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A Beginner’s Guide To Forming A Real Estate LLC: Part 1

For the better part of a decade, real estate investors have favored the protection offered by limited liability companies (LLCs), as opposed to other similar legal entities. While they are not the only option for consideration, most real estate investors find the benefits offered by LLCs to be the most accommodating. The following highlights the benefits of structuring your real estate business under an LLC:

According to Legalzoom:

A limited liability company is a separate and distinct legal entity. This means that an LLC can obtain a tax identification number, open a bank account and do business, all under its own name. The primary advantage of an LLC is that its owners, known as members, have “limited liability,” meaning that, under most circumstances, they are not personally liable for the debts and liabilities of the LLC.”

LLCs were not introduced in the United States until the second half of the 20th century—1977 to be exact. As far as legal entities go, they are relatively new. In fact, the sole purpose of their existence, at the time of conception, was to accommodate the stringent needs of oil companies in Wyoming. Today, every state has enacted legislation to create some variation of the LLC business structure. It wasn’t till about 10 years ago that individual real estate investors really started taking a keen interest in the benefits provided by LLCs. Prior to LLCs, real estate investors seeking limited liability protection were largely limited to using corporations to acquire title—a form of entity that has potential drawbacks. For all intents and purposes, investors made the transition to LLCs to reduce their exposure to personal risk. However, the ownership of investment property through an LLC is also accompanied by significant tax benefits and an ease of administration not witnessed by other legal entities.

LLCs vs. Liability Insurance

Forming an LLC to hold tangible property assets is a good idea if you are actively investing in real estate. However, LLCs may not serve as the best holding vehicle for every property owner. Did I lose you yet? Just because LLCs offer a multitude of benefits to real estate investors and their particular industry, it does not mean they are the right choice for every investor. Keep in mind that the field of real estate investing is incredibly diverse, and it would be nearly impossible to find one legal entity that protected every business. Having said that, many investors believe the threat of a theoretical lawsuit does not warrant the commitment required to run and maintain a legitimate LLC. Those of this school of thought may be more inclined to inquire about affordable liability insurance.

With that in mind, entrepreneurs that rely solely on insurance as a means of protection take on ill-advised risks. It is not uncommon for the average liability insurance policy to have limits, exceptions and addendums that convolute coverage. Essentially, liability insurance does not cover all your corners. While the chances of a lawsuit being filed that exceed the limitations of your policy are remote, they are by no means impossible. Of particular concern, however, are the devastating effects that can result from a lawsuit that is not covered by your policy. On the off chance your policy does not cover a situation, the consequences can be devastating to a real estate investor’s business.

Current laws make the prospect of starting an LLC very intriguing to real estate business owners. While they may require more effort on your part, there is no denying the positive impact they can have on a business. They provide a lot more protection for business owners than liability insurance. But the real benefit is the peace of mind. Investors can sleep comfortably knowing they are safe.

LLCs Limit Personal Liability

Investing in real estate is a rather lucrative career choice. There is traditionally a lot of money involved in every deal—at least more than the average individual can cover on their own accord. Having said that, it is absolutely imperative for respective investors to protect their personal finances (those outside of the business). First and foremost, LLCs limit personal vulnerability to potential lawsuits related to the property. This is perhaps the most intriguing aspect of an LLC to investors of every level.

Any lawsuit that comes against an LLC is aimed specifically at the company, not the individual responsible for it. If the property in question were owned by an LLC, the owner’s risk exposure would be insulated by the protection of the company, leaving only the assets owned by the LLC (as opposed to all of the owner’s personal assets) exposed to potential lawsuits. In other words, personal finances would not be in jeopardy.

Pass-Through Taxation

Assuming liability coverage is the most important factor of forming an LLC, taxes are a close second. In fact, some real estate investors consider framing their business structure as an LLC based solely on tax benefits. Liability protection may just be an added bonus to some.

A 1988 court ruling enabled real estate investors to avoid double taxation by acquiring property through an LLC. As defined by the default tax classification rules, the Internal Revenue Service (IRS) classifies a real estate holding company with one owner in the same way they would a sole proprietorship, otherwise more commonly referred to as a “disregarded entity.” Accordingly, any income and capital gains generated by the LLC would transcend to the owner, who, as a result, would only have to pay taxes as an individual. However—and here is where LLCs come in really handy—the respective owner still enjoys the protection against liability.

Seeing as how there is no separate tax accompanying the formation of an LLC, business owners are in a position to avoid double taxation. Neither the rental income generated by a property, nor the appreciation in value upon disposition incurs tax penalties. Additionally, the owners of a single-member LLC can use mortgage interest as a deduction around tax time. In forming an LLC, you are not only subjected to fewer taxes, but you are awarded more deductions.

Real estate companies featuring more than one owner, however, are viewed differently in the eyes of the IRS. Otherwise known as “multimember” LLCs, these business entities are taxed similar to that of a partnership. Multimember LLCs also enjoy the benefits of pass-through taxation as the LLC passes its profits and losses through to its members. Each respective owner is then responsible for reporting their share of the profits (or losses) on either a Schedule C, K or Form 1065 with their individual income tax returns.

As the owner of an LLC, single-member or multimember, you are entitled to the benefits of pass-through taxation. Again, all of these tax benefits are in addition to the liability protection shield that was previously discussed.

by Than Merrill

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