For my next real estate purchase, I’m investigating partnering with a couple dudes. Their construction experience and my property management experience should make for a solid team. Together, we want to buy distressed multi-family properties, fix them up and rent them out. These partnership discussions naturally brought up questions on the best legal structure we should use for owning these properties. To help figure out what to do, we met with a lawyer, an insurance agent, and an accountant (which sounds like the start to a bad joke). I’d like to share what I learned.
By the way: I am not a lawyer, an insurance agent, or an accountant. When figuring out what legal structure is best for you, talk to your lawyer, insurance agent, and accountant first. The purpose of this article is to give you a sense of your different options.
To start, you have many options for owning real estate: in your own name (as an individual), as an LLC, an S-Corporation, a C-Corporation, Real Estate Investment Trusts (REITs), and Deed of Trusts. Each have their own pros and cons. Let’s dive into them (with a minimum of techno-babble).
Individual
The most common type of ownership is as an individual. This actually provides many benefits: you don’t need to keep all your finances separate (though I still would), there are no extra legal costs, insurance is cheaper, and financing through a bank is typically easier. The big downside is liability: if someone sues you, they can go after everything in your name. That’s why as you start to accumulate more property, it makes sense to own real estate using a different legal structures.
LLC (Limited Liability Company)
The most common non-individual legal structure is an LLC. In theory, it separates anything owned by the LLC from everything else. The trick is to treat it like a completely separate “person” in real life, not just on paper. That means you need to keep everything separate: bank accounts (all income and expenses), tax ID, tax filing, and meeting minutes that capture big decisions. Plus, to be fully compliant, you should also separate your tools: computers, phones, shovels, drills, rental agreements, storage, etc. When getting started, that second list is difficult to do if you already own some property in your individual name. Though, it can be done! 99% of the time an LLC will be recommended to you. By the way, if the LLC is owned by a single member (ie. one person), then you don’t have to file a separate tax return, which is nice.
S-Corporations
S-Corporations are similar to LLCs with three differences worth pointing out:
- An LLC allows for an unlimited number of owners, whereas a S-Corp can only have 100. Though, it’s much easier to transfer ownership in an S-Corp.
- S-Corp’s formalities are a little stricter. For example, you have to file a separate tax return no matter what.
- A big benefit comes if you’re activity working in real estate as your main occupation. Normally that would be mean all your income is earned income, and therefore you would have to pay the FICA tax on all of it. Instead, you can pay yourself a “reasonable salary” and only pay FICA taxes on that “reasonable amount”. The remaining part is treated as unearned income.
Can you see why you’ll want to talk to a lawyer and accountant about your specific situation first?
(Read more about S-Corporations)
C-Corps, REITs, Trusts
C-Corporations usually don’t make sense for real estate investing. REITs probably also don’t make sense for the DIY landlord since you need a minimum of 100 shareholders and pay out 90% of the taxable income to those shareholders. Finally, a trust is used to hide the real owner and simplify property transfers.
(Read more about C-Corporations, REITs, Trusts)
I Picked My Legal Structure, Now How Should I Divide Up My Properties?
This is easiest to explain in a video. I use an LLC as the example and outline two common options for holding multiple properties.
Like I talked about in the video, there are two big take-aways to keep in mind when deciding on the best legal structure:
#1 Start simple at the beginning. If you want, you can get more complicated in the future by splitting your properties into separate LLCs. But if you only own a couple, keep it simple.
#2 Strive to do everything legally correct. If maintenance needs to happen, do it. If accounting and tools need to be separate, do it. That’s the biggest thing you can do for your own protection.
How do you legally structure your real estate ownership? Share with a comment below.
I’ll kick things off. Our first couple of properties are held in our individual names. We also have an umbrella policy that covers each of the properties. When we bought our larger multi-family property we put it in an LLC. Going forward, we’ll probably create clusters of properties in LLCs.