Selecting the right entity structure for your real estate deal can mean the difference between building and losing incredible wealth. It’s vitally important to incorporate correctly to protect yourself, your assets, and your wealth. I get a lot of questions about entity structuring, particularly on legal, tax, and compliance issues. Your goal is to find one that meets all three criteria. One size does not fit all. Structures can be changed.
This is the first of a four-part series of Questions and Answers related to entity structuring.
QUESTION: I have seen that many investors have an LLC. What are the benefits to a landlord that only has one property? Should I create one?
My Answer
I usually advise my clients to form entities based on three factors – legal protection, tax reduction, and compliance. So if you have equity in the property that creditors could come after, you definitely want to consider an LLC. Insurance is your first level of protection and you should have a good umbrella policy! But what if you have a judgment against you that is higher than your policy limit? You will be personally liable for what your insurance does not cover. An LLC will protect your personal self from this liability. The minimum hassle and expense of an LLC are well worth their limitless protection. Right now, the best one I see out there to use is the MULTI-member LLC with a GOOD COMPREHENSIVE OPERATING AGREEMENT/UMBRELLA POLICY. Here are the main advantages:
1. LLCs have the least compliance requirements. No minutes, BOD meetings, or even no formal agreement but I strongly suggest using a comprehensive operating agreement. I currently use a 121-page one for my clients.
2. Multi-member LLCs can help in asset protection by dealing with bottom-up creditors (has a claim and/or gets a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager, or employee). It also deals with top-down creditors (gets a judgment against the member because of the member’s acts or omissions, rather than the acts or omissions of the LLC, its managers, or employees). With a good operating agreement and an umbrella insurance policy, you can minimize (NOT MITIGATE) your exposure.
3. Multi-member LLCs can help with the reduction of IRS audit exposure since 8825(rental property form for a partnership) is audited a lot less than a schedule e(rental property form for an individual/sole proprietorship). So while you may not have all the asset protection you want, a good multi-member LLC with a carefully drafted operating agreement and an umbrella insurance policy is the best shot out there for a Landlord.
QUESTION: “I have just completed my real estate broker course and am waiting to take the state exam. I already set up an LLC a couple of years ago to buy and flip properties. If I do set up my own real estate brokerage office as opposed to working with a non-licensed partner, will it be ok to use my existing LLC to buy sell, and broker properties, or do you recommend setting up a new separate LLC? Thanks in advance for your suggestions.”
My Answer: This is ok to maintain history as long as you originally set up the LLC right by not using your home address or yourself as the resident agent. These are asset protection busters. You would only need to update your operating agreement for the new brokerage office.
Question: “I have never heard of these certificates for LLCs. Is this unique for certain states or just window dressing for clients who want something on paper?”
My Answer: It is window dressing. Just like “stock certificates”. How many small corporations do you know of actually have a piece of paper that designates the number of shares they own?
QUESTION: What are the advantages/disadvantages of creating an LLC when buying a commercial property? I understand how LLCs offer legal protection in a business situation, but how does it apply to real estate?
ANSWER: I usually advise my clients to form entities based on three factors – legal protection, tax reduction, and compliance. So if you have equity in the property that creditors could come after, you definitely want to consider an LLC. Also, an LLC is TOXIC if it does not shield you, causing your personal assets to be totally exposed. You, therefore, are not protected from legal actions (when you should). It is not the size of the entity, but rather the existence of complete and proper documents which provide the protection from personal liability for the LLC members.
Toxic LLCs do not properly deal with BOTTOM-UP CREDITORS (has a claim and/or gets a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager, or employee) as well as TOP DOWN CREDITORS (gets a judgment against the member because of the member’s acts or omissions, rather than the acts or omissions of the LLC, its managers or employees).
QUESTION: I am looking to purchase my first investment property and I am wondering if I should set up a DBA, an LLC, or incorporate. I am an individual investor, but will also put my wife on the deeds. I plan to make her a partner. Can anyone advise me which option (DBA/LLC/Corp) would be best? What are the pros and cons?
ANSWER: Here are the Advantages of Incorporation
• Protect yourself from liability – The most important reason to incorporate your business is to protect yourself from business liabilities.
• Establish perpetual existence – Perpetual existence means that the life and continuation of the business will not be affected by the withdrawal or death of one of the owners.
• Gain tax advantages – There are tax deductions for a wide variety of operating costs which will substantially cut back your company’s overall tax liability.
• Enhance business image – Another essential reason to incorporate your business is that it adds credibility to its operation. The perception of a business is improved by its incorporation and use of “Inc.,” “Co.,” or “LLC” following the name of the business.
• Improve Management Ability- The authority of an incorporated business is centralized, which usually means a Board of Directors.
• Ease of Incorporating – Incorporating does not take time and can cost you less if you do not use a lawyer.
Here are different types of Entities to consider:
1. LIMITED LIABILITY COMPANIES (LLC): The legal rights of members are governed by state LLC statutes (like corporations), but LLC laws vary from state to state.
2. PARTNERSHIPS: In a partnership, each partner is jointly liable for all partnership debts. These are inexpensive and simple to form. General partnerships are not recommended for real estate investments because of the liability exposure.
3. LLC-PARTNERSHIPS: In most cases, the LLC partnership will be the ideal entity preference for real estate ownership. The corporate structure of an LLC protects its owner-members and their personal assets.
4. LIMITED PARTNERSHIPS (LP’S): There is limited liability for the limited partners, but personal liability for the general partner.
5. CORPORATIONS: Corporations give their shareholders limited liability protection.
6. DBA: If you file a DBA the property is still held personally. If there is any type of liability exposure on the property you will open yourself to be sued personally.
Place the property in an LLC. The LLC will help contain the liability exposure inside of the LLC.
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. You can get more information at Wealth Building Plan.
