Real estate investors have a lot at stake especially if you buy and hold (rent to tenants). You are responsible for everything that happens at the property – good and bad. Even if you have the best tenants, life happens and accidents occur. Anything that happens on your property could become your liability, especially if the injured sues you unless you set up your business structure to protect yourself.
If you get sued and you don’t have any legal protection, you are solely responsible for the finances and the affected can come after your personal assets. That’s why if you invest in real estate it’s important to protect your assets. If you don’t, you could end up losing your personal assets.
As a sole proprietor, your business and personal life are one. If you prefer to separate the two, you’ll need to consider either an LLC or S Corp for real estate. Both entities protect your personal assets but have different benefits.
Below we discuss the pros and cons of each to help you decide which may be right for you.
Benefits of LLC for Real Estate Investing
An LLC is a legal entity. You register it with the secretary of state and it becomes separate from your person. As the name suggests, the liability is limited to the company and not your assets. For example, if someone slipped and fell and had thousands of dollars in medical bills, they could only come after the LLC (your business) to cover them. They could not come after your personal assets – it separates the business from your personal life. This is the case even if they exhaust all resources you have in the LLC, but have personal assets – those assets remain untouched.
Other benefits of operating your real estate business as an LLC include:
- Gives you a more professional appearance when marketing properties for rent. Tenants often feel better renting from a company than a person.
- It’s easy to transfer the LLC to other owners. You don’t have to sell the property, but instead, transfer ownership of the LLC, leaving the real estate untouched.
Disadvantages of LLC for Real Estate Investing
Like any business decision, there are drawbacks of starting an LLC for real estate. Here’s what you should know to help you decide.
- It could trigger the ‘due on sale clause.’ When you transfer a property from individual ownership to an LLC but you have financing on it (a mortgage), the mortgagor can demand full payment of the mortgage due to the transfer since most mortgage deeds don’t allow transfers.
- Transferring property to an LLC can also incur transfer taxes whether or not you have a mortgage. This varies by state, though, as not every state charges transfer taxes. Find out your state’s requirements before deciding.
- Income ‘passes through’ to the individual (owner), which means you are responsible for the entire self-employment tax of 15.3% plus your individual tax rate on the income earned. You can’t offset the taxes since 100% of the income passes through to you.
Benefits of S Corp for Real Estate
An S Corp for real estate protects your assets just like an LLC, but it also affects how you’re taxed. If you elect an S Corp, you and any partners become ‘employees’ of the corporation. This matters most in how you’re taxed and is the largest benefit of the S Corp.
As an S Corp, you draw a salary from the company. The salary is your ‘pass through’ income and is subject to self-employment tax plus your ordinary tax. But, any money you receive as dividends, which is how you receive the remainder of the profit isn’t subject to self-employment tax.
Let’s say for example, you earn $75,000 a year from your real estate investment. As an LLC, you’d pay 15.3% of the $75,000 in self-employment tax or $11,475. If instead, you had an S Corp, and you withdrew a salary of $35,000 and received the rest in dividends, you’d pay $5,355 in self-employment tax.
Disadvantages of S Corp for Real Estate
Like LLCs, S Corps have some drawbacks including:
- It’s a more formal process. You must follow the legalities involved in creating an S Corp including issuing stock shares and holding at least one shareholder meeting a year.
- You can’t form an S Corp if you have only one owner, the IRS automatically considers you a sole proprietor for tax reasons.
- You may be required to file annual reports depending on the state you reside.
Key Reasons to Select LLC over S Corp
Knowing the pros and cons of each option, which is better, LLC or S Corp for real estate? While there’s no cut and dry answer, sometimes it’s better to pick an LLC over an S Corp including:
- You own the real estate yourself with no other owners
- You don’t want the hassle of issuing stock, holding shareholder meetings, and creating reports
- You intend to have many investors in your company (S Corps allow a max of 100 owners/investors)
Key Reasons to Select S Corp over LLC
Sometimes an S Corp makes more sense than an LLC, especially in these situations:
- You want to save on self-employment taxes and are a single owner or partnership
- You can handle the responsibility of running an S Corp including the legalities that come along with it
- You plan to continually buy, flip, and sell properties rather than just buying and holding one or two properties.
Final Thoughts
No two investors will benefit the same from an LLC or S Corp for real estate. The final outcome depends on what you intend with the business, and how you want to handle the taxes and income. If you can get by drawing a small salary and don’t mind the extra work that comes along with owning an S Corp, it may deliver the most savings.
However, if you’re investing less formally and don’t have the time or patience for the legalities involved in an S Corp, the LLC can protect you just as well, you just won’t get the same tax shelter as you would from an S Corp.