LLC, and how to protect security interests.
Single Member LLCs: Single member LLCs are often used for wholly owned subsidiaries. They have pass-through taxation, yet are treated as separate entities for liability purposes.
The primary concerns of an owner in structuring an LLC to purchase real estate include (a) creating the LLC in a jurisdiction that has the right balance of legal protection and accessibility; (b) choosing a management structure that provides fairness, protection, and expertise; and (C) documenting membership interests in ways that minimize asset protection and tax concerns.
Although the single member LLC, properly formed and managed, protects the owner from liability arising out of a claim related to the real estate owned by the LLC, in many jurisdictions, including California, an owner's membership interest in the single member LLC will be subject to attachment by creditors for liabilities of the owner arising outside the property owned by the LLC. For example, if the owner is subject to a large monetary judgment for a business-dealing unrelated to the real estate in the LLC, the judgment creditor can take the membership interest (and the property owned by the LLC) in satisfaction of the judgment. This result is avoided in multi-member LLC's. Further, some states still shield an owner of a single member LLC from that type of liability, and consultation with a legal advisor on that topic is recommended.
In addition, if an individual owns multiple properties, it is advisable to form separate LLC's to hold each piece of property, to prevent cross-collateralization, or putting all of the real estate at risk from a claim arising out of only one of the properties.
Corporations: Corporations may be either "C" corporations or "S" corporations. Corporations are not used for real estate investments as frequently as LLCs, because of LLCs' preferable tax characteristics. However, there are a number of situations in which corporations do hold real property, such as part of a portfolio of assets, including equipment, inventory, and other assets of an ongoing business operation, which assets are not as negatively affected by being held in a corporation. However, if the only asset to be held by the entity is real estate, a corporation is not the recommended vehicle.
MINIMIZING RISK WHEN PURCHASING REAL ESTATE WITH LLCSIn addition to forming an LLC as a basic form of protection, owners can increase that protection by using single purpose entities, seeking limitations on guarantees, considering use of a particular state's law, purchasing adequate insurance, and carefully drafting the operating agreement.
An experienced business attorney at Schneiders & Associates, LLP can provide advice and assistance regarding the best practices mentioned above for minimizing risks.
CRITICAL TAX CONSIDERATIONS BASED ON CHOICE OF ENTITYPartnerships (and LLC's taxed as partnerships) and S corporations have pass-through taxation, which means that tax is assessed on the member, partner, or shareholder obtaining income, rather than on the entity itself. By contrast, C corporations are taxed first at the entity level and then, a second time, at the shareholder level. LLCs can elect to be taxed as corporations, but when holding real estate, an LLC should elect to be taxed as a partnership.
An S corporation must divide profits according to share ownership. By contrast, an LLC can divide profits in any way it chooses. Part of the flexibility of partnerships (including LLCs taxed as partnerships) is that they can set up different classes of owners with different benefits.
Members of an LLC may be able to deduct business losses on their individual income tax returns, which is a benefit of LLCs taxed as partnerships. However, deduction of losses is subject to various tax restrictions, such as risk of loss rules and passive loss limitations.
LLCs usually can be converted to other types of entities without tax consequences, in contrast to conversion of corporations.
In California, LLC's are subject to a $800 franchise tax each year, just like a partnership or corporation. However, LLC's are also subject to an additional tax called a gross receipts tax. This tax is calculated based upon the LLC's annual gross revenues, and can be as much as $11,790 per year.