Possibly THE most frequently asked question of me is "What is the best
business entity for me to use for real-estate investments?" My recommendation to most
people is that a limited liability company (an "LLC") is the best entity for this
type of business. Here's why:
- Excellent liability protection
- Flow-through tax treatment
- Ability to transfer properties in and out of an LLC
- Charging Order procedure (for Nevada LLCs)
Liability Protection. An LLC is similar to a C-corporation ("C-corp")
or a Sub-Chapter S corporation ("S-corp") in that it exists as a separate corporate
entity. It provides full liability protection to its officers and directors (called
"Managers") and its shareholders (called "Members"). Even though you
will, of course, have excellent insurance plan coverage in place, there are still many risks
associated with owning property, especially if you are intending to hold rental properties.
Tenant injuries are a prime concern, but even with vacant property, a trespasser could injure
themselves on the property and sure for hazardous conditions. Owning property in your own name
means that in the event you are sued and found guilty, anything your insurance policy does not
cover will come out of your own pocket. Putting an LLC entity between you and this personal
liability means that your assets will stay protected.
Flow-Through Tax Treatment. Unlike a C-corp, an LLC does not pay income taxes. It
is a "flow-through" entity, meaning that, like a S-corp, the tax on the profits (as
well as the write-offs on any losses) are passed through to the Members.
The flow-through tax treatment becomes important when you decide to sell a
property, or convert it to personal use. For example, if your C-corp were to sell property
netting, say, $400,000, that profit would be subject first to a capital gains tax of
approximately $136,000. After deducting the capital gain tax, approximately $264,000 would be
left over to distribute to the shareholders. Unfortunately, that distribution would be
considered a dividend and taxed accordingly. Assuming the top dividend tax rate of 39.1% was
used that nice $400,000 profit would wind up being approximately $160,775 in your pocket. Not
so attractive to you, but the government certainly makes out like a bandit. Selling that same
property through LLC or an S-corp would mean that no capital gains tax would be paid at the
corporate level. You as a member, would pay capital gains tax on your share, but at a lower
rate than a corporate entity would be charged, thus saving over $150,000 in taxes.
Ease of Sale. LLC's have an extra advantage over an S-corp (or a C-corp) where
you want to convert a property to personal use, or trade it (called a "like-kind
exchange") for another home of similar value. If held in an S-article1 corp the
conversion or trade of property would be considered a sale with the accompanying tax
consequences. Held in an LLC, there are no tax consequences to converting or moving the
property in order to achieve a tax free exchange.
Charging Orders. In Nevada, a charging order is the sole legal means by which
a creditor may attach a judgment to an LLC. If tenants were to injure themselves on your
property, win a lawsuit and your property insurance left you partially uncovered, the balance
of the judgment owed could be attached to the LLC through a charging order. Effectively, the
judgment holder would become a non-voting member of your LLC, with the right to receive a
share of profits, if the LLC decides to distribute profits to it members. That's it. They
cannot force a sale, or even a profit distribution, as they are a non-voting member, with
no control whatsoever over how the LLC is operated. And, in a fairly ironic twist, any monies
allocated to a judgment holder through a charging order would be treated as income and be
subject to capital gains tax. This allocation may not be accompanied with any money, thus
causing phantom income to the creditor, whereby taxes are owned without money used to pay
them. Unkind and unfair to creditors? Perhaps. But in Nevada, that’s the law. Remember though,
not every state uses the charging procedure as the sole creditor remedy. It may be worth your
while to create a Nevada LLC to hold your properties and then qualify the Nevada LLC to do
business in whatever state (or states) your properties are held. One final point to consider
while on the subject of charging orders is to limit the number or dollar value of properties
held in an LLC. If you have one property in an LLC and that LLC becomes subject to a charging
order, then you can delay payment of judgment by not making any Member distributions. However,
if all of your properties are in that LLC, the charging order will apply to all distributions,
and not just those from the property in question.
Choosing to make no distributions to delay payment of the judgment would result in you
being cut off from your own profits.
Do I ever NOT recommend using an LLC for real-estate holdings? Yes. In California, there
is an additional franchise tax fee of over $1,000 per year levied on LLCs with gross receipts
(not profits) over $250,00.
However, Californians (or out-of-state residents holding property in California)
can form a Limited Partnership instead. Same great benefits, but without the extra franchise
fee. As well, for gifting and estate planning purposes limited partnerships may offer a slight
advantage in terms of legal certainty over the LLC. But absent these considerations, the LLC
is a superior entity for holding real estate.
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Garrett Sutton is available for questions or consultation at (775)824-0300 or at
gsutton@sutlaw.com.
For more information, a complete overview of the most effective uses of LLCs and Limited Partnerships,
please see my book, How to Use Limited Liability Companies & Limited Partnerships, published by SuccessDNA,
Inc.
