There are many ways that investment real estate can be held, including tenancies in common, corporations, limited liability companies (LLC’s), limited partnerships, etc. Because insurance will not cover certain types of liability (for example, mold and other environmental hazards) and policy limits may be exceeded, having an appropriate entity hold the property is advisable.
There is often discussion about tenancies in common. A tenancy is common is not an entity but a form of ownership where multiple people or entities are listed as owners on the deed. The primary advantage of a tenancy in common is that it’s easy to move investors in and out of the investment group while doing 1031 exchanges – and preserving 1031 exchanges for those leaving. The key disadvantage is that each tenant-in-common is fully liable personally for all debts, lawsuits, etc. regarding the property, since tenancies in common are treated like general partnerships. One approach is for each person or couple to form his/her/their own entity (such as an LLC), and that entity can then invest as a tenant in common.
Turning to entities, one question is how many pieces of real property should be in each entity. Since the purpose is to keep liability from one property from affecting another, at the very least each high-risk property (e.g., apartment buildings), should be in its own entity.
Another question is where the entity should be formed. If you own only a few properties, from a purely economic perspective it makes no sense to form an LLC in a state other than where the properties are located. A California resident pays California tax on all of his/her income, even if that income comes from outside California; this is also true for residents of many other states. Also, if you have an out-of-state corporation or LLC but that entity is “doing business” where the property is located, you have to register that LLC or corporation as an out-of-state entity with the state where the property exists – and the filing fees and annual franchise tax generally are the same as if you set up the entity there in the first place. Finally, an increasing number of states tax revenues generated within their borders, even if the property is held by an entity formed in another state.
Still, the state where the entity is created can be important if one or more of the principals is concerned about being sued personally (because, for example, that person has an occupation – such a surgeon – where he or she is likely to be sued). In some states (California is not one of them), creditors cannot attach membership interests in an LLC on the theory that it unfairly harms the other members. At the moment, this list probably includes Arkansas, Illinois, Nevada, Connecticut, Louisiana, Oklahoma, Delaware, Maryland, Rhode Island, Idaho, Minnesota, Virginia. (Bankruptcy law may require that there be at least two owners for this to hold.)
Even in states other than these, having assets in an LLC or limited partnership is better than having assets in a corporation. With corporations, creditors generally can obtain the stock and then can vote it. If they get enough stock, they have control over the company. With LLC’s and limited partnerships, usually the best creditors can get is a right to receive the owner’s profits (if there are any) – but they have no say in the management of the entity.
If claims by creditors against an owner of an entity personally (versus claims against the entity itself) are not a concern, then if you can set salaries and bonuses so that there is no profit, a “C” corporation may be the best choice of entity, since certain fringe benefits are tax deductible but are not counted as income for employees: health insurance premiums, life insurance, child care, and business-related meals, travel and lodging, etc. If the entity is going to have profits, a “C” corporation is a bad idea because there is effectively double taxation of profits: the corporation pays taxes on its profits and the employees and the owners pay taxes on their salaries and dividends.
To avoid the double taxation of a “C” corporation, a limited liability company (“LLC”), limited partnership or Subchapter S corporation must be used, since (with some relatively minor exceptions) there is no income tax on the entity’s profits; instead, the profits “pass through” to the owners. Often the best entity for real estate is an LLC. Still, one approach to receive the tax advantages for fringe benefits that a “C” allows is to have an LLC as the operating company, and have the LLC owned by multiple C corporations, one for each “real owner” of the LLC.
Subchapter S corporations often appear attractive because, although one must set a “reasonable” salary for any owner who is doing any work on behalf of the corporation, no self-employment tax has to be paid on any profit pass-throughs. (The self-employment tax is equivalent to withholding for employees for Social Security and MediCare, but includes both the employer and employee portions; currently this is currently 15.3%. This is in addition to income tax.) The primary drawback is that the IRS can terminate a corporation’s “S” status if its income from passive investments – such as rents – is more than 25% of its total income for more than three years in a row. If this happens, the S corporation is taxed as a “C” corporation.
For this reason, probably most entities that are formed to hold real estate are limited liability companies (“LLC’s”) despite some drawbacks.
