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For decades, the partnership or limited partnership were the entities of choice for real estate investment and real estate developers.
The primary attraction of the partnership form is pass-through taxation. In the early years of a real estate investment, high interest payments and depreciation create tax losses. When the property is held in an entity that is subject to pass-through taxation, the investors get to take the tax losses on their personal tax return. Thus, they get to build equity and have positive cash flow while reducing their taxable income. Plus, the property is hopefully appreciating at the same time.
The LLC, however, trumps the partnership as the entity of choice for real estate investment. Like the partnership, an LLC can choose to be taxed as a pass-through entity.
Where the LLC beats the partnership is in limiting the liability of the owners. You don’t need me to tell you that owning real property–whether commercial or residential (apartments, etc.) creates exposure to legal liability.
Owners are subject to lawsuits from anything from slip and falls to even being responsible for crimes committed against residents. In a partnership, every partner is personally liable for debts of the partnership.
A limited partnership does protect the limited partners from liability exceeding their investment, however, every limited partnership must have a general partner, who has unlimited personal liability.
In an LLC, every owner–called members–are protected from personal liability for the debts of the LLC.
Guide to Forming a Real Estate LLC
Forming a real estate LLC is not procedurally much different from forming any other LLC.
First, the organizer of the LLC files Articles of Organization with the state you wish the form the LLC in. For a real estate LLC, I would suggest forming the LLC in the state in which the property is located.
If you do not, then the LLC will have to file as a foreign entity in order to do business in the state where the property is located, thereby spending more money on state filing fees and legal fees.
Neglecting to file as a foreign entity means that the LLC cannot bring a lawsuit in that state–quite a handicap for a real estate investor who often must file suit to enforce leases, evict non-paying tenants, and collect from tenants that damage your property.
The second step is to create your Operating Agreement. This is the legal agreement among the members of the LLC that governs their business.
A custom Operating Agreement for your LLC allows tremendous flexibility in managing your business. You can go far beyond simple equal shares and instead have some members contribute more upfront capital, others contribute their credit, allocate losses and profits differently between members and over time, etc.
The possibilities are really limited only by your own (and your attorney’s) imagination.