Real estate deals, especially those that involve investments, pose a substantial amount of risk. There are many “what ifs” in real estate investing, including: What if someone gets hurt on my property? What happens if I fall behind on my mortgage on one property but keep up with the others? What are the tax obligations if I obtain a mortgage in my name?
The main reason for establishing a business entity such as an LLC or corporation is to protect your personal assets against a lawsuit. However, incorporating your real estate business offers other advantages.
If you operate your business in your own name, you will be financially responsible if someone files a lawsuit against your business or if you face expenses that you cannot afford. When you join, your personal assets will be protected if the business runs into trouble.
Instead of obtaining a mortgage on a property in your own name, you can obtain a loan from the bank in the name of your business. This offers even greater protection as the LLC or corporation will own the property, not you, especially if you form an LLC or corporation for every property you purchase for rental purposes.
For even greater protection, you can take the step of keeping each property in its own corporation or LLC. This further limits the liability for the specific investment. If someone sues you for an injury to property A, the liability ends with that LLC and it will not involve companies that own property B, C, and D.
As a sole proprietorship, you can deduct many business expenses associated with your real estate business, including mortgage fees and interest, building materials, maintenance, and more. However, there are many operating expenses that you cannot deduct unless you form an LLC or form a partnership. This includes employee wages and many types of insurance that you will need. When you convert your real estate business to a corporation, you can deduct 100% of these business expenses from your earnings before allocating income to yourself and the other owners.
If you sell or rent property, the people who do business with you will want to know that they are dealing with a legitimate company. As silly as it may sound, the word “incorporated” or “LLC” in your name makes your company seem more reputable and attracts higher-quality customers.
You can sell your business
Once your business is profitable, you have the option to sell it if you wish, but only if it is incorporated. If you operate as a sole proprietor, you are the business. If you ever plan to sell your business, you must create a separate entity that can be transferred or sold and continue to operate.
If you operate your business as a sole proprietorship, you will be taxed on all profits, even if you decide to reinvest them in the business. If incorporated, the business is now an independent taxpayer paying a lower tax rate. You can choose to take a small salary and leave the rest of your earnings with the business to lower your income tax rate.
Multiple investors, such as investment clubs, should also consider forming an LLC or incorporating. If you do not incorporate or create an LLC, all investors in the project are considered partners, which means that they will all be responsible for the actions of others. If you form a limited liability company, you will also have greater flexibility in management, as the operating agreement can grant and limit obligations, powers and rights for each owner.
The bottom line
Real estate is a complicated business. Why increase your risk more than necessary? Consult with a corporate services company and an attorney to determine if forming a business entity is the right decision for you.