What’s the Best Legal Structure When Buying Real Estate?

Written on April 12, 2016 by , updated on September 8, 2017

Legal StructureI’m a mortgage underwriter and I work with real estate investors on a daily basis. Regularly, I am asked which legal structure is best for real estate!

It’s a tough question to answer because everybody’s risk profile and tax issues are different. And if you buy real estate with others, the issue is even more complex.

Full Disclosure: I’m not a lawyer.

I highly encourage you to speak with a lawyer to seek advice on this issue.

I can, however, give you a rundown on some of the different legal structures that are available for real estate investments to help you better understand the issues before you call an attorney.

Individual

This is a fairly common way to buy real estate. However, buying and renting out properties in your own individual name creates the most liability for you personally. Anyone can find out how much property you own by conducting a deed search online using your personal name.

The rental income for rental property is reported on your Schedule E. This can have its own set of issues for your personal taxes.

The biggest benefit of this legal structure is its simplicity. There’s no extra legal costs since your name is already established. Insurance is also cheaper when the property is in your own name.

Another benefit is that it might be easier to obtain financing when you buy a property in your own name. Although every lending institution is different, some lenders don’t lend to companies; they lend only to individuals.

Limited Liability Company (LLC)

Buying properties in a limited liability company is extremely common. LLCs are pass-through entities, meaning the LLC does not pay taxes.

The earnings or losses are passed through to your personal income tax return.  This is a significant issue when it comes to cash flow.

One big benefit to LLCs is there is no limit to the number of owners. I know several real estate investors who raise money from hundreds of investors. This is possible with a LLC.

Related: Should Landlords Set Up an LLC for a Rental Property?

S Corporations

I’m a big fan of S corporations. Why? Because in the state of Tennessee, where I’m from, the annual filing fee for an S corporation is $100, compared with $450 for a LLC. Who knows why? But a lawyer once told me this was because most people prefer LLCs. Maybe that’s the reason, and maybe it isn’t. But I’m taking advantage of it.

S corporations are very similar to LLCs. But there is one big exception: the number of owners.

With an S corporation, you are limited to 100 owners. But for me, this is not an issue.

Related: IRS S Corporations

C Corporations

C corporations are very different from the other legal structures mentioned. C corporations are true corporations that pay taxes.

Venture capitalists and a lot of other investors often prefer to invest in C corporations because there is no limit to the number of owners. Additionally, the earnings of the company do not flow to your personal tax return, so you don’t have to worry about income tax liability.

The big negative with C corporations is that there is double taxation if you want to get the cash out. Most investors get their cash out of a C corporation by the company declaring a dividend. You have to pay personal income taxes on the dividend income.

That income has already been taxed and paid by the company.

Related: 

Real Estate Investment Trusts (REITs)

Most people think of real estate investment trusts as big, publicly traded real estate companies. However, you can have a non-publicly traded REIT. The entity must distribute 90% of its income to shareholders to comply with becoming a REIT.

This is very efficient. However, it makes it very hard to grow. The majority of non-publicly traded REITs that I know of either sell more shares in the company or sell properties to raise capital.

Related: IRS U.S. Income Tax Return for Real Estate Investment Trusts (pdf)

Trusts

I have never put a property in a trust, but several of my friends put all their properties in trusts. Their prime motivation is to keep properties out of their personal name. They have their attorney’s address on all the documents of the trust, making it extremely difficult to figure out which property they own.

It’s easy to create a trust and sell properties in the trust. When you sell a property, you can transfer any interest with an “Assignment of Beneficial Interest” document.

As such, a transfer of an interest in a trust can be done effortlessly with an “Assignment of Beneficial Interest.”

This is a recommended legal structure for family estate planning. By having all your properties in a trust, you can easily avoid probate court. You simply need to set up a trust document to name “contingent beneficiaries” upon the death of the original beneficiary.

One big negative with trusts is lending. It can be very difficult to get a loan on a property when the deed is in the name of the trust.

Related: IRS Form 1041, U.S. Income Tax Return for Estates and Trusts

Summary

Every legal structure listed above is different. Don’t look for a one-size-fits-all answer. For instance, I use a combination of several entities for my real estate investing, depending on the specific deal.

Do you have a preferred legal structure for your real estate investing? Let me know in the comments!

 

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1 CommentLeave a Comment

  • Ali

    Hi Jimmy-

    Based on my conversation with Wells Fargo loan officer, a commercial loan is required (which has it’s own bells and whistles ofcourse such as higher interest rates etc.) to put a real estate under a LLC name. The other approach I have read about is that people usually buy it under a personal name with personal loan and then change the deed to LLC name but this approach is not legal based on my conversation with Wells Fargo loan officer as the personal loan prohibits that. What are your thoughts or experience?

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