What is the best legal entity for real estate investing? In the following video, you're going to discover what a legal entity is, why understanding legal entities is important for real estate investors, the different types of entities for real estate investing as well as what the best one is for most people. DISCLAIMER: The following is NOT legal advice. Before making any decisions on legal entity structure, consult a qualified attorney as well as as accountant.
One big disclaimer:
I am NOT giving you legal advice in this video. Nor am I giving you accounting advice either. I am going to recommend prior to you setting up anything, that you speak with a qualified attorney as well as accountant, to make the best decision on if and when and what type of entities you need to create if you're going to be real estate investing.
Since I'm not an attorney and not an accountant, I'm probably going to tell you stuff they wouldn't tell you. What I'm going to share with you comes from the school of hard knocks. Comes from a lot of years of making good and bad decisions, and this is the kind of stuff that I didn't read in books. In fact, in this training here im going to probably contradict some things you may have read in some other famous books, because it is interesting what happens in the real world with this stuff. Let me put myself in your shoes for a moment. Maybe you're first getting started or you're contemplating becoming a real estate investor. Maybe you're trying to consider what you need to do as far as an LLC. You need to set one up? When do you set it up? Do you even set up an LLC? What is an LLC? Do you set up a corporation? I'm going to try to answer some of those questions pretty briefly, and then I'm going to get into more of what it means to be a real estate investor.
Okay, the first thing, I think this is extremely important, is that in business, if you do not set up an entity and you start doing business, you are by default a sole proprietor. A sole proprietorship, that can do wonders, right? This is your default. If you're doing business, any kind of business, real estate investing or otherwise, you're automatically a sole proprietorship. That's just the way the law works. When I was living out of my truck and I was flat broke and homeless, my first few real estate deals, I did them as a sole proprietorship.
Now most attorneys and accountants, they freak out and they gasp when you mention the idea of doing business in a sole proprietorship, because of one main missing element. What you're missing from a sole proprietorship, is what they call liability protection, okay. Liability protection. Let me break that down for a second. It's not that scary to understand the concept. The concept is this. If you do something in business and you're operating as a sole proprietorship, you could have a business name, you could name your business Successful Investments, but if you don't have a legal entity set up, you're still operating as a sole proprietorship. If something goes wrong, somebody sues you, something happens, they can sue you personally and take all of your personal assets along with whatever happened in the business.
What Kind of Entity Do You Choose?
Now, when I first got started, I was homeless, broke, whatever. I didn't have anything to lose, so you know, I mean if somebody sued me, what were they going to get? Nothing, right? When you're first contemplating this, if you are absolutely flat broke and have nothing at all, just keep in mind that yes, it's still important to consider getting a legal entity set up, yes, but it's not the end of the world because you don't have a bunch of things to protect. However, what if you already have a pretty significant set of assets and you're looking to get into real estate investing? Let's talk about the different kinds of entities and what can happen.
Sole Proprietor with Liability Insurance
Well here's the first thing. What some investors do is they continue to operate in a sole proprietorship. Let me explain. What they do, is they get liability insurance, okay. They would talk to an insurance broker and they would get an insurance policy that protects them up to say, two million or three million. They get a liability protection policy and they continue operating a sole proprietorship. Why? Why would any real estate investor in their right mind operate like this? Interestingly enough, in most cases, you actually do better from a tax perspective if you operate out of a sole proprietorship. I bet you didn't know that. You file your expenses under Schedule C. Any accounting people would know what I mean by that.
There's a gentleman, I know that he owns over 350 single family home rentals. He owns them all free and clear. There are a lot of them are junkers in the ghetto, but he owns all of them in a sole proprietorship.
In his state if he owns real estate in a sole proprietorship, he doesn't have to pay a state excise tax. However, if he owned that real estate in an LLC or a corporation, he would have to pay an excise tax. Does that make sense? Certain taxes can get triggered on a state level. Not a federal level, but a state level, if you own real estate in certain entities. That's one of them, is LLCs or corporations. This particular gentleman owns all those properties with sole proprietorship, and he protects himself in the case of a tenant trying to file a lawsuit against him with a liability insurance policy.
