The descriptions of these entities are organized according to their functional characteristics, such as formation, management and conduct of business, firm property, ownership interests, dissociation of owners, and dissolution of the firm. This allows the reader to compare and contrast the alternatives offered by the various forms.
Tax Law and Business Law Considerations of Real Estate Entities
Investors can choose from several different organizational forms for purposes of purchasing real estate. Most organizational entities are separate and apart from the assets and liabilities of any other entity or owner. The choice of entities in owning real estate is usually dependent upon a combination of business law and tax factors.
Tax law considerations include:
- Federal and state income tax treatment and consequences
- The nature of the property to be owned by the investors
- Distributions of cash and appreciated property
- Organization, re-organization, sale, and the ability to do business in another state
Business law considerations include:
- The number of individual investors
- An investor’s anticipated involvement in the operation and management of the real estate
- The risk involved in the investment
- Allocations of management authority within the entity
- Sharing of profits and losses
- Duration of the entity, transferability of interests, exit strategies, and liquidation
Common Organizational Structures for Owning Real Estate
Several different ownership structures exist for purposes of owning real estate. Some of the more common forms include:
- Individual/Sole Proprietorship
- Corporation (C-corp & S-corp)
- Limited Liability Company (LLC)
Many investors choose a limited liability company as their organizational form to purchase real estate because of its tax treatment, flexibility in power structure and management responsibilities, and limited liability. The best way to understand the unique features of an LLC is to distinguish it from the other entities.
We will begin our discussion with the most basic of all forms: a sole proprietorship.
A sole proprietorship is owned by a single person and exists absent a statutory scheme. It has no separate legal existence from its owner. In other words, no legal formalities are required to bring this form into existence. There are no organizational or operational costs, and no qualification requirements exist for doing business in other states.
The sole proprietor may hire employees or independent contractors; however, all the decision-making is centered with the individual owner. The owner is not insulated from liability and directly assigned all profits and losses. Also, the sole owner does not need to file a separate tax return. Only minimal reporting to is required through Form 1040 and Schedule C. The income or loss of Schedule C is added or subtracted to the 1040 to determine tax liability. Business profits are subject to only one tax at the individual level.
Tenants in Common
Another way to hold an interest in real estate is as tenants in common. Tenancy in common (TIC) is the ownership of real estate by more than one person, with each owner retaining an undivided interest in the property. Like the sole proprietorship, no entity is formed to own that interest. An investor can own the interest as he wants on his tax return.
Tenancy in common also allows for continuous ownership upon death or bankruptcy of any other owner. The owner may sell his interest, initiate a sale and partition suit (which is essentially a forced sale which generally occurs because the owners of property are unable to agree upon certain aspects of the ownership), or dissolve the tenancy in common. The TIC interest goes to the heirs of that owner rather than to the other tenants in common. The agreements between tenants in common usually deal with the sharing of expenses and provide one owner with the right to buy out the other owner when used.
In the first of this series on selecting a real estate entity, we looked at the sole proprietorship and tenant in common entities, each of which have distinct characteristics that could influence why one may or may not choose to select them. In our next installment on entities for real estate purchase, we discuss partnerships.