Set up a LLC or not?

General Real Estate Investing
1

Hi All -

I need some advice.

I plan on purchasing a rental property with a friend. We eventually plan to buy more than one property. We will split the cost 50/50 along with the profit. We plan on opening a joint bank account and having money in there for expense and income.

We are thinking of setting up a LLC and buying property under the business name. What are the pros/cons of doing this? Does it make sense to do this or should we just buy the property as joint owners without setting up a business?

2

You should look at the threads over in the Asset Protection / Legal forum regarding whether or not to form a LLC. My wife and I set up an LLC in the beginning with plans to buy multiple investment properties. In the beginning, I thougth the LLC would provide more liability protection than it actually does with me performing a good amount of the work on the properties. Whatever way you go, just make sure you have things in writing regarding contributions from each of you so everyone knows what their role is for the venture. You also need to think about what happens in the future if one or both of you no longer want to do this. How will a buy-out be handled or liquidation of assets?

3

Thanks Ill take a look at that forum.

4

An LLC is better than a general partnership. When you get bigger, you can place the rental properties under different LLCs and if need be, place those LLCs under a S-corp or C-corp. The only downfall/con to a LLC in what you describe might be self-employment tax. However, check with an accountant that knows real estate investing to go over your plans and give you better direction.

Just make sure you put an agreement in place for the following events:

  1. Divorce. If you or any partner gets divorced, or marries then gets divorced, you want to put in protections in place so the ex doesn’t get control of the LLC.
  2. Death. If one of the partners dies, then put in place what happens.
  3. Disability. If one of the partners becomes disabled and cannot contribute mentally, physically or financially to the LLC, what happens then.
  4. Departure. One of the partners wants to leave. What happens then?

Good luck!

5

Anytime you hear the words “LLC” and “tax” in the same sentence, beware of someone who doesn’t know what they’re talking about.

There is no tax code for LLC. So you will either have to tax it as a partnership, C-corp or S-corp.

From the IRS perspective, the LLC IS a partnership, C-corp or S-corp. LLC is purely a liability protection construct of state law. It has nothing to do with the federal tax code.

So there is nothing about an LLC that will in any way impact self employment tax (or any other tax) in and of itself.

Rental income is always passive and not subject to self employment tax, irrespective of what type of entity holds the property. Flipping income will always be ordinary income subject to self employment tax, again irrespective of what type of entity holds the property.

Whether you use an general partnership or an LLC taxed as a general partnership, the key is the partnership agreement. You need to decide on EVERYTHING up front and PUT IT IN WRITING.

who’s gonna do what and who’s gonna get what in compensation. Who’s gonna go when the water heater goes out at 2 am. Who’s gonna pay when the roof leaks and you have to fund the entire repair because his daughter’s getting a $40,000 wedding. What’s gonna happen when he dies and now you own a property together with his widowed wife who has remarried a mobster. What’s gonna happen when he gets divorced and his wife’s atty sends you a letter that ties up your half of the partnership in court. What’s gonna happen when you’re ready to sell because you’re fed up dealing with snotty tenants and a deadbeat partner and he doesn’t want to. What’s the exit strategy? Who’s gonna pay the mortgage when it’s been vacant for a year and the house is about to go into foreclosure? When it gets foreclosed, and you can’t sell because it’s underwater, who signed the personal guarantee with the bank?

Yep, I’ve seen all this happen.

Decide in advance. PUT IT IN WRITING. Always and I do mean always have an exit strategy, and a plan B, and a plan C. Plan D doesn’t hurt, either.

If you want liability proection, look at an LLC. However, if you’re going to be managing the property yourself, the LLC will not protect you from your personal actions (negligence), so just use a partnership (no state registration required in most states). Even if you just jointly own the property, you’ll have to split it to get it on your personal tax returns anyway, so it makes no tax difference either way.

Jointly owning property may come with some legal risks I’m not familiar with. I’d talk to an atty before jointly owning property with someone. But that’s me.

6

Yeah, someone should tell these people something too:

http://www.crslaw.com/Newsviewer.asp?Article=453576
http://www.nysscpa.org/cpajournal/2006/606/essentials/p32.htm
http://www.llc-made-easy.com/self-employment-tax.html
http://www.alberty.com/newsletter_fall00.html

Hell, just Google “LLC self employment tax” and see how all these CPAs are talking about this non-issue.

7

from link #1: These exceptions (from self employment tax) generally include: (i) rentals from real and personal property;

from link #2: Certain types of income, including real estate rentals, dividends, interest, and capital gains, are not necessarily considered SE income

link #3: does not reference rental income

from link #4: Certain types of income is not subject to self-employment tax. For example, rentals from real estate

which appears to me to be exactly what I said, and exactly the opposite of what you said:

The only downfall/con to a LLC in what you describe (joint ownership of rental property within an LLC--wag) might be self-employment tax.

You’re 0-4-1. Are you really sure you want to start a pissing match over which one of us knows more about LLC taxation?

8

Pissing match? Not even. Look at what I wrote: “The only downfall/con to a LLC in what you describe might be self-employment tax. However, check with an accountant that knows real estate investing to go over your plans and give you better direction.”

Key word is “might” and “check with an accountant”. You, on the other hand, are talking in absolute when you do not know the specifics of his strategy and it’s implications. Apparently self employment tax is a consideration when forming an LLC. You might be knowledgeable on how to avoid it, depending on the entity formed and certain functions, but you cannot argue an absolute when you are not acting in capacity of his personal accountant based on the specifics of his investing tactics.

9

Yes, I can. As I stated: rental income is always passive and is not subject to self employment tax irrespective of the type of entity that holds the property.

The tax code is absolutely clear.

10

OK, then I concede based on my lack of knowledge on the tax code.

11

That probably should have been your ‘going-in’ position…

Keith

12

It was, but I thought I had a logical argument to express until I got my butt kicked. :wink:

13

HINT: mcwagner is NOT the right guy to argue tax code with…it never ends well. :doh

LOL…

Keith

14

In all fairness, my “beware” statement was probably a bit harsh.

It’s all good.

By the way, there is one case where rental income is not passive: when the rental is incidental to regular business income. ie: you have a flipping business (ordinary income) and you end up with a short term rental on your hands. However, the choice of entity still has no impact on how the income is taxed.

This may help: income tax is based on the character of the income. This character does not change as it passes through from an entity to the owner. Capital gain income in the partnership remains capital to the partners; passive remains passive, etc.

15

Thank you for the followup. I didn’t see you as being harsh. It is great when someone can explain something in a cognitive, logical manner. Again, thanks for the contribution. I learned something.