When purchasing investment property, it is better not to own the property in your personal name. Both a Limited Liability Company (LLC) and a Corporation (Corp) offer creditor protection. They create a separation between personal assets and assets owned by the business. In the event of any lawsuit or liability, exposure is limited to the business’s assets. However, when choosing a business entity to hold real estate for investment, an LLC is preferable.

1. LLCs avoid double taxation.

An LLC is a disregarded entity which results in the profits taxed as income to each individual owner. A corporation is not a see-through entity. The corporation pays taxes on all profits. To pass income to the shareholders, they must be W2 employees or receive dividends which count as individual income. Either method causes the same profits to be taxed again. You can avoid double taxation by electing S Corp status, but you do not avoid any other drawbacks of a corporation.

2. Transferring existing real estate into a Corp may be a taxable event.

If someone transfers real estate to a corporation in exchange for stock, they recognize a capital gain. They are taxed on the difference between the original purchase price and the fair market value at time of transfer. One exception is when the transferor has “control” of the corporation immediately after the transfer. In general, “control” is defined as 80% of the vote and value of the corporation. As you can imagine, this exception doesn’t always apply when there are multiple business owners.

3. Taxed for Debt Relief.

When real property transferred into a Corp has a mortgage, capital gains tax is due even if the transferor has a controlling interest. Since the corporation assumes the mortgage liability, the transferor recognizes a capital gain to the extent the mortgage exceeds the original purchase price. For example, if the tax basis (sale price) was $100,000 and the mortgage is $500,000, the transferor is taxed on the $400,000 gain because it is “debt relief.”

4. No Step Up in Basis

Corporations never die so when an individual owner passes away, there is no step up in basis to fair market value. If the real estate appreciated, heirs inherit capital gain if they want to sell the underlying property. The issue is that step-up applies only to the stock shares but not the underlying real estate.

5. LLCs are easier to operate than a Corporation.

Corps require shareholders to adopt by-laws and hold annual meetings. The transfer of shares between shareholders or to a third party requires the issuance of new stocks. LLC ownership interests transfer easily from one member to another or to third parties via an Assignment of Interest. Once a property is titled in the name of the LLC, a change in ownership does not require a change in the deed or trigger a taxable event.

Choosing the right business entity is an important step that should always be taken under the advice of a tax professional. Making sure you have an efficient business succession plan is just as essential.