Know All Your Holding Entity Options

1. Introduction

The entity choices available to today’s real estate investor are numerous. It seems as time goes by more entity forms are created. It also seems that a particular form will go in or out of style depending on the whims or experience base of the investor’s attorney and/or accountant. A brief explanation of the entity choices follows.

2. Individual Ownership

Individual ownership of real estate means that the title to the property is held in the name of the owner(s) and is operated for legal and tax purposes as his, hers or their own. Individual ownership includes property held as:

Sole and Separate: The default for someone buying property on their own.
Tenants in Common: A typical way two or more individuals acquire an equal (or unequal) interest in real property. Each co-owner’s interest is separate property.
Joint Tenants: A typical form of holding equal interests in real property by two or more persons. If one joint tenant dies, his or her share generally passes automatically to the other joint tenant by right of survivorship.
Community Property: Also called “Tenancy by the Entirety” in non-community property states. A typical form of holding equal interests in real property by a husband and wife. Even though title is in the community, each spouse’s interest is separate.

The greatest advantage to individual ownership is its simplicity. The costs and record keeping requirements associated with such ownership are minimal. The most notable drawback is the unlimited personal liability for the owner(s) of the property. Liability is unlimited for debts arising out of its operation and for any potential tort liability associated with its ownership and operation.

The tax effect of holding investment property as an individual is that losses from the operation of the property are deducted from the individual's income (assuming the losses are not limited by the passive loss rules) and profits are added to it.

Individual ownership assets, with the exception of joint tenancy assets, can be willed to your heirs.

3. Partnerships

Real estate owned and operated by a partnership may be held in one of four basic forms.

General Partnership: The General Partnership essentially has one type of partner — an individual who has unlimited joint and several liability for partnership obligations. Partners in a General Partnership have unlimited personal liability and also have a mutual agency relationship between them, so that they have equal ability to bind the partnership and to participate in its management.
Limited Partnership: A Limited Partnership is a partnership that differentiates the rights and obligations of its individual partners. The partnership itself is made up of two classes of partners, general partners and limited partners. The general partner in a Limited Partnership has the same unlimited personal liability for the partnership debts and torts as the partner in the general partnership. The limited partner(s), however, in most circumstances are only liable financially and then only to the extent of their agreed-upon capital contribution.
Family Limited Partnership: A Family Limited Partnership (FLP) is a partnership which exists between members of a family. “Family” includes only an individual's spouse, ancestors, lineal descendants, and any trusts established primarily for the benefit of such persons.
Limited Liability Company: The Limited Liability Company (LLC) is for federal purposes a “passthrough” entity like a partnership, but gives the limited liability protection of a corporation to all of its members.

General, Limited and Family Limited Partnerships as well as LLC’s are pass-through entities, with tax consequences being passed through to each individual partner/member. This means that all items of income, deduction, loss and credit will be allocated to the partners/members in proportion to their interests in the partnership.

The partnership form of ownership offers a great deal of flexibility for partners/members who are interested in enjoying different rights with respect to cash flow, liquidation proceeds, profits and losses, management responsibility as well as liability.

Excellent lawsuit protection is afforded the properly managed Limited Partnership, FLP or LLC. That is, if the general partners or managing members are sued and a judgment awarded their creditors, then in most cases their creditors will not be able to go after the remaining Limited Partnership interests. Better yet, the creditors will most likely not be able to go after the property inside the partnership.

If a judgment should be declared against one of the limited partners, then the creditor, in all likelihood, will not want to go after their Limited Partnership interest.

The limited partnership statutes in most states restricts an individual creditor to merely getting a “charging order” against the debtor's partnership interest. The creditor will have no right to demand the dissolution of the partnership. A charging order will give the judgment creditor only a right to the income portion of the limited partner's interest. And since these Limited Partnership interests have no right to income until declared by the general partner, the creditor will be left holding a worthless judgment.

To further frustrate a would-be creditor, some attorneys include a “poison-pill” clause which would force the creditor to report taxable income on partnership earnings that they have no current right to receive.

4. Corporations

Real estate owned and operated by a corporation may be held in one of three basic forms.

C - Corporation: A “C” corporation is a separate legal and tax entity formed in accordance with the requisite formalities required by state law.

The profits and losses achieved by a corporation will not be passed through to its owners but rather will be taxed separately. Because of this, the “C” corporation is not a favored entity for the type of real estate investment which is anticipated to produce tax losses. Similarly, should the “C” corporation generate profits, these profits will be taxed first to the corporation and then, upon distribution, to the shareholders (i.e. double- taxation) as dividends.

S - Corporation: An “S” corporation has a blend of the characteristics that are associated with partnerships and “C” corporations. Specifically, an “S”corporation, like a partnership, avoids the problem of double taxation upon its earnings and also permits the pass-through of losses to its shareholders. “S” corporations, however, are restricted under the law as to the type and quantity of shareholders and as to type of income generated.
Real Estate Investment Trust (REIT): A REIT is a hybrid between a corporation and a trust. Shares in a REIT are viewed as a hybrid between a bond and a stock with special tax advantages. In general a REIT does not pay corporate income tax. The dividends it pays its shareholders are tax deductible to the entity. In order to maintain its staus, a REIT must distribute 95% of its real estate investment income

The most beneficial aspect of owning real estate in the form of a corporation or a REIT is that of limited liability. Since the corporation is a separate legal entity, in most cases it can shield the individual investor(s)/stockholder(s) from personal liability.

