There are two ways to NEVER hold real estate- individually and joint tenancy. It's tempting because it's easy- what's easier than having to basically do nothing? The problem is that your property is exposed, not only to the lender (direct creditors), but also to your personal creditors. Your other assets, including personal assets not related to your real estate investment(s) are exposed to property-related creditors; and assets pas through wills and probate which can be expensive and time consuming. Joint tenancy has a right of survivorship- at first death, the property transfers outside of the will and probate to the remaining joint tenants until only one remains- but all the same risks of individual ownership apply, but with the extra added fun of your partner's creditors-- personal and otherwise, and unrelated to the property- can come after your investment-- one of the joint tenant's creditors could force the sale of the property.
One layer of protection chosen by average investors is a land trust. In a land trust, the trustee holds the title of the real estate, but all of the rights and conveniences of ownership are retained by the beneficiary. It provides some privacy as beneficiaries are not listed on any public record- the trustee would need to be subpoenaed to reveal the identity of the beneficiaries. The death of a beneficiary doesn't end the trust, so if beneficiaries are added properly it is a good estate planning tool. Additionally, a judgment against the beneficiary of a trust doesn't create a lien against the legal title to real estate automatically. If, however, the beneficiary of a land trust is revealed by the subpoena process, it is as if the property is held individually for liability / creditor purposes.
Most people know to "sail any ship but a partnership", so never enter into an agreement- verbal or written- with another party to do business together outside of a legal entity. I call this "half the income with all (unlimited) risk-- you are not only responsible for your own decisions, but you are jointly and severally liable for the decisions of your partners.
A limited partnership (must be filed with the state) can limit the liability of limited partners to their capital investment provided they have no active / management control of the business. GP's retain unlimited liability. A big plus is profits and losses pass through LPs as passive income, which is taxed at the lowest tax rate. An LP still maximizes exposure- for example, the charging order. A charging order means that the general partner is directed to pay over to the judgment creditor any distributions from the partnership which would otherwise go the debtor partner, until the judgment is paid in full. I know what you're thinking- and it's true. Sort of. The GP would simply not make distributions. Eventually, an agreement could be reached to discount the judgment amount and settle. The LP could go on investing, and re-investing funds, and paying its bills and the judgment creditor would be out in the cold. There are circumstances under which the judgment creditor with a charging order may force the foreclosure of a limited partnership interest. If that happens, the judgment creditor doesn't simply take any distributions, but actually BECOMES the LP which gives the creditor considerably more leverage to get paid the full amount.
A corporation (all corporations are C corporations unless or until an "S election" is made with the IRS which results in tax treatment as a partnership (pass-through). Shareholders are shielded from the debts of the business and personal liability (provided corporate formalities are followed, and records are kept). Generally speaking, depending on the state, shareholders are not publicly recorded. C's can have some favorable tax treatment- cafeteria benefits (really cool- we love the small, closely held private corporation model for this reason-- though we don't own real estate in our C corp-- that's another story) which can include education, life and health insurance, child care, and even fitness facilities, meals, and other benefits- pre tax). If corporate formalities are not followed rigidly, however, you're toast. It's shocking how little even professionals know about C corporations- for example, someone- without even having finished reading this has probably already replied re: "DOUBLE TAXATION!!!". Only distributions are double taxed (dissolution distributions may be included in this). Many big, publicly traded corporations (MicroSoft comes to mind) do not make distributions. There's no requirement to make distributions. For tax reasons, however, rental income for corporations is taxed as ordinary income rather than passive income. Not only that, but if your corporation's income from rents is greater than 50%, you'll be the proud shareholder in a personal holding corporation-- with a special 40% tax rate.
Most likely, the majority here hold their properties in an LLC. LLC's combine the limited liability of a corporation with the pass-through income of an LP- and they allow simple, flexible operating agreements which are easily adapted to the needs of the business / members. They are the best of both worlds- corporate asset protection with passive income tax rates. Depending on the state you're in, the rules can be, um, interesting? For example- IL has the "series LLC"-- and the laws governing LLC's can be unpredictable. A judge, for example, may rule you're partnership- or a corporation. There's slightly more risk.
