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:
- Minimize taxes due to the IRS and State agencies and in turn result in a higher overall return on investments
- Allow for maximum asset protection against potential lawsuits and creditors
- Provide privacy to the owner(s) of the property
- Allow the investors to achieve a wide range of flexibility and options regarding the management and control of the property, and
- 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.