The Real Estate LLC Holding Company: Clear Benefits and Areas to Beware
Setting up an LLC for your real estate investment can have pros and cons. Retain an experienced real estate attorney to make sure that your LLC is set-up and run in a way that avoids the pitfalls.
The modern Limited Liability Company first began in Wyoming in 1977. The first LLCs were primarily small oil drilling concerns set up as an alternative to sole proprietorships. The goal was to limit the personal liability of the owner or partners involved with oil exploitation. Florida followed in 1982 as the second state to register companies with this formation type. The LLC quickly became, and remains to this day, the most common business entity type for real estate holding companies in Florida. All 50 states now have LLCs as well. The Federal Government recognizes the entity type as having a unique tax liability status under specific circumstances. Let’s explore the benefits and challenges faced by investors who form an LLC as the holding company for a Florida-based property. You will find that while the pros outweigh the cons for most investors, having a legal expert on your side is the best way to protect your LLC and tour real estate investment.
Liability. As the name implies, LLCs insulate individual owners or owning partners from personal risk. The LLC that owns the property can be sued if, for example, a tenant slips and falls or suffers from a personal injury while on the property. A court will, in theory, recognize that the LLCs owners are not personally liable for the damages brought in the civil case. In practice though, there are limitations to the LLC’s “limited liability” protection. We explain these limitations in the “Cons” section of this article.
Tax. LLCs can be considered “pass-through” or “disregarded” entities for taxation purposes. This means that the LLC can, in certain cases, pays no taxes. Based on current IRS rules, the partners of the LLC (or the individual in a single member LLC) have the same tax liability as if the taxes were due by them directly. This avoids the costly issue of double taxation inherent in C Corporations. C Corporations are taxed at the corporate entity level and then owners are taxed on that same income again as individuals.
Flexibility. LLCs are very versatile in terms of what they can do and who can open them. LLCs can be owned and managed by separate individuals. This means that owners, employees or even outside contractors can manage the LLC without being given ownership in the business or property. In contrast, corporations have to be managed by legally appointed directors and officers. LLCs can also distribute profits in any way that they want. To anyone. Corporations have to follow statutory rules that require distribution proportionate to ownership. LLCs thus have more leeway to provide profit sharing plans and bonuses to those who work for the entity but who do not have an ownership stake in it. Also, non-citizen, non-US residents can use an LLC as a vehicle to buy US properties. Corporations have stricter residency requirements in many states. Finally, LLCs can be used to facilitate estate transfers to heirs and others. While this process is complex and must be done gradually, it potentially avoids the extensive tax and reporting requirements otherwise involved with inheritance and transfer of title.
Overstated protection. Many business owners who do not have a legal background swear by the LLC as being the only corporate entity that protects the personal liability of the owners. This is simply not true. S corp and C corp liability protection are virtually identical to those of an LLC. Even some partnership structures provide similar protection. The danger of overcommitting to the LLC’s protective powers is that, in practice, many LLC owners may be personally liable if sued by tenants and third party users of their property. How? If the ownership of an LLC engages in practices that blend their individual accounts with that of the business, the LLC may be disregarded as a legal entity and a court may choose to consider the ownership liable. This is often referred to as breaking the corporate shield. Breaking the corporate shield can happen if an owner blends business finances, does not treat herself as an employee with a reasonable wage, or takes personal payments instead of paying vendors, financial institutions and other creditors.
“In practice … there are limitations to an LLC’s ‘limited liability’ protection. ”
Cost. Properly structuring and operating an LLC holding company brings higher costs than that of a single proprietor with direct ownership in a piece of real estate. These costs go beyond the company registration fees and annual report filing fees. For example, to respect the corporate shield, the owner or owners may have to pay themselves as employees incurring tax, insurance and unemployment compensation. Bank fees are usually more expensive for LLCs and corporations in general. While there are certainly merchant banks that are exceptions to this rule, it is generally the case that checks made of the LLCs must be deposited and never “cashed at the counter”. Landlords must be careful to avoid skirting this rule by, for example, collecting some tenant checks made out to them personally. Once again, mixing personal and business accounts risks forfeiting the LLC’s coveted liability protection.
Lender Issues. If you are a property owner and your LLC is created after you have bought a property, then beware of “due on sale” clauses that your lender may have included on the mortgage. These clauses typically would require an individual owner to pay off the entire mortgage, at once, before transferring the property title to an LLC. While there are ways around this, it is essential to hire a lawyer versed in entity formation of real estate holding companies. An experienced real estate attorney can navigate the related issues much easier than someone without a legal background.
Chain of Title Issues. Beware too, of the options property owners have for the types of title documentation to include in the transfer of property to a real estate holding company. In Florida, there are effectively two options for title documentation: quitclaim deeds and warranty deeds. Choosing the right option affects the potential for your LLC to effectively sell the property for investment income in the future.
Since 1982, Florida real estate investors have benefitted from the convention of forming LLCs as real estate holding companies. Indeed, there are clear benefits of the LLC structure as a real estate holding company in Florida. However, serious pitfalls undeniably exist. Hire an experienced real estate attorney to ensure that best practices are followed in the formation and day-to-day running of your LLC. South Florida Law is an experienced law firm operating in the real estate niche. Are you considering setting up an LLC as a real estate holding company in the State of Florida? If so, then contact us or call us today for a free consultation (954) 900-8885.
Burton Landau, Esq is Founding Partner of South Florida Law, PLLC, with an emphasis in Real Estate Law. He graduated Cum Laude with a Master’s in Business Administration from the H. Wayne Huizenga School of Business and Entrepreneurship at Nova Southeastern University and his Juris Doctorate from St. Thomas University School of Law. Mr. Landau is fluent in Russian.