The difference between amateur and professional real estate investors has nothing to do with the size of their portfolios. The fundamental difference is this: while amateurs make a hobby of buying and selling properties, professionals treat real estate as what it is—a business. If you’re going to succeed in multifamily real estate investment, you need to go and do likewise. Part of that means setting up the legal structures that define your business as a stand-alone entity. As you advance, that’ll also involve structuring multiple entities depending on the specific properties and investor relationships you want to protect.
Structuring your business, however, is about more than making yourself look and feel like a professional. More importantly than all that, your legal structure will provide you two key benefits: personal liability and tax sheltering.
In today’s post, I want to look at four of the most common types of business structures to help you decide which one will be best for you.
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Sole Proprietorship
A sole proprietorship is just as it sounds: a one-man shop for real estate investment. This is otherwise known as the no-structure structure.
What are the advantages?
Ease and simplicity. To buy real estate as a sole proprietor, all you have to do is use your legal name and social security number. You could use a DBA to buy and sell property under a company name, but the legal structure will essentially be the same.
What are the disadvantages?
As a sole proprietor, you’re on the hook for any and all damages resulting from lawsuits filed by tenants and business associates. If a judge were to rule against you in court, they could go after all your assets, including your personal home.
As if that weren’t bad enough, sole proprietorships do nothing to shelter you from unnecessary taxation. In fact, all your non-passive income will be subject to an additional 15.3% self-employment tax.
Is it good for multifamily real estate investment?
No. Full-stop.
Incorporation (C-Corp)
On the opposite end of the spectrum from the sole proprietorship, incorporation forms a more rigid, tangible business structure. There are two types of corporations you can set up: a C-Corp and an S-Corp. Let’s look at the C-Corp first.
What are the advantages?
Two significant advantages attend incorporation. First, using your corporation to hold property will protect your assets from any potential judgments against the corporation. Second, you can borrow funds in the company’s name, which can also be a useful tool in shielding yourself from personal liability.
What are the disadvantages?
In a C-Corp, your income properties will be subject to double taxation: first, at the corporate level, and then at the personal level for any distributed income. If you try to get clever and hold back that income from distribution, the IRS will hit you with a 15% personal holding company (PHC) tax. Double taxation will also bite you when it comes time to sell properties you’ve owned for more than a year. Whatever gains you realize will be taxed at a high corporate rate. Any distributions you take from those proceeds will again be taxed at your personal rate.
Is it good for multifamily real estate investment?
In some circumstances, investors will use a C-Corp primarily for purposes of financing. In most cases, however, there are better options for offering liability protection without having to take on an additional tax burden. The S-Corp is one of them.
Incorporation (S-Corp)
The S-Corp is similar to a C-Corp in terms of its legal structure and filing requirements. The S-Corp, however, enjoys a special taxation status under the Internal Revenue Code Subchapter S.
What are the advantages?
The S-Corp is not subject to double taxation. Instead, profits and losses pass through to the company’s shareholders. As an added benefit, shareholders can be “hired” as employees of the corporation. This gives you the flexibility to distribute a portion of profits as bonuses which are not subject to ordinary Social Security and Medicare taxes.
What are the disadvantages?
Not all states recognize the S-Corp’s special status and, consequently, tax both corporations in the same way. Also, only individual U.S. citizens can participate as shareholders. Other entities (other C-Corps, partnerships, LLCs) cannot own a stake in your S-Corp. No more than 25% of an S-Corp’s income may be passive—including rental income. Any excess will be charged at the max corporate rate of 35%. For multifamily real estate investors, that represents a serious problem.
Unfortunately, whether you go with a C-Corp or an S-Corp, you won’t be able to avoid paying up to 35% in capital gains taxes. While you may be able to use a 1031 exchange to mitigate that tax burden, each shareholder will need to be eligible for the exchange.
Is it good for multifamily real estate investment?
If it weren’t for the added tax on excess passive income, the S-Corp would be an attractive option for real estate investors. With a long-term strategy focused on generating passive income, however, that makes the S-Corp functionally equivalent to a C-Corp, only with a free-pass on double taxation for 25% of your income.
Partnership
Somewhat like incorporation, partnerships are a legally binding arrangement between two or more entities with specific guidelines for how the business will be run. Unlike a corporation, however, the partnership is not a legal entity in and of itself. There are two types of partnership: general and limited.
What are the advantages?
Since partnerships are not legal entities, they’re not subject to double taxation. All income and losses pass through to the partners themselves and are taxed individually.
What are the disadvantages?
General partnerships offer nothing in the way of liability protection. For that, you would have to up a limited partnership, which is made up of at least one general partner and then one or more limited partner. As a passive investor, the limited partner is shielded from personal liability judgments. That partner must, however, remain truly passive. If they participate materially in any part of the business, they will lose their limited status.
Is it good for real estate investment?
Partnerships used to be more widely used, but their precarious liability protections have caused investors to look for a better solution.
Limited Liability Company (LLC)
In recent years, the LLC has emerged as a great hybrid solution for real estate investors. With the liability protection of a corporation and the tax advantages of a partnership, the LLC as the superior choice for most real estate investors.
What are the advantages?
Like a corporation, an LLC requires an operating agreement, only without the requisite annual meeting and elected board of directors. Instead, an LLC can be managed directly by its shareholders or indirectly by a designated manager.
In most cases, using an LLC to buy and hold your real estate investments will protect your assets from any judgments levied against the LLC itself. If the LLC is set up as a pass-through, then you get to enjoy this benefit without having to pay any additional corporate tax. Also, in an LLC you can distribute profits and losses as you see fit, allowing you the flexibility to negotiate tax-preferential treatment for certain outside investors based on their individual needs.
What are the disadvantages?
An LLC won’t protect your personal assets against every legal judgment. If a tenant sues after being discriminated against by an on-site manager, for example, then you’ll be protected because the suit took place entirely within the LLC. If, on the other hand, you yourself were to cause someone harm—a motor vehicle incident or an instance of proven personal negligence—both you and the LLC could be on the hook. Using personal finances to fund an LLC can weaken the barrier between your company and your assets. If you fail to keep all your finances strictly insulated from the LLC, a lawyer can and will come after your assets in court. On the financing side, any recourse loan written for a property within the LLC will likely require a personal guarantee from each member. If you sign that guarantee, then you’ll be liable for any remaining debt obligations should the LLC default on the loan.
Is it good for real estate investment?
Of the structures we’ve looked at, the LLC is your best bet. It gives you all the personal liability advantages of using a legal entity to buy and hold real estate with none of the additional tax burden.
Conclusion
Based on what I’ve shared above, the LLC will be the better choice for most of the investors who read this blog. Of course, your best bet will be to chat with your lawyer before you make any final decisions.
A parting word of advice: whichever structure you decide to employ, supplement your personal liability protection with a high-value umbrella policy. These policies are relatively cheap and could potentially save you millions of dollars in the long run.
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