Are you like the majority of real estate investors who are focused on finding good deals, buying, selling, and turning a great profit? If so, you can not forget to protect what you have accumulated. It only takes one lawsuit and your entire investment empire can come crashing down. This is exactly what one or our clients faced when they received the following letter from an attorney representing one of their tenants:
Does it matter if mold really exists in the house or not? Does it matter if the person is truly injured? The sad answer is NO. This lawsuit will progress and if this were you, your investing would most likely come to a grinding halt.
The problem for many investors is you are great targets for lawsuits because you own assets and engage the public. You have something of value that someone can take, and take they will if an opportunity presents itself. So, to assist you in preserving your assets you need to familiarize yourself with Land Trusts, Limited Liability Companies, and Corporations. Each of these tools is essential for the serious real estate investor who wishes to minimize risk and reduce taxes.
Asset Protection For Rental Real Estate
The biggest mistake any real estate owner can make is to place their rentals in a corporation for asset protection. Yes, a corporation provides asset protection. But it is not very efficient from a tax perspective. If you hold real estate, the preferred entity is the Limited Liability Company, “LLC”. The LLC, like a corporation, provides asset protection for its members from the liabilities associated with rental real estate. (This, of course, assumes that you hold your rental real estate in the LLC.) However, unlike a corporation, the LLC allows depreciation and real estate losses to flow on to its members’ individual tax returns. In a corporation, these valuable benefits can be lost. Unlike a corporation that can produce taxable income if you refinance the property and take the money out for additional investment, an LLC allows money to flow freely. Taxes for LLCs are based on actual income, not borrowed funds.
How Many LLCs?
The number of LLCs you use in your asset protection plan depends on your level of risk tolerance. Some investors cannot stomach the thought of losing more than one property and thus, place each rental in its own LLC. Other investors choose to group properties based upon equity values. For example, three properties in one LLC might be an acceptable risk of loss if the sum total of equity is less than $250,000. The number of LLCs is a personal choice but it is extremely important to choose the appropiate form of LLC to hold your real estate. All LLCs are not created equal. If you are investing in real estate you need an LLC tailored to real estate and not an off the shelf standard operating agreement that does not contain specific real estate provisions. We have reviewed hundreds of LLC documents and 99% of the time the documents do not work as marketed.
What Provisions Should a Real Estate LLC Contain?
We prefer to draft our LLCs so they are manager-managed rather than member-managed. Why? Members must be listed with the secretary of state when you establish a member-managed LLC. Only the manager is listed for a manager-managed LLC. Splitting hairs? Not really unless you are comfortable with your renters and potential creditors knowing what businesses you own. Other considerations include having appropriate language in the LLC documents so members can participate in certain decisions related to real estate and not in others. The operating agreement should cover such topics as refinancing, distributions, rents, property management, lease options, and much more that only an LLC tailored to real estate would contain.
Asset Protection For Quick Turn Properties
When an investor turns his focus to buying and selling properties a dilemma develops quickly. The dilemma is an IRS classification termed “Dealer Status.” To be a Dealer in real estate you must have an intent to buy and sell real estate versus holding real estate for investment. The key word here is intent. If you intend to rehab property, buy depressed properties then sell for a quick profit, or wholesale properties then you definitely are treading in Dealer Status territory. If you are classified by the IRS as a dealer then you face losing the following tax benefits provided to real estate investors:
- 1031 tax-free exchange potential
- Loss of depreciation deductions
- Long term capital gains rates on sales of properties held for over one year.
- Deferral of gain on installment sales
- Passive income
Another concern is liability protection. Without the proper entity to shield you from potential lawsuits everything you own could be subject to loss. To minimize both the negative tax implications and the liability associated with these activities we recommend utilizing a corporation for this form of investing. The corporation is a separate legal entity that provides asset protection for its owners and removes the business activity of quick turning property from your personal return. Thus, the corporation becomes the Dealer and you remain an investor.