Choosing a legal entity for your real estate investment business is an important decision that has both legal and tax consequences. The wealthiest real estate investors are not just skilled at spotting a good investment or closing a deal—they are knowledgeable and savvy about all aspects of their business, including the way it is legally organized and operated.
Your wealth as a real estate investor is held predominantly in the hard assets of the residential and/or commercial real estate you own. To protect your business, you must focus on protecting those assets, as well as your personal assets that are separate from the business. The legal entity you choose for your business will play a vital role in the level of asset protection you have.
Whether you are just starting your real estate investment business or you are considering restructuring your existing business for more legal and tax benefits, you must consider several factors including the extent of your personal assets, your debt-to-income ratio, the tax laws in your state, and contributions from other investors.
One type of legal structure that many of the most successful real estate investor opt for is the LLC and LP hybrid. To better understand what an LLC and LP hybrid is and why it might be the best choice for your real estate investment business, we will first explore all of the options you have available when choosing a legal entity for your business. Note that every real estate investment business should consult a CPA and attorney to assess their individual circ*mstances and determine the best structure for their business.
Sole Proprietorships for Real Estate Investing
A sole proprietorship is kind of a “default” business structure, which is formed when a person is engaging in business in their individual capacity, without having formed a separate legal entity. The assets and income of the business are entirely owned by the individual and all income from the business is taxed as personal income.
Unlike other legal entities where business income “passes through” the business to the individual, all income from the business is considered immediately earned by the sole proprietor. All property purchased by, transferred to, and owned by the business is simply owned by the sole proprietor personally.
The advantages of this business structure are that it is very easy to start. No paperwork is required to form a sole proprietorship. As a real estate investor, you simply purchase or invest in real estate. Depending on the laws in your state, there may be a requirement to register your sole proprietorship, but this registration does not create your sole proprietorship, it simply is a requirement to comply with state law. Your sole proprietorship is created automatically, by default, when you start doing business.
If you choose to use a trade name to conduct business, rather than your legal name, you may need to file a “Doing Business As” (DBA). You also do not need to file taxes separately for your business. You simply include business income and deductions in your personal income tax return.
However, if you are a real estate investor there are major disadvantages to operating your investment business as a sole proprietorship. First, unlike other entity options, a sole proprietorship offers no degree of asset protection from creditors or lawsuits, because your business assets are also personal assets. Furthermore, depending on your debt-to-income ratio and how you choose to finance your investments, you may be able to begin as a sole proprietor, but if and when you exceed the debt-to-income ratio permitted by your lender, you will have to form a separate legal entity to obtain commercial financing.
LLC
A limited liability company (LLC) is a common entity choice for real estate investors and offers many advantages. Choosing this structure for your real estate investment business allows you to limit your personal liability in the business to the money you contribute and the debts you co-sign for. This includes personal assets that you contribute as collateral to a loan.
In an LLC, owners are known as “members”. If you are the only owner in your real estate LLC, you have a single-member LLC. In a single-member LLC, all business income will “pass through” the entity and be treated as personal income for tax purposes. However, you will not be personally liability for the debts, claims, and liabilities of the business, beyond the amount you contribute. To form an LLC, you must file Articles of Organization with your appropriate state government authority.
Protection for your personal assets in an LLC is not absolute and a court will overlook the LLC structure and hold you responsible for claims against the business if certain conditions are present. Specifically, if a court finds that: (1) there is a “unity of interests” between you as an individual and the LLC; and (2) it is necessary to look past the LLC structure to prevent fraud or injustice, they will do so. This is called “piercing the corporate veil”. Examples of factors pointing toward a “unity of interests” include commingling personal and business funds or evidence that the LLC is a sham entity. In addition to finding a unity of interests, in order to “pierce the corporate veil” and disregard the protections an LLC typically affords, the court must find that doing so is necessary to stop the sham entity from committing or furthering fraud or injustice.
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