Real estate investment is a time-honored and often exciting way to grow wealth and find financial independence. But compared to many other business activities, real estate investment often carries more legal risk and involves more tax complexity. A one-size-fits-all business structure may leave real estate investors exposed to liability and paying higher taxes.
Real estate investments have a lifecycle that requires a holistic approach to planning. The right business entity for a real estate investor must anticipate the events that occur throughout the three main real estate investment phases:
- Acquisition. In the acquisition phase, the investor acquires the property. The investor may also develop the property (if it is raw land, for example) or rehabilitate the property (if there is an existing home or building) to prepare it for operation.
- Operation. Some real estate investors plan to hold the property for some time. Most often, the investor will rent the property during this time. If the investor has a “buy and hold” strategy that seeks long-term income from the property, the operation phase may be indefinite. If the investor bought the property primarily for quick resale—for example, a “fix and flip” strategy—there may be no operation period.
- Exit. At some point, the investor will no longer own the investment. The investor could sell it or, if he or she holds it until death, pass it on to family members or other beneficiaries. In either case, careful planning on the front-end avoids paying unnecessary taxes on exit.
Each stage of the real estate investment lifecycle involves agreements with different stakeholders, including lenders, contractors, tenants, buyers, and sellers. A default on any of these agreements can result in breach-of-contract lawsuits or other legal threats. Real estate investors may also face ongoing lawsuits for slip-and-falls and other personal injury claims, many of which are frivolous.
Any real estate investor that plays the game long enough is likely to be involved in legal disputes. Any dispute can result in a judgment against the real estate investor. Without proper planning, the real estate investor’s assets—including personal assets—are potentially subject to legal claims. The investor may wake up to find his home or bank accounts under seizure by a plaintiff’s attorney seeking to enforce a judgment.
Real estate also involves tax complexity. Real estate is a tax-favored investment, with many loopholes that allow real estate investors to save taxes. To take full advantage of these loopholes, real estate investors must hold their investments in business entities that allow them to use tax losses and reduce taxable income. A one-size-fits-all business structure often leaves valuable tax savings on the table.
The risks associated and tax complexity with real estate ownership are often unavoidable, but proper planning can provide protection and tax savings. This planning requires real estate investors to use business structures designed specifically with real estate investment in mind. For the reasons explained below, LLCs provide the best business structures for meeting the legal and tax needs of real estate investors.
LLCs are the entity of choice for real estate investment. This article explains why LLCs provide a winning combination of enhanced liability protection, organizational efficiency, and tax-saving opportunities that are unavailable to other business entities.
LLCs Provide Better Liability Protection for Real Estate Investments
Most people form businesses to protect their personal assets from liability for business debts and obligations (inside liability). Inside liability protection prevents a successful litigant from going after a founder’s personal assets to satisfy a business obligation.
While both LLCs and corporations protect against inside liability, LLCs have an advantage that corporations do not: LLCs can also use charging order protection to protect the business assets from the owner’s debts and obligations. This two-way protection is especially beneficial to real estate investors, who often have multiple investments to protect.
To maintain their liability protection, business entities must operate as businesses (and not as the owners’ alter egos) under a set of requirements called corporate formalities. Failure to follow corporate formalities can result in loss of liability protection (through a remedy known as veil-piercing). Because LLCs have fewer corporate formalities than corporations, they are at less risk for veil-piercing claims.
LLCs Can be Used to Create Multiple Levels of Liability Protection
Most real estate investors own (or plan to own) more than one investment. Sophisticated LLC planning involves isolating liabilities so that a claim against one investment does not affect other investments. There are two primary ways to isolate liabilities using LLCs:
- Holding Company Structure. The holding company structure involves using a parent LLC as a holding company to operate the real estate investment business. The holding company owns subsidiary LLCs that are formed to hold each investment property. See Holding Company Structure for LLCs for an explanation of the benefits of the holding company structure.
- Series LLCs. Series LLCs provide the same type of protection as holding companies, but without requiring the formation of multiple LLCs. Instead of forming a parent LLC and a group of subsidiary LLCs, real estate investors can form a single series LLC with multiple series. See What are Series LLCs? for an explanation of the benefits of series LLCs.
The flexibility of the LLC structure makes it relatively easy to set up multiple layers of protection by isolating assets into separate LLCs. The strict eligibility rules that apply to S corporations do not permit this flexibility.
