What Type of Legal Entity Should I Hold my Real Estate In?

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One of the most common questions we get asked when we teach is “What type of legal entity should I hold my real estate in?”  Unfortunately, the correct answer to this question is most likely “IT DEPENDS”. For real estate investors, the best legal entity to hold title to your investment properties should accomplish the following 5 objectives:

  1. Minimize taxes due to the IRS and State agencies and in turn result in a higher overall return on investments
  2. Allow for maximum asset protection against potential lawsuits and creditors
  3. Provide privacy to the owner(s) of the property
  4. Allow the investors to achieve a wide range of flexibility and options regarding the management and control of the property, and
  5. Minimize the complexity and cost of maintaining the legal entity(s).

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LLC v.s. Trust

You may have heard people tell you “Always use LLCs for real estate”, and another person may say “Always hold your real estate in a Trust”. As a real estate investor, it can be both confusing and frustrating to receive such definitive, yet contradictory advice. As a result, a lot of investors are left to wonder – just which one is correct??

To make things even more complicated, each state has its own taxing authority with different rules on how income is taxed.

An Example of Why Choosing a Legal Entity is Tough

For example, if you own investment properties in Tennessee and you have a Tennessee LLC, then you have to make sure that your entity is set-up correctly in order to minimize your tax bill. Tennessee is one of those states where LLCs are subject to both franchise and excise taxes.  The franchise tax is calculated as .25 cents per $100 of the net value of all of your investment property held within the LLC, up to a maximum of $100.

The Franchise tax is due each and every year, even if your company did not have any activity during the year. In fact, the Franchise tax is due even if your LLC has been forfeited, revoked, or suspended.

In addition to the Franchise taxes, Tennessee also charges an Excise Tax of 6.5% of Tennessee’s taxable income.

Before you get too discouraged, here is where the loophole comes in. If substantially all of the income within this entity is “passive income” and this entity is owned in majority by family members, then you may be exempt from the Tennessee Franchise and Excise Taxes.

So what exactly is “passive income”? Rental income that you receive is generally considered passive income. Also, if you invest in trust deeds that provide with you interest income, that also generally qualifies as passive income. The second criteria is simply that the LLC must be owned at least 95% by family members (ie: spouse, parents, kids, grandkids.)

If your LLC meets both criteria above, then you may be exempt from the Franchise and Excise taxes of Tennessee. Generally, you must file the appropriate paperwork with the Tennessee Department of Revenue to claim this exemption when the LLC is originally formed.

If you have a Tennessee LLC but have not filed the application for exemption, it may not be too late so make sure you file the appropriate application for this.

Related: Top 3 Real Estate LLC Myths: Busted!

So What Type of Legal Entity Should I Hold my Real Estate In?

Simple answer:  It depends.

Just like the example of Tennessee above, there are numerous moving factors at play that can affect what legal structure you should take, and only a tax professional or lawyer can tell you definitively what is best in your case.

qwrrty

About Author

Amanda Han

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

16 Comments

  1. Interesting article you bring up two types of entities, the latter entity is a mystery to most investors, then you go on to tell us basically nothing about the application of either.

    • Agreed. The headline of the article suggests it’s going to provide useful information but ultimately does no such thing. “It depends on your situation” isn’t in the least bit helpful. Article title is classic link baiting.

  2. Dennis thanks for your comment. You are correct…there is no one size fits all answer when it comes to entity structure as every person’s financial profit is different and also their risk tolerance and exposure level as well. The best thing to do is to make sure that you understand some of the basics of the different entity types but get the guidance of your CPA and attorney prior to forming the best legal entity for your situation.

  3. I’ve heard of people putting real estate into trusts, and then moving the trusted interest into an LLC as a way to hide this move from the bank. Because if you put it directly into an LLC, you would be subject to the alienation clause, and the bank could call you on the note.

    In general, I believe in the philosophy that if you can’t do something in the open, i.e. if you can’t tell your own mother what you did, then you shouldn’t do it.

    My in-laws own 30+ rental properties and have been landlords for 20 years. They don’t use LLCs. They said it really makes things hard. Banks won’t talk to them for financing. Other people have pointed out that in certain states or counties, you can’t represent yourself in court if you have an LLC, and hence must hire an attorney.

    My in-laws haven’t been sued over slip-and-falls, which seems to be the big reason I hear about people “hiding” their property in LLCs. Heads up: you can still get sued whether or not the property is in an LLC. I just haven’t seen someone post anything to date that says, “Wow, my LLC really saved my neck that time.” It sounds like proper cash reserves and probably the right insurance policies (rental home owners + umbrella policies) seems to be a better and more cost efficient way to hedge risk.

    • Cheryl Carrier on

      Greg, I may be naive and stupid but I do what your in-laws do. I have a large umbrella and insurance on all my properties. I’ve been doing this for 30yrs. Knock on wood, I’ve never been sued. This topic has come up many, many times. It’s not that tough to “pierce the corporate veil”. I don’t think that I am negligent on any of my properties; but anyone can sue you whether they have a case or not. The legal fees are what I expect my insurance to cover.

      Now, my husband has large commercial and many layers of corps, LCC’s, etc. I don’t have the same exposure (I hope!). VA is a tenants by the entirety state; so I may transfer my stuff out of his name. You guys are making paranoid!

