Difference between Real Estate Trust & LLC + Which one to Use
Imagine that you have found your dream real estate property and cannot wait to put your name all over it. So, you look for a source of funding either through an experienced personal money lender, credit unions or other sources. This may not be much of a hustle compared to the liability you are bound to once you own the property.
Owning a property and choosing to rent it out comes with a lot of liabilities to you as the property owner. Therefore, we highly recommended that you shield yourself from these liabilities by purchasing it under the name of another entity through an LLC (limited liability capacity) or real estate trust. The next big question then is which one to use? And why?
What is an LLC?
LLC (limited liability capacity) is a business structure that shields personal assets of a property owner from legal or financial obligation. This implies that LLC provides a clear distinction between personal assets and business assets, and in the occurrence of a lawsuit against the property, your personal assets remain untouched.
LLC can be owned individually or partially through partnerships and corporations. It is not a rigid structure that is constrained by the initial size of the members of the LLC, it is able to scale up and down.
How do you set up an LLC?
If you are a property owner and would like to pursue the LLC route, we advise that you do so as soon as you purchase the property. This is because once a property is under your name, you become liable to the property. There are 5 general guidelines that should be followed. It is important to note that these guidelines vary based on the regulations of the given state, be sure to check with your state before setting up an LLC.
- Choose a non-existent business name.
- Choose a registered agent that receives official documents on behalf of your LLC.
- Prepare the LLC operating agreement.
- File an “Article of Organization” document with the state.
- Obtain any necessary business licenses and permits.
Benefits of LLC
As a property owner choosing an LLC comes with the following benefits:
The increasing popularity of LLC is rooted in its primary benefit, limited liability. As stated above, LLC ensures that your personal assets are protected from any property debts or lawsuits even if the property assets cannot afford to pay the judgement.
LLC provides the option of anonymity through management flexibility. The property’s owner is not required to handle day-to-day operations of the property’s management as they can allocate this responsibility to an agent or manager. The agents and managers are then required to report to the property owner of all operations.
This is profoundly beneficial to individuals who want to keep a low profile as well as keep their investments on the low.
Once you opt for LLC as your investment vehicle, you are taxed by the IRS as a sole proprietor (if you are a single-member LLC), a partnership (if you have more than one member) or as a corporation (either S-Corp or C-Corp).
Unless the LLC is a C-Corp you are not subject to separate federal taxes instead each owner is taxed through their personal income tax. The latter is because the profits and losses of the property are passed to the owner who then submits this information for taxation.
However, property owners must pay self-employment taxes which might put them in a higher tax bracket. In such instances they might save money by choosing to be taxed as an S-Corp.
The key drawback with LLC is financial fees, states charge an annual fee of $70 – $300 to file an LLC.
What is a Real Estate Trust?
Now that we have looked at LLC as an investment vehicle, let us dive into another investment vehicle, real estate trust.
A real estate trust is a legal vehicle that passes assets in which trustees hold the title to the property for the benefit of one or more beneficiaries. This option is favourable for commercial and multifamily properties, it is also widely used for estate planning by an owner.
What are the different types of RETs?
There are three different types of RETs:
1. Equity RETs -majority of RETs are publicly traded equity RETS. They own and operate income-producing real estate. Revenue is generated through renting out the property not reselling of the property.
2. Mortgage RETs – they lend money to real estate owners directly through mortgages and loans or indirectly through mortgage-backed securities.
3. Hybrid RETs – these are a combination of the strategies used in equity RETs and mortgage RETs.
Benefits of Real Estate Trusts
As a property owner choosing real estate trusts over LLC have the following benefits:
Trusts are useful in documenting the relationship and the ownership interests of all owners in a consolidated fashion. This makes it useful for larger real estate investments that house multiple owners.
Trusts are beneficial to individuals who want to evade estate tax on their investment properties. They make it possible by transferring it to their heirs under the real estate trust.
The downside of real estate trusts is the high frequency of change of the rules around how much an individual should put in the trust for estate planning. Furthermore, the partners will also have modifications that they will need to be added in the trusts. These changes require financing to make them effective in additional to the original fees.
Which one is better, LLC or Real Estate Trusts?
Having outlined the details and benefits of both LLC and Real Estate Trusts, it is clear that both are beneficial but are tailored to suit different groups and individuals. Trusts are beneficial for commercial and multifamily properties however LLC is far more a beneficial structure. LLC provides flexibility, anonymity and reduced liability. It also reduces taxes imposed to you as a property owner.
Regardless, we advise that you place your property in an LLC, real estate trust or any other investment vehicle without delay after purchase of the property.
Adam Smith has spent the last 5 years in the Private Money Lending world helping real estate investors secure financing for their non-owner occupied real estate investments. When he’s not thinking about real estate, Adam is an avid Jazz music fan and fisherman.