New real estate investors need to set up their rental property business in a way that protects them while still being scalable to their investment goals. Creating a business entity this business entity is an important step for real estate rental property investors.
Investors have choices available in how to structure their business entity for management and taxation purposes. Actually establishing the business is one of the easiest steps in stepping into real estate investing. Depending on the structure investors decide to use, setting it up can be as simple as completing an online form and paying the fees.
Is real estate investing a business?
Some people think that renting homes isn't really a business. Financially speaking, renting residential real estate generates passive income. Since most real estate investors don't have to pay self-employment taxes when reporting rental property income, some consider this not to be a business. However, many individuals live off the passive income generated from renting properties. They manage a rental property portfolio and run it like a business.
If the business plan calls to create a rental property portfolio, investors are better off treating it like a business. Chances are you plan on picking a niche or rental property market to focus on. Most investors come up with a strategy to manage and scale the investment portfolio. Investors may hire a property management company to assist with the management and repairs on the rental properties.
Steps before officially establishing your business
Formally establishing the rental investment business entity isn't necessarily the first thing new real estate investors should do. The first issues to tackle include how the investors will find financing, establishing investment business goals, and creating a business plan. Investors should take these steps before filing any official paperwork as the financing and business goals play a role in what business they file to create.
For example, if the investor’s goals for real estate investment are to buy rental properties with the intention of renting them over the long-term, it might make sense to have an LLC for every property or to create an S-corp. Someone interested in a business focused on rehabilitation and short-term resale might find creating LLCs for every property cumbersome. They prefer to establish an overarching LLC to hold all their short-term resale properties.
Getting the right advice
Online real estate investors will find a treasure trove of advice about the different business entities and how to structure a real estate business. We include information on the structures in the sections below. Online research from reliable sources is a starting point, but your best resource when starting a business is to consult with your lawyer, attorney, and/or CPA on protecting yourself and your assets when establishing a real estate investment company. No two investors have the same situations and goals, so personalized advice from these professionals is worth your time and money.
Fortune Builders recommends new real estate entrepreneurs network through local real estate investor clubs to learn how others have established their businesses. New real estate investors need to establish efficient management systems, possibly hire a manager, find reliable vendors, and watch their finances. Finding mentors who have been there before increases the investor’s chances of success.
Establishing a legal entity as a real estate investor
Once an investor finances and buys their first real estate investment property, they have started a real estate investment company, even if the purchase was executed under their personal name as a sole proprietor.
However, operating as a sole proprietor puts the investor’s personal assets at risk. The earlier investors can incorporate their rental property business, the more protected they are from liability and loss. Plus, formally creating a structure at the beginning makes scaling later a little easier. Transferring a property title from your personal name to business can be a complex and costly process.
What business entity is best for a rental property business?
When it comes down to formally establishing a structure for a rental property business, investors have to consider the legal and tax implications of the different structures available. These decisions could mean the difference in thousands of dollars paid to IRS or in how personal property is protected from liability claims.
#1- Sole proprietor
A sole proprietor is the simplest form of business. The operator engages in a business activity without any formal organization.
Starting a real estate investment company as a sole proprietor doesn't require the investor to file any paperwork with the state of Texas. This allows the investor to legally engage in business without formally establishing an entity. However, if the investor plans to do business under assumed name, they do need to file an assumed name certificate (also known as DBA, “doing business as”) with the County Clerk's Office where the business will operate.
Even if real estate investor doesn’t need to formally file for a business under a sole proprietorship, if the business plan includes hiring employees you’ll need an Employer Identification Number (EIN) for tax reporting purposes with the IRS. Do this online at the IRS website. Having an EIN serves a dual purpose if the investor wants to open a business bank account.
While it’s relatively easy to get going with a sole proprietor structure, it is not a legal entity. It leaves the real estate investor directly responsible for business actions, including all debts. The investor is personally held liable meaning personal wealth is potentially at risk. Judgments in any litigation could freeze personal bank accounts and result in the seizure of personal property.
