LLC vs S Corp For Real Estate: Everything You Need to Know
When comparing an LLC vs. S-Corp for real estate, it's important to look at the benefits of each business structure.3 min read
2. Disadvantages of Forming LLCs for an Investor in Real Estate
Updated November 3, 2020:
When comparing an LLC vs. S-Corp for real estate, it's important to look at the benefits of each business structure. Over the past few years, limited liability companies (LLCs) have grown in popularity among businesses that hold real estate property titles for investment purposes.
The first LLC was formed in the United States in 1977. This happened when special legislation was enacted by the Wyoming state government to protect the oil companies in the area. Before LLCs existed, investors in the real estate industry could only form corporations to obtain titles, but this business entity formation has a number of possible drawbacks. After Wyoming led the way, Florida came next with an LLC statute, which was enacted in 1982. Since then, all states in the country have some type of legislation for structuring LLCs.
Benefits of Forming LLCs for an Investor in Real Estate
- Protection from personal risk
- Potential tax benefits when owning investment properties
- Easier formation and administration
These benefits make LLCs very desirable for real estate investors.
The major benefit of an LLC for a real estate investor is the limited personal risk in relation to legal action against the property. For example, an investor leases a property to a tenant. That tenant throws a party for their friends. During the party, a party guest falls off the balcony and becomes injured. With the legal climate as it is today, the likelihood of that injured guest taking legal action is high. The claim could include an unsafe condition on the balcony, which means the property owner would likely be included in the suit.
If the real estate investor-owned that property personally, their personal assets would be at risk in the lawsuit. However, if the property was owned by the investor's LLC, the personal assets are not at risk. Forming an LLC provides an insulating layer against personal liability in business legal issues. Only the LLC-owned assets would be at risk if a lawsuit was filed.
LLC owners can also take advantage of pass-through taxation, which is a benefit of this type of business formation. The IRS provided Revenue Ruling 88-76 in 1988, which allowed LLCs in the state of Wyoming to be taxed as partnerships while taking advantage of the corporate-level liability protection. When the IRS released this revenue ruling, it changed the game for business owners. Real estate investors could now acquire property through their LLCs to eliminate personal liability while avoiding being taxed twice.
Disadvantages of Forming LLCs for an Investor in Real Estate
Many benefits exist when you hold property assets through the LLC, but you should look at all business entity formation options before you choose to form an LLC. An LLC isn't always the best property holding option for all owners of property. In some cases, forming and managing an LLC for the sole purpose of avoiding the potential threat of legal action may not be worth it, especially since liability insurance is an affordable option.
If a real estate investor relies only on liability insurance as protection for their personal assets, they have to see the risk that comes with that decision. Most liability insurance policies come with carve-outs, limits, and exceptions, which means that a loss in excess of the limits could devastate the investor. Based on the current market trends and existing laws, real estate LLCs will continue to become more popular as a way for a property owner to utilize all benefits that come with forming an LLC.
The IRS default classification rules include a single-owner real estate holding company as a sole proprietorship or a disregarded entity. With that business formation, capital gains and income will pass through the business to the owner, who then pays the individual tax on the money. This eliminates double taxation while allowing the business owner to maintain liability protection. The mortgage insurance incurred by the owner of a single-member LLC can be deducted, in accordance with the rules of the IRS.
When a real estate holding company has multiple owners, referred to as a multi-member LLC, the IRS will typically assess taxation that is similar to a partnership. This means that LLC must file a tax return for informational purposes but doesn't need to pay taxes as a business entity.
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