How to Organize Your Real Estate Investments

The real estate market continues to be strong, attracting many people to invest in various types of properties, from single-family homes to commercial real estate. Investors stand to make substantial profits--from rental income during the period in which the properties are held as well as gains when the properties are sold. However, these opportunities can be dashed by exposure to liability. A claim by one injured tenant, for example, can wipe out a property owner’s investment and his or her personal assets without the proper protection. Here’s what you should know to protect yourself if you are going to invest in real estate.

Set up a business entity
The law provides you with several options on how to form a business to own and operate real estate investments. Statistics show that nearly one third of all small businesses are organized as S corporations--which is a corporation that elects to have its income taxed directly on shareholder returns, eliminating the corporate level tax--compared with only 12% operating as limited liability companies (Source: NFIB Small Business Poll--Business Structure, 2004).

What type of business entity is the best choice for you for real estate investments? A corporation can offer you personal liability protection but won’t necessarily give you any tax edge. A partnership may offer tax advantages, but won’t protect you from personal liability. A limited liability company, or LLC for short, is a hybrid entity that combines the best of what a corporation and a partnership can offer and may be the perfect solution for you.

With an LLC, no matter what happens to the property, your personal assets, including your home, cannot be touched by creditors of the LLC. And you not only gain personal liability protection, but also important tax and other advantages. Daren Hornig, head of Dwelling Quest LLC (www.dwellingquest.com), a residential real estate services firm in New York City with over $250 million in sales each year, says “the LLC gives you a flexible way to protect yourself as if you were a corporation but you get better tax treatment” and notes that his customers are routinely using LLCs to buy brownstones and other properties because of these features.

An LLC is set up under state law. Usually this means forming your LLC in the state in which you own the property and do business. You can use an LLC whether you are the sole owner or have one or more co-owners. LLC owners are called “members.”

Pass-through tax treatment
For federal income tax purposes, the LLC is not a taxpayer*--it is merely a conduit to pass income, gains, losses, expenses, and tax credits to its owners. Each owner of an LLC reports his or her share of the LLC’s income, losses and other items on a personal tax return.

• Single owner--For federal income tax purposes, the LLC doesn’t exist (it’s even referred to as a “disregarded entity”). The LLC doesn’t file any separate return. Instead, LLC income or loss is simply reported on the owner’s personal income tax return--he or she completes Schedule C, which is attached to Form 1040 (assuming the LLC owner is an individual and not a corporation).
• Multiple owners--the LLC files a partnership return (Form 1065, U.S. Partnership Return of Income). This acts as an information return to tell the IRS about the business’s activities. Schedule K-1 of Form 1065 is used to allocate income, deductions, etc. to members, usually according to their ownership interests. Each owner then reports this allocation, called a “distributive share,” on a personal tax return (specifically on Schedule E of Form 1040. For example, say you own 50% of an LLC that owns a rental apartment building. You report 50% of the net rental income from the LLC on your own tax return. (Allocations can vary from actual ownership interests in some situations as provided in the LLC’s operating agreement.)

Note: An S corporation is also a pass-through entity. However, there are substantial tax differences between S corporations and LLCs, one of which is explained below.

For state income tax purposes, the rules for LLCs vary from state to state. Most states follow federal income tax treatment. In addition, several states impose an annual fee on LLCs (referred to as a franchise tax, renewal fee or registration fee)--usually between $100 and $800, depending on your state.

Tax savvy
One key advantage of the LLC is the ability of owners to deduct their share of the LLC’s net loss for the year on their personal return. This loss from operations results when deductions (e.g., property taxes, mortgage interest, maintenance costs and depreciation) exceed income from the LLC (e.g., rent). The net loss can be used to offset the owner’s income from other sources, such as wages and interest income.

Loss limitations. Unfortunately, the tax law is highly complex and imposes many restrictions. A deduction for operating losses for the year cannot exceed your “basis” in the LLC. For instance, if you own a single property that has a net loss for the year of $50,000 (after taking into account not only out-of-pocket expenses but also an allowance for depreciation) and your basis is $40,000, you cannot use the entire $50,000 loss--you can only deduct $40,000 because of the basis limitation.