Some of you may be watching this, you may be from Canada. Many Canadian real estate investors do the same thing. That's because when it comes to Canadian legal entities, in most cases if you want to set up a corporation you have to have five employees. Well shoot, most real estate investors never get to employ five employees. You don't need employees really. This is a great option. Also, I know of people that do a lot of short sales, where they buy short sales. These days when you make an offer on a short sale, banks want to see a personal name. A lot of them make offers in their own personal name and they're operating as a sole proprietorship and they have a liability insurance policy. That make sense? All right.
What I gave you here that wisdom, you'll hear nowhere else, but it's true and it's very accurate. It can be an easy way to get started. You don't have to set up an entity. The only thing though is liability insurance policies aren't always cheap. In some cases it's actually cheaper to go with a legal entity. That's the first one. By default, if you're operating a business, you're already a sole proprietorship.
The next thing I want to mention is something called an LLC. That is a limited liability company. Limited liability company. This is what is used most often for most small businesses. Most small businesses are set up with an LLC. It's because they're flexible. They're a lot easier to set up, there's a lot less minutiae that has to be dealt with as far as corporate paperwork and those sorts of things. They can be filed easily, set up, I mean it's just ease of use, okay. Now the cool thing about an LLC is that it can be taxed as a sole proprietorship or it can be taxed as an S Corporation. I'm going to say Sole P or an S-Corp. I have LLCs that are taxed as sole proprietorships, and I have taxed as S Corporations. That can be nice when it comes to eliminating self-employment tax.
One of the problems with operating as a sole proprietorship or as your LLC being taxed as a sole proprietorship, is self-employment tax which can get expensive once you start making a lot of money. That's when we go back to what I said at the beginning of the video, and that is before you set anything up, I want to recommend you talk to both an attorney and an accountant, because they may have competing views. The attorney is going to talk and focus on liability protection, and the accountant's going to focus on how to save you most in taxes. If you can set up an LLC taxed as an S Corporation, that can be pretty sweet, although if you're not making much money at all it's not helpful. There's a balance there.
For most cases, you'll probably be setting up an LLC. If you want it to be taxed as an S Corporation you can do that. The final thing is certainly some people set up what's called a corporation. I'm going to call an S Corporation. You're probably never going to be big enough to set up a real corporation, those big big big things. Those are a lot more expensive, they get taxed at the corporate level, whereas S-Corp, the tax still flows back down. This right here you may use this as well. Again, your accountant or your attorney may bring this up as an option. I still vote that you go with the LLC, S-Corp, but again I'm not giving you legal advice or accounting advice.
I'm going to give you an incredibly important tip here. Okay. Real estate investing can be broken up into two activities. Active and passive.
Active is you buy a property, fix it up, resell it. You talk to motivate sellers and flip properties, you're wholesaling, you're moving and grooving, you're doing deals.
Then the passive side is where you buy a property and lease it out and you get rental income. That's your passive income. This is the rule of rule of rules. Okay, here's the rule. I'm going to put it in red it's so important. Okay, this is it. You want to separate those two activities. Separate passive and active. The reason why is for tax purposes.
It is potentially possible that if you own rental property in the same entity, which could have been your sole proprietorship if you were doing it in your own personal name. If you're both flipping properties and owning long term rentals in the same entity, then what can happen is the IRS can say that all of your rental income is going to be taxed at the ordinary income level, which is a nightmare. Rental income can be taxed a lot less because it's rental income, or passive income. You separate the two. Any time you own a rental property, put that into a legal entity that is separate from what you're doing with your active stuff.
Keep Things Separate
Maybe you're doing your active stuff in your sole proprietorship, but then you set up an LLC for your rental income, or vice versa. Maybe you set up an LLC for all of your flipping and wholesaling, and then you do all of your rental income out of your sole proprietorship with your liability insurance. Maybe you do all of your activity out of the S Corporation. This is all your active stuff and then all your long term stuff is out of your LLC. You got to separate the two. Does that make sense? Huge huge huge detail. If you don't separate the two you're going to really get hit on taxes.
Which State you Should Set Your LLC in
All right, this right here really encompasses the majority of this whole concept. I think another question a lot of people bring up, is where to set this thing up. Do you set it up in your own state? Do you set it up in some wonderful state halfway across the country? I'll say this: In most cases you're better off putting it in your own state, because that's where you're going to be operating your business. Now, some people like to set up their LLCs in Wyoming. That seems to be the favorite state these days, because of the non-disclosures and some other things that you can do. You can go through all those headaches and hassles, and again, talk to an attorney about that, but in most cases it's probably a lot simpler to set it up in your own state.
