How to Structure Real Estate Investment
In this article we discuss how to properly structure real estate investment.
Creating the right structure for a real estate investment is essential and must help ensure you protect your investment while optimizing the tax structure. The right structure must fit for a specific purpose and situation in place. There is no one perfect structure for the deal which would ultimately fit everyone regardless of asset.
The main structure types used by investors in real estate deals are:
* Limited liability company (LLC)
* Limited Partnership
S-corporation shareholders are individuals, trusts and estates. Partnerships, corporations, and nonresident aliens cannot be shareholders of an S-corporation. S-corporations do not pay federal taxes on the company level, so pass-through taxation applies. The transfer of interests in an S-corporation is possible without any tax consequences.
Many real estate investors engage in flipping real estate which means that an investment strategy is solely concerned with buying and selling an asset for quick profit. When this strategy is applied, real estate is considered an inventory and an investor is considered a dealer. Thus, as a dealer an investor is not allowed to take advantage of the following tax benefits which long-term investors in the real estate market are entitled to:
* Depreciation deductions;
* Installment sales method for recognizing gain;
* Section 1031 Exchange.
Short-term real estate investors should form an S-corporation or LLC which would be taxable as an LLC Corporation. This allows an investor to avoid social security tax on some share of the profit earned from flipping real estate. The up-front and annual charges for an S-corporation are usually low and can be deducted as a cost of doing business. Investors in S-corporations are entitled to dividends regardless of whether they have voting rights.
Limited Liability Company
LLC is considered the best structure for most real estate investors whose strategy is to “buy and hold” their investments. When you buy and hold a property it is considered a capital asset. The sole purpose of a buy-and-hold strategy is rental income and capital appreciation over a longer period of time.
Most deal syndications that engage a sponsor are structured as LLCs. The LLC is formed for the purposes of buying, holding and selling an asset. A company is formed that holds real estate assets while both sponsor and investors are granted ownership in an LLC through issue of shares. A sponsor is considered a Class B manager in an LLC and an investor is Class A. Class A investors are formally included in the operating agreement of an LLC that describes their share of ownership. In some cases, LLCs will grant members voting rights which can be used for large decisions such as management change, restructuring returns, or dealing with death or interest transfer of existing board members. It is important to understand the type of rights you have as an investor and the level of transferability, if any, your shares have according to the LLC’s operating agreement. The IRS taxes single-member LLCs as sole proprietorships and 2+ member LLCs as partnerships. An LLC can also choose to be taxed as C-corporation or S-corporation. LLCs that have more than 100 members cannot choose to be taxed as S-corporations.
Opposite to corporations, LLCs must state in their operating agreement how their members are assigned voting rights because voting rights decide majority ownership in cases of major events concerning the investment like sale, refinancing, major leases etc. Voting rights here are more important than majority ownership percentages. LLC operating agreements usually describe one of two forms of voting rights. The first one permits voting power based on member ownership percentage.
The higher the percentage of ownership, the higher the voting power of the member. The second one states that each member, regardless of level of ownership, is assigned one vote. So in a five-member LLC the majority vote is 3 out of 5 members voting in favor of or opposed to a particular decision. Also unlike icorporations where owners can control their voting rights by buying or selling shares, voting rights are agreed in an operating agreement up front in an LLC and any changes to the distribution of voting have little legal power later on.
In an LLC, the membership board is split between managers and other members. Even though a manager is theoretically responsible for making the decisions, voting rights must be specified in the operating agreement. Unless an operating agreement states that other members have no voting rights, other members can still participate in a decision-making process and override manager decisions, although oftentimes a manager would be granted higher voting power.
There are many benefits of forming an LLC compared to other ownership structures for the purposes of real estate deals, rendering the LLC the most often chosen ownership structure especially in the commercial real estate market. Here is a list of some of an LLC’s benefits.
* Corporations are required to have officers and directors while LLCs have no such requirement and can easily be managed by owners and third-party managers. The LLC has a greater level of flexibility in relation to management responsibilities than either the corporation or partnership.
* In the many states, LLCs may pay lower state upfront and annual fees than corporations.
* LLCs allow for greater flexibility in the distribution of profits, governed by an operating agreement. Cash flow distributions are not required to be pro rata according to ownership like with an S-corporation, providing LLC investors with an opportunity of implementing a waterfall structure, carried interest, or any other additional performance compensation to any one of the members.
