This article was originally published in the June, 2021 AZREIA (Arizona Real Estate Investors Association) Newsletter, available here.
By: Michele Leonelli
So you’re keen to invest in the molten-hot real estate market here in town. Your next question, rightly so, is: “What investment structure should I use?” In order to answer this, you’ll need a solid understanding of the various entity structures, their pros and cons, and the mechanics required to establish each. Don’t worry, we’ve got you covered. Below is an analysis of the 3 most common investment structures we see, and their corresponding features. HOWEVER, this is only an overview – if you’re looking to jump into action, get in touch with us at Phocus Law.
Sole Proprietorship. The sole proprietorship is the easiest investment structure to set up. A sole proprietorship automatically exists when an individual goes into business for themself without forming any legal entity. It requires no government filings and no permissions. As it is just an extension of the individual, there also aren’t any legal agreements or contracts necessary as there would be in the case of a partnership, for example. In a sole proprietorship, the investor would identify the property in which they want to invest and then typically seek a loan from their lender, with the loan being obtained in the investor’s personal name. If the loan is approved, the loan will almost always be secured by a mortgage or deed of trust on the property, as it would be under any entity type. Now, the investor can acquire the property, and if they default on the loan, the lender will take ownership of the property. Sometimes, if the loan is particularly large or risky, the lender will also require that the investor put down other collateral (such as other assets they own). This would allow the lender to quickly execute on the additional assets. However, because the loan is obtained by the individual, unless the investor succeeds in obtaining a “non-recourse” loan, the lender can collect against all of the investor’s individual and community assets. This exposure to personal liability is one of the significant downsides to the sole proprietorship’s suitability as an investment vehicle.
General Partnership. This is a common option for people looking to pool resources, such as money, knowledge, and time, for making an investment. Like with the sole proprietorship, a general partnership doesn’t require any filings or permissions, aside from making a declaration to the IRS that the entity exists as a taxable partnership. Unlike a sole proprietorship, however, the investors will need to draft a partnership agreement. The partnership agreement will be the document that governs their respective rights and responsibilities – it will detail important elements like what each partner’s role is, the nature of payouts from the investment, and the contributions of each partner. One significant advantage of a general partnership over an LLC is that there are very few regulations on how the partners set up and govern their partnership, whereas there are many statutory baseline obligations burdening LLC members.
One of the chief problems with general partnerships as investment vehicles is that they expose their partners to sole and separate liability for the actions that the other partners take on behalf of the partnership. So, if one partner makes a poor decision for the partnership, creditors or claimants could come after the separate assets of any of the partners. To avoid this liability becoming personal, investors can form their own LLCs and have those LLCs be the partners in the general partnership. By doing so, each partner’s liability would cease with the assets held by the partner’s LLC. Be aware that having LLCs as partners in a general partnership will cause a bit of additional complexity in your annual tax returns.
Limited Liability Company. The limited liability company (“LLC”) is probably the most common vehicle for multi-party investments that we see. This is because it is relatively easy to set up, requires few legal documents, provides a fair degree of flexibility (when utilizing a well-drafted operating agreement), and provides a high amount of protection to its members (the LLC term for “owners”) from personal liability. To elaborate, setting up an LLC requires filing the articles of organization, and paying a filing fee. At the same time, the members should agree to the terms of an operating agreement. The operating agreement is the chief governing document of the LLC, and it lays out important information like: (i) who the members are and what their ownership percentages are; (ii) how the LLC will be governed – how decisions will be made; (iii) how and when the LLC can spend or raise money; and (iv) how members can (or must) leave or sell their membership interests. Part of the beauty of the LLC is that state law typically allows a large amount of flexibility for the members to choose the operating agreement terms that best fit their business. With the LLC formed and the operating agreement signed, the LLC can raise money by first obtaining an EIN and opening a bank account, and then allowing its members to contribute capital, or seeking a loan from a lender to pursue their first investment.
Correctly selecting and setting up any of these investment vehicles requires forethought and a deep understanding of the pros and cons of each structure. Are you interested in pursuing one of the above as a way to invest in real estate? Come talk to us at Phocus Law – this is one of our favorite topics and we would love to help you!