Proper Entity Structure to Purchase Investment Property
Home purchases for personal use are usually made in the name of the buyer. However, purchasing property for investment purposes may be better served using an alternative avenue.
In California, entities can purchase properties in a similar manner to a standard individual acquisition. Purchasing through an entity can potentially shield the buyer from implications in the future, like a tenant lawsuit, and alter the applicable tax structure – a large benefit for investors. As such, many savvy investors choose to create a legal entity with which to purchase property. This article serves as an overview of the available legal entities that can be used to purchase property, as well as an examination of the best choice for legal protection.
Legal Entity Structures
In the United States, legal entities exist in several different forms. Not all are appropriate for purchasing property, however, so it’s important to understand the differences as well as pros and cons. Investors should consult with their legal tax, accounting tax advisors to confirm what structure is most beneficial for their individual circumstances.
A sole proprietorship refers to a business venture managed by a single individual for tax purposes. There is no way to establish a sole proprietorship; the concept of sole proprietorship comes into play naturally by way of generating income as a non-W2 employee. Sole proprietors do not need to file individual business tax returns; instead, a Schedule C is used to capture earnings for the purpose of paying self-employment taxes. These taxes fall into a separate category of income tax as there is no employer to pay a portion of Social Security and Medicare tax and thus this burden must be handled directly by the taxpayer.
The average property owner who buys a rental property in their own name is generally by default a sole proprietor. Any rental income or expenses will be reported on a Schedule C and the property owner will pay self-employment tax on any net profit.
Unlike most entities, in which there is a formal establishment process and required fee payments, sole proprietorships come into being naturally. Those seeking protections in purchasing property will generally find no benefit in a sole proprietorship as there is no legal distinction separating business activities from personal activities.
A partnership is a legal business entity formed by the agreement of two or more individuals or entities to enter into a working relationship together. Each partner is assumed to be an owner in proportion to the initial amount invested, and the partners are jointly responsible for debts and other obligations.
Partnerships exist in two different forms: general partnerships and limited partnerships. In a general partnership, all partners are active participants in the business and are responsible for both income as well as obligations. In a limited partnership, partners are split between general partners and limited partners. Limited partners are essentially investors only and do not materially participate in the course of business. They are by and large shielded from liability.
The biggest benefit to a partnership is the tax advantages available. Partnerships don’t pay any tax directly; instead, a partnership functions as a pass-through entity and all income and expenses flow through to the general partners. Partnerships file a Form 1065 that creates K-1s that are then entered into the partners’ individual 1040 tax returns.
The cost to establish a partnership is minimal in California and maintenance costs aren’t significant. However, there are other downsides to consider. A partnership can be a good option for those purchasing investment property jointly, but this is not a common scenario. In general, property purchases are an individual venture and bringing in a partner can make the process unnecessarily complicated. Further, general partners face many of the same liability challenges as sole proprietors.
Limited Liability Company
A limited liability company, better known as an LLC, is a form of legal entity in which the LLC’s owners are not liable for the company’s liabilities or debts. Effectively a hybrid of a corporation and a sole proprietorship, LLCs are still pass-through entities in which income and losses are still reported on an individual’s personal tax returns but there is greater protection from liability. An LLC separates the assets of the business from the assets of the owner; in real estate investing, this essentially means that the properties purchased within an LLC do not directly belong to the LLC operator.
To establish an LLC, articles of incorporation must be filed with the state. Filing fees for LLCs are several hundred dollars with maintenance fees of a similar amount due every one to two years. In California, fees include $85 to establish and an additional amount around $100 for a business license. An annual fee of $800 also applies.
As with a partnership, LLC taxes are filed using Form 1065 and owners report income on their 1040 returns using a K-1. However, LLCs offer a valuable tax savings opportunity that other alternatives do not: the opportunity to be taxed as a corporation. By filing IRS Form 8832, Entity Classification Election, LLCs can be taxed at the flat corporate rate versus the higher personal tax rate. For real estate investors who regularly earn significant profits, this election can be an effective way to save on taxes.
An LLC is a very common choice for real estate investors due to the relative ease of establishment, the lack of partnership requirements, and the protection from liability not offered by other flow-through entities. LLCs are affordable to establish, easy to maintain, and offer protection, making them a very safe and popular avenue.