* Pass through taxation is perfectly allowed with an LLC which means that your income is taxed only once on your personal income level. However, in a C-corporation for example investors are taxed twice: first on the level of dividend distributions and next on the level of their personal income tax.
* Ownership and investment by a foreigner in US real estate is allowed through an LLC structure.
* LLC owners are allowed to transfer their ownership in real estate assets managed by the company. It is entirely possible to pass full ownership of an asset or portfolio owned by an LLC to family members without recording a new deed.
Real Estate Limited Partnership
A real estate limited partnership (LP) is usually used in developments or long-term management of real estate projects. As an investor you can enter an LP by buying shares in one of the partnerships or by setting up a new partnership. The partnership is governed by the limited partnership agreement and controlled by a general partner (sponsor) who also controls the property. Limited partners are owners of an entity in full or have an absolute majority of shares, usually above 80%. Because forming an LP is very expensive, it usually pays off for projects of $10 + million in value.
LPs can offer its limited partners certain tax benefits. For instance, profits distributed through the partnership are not taxed, and limited partners are allowed to pass through all of the tax losses.
In some cases, LPs may set the terms which would require minimum amounts of investment as projects are usually heavy, but this is negotiable in limited partnership agreements. An LP agreement would set timeframes for property acquisitions as well as return targets for specific dates in the future. Often the investment strategy of an LP would include repositioning and then refinancing of a property accompanied by a large portion of equity as dividends to its partners.
The key issues to consider when choosing a structure for an investment are asset protection, taxation, and costs.
The real estate investment management process includes dealing with third parties, whether you are managing the property physically yourself or a sponsor does the job. The more we deal with third parties in any business, the more we are exposed to potential liabilities and expose our assets to risk.
While structuring a property investment any potential liabilities must be considered and valuable personal assets should be locked from claim by creditors in the event of a bankruptcy. Oftentimes locking your valuable possessions in an entity which would be hard for a creditor to claim against you in case bad things happen is a prudent move. If you own real estate in a TIC or partnership structure, you are personally liable for all obligations associated with an investment. However, in an LLC or S Corporation there is no liability beyond the amount of investment unless a personal guarantee is signed.
Tax optimization is probably the most important issue to consider during deal structuring. Not taking taxation into account can potentially cost a lot. For example, it would definitely pay off to blend properties into one entity in cases where one generates taxable return and the other does not. This would minimize overall tax liability by offsetting income from one property with losses from another property.
There are significant limitations from the tax authorities in relation to who can and who cannot own shares in an S-corporation structure. Each of theowners of an S-corporation must hold US citizenship or be a permanent resident. Additionally, an owner must be a trust, individual or estate. If any of the owners are business entities or are not US Citizens or permanent residents, a different ownership structure shall be used.
Up Front Cost
The costs of formation of the entity are definitely noteworthy. Both LLCs and S-corporations are formed by filing paperwork with the government which will involve some feeling fees. While the fee is nominal, LLCs, S-corporations, and grantor trusts would all require the preparation of organizational structure documents by an attorney. In addition, an S- corporation will require the filing of a federal tax form. In a partnership, an attorney will also be required to prepare a partnership agreement. The costs of the legal assistance depend on the owners’ unique needs as well as area and specific attorney hired.
Ongoing costs are required of many ownership structures for the purposes of tax fillings or state entity maintenance costs. For instance, LLCs and S-corporations require annual state filings and fees. Most of the ownership structures also require paying a third party to file annual federal income tax returns for you. Partnerships, LLCs, S-corporations, and grantor trusts are usually pass-through entities which means that the income tax is paid by the owners. On the other hand, TICs (Tenancy in common) are not required to file tax returns on an annual basis.
Deferral of Capital Gain Tax
Using Section 1031 exchanges is proved to be a good way to defer the taxation on capital gains and is very popular among real estate investors. However, there is a big IF with the 1031 exchange. Investors can use Section 1031 exchanges only IF all of the owners would be willing to structure their next investment together. There is no problem using the exchange while investing solo, but the moment a group of investors enters the deal this becomes more complex. If all of the investors are willing to move in a different direction upon the sale of an asset, only a TIC structure would allow for doing a 1031 exchange. In a TIC structure it also doesn’t matter if only one of the owners is willing to make use of Section 1031 exchange or all of the investors.