  4. This is how I do it in Colorado: The property is held in or purchased by a trust (trust is the owner). The beneficiary of the trust is my LLC. The name of the trust and trustee are the only things recorded at time of purchase. Beneficiary is unknown to everyone except your trustee (and yourself, of course).

    Trust for anonymity, LLC for protection. They work very well together.

  5. Great article with very good points related to taxes. I’d be interested to see a follow up article written by an attorney to discuss the legal side of this issue. Amanda – what are the tax implications if the properties are held in LLC that was formed in a different state (properties in TN held by CA LLC). Jason – same question for you, is the beneficiary LLC also was formed in Colorado?

  6. Lots of comments on an article with no usable info.

    Simply spelled out their are ups and downs with everything in investing, so just wrote your entire article in one sentence.

    Let me add some useful info, holding a property in a trust to obscure ownership is just dandy if you do not plan on refinancing in the future as no bank will finance without first removing the property from the trust, getting a signature from a person with credit. Some lenders require the deed to be out of the trust for up to one year before they will lend on it.

    However if you are dealing with a long term hold, can go from the seller to your trust, have a person or entity that, one does not have your name as the trustee, or an LLC that can be traced to yourself, a trust is the only smart way to go.

    The beneficiary of all trust properties should be a family trust, with whoever as many as you want to benefit from the assets held in the trust. You will and that of any of the beneficiaries should simply state “Everything they own that is not in the trust at the time of their death is bequeathed to the trust”. If you kick the bucket with the above in place any debt collectors will give up trying to collect from the deceased as there is no probate for trusts, and no way in heck to collect from a penniless corpse.

    The way around who will manage the property is dealt with via an LLC, to remove the personal liability.

    My properties are held as above, but all of the original financing (and the reason I don’t mind paying 7.75% interest) was created allowing the trustee to sign the note “as trustee” later the trustee was fired so to speak and a new trustee put into place.
    What this created was a non recourse loan, with no person responsible, none of the mortgages show up on a credit report, the property is the only collateral for the loan.

    You can see how pre 2005 trusts were the only way to go because the lenders had no idea what they were doing creating these notes.
    In todays lending climate if one did not want to move the property from the trust they could seek commercial financing. The downfall is on a long term hold having a short term is not a good idea unless the note is going to be accelerated and most commercial lenders don’t like you to do that.

    I don’t think I need to explain an llc, but the idea of piercing the corporate veil is not ever going to really happen with an llc, this is lawyer / insurance company scare tactics.
    Llc’s require such simple requirements to keep in good status you would have to be a simpleton to mess this up.

    The truly big picture is in residential small properties, having great insurance with a large dollar figure payout and running your company properly will make the probability of a large judgement near impossible to happen. No one is going to get a million on a slip and fall, at your duplex. Just don’t rent to creeps, or losers who sue as a second means of income like this fellow, a simple search of the court records would have saved all of these landlords.
    http://blog.nj.com/njv_barry_carter/2011/05/carter_newark_man_acts_as_his.html

    • Dennis,
      I agree with your original comment that it would have been nice to have more substance in the article. However, I have to point out one problem in your comment. Keeping your LLC does NOT guarantee that you will never be personally liable. At least here in Colorado, you can be held liable for anything you personally do, which would be most everything the LLC does if you are the sole member and there are no employees. Of course, everything depends on the situation, this is not legal advice, and this will vary by state.

      Adrian

  7. Thanks for all the comments! I think this is my post with the most heated comments yet! There are so many different ways to structure entities and I Iove hearing about all the creative ways that some of the people I work with use. To clarify, my posts are simply a way to share my personal experiences as it relates to real estate investing. As with most other licensed professionals on this site, we always want to be clear that we are not providing any tax, legal or investment advise. There has been talks of simplifying the tax code for as long as I can remember but to date….seems like the law gets more and more complicated every year. Hopefully there will be a day when we can say “all investors should use XXX as a legal entity”….but realistically nothing in life is ever that black and white. =)

  8. I have tried to read as much as possible and come with an answer. I couldn’t. I couldn’t find a clear cut example that said “this will save me money down the road and is worth the up front costs.”

    The final straw was when I read this: http://www.johntreed.com/entity.html

    It really lays out the fallacies in assuming there is some corporate structure in the “law” designed to protect you from “lawyers”.

  9. I’ll kind of agree that I didn’t get what I expected out of this.
    For those using a TN LLC it would be useful not so much otherwise.

    Knowing your expertise is taxes what advantages or disadvantages are there to using trusts?

    • Shaun:

      Yes for TN investors if you can meet the exceptions above then LLC is not an issue from a tax perspective. For your question on trusts-the answer is it depends of course! Typically for living trusts or land trusts they are disregarded for income tax purposes so that means no tax benefit (or detriment). The land trust typically provides you with privacy protection where the living trust is to assist you with minimizing probate costs upon death. Again-income tax wise both of these trusts are disregarded. There are other more advanced trusts like charitable lead trusts (CLT) or charitable remainder trusts (CRTs) which allow you the donor to get a tax deduction for the net value of the asset that is donated into the trust (ie real estate). Now these trusts do give you tax savings so make sure you speak with your tax advisor if you are interested in using these types of charitable trusts.

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