Options for owning real estate: choose carefully.
This article provides a brief overview of the most common options. Joint TenancyIn a joint tenancy, two or more people own equal, undivided interests in the property. The main advantage of this form of ownership is the right of survivorship: If one owner dies, his or her share passes automatically to the surviving owners, without the need for a will or probate. Also, an individual joint tenant can trade his or her interest in a tax-free Sec. 1031 exchange. Partners, shareholders, and limited liability company (LLC) members generally can't complete a 1031 exchange of their interests in the entity (although the entity can complete an exchange of the underlying real estate).
There are several disadvantages, though:
* Each joint tenant is assumed to have an equal share, so there's no flexibility in allocating capital and profits interests.
* The owners must share control: Sales and other actions require the consent of each joint tenant.
* Each joint tenant is "jointly and severally liable" for the mortgage and other property-related debts. In other words, if the other parties don't pay, you're personally liable for the entire amount.
* There may be negative tax consequences when an interest passes through right of survivorship.
This form of ownership provides a simple, effective way for multiple real estate investors to pool their resources. Each tenant-in-common owns a separate, undivided interest in the property. This means that each co-tenant has the right to possess the entire property and co-tenants cannot exclude each other from the property. Tenancy-in-common interests need not be equal--typically, they're in proportion to an owner's capital contribution--and there's no right of survivorship (unless the parties agree otherwise). Owners are free to sell their interests, borrow against them, use them in a 1031 exchange, or pass them on to their heirs. A transferee becomes a co-tenant along with all the other co-tenants.
Tenants-in-common share profits and losses according to their respective interests. Generally, they're liable only for their share of property-related expenses and debt, unless the co-tenants agree otherwise. Typically, lenders require co-tenants to assume joint and several liability for the mortgage.
A disadvantage of tenancy-in-common is that co-tenants have a limited ability to conduct business as a group. Otherwise, they risk being treated as a partnership.
Holding real estate as a partnership is more complicated and expensive than joint tenancy or tenancy-in-common. Because a partnership is a separate legal entity, you'll have to draft a partnership agreement, file various documents with the state, and file annual partnership income tax returns. But partnerships offer several significant advantages. They're "pass-through" entities, so there's no entity-level tax. Instead, all income, loss, deductions, and credits are passed through to the individual owners and reported on their tax returns.
Partnerships also offer a great deal of flexibility to allocate profit and loss according to criteria other than ownership interest. For example, suppose that Adam, Brian and Carl form a partnership to own and manage a rental property. Adam and Brian each contribute 40 percent of the capital. Carl contributes only 20 percent but agrees to manage the property. Although Carl has a 20-percent capital interest, the partners can agree to allocate more of the partnership's profit or loss to Carl in exchange for his services.
Another big advantage of partnership is that partners can often deduct losses that exceed their investments in the partnership. The reason for this is that a partner's tax basis generally is increased by his or her share of the partnership's debt. If the real estate is refinanced, any additional mortgage debt increases the partners' basis, and the refinancing-proceeds can be distributed to the partners tax-free to the extent of their basis. C corporations and S corporations don't provide this advantage. Limited partnerships and LLCs do, although the benefits may be limited under certain circumstances.
The biggest disadvantage of partnership is that partners are personally liable (jointly and severally) for the partnership's debts. C Corporation
C corporations offer two main advantages:
* Liability protection-A shareholders' liability is generally limited to his or her investment in the corporation; and
* Ease of transferability --It's generally easier to transfer stock than it is to transfer a partnership interest.
But these advantages come at a steep price: Corporate profits are taxed twice--once at the entity level (corporate income taxes) and again when profits are distributed to shareholders as dividends. Also, unlike partnerships, corporations have no flexibility to separate capital and profits interests, and shareholders receive no current benefits from the corporation's losses, credits, or other tax attributes.
An S corporation combines the liability protection of a corporation with the pass-through tax treatment of a partnership. But while it avoids double taxation, shareholders are restricted in their ability to take advantage of corporate losses and tax credits and, like a C corporation, there's no flexibility in allocating profit and loss. In addition, S corporations have a number of tax disadvantages, including restrictions on the number and type of shareholders.
Limited partnerships also combine liability protection with pass-through tax treatment. Although general partners remain personally liable, a limited partner's liability is generally limited to his or her investment in the partnership. A limited partnership has a partnership's flexibility in allocating capital and profits interests, but limited partners are strictly limited in taking advantage of partnership losses and tax credits.
Another disadvantage is that limited partners cannot participate in managing the partnership in any meaningful way without losing their liability protection.
In recent years, the LLC has become a popular entity for holding real estate. It comes closer than other pass-through entities to combining corporate limited liability with the lax advantages and flexibility of a partnership. LLC "members" are shielded from personal liability regardless of their level of involvement with management. And LLCs have a partnership's flexibility in allocating profit and loss.
Also, as in a partnership, LLC members can deduct losses that exceed their investments in the entity. To fully deduct losses, however, LLC members may need to take additional steps to ensure their share of debt is "at risk." There are several ways to do this, including pledging non-business property as collateral for the mortgage or structuring the mortgage as "qualified non-recourse financing."
Consult Your Advisors
These are some of the options available for owning real estate. Others include tenancy by the entirety (which offers creditor protection for married couples), trusts, and real estate investment trusts (REITs). Your advisors can help you determine which form of ownership is best-suited to your needs.
BY: MARC WIEDER, CPA, PARTNER--ANCHIN, BLOCK & ANCHIN LLP
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|Comment:||Options for owning real estate: choose carefully.|
|Publication:||Real Estate Weekly|
|Date:||Jun 26, 2013|
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