Hey There, 👋 Mo here!

Today, we are talking about “entity protection”. If you’re on social media, there’s a specific subset that talks about “LLCs” and how it’s the end-all-be-all.

That isn’t necessarily true. Everything is a case-by-case basis. Consult a lawyer to see which business structure suits you. This is not professional advice and I am not a lawyer.

*my lawyer would probably advise me to say this and I pay too much money to ignore advice

Choosing the Optimal Business Structure for Real Estate Investing

Why is picking the right entity important?

When starting out in real estate investing, selecting the right business structure is a critical decision.

The legal entity you operate under impacts everything from liability protection, taxation, fundraising, and management flexibility to operations, profit distribution, and succession planning.

The real grittiness falls within your operating agreement or how the bylaws of the company are written. Those bylaws dictate everything.

Picking the wrong structure can leave you personally exposed to lawsuits if tenants get injured on a property. Or lead to getting double taxed on rental income and sales profits, severely reducing your returns.

This is a list of some of the most common legal entities real estate investors utilize:

• General Partnerships

• Limited Partnerships

• Limited Liability Companies (LLCs)

• C-Corporations

• S-Corporations

• Real Estate Investment Trusts (REITs)

• Joint Ventures

You'll learn how each entity affects liability coverage, taxation, fundraising potential, governance flexibility, and more so you can make an informed decision.

We'll also provide concrete examples of how real estate investing companies utlize these various structures in the real world. Let's dive in!

General Partnership Overview

A general partnership (GP) is the simplest structure where two or more individuals jointly operate a real estate investing business without having to officially register the entity.

For example, if Mo and Kush want to begin buying rental properties together, they can form a 50/50 general partnership by just drafting up a partnership agreement.

In a GP, profits, losses, and expenses are passed through to partners to report on their personal tax returns based on their ownership percentage.

Tom and Sue would each report 50% of the partnership's rental income, deductions, and other items on their individual tax returns.

GPs offer no liability protection for partners - they are each personally responsible for all partnership debts and legal liabilities.

If Tom is sued over a property defect, Sue's personal assets are also at risk even though she wasn't directly involved. This is also true for mortgages – especially if you have recourse debt.

While general partnerships are easy to set up, they provide zero asset protection. GPs are most appropriate for smaller, short-term partnerships between trusted friends or family members. They are too risky for serious real estate investors.

Limited Partnership Overview

A limited partnership (LP) grants some liability protection by containing:

- General partners who manage the entity and have unlimited personal liability

- Limited partners who are passive investors with no direct managerial control aka “money partners”

For example, an LP focused on building a portfolio of rental properties could have 2 general partners who actively oversee operations while 10 limited partners simply contribute investment capital.

The general partners have full authority to make business decisions on behalf of the LP and enjoy all the profits. But they are also personally responsible for debts and liabilities like in a GP. GP’s are in charge of the day-to-day including asset management, lining up debt/equity, and investor relations.

The limited partners have no management authority but gain liability protection - their exposure is capped at their capital contribution.

LPs provide a way to raise funds from passive investors while allowing the general partners to retain control over decision-making. The tradeoff is that limited partners' return on investment is often lower than the general partners' returns due to the difference in liability exposure.

In real estate investing, you'll often see large syndications structured as LPs for this exact reason. The fund managers serve as general partners while accredited investors provide capital as limited partners.

The way a GP/LP relationship works with compensation is usually an asset management fee, a promote/carry often after a hurdle rate, and occasionally construction management fees, loan doc fees.

I can do a separate topic about fees if there is enough demand 

LLC for Real Estate Investing

A limited liability company (LLC) is a flexible entity structure that combines the pass-through partnership taxation of a GP or LP with the liability protections of a corporation.

With an LLC, owners receive membership interests rather than stock shares like in a corporation. Profits, losses, and expenses pass through to the members' personal tax returns avoiding double taxation.

For example, real estate investor Janice could form an LLC and obtain rental properties under the LLC's name. She'd report the properties' income, deductions, and losses on her personal return.

