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.
Here is a summary 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 (have a claim and/or get 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: In 2005 I entered into a partnership with my brother and a couple of friends. We purchased a single-family house to rent out. We (over)paid around $27,000 for the house. The property is titled in my brother’s name, as is the mortgage on the property, with a current balance of $2,000. A few years back, as the partnership began to lose money, I bought out two of the partners. I now own about an 80% interest in the partnership.
I would like to buy out my brother’s interest so that I can eventually either sell the house utilizing a 1031 exchange or re-finance the house at current low interest rates (I can qualify for a conventional mortgage). I don’t want to sell the house out of the partnership and get stuck paying depreciation recapture. The house will sell for $35k.
In order to do a 1031 exchange or refinance the house, I need it to be deeded in my name. Can I buy my brother’s share of the partnership and then have the partnership deed the house over to me without triggering any tax consequences? Will the partnership (a general partnership, we never filed formation documents with the secretary of state) cease to exist if I buy out my brother’s interest? Will there be some seasoning period required, or should I be able to re-fi right away if I acquire 100% of the partnership?
ANSWER: The partnership can certainly sell relinquished property held in the entity’s name and then purchase like-kind replacement property to be held by the same entity and still qualify for 1031 Exchange treatment. So even if it is owned just by you or you and your brother, you can still do it in the name of the LLC. Now if you need to refinance then you would need to deed it out of the LLC back into your name. You can certainly buy your brother’s share in the partnership and then transfer the property into your name. There is no seasoning requirement or tax consequences except that your brother may have a gain or loss on the sale of his partnership interest to you. Please keep in mind that whether you sell the property in your name or in the name of the LLC, there will be depreciation recapture except you are saying not having depreciation recapture since you are going to do a 1031 exchange.
QUESTION: Growing our RE business in the US certainly has its growing pains. In structuring our entities, (we function in Florida, Georgia, and soon in Texas), we have been informed that “…your company is a dealer in real estate sales and purchases, not an investor (1031 exchange tax deferral is not allowed for dealers)”.
How are your 1031 exchanges handled? Is this an entity-focused restriction, or an activity-focused restriction? I see the reasoning on an individual basis, but how many flips does it take before you are considered a dealer?
ANSWER: It all boils down to intent. If your intent is to buy, fix, and flip then you are a dealer and cannot 1031 exchange. If your intent is to Buy, and hold but then decide to flip, then you can 1031 exchange and there is also a holding period requirement when next you want to sell the replacement property for another one. Most people usually recommend 12-18 months but if you are flipping within a short period of time, then you are a dealer and subject to S.E. tax. You could come up with an entity structure that minimizes not eliminate your Self Employment taxes
QUESTION: I have a rental property in Colorado and have created a Colorado LLC to hold it. However, I bought the property under my own name and have a small mortgage under my name. The mortgage company won’t let me transfer the title to the home to the LLC with the mortgage in my name. I could pay off the mortgage, but that would leave me more cash-poor than I care to be. A friend suggested that I lease the property to my LLC (it’s a single member) and that would give me the legal umbrella of the LLC and still keep the mortgage company happy. Has anybody ever done this or heard of it being done? Thanks.
ANSWER: Usually, the mortgage company will not let you transfer the title without triggering the due on sale clause. I have usually just transferred without getting them involved and as long as the mortgage is being paid, then you are fine. Going on almost 10 years of my properties being in an LLC still with a mortgage in my name. Leasing the property to your LLC is good for dealing with tenants but no protection in dealing with creditors as it will still show your name on the title.
QUESTION: “A client came to me and asked why he did not get any stocks from an LLC. I told him that LLC does not issue stocks. He told me that he once went to an attorney to set up an LLC. He keeps insisting that the attorney told him he would have such and such amount of stocks in that LLC. Am I missing something?”
ANSWER: You are missing what is commonly called “Units of Membership”,” Units of Ownership”, or “Membership Certificates”. They look like shares of corporate stock and result in basically the same as shares of the corporate stock. I have made them in the past for a client with my PC.
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?”
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: “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?
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. The only other consideration is if you plan to keep buying and flipping properties, then at some point, you may want to spin off one of your businesses into its own separate entity to keep liability for each business separate.
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.
