The Proper Way To Structure Your RE Investing
Choosing a legal entity for your real estate investment business is an important decision that has both legal and tax consequences. The wealthiest real estate investors are not just skilled at spotting a good investment or closing a deal—they are knowledgeable and savvy about all aspects of their business, including the way it is legally organized and operated.
Sole Proprietorships for Real Estate Investing
A sole proprietorship is kind of a “default” business structure, which is formed when a person is engaging in business in their individual capacity, without having formed a separate legal entity. The assets and income of the business are entirely owned by the individual and all income from the business is taxed as personal income.
Unlike other legal entities where business income “passes through” the business to the individual, all income from the business is considered immediately earned by the sole proprietor. All property purchased by, transferred to, and owned by the business is simply owned by the sole proprietor personally.
The advantages of this business structure are that it is very easy to start. No paperwork is required to form a sole proprietorship. As a real estate investor, you simply purchase or invest in real estate. Depending on the laws in your state, there may be a requirement to register your sole proprietorship, but this registration does not create your sole proprietorship, it simply is a requirement to comply with state law. Your sole proprietorship is created automatically, by default, when you start doing business.
However, if you are a real estate investor there are major disadvantages to operating your investment business as a sole proprietorship. First, unlike other entity options, a sole proprietorship offers no degree of asset protection from creditors or lawsuits, because your business assets are also personal assets. Furthermore, depending on your debt-to-income ratio and how you choose to finance your investments, you may be able to begin as a sole proprietor, but if and when you exceed the debt-to-income ratio permitted by your lender, you will have to form a separate legal entity to obtain commercial financing.
LLC
A limited liability company (LLC) is a common entity choice for real estate investors and offers many advantages. Choosing this structure for your real estate investment business allows you to limit your personal liability in the business to the money you contribute and the debts you co-sign for. This includes personal assets that you contribute as collateral to a loan.
In an LLC, owners are known as “members”. If you are the only owner in your real estate LLC, you have a single-member LLC. In a single member LLC, all business income will “pass through” the entity and be treated as personal income for tax purposes. However, you will not be personally liability for the debts, claims, and liabilities of the business, beyond the amount you contribute. To form an LLC, you must file Articles of Organization with your appropriate state government authority.