The aim is to get the most favorable tax treatment, with the maximum liability protection- and this requires the use of a combination of entities. This is especially true if you both "flip" and buy and hold. Investment properties- your buy and hold- are defined as property intended to be held for long term income and/or appreciation (capital gains). Dealer properties- your fix-and-flip properties are those intended for immediate resale for profit- short term capital gains. It is absolutely critical that these two activities be separated. Dealer properties cannot be depreciated, the profit is taxed as ordinary income, not capital gains, it is subject to FICA, ineligible for 1031 exchange, and even if sold via an installment agreement, all taxes are due on the profit in the year of the sale. Dealer (earned) income is not subject to passive loss rules like investment income (which restricts your ability to deduct passive losses over a certain AGI threshold- used to be $125K), and you can contribute to IRAs and pension plans based on dealer income. The black cloud over dealer activities is that the IRS can arbitrarily determine that ALL of your activities are dealer activities- all of the sudden you effectively lose key advantages of investment property, most notably capital depreciation.
(I learned all this years ago from an attorney and applied it. I can recount it because I took good notes- AND I applied what I've learned and I still use it to this day)
Investment property: We have an LLC which acts as a GP for LP's in which we hold our investment properties. We are the Limited Partners.
Dealer Property: We have a C corp which is our management and marketing company (and consulting). Our flips (dealer) are purchased using an LLC owned by the C corporation creating bright lines for tax treatment.
This approach can be frustrating- especially at first. The worst part by far is training your "experts" each of whom know a lot about a little, but few of whom can see the big picture. Experts- CPAs and attorneys in particular know surprisingly little about the other's realm. But being an entrepreneur is not a group effort. You're it. It's YOUR RESPONSIBILITY to learn every aspect of your business, and in particular to have enough general working knowledge of the law and the tax code to direct your experts. Advisors seldom act in that capacity, and even when asked to do so, more often than not don't know enough off the top of their heads to answer or your questions, or properly advise you. They look at Google- which is what you could (and should) just as well do yourself. I don't take a completely dim view of advisors- I'd have a tough time of it trying to find someone with the education of an attorney and a CPA to do what they do for a few thousand dollars a year-- I just do it all with my eyes wide open recognizing that I'm getting exactly what I'm paying for. However, the advantages outweigh the inconveniences with this approach-- someone once said, "Discipline weighs ounces, regret weighs tons". You can't get insurance while the place is on fire, and you can't change your mind about your entity structure after you're sued.
What are the advantages?
Entities that "do stuff"- create liability e.g. property management- don't hold title to assets. You can choose a different fiscal year for your corporation, which can allow income shifting potential. You get maximum tax benefits of a structure that allows you a salary, benefits, pass-though self employment income, and all forms of losses.
LP's have a long history of legal precedents re: liability protection. Perfect place for buy and hold properties. Remember that judgment creditor issue? Try this on for size: a judgement creditor gets the right to distributions, and the GP decides whether to make distributions. However, because profits flow through a partnership, the GP can allocate profits on a form K-1 filing, but not distribute a penny. This creates a problem: phantom income. This provides a significant deterrent to frivolous lawsuits. Assets in the LP can be freely rented, sold, exchanged. Profits can be used to pay other corporations for services-- all without paying creditors.
Having a C corp in which all of our "doing stuff" happens- like rent collection, lawn maintenance, etc. but in which there are NO ASSETS provides for substantial liability protection, PLUS, extensive fringe benefits are tax free to employees, and deductions to the company. This may include medical insurance, health, life, and medical expense reimbursement. Unlike other entities- C corps can make contributions to these plans even if it creates a loss for the business. In addition, meals and lodging when for the corp's benefit, education / seminars, moving, and even fitness facilities can be deductions to the corporation, but not income taxable to the employee. The list of possible "cafeteria plan" benefits is extensive- child care, elder care, alternative medical treatments, special diets, a company car, etc. A C-Corp's first $15K of income is taxed at 15%, and (if I'm not mistaken) it allows for $50K in retained earnings.
There. Now, it is important that I let all readers know that this is not intended to be legal, financial, or tax advice. You should seek the advice of an appropriately licensed, qualified professional advisor before making any decisions. After all, if you make business, investment, financial, and/or decisions that may affect you legally, or carry tax implications based on message board post- you're a fool.
