Choosing An Ownership Entity For Real EstateFebruary 15, 2008
When you acquire real estate for business purposes, you probably don't want your operating company to be the owner of record. Usually preferable is holding the real estate in a separate entity that then leases it to your operating company.
But what kind of separate entity is best for owning real estate? A corporation, partnership or limited liability company (LLC)? Or should you individually own the property? To further complicate matters, partnerships can be either general or limited, and corporations can be the C or S type. The answer depends on four primary considerations:
- Tax consequences
- Personal liability protection
- Management structure
- Ownership-interests transferability
The importance you place on each of these will determine the right ownership entity for your real estate acquisition.
Consider the Tax Consequences
In deciding the best ownership entity for your situation, first consider the tax treatment of the various entities. A C corporation is generally the least-preferred way to hold real estate. Why? Because the earnings distributed to shareholders are taxed twice: first as corporate income and again as dividend distributions.
By contrast, all the other ownership types under consideration -- partnerships, LLCs, S corporations and individual ownership -- are "pass-through" entities. This means the property's income (or loss) passes through the entity to the owners and is taxed only once as individual income.
Let's assume that your real estate falls in the nonoperating or passive category. That means that you won't reinvest the property's income back into the property by making capital improvements. Instead, you'll distribute most of the income each year to the owners. But if you own "active" or operating real estate -- such as a farm or an ongoing housing development -- you typically reinvest significant income back into the property, rather than distribute it to the owners. Owners might consider using C corporations only for operating, not nonoperating, real estate because income is not distributed to shareholders, so it's taxed only once at the corporate rate.
As for taxes, the S corporation has some disadvantages. For example, some losses (including nonrecourse debts) don't pass through the corporation to offset pass-through gains. Otherwise, the tax treatment of S corporations, LLCs, partnerships and individual ownerships are virtually identical.
Learn the Liability
Corporations and LLCs shield individual owners from liability based on the entity's debt. Individual ownerships and general partnerships offer owners no liability protection at all. A limited partnership shields the limited partners -- but not the general partner -- from liability.
If we consider only those first two criteria -- tax and liability -- clearly LLCs and S corporations are the best entities for owning real estate. They are pass-through entities for tax purposes, and they shield owners from personal liability. But because S corporations can't pass through some losses, LLCs are becoming the entity of choice for real estate owners.
Mind Your Management
The way you intend to manage the property may influence your entity choice. Owners who want to maintain control of transactions involving the property would benefit from choosing either:
- A limited partnership and serving as the general partner
- An LLC and being the sole manager
On the other hand, if you intend to elect a board of directors and depend on them for advice and decision making, you might want a more corporate structure. In that case, the S corporation might work better. You could also work with a board of managers in an LLC.
Again, LLCs fit either criterion: strong control by one owner-manager or management by an elected board (or by all the members). That makes it hard to beat as a way to own real estate.
Contemplate The Transferability
Because of fewer restrictions on transferring stock, a corporation is usually the easiest entity to buy, sell or trade shares in than any other form of ownership interest. For example, agreements between the partners -- such as buy-sell agreements -- restrict many partnerships. C corporations may be the easiest of all to transfer, because either an individual or another corporation may hold C corporation shares. Only individuals and special trusts may hold S corporation shares. Also, S corporations can issue only one class of stock, but C corporations may issue several classes.
LLCs and partnerships tend to suffer under partnership-type agreements that, for example, give other owners first-refusal rights when a buyout offer is received.
In fact, LLCs entail more planning to form than a corporation, because they are much more flexible and require making many more choices. Forming a corporation is an established procedure while forming an LLC depends on the nature of each transaction. So you'd be wise to get input from your accountant and legal counsel before you start the formal application procedure with the appropriate government agencies.
Make a Wise Choice
As you can see, many factors can influence your choice of ownership, including your own business and personal situations. You'll want to avoid a costly wrong choice.
We can help you review your current properties and the tax and other consequences of available ownership forms.
The way you intend to manage the property may influence your entity choice.
2 Good Reasons To Hold Real Estate Outside Your Business
You are usually better off holding real estate in a separate entity, rather than in your company. Why? Here are two good reasons:
- A separate entity diversifies your risk. If your business fails or gets into serious debt, its trade debt won't affect the real estate's value. If necessary, you could shut down the business and hold the real estate as an investment or sell it at full-market value. Conversely, problems with the property will not affect your company's viability -- though environmental contamination, for example, might lead to bad publicity and lawsuits.
- You can exclude the real estate from your business-succession plan. You can transfer company shares to key employees without transferring your real estate ownership. Thus, they benefit from the increased value of the business, owing in part to their efforts. But the employees don't directly benefit from the real estate's appreciation, which is unrelated to their productivity.