For the most part, everyone is aware of the nursery tale, “Goldilocks and the Three Bears”; if you are unfamiliar with the story then I will give you a brief recap. Once there was a little girl named Goldilocks who wanted to incorporate her real estate property. She was unsure of which tax entity to use and the legal ramifications of each choice. She tries out a Corporation, Partnership and then a Joint Venture. There is some part about breaking and entering and something to do with three bears but for the sake of this blog post we are going to focus on the boring parts. If you own real estate or have the intentions of owning real estate property you probably have asked yourself which tax entity is right for you. The following is a list of options and the pros and cons of each tax entity.
Sole Individual Ownership
Sole proprietorship is an unincorporated business with a single owner who pays tax at the individual level. There is no startup cost and all profit or loss is shown on schedule E of the sole proprietor’s 1040. This is one of the most common forms of ownership for small rental properties because of the low cost and minimal regulations. However, since there is no distinction between the real estate entity and the individual, the sole proprietor is personally liable for all the debts and obligations incurred by the real estate property. In most cases, the individual owner may safeguard against personal liability through proper management, upkeep of the property and purchase of liability insurance sufficient to protect the individual’s assets.
Common and Joint Ownership
Common and joint ownership are fairly similar to sole individual ownership but differs when it comes to legal treatment. Common ownership is transferable, unless expressly stated otherwise, while joint ownership is more restrictive; as a general rule, ownership passes to the surviving owner upon death in a joint ownership while ownership passes to the individuals estate in a common ownership. These types of ownership exist when two or more people hold title to a property but don’t treat the ownership as a partnership for tax purposes. The main distinction between a partnership and a common or joint ownership is the tax treatment. In a partnership, the income, expenses and any elections must be reported at the partnership level. This means a return will have to be filed reporting income and expenses for the real estate property separately and then the profit or loss will flow onto the individual’s return. Common and joint ownership have the benefit of allowing multiple ownership while having the ease and cost savings of a sole proprietorship.
C Corporation (C Corps)
C corps offer the benefit of unlimited growth potential through the sale of stocks, which means you can attract some very wealthy investors. Plus, there is no limit to the number of shareholders a c corp can have. This may be a benefit in some situations where there is substantial real estate holdings but is not often used because of double taxation. Income and expenses are reported at the corporate level and taxes are paid on net income. When dividends are issued to stockholders they must report dividend income on their personal return as well. It is more common to see large real estate holdings reported as a partnership.
Limited Liability Company (LLC)
A LLC is a business entity whereby the members of the company cannot be held personally liable for the company’s debts or liabilities. LLC’s are essentially hybrid entities that combine the limited liability characteristics of a corporation and the pass through reporting of a partnership or sole proprietorship. LLC’s requires state registration and has higher startup and maintenance cost than a sole proprietorship, common or joint ownership. However, when factoring in the potential risk of personal liability, LLCs are cost effective in the long run.
A partnership is a business entity that is formed when at least two or more people agree to go into business together. Unlike other business entities such as a corporation or a limited liability corporation (LLC), no state filing is required to form a partnership. Because general partners are not incorporated they share unlimited liability for the debt or liability incurred. The main distinction between common ownership, joint ownership and partnership’s, in this regard, is general partners are held liable for the actions of other general partners while common or joint owners are not. This means even innocent partners can be held responsible for the actions of another partner if he or she acts inappropriately or illegally.
Limited Liability Partnership (LLP)
A limited liability partnership (LLP) is a partnership in which some or all partners have limited liabilities for debt and liabilities incurred at the partnership level. It therefore exhibits elements of both general partnerships as well as corporations. In an LLP, one partner is not responsible or liable for another partner’s misconduct or negligence. This is one of the most beneficial reporting entities for larger real estate holdings that want to attract investors.
The above list is just a brief overview of different reporting entities and can have several pros and cons depending on the taxpayers needs. In most cases, it is better to incorporate a real estate property to safeguard personal assets, but it is not required. It is important to discuss with your CPA or legal counsel which reporting entity fits just right.