Setting up legal business entity - Tax, Legal & Accounting considerations?

Question

Hi All,

I am working with a business partner to invest in real estate. Our near-term strategy is probably best described as BRRRR single family residential (detached SFR). We are currently in the planning stage, but hoping to put money to work within the next ~6 months or so.

Know question of "to LLC or not to LLC" is probably one of the most repeated / annoying questions from newbie investors, but was hoping to connect with experienced investors, legal professionals, CPAs, etc. who could help shed some light on our situation.

Here's some background context:

- Two business partners, both based in CA (both have W-2 background in Finance)

- Looking to invest both in / out-of-state, but our 1st deal will likely be out-of-state given capital constraints

- We are planning to use a Pledged Asset Line of Credit (i.e., revolving credit line collateralized by stock / bond portfolio) instead of HML / private loans to finance upfront purchase / rehab

Would love to get the community's input on the various ways to structure the business entity (LLC? Partnership? Tenancy in Common?), with a specific focus on the following topics:

1) What are the financing considerations for permanent / cash-out refi financing (e.g., 30-yr fixed conforming)?

- My understanding is that an LLC structure would disqualify us from Fannie / Freddie loans so we would get less favorable lending terms (rate, term, amortization schedule). Does this mean that I'm effectively losing access to favorable financing in exchange for legal liability protection (which I could instead purchase via insurance)?

2) Are there any tax implications around structuring one way vs. the other?

- Would interest expenses under one structure be deductible against my personal (W-2) Ordinary Income? Any tax-efficient strategies that folks have used in similar situations?

- If we purchased under one structure, then decided to move to another at a later date (e.g., Tenancy in Common -> LLC), are there any tax complications we should keep in mind? e.g., having an "inside" vs. "outside" cost basis when contributing owned property into an LLC?

3) We plan to spit ownership 50/50 and are trying our best to keep things simple. What is the best structure for easy / simple / clean bookkeeping?

- Has anyone run into trouble with bookkeeping using any particular entity structure? Any war stories folks care to share?

- Like most others on this platform, we're looking to build a long-term, sustainable business that minimizes day-to-day headaches... we're willing to invest upfront / be proactive to structure things "correctly" and avoid challenges in the future (e.g. trying to separate personal vs. business receipts and figuring out which goes where)

Sorry for the long post but hopefully this can spark a productive discussion for everyone involved. Please feel free to comment or DM - looking forward to connecting with the community and trade notes!

Best,
Rich

Sean Morrison · Answer

Disclaimer: I am an attorney, but I am not your attorney. This is not legal advice, just friendly information.

Typically, and LLC is an easier vehicle to navigate since it includes the liability protections, plus outlines the agreement between the partners. Keep in mind that the LLC will need to be registered to do business in CA and pay that fee, even if it owns the home and does everything in the other state.

Changing from partnership (or TIC) to LLC and reverse should not have tax ramifications, since the IRS disregards LLCs anyway and considers it a partnership. If the LLC changes to corporate taxation, that will be a change. If you want to move the LLC or change it later, that will depend on the states involved (whether it can be domestication or conversion, which is way beyond this forum post).

If the financing is a necessary piece, then at minimum there should be a comprehensive partnership agreement. A partnership can still be useful, and you could get a DBA for banking purposes.

In my experience, a "simple" business relationship is best done with a detailed "complex" partnership or LLC agreement. That's because a strong agreement outlines the various problems and provides solutions up front. Got a problem? Check the agreement for the solution.

Conversely, a simple agreement leads to a complex relationship, because each time something happens, the parties need to sort it out, which leads to new disagreements. You'll end up spending time coming up with solutions, rather than focusing on making money.

David M. · Answer

@Richard Choi

Well, since you are investing with a non-spousal partner, best to go with a LLC.

Yes, a legal entity is not eligible for a conforming loan.  So, you'll have to go with commercial financing.  That's the cost of doing business.  I don't think you are missing out on much since all but the "investment" conventional loan requires owner occupation.  I figure you guys wouldn't be moving in together for your brrr's.

You still need insurance when using a LLC...  You don't save money with a LLC..

Bookkeeping is bookkeeping.. If anything with a LLC it forces you to be cleaner since you can't/shouldn't be co-mingling funds with the LLC (as part of maintaining the corporate veil).

As a whole, nothing about brrr itself would help you with your taxes.  So many new investors get "sold" that real estate investing will decrease their w-2 income as part of the "tax benefits."  The tax benefits is that you get to take depreciation (lemonade out of lemons in my opinion) and you get to take the expenses as deductions against the rent.  Also, if you have lots of losses, then you probably aren't making much money...

Good luck.

Katie Balatbat · Answer

@Richard Choi

Congrats on getting going!

An LLC or a Tenant-in-Common/Co-Ownership Agreement could probably work for you, both with their pros/cons.  An LLC would give you that added level of liability protection as well as a centralized bank account and name to make administrative hassles far easier.  An LLC operating agreement would cover several what-if situations, though you are a little more tethered to each other if you needed to separate.  A TIC Agreement would probably be easier for eventually separating and saves the $800 and all that, but is a little bit more of an administrative nightmare when it comes to bookkeeping, tax reporting, etc.  If you are concerned about due-on-transfer clauses as well, a TIC Agreement may be superior.  If you need referrals for professionals who can assist in San Diego, let me know.

*This post does not create an attorney-client or CPA-Client relationship.  The information contained in this post is not to be relied upon.  Readers are advised to seek professional advice.

Eric Williams · Answer

Yeah for tax purposes the partnership isn’t a choice in this case.

More than a single member LLC is a general partnership by default under check the box.

You’re going to have a 1065 Federal and state filing requirements.

Also that liability protection isn’t given. Do some research on why shields have been disregarded in your state and avoid.

Richard Choi · Answer

Thanks Katie - appreciate the helpful insight! Would love to connect... I'll DM

Setting up legal business entity - Tax, Legal & Accounting considerations?

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