We explore the pros and cons of different business entity structures used for real estate investments including Sole Proprietorship, Partnership, LLC, and S-Corporation.
Amanda E. Clark
Whatever type of real estate investments you own, the hope is to generate cash flow in an appreciating asset. Of course, given the unpredictable nature of the real estate market, you may also experience seasons of liability and loss. These financial complexities point to the urgent need for every real estate investor to choose the correct business structure, ensuring both the right legal protections and the most efficient tax structures.
There are several structures to choose from. Forming a Limited Liability Corporation (LLC) is quite easy, requiring only modest LLC annual fees. Structuring as an S-Corp is a bit more complicated while choosing to operate as a Sole Proprietorship or Partnership requires virtually no upfront work at all. But which of these business structures is the smartest?
You may choose to operate your real estate business as a sole proprietor. This is extremely easy, as it basically means you’re not creating a new legal entity at all. Instead, you’re conducting your business under your own name.
While Sole Proprietorship is certainly the easiest and least expensive way to start a real estate business, there are some significant downsides. The first is that, since there is no legal distinction between you and your business, all of your real estate debts and liabilities become your personal debts and obligations. And, if anyone ever brings a lawsuit against any of your properties, the lawsuit is really being levied against you personally. There is no legal protection in place to safeguard your personal assets or your family’s assets.
The other potential drawback is that, if you ever decide to bring investors into your business, doing so may be tricky. Because Sole Proprietorships cannot offer “shares” in the company, finding people to invest is famously difficult.
Another way to structure your real estate business is as a General Partnership. For the purposes of landlords and real estate investors, this option is very similar to choosing a Sole Proprietorship, only instead of running things on your own, you’ll share assets, debts, and management responsibilities with a business partner.
Partnerships can sometimes be advantageous, but they ultimately have the same kinds of drawbacks you’d find with a Sole Proprietorship: No legal protections should you be hit with a lawsuit and no good mechanism for attracting investors.
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Still, another option is to establish your real estate business as an LLC.
While setting up an LLC does involve establishing a new legal entity, and thus requires more setup than adopting a Sole Proprietorship approach, it’s a simple and fairly inexpensive process in most states. And, there are significant advantages to establishing a legal separation between yourself and the business.
The most significant advantage is that the LLC establishes a wall of separation between your personal assets and liabilities, and your business assets and liabilities. So, if someone brings a lawsuit against you, things like your personal bank account, or your family’s retirement accounts, cannot be targeted.
There are also some potential tax benefits. Structuring your business as an LLC allows you to be taxed as a “pass-through” entity. This means no taxation on the business itself, and thus no “double taxation” (that is, taxation on the business and then on your personal income from the business).
Downsides? There is some paperwork involved and in some states like California the set up fees can be prohibitive. Additionally, LLCs cannot sell shares, so you may encounter some of the same challenges when it comes to finding investors. With that said, LLCs may have more financing options in terms of business lines of credit.
A final option to consider is structuring your real estate investment business as an S-Corporation.
Of the four models we’ve discussed, this one is by far the most difficult and expensive to establish, as it will likely require the guidance of an attorney.
With that said, an S-Corporation offers some noteworthy advantages, including the chance to be taxed according to corporate tax rates (thereby avoiding self-employment tax). And like an LLC, the S-Corp establishes a clear separation between the owner and the business, so you’ll not have to worry about personal assets being threatened by legal action.
Finally, an S-Corp will provide a number of ways to attract investors should you choose, including options to entice venture capitalists, angel investors, and new partners.
There’s not necessarily a right or wrong answer here, but generally speaking, the larger your real estate investment portfolio becomes the more complex the structure is likely to be. For most real estate investors, establishing an LLC represents the best balance between convenience, legal protection, and tax advantages.
As with any such matters, however, it’s best to consult with a business attorney if you have any hesitation, or if you simply want to discuss the options best suited to your particular real estate business and your long term financial goals. Remember that this decision can have a profound impact on your company's future, so it’s definitely not a decision to make lightly!
As a self-managed real estate business owner, it’s always good to use property management and accounting software that would allow you to effectively collect rent online, property maintenance, tenant screening, rental accounting, tax accounting & reporting.
Amanda E. Clark is a contributing writer to LLC University. She is a graduate of Eastern Michigan University and holds degrees in Journalism, Political Science, and English. She became a professional writer in 2008 and has led marketing and advertising initiatives for several Fortune 500 companies. She has appeared as a subject matter expert on panels about content and social media marketing. She regularly leads seminars and training sessions on trends and tactics in professional writing.