The LLC (Limited Liability Company) can play an essential role in protecting your personal assets in the unfortunate scenario where the property is sued. Other business structures — namely the C Corporation and the S Corporation — do offer the same asset protection benefits. However, the LLC brings some unique tax advantages that make it the preferred business structure for real estate investors and builders.
The LLC’s main benefit is to limit the liability of the owners (separating your personal property from company property). There are no shares. An LLC does not file separate taxes; all company profits flow through to the owners and are taxed at the personal income rate. It’s great for businesses that want liability protection, but minimal formality — i.e. no exhaustive meeting minutes or addendum filings. It’s also the perfect structure for a business with foreign owners since anyone (C Corp, S Corp, another LLC, a trust, or an estate) can be an owner of an LLC.
The C Corporation and the Problem of “Double Taxation”
In the eyes of the IRS, the C Corporation is a separate entity. The Corporation is taxed, and any money paid out to the owners in the form of a dividend is taxed again on their personal income statements. This is commonly referred to as “double taxation” and can make owning a corporation very expensive to the small business owner.
The LLC (as well as the S Corporation) eliminates this double taxation penalty. The LLC is considered a pass-through entity. It does not file separate taxes; rather, any business income or loss is reported on each individual owner’s tax return. In the case of a single member LLC, the LLC taxes would be filed under the individual member’s tax return; in the case of a multi-member LLC, the LLC would generally file a partnership tax return.
All LLC profits flow through to the owners and are taxed at the personal income rate – which depending on circumstances can be lower than what Corporations pay (of course, you should always check with your CPA or tax advisor regarding your specific situation…).
The LLC and Losses
The IRS also allows any loss of the LLC to pass through to individuals. This loss can offset other sources of income – in effect, reducing your overall tax liability. And as an added bonus, in an LLC, members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss. For the S Corporation, this is not the case.
Let’s say you invested $10 in ABC property. Your tax basis is $10. You mortgage the real estate and borrow $20. Rental income and values decline leaving your property with a $20 loss at the end of year one. Simply stated, you’ve lost $20 through investment activities in ABC property.
If you had created an S Corporation, the IRS will only allow you to take a $10 loss on your personal income tax (because the tax basis is $10); the remaining $10 loss will be deferred. But with an LLC, you’re allowed to deduct the entire $20 in the first year.
Again, it’s always wise to consult with your personal tax advisor, but generally speaking, most real estate investors choose the LLC for their investment properties.