There are many reasons why you should hold the investment property in a separate legal entity. These range from liability protection, depreciation and tax benefit vs various management and operation trade off by adopting a particular structure. A separate corporate structure is required for an investment property as properties held in a personal capacity can result in unlimited liability in the worst case.
In our experience, a good lawyer is always worth it as they have the experience and expertise to navigate the landscape better than any armchair legal analyst. The article’s goal is to get you the basics and the key points, so you have at least a baseline to start with.
Two of the most common structures adopted by real estate investors in holding investment properties are through a limited liability corporation or a real estate limited partnership.
Limited Liability Corporation (LLC)
LLCs are a common form of corporate structure where owners are liable for companies’ debt or other obligations. It is a mix of partnership and corporate structure. LLCs are typically structured with an Article of Organization, which outlines the rights, obligations and other relevant treatments between the members.
What is a Real Estate Limited Partnership?
A partnership is a private agreement formed between parties to operate an asset or group of assets. Relationships in a partnership are outlined in a partnership agreement.
Partnerships require a general partner and limited partners. The limited partners’ liability is limited to their share of the partnership, while the general partner’s liability is unlimited. This is because being a limited partner means their involvement is of passive nature while the general partner is solely responsible for the management of the partnership.
The general partner can manage their unlimited liability by using a limited liability structure to enter into the partnership for example, structure the general partner itself as a LLC.
Real Estate Private Equity Partnerships
Interestingly, in the alternative real estate investment area. Most investors prefer to use LLC as the ideal holding structure for real estate investments. Some of the biggest commercial real estate asset owners like the real estate PE firms are structured as partnerships. These funds are structured where the sponsor is the partnership’s general partner, an LLC, and the private real estate fund investors are designated as limited partners.
LLC vs Partnership: Pros and Cos
Real Estate Liability Protection
Liability protection is one of the most important reasons it is best practice to have the investment property held in a separate legal entity. This is to limit the extent of personal liability if an accident occurs on the property.
The only question is, what is better LLC vs partnership for real estate and the answer is both entities do a good job where no one if more beneficial from the other.
What About Taxes?
Investors prefer to use LLC and partnerships in real estate vs C corporations because they allow using a flow through tax treatment. This means earnings on income and capital gains are only taxed once at the LLC member or partner level while in a C corporation, taxes are paid on the company level and again when it passes through to shareholders.
Depreciation Benefits LLC vs Partnership
In one aspect where LLC comes ahead of the partnership is on the depreciation treatment of long-term properties. To capture depreciation benefits, the person taking the deduction on the tax return must have some involvement in the property’s operation. As mention above, the limited partner is passive and, therefore legally, is not involved in the daily operations and thus should capture the depreciation benefits.
The above does not apply if the equity investment in the LP is still on a positive basis. If that case, the LP can still receive depreciation benefit, but this means it is the extent of the partnership’s equity investment. In most instances, when the investment is realized, the lower cost base will be the starting point for capital gains tax calculation.
On the other hand, LLC members can take advantage of the depreciation benefits that limited partners cannot, as LLC members are still involved in managing the corporation as a member.
Debt or Financial Liabilities
Under an LLC, the obligations of the LLCs is self-contained in the entity itself. For partnerships, debt is usually held jointly but severally in proportion. This means that each partner is responsible for their share of the debt.
Why Most Investors Prefer LLC vs Partnership in Real Estate
There is a long history of debate for investors in choosing the right investment structure in holding real estate investments. LLC has become the preferred choice given the list of advantages over partnerships.
- First and foremost, LLC’s structure is most aligned with the management of real estate assets, whether this is entering into property management contracts or delegation of responsibilities to a specific LLC member.
- Ease of asset transfer. Transfer of LLC interest has limited tax consequences vs transfer of partnership interest. For example, LLC owners can partially be gifting membership interest to other parties overtime that the LLC’s interest is passed on to wider family members with limited tax or fees. There are usually restrictions in the transfer of partnership interest in partnership agreements. Likewise, if the asset is transferred directly in whole, it will pass numerous tax and fee thresholds, depending on the state where the asset is located.
- In some instances where each LLC member is compensated differently due to their contribution. LLC enables an easier means of distributing a disproportionate share of the cashflow per an agreement between them.
- You can create an LLC by your self while a partnership requires at least 2 parties, the general and limited partner. The two-party requirement means there is an additional layer of administrative burden that sometimes you can do without. LLC is in general known to be administratively light and inexpensive filing costs which is always helpful.
In most instances above, it shows why hands down the LLC vs partnership in real estate debate has won by LLC.
C Corporation vs LLC Tax Benefit
C corporations are not even close in the running in the choice of what is better LLC vs partnership for real estate. C corps are way more unwieldy, inflexible and expensive to boot from a double taxation perspective.
However, if we take a contrarian view on this, those with a multi-generational approach in real estate investing C corp could ultimately be a better choice for those consistently in the higher tax bracket.
The reason being tax rate in C corp is generally lower than the highest tax bracket. If the capital is known not to be needed for a long time, the tax savings between C corp and LLC income effectively the marginal tax rate for the investor can become meaningful as capital is built up in C corp. It can be distributed when the investor retires when the investor / marginal tax rate’s overall income is lower. Additional tax benefits could be gained by gifting the shares to other family members within the gift limit.
The summary above provides a good overview and starting point for those looking to structure their investment property the right way. However, nothing should be constituted as legal advise and we highly suggest getting in touch with a good lawyer.