Starting a real estate holding company has become a time-honored tradition of today’s most prolific entrepreneurs. If for nothing else, there are few vehicles capable of protecting a new business owner both from themselves and the malicious intents of others.
Truth be told, a real estate holding company can be intimidating to first-time business owners, and for good reason. A holding is the legal foundation on which your entire company will be built. It is worth noting, however, that starting one is not as daunting as it may seem. Yes, it is integral to the start of a business, but that doesn’t mean you should be intimidated. Instead, investors should mind due diligence and embrace the many advantages a holding company can provide.
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What Is A Real Estate Holding Company?
A real estate holding company is a legal entity designed to protect business owners from the risks that come with owning investment properties. Real estate holding companies, also known as limited liability companies (or LLCs), do not participate in business operations themselves but own different assets. The purpose of this structure is to essentially prevent business owners from being personally responsible for debts or other liabilities incurred by the entity, thus the name “limited liability.”
Although the enactment of LLCs can be traced back to the 1970s, real estate investors have largely begun to take an interest in the past decade’s benefits. They are now often used as a tool to reduce personal exposure to monetary and legal risk. Through a holding company, owning investment properties is also known to create significant tax benefits, and ease of administration when compared to other legal entities.
While real estate holding companies are not the only way to protect a business, most investors find the benefits to be the most accommodating. In other words, if you want to learn how to start your own business, it could not hurt to look into forming one for your protection.
Who Needs A Real Estate Holding Company?
A real estate holding company is typically a great choice for short-term and long-term investors. Any real estate investor can benefit from protecting their personal assets from any business liability, and it’s also smart to keep your real estate income separate from your personal income. Holding companies are relatively inexpensive to start, and the benefits generally outweigh the cost and upkeep to maintain them. Note that you do not need to start an LLC if you’re just purchasing a home as your primary residence.
There are a few real estate investing niches that could especially benefit from a real estate holding company. These include fix-and-flip investing, passive income investors, and those involved in commercial real estate. First-time investors may also benefit from an LLC, as it can provide additional legal protections. No matter your investment strategy, learn about the various ways a real estate holding company could benefit your business before deciding.
Do Holding Companies Pay Taxes?
Holding companies do pay taxes, though they can vary slightly depending on the organizational structure. For example, a holding company with one business owner will typically be treated as a sole proprietorship. This means the entity itself is not required to file with the IRS, and instead, owners will need to report all profits (or losses) in their tax paperwork. On the other hand, a two-person LLC will be treated as a partnership. This means each owner will be responsible for paying taxes on their share of the returns. For more specific information on how a holding company is taxed, be sure to consult a professional with any questions.
Holding Company Structure
Generally speaking, the holding company’s structure will look something like this: the holding company or LLC is at the top, and individual subsidiaries exist underneath it. For real estate, the subsidiaries will typically be investment properties. The holding company itself will not have a hand in day to day operations of each property but will instead serve as a parent company. There are several benefits to utilizing this structure, which we will discuss below.
Real Estate Holding Company Example
An example real estate holding company may help illustrate what this business structure would look like. In this example, I want to start Business Holding Company, LLC. After I follow the necessary protocol (filing with the state, paying fees, etc.) I decide to purchase an investment property. The property will be owned under Business Holding Company, LLC, with a property manager in charge of operations.
Let’s say I purchased an apartment complex before starting Business Holding Company, LLC. In this case study, I now want to move that property into my newly formed LLC. To do so, I would obtain a deed, file the necessary paperwork, and then transfer the property ownership. I would also update any documents that need to reflect the change in ownership, like tenant agreements and leases.
Now, I have two properties operating under Business Holding Company, LLC. The holding company’s balance sheet would then reflect the combined operating income, liabilities, and ROI. As an owner, I would be responsible for oversight and support. While this is an oversimplified example, it can serve as an overview of what a real estate holding company might look like.
Why Start A Real Estate Holding Company?