#2- General partnership
When two or more people decide to carry on a business for profit, they can establish a general partnership. This partnership generally operates in accordance to a partnership agreement, but Texas has no requirement that this agreement has to be in writing or filed with the state.
Should the partnership be conducted under an assumed name, the partnership will need an assumed name certificate (DBA) to be filed with the county clerk's office where the business is maintained.
#3- Limited Liability Corporation (LLC)
A common choice for real estate investors, the limited liability corporation or LLC has few regulatory reporting requirements while still establishing a formal business structure that protects an investor’s personal assets. LLCs can be established by individuals, partners, and groups.
One advantage to an LLC is that if someone files a lawsuit, only the assets owned by the LLC are at stake. Another benefit is the pass-through taxation. All income made by the LLC flows through to an investor’s individual tax return without being taxed as business income first. This minimizes the amount of money taken out of the income for taxes.
According to Legal Zoom, a single-owner LLC could deduct mortgage interest similar to sole proprietor. They could “avoid double taxation on both the rental income generated by the property and the appreciation in value of the property upon disposition.”
Establishing a rental investment business as an LLC allows the investor to open separate bank accounts from personal accounts. Using separate accounts simplifies claiming business expenses when it's time to file federal taxes.
Since LLCs have structural flexibility and favorable taxation, real estate investors can set up their business in different ways. Consult with law professionals familiar with setting up business entities regarding if an LLC is the best choice for you and their recommendations for a business structure based on your investment goals.
To start an LLC in Texas, first conduct research to see what business names are already taken. The business name must include the phrase “limited liability company” or an abbreviation like “LLC.” Some restricted words that require additional licensing before they can be part of an LLC name.
All LLCs must nominate a Texas registered agent for the business. A registered agent is an individual or business entity responsible for receiving legal documents on behalf of the business. For an individual LLC, this would be the investor.
An LLC’s owners are called “members.” Texas requires owners indicate when filing if the LLC will be member-managed or manager-managed. The first option is ideal if the LLC has a small number of members in close proximity that are able to host frequent meetings and document signings. Manager-managed is when the LLC’s members do not wish to be involved in the daily management of the business entity.
Texas does not require LLCs file an operating agreement, but having one is always a good idea.
Once the investor is ready, establish the LLC by filing a certificate of formation either online here or by mail. As of 2019, there was a $300 non-refundable state filing cost.
An LLC will need the EIN for federal tax purposes, to open business bank accounts, and hire employees.
Texas considers corporations to be, “a legal person with the characteristics of limited liability, centralization of management, perpetual duration, and ease of transferability of ownership interests.” The owners are called “shareholders” while the people who manage the business and its affairs are called “directors.” Texas corporate law does allow for shareholders to eliminate the directors through shareholder agreements.
Most corporations are owned by shareholders, managed by a board of directors, and administered by officers.
Real estate investors have two choices when it comes to setting up a corporation: the “C-corp” and “S-Corp.” The main difference lies in taxation.
Texas does not regard S-corporations any differently from C-corporations. In its point of view, electing to be an S-corporation is a federal tax election. Real estate investors considering this route should consult with the IRS or taxation legal counsel.
From a federal taxation perspective, the S-corp tax treatment is generally more favorable. The corporation is a pass-through entity similar to an LLC. The company does not owe any tax liability. Its stock is transferable. Shareholder owners can sell their ownership interest without the approval of other shareholders.
The S Corporation does have some limitations. It cannot have more than 100 shareholders and it must be a domestic business entity. All the shareholders must be US citizens or legal residents of the United States. The IRS goes into detail about the requirements to obtain the S-corporation status here. Gain some idea how IRS treats S-corps with Form 8825, Rental Real Estate Income and Expenses of a Partnership of S-Corporation. This form is useful for determining an investor’s tax liability.