An S corporation is a form of legal entity that offers significant liability protection. As a form of corporation, S corps are still pass-through entities but operate as an independent legal body, functioning as a “light” version of a C corp, so to speak.
S corporations are taxed using Form 1120-S and, like partnerships and LLCs, income passes through to an owner’s personal return. This means the entity itself is responsible for its own liabilities but not its own taxes. Unlike C corps, S corps are only required to file taxes once a year. However, S corps are often the subject of scrutiny by the IRS and improper filings can actually result in dissolution of the entity. This is because the corporation aspect of an S corp requires a particular payout of salaries and dividends, and failure to do so can lead to fines and penalties.
S corps have fees associated with doing business that exceeds those of LLCs and partnerships. In California, the franchise tax rate is 1.5% of net income with a minimum of $800. Government fees can also apply, as well as any legal assistance used to establish an S corp properly.
The added protection provided by an S corp is certainly a benefit, as is the advantage of no double taxation. However, S corporations do have some disadvantages. They can only be formed by U.S. citizens or permanent residents, so they are not options for foreign investors. The requirements related to dividend payouts aren’t always ideal either, especially for a company with a single shareholder.
C corporations, often referred to simply as corporations, are the most common entity structure for large businesses in which owners and operators do not want to take on any of the legal or tax obligations on a personal level. In terms of liability protection, the safeguards are the highest in C corporations versus other forms of legal entity.
A C corporation is completely separate from the owners and retains all of the income, assets, and liability associated with doing business. C corps are not pass-through entities, so taxes are filed and paid on behalf of the corporation rather than the material participants. However, shareholders do have to report earnings (when paid out in the form of dividends) on their own tax returns, which means that C corporation profits are effectively taxed twice. C corps must file taxes using Form 1120 on a quarterly basis, requiring far more time filing taxes than other entities require. Most individuals without a solid tax background will require the assistance of a CPA.
In addition to the tax challenges, C corporations are complex legal structures that can be quite costly to establish and maintain. Incorporating requires relatively low fees – in California, it is currently $100 with additional handling fees as well as an additional $100 for a business license and an annual reporting fee of $25 – but incorporation is challenging, and an attorney is recommended. Franchise fees also apply to C corps. C corporations can also have complex rules requiring the use of stock and shareholder participation. However, rules related to issuing dividends do apply, so C corp owners should be sure the distinctions between salaries and dividends are clear.
C corps do have some appealing characteristics, including the tax rates and total liability protection, but the complications involved with incorporation and the associated costs make this entity type largely undesirable for individual investors. An investor who wishes to turn personal investing into a corporate opportunity may wish to put further energy into weighing the pros and cons but in general, a C corp is going above and beyond what the average investor needs.
Purchasing Real Estate With a Legal Entity
Purchasing real estate with a legal entity can be a benefit, especially for those facing potential liability related to use. Things like tenant lawsuits can be damaging to individual owners, and a legal entity can safeguard against some of the potential financial and legal ramifications that may arise in property ownership.
Choosing a legal entity is in many ways a personal choice. Different investors will have varying needs ranging from partnerships with other investors to expected profits from rental properties or fix and flips. However, in most cases, an LLC is the best possible choice for those who would like to reduce liability without a significant investment of time and money. LLCs are affordable to establish on an ongoing basis, easy to maintain, and relatively straightforward. While a CPA or attorney may be required, the benefits often outweigh the downside. Further, the opportunity to elect a corporate tax rate can provide savings under certain tax situations.
However, an LLC isn’t right for every investor. Those who are not interested in significant investment opportunities may be better off continuing to operate as a sole proprietor. Evaluating the pros and cons is a key part of property investment in general, and this applies to legal entity selection as well.
Establishing a legal entity can be an excellent way to provide additional protection during real estate transactions. Understanding the ins and outs of the various options can be a critical way to save money, safeguard against liability, and ensure ongoing investment activities.
As a reminder, this article is for informational purposes only, and we recommend consulting with an attorney or CPA.
Scott Clift is a licensed real estate broker with Westpark Loans. He has been in the real estate industry since 1994. His team of seasoned professionals specialize in providing real estate loans for investors and other self-employed individuals. When you are ready to invest in real estate, call Westpark Loans to secure your financing at (844) 574-LOAN or by visiting westparkloans.com.