Essentially, your tax basis is the money you put into your LLC. For example, you invest $100,000 in an LLC to acquire property and you’re the sole owner of the LLC. Your basis in this case is $100,000.

Basis is also increased by any loans you make to the LLC as well as your share of LLC loans from third parties used by the LLC to acquire an asset. More specifically, you can increase basis by your share of nonrecourse loans to the LLC, which are loans on which no member is personally liable, such as a mortgage on property. Thus, if the LLC uses a mortgage to acquire property, your basis is increased by your share of this debt. (In contrast, if an S corporation mortgages property, the shareholders cannot increase their basis in the S corporation.)

Continuing the example above, if the LLC uses your $100,000 as a down payment on realty, and then obtains a mortgage of $400,000, your basis becomes $500,000--your initial $100,000 cash investment in the LLC, plus the $400,000 LLC debt from a third party. (Special rules apply for recourse debt.)

Another limit that can affect a property owner’s ability to deduct pass-through losses is the passive activity loss (PAL) rules. Rental real estate holdings are considered passive activities the losses from which are currently deductible only to the extent of income from passive activities. Losses in excess of passive activity income are carried forward and can be deducted in future years if there is passive activity income at that time or if you sell off your interest.

Exceptions to loss limitations:

• Losses are not limited if you are considered under the tax law to be a real estate professional. This requires you to spend a certain number of hours each year working at real estate activities.
• Losses up to $25,000 in excess of passive income can be deducted each year even though you are not a real estate professional as long as you actively participate in the venture and your adjusted gross income is no more than $100,000 (the $25,000 limit phases out for AGI over $100,000, so that no deduction can be taken if AGI exceeds $150,000).

Yet another limit is the at-risk rules that restrict current loss deductions to the amount of your economic risk in the activity--your cash contributions and borrowed fund that you are personally obligated to repay.

For more information about these rules, see IRS Publication 925, Passive Activity and At-Risk Rules, at www.irs.gov.

Separate LLCs
If you are buying more than one property, it’s a good idea to use separate LLCs for each one. The reason: Liability against a property becomes self-contained. If there is a problem at one location, your other properties are fully protected and are not impacted by actions against that one property.

If your properties happen to be in Delaware, Iowa or Oklahoma, state law there permits you to use a single LLC umbrella, called a series LLC (also referred to as a cell LLC). In this type of organization, the debts and liabilities of each LLC remain separate from those of the other LLCs. But having a master LLC makes things administratively easier and less costly. Even though each LLC runs separately, initial filing fees may be lower and only a single tax return is required for the umbrella LLC. You may recognize that a property is owned by a series LLC if it is titled “ABC Property LLC, Series X.”

If you already own a business, such as a professional practice, and are thinking about buying property for the business--perhaps a professional building from which to operate--watch out. You can, of course, have the practice buy the property, but this usually isn’t a good idea. It is advisable for you to buy the property yourself, using an LLC, and then lease it to your practice. In this way, you retain maximum flexibility over buying and selling the property. What’s more, if there are any legal actions against the practice, you can better protect the separate property owned by the LLC. This same strategy works if your business is, say, an incorporated manufacturer that wants to own the plant or a retailer in a strip mall.

Other LLC benefits
When it comes to managing your property and running the LLC, this type of business organization offers optimum flexibility. You can do it yourself, hire professional property managers or leave things to other members. Choose the management arrangement best suited for your personal situation.

LLCs give you flexibility when it comes to co-owners. You can also partner with anyone you choose and use an LLC for your business. For example, you might have a foreign investor in your company, something you couldn’t do with an S corporation.

 

This article was written for BizFilings by Barbara Weltman, a popular guest speaker on small business issues. She has lectured at national and regional conferences sponsored by prestigious forums such as SCORE, Barnes and Noble, The Learning Annex, and the U.S. Small Business Administration.

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