Doubters Inc. (or: Should you Incorporate?)

When I read Rich Dad, Poor Dad I was very interested in his section talking about incorporation. He talked about how rich people created companies and then exploited taxes laws that individuals could not. He referred to buying his car through his company and taking trips to Hawaii, essentially tax-deductible. As it turns out, he was being a little loose with his application of tax laws. From John T. Reed's website (a real estate investor who critiques gurus):

"Both corporations and sole proprietors pay expenses before they pay taxes. Sole proprietors pay taxes only on the net income of their businesses, which means after expenses."

A lot of buzz has been made about LLC's, which stands for Limited Liability Company, and how they can do great things for your business. Most talks on the subject concern either taxes or liability concerns. Let's take a look at the implications of creating an LLC.

It turns out that when creating a business (such as real estate) there are two ways to deal with taxes. You can be taxed as an individual or you can be taxed as a corporation (taxation as a corporation can be somewhat complex). One of the advantages of LLC's is that you can actually choose either of those tax structures.

If you choose to be taxed through your person, that's considered under law as being taxed as a sole proprietor (if you are alone in your venture) or as a general partnership (if there are multiple owners/investors). Both forms treat the business's finances as extensions of your own. Each year you take your profits (mostly rental income) and add it to your personal income. Then you subtract all of your expenses and other deductible items such as your mortgage interest and the depreciation you want to claim. For most investors this will actually drop you below your original taxable income (thus the tax advantage of real estate). This is also called pass-through taxation. If you do claim a profit, even after depreciation, then it will be taxed at your personal tax rate (probably 25-35%).

If you choose to be taxed as a corporation, then the business's finances are kept completely separate from your own. You file taxes separately for yourself and for your business. If your company is producing a profit, even after all the deductions you claim, you can benefit from a slightly more generous tax scale. The first $50,000 in profit generated by your company is taxed at only 15%. But there's a catch. Any time you try to transfer money to yourself from the corporation, you have to report that money as income on your personal tax return the following year. This is often called double-taxation.

For example, Jack is in the 25% tax bracket, and his company cleared $10,000 this year. If he files as a sole-proprietor then he will have to pay $2,500 in taxes and he walks away with $7,500 which is his money to do with as he wishes. He can go on a vacation or re-invest the money in his company.

If Jack files as a corporation then his company only owes $1,500 in taxes. So his company saves $1,000. If Jack intends to use that money to expand his business this is a good deal. However, if Jack wants to withdraw the profit to go on vacation, then he must report the money ($8,500) on his personal tax return the following year, and he'll pay taxes (25% = $2,125) on those gains. So he ends up paying a total of $3,625 in taxes.

As I mentioned above, one of the advantages of LLC's is that you can choose how your business is taxed (other forms of incorporation such as a C-Corp must be taxed as a corporation). If you are like most investors, however, you will probably stick to the rules of the sole-proprietorship. This is the default method of taxation when you own rental property, so forming an LLC doesn't offer any advantages there.

The second main reason that people form LLC's is to deal with liability issues. Under federal laws all assets outside of an LLC are safe if the LLC is sued. In other words, let's assume that you form an LLC and buy 2 houses. Let's say that you order a tremendous amount of work to be done on those homes, but never pay a dime. when the companies who did the work sue for pay, the worst that could happen is that you lose the 2 homes. Those companies could not come after your personal assets (your own home, your 401k, your college fund, etc.)

However, as with most things, there are loopholes. If you are sued under a tort (a lawsuit resulting from negligence), then not only can they sue your LLC for damages, but they can also sue you for your personal negligence. Now when McDonald's gets sued for pouring scalding coffee on a customer, it's shareholders can't be sued because they are passive investors. However the manager of that particular branch could be sued (as well as people further up the chain of command) because they are directly involved in the activity that caused the negligence to occur. If you do not take part in the daily management of your real estate (which is probably a bad idea to begin with) then forming an LLC could protect you. But since most investors will also manage their homes, an LLC would offer little protection from negligence, which is easily the most costly form of liability.

Secondly, if you do get sued you will most likely head to small-claims court. Most landlords choose to represent themselves as opposed to paying for lawyer. If you incorporate you most likely will not be allowed to represent yourself in court, instead you'll be forced to hire legal council. You could win your lawsuit and still lose a tremendous sum of money in legal fees. This is a matter of state law, not federal, so check out the laws where you are buying.

Finally, a last point to consider is that lenders are more wary of LLC's than individuals, and for good reason. As a result lending restrictions for LLC's are far stricter. If I buy a house to live in, the bank will give me a good rate because they feel relatively comfortable that I will do everything to protect where I live. If I buy my house as an investment property (you will be asked this question when applying for mortgages), but sign personally for it, they will give me a slightly worse rate because they know that since I don't live there I won't work as hard to save the house when things go bad.

But if I try to get a mortgage though an LLC, alarm bells go off in the bank. Not only is an LLC far more likely to default than an individual, but if you DO foreclose they can't come after you. Biff and I inquired about getting loans through LLC's while trying to secure a loan for House #1. The best rate we were quoted was a 70% loan at 16% interest. The loan we ended up with, we signed personally for it, was a 90% loan at 5.25% interest (in a 7-year ARM). If we had tried to borrow money through an LLC we would have had to put down three times as much cash and paid three times as much interest.

One way around this is to sign for the loan personally, but put the title in the name of the LLC. Unfortunately this is even more disastrous than signing as an LLC. If you do get sued and end up losing the house, the bank will still come after you, personally, to pay off the balance of your mortgage.

So why would you even consider an LLC? Most people I've spoken with or read about who look seriously into it choose instead to remain a sole-proprietorship or a general partnership. To deal with liability, these investors simply purchase a large umbrella insurance policy. This policy costs very little, but is far better protection for a real estate investor than an LLC ever could be.