A separate attractive characteristic of corporation ownership is that of ease in transferability. Since ownership is reflected by stock, it is much easier to transfer complete and/or partial ownership in real estate.

5. Trusts

A trust is one of the most flexible holding and planning vehicles. A trust can be configured as a “revocable” instrument with characteristics that are very similar to those of outright individual ownership and/or that of a partnership. A trust can also be configured as an “irrevocable” instrument with characteristics that are very similar to those of a corporation and/or that of a limited partnership.

A trust can be described as a contract between three (3) people or groups of people. The Grantor (or Trustor or Settlor) is the person who establishes the trust. The Trustee is the person or entity that manages the trust assets. The Beneficiary is the person(s) or entity(s) that will receive income or corpus during the term of the trust or at its termination.

Living Trust: A Living Trust is created while the trustor is still living and can be revoked or amended during his or her lifetime. Assets in the trust, such as real property, will avoid probate. Without question, this is one of the most powerful estate planning devices in use today.
Land Trust: A Land Trust is used to hold title to real property, identifying the representative capacity of the trustee, but without identifying the other parties to the trust. Under it, the settlor-beneficiaries retain full powers of management and control over the trust property.
Business Trust: A Business Trust is a entity by which individuals may combine their resources to operate a business for profit without the inherent liabilities of a partnership or the double taxation of a corporation. A Business Trust is created when one or more persons transfer the legal title in property to trustees to manage and control the property and to pay the profits to the creators of the trust or their successors.
Bypass Trust: The Bypass Trust or Credit Shelter Trust is an irrevocable trust which is funded at the death of the first spouse using the decedent spouse’s unified credit. This is an excellent estate planning and asset protection tool used to protect real property assets from creditors and the government.
Q-TIP Trust: The Qualified Terminable Interest Property (Q-TIP) Trust allows the first spouse who dies to give lifetime benefits (like income earned) to his or her surviving spouse while still retaining the right to name the persons who will ultimately inherit the trust assets. This too, is an excellent estate planning and asset protection tool used to protect real property assets from creditors.
Disclaimer Trust: The Disclaimer Trust allows the surviving spouse to fund an irrevocable trust with appreciating real property assets while retaining lifetime benefits, like income earned. This too, is an excellent estate planning and asset protection tool used to protect real property assets from creditors. It also helps to minimize total estate taxes paid by taking “double” advantage of the lower estate tax brackets for a high net worth estate.
Grantor Retained Income Trust (GRAT or GRUT or QPRT): The Grantor Retained Income (or use when it comes to a QPRT) Trust is used as an estate planning and asset protection tool, to reduce the value of a gift while transferring all future appreciation of the assets to the beneficiary. In a GRAT or GRUT, the grantor receives a fixed or variable income stream for a fixed period of time. The QPRT allows the grantor use of their personal residence for a fixed period of time.
Private Annuity Trust: The Private Annuity Trust is a vehicle used to delay the gain on the disposition of a real estate interest by allowing the owner to currently dispose of the property without realizing the full capital gains. Variations of this vehicle allow for the transfer of highly appreciated assets to heirs free of estate taxes. In either case, the owner/beneficiary receives a lifetime income stream. This too, is an excellent estate planning and asset protection tool used to protect real property assets from creditors and the government.
Foreign Trust: Foreign Trusts, revocable or irrevocable, are primarily used for creditor protection purposes. The trustee is usually a financial institution located in a tax haven jurisdiction. Given the domestic FIRPTA rules, real estate tends to be an undesirable asset to be held directly by such a trust. Most foreign trusts used to protect domestic real estate holdings are structured with shared appreciation mortgage instruments as their asset(s) under trust.
Charitable Lead Trust: A Charitable Lead Trust is an asset protection, income tax and estate tax planning tool. The grantor transfers an asset to the trustee of the lead trust. The trustee will then pay a fixed or variable income stream to a selected charity for a fixed number of years. A current income tax deduction will be allowed for the present value of the income stream paid to the charity. At the end of the term of years, the asset will pass to the grantor’s designated beneficiaries at a reduced estate tax value. During the term of the trust, the trust's assets may be sold without a capital gain tax liability.
Charitable Remainder Trust: A Charitable Remainder Trust is an asset protection, income tax and estate tax planning tool. The grantor transfers an asset to the trustee of the remainder trust. The trustee will then pay a fixed or variable income stream to the grantor or his or her designee for life or for a fixed number of years. A current income tax deduction will be allowed for the present value of the remainder interest that will flow to the charity. At death or the end of the term of years, the asset will pass to the grantor’s designated charitable beneficiaries free of estate tax. During the term of the trust, the trust's assets may be sold without a capital gain tax liability.

RealTax professionals have the competence and experience to help you decide which holding entity option is best for you. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.