Real estate comes in all shapes and sizes and there are numerous ways to invest in it. Smarter investors look very closely at how their real estate business is structured because the wrong structure can cost them a lot of time, effort and money, while the proper structure can save and protect their hard earned assets.
There are three basic types of business structures, the sole proprietorship, the partnership and the corporation (including limited liability corporations or LLCs). Each of these structures, like everything else in this world, has pros and cons attached to it. Let’s look at each one.
Sole Proprietorship
The sole proprietorship is just what it sounds like, you, the individual investor conducting your real estate business. Usually individuals set up a business name, such as ABC Properties, and then set up their accounts to read as Joe Investor, doing business as (DBA) ABC Properties.
Pros
- It is easy. Pick a name and you are in business.
- It is simple. Set up a separate DBA bank account and off you go. Plus the income tax returns are just included with your personal 1040 form.
- It is easy to end. Just stop it.
Cons
- There is no liability shield. Everything good and bad passes through to you.
- You are visible as the owner. There is no anonymity.
Partnerships
Partnerships are created when two or more people get together for some sort of business venture. In real estate investing, partnerships are usually formed because one or more partners have some sort of specialized experience needed for the particular deal. Or, one or more partners may be bringing their money to the table to fund the deal.
Pros
- They are easy to set up and start. No public documentation is generally required.
- They can be easy to dissolve and can even be specific to a particular deal.
- Partnerships can bring together people that will make an otherwise unworkable deal workable. One partner may have money, rehab experience or a list of potential buyers for example.
Cons
- No liability shield protection.
- Enhanced level of bookkeeping and federal income tax knowledge needed. The IRS Partnership Form 1065 is needed for example.
- Partnerships can get messy. A partnership operating agreement is a must and it should be reviewed by a qualified attorney.
Corporations and LLCs
Corporations and LLCs are legal entities. They are separate and distinct from you the individual.
Pros
- Liability shield is in place between you and your investments.
- They are fairly easy to set up.
- They can provide you with a more professional image.
- They can help maintain anonymity.
- Depending on your business, they can provide various federal tax benefits.
- Can be a good way to raise funds.
Cons
- Require paperwork to be filed with the state along with initial and annual filing fees.
- The laws and rules governing corporations can be complicated.
- There are annual paperwork, meeting and filing requirements that must be completed.
- You will often need to pay for professional legal and accounting advice (In Tennessee for example, a corporation or LLC must hire an attorney to represent it in court for example)
- There are increased bookkeeping and tax reporting requirements. You must keep all monies separate if you wish to keep that liability shield in place.
- Banks will not lend to newly formed corporations. In general, a corporation must be in place for at least three years before a bank will consider lending to the corporation. So you will not be able to put your investments in the corporate name anyway.
Which one is right for you? That depends on what you are doing and what your comfort level is. For those just starting out in real estate investing, I would keep things simple with a sole proprietorship or a partnership. Don’t over complicate your life when you are just starting out. If you are worried about getting sued because you do not have a liability shield (and you should be!), just be sure to get a liability insurance policy of at least $1 million to $2 million.
As your real estate business grows and expands, you may want to consider an LLC or corporation, you may even want to consider having several of them. Why? Because it is more advantageous tax wise to put long term holds into an LLC and it is more advantageous to use an “S” corporation if you do a lot of retail and wholesale flips. So if you do both in your business, you may want both types of structures. Plus as you continue to read this site and become larger and more prosperous, you will become a bigger target and may want the protection a corporate shield offers. If you own a lot of properties, you may want several different LLCs to “split up” the properties into different entities for asset protection purposes.
Again, it is all up to you and what you want to do and what your comfort level is. I know investors with layers of corporations and I know investors who have done hundreds of deals and own dozens of properties as sole proprietors. It just depends on the individual. In the end, there is no “right” structure.
Whatever you do, don’t just take my word for it. Do your own research. Check with and talk to a qualified attorney and accountant in your local area about these issues. There are local rules and regulations that may make your situation unique.
Until next time, invest smarter!
