In real estate transactions, a number of guidelines and restrictions are in place to protect the interests of both buyers and sellers while ensuring that all parties to the transaction comply with applicable legal, financial and tax laws. Ownership of real property comes with a host of obligations and benefits. The extent of one’s obligations and benefits as a property owner will depend on the legal entity used to acquire ownership of the real estate.
Sole Proprietorship
Acquiring property as an individual is a common approach, and this process is straightforward with a sole proprietor at the helm. The sole proprietor makes all the decisions and accepts all the responsibilities of real estate ownership, which means there is no separate legal entity involved in the process.
- No other legal formalities are required to acquire real estate as a sole proprietor.
- No organizational and operational costs are required as the owner performs the responsibilities or outsources as needed.
- Reporting requirements are minimal with the owner using Form 1040 and Schedule C to report tax liabilities.
- Any profits generated from acquisition and disposition of real estate will be taxed at the individual level.
- As an individual owner, all liabilities related to ownership of real estate, including liabilities for defects in the property, financing, tax liabilities and assessments belong to the individual owner.
When more than one person is involved in ownership of the property, and each individual has an undivided interest, ownership may be a tenancy in common, or TIC.
- Tenancy in common is considered a natural state because no other legal entity needs to be formed for the TIC to exist.
- Investors involved as tenants in common will report the ownership interest in the property on their tax forms in any way they wish provided they meet the legal requirements for that entity.
- One of the major advantages of TIC is continuous ownership of the interest in case of death or bankruptcy of other owners. Each owner may sell, assign or force a partition sale when owners have irreconcilable disagreements.
- Interest in the property automatically goes to the estate or the heirs of a deceased owner and not to the surviving tenants in common.
- A TIC is useful in assigning obligations for expenses pertaining to the acquisition, maintenance and disposition of the property.
- Each tenant in common may buy out the other owners, and the tenancy in common can be dissolved through mutual agreement.
General and Limited Partnerships
A group of individuals may own and hold title to a property as co-owners in a General Partnership. The Internal Revenue Service defines a General Partnership as one where the partners own the assets and capital jointly, manage and control the assets jointly and share in the profits and losses.
- In a General Partnership, no taxes are assessed on the partnership level, avoiding double taxation, which could mean significant tax benefits when the investment portfolio consists of potentially high-yield fix-and-flip foreclosures.
- There is some assurance of continuity of ownership, and each partner participates in management and decision-making. However, the partnership does not exist in perpetuity.
- The decisions made by one partner may bind all other partners.
- Each general partner may be exposed to unlimited liability related to ownership of real estate.
When more than one owner is involved, a Limited Partnership may be established to serve as the acquiring entity that will hold title, manage and remain responsible for ownership obligations up to a limited extent. A real estate Limited Partnership is established by filing the necessary paperwork with the county clerk or the office of the Secretary of State.
- A Limited Partnership will define the liability of each partner for the property. This liability will be limited to the amount that each partner submits as “at-risk” capital.
- The Limited Partnership survives the death, bankruptcy or withdrawal of a partner, ensuring continuity of the business entity, which is important for projects that are not highly liquid such as rehab and resale of foreclosure properties.
- A Limited Partnership includes general partners who will make financial decisions about the partnership. The limited partners cannot be involved in the management of the entity or properties to preserve their limited liability status.
- Partnerships are valuable when raising capital for financing auction homes that may require cash offers. It helps to raise the capital and to spread the risks involved in acquiring distressed properties.
Corporations
Corporations have a separate legal existence from the individual investors. As a legal entity, corporations shield the individual investors from all debts, and shareholders have limited liability subject to certain guidelines such as no commingling of funds and other assets. Unlike partnerships, corporations are created by filing incorporation papers, including articles of incorporation and by-laws that will define how the entity is managed.
A C-corporation may be organized following any form of power structure with no restrictions as to how each shareholder can participate without risking their limited liability status.
- The directors and shareholders of a C-corporation cannot be held personally liable for the debts and other obligations of the corporation.
- The corporate entity survives the loss of any shareholder and can exist in perpetuity.
- The corporation must adhere to the guidelines of corporate operations to avoid risking personal liability in cases where it can be proven that ownership and interests of individuals are too closely aligned with that of the corporation.
- Profits are subject to taxes on the corporate level, and shareholders should also report any personal gains, earnings and profits from the corporation on their individual tax returns.
An S-corporation separates the individual shareholder from the company in terms of operations and liabilities. The corporation exists as its own legal entity separate from the individual shareholder. An S-corporation is created by filing articles of incorporation, creating bylaws and appointing officers. Compliance with corporate formalities ensures separation of business entity and individuals to limit personal liabilities.
- The individual shareholder must establish separate entity from the corporation by using a payroll to process self-payments and maintaining separate records for minutes of meetings.
- Use a Form 1120s to report business income, profits and losses. This form is part of the Form K-1 packet that helps the individual shareholder in an S-corporation to limit self-employment taxes that would be applied when using a different entity.
Determining the Best Business Entity
Each legal entity has its own set of advantages and challenges when it comes to building a real estate portfolio especially in dynamic markets. Corporate entities may provide the most liability protection and tax benefits especially for buy-and-hold investors while fix-and-flip investors may choose a partnership or sole proprietorship that requires less paperwork. You should be aware that you have the freedom to use one entity for one project and shift to another for different projects. This means that you can invest as a sole proprietor in smaller projects and join Limited Partnerships for other projects.
Auction.com is the largest online marketplace for residential properties that are bank-owned or currently in some stage of foreclosure. Use the Auction.com Help Center to help you decide your best approach to acquiring distressed properties to build your asset portfolio quickly.
The information in this blog post is being provided for informational purposes only and not for the purpose of providing legal or real estate investment advice, and no liability is assumed by Auction.com LLC with respect to such information.
Sources:
Selecting the Entity For a Real Estate Purchase – Corporations
https://www.accruit.com/blog/selecting-entity-real-estate-purchase-%E2%80%93-corporations
Selecting the Entity For a Real Estate Purchase – Part 1
https://www.accruit.com/blog/selecting-entity-real-estate-purchase-%E2%80%93-part-1