Setting up a real estate holding company has become increasingly popular in the last decade, and for good reason. By incorporating their businesses, real estate investors can gain access to unique benefits and enhance the long-term health of their businesses. Real estate holding company benefits include, but are not limited to, the protection of investors from personal liability, pass-through taxation, and the building of credit for your business.
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Holding companies can protect business owners from liabilities and debts incurred by their properties.
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A holding company prevents double taxation on investment properties.
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The business structure allows investors to more easily manage their properties.
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As a whole, LLCs pay less fees when compared to corporations.
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Holding companies provide investors with more flexibility to distribute their profits.
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Real estate investment company enables investors to purchase properties in the U.S. and abroad.
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A holding company is more easily transferrable than other entity types.
Furthermore, those wondering how to set up a real estate holding company will be pleased to find out that they are relatively easy to register. The sections below will expand upon each of the main benefits, along with some of the lesser-known perks.
Limits Personal Vulnerability
Investing in real estate is a rather lucrative career choice. Traditionally, there is a lot of money involved in every deal—at least more than the average individual can cover on their own accord. Having said that, it is absolutely imperative for respective investors to protect their personal finances (those outside of their business finances). First and foremost, LLCs limit personal vulnerability to potential lawsuits related to the property, which is perhaps the most intriguing aspect of starting a holding company.
Any lawsuit against an LLC is aimed specifically at the company, not the individual responsible for it. If an LLC owned the property in question, the owner’s risk exposure would be insulated by the company’s protection, leaving only the assets owned by the LLC (as opposed to all of the owner’s assets) exposed to potential lawsuits. In other words, personal finances would not be in jeopardy.
Pass-Through Taxation
Assuming liability coverage is the most important factor in forming a real estate holding company, taxes are a close second. In fact, some real estate investors consider framing their business structure as an LLC based solely on tax benefits. Liability protection may be a bonus to some.
A 1988 court ruling enabled real estate investors to avoid double taxation by acquiring property through LLCs. As defined by the default tax classification rules, the Internal Revenue Service (IRS) classifies a real estate holding company with one owner, in the same way they would a sole proprietorship, otherwise more commonly referred to as a “disregarded entity.” Accordingly, any income and capital gains generated by the business would transcend to the owner, who, as a result, would only have to pay taxes as an individual. However, the respective owner still enjoys protection against liability. It is the best of both worlds.
Seeing as how there is no separate tax accompanying the formation of an LLC, business owners are in a position to avoid double taxation. Neither the rental income generated by a property nor the appreciation in value upon disposition incurs tax penalties. Additionally, the owners of a single-member LLC can use mortgage interest as a deduction around tax time. In forming an LLC, you are not only subjected to fewer taxes, but you are awarded more deductions.
However, real estate companies owned by more than one person are viewed differently in the eyes of the IRS. Otherwise known as “multimember” LLCs, these business entities are taxed similarly to a partnership. Multimember LLCs also enjoy the benefits of pass-through taxation as the LLC passes its profits and losses through to its members. Each respective owner is then responsible for reporting their share of the profits (or losses) on either a Schedule C, K, or Form 1065 with their individual income tax returns.
As the owner of a real estate holding company, single-member or multimember, you are entitled to pass-through taxation benefits. Again, all of these tax benefits are in addition to the liability protection shield that was previously discussed.
Additional LLC Benefits
Real estate holding companies came to prominence approximately 10 years ago, as real estate investors were made privy to the upsides they offer. However, there is more to this designation than meets the eye. Real estate holding companies are relative to other legal entities that, while not unique, apply to the use of LLCs when holding real estate assets. Those perks include, but are not limited to the following:
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Ease Of Management: The structure presented by an LLC makes delegating management responsibilities and positions a lot easier. Whereas a corporation is statutorily required to have officers and directors, LLCs are free to be managed by their owners, or even a third-party.
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Cost: There are a lot of states that impose additional fees on the authorized number of shares a company has. While LLCs are still subject to these fees, they may pay less than corporations. State registration and maintenance fees are therefore lower for businesses structured under an LLC.