One drawback already mentioned is that, with an LLC, each owner who a) is empowered to sign contracts on behalf of an LLC (which includes managing members and members of LLC’s that are member-managed) or b) spends more than 500 hours in a year on the LLC’s business probably has to pay the self-employment tax on ALL money that he/she receives that is in addition to his/her compensation as an employee (where withholding is already being done). While it is possible to try to avoid this by designating someone as the manager who is not a member (e.g., an affiliated corporation), that still does not help members who work more than 500 hours in a year on the LLC’s business. There is an exception if the income arises from real estate rentals. For example, if the business is solely involved in real estate leasing, the rental income generated would not be subject to the self-employment tax in an LLC.
Another disadvantage of a California LLC (or any LLC “doing business” in California) is that it must pay a California tax based on the amount of annual revenues between $250,000 and $5 million. The tax is set by a chart, but is approximately 1/4 of one percent of revenues (not profits).
If the annual revenues are expected to be excess of $500,000, it may well be worth it to create a limited partnership with an LLC (or corporation) as the general partner holding a 1% interest. This limits the California tax on LLC revenues to 1% of the limited partnership revenues. The reason that it usually only is worthwhile if the annual revenues will be in excess of $500,000 is that you need to form two entities: the limited partnership and the entity for the general partner. (You want an entity as the general partner because the general partner has unlimited liability for the partnership.)
A family limited partnership is simply a limited partnership where all the owners are family members. Similarly, a family LLC is simply an LLC where all the owners are family members. Frequently the purpose of these is to transfer business interests or real property to the next generation. A transfer of ownership to a child in excess of the $11,000 per person annual gift exclusion per person will reduce a parent’s lifetime gift tax exemption (currently $1.5 million) that is permitted under federal estate tax laws. For this reason, the value of the ownership transferred to a child is often discounted from a proportional share of the fair market value. There are at least two reasons to justify this. One is that there is a substantial value in being able to control a business. If, as is usually the case, the ownership transferred at any one time is relatively small and therefore does not carry the ability to control the business, the value of the interest being transferred is less. Another is that, because there generally is no public market for the interests in the business, it is often difficult to sell the interests later. Discounts frequently range from 10% to 50%. It is very important that these types of discounts be documented by an appraisal, in case the IRS challenges the discounted values.
A relatively new type of entity that many real-estate investors are looking at is the Delaware Series LLC. This is a single LLC with one or more “series”. Each “series” is treated much like a separate subsidiary – except there are not the same formation and administration expenses. Generally each piece of property is put into a separate series of the LLC. For investors owning three or more pieces of property, a Delaware Series LLC can offer very substantial savings over forming and maintaining multiple regular LLC’s.
Transfers of property can affect 1031 exchanges, trigger transfer taxes and generate property-tax reassessments. Be careful. With 1031 exchanges, generally you cannot change the owners between the two legs of the exchange. In other words, the owners who sold the first property will need to be the same owners of the new property – and have the same ownership percentages. Transfers of some or all of an interest in a property can also trigger transfer taxes (at least to the extent of the value of the property transferred). Transfers, even partial ones, may also generate property-tax reassessments, and not just in California. Still, because a single-owner LLC (and probably an LLC owned by spouses) is considered “transparent” by the IRS, a sole owner of property (or spouses who own property) probably can sell a property in the first leg of 1031 exchange as an individual (or as a couple) and have the LLC take title to the new property. In addition, this type of transfer probably will not be subject to transfer taxes or trigger a property-tax reassessment. Also, in general, transfers of some or all of a property from one spouse to another generally do not lead to the imposition of transfer taxes or cause property-tax reassessments. Once property is in an LLC, transferring some of the ownership interests in the LLC may cause transfer taxes or property-tax reappraisals (unless 2% or less is transferred in a given year).
Copyright 2005 Bruce E. Methven. All Rights Reserved. This article may be copied for non-commercial purposes, but all identifying information must be left on it.
Bruce E. Methven
Methven & Associates
2232 Sixth Street
Berkeley, CA 94710
phone: 510-649-4019
fax: 510-649-4024
www.methvenlaw.com
bmethven@methvenlaw.com
