Real Estate Investors Should Incorporate
“The main reason real estate investors should incorporate is to protect your personal assets against a lawsuit — say, if someone gets injured on your property.”
One of the big pitfalls of starting a small business, such as real estate investing, is how to protect your personal assets from your business investments, and the other way around. As real estate investors, if you buy everything in your personal name, you run the risk of a single lawsuit wiping out not only your investment, but also your personal property. As such, I generally recommend that all small business owners incorporate their business in some way as to provide maximum reasonable protection for your assets.
There is one good reason to buy property in your own name solely, and that is for a refinance. Real estate investors who buy real estate and plan to refinance the property to get cash out, or to pay off a hard money loan, almost all conventional banks will require the property be in your own name. If you know this is your plan going in, then I recommend you buy the property in your personal name and keep it in your personal name until the refinance takes place. This will leave you exposed to the liability of the security deed, and any consequences of foreclosure or defaulting on the loan, but it is the only way to get the refinance done in the first place. Buying originally in your own name will save you from troubles with possible seasoning issues down the road. Even in this instance, I still recommend putting the property into a business entity of some sort after the refinance is complete.
If you are not planning on refinancing the property, then I strongly recommend creating an entity of some kind. Once this entity is set up you should buy the property in the entity name as often as possible. Cash buys and most hard money lenders will allow a purchase into a company, although most hard money lenders will still require a personal guarantee for you the real estate investors. This creates a strong separation of business assets and personal assets that will be important if there is ever any litigation against your company or you personally. Even the most upstanding and careful individual can find themselves embroiled in a lawsuit, and its best to protect yourself as best you can.
Some real estate investors stick to a strategy of one company that holds all their properties. Other real estate investors make a separate company for each property. While the latter provides more protection, it does have a much greater amount of administrative filings and costs to keep all the companies going.
Once you have decided to form your company or companies, there are a number of steps you have to take to make it happen. I strongly recommend consulting with an attorney at least for the first few companies you put together. After that you may feel confident to try doing it completely by yourself. Most attorneys have very reasonable rates for setting everything up and allows you to save yourself the headache.
Instead of incorporating, though, Richmond real estate attorney Katja Hill suggests you set up a limited liability company, or several LLCs, to hold your properties.
LLCs are easier to maintain, she says, than the “S corp” corporate structure that’s also used by small businesses.
Top Reasons for Real Estate Investors to Incorporate
#1 Protection from personal liability
If you do business in your own name, you are risking everything you have. A corporation will separate your business from your personal assets. If you have a real estate deal that goes bad, a liability you can’t pay, or a lawsuit against your business, a corporation will be there to protect you.
#2 Less risk of an audit
If you are a broker, property manager, or anyone else who reports income on a “Schedule C,” you are a high risk for an IRS audit. The IRS audits Schedule C businesses much more often than small corporations. Simply by incorporating, you may reduce your risk of an audit by as much as 300%.
#3 It’s easier to sell the business
I have a friend whose realty company has his name all over it. In fact, without him, the business has no name. The point is, you can’t sell a business if the business primarily relies on you. You need to set up an entity that stands apart from you that can be sold as an ongoing business.
#4 Fringe benefits
You probably know that things like health insurance, medical costs, and life insurance are not fully deductible as an individual. However, if you set up a “C” corporation, you can deduct 100% of your medical insurance, medical expenses and up to $50,000 of term life insurance.
#5 Tax savings
A corporation can be an excellent device to turning nondeductible expenses into deductible expenses. For example, the old “home office” is a trap for small business people who try to claim the expense on their personal tax return.
However, if your corporation leased the same space from your home, you reduce the risk of being audited for the same deduction.
#6 Income splitting
If you operate as a sole proprietor, you are taxed on all profits you make, even if you reinvest the money into the business. A “C” corporation is a separate taxpayer from you.
The corporation pays its own tax, but usually at a lower rate than you pay (“C” corporation tax is only 15% up to $50,000). If you take a small salary and leave the rest of the profit in your corporation, you can effectively reduce your overall income tax.
Let’s face it, folks, a corporate entity just looks better. People will think you are more savvy if you are “North American Realty, Inc.” rather than “John Smith Realty.”
A corporation gives you privacy from prying eyes. It also gives you a buffer zone from your tenants. You don’t want your tenants to know you are the owner.
You are at a distinct negotiating disadvantage when you are the “greedy landlord.” Instead, you should represent that you are an employee of the management corporation. That way, you are just the “go between.”
Real estate cannot get up and walk away. If a corporation owns your real estate, it can be moved easily, since the corporate stock can be transferred. If your real estate is owned in a corporation or other entity that has transferable ownership, the ownership goes where you go.
This is important in estate planning. If you own real estate in more than one state, your heirs must go through probate proceedings in each state. By converting the real estate into personal property (stock certificates), there will only be a need for probate in the state in which you die.
#10 IRS “dealer” status
If you buy and flip houses, you may be considered a “dealer” (rather than an ” real estate investor”) by the IRS. Dealers cannot defer paying income taxes on installment sales. Dealers must pay self-employment taxes on all gains. Dealers cannot depreciate property.
If you also have rental properties, the IRS can reclassify ALL of your properties as dealer properties and hit you with a big tax bill. If you use a corporation to buy and flip and another entity (such as a limited liability company) to hold your long term rental properties, you avoid the risk of this reclassification.
I hope these “top ten” reasons why real estate investors should incorporate your real estate business help you to decide whether a corporation should be part of your overall asset protection strategy.
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by: William Bronchick, J.D.