One thing to keep in mind is especially when you do a lot of active investing, it's not always a good idea to set up your entity in Wyoming if you're doing business in say, Texas. When you're working with sellers and they try to look you up and they hire an attorney maybe to look you up, and they see that you're not even in business in Texas, then all of a sudden you're in a bigger heap of trouble and you need to have filed some documents to be able to do business in Texas.
My vote is just set up the entity in your own state, and make sure you talk to a local accountant, local attorney to make sure you set it up correctly.
I know in Tennessee, when I owned a bunch a real property up there, what I did was I set up an LLC, and the two ... Excuse me. I set up a partnership, and the two partners were LLCs, and that's how I avoided paying the excise tax in Tennessee. There's some cool creative things you can do there as well.
Also keep this in mind. The simpler the better. The more entities, the more you have to pay each year for the annual fees and all sorts of things. I get the question sometimes, "Phil, how many rental properties should I put into an entity before I set up a new one?" Well I got this point to make. Once you start bringing in some real rental income from rental properties, you'll be able to answer that question yourself. Do you put five into one LLC? Do you put one property per LLC? My vote is actually, depending on which state you're in, move the property into a land trust with a different name, and then that way you can throw them all into the same LLC.
When anytime somebody was trying to search to see how many assets you had and they were going through the county records, they wouldn't be able to figure out what you own, because every single property is owned in a different name, of a trust. That's going into a different realm there as you can see. There's ways to get around it. I think you should keep it simple with your entities, because you're going to be filing tax returns on each one which does cost money. All these things are going to be expensive if you keep piling up too much complication. Does that make sense? At the very very least, if you're going both own rental property and be flipping, make sure you have two entities. That way you can avoid your rental property income being taxed as ordinary income.
Best Legal Entity For Real Estate Investing
Obviously it depends. It depends on what state you're in, it depends on what your situation is and how much money you're actually going to be making in that thing. In most cases, for most real estate investors, you can set up an LLC. That's so easy to go and set up. By the way, as it relates to paying people to set up your entities, you want to talk to the attorneys and the accountants to get the information on which entity to set up. The actual physical setting up, sure you can hire somebody. They're going to charge you 300, 500, 900 bucks. I have set up so many entities over the years.
Setting Up Entities
- You can just go online.
- You can just go to the Secretary of State.
- I'm not giving you legal advice here, but you can and you can just set this thing up, pay the filing fee and be done with it.
There's only like three check boxes and a couple of fill in the blanks. I mean it is so simple to set these things up. You get an EIN number from the irs.gov website. That takes you all of three minutes. Setting up entities is so simple. Knowing which entities to set up and use, that's the part where you need these professionals, because they know all the different angles, Well, I hope this helps on understanding which legal entities to set up.
If you're first getting started, you may just go with the sole proprietorship and get you some liability insurance, or you may set up your first LLC. Then you can always start as being taxed as a sole proprietorship and then change it to be taxed as an S-Corp later if you don't know which one to elect. Just get started and try something.
If you're a traditional real estate investor, which we don't talk about that much in my videos, but you might be one of those. You have a very very big problem if you're going to a bank to get a mortgage. Banks are going to give you a mortgage, but they're going to expect you to own the property in your personal name. If your name is the one that's on the loan, they want that to match what's on the Deed. They won't even let you own the property in an LLC, they'll make you own it in your personal name. This happens all the time, and it drives real estate investors nuts. They're, "What? I want to be in business in an LLC," then they say, "What I'll do is, after I buy it, I'll deed it into my LLC, and now it'll be in my ..." Well you can that, but then you've just breached the Deed of Trust, the clause in there that talks about not being able to change title.
Not that the bank may do anything about it, but I think the bigger lesson here is this. If you're going to be a traditional real estate investor and you're going to be using normal bank loans and they're going to expect you to become the owner, well then just put everything in your personal name, get liability insurance, and then do all your flipping and stuff out of an LLC, or, become a creative real estate investor whereby, since no banks are necessarily involved, you can move anything into an LLC, which is what I've always done. I've never gotten a bank loan to buy a rental property in my entire business career. I just always move mine to an LLC and I take it over subject to. I do owner financing. I become the owner, but I can own it in an LLC right there. I don't have to do any trickery, I don't have to worry about owning it in the sole proprietorship.