Investing in real estate can be a lucrative venture, but how you hold title to your investment could be crucial to your overall success. The choice of entity structure can affect your tax liability, liability protection, ease of management, and ability to borrow. Let’s explore the various entity types commonly used to hold title to investment real estate.
Sole Proprietorship
A sole proprietorship is the simplest form of business entity. It’s owned and operated by one individual who retains complete control over the property.
Pros
Simplicity: Easy to set up and manage, with minimal paperwork.
Direct Control: The owner makes all decisions and receives all profits directly.
Cons
Liability Exposure: The owner is personally liable for any debts or legal issues, which can put personal assets at risk.
Tax Implications: Income from the property is taxed as personal income, which can lead to higher rates depending on total income.
Limited Liability Company
A limited liability company (LLC) combines the flexibility of a partnership with the liability protection of a corporation. It can have one or more members.
Pros
Liability Protection: Members are generally not personally liable for the debts of the LLC, protecting personal assets.
Tax Flexibility: LLCs can choose to be taxed as a sole proprietorship, partnership, or corporation, providing potential tax advantages.
Cons
Complexity: More paperwork and regulatory requirements than a sole proprietorship.
Costs: Initial setup and ongoing maintenance fees can be higher than other structures.
Corporation
A corporation is a separate legal entity that is owned by its shareholders. This structure is less common for real estate investors but can be beneficial in certain situations.
Pros
Limited Liability: Shareholders are typically not personally liable for the corporation’s debts.
Tax Benefits: Corporations may have access to certain tax deductions and benefits.
Cons
Double Taxation: Corporations can be subject to double taxation—once at the corporate level and again on dividends paid to shareholders.
Administrative Burden: More complex to operate, with formalities like annual meetings and record-keeping requirements.
Partnership
A partnership involves two or more individuals who agree to share profits and losses. Partnerships can be general or limited.
Pros
Shared Responsibility: Partners can share the management and financial responsibilities of the investment.
Pass-Through Taxation: Partnerships are typically not taxed at the entity level; profits and losses pass through to the individual partners’ tax returns.
Cons
Liability Issues: In a general partnership, all partners can be personally liable for the debts of the partnership.
Potential for Disputes: Differences in management styles or investment philosophies can lead to conflicts.
Trust
A trust is a legal arrangement where a trustee holds and manages assets for the benefit of the beneficiaries. Real estate can be placed in a living trust or a land trust. When dealing with trusts in the context of lending and real estate financing; it's important for lenders to understand the distinctions between revocable and irrevocable trusts, as each type has different implications for ownership, control, and liability. Here’s a breakdown tailored for lenders:
Pros
Estate Planning Benefits: Trusts can help avoid probate and facilitate the transfer of assets upon death.
Privacy: Property held in a trust can remain confidential, protecting the owner’s identity.
Cons
Complexity and Cost: Setting up a trust can be complicated and may involve significant legal fees.
Restrictions: Depending on the type of trust, there may be limitations on how properties can be managed or sold.
Revocable Trusts
A revocable trust is a trust that can be altered or revoked by the grantor (the person who created the trust) at any time during their lifetime.
Key Features:
Control: The grantor retains control over the assets within the trust and can modify the trust terms, change beneficiaries, or dissolve the trust entirely.
Tax Implications: Since the grantor retains control, the income of the trust is typically reported on the personal tax return of the grantor, meaning there are no separate tax obligations for the trust.
Asset Protection: Generally, the assets in a revocable trust do not provide protection from creditors. Because the grantor can alter the trust, creditors can claim the assets.
Implications for Lenders:
Creditworthiness: Lenders will evaluate the creditworthiness of the guarantor since they remain in control of the assets and can make decisions about the property.
Personal Guarantee: If the grantor is also the borrower, lenders may require a personal guarantee, as the grantor’s assets remain reachable by creditors
Loan Documentation: The trust agreement may need to be included in loan documents to clarify the structure and control over the trust’s assets.
Irrevocable Trusts
An irrevocable trust is a trust that cannot be altered, amended, or revoked by the grantor once it has been established, except under specific circumstances defined in the trust agreement.
