Creating a real estate holding company
The role of a real estate holding company is to facilitate property ownership in terms of business and legal procedures. You can secure your real estate and other assets of your company by conducting all the business operations under its name.
What is a holding company and the reason to create it
To define holding company we can say that its only role is to own assets – it doesn’t produce goods or provide services. However, it is useful when you want to engage investors or take a bank loan – you can apply for the mortgage in the name of the company.
Another reason to form a real estate holding company is to protect your personal assets in case of an accident. If someone gets injured on the property owned by the holding company, then the company is liable for any legal claims, and not you as an individual.
Most of the real estate holding companies are created as limited liability companies, i.e. LLC. By establishing an LLC, you can protect your business while filing your income on the personal tax return. In order to create a real estate LLC, you need to submit a Certificate of Formation (in some states called the Articles of Organization) to the Secretary of State or other company register office in the state where your company will be located.
You will also need to pay the fee which ranges between $50 and $200, depending on the state regulations. Most states will require registration renewal each year, accompanied by renewal fee. In order to make your company’s transactions lawful, you’ll need to request the tax ID number from the IRS.
Here is the example of how you can benefit from owning a real estate holding company. Let’s say you purchase the property where you want to open a café named “Go-To Café”. However, you don’t want to take any liability risks with your café, so you establish a holding company named “Café Lot, LLC” under which you buy the property. Now, let’s say a guest suffers an injury while on your property.
They’ll be able to take legal actions only against Café Lot, LLC, which will bear the cost, but not against Go-To Café. This way, you’ll be able to continue operating your business without interruptions, while the holding company takes responsibility for the accident.
Although there are numerous benefits in owning a holding company, there are still some risks to it. For example, there are fees and taxes to be paid and papers to be kept in order, along with managerial complications that can be intimidating for a rookie investor. In case you don’t have any experience in forming and operating a company, it would be smart to hire an attorney and minimize the risk of failing to abide the law in any way.
Some investors choose Liability Insurance over LLC
For some people, it is too much of a hassle to deal with all the paperwork that forming and managing a holding company requires, so they opt for more affordable liability insurance instead. The downside of this type of insurance is that it has many limits and exceptions, and provides less efficient legal protection than the LLC.
Even though the chance of exceeding those limits is low, it can be disastrous if it happens. It’s not a surprise that, according to the current trends, investors more often choose LLCs over liability insurance.
LLCs Protect Owners from Personal Liability
A holding company imposes a barrier between your own assets and the legal action that could potentially target them. We will use the Café Lot, LLC from the previous example. For instance, you lease the property owned by your holding company Café Lot, LLC to a tenant.
On one occasion, their customer trips over a step and break a limb. Consequently, they decide to sue the owner for unsafe conditions. In most cases in the USA, the accidents result in lawsuits directed to the owners of real estates in which the accidents took place.
Only the LLC properties, in this instance the Café Lot, LLC, would be exposed to the lawsuit. On the contrary, if the property wasn’t owned by the holding company, but by an individual, then their personal assets would be subject to the court proceedings.
Single & Multimember LLCs Pass-Through Taxation
Unlike C corporations, in which double taxes are paid by the shareholders and corporation itself, LLCs enjoy the pass-through taxation rule which was implemented in 1988 with IRS’ Revenue Ruling 88-76. The rule, that’s been in effect since then, stated that LLCs in Wyoming would pay taxes as partnerships while enjoying the same protection from liabilities as corporations.
There is a third kind of corporations, S corporations, that don’t pay double taxes like the C ones. They use the same pass-through taxation benefits like LLCs and are a good choice for smaller businesses. However, these corporations have many restrictions and different legal protection that wouldn’t work well in the real estate industry.
Pass-through taxation implies that the company’s profit and capital gain taxes pass through to the owner/shareholder directly. They pay the tax as an individual, and not additionally on a corporate level, while having their personal property shielded against any legal actions.
The owner of an LLC for real estate won’t pay taxes on both the property renting income and the value appreciation of the real estate upon disposition. In addition, according to the IRS, a single-member owner of an LLC can exclude mortgage interest similarly to the single proprietor.
A multimember LLC (owned by several people) pays taxes as a real estate partnership based on the IRS rules. That means that the company reports an “informational” tax return without actually paying taxes.
Advantages and disadvantages of Real Estate Holding Companies
We have already mentioned the protection of personal assets from potential lawsuits as one of the biggest benefits that a holding company provides. Let’s summarize them all:
- Liability protection
- Tax incentives
- Easier to subsidize
- Simpler to expand
- Leverage financing
- Control over voting
On the other hand, there are some downsides in forming a holding company. One of them is the risk of higher taxation. At least 80% of the subsidiary company stock must be owned by the holding company, or else, the revenue is taxed as capital gains, and it includes earnings from the sale of real estate, bonds, stocks, or other holdings.
Purchasing Real Estate with Retirement Funds
If you choose this option, expect the IRA to own the real estate holding, and not you as the IRA account holder. The LLC formed in this case would be a rental real estate holding company that serves to secure a long-term growth of the funds. LLC for rental property is the most appealing to the housing market investors who own more than one property.
Ending thoughts on having a real estate holding company
If you possess real estate on which you or your tenants want to run a business, it would be prudent to establish a holding company and own the property under the company’s name. Make sure you familiarize yourself with the details of the process to avoid any complications in the future. Forming an LLC for rental property should also be carefully planned, since there can be traps for the unwary.