You’ve decided that it’s time to try your hand at real estate investing. You’ve read about the potential tax savings and you want to give it a try…great! But before you jump in, there are a few important things you should think about to ensure you’re protecting your personal assets and optimizing your tax position.
One way to protect yourself is to form a business entity to shield your assets and maximize tax advantages. Choosing an entity type can be complicated, and a wide array of factors will influence which type of entity is best for your unique situation.
Here are 5 mistakes to avoid when forming an entity for your real estate business:
- Choosing the wrong type of entity – What type of entity is best for your situation? An LLC? An S Corp? A C Corp? What are the potential tax implications of each type? What are the operational advantages of the various entity types? What is your exit strategy? How long do you plan to hold your investments? Do you plan to wholesale? Flip properties? Buy and hold? Each of these strategies may require a different business entity. Advice abounds on all sides, but this isn’t a one-size-fits-all choice. Sit down with an experienced professional to discuss your situation and requirements.
- Incorporating in the wrong state – After you have decided how you will incorporate, the next important question is: Where? The state where you incorporate your business can have a significant impact on your tax situation. It may also have an impact on reporting and regulatory compliance requirements.
- Not setting up a proper operating agreement – The operating agreement is your business’ “rules of engagement.” Another way to think of it – if your business was a computer, your operating agreement would be the OS. It spells out how the entity is to be constituted; how it will be operated and how it will eventually be disposed. Thought and careful consideration need to be put into the creation of the operating agreement, and if you’ve never created one before (and even if you have,) it’s a good idea to engage a professional to walk you through the factors which should be considered.
- Comingling of funds across entities – If you already own a business, you may be tempted to use monies from your current business to fund the creation of your new enterprise. However, it’s advisable to develop and maintain a strict firewall between businesses. Failing to do so can have potential tax and liability issues for both entities.
- Failing to consider if multiple entities are required – There may be advantages to creating your business in multiple entities, especially if you plan on owning a lot of properties or properties across multiple states. Having multiple entities may make it easier to comply with state tax filing requirements. They may even prevent your entire portfolio from being put at risk in the event of an accident or adverse event at any single property. It’s also advisable to have different entities if you have different real estate investment types. For example, “fix and flip” businesses have different needs than buy-and-hold rental businesses.
There are many factors that should be considered when organizing your real estate business, and these are just a few. If you’re ready to begin your real estate investment journey and need guidance about setting up your business, let’s talk.
