The first decision has been made: you and a friend have decided to invest in real estate. A number of large and small decisions will now follow. What type of entity should you form, and where should you form it? How much are you willing to spend, and which property will you purchase? How much will you spend on the renovation? Will you hold the property to rent, or flip it and sell?
Limited liability companies or LLCs are often the preferred entity for real estate investment. While you could take title in your individual capacity, doing so does not offer any limited liability protection for the owner(s) personal assets. Thus, if a tenant were to slip and fall, all of the personal assets of the owners are exposed to cover the cost of claims made. A corporation offers the same limited liability protection as an LLC but is less flexible when it comes to management of the entity. While land trusts are the subject of many seminars and books, their use is exceedingly rare, the limitation of liability is not absolute, and particularly for properties with multiple owners, governance of the trust can be unwieldy.
Given the limited liability benefits, a LLC can provide, putting multiple properties within the entity will expose each of those properties to the liabilities of any other property within the LLC. For this reason, it is recommended that each property be held in a separate LLC.
If a property is already owned by one or more of the investors, the parties must consider the ability and cost of transferring the property to a limited liability company. Whoever is on title may be required to obtain the consent of the lender to transfer the property to an entity, and it is possible that the lender may not consent. The laws of the state where your property is located may also impose transfer and recordation taxes (or your state’s equivalent), even if going from an individual to a single member LLC owned by the same person. So, before forming an entity, it is important to speak to your lender and an attorney about whether your property can be conveyed, and the costs of doing so.
The next question is where to form the entity. Generally speaking, the entity should be formed in the state where the property will be located. Whether another state’s laws provide any benefit over the state where the property is located depends on a variety of factors, including where the owners declare residence, whether the property is being flipped or rented, and which states are in question.
An Operating Agreement can and should be used to govern the rights of management and ownership in any real estate investment LLC with multiple owners. By its nature, real estate is a risky investment. It is not unusual for new investors to face obstacles and to lose money on the first investment. Understandably, this can cause strain between the owners. Having a carefully drafted Operating Agreement will set and manage expectations of the owners. For example, how much is either owner permitted to spend before the consent of the other owner is required? How to decide whether to rent or sell, and at what price? What happens upon the death of one owner? Can an owner liquidate his/her investment? What happens upon the death, disability, bankruptcy of an owner? What is the purchase price for an owner’s interest in the company, and how is it paid without putting a strain on the cash flow of the entity? Resolving these important questions in advance of the investment will help resolve future disputes.
ABOUT JORDAN SAVITZ
Jordan.Savitz@offitkurman.com | 240.507.1729
As a member of Offit Kurman’s Business Law and Transactions practice group, Jordan Savitz advises clients in all stages of the business life cycle. He assists clients with matters including, but not limited to, choice of entity, complex operating and stockholder agreements, compliance with Rule 506 of Regulation D, real estate leasing, employment agreements, website terms and conditions, trademark filings, complex contract drafting and negotiation, succession planning, as well as stock and asset purchase agreements.
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