How LLCs can help or hurt your real estate investing business, part two.
Last month’s article discussed how a separate tax-paying entity can help the real estate investor appear more bankable. Here are two more important considerations.
#2 Using Disregarded LLCs to Hold Multifamily or Commercial Real Estate
It’s tempting to set up an LLC for asset protection and at the same time treat it as a disregarded entity for tax purposes (a disregarded LLC is ignored for tax purposes) so you can avoid the annual CPA cost of filing an additional tax return. This penny-pinching investing strategy will cost you down the road when the time comes to exit your investment. When selling commercial/multifamily property held in an LLC, the buyer’s lender will ask for copies of the entity’s two last filed tax returns. The underwriter will use the tax returns to verify the property’s income and expenses. If you set up a disregarded LLC, you will not have a separate tax return to provide the underwriter so the risk factor of making this loan increases. You may find your buyers fall out of financing and as a result, you are forced to owner carry. This is never a good move because it prevents you from engaging in a 1031 and it runs the risk your buyer does not know how to operate the property and you end up taking it back and starting the rebuilding process anew. This same issue will come up if you seek to refinance. When setting up your LLC you should be thinking down the road and keeping your plan flexible and your options open.
#3 Not Keeping a Clean 1040 Schedule E
Any investment real estate you own in your personal name or in a disregarded LLC will show up on your 1040 Schedule E on page one. If you hold real estate through an LLC treated as a partnership or S-Corporation for tax purposes, it will appear on your 1040 Schedule E page 2. What is the distinction and why does it matter to you? The difference really comes down to how underwriters calculate your income or how institutional lenders evaluate your experience. From the lenders’ perspective, the simplest way to explain the difference is k-1 income from rentals is typically calculated at 100 percent while rentals held in your own name of through disregarded entities will be calculated at 75 percent.
This difference can make or break your debt-to-income ratio. From the institutional lender perspective, when you are seeking to put together larger deals you want to look like an experienced investor. Number of properties owned, length of investing, and how your tax returns and overall structure looks can make these deals come together. Experienced investors typically invest through partnerships (LLCs taxed as partnerships) and this is carried onto their tax returns. New investors or accidental landlords typically hold rentals in their own name. So how do you want to be perceived? When you start working on larger deals looking like the experienced investor can only help you in building your investing portfolio.
These comments are generally geared toward traditional lending (e.g., Freddie/Fannie products). Having a relationship with a portfolio lender will change some of the analysis for you but the purpose of entities should be to help you achieve your investing goals. How you set up your structures will have an impact and the question you should ask yourself is do you want your planning working for or against you? If you would like to attend one of our 3-Day Tax and Asset Protection Workshops for Real Estate Investors, register as a Think Realty subscriber.
Learn more about Anderson Business Advisors at andersonadvisors.com.