Real Estate Investments and Limited Liability Companies (LLCs) - dummies

Real Estate Investments and Limited Liability Companies (LLCs)

By Jennifer Reuting

You can do nothing worse than hold investment property in your own name. Please read that statement again and again until it’s a mantra that keeps repeating in your head. So now that you know you need some kind of entity to protect your investment real estate, you can compare corporations to LLCs.

Knowing when corporations can kill

The limited liability company has an acute advantage over all other entities when it comes to holding real estate. With all the characteristics of LLCs — flexibility, pass-through taxation, dual-layer liability protection — it’s almost as if they were made for real estate.

If you’re using an entity to hold real estate assets, you’re most likely looking to gain passive income from the investment. If you were to place that rental property into a corporation, all the passive income you earn would be subject to double taxation — first at the corporate level and then individually when you remove the profits.

What’s worse is that because assets cannot be freely transferred into and out of a corporation, you’ll face a pretty severe taxable event when you decide to sell. Oh yeah, and you’ll face double taxation on that income as well.

To get around double taxation, real estate investors used to use S corporations for holding property. If you remember, S corporations are just like regular corporations but have a pass-through tax status. They also come burdened with a slew of ownership restrictions. But the big thorn in your side comes when you want to transfer the property out of the corporation. Unlike an LLC, an S corporation cannot do so tax free.

You may remember the one big advantage of S corporations is that profits aren’t subject to self-employment tax. Well, that perk doesn’t apply here. Because real estate isn’t an active trade or business and generally involves only the passive holding of property, the income derived from it isn’t subject to self-employment tax anyway. Only regular income tax applies.

So the S corp’s one claim to fame doesn’t even apply in this scenario. The only time to consider using an S corporation with real estate is if you’re so active in your real estate endeavors (rehabbing, flipping properties, and so on) that the IRS considers it a business. In this case, you have some number crunching to do before selecting your entity type.

Protecting real estate with LLCs

An LLC, when used to hold passive real estate investments, rocks your tax bill. First, when purchasing a property, it can usually be transferred into an LLC without creating a taxable event. Second, whatever profits you acquire from the property are considered passive and subject only to regular income tax. And third, as you get older, your limited liability companies fit perfectly into your estate planning strategy.

With an LLC, profits do not need to be allocated and distributed according to the ownership percentages. You can choose to dole them out however you want. For example, if you own only 10 percent of the limited liability company but want 90 percent of the profits (and the other members are okay with that setup), then that’s what you get.

This is just one more advantage that LLCs have over C corporations and S corporations.

Because an LLC’s losses are passed on to the owners, if you own multiple real estate properties, each within its own LLC, and one of the properties encounters a hefty loss, you can deduct that loss at tax time against the income from your other properties. Typically, this sort of loss is deductible only against passive income, such as real estate.

However, if you work with your accountant or corporate consultant and structure it correctly, you may be able to deduct the loss against active income (such as dividends). You can do so by becoming an active real estate investor who spends a certain amount of time each year handling the day-to-day management of the properties.

If you are a silent investor and you want your operating partner(s) to add some skin to the game, you may want to consider using a limited liability limited partnership to hold your property — assuming that your state allows them, of course (not all states do!).