Use Of LLCs By Self-Directed IRA Real Estate Investors Grow In Popularity
May 25th, 2018
Here’s a recent article from our own Adam Bergman that originally appeared on Forbes.com –
Wyoming passed the first limited liability company (“LLC”) statute in 1977 creating a new entity type that combined the benefits of corporate limited liability protection with the pass-through tax treatment of a partnership. The IRS blessed the LLC concept some ten years later. From then, all fifty states established LLC laws and the LLC has become the entity of choice for almost all new small businesses and investment ventures.
Real estate investors have become the latest group to embrace the LLC. According to the Rental Housing Finance Survey from the Census Bureau and Urban Development, in 2015, fifteen percent of all rental properties were owned by LLCs or limited partnerships. Additionally, in 1991, 92 percent of rental properties in America were held individually. By 2015, that number dropped to 74 percent, largely driven by the growth in popularity of LLCs.
There are three main reasons real estate investors have been establishing LLCs in growing numbers:
- Tax Benefits: A corporation (sometimes referred to as a C corporation) is an independent legal entity owned by shareholders. This means that the corporation itself, not the shareholders that own it, is held legally liable for the actions and debts the business incurs. Corporations are known to have double tax – first, when the company makes a profit, and then to the shareholder on their personal return when dividends are paid. Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns. In the eyes of the federal government, from a tax perspective, an LLC is not a separate tax entity, so the business itself is not taxed. In other words, an LLC does not pay business or corporate taxes. This is a very significant fact.
For example, if we assume a 21% income tax rate for both corporation and individuals and a “C” Corporation earned $1,000 in profits, the “C” Corporation would be required to pay tax of $210 (21% of $1,000) and then the shareholder would be required to pay tax of $165.90 (21% of $790) if the remaining funds were given to the shareholder in the form of a dividend. Whereas, in the case of an LLC, there is no entity level tax so the $1,000 would flow directly to the LLC member and a tax of only 21% would be imposed at the shareholder level. Comparing this with the “C” Corporation example, by using an LLC, the individual would save $165.90 in our example (total tax of $375.90 with a “C” Corporation versus $210 in the case of an LLC.
- Limited Liability Protection: LLCs, like corporations, are recognized as separate legal entities, meaning individual members of an LLC are protected from debts, obligations and liabilities of the company. In an LLC, all members are automatically provided limited liability protection. Thus, if your business is sued or becomes insolvent, its members will generally not be held personally liable for the debts and liabilities of the LLC.
- Privacy: Depending on the state where the LLC is formed, identifying the owner of the LLC could prove difficult. LLCs are required to appoint a registered agent who can receive legal notifications, but most states do not require one to name the financial beneficiaries or owners of the LLC. That information is typically left to the operating agreement, which is a private document not filed with the state.
For retirement investors seeking to buy real estate with a self-directed IRA or 401(k) plan, using an LLC has also become increasingly popular. For example, with a self-directed IRA, the LLC would be wholly owned by the IRA and managed by the IRA owner. This is known as “checkbook control.” Unlike individuals or taxable entities, retirement accounts do not generally pay tax on any income or gains generated from a real estate investment. Accordingly, retirement investors are more focused on taking advantage of the non-tax benefits LLCs offer, such as limited liability protection and privacy. In addition, using an LLC allows self-directed IRA investors to make real estate investments quicker and more cost effectively because the IRA custodian is less involved in the process.
The use of an LLC to make real estate investments has become increasingly popular for individuals and retirement investors and the trend is expected to continue.