Investors need to consider which form of ownership structure will accomplish their goals when they invest in real estate. They want to make sure to pass their interests to their surviving heirs at their death. They also want an ownership structure that will enable effective management of their properties. It is also important to consider the tax implications and limiting their personal liability. A group of investors who combine their funds and managerial resources frequently use partnerships, limited partnerships, corporations, limited liability companies or real estate investment trusts (REITs) to own and manage their properties. What are the advantages and disadvantages of these forms of ownership? The following are the most often used forms of ownership of real estate investments.
1. Tenancy in Common (TIC):
Tenancy in common refers to a structure in which two or more people jointly own the property in their own names. Each owner can have a different percentage of ownership interest in the property or they can all own equal shares. Each owner’s interest can be separately conveyed to third parties and each of their interests passes to their heirs upon their death. Each investor owns an undivided interest in the property, in the income and expenses of the property and in the gains and losses on the sale of the property in an amount equal to their percentage of ownership. Tenancy in common ownership can be transferred by deed, will or intestacy. The owner’s liability is unlimited; all owners could be 100% liable for any claims or liabilities arising from the property. Another disadvantage is that it is harder for the investors to finance an acquisition with this ownership structure, so it is most often used when the investors are purchasing the property with cash. One potential disadvantage relates to decision making. With TIC ownership, all of the investors must agree in order to sell, lease, or finance the property. If one of the investors dies or transfers their ownership interest to a third party, the remaining investors could have a stranger for a partner. The advantage of this ownership structure is that typically it is not subject to the Securities and Exchanges Commission (SEC) disclosure and registration requirements, assuming that the TIC group is a limited number of investors. For many investors, not being subject to SEC laws and oversight is a welcome advantage for choosing Tenancy in Common ownership.
2. General Partnership:
General Partnership involves co-ownership of the investment, usually through a written partnership agreement. Two or more individuals agree to share in all assets, profits, and financial and legal liabilities of a jointly owned property. A general partnership is created by executing a partnership agreement which describes the partners’ ownership rights, obligations, liabilities, and control of the business. The co-owner’s liabilities are unlimited, and their losses and liabilities can attach to their other assets. General Partnership interests can be transferred or assigned to third parties, but many partnership agreements give the existing partners the option to purchase the interest being transferred in those circumstances. Partnership interests can be inherited by will or intestacy, subject to the purchase rights of the surviving partners. A general partnership must have a minimum of two people and typically all partners must agree on any major decision, such as to sell or lease the property or to mortgage the property. The right to share the control is an important factor in the general partnership; unless otherwise specified in the partnership agreement, each partner has the equal right to participate in the management of the partnership business. The income, loss, tax deductions, and other financial results are passed along to the individual partners. The general partnership is easy and less expensive to form and not subject to the corporation double taxation.
3. Limited Partnership:
Until the rise of the LLC, limited partnerships were one of the most attractive structures for ownership of real property investments. A limited partnership is comprised of one or more general partners who manage the business and who are personally liable for partnership debts and one or more limited partners. Limited partners do not participate the daily management of the investment; typically, they contribute capital and share the profits and loss of the business.
To form a limited partnership, two or more people or entities must file a Certificate of Limited Partnership with the State corporate registry. There is also a separate limited partnership agreement which specifies the rights and responsibilities of the parties and the way profits and losses are to be shared. The general partners are responsible for the company’s financial obligations and management and they have unlimited personal liability. Many limited partnerships have a corporation as the general partner to limit the liability of the individuals managing the partnership. Like a corporation, the general partners offer centralized management and no taxation at the entity level. The liability of limited partners is limited to their capital contributions. Limited partnerships have the tax advantage of a partnership with the limited liability of a corporation.
Corporations, like general partnerships, centralized their business management in a board of directors elected by the shareholders. The directors elect the executive officers of the corporation to run the business. Forming a corporation involves filing articles of incorporation with the secretary of state and obtaining a corporate charter. Personal assets and corporate assets must not be commingled. The corporation should have sufficient capital.
The corporation is subject to double taxation: the corporation is first taxed on its earnings; then shareholders are taxed individually on their corporate distributions. Shareholders may not deduct corporate expenses and losses from their individual taxable income. In some circumstances a corporation can elect to be taxed as a partnership by filing a form, known as a Subchapter S election, with the IRS. There is no double taxation for a Subchapter S corporation and shareholders can deduct corporate losses on their individual returns. They are limited to no more than 100 shareholders, and there are other requirements to form a Subchapter S corporation. Shareholders in corporations have limited liability and their personal assets are not subject to attachment for corporate obligations unless they separately guaranty an obligation of the corporation. The corporation has perpetual life, which is not impaired by the death, bankruptcy, or incompetency of one of its shareholders. In some States, the corporation’s shareholders can be liable for employee wages or for environmental obligations of the corporation under certain circumstances. Corporate shares can be freely transferred or inherited by will or intestacy.
5. Limited Liability Companies (LLCs):
A limited liability company (LLC) is similar to a corporation in that it has the personal liability protection, but it is not subject to the double taxation. An LLC can be owned by one or more people, who are referred to as “members”. An LLC with one owner is a single-member LLC and an LLC with more than one owner is a multi-member LLC. LLCs can be formed by filing Articles of Organization with the Secretary of State in the State. Multi-member LLCs can select their members (or an individual who is not a member) to manage the business of the LLC. Typically, LLC members cannot generally transfer their interests in the LLC without the consent of other members or without giving the other members the right to purchase the transferred interests. All members in an LLC can participate in the business without incurring personal liabilities. It is a business structure that offers a great deal of flexibility in the financial structure and management of the business. The loss and profits go directly to the members of the LLC and the tax benefits and liabilities pass along to each of the members. Because of the flexible structure, most investors now choose to form LLCs for their real estate investments.
6. Real Estate Investment Trust (REITs):
A real estate investment trust is a company that owns, operates, or finances income producing real estate. Trust investors (beneficiaries) transfer cash or property to the trustees, who use the cash to purchase and hold legal title to multiple properties for the benefit of the investors. The trustees then issue transferable trust certificates to the investors and manage the trust properties. REITS pool the capital of numerous investors and invest in multiple real estate properties, including apartment buildings, cell towers, data centers, hotels, medical facilities, offices, retail centers and warehouses. Most REITs are publicly traded companies and must distribute at least 90% of their net income to their investors each year. REITS are not taxed on the portion of ordinary income and capital gains that are distributed to shareholders. Five or fewer individuals may not own over 50% of the value of the trust stock. At least 75% of the REIT’s income must come from real estate sources such as rents, mortgage interest, and gains from the sale of real estate. There are three types of REITs---mortgage, equity, and hybrid. Mortgage REITs are mainly involved in the financing real estate developments. Mortgage REITs usually borrow money from lenders and then loan this money, along with investor’s capital, to builders and developers. Equity REITS use investors’ money to purchase real estate properties and finance the real estate properties with long term mortgages to produce a stream of income derived from the real estate. A hybrid REIT invests in both real estate properties and mortgages.
Knowing the benefits and burdens of the different forms of ownership structure for real estate investments will benefit you as you choose the structure for your own investments. It should help you to select the right entity for your real estate investment. You should always be sure to consult with an accountant and an attorney before making your final decision on the form of entity you will use for your investment.