There are a variety of entities for investing in real estate: sole proprietorship, C corporation, S corporation, limited partnership (LP) or a limited liability company (LLC). Clients often ask what the best option is and what will be the best for them from a taxation perspective. Here are some of my recommendations for purchasing investment real estate:
General Recommendations
You should have your entity selected at the time you enter escrow. If you change your mind, the title and lender approvals all need to be in the name of the owning entity. This could cause a delay in the closing of your investment property. It is important to seek advice from a professional before purchasing real estate so you can be in the best position.
If you are investing in real estate with another party, you are forced to set up C corp, S corp, LP or LLC. Most lenders will require an entity for lending as part of their requirements.
Entity Selection Recommendations
A poor choice of entity is C corporation (tax paying) or S corporation. The C corporation will result in double taxation. If you purchase real estate in the C corporation, upon sale you will have taxed at the corporate level. This tax may be as high as 35% at the federal level. The net after tax proceeds are given to the shareholder. These proceeds are taxed at the individual level. The result is double taxation.
The S Corporation can limit flexibility when and if you choose to sell the property. If 2 people own the shares of the S corporation 50/50, and they choose to sell the property and use the proceeds to purchase property individually, it can limit their options. For example, one shareholder wants to buy an apartment building and the other one wants a strip center. If you distribute the real estate to the shareholders to exchange for other real estate, then upon distribution you will incur income tax base upon the fair market value of the asset. This is an inhibitor to enacting a 1031 exchange, which is another real estate investment strategy.
I recommend my clients purchase real estate assets in a LP or LLC. The LP should be a 99% ownership with a 1% general partner as a S corporation or LLC. This provides you the maximum flexibility for sale. You may enact a 1031 exchange at the LP level or you may drop the property to you and perform a 1031 at the individual level. All of these movements may be accomplished without incurring income tax. The C or S corporations require you to pay income tax at the time you distribute the asset to the shareholder. The LP or LLC does not have this requirement.
In California, the annual cost for a LP and S corporation will be minimum in income tax of 1.6%. The LLC has a minimum tax of $800 and has a gross receipts tax. This could be as high as $11,790. So an easy way to keep your tax cost down is using the 99% limited partnership with a 1% LLC general partner.
For more information about real estate investment strategies call Ron Stumpf at 714.569.1000.
