LLC vs Partnership for Real Estate
LLC vs partnership for real estate is a valid concern for business owners wanting to protect themselves from vulnerability.4 min read
2. Beneficial Management Structure
3. Reduced Taxation on Appreciated Property
4. Property Transfers
6. Self-Employment Tax
Updated November 23, 2020:
LLC vs partnership for real estate is a valid concern for business owners wanting to protect themselves from vulnerability. By using a business structure for real estate investment, owners increase their chances of avoiding personal liability for accidents that may take place on the property.
About LLC vs Partnerships for Real Estate
Owning property, whether as an individual or in a general partnership, results in unlimited liability. This means the property is vulnerable to guests, tenants, and even trespassers in some cases to file a lawsuit for imagined grievances. If they win the case, your home, personal possessions, and bank account are at risk to satisfy a judgment. When a limited liability company (LLC) or limited partnership (LP) is involved, the liability is limited to the extent of the assets of the LP or LLC.
Beneficial Management Structure
Limited Liability Company
An LLC or LP may provide the management structure that suits your needs. With an LLC, you have access to a flexible schedule that allows two options: member-management or manager-managed. All members have limited liability, and in some states, an LLC can be formed by one person only.
A limited partnership does not have the option of formation by one person. It requires at least one general partner and one limited partner. The general partner is held personally liable. This can be circumvented by forming an LLC or a corporation to serve as the general partner. Two additional reasons for using an LLC or LP for real estate investments are to gain benefits from estate planning and gifting opportunities when available.
Reduced Taxation on Appreciated Property
Although a corporation may seem like the best option for a business owner, when it involves real estate investments, it is not the recommended choice. When real estate is held in either an LLC or LP and the property is sold to a third party, there are tax benefits to be gained.
Unlike a C corporation, which has double taxation, LLCs, LPs, and S corporations are allowed to use a flow-through tax treatment. This means they are only taxed one time. Also, appreciation on the property will result in less tax when it's held by an LLC or LP.
If an owner chooses to transfer the property to your personal use or to an LLC member of LP partner, there are benefits. For example, this would not result in any tax consequences. Even though limited liability is available with other business entities, there are tax repercussions. This makes an LP or LLC a better option.
When a rental property is owned, depreciation is one of the benefits. This is due to the cost of the property being amortized. This can take place over the course of the loan or the period it is owned. General partners would not be allowed to take advantage of the expense of depreciation if the general partner participated in the operation or management of the rental property.
When the objective of a piece of existing real estate is to buy, remodel, and sell within one year, this can be considered an active trade or business by the Internal Revenue Service. Unlike a passive income from a rental property, income generated from an active trade or business is subject to self-employment tax. This is a 15 percent tax to cover Social Security and Medicare by employed individuals.
To reduce self-employment tax to a minimum, an S corporation is the best choice of business entity. This is because the rules for an S corporation allow the business owner to draw a reasonable salary that's subject to Medicare and Social Security.
Once those figures are deducted, the remaining profit is taken out as distributions and is not subject to self-employment taxes. In contrast, all of an LLC's business income under the same or similar circumstances will be subject to self-employment taxes. Using an S corporation structure versus an LLC structure can result in significant savings for the business owner.
When a property is held as a cash flow investment, an LLC structure is generally the choice. This is due to:
- Distribution rules being more liberal for an LLC. LLC distributions are on an at-cost basis.
- The fact that members file a K-1 Form and pay taxes on profits as if were income.
When dealing with investment real estate property, speak with an attorney specializing in this area. Contracts and statutes vary from state to state and change often.
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