Should Real Estate Investors Form an LLC? How to Choose the Right Entity

‘Should I make an LLC?’ is a question every real estate investor is forced to ask at some point in time.

Real estate investors and business owners are pushed into making this decision for their business with little or no actual legal background. Social media marketing and other ‘experts’ only muddy the water for entrepreneurs.

It is a hard decision, but one of the most important, and can wind up being one of the most costly. Entity selection is also not permanent and does require a certain level of fluidity.

An LLC with no S-Election might be the best answer for a business owner. Becoming a partnership and selling some equity might also be the best option in the future as well. And sometimes, after being a partnership, converting to a C-Corporation might be best after ten years of running a business.

These choices are not binary and require significant nuance and understanding.

However, all choices can be broken down to a few options, and that helps the lens through which to view everything else.

I’ll break down my four pillars for entity selection:

• Tax Factors
• Speed
• Asset Protection
• Selfish Reasons

But first, here are the different kinds of entity structures you can pursue.

What Are the Most Common Legal Entity Structures for Businesses?

There are more, but these are the most common.

• Corporation (Inc)
• Limited Liability Company (LLC)
• Limited Liability Partnerships (LLP)
• General Partnership (GP)
• Limited Partnership (LP)

These are legal definitions and can have bearing on tax treatment, but do not always. An LLC can become a C-Corporation, an S-Corporation, a sole proprietor, or a partnership. We will discuss the issues or benefits of one another.

You can choose any of these options to be treated differently for tax purposes.

While a few of these are more likely than not going to be exactly what they sound like for tax, like a Corporation being a C-Corporation or S-Corporation, an LLP being a partnership, a GP being a partnership, an LLC can be any and all of these options.

We’ll break down which you should choose and why below.

Avoid S-Corporation Elections

This disclaimer is important.

Why do we NOT make S Elections, and we don’t want to make them too prematurely in our business, and we want to never make them for real estate.

We create a lot of pain if we put real estate into Corporations. It becomes very difficult to unwind at the end of the day.

How Do Tax Factors Influence Entity Selection for Real Estate Investors?

Tax Factors is probably why many of you are even reading this article. And typically, we have to ask a lot of questions to get to the right answer.

For real estate investors, the easiest answer is to choose an SMLLC. However, it is ideal to ask plenty of questions about future steps

• Are you a service business?
• Are you a heavy real estate or asset business?
• Are you taking outside investors?
• Is your family investing with you?
• What’s your 5-year goal?
• Cash flow? Or growth to sell?

A Real Life Example

Two close friends want to begin investing in real estate together. They don’t know the best legal option, and tax election to go with their business.

I would recommend that they form a multi-member LLC (MMLLC), which would create a partnership filing.

This gives them the ability to either bring in more partners and capital later, while giving them flexibility with depreciation losses at the same time. I would not recommend an S-Corporation in this kind of example, as it would fully limit their exit opportunities and ability to take depreciation losses.

However, if they were able to grow to $5-10M in assets and created a management company that would hire employees to help them manage the properties, an S-Corporation might make the most sense.

Why? Because service businesses, like a management company, are not heavy asset maintained, and can be subject to higher levels of self-employment. This election can help them limit this exposure.

When do C-Corporations make sense?

C-Corporations are for companies or businesses that are looking to scale and keep cash within the business.

An example would be a tech start-up that is looking to sell to private equity at some point in the future, or a roofing company that wants to eventually sell to private equity.

That is the potential downside of a C-Corporation, as most profits are taxed twice. You may pay yourself payroll as an owner-employee, but you must not overstate your compensation too drastically to avoid paying ANY distributions.

But for tax purposes, an SMLLC or a partnership is the best route for both real estate owners and founders

How Does Entity Structure Impact Asset Protection?

Now I am not an attorney, BUT what attorneys have told me is that legal entities like Incorporations and Limited Liability Corporations (LLCs) can provide asset protection IF you follow the actual rules and treat this like a separate entity.

However, if you mix too personal with business, you might have adverse consequences in both an IRS Audit or in legal proceedings outside of tax.

Using Generative AI is not an advisable action to form legal documents, let alone complex Operating Agreements for your entities. If you’re having LLMs do it all, you might wind up ending in legal trouble.

See United States V Heppner. (And now other related cases)

How Quickly Do You Need to Start Your Business Entity?

Speed: how fast do you want to move? Do you need to get rock and rolling today? Then I would look into an SMLLC, or even an operation.

If you’re just starting a side hustle or some smaller endeavor, I’d roll with this one.

I’d say a massive chunk of businesses start this way, and that’s totally fine.

I’d say too many people here wind up creating an S Election, and we don’t want to do that.

What Personal or Strategic Reasons Might Affect Entity Selection?

‘Selfish’ reasons can be quite several things. It can be for whoever is bringing capital to the table, protecting family members from blowing up a business, or other personal items.

One example that I have seen is seeing a business start-up, but ensuring that the business would qualify for a § 1244 loss. Why is this?

Because over 50% of businesses fail in America, and if this fails, and money is lost, the capital investor can at least find a way to recoup some of their lost investment via tax deduction.

Having a well-structured operating agreement is vastly important for family businesses as well. Family relations can be quite complicated, and therefore, having strong operations in place helps avoid this potential fallout.

For example, if a sibling decides they have a 25% voting percentage and wants a distribution, they can hold up many decisions in the partnership. But if it is clearly outlined in the operating agreement that only certain members have voting rights, these kinds of situations can be completely avoided.

Choosing the Right Entity Structure

Entity Selection is not the easiest item in the world, and bringing in a bench of strong professionals to assist you is the best way to start.

The accounting, bookkeeping, and tax implications can either push you forward or pull you back.

Click here to have a free call with us, and let’s see how we can help!