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Flexibility: LLCs award real estate investors the ability to exercise incredible flexibility during profit distribution. Unlike that of an S Corporation, LLCs do not have to be pro-rata (in proportion) in the distribution of cash flow. In other words, an LLC member can financially reward the “sweat equity” put forth by a specific individual.
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Versatility: Unlike that of an S Corp, LLCs promote foreign ownership and investment in U.S. real estate.
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Transferable: The structure of a holding company makes it easy for anyone to transfer ownership. Real estate holdings can be “gifted” to heirs each year without actually going through the process of signing a deed. In fact, gifting property allows owners to avoid certain taxes.
How To Start A Real Estate Holding Company
Starting a real estate holding company is not as complicated as it may seem. Investors can familiarize themselves with the process and get started today. Here is a step by step guide to starting a real estate investment company:
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Choose a business name: First and foremost, you will want to research your state’s rules on setting up an LLC, such as through this guide provided by the U.S. Small Business Administration. The first step is selecting a business name, which will always be followed by a comma and the letters “LLC.” Make sure to run a search to make sure that your desired business name is not already taken.
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File the “Articles of Organization”: Once the business name and business address are determined, a document entitled the “Articles of Organization” must be filed with your state’s LLC office typically the Secretary of State. The document is often available as a simple, fillable form found on the Secretary of State website, along with submission instructions. Once prepared, the document can be submitted by mail or in-person with a filing fee.
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Create an Operating Agreement: An operating agreement outlines the roles and responsibilities of each member of an LLC. This document does not need to be formally filed with the state, but it should document how the business will be organized and run internally. An operating agreement may include the method of choosing managers, rights and duties of members, ownership and operation rules, voting procedures, members’ percentage interests, and how profits or losses are distributed.
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Publish your intent to file: Although required only by a few states, find out whether or not you are required to publish an intent to file through your local newspaper. Otherwise, your LLC is considered officially formed once your Article of Organization are accepted and approved by your Secretary of State.
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Obtain required licenses and permits: Once your business has officially been set up, you can take your process a step further by obtaining any business licenses and permits that might be required. Also, do not forget to apply for a tax identification number through the IRS for your new business.
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Real Estate Holding Company Vs Other Legal Entities
Business owners are aware of the vast amount of legal entities they may structure their companies under. While more recognizable than the average legal entity, an LLC for real estate investment is but one of several options. In fact, due to their recognizable nature, most business owners choose an LLC structure because they are unfamiliar with the many legal nuances associated with other options. Others assume LLCs are the best way to go. In reality, no one entity encompasses or covers the needs of every business. While most real estate investors favor LLCs, there are other options available. While different in their own right, corporations and partnerships share many similarities. The following is a breakdown of other legal entities:
C Corporation
A corporation stands alone as its legal entity, and protect their owners from personal liability for corporate debts and obligations. By default, corporations are taxed on multiple levels (corporate tax and income tax). The advantages of a C Corporation are as follows:
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Owners are only personally liable up to the amount invested in the corporation.
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Owners have the option of either participating as a manager or solely as a passive investor.
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There is no limit on the amount of shareholders a corporation can have at a given time.
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The transfer of ownership is relatively easy. All an owner has to do is sell their shares.
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Corporations transcend the life of their owners. Despite the loss of an owner, the corporation will continue to exist.
S Corporation
An S Corporation is created under state law, much like the C Corporation. However, unlike a C Corporation, it elects to be treated as a pass-through entity for tax purposes. Moreover, S Corporations are not subjected to double taxation because of the nature of a pass-through entity. The advantages of an S Corporation are as follows:
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S Corporations are privy to many of the same benefits exercised by C Corporations.
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Thanks to a special tax election, S Corporations avoid double taxation.
Sole Proprietorship
While not officially considered to be a separate legal entity, a sole proprietorship is the simplest form of business. In fact, by default, once you start a small business, you become a sole proprietorship. Having said that, there is no separation between the business and the individual—the two are synonymous. The advantages of a sole proprietorship are as follows:
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There is no paperwork to get started.
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Lowest initial costs of all legal entities.