If an S-Corp sounds appealing to you, find further information about S-corporations and how to structure their taxation more favorably for investors.
The C corporation, or the C-corp, is typically better for larger businesses. It allows for the business to publicly trade shares through an initial public offering (IPO). This makes the business more attractive to potential investors and shareholders because it allows for a wider ownership in the business.
The biggest difference between a C-corporation and an LLC is how the income is taxed. The C-corp files a separate tax return. Profit does not flow through to the business owner or shareholders as with an LLC or an S-corporation. The business must pay corporation tax on any earned profits. Some of its profits can pass to shareholders as dividends.
Forming a corporation in Texas
To create a “C” or “S” corporation in the state of Texas requires filing a certificate of formation with the secretary of state. This can be done 24/7 online in SOS Direct or by mail. As a corporation, the filing must include:
- Names and addresses of organizers
- Names and addresses of directors
- Registered agent and registered office
- Corporate purpose
- Stock structure
- Duration of the corporation, if not perpetual
The company name must include the words “company,” “corporation,” “incorporated” or “limited.” As with an LLC, investors must verify their chosen name is not taken in Texas.
Corporations need to file Form SS-4 for an EIN number. The IRS has a useful reference page about forming a corporation, income tax, excise taxes, and employment taxes.
Structuring your rental investment business
How have real estate investors used these business entities to set up their businesses?
#1- Individual LLCs per property
One common method real estate investors use and lawyers support is to create an LLC for each individual property in the rental portfolio. This allows investors to take advantage of an LLC’s taxation benefits while minimizing the risk. For example, if the investor owns three rental properties under one LLC umbrella, all three of those properties could be at risk if the organization faces a liability lawsuit. The downside is the larger the rental investment portfolio, the more complicated tracking each individual LLC might become.
#2- The 3-part structure
For real estate investors planning to dabble in real estate rehabilitation and long term rental investment properties, Royal Legal Solutions proposes a three-part company structure. The thought is this structure could reduce your tax burden and your liability. The business is set up like so:
- Operating Company: This is generally a corporation created to shield the real estate investor from personal liability
- The buy-and-hold LLC: this organization is for the properties held for longer than a year and structured to be friendly for long-term capital gains taxation
- The fix-and-resale LCC. This organization is for properties intending to be held less than a year.
The thought process behind this structure is to not put all your eggs in one basket. By keeping everything separate, the investor creates some anonymity and protection from lawsuits. A similar structure if can be followed for real estate investors not planning on creating a fix-and-resale LLC. Create an operating company that oversees the individual property LLCs.
Handling the management
Regardless of how the real estate investment business entity officially classifies, all investors face regulatory requirements. Investors will pay taxes and insurance on the property, make sure it is up to code, consider zoning issues, and qualify tenants. Investors acting as landlord must comply with Texas State Law on renter’s rights.
As the real estate investment portfolio grows, investors find they need assistance with the workload. Property managers allow real estate investors to grow their portfolio without adding the additional work behind managing the rental property. The manager oversees the property maintenance, marketing, and tenant screening. Hiring a property manager for the real estate company or portfolio influences the business structure that investors choose to put into place.
An alternative option is to hire a property management company to perform the same functions for a percentage of the property rent.
Using real estate agents
Starting a real estate investment business is a big step. It helps to have a partner familiar with the real estate market and the industry.
A local real estate agent will give sound advice on stepping into the real estate investment business. They can give new investors ideas on what areas have increasing demand and what current buyers or tenants are looking for in their properties.
Real estate agents cultivate extensive networks useful for real estate investors. They can put you in touch with qualified real estate lawyers and taxation professionals with experience assisting real estate investors.
In short, a real estate agent will be a long-term partner in growing your real estate investment portfolio. You want someone who works with investors and is willing to give you realistic numbers about a property’s potential. At Chicotsky Real Estate Group, we help Fort Worth real estate investors source the best properties for their investment goals. Please see our other resources about rental properties.