Should I Create an LLC to Hold My Investment Property?
There are many ways to hold a parcel of real property, each with unique benefits and drawbacks. At some point, most individuals looking to generate additional revenue through investment properties will debate whether or not they should purchase and hold a piece of real estate through a business entity such as a limited liability company (aka LLC).
Holding property through a business entity adds a layer of separation between an individual owner and their real property. Doing so can help to protect the investment property from an individual’s debts and liabilities, and helps protect the individual from the investment property’s debts and liabilities.
The decision on whether to purchase property through an LLC depends on many factors and the specific preferences and goals of the buyer. This article is intended to provide a basic outline of the general concept of incorporation, and some of the primary benefits that are provided with an incorporated entity. For more detailed information, you may wish to consider speaking with a business attorney that can help assess your particular real estate venture.
It is first important to distinguish the difference between holding an investment property as an individual and through an incorporated entity. If you hold property as an individual, your real estate business is not registered with the Secretary of State, and you simply hold the parcel as personal property. If you are acquiring an investment property and running it under your own name, your venture is a sole proprietorship. If you are acquiring a property with additional individuals, then it is likely a partnership.
These types of structures are desirable because they are the least expensive to start and the most flexible in terms of management and operations. They are also very simple in terms of taxes. Because the structures are non-incorporated, incomes are taxed as your own personal income.
However, sole proprietorships and partnerships also have many drawbacks, the most important of which is personal liability. For a non-incorporated entity, each owner can be personally liable for the debts and liabilities arising from the property, the other owners, and vice versa.
This means that if someone wanted to bring a lawsuit in connection with the property, they could also sue the owners personally, and attempt to collect from their personal bank accounts or assets such as homes. In addition, if someone wanted to bring a lawsuit against an individual owner, they might be able to go after the property as part of the action or judgment.
Protection of Personal Assets
If a party is considering bringing a lawsuit for money damages, they will first look for a source of money from which to seek recovery. If you are involved in a real estate dispute, and you have significant personal assets, it would be tempting for the other party to go after those assets to satisfy the business-related debt.
However, when a business entity such as an LLC is incorporated, it becomes a separate legal entity that has its own assets, its own bank accounts, and usually its own tax ID. In California, incorporated entities primarily include LLCs and corporations. One of the primary reasons that a real estate purchaser will consider incorporating is what is known as “limited liability.”
Incorporated entities provide limited liability for its owners, which means that the owners are not held personally liable for the debts and liabilities of the business, or for the liabilities of other owners. Personal liability will be limited to the amount that is invested in the company itself.
This limited liability is not absolute, however, as the owners must treat the incorporate entity properly by following the proper formalities, and maintaining separate assets. Further, the owners may be personally liable for other types of intentional misconduct. However, assuming the owners follow the proper corporate formalities, properly maintain the business assets, and are not engaging in any improper conduct, then they can enjoy the benefit of limited liability while running their investment property.
Having general liability insurance or a real estate lawyer can help mitigate your exposure or defend your assets. But a corporate entity adds another layer of protection when engaging in a real estate venture. This limited liability protection reduces the owner’s personal exposure to liability and allows owners to operate their property without the fear that their personal assets may be at risk due to their business venture. This protection tends to be a primary factor in deciding whether to incorporate.
Protection of Business Assets
In addition to protecting the owner’s personal assets for the liability of the business, it also works in the reverse. It also protects the real property from the personal liability of the owners. If you are involved in a personal legal dispute, and you have real property assets with significant value, it would be tempting for the other party to go after those assets to recover their losses.
As a sole proprietorship or partnership, there is no liability protection, and so a suing party may be able to go after real estate assets to recover their damages. However, if the real estate is held through an incorporated business entity, and assuming the entity is treated properly, and liability protections maintained, the suing party would not be able to go after the property. To reduce risk under either of these scenarios, then you should consider forming an LLC to hold the property.
Aside from limited liability, you may wish to form a business entity if you plan to seek additional investors in your real estate venture. Because of limited liability, and other benefits of incorporated entities, investors will usually require a real estate investment to held through an incorporated entity before they will invest. Incorporated entities provide more protection for all owners, have formalities that must be followed, established management structures, and so are preferred by investors as it better ensures that their investments will be protected.
Other Reasons to Incorporate
Incorporated entities such as LLCs and corporations have many other unique aspects and characteristics that make them desirable for business owners. Other issues to consider are how many owners there will be, property management preferences, tax preferences, and what the long-term goals are for the property.
LLCs have fewer formalities to maintain, are therefore typically less expensive to form than corporations, and are taxed the same as if you were a sole proprietorship. Corporations have more formalities to maintain, including a board of directors, officers and shareholders, more corporate documentation, annual meetings, and minutes, and are subject to double taxation. However, angel and venture capital investors typically prefer corporations as their investment vehicles, so it may be worth the additional formality requirements if you plan to grow your real estate company down the road and take on larger investors.
One of the drawbacks of forming a business entity is that there are certain filing and legal fees incurred in forming the business. In addition, most states such as California have annual tax payments that must be paid to operate and maintain the business.
The decision of whether to incorporate as an LLC or corporation is also based on many different factors, preferences and business goals. However, it is good to be aware of these concepts when considering whether or not to form a business entity.
The decision to acquire and hold a parcel of real estate through an incorporated business entity will primarily depend on the personal liability you may be exposed to in running your venture, your long-term investment goals, and your risk tolerance. Limited liability is one of the primary reasons an owner would choose to incorporate and is typically the first issue that is considered.
If you hold property that is not involved with much interaction with other individuals or businesses, and if you do not anticipate any legal disputes as an individual, you may not need to incorporate. However, if you have significant personal or business assets, or are potentially at risk of a lawsuit, you should consider holding the property through an entity.
If you have any questions about acquiring or holding real property through a business entity such as an LLC, you should contact a real estate attorney to discuss the matter in detail. A real estate lawyer can help analyze your particular business venture and potential liability, help you decide whether or not to incorporate, and if you should incorporate, can help you choose a business entity that will best fulfill your goals and protect the continued success of your investment property.