LLCs Avoid Double Taxation
Perhaps the biggest tax benefit of LLCs is their ability to avoid double taxation. Unless an LLC elects to be taxed as a C corporation—something that rarely happens in the real estate investment context—the LLC passes all income through to the owners, who report it on their tax returns. Because the LLC is not taxed separately from the owners, all income earned by the LLC is taxed only once, when it is earned by the LLC.
LLCs Allow Pass-Through of Losses
The pass-through taxation that applies to LLCs allows owners to use tax losses generated from a real estate investment to offset income on their personal returns.
An owner’s ability to deduct losses may be limited by other rules, such as the passive loss or at-risk rules.1 They may also be limited by Internal Revenue Code § 704(d), which prevents an owner from deducting LLC losses in excess of the owner’s basis in the LLC interest in the year in which the loss occurred. Any disallowed losses are carried forward indefinitely and may be used to offset income in future years when the owner has enough basis to use the losses.2
But an owner’s ability to deduct losses is enhanced by the inclusion of LLC debt in the owner’s basis. As discussed below, the increase in basis allows owners to deduct a greater amount of losses than they could deduct if the business were organized as an S corporation.3 This allows owners to leverage entity-level debt to deduct losses, even when (in some cases) the owner is not personally liable for debt.
LLCs Save Taxes on Contributions and Distributions of Appreciated Property
Real estate investment involves a mismatch of assumptions regarding changes to property value. The tax assumption—that the property will decrease in value over its useful life—almost always conflicts with the real-world increase in property value.
- In real-world value, real estate usually appreciates. Property is worth more the longer the owner holds it.
- For tax accounting purposes, improved real estate (real estate with buildings on it) is considered to lose value. To account for this deemed loss in value, the investor may recoup his or her initial investment (basis) through depreciation deductions over the useful life of the property.
To maximize tax savings, real estate investments should be structured using business entities designed to reflect the fact that real estate value appreciates over time, but is depreciated for tax purposes.
These conflicting concepts create a disparity between the investor’s basis in the property and its value. When a liquidation event occurs—for example, if the property is sold or treated as having been sold—the investor will be taxed on the difference between the property’s basis and the sale price (the built-in gain).
Because real estate tends to carry built-in gain, special tax planning is necessary to ensure that the IRS does not treat transactions between the owner and the business as taxable sales. This is not a problem for LLCs.
- Contributions of Appreciated Property to LLCs. Regardless of whether the LLC is taxed as a partnership4 or disregarded for tax purposes,5 the contribution of appreciated real estate to the LLC is not a taxable sale. Neither the owner nor the LLC is taxed on the contribution. The LLC simply takes a basis in the property that is equal to the basis that the contributing owner had in the property,6 and the contributing owner takes a basis in his or her LLC membership interest that is equal to the basis in the contributed property.7 This system preserves the built-in gain without taxing the LLC or the member on the contribution. See Tax Consequences of Contributions to Partnerships for a more detailed explanation.
- Distributions of Appreciated Property from LLCs. When an LLC distributes appreciated property to a member, both the LLC and the member escape taxation.8 Instead, the built-in gain remains with the property. The partner takes a tax basis in the property that equals the LLC’s basis in the property immediately before the distribution.9 This basis carryover helps ensure that the built-in gain remains with the property and will eventually be taxed when the member sells the property. See Tax Consequences of Distributions from Partnerships for a more detailed explanation.
Under these rules, LLC owners can both contribute and receive appreciated property without triggering a taxable event. The ability to make tax-free contributions to and distributions from LLCs gives them a significant advantage over corporations, which are subject to different rules:
- Contributions of Appreciated Property to Corporations. Regardless of whether the corporation is taxed as a C corporation or an S corporation, shareholders cannot contribute appreciated property in a tax-free exchange unless, immediately after the contribution, all contributing shareholders control the corporation. To “control” the corporation, the contributing shareholders must own stock possessing at least 80 percent of the total voting power of all classes of voting equity and 80 percent of each class of nonvoting equity.10 This control requirement is an impediment if a non-controlling owner wants to contribute appreciated property to the LLC. See Tax Consequences of Contributions to C Corporations and Tax Consequences of Contributions to S Corporations for a more detailed explanation.