All LLC members have protection from personal liability for debts and lawsuits against the business. If Janice's LLC is sued, her personal assets are shielded.

LLCs allow owners to shape managerial rules and voting rights through the operating agreement. Compared to corporations, LLCs offer greater flexibility in defining governance processes.

Overall, the blend of pass-through taxation, unlimited membership, and strong liability shields in an LLC makes it the most suitable entity for most real estate investors.

You have to be careful to not pierce the corporate veil and use your LLC for personal expenses. Most real estate investors including myself have separate LLC’s for each different property.

C-Corporation Overview

A C-corporation is the most formal business structure. Owners receive shares of stock representing ownership interests based on percentage equity and become shareholders.

Day-to-day affairs are handled by appointed directors who hold shareholder meetings and vote. The directors then appoint officers like CEO, CFO, COO to manage operations.

For example, larger commercial real estate companies often use C-corps because they allow for raise substantial investment capital through issuing and selling stock shares in public offerings. REITs are structured as specialized C-corps.

While C-corps provide limited shareholder liability and fundraising potential, income is subject to double taxation. Profits are first taxed at the corporate level. Any dividends distributed to shareholders are then taxed again at their personal income rates. This results in substantially lower returns for real estate investors.

S-Corporation Overview

An S-corporation is a special corporate entity that provides liability protection like a C-corp but is taxed similarly to partnerships. Income, losses, and expenses pass through to owners’ personal returns avoiding double taxation.

S-corps are limited to 100 shareholders maximum and there are restrictions on non-resident and foreign shareholders. Owners receive a proportional share of profits based on ownership percentage but must pay themselves “reasonable compensation”.

For real estate investors who want to raise more capital than an LLC allows while avoiding C-corp double taxation, S-corps can offer a compromise. However, the ownership limitations make them impractical for larger real estate investment firms.

REIT Overview

A real estate investment trust (REIT) is a C-corp structure tailored specifically for real estate companies. To qualify as a REIT, 90% of income must come from real estate activities and at least 90% of taxable profits must be paid to shareholders as dividends each year.

This avoids double taxation and unlocks benefits like deducting dividends paid to investors. However, extensive regulations come with REIT status - they are overseen by the SEC, must have 100+ shareholders, and meet dividend and asset thresholds.

Publicly-traded REITs like Equity Residential allow everyday investors to gain exposure to large-scale real estate portfolios. But the compliance complexity limits applicability for smaller real estate investors.

REITs can be public or private. All REITs are essentially institutional and aren’t suited to smaller investors. Partners in REITs are usually pension shops, life insurance companies, national debt lenders, and UHNW individuals.

Here are two additional paragraphs covering real estate investing joint ventures:

Joint Ventures

Beyond the standard entities already discussed, real estate investors sometimes enter into joint ventures (JVs) for individual projects or properties.

A joint venture allows investors to team up on a short-term basis to acquire a specific asset or development deal too large for any single investor. For example, Investors A, B, and C could form a joint venture just to purchase and renovate a 100-unit apartment complex.

The JV acts as its own legal entity for liability protection and is essentially a temporary partnership. The investors would agree upfront on ownership stakes, voting control, profit-sharing, execution responsibilities, timelines, and exit strategies related to the project.

Once the joint venture completes the acquisition, renovation, stabilization, and sale of the asset, the JV would be dissolved. Investors A, B, and C go their separate ways.

Joint ventures allow pooling resources and expertise for larger real estate projects that investors couldn't take on alone. They are customized short-term partnerships tailored to an individual deal rather than an ongoing investing strategy.

Key Takeaways

When choosing a real estate business structure, assess your goals for liability protection, taxation, capital raising, investor limitations, governance flexibility, and regulatory oversight. Meet with attorneys and accountants to determine the optimal approach.

No single entity is right for every real estate investor. For example, hard money lending funds may prefer LLCs for the liability coverage while crowdfunding platforms lean toward C-corps to issue shares publicly. Evaluate your own unique objectives.

Selecting the right structure from the start allows smoothly growing a real estate portfolio while protecting your assets. Get informed so you can make the best entity decision upfront.