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No extra tax filing requirement, as profits or losses can be reported on the owner’s tax return.
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The business is reliant upon one individual.
Real Estate LLC Vs Liability Insurance
Perhaps you are not sure if forming a holding company for real estate is the right fit for you, or perhaps you are considering taking out an insurance policy instead. Rightly so; just because holding companies offer a multitude of benefits to real estate investors and their particular industry does not mean they are the right choice for every investor. Keep in mind that the field of real estate investing is incredibly diverse, and it would be nearly impossible to find one legal entity that protected every business. Having said that, many investors believe the threat of a theoretical lawsuit does not warrant the commitment required to start an LLC. Those of this school of thought may be more inclined to inquire about affordable liability insurance.
Having said that, entrepreneurs that rely solely on insurance as a means of protection take on ill-advised risks. It is not uncommon for the average liability insurance policy to have limitations, exceptions, and addendums that convolute coverage. Simply put: liability insurance does not cover all your corners. While the chances of a lawsuit being filed that exceeds your policy’s limitations are remote, they are by no means impossible. However, of particular concern are the devastating effects resulting from a lawsuit not covered by your policy. If your policy does not cover a situation, the consequences can be detrimental.
Current laws make the prospect of forming a real estate holding company very intriguing to real estate business owners. While they may require more effort on your part, there is no denying the positive impact on a business. They provide a lot more protection for business owners than liability insurance. But the real benefit is peace of mind. Investors can sleep comfortably knowing they are safe.
Starting A Real Estate Investment LLC Next Steps
Now that you have set up your company, you may be wondering what to do next. The steps outlined below are mechanisms that will help protect your business in more ways than you could possibly imagine.
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Obtain an Employee Identification Number (EIN).
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Get your business licensed and permitted.
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Open a separate bank account.
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Apply for a business credit card.
Get started by establishing an employer identification number (EIN), otherwise referred to as a federal tax ID, a unique number assigned to businesses by the Internal Revenue Service (IRS). When applying for your EIN, you will need to provide the type of entity you are starting and the date it was founded. Obtaining an EIN is required by the IRS and will allow your LLC to open a business bank account, protect against identity theft, and build credibility as a sustainable business.
Not unlike the federal tax ID, applying for a business license or permit is not associated with the same process of forming an LLC. That means you will need to remain diligent in your efforts to run a legitimate business and file for a business license or permit on your own accord. Consequently, there is a fine for operating a business without them. To help clear things up, SBA.gov has identified state-specific license information. However, to be certain, be sure to contact your local municipality and follow their recommendations. If you have already formed an LLC, you are required to open a separate account. In doing so, you separate your finances from your business finances, which can go a long way in asset protection. Simple as it may be, diversification is a viable protection strategy.
In the same vein as opening a separate bank account, newly acquainted LLC owners will want to apply for a company credit card. This is to maintain the “corporate veil” that protects your assets and differentiates business expenses from personal ones. Having a company credit card essentially eliminates the possibility of record-keeping confusion and placing all of your eggs in one basket.
Costs of Setting Up A Holding Company
The cost of setting up a holding company for your real estate investments will vary based on which state you live in. If you’re setting up the LLC yourself, the average state filing fee is between $10 to $800. If you’re working with an attorney or financial planner, they will charge you for their time. In addition, you’ll be responsible for paying an annual fee, which ranges from $0 to $800 depending on your state.
Summary
As a real estate investor, you should be aware that your particular industry is prone to risk. Without sounding too negative, there is simply no way to eliminate all risks associated with starting a real estate investment company. However, with the right education and legal designation, you can effectively mitigate a great deal of risk. Accordingly, complying with the formalities set forth by an LLC will protect your business from many threats.
After having gone over the basics, you now are equipped with an understanding of the benefits of starting a real estate holding company, how they compare to other legal entities, the difference between an LLC and liability insurance, and which option is best for your business. Once you have decided that setting up a real estate holding company is right for you, be sure to review the general steps, and your business will be up and running (and protected) in no time.
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