- Distributions of Appreciated Property from Corporations. When a corporation distributes appreciated property to a shareholder, the corporation recognizes gain as if the property were sold to the shareholder at fair market value.11 The shareholder is also taxed on the income, although the tax treatment can differ depending on whether the corporation is a C corporation or an S corporation. See Tax Consequences of Distributions from C Corporations and Tax Consequences of Distributions from S Corporations for a more detailed explanation.
Because being taxed as a corporation forfeits the ability to transfer property between businesses and their owners without paying taxes, most real estate investment businesses are formed as LLCs.
LLCs Allow Owners to Use LLC Debt to Reduce Taxes
Most real estate investments are highly leveraged. Real estate investors tend to use the “other people’s money” principle to maximize returns on their own investments. Although a small minority of real estate investors may finance deals with cash, most real estate investors look to banks, investment partners, or private lenders to finance their deals.
When an LLC borrows money—for example, to finance development costs—the owner’s basis in her LLC interest is increased by the owner’s share of the debt.12 This basis increase for entity-level debt has two important benefits to the owner:
- Higher Basis Allows Loss Deduction. An LLC member cannot deduct LLC losses in excess of his or her basis in the LLC.13 Having a higher basis in the LLC gives the owner the ability to use the LLC’s losses to offset taxable income.
- Higher Basis Lowers Taxable Income. If an owner receives a distribution of cash from the LLC in excess of the owner’s basis in the LLC, the owner must recognize taxable gain on the distribution.14 Having a higher basis in the LLC allows the owner to reduce the taxable gain on a distribution.
The ability to increase an owner’s basis for entity-level debt gives LLCs an advantage over S corporations, which cannot include entity-level debt in the owners’ bases. This advantage allows LLC owners to reduce taxable income in ways that owners of S corporations cannot.
LLCs Allow Owners to Step-Up Basis of LLC Assets
Unlike corporations, LLCs can use a 754 election to adjust basis in LLC property when an owner dies, retires, or sells his interest. A 754 election benefits buyers by allowing them to increase the buyer’s share of inside basis to match the amount that the buyer paid for the interest. The buyer is treated the same as if the buyer had purchased a proportionate share of the underlying assets of the LLC. If the sale resulted in taxable gain to the seller, the buyer will benefit from the 754 election.
LLCs Allocate Built-in Gain or Loss to the Contributing Owner
When an owner contributes appreciated property to an LLC and the LLC later sells the property, the owner that contributed the property is taxed on the built-in gain. This rule protects other owners from having to pay tax on appreciation that accrued before the property was contributed to the LLC.
S corporations provide no such protection to the other owners. When an S corporation contributes appreciated property to the corporation and the property is later sold, all owners must pay a proportionate share of tax on the pre-contribution gain. While this is beneficial to the owner that contributed the appreciated property, it is usually unfair to the non-contributing owners.
LLCs Provide Flexibility to Make Special Allocations
As discussed at LLC Allocations vs Distributions, LLCs may make special allocations of profits and losses among their owners in a way that differs from the way that the owners divide the business equity. The ability to make special allocations gives LLCs the flexibility to accommodate economic arrangements between the owners that make use of the owner’s specific tax profiles. This ability is lost with S corporations, which must allocate all items of income and loss in proportion to the shareholder’s interest in the corporation.
- I.R.C. §§ 469 and 465.
- I.R.C. §704(d).
- I.R.C. § 704(d).
- I.R.C. § 721.
- If the LLC is disregarded for tax purposes, transfers from the owner to the LLC, or from the LLC to the owner, are treated as though they did not occur.
- I.R.C. § 723.
- I.R.C. § 722.
- I.R.C. § 731(b). There is an exception to this rule: The LLC may recognize gain or loss if a distribution of money or property to a member disproportionately changes the member’s interest in I.R.C. § 751 “hot assets.” See I.R.C. § 751(b).
- I.R.C. § 732(a)(1). Under I.R.C. § 732(a)(2), the LLC member’s basis cannot exceed the adjusted basis of the member’s interest in the LLC, reduced by any money distributed in the same transaction.
- I.R.C. § 351.
- I.R.C. § 311(b).
- I.R.C. § 752.
- I.R.C. § 704(d).
- I.R.C. § 731(a).