Making Informed Entity Selection for Real Estate Ownership
June 13, 2023
Making Informed Entity Selection Decisions
The life cycle of your real estate venture or property management company should be planned with the end in mind. Decisions made today can have a critical impact on the taxability of your investment, including on the exit strategy.
In this article, we’ll explore the advantages and disadvantages that the type of entity chosen for a real estate venture or property management company can have on the tax strategies available during your project’s life cycle. CPAs and attorneys regularly advise clients concerning the appropriate entity for their endeavor. The choice of entity is a very important decision, as proper entity selection will ideally provide legal protection, highlight opportunity to save tax dollars and maximize flexibility in operations.
The following types of business entities are options to own real estate or operate a related business:
Sole Proprietorship: Many single owners of real estate are an individual. The income earned from the real estate is reported on the taxpayer’s individual tax return. Owners must pay federal and state tax on the income from the property, including any gains from the sale of a property. The advantage to owning as an individual includes simplicity, control and the ability to make all management decisions for the property. The disadvantage is that this type of ownership comes with unlimited personal liability. If you choose to own title to your real estate as an individual, be sure to consult with an attorney about potential legal liability issues, title issues and carrying an adequate level of property and casualty insurance.
Single Member LLC: A single member LLC provides all the simplicity of a sole proprietorship but offers the property owner legal limited liability protection. A single member LLC has the same tax impact as a sole proprietorship. It is disregarded for federal tax reporting purposes, and all income is reported on the individual’s tax return and taxed at the individual’s tax rate.
C Corporations: Real estate can be owned in a C Corporation. A C Corporation is a separately identified entity from its owners and follows a separate formal legal structure. It does provide legal limited liability protection. The greatest disadvantage comes from the impact of “double taxation,” where the C Corporation pays its own tax on the income from the real estate and again when a distribution is made, as the shareholders pay income tax on the dividends received. A C Corporation is also less flexible in allowing property distributions and special allocations amongst owners. In general, despite lower tax rates, it is generally not a good idea to own real estate in a C Corporation due to the double taxation and higher degree of administrative complexities.
S Corporations: A solution to the issues associated with C Corporations is to elect to treat the C Corporation as an S Corporation for income tax purposes. An S Corporation provides the limited liability protection provided by a corporation, while allowing the shareholders to earn salaries, take distributions which are only taxed once and obtain certain tax-free fringe benefits. An S Corporation also avoids the double taxation issues of a C Corp, while passing through income and expenses to the individual owners to report on their individual returns at their personal income tax rate, including capital gains. An S Corporation also limits the owner’s exposure to self-employment taxes, since the owners receive a salary as an employee of the corporation.
There are disadvantages to an S Corporation. Primarily there are certain limits on the entity structure, including restrictions on the number of shareholders and a requirement that only one class of stock be allowed. Also, it can limit flexibility in sharing income amongst multiple owners or distributing certain assets from the entity.
Partnerships and Limited Liability Companies: A partnership/LLC is the most common form of ownership of real estate today. Partnerships pass income out to its partners as it is earned, therefore it is taxed on the partners’ individual tax returns. The flexibility of partnerships offers a multitude of planning opportunities and flexibility. The formation, ability to specially allocate income, deductions and credits, and multiple exit strategies are some of the greatest benefits of operating as a partnership.
Property Management Companies: All the entities discussed above could be used for the operation of a property management company. However, since a property management company is often considered to provide a service, it can expose those owners operating the business to payroll taxes on their share of income above and beyond their salaries. Sole proprietorships, single member LLCS and partnerships can subject these owners to this tax. Owners can use a C corporation or S corporation to minimize this exposure.
Choice of entity cannot be made in a vacuum. All elements – the type of activity to be conducted, the availability of cash and the use of leveraged debt, legal considerations, exit strategies, and retirement and estate considerations all come into play when developing an entity strategy. It is recommended that you consult your legal and tax advisor before selecting your entity choice to own or operate your entity.
How Cherry Bekaert Can Help
Cherry Bekaert can help your company grow and excel, regardless of the economic climate. Our Real Estate & Construction Group professionals can customize a strategic plan, tailored to your business goals, to cover objectives such as effective tax strategies, structuring developments and profitability analyses. We can ensure you have strong industry relationships, while staying ahead of trends to provide timely and actionable advice. Reach out to your Cherry Bekaert advisor to learn more about how our industry-driven insights can position your business for success.