Key Features:
Loss of Control: The grantor relinquishes control over the assets, as they cannot change the trust terms or reclaim the assets.
Tax Implications: The trust is treated as a separate tax entity, meaning it has its own tax ID and must file its own tax returns. Income generated by the trust’s assets is taxed at the trust level.
Asset Protection: Since the grantor no longer owns the assets, they are generally protected from creditors, providing a level of security for the beneficiaries.
Implications for Lenders:
Creditworthiness, of Beneficiaries: Lenders will evaluate the financial profiles of the beneficiaries, as the grantor's control is limited.
Limited Recourse: In case of default, lenders may have limited recourse against the assets held in an irrevocable trust since the grantor does not have direct access or control.
Complex Documentation: Loan agreements may need to include detailed provisions regarding the trust to ensure clarity on ownership and responsibilities.
Lender Considerations Regarding Trusts
When evaluating loan applications involving trust-held properties, understanding the differences between revocable and irrevocable trusts is essential.
Revocable trusts: Maintain the grantor's control and flexibility, which may align more closely with common lending practices.
Irrevocable trusts: Provide greater asset protection but limit the granter's control and can complicate lending relationships. Lenders must carefully assess the trust structure, the creditworthiness of the involved parties, and the potential implications for securing their loans.
Lender Requirements of Entity Borrowers
If debt is secured against an entity-owned property, it’s important to understand the entity is the borrower not the owner(s) of the entity. Since an entity can protect the individual owners against personal liability including debt, the risk to lenders can increase if the value of the asset becomes less than the debt owed. To mitigate this risk, lenders will often require each owner of the entity with 20% or greater ownership interest to personally guarantee the loan.
Guarantors
All credit decisions will involve careful evaluation of the entity ownership structure and legal authority. Below is an overview of common lender requirements of entity owners:
Personal Guarantee(s): A legal commitment from an individual(s) to personally repay a loan if the entity defaults. A common requirement of lenders and is often required of all owners with greater than 20% ownership interest in the entity.
Personal Financial Statement(s): Guarantors might be required to submit personal financial statements detailing assets, liabilities, income, and expenses.
Experience: An important factor in credit decisions. Lenders often use the track record(s) of all entity members/shareholders with greater than 20% ownership collectively to meet experience requirements.
Background Report(s): Typically, lenders require owners to have a clear background history without the occurrence of specific negative events. These may include bankruptcy, foreclosure, notice of default filings, and felony convictions.
Credit Report(s): Strong credit profiles are often necessary, common FICO score requirements range between 650 and 689.
Liquidity Reserves: Expenses such as budget overages and interest payments might not be included in the loan, lenders usually require a minimum of 10% of any budget holdback plus 6 months of interest payments.
*Note: Requiring personal guarantees from owners with more than 20% interest is a common practice among lenders to safeguard their investments. This requirement not only serves as a risk mitigation strategy but also ensures that key stakeholders are invested in the success of the entity and its financial obligations.
Compliance and Legal Considerations
Lenders must ensure that the entity complies with relevant laws and regulations. Proof of its legal formation and active registered status within the state of operation.
Requirements
Legal Compliance: Lenders will require proof the entity is in good standing within its state of formation and operation (statement of good standing).
Compliance with Anti-Money Laundering (AML) Regulations: Lenders may conduct checks to ensure that the owner(s) comply with AML laws, which could include asking about the source of funds.
Final Thought
Choosing the right entity structure for holding investment properties is an important decision. Each option has its own set of benefits and drawbacks. The best choice will depend on your specific circumstances, goals, and risk tolerance. Before deciding, seek the professional advice of a licensed real estate attorney and/or Certified Public Accountant (CPA) who can provide custom-tailored advice based on your situation. With the right entity structure in place, you can enhance your investment strategy while protecting your assets.
If you'd like to learn more about available financing options for investment opportunities you may be considering, inquire at info@brenance.com and one of our experts will assist you. *All financing options available are investment-purpose only, the real estate securing the loan must be non-owner occupied.
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