When people jointly invest in real estate, whether with a friend, family member, or business partner, they frequently don’t think much about how they take title. Yet, real estate ownership structure can play a key role in meeting the investor’s economic goals.
Some popular ownership structures for real estate investments include:
Each of these has advantages and disadvantages, and the choice of structure depends upon the owners’ investment goals. Some key factors to consider when selecting an ownership structure are as follows:
Who the Investors Are. Federal tax law places significant limitations on who can own shares of an S Corp. Generally, S Corp owners must be individuals, estate, and certain types of trusts. All owners of an S Corp must be US citizens or permanent residents. If any of the owners will be business entities or are not US Citizens or permanent residents, a different ownership structure must be used.
Up Front Cost. Up front formation costs can be a factor for some investors. LLCs and S Corps are formed by filing paperwork with the state, which involves a filing fee. Although the fee usually is nominal, LLCs, S Corps, and grantor trusts all require preparation of organizational documents by an attorney, and an S Corp also requires the filing of a federal tax form.
Although not technically required, from a practical matter, an attorney should prepare a partnership agreement for any partnership. Unless TIC owners are spouses, it also is advisable to have an attorney prepare a TIC or Co-Ownership Agreement for TIC structures.
The costs of these legal documents will depend upon the complexity required to meet the owners’ unique needs.
Annual Costs. Many ownership structures require ongoing costs due to required tax filings and/or state entity maintenance costs. For instance, LLCs and S Corps require annual state filings and fees.
Most of the ownership structures also will require paying a tax preparer to file annual federal and state income tax returns. Partnerships, LLCs, S Corps, and grantor trusts all typically are pass-through entities, meaning that taxes on their income are paid by their owners. However, they all are required to file annual federal and state income tax returns. On the other hand, TIC income also is paid by the owners, but TICs are not required to file tax returns.
Owner Protection from Personal Liability. Although real estate investors typically purchase liability insurance to protect their investments from common risks, insurance doesn’t cover everything. In particular, insurance doesn’t cover mortgage loan and contract liability.
Investors who own their real estate in a TIC or partnership structure typically will be personally liable for all obligations associated with their investments. However, by selecting an LLC or S Corp as their ownership structure, investors will not have liability beyond the amount they invest unless they sign personal guarantees.
Probate Considerations. Investors also may be concerned about their real estate investments being “tied up in probate.” Although any structure will be subject to any applicable federal or state estate tax, it is possible to structure an investment so that it is not part of the probate estate. The best way to do this will depend upon the investors’ individual estate planning needs.
For example, in a TIC structure, multiple owners can own jointly with survivorship so that when one owner dies, the others take ownership of his/her interest. However, this only works where the investors are spouses or want to leave their investment to their co-investor upon their death.
A grantor trust is commonly used to avoid state probate, and it can be used when two unrelated real estate investors each want to leave their investments to their heirs. However, the cost of preparing the trust instrument in such instances can be significant.
Although sometimes possible, survivorship rights are not common with LLCs, partnerships, or S Corps. Owners electing to invest through these structures should expect that their investments will be part of their probate estates.
Deferral of Tax on Gains Upon Sale. Many real estate investors rely upon Section 1031 exchanges to defer taxation of their gains upon sale of their investments. Any of these ownership structures can do a Section 1031 exchange IF all the owners want to invest together in their next real estate investment. Should the owners want to go their separate ways after they sell the real estate, only the TIC structure enables them to do so while preserving the ability of one (or all) of them to do a Section 1031 exchange.
These are just highlights of the factors involved in structuring a real estate investment. Although not every real estate investment is successful, with careful planning and the advice of an attorney experienced in real estate investments, real estate investors can position themselves and their heirs for long-term real estate investment success.