LLC offers flexibility for real estate development
January, 2005
Escalating home prices and available land have presented an excellent market for real estate development and investment in Clark County over the past few years. These opportunities have brought new investors to the market, and these people, as well as anyone considering real estate development, should carefully consider how to structure their ownership in a real estate project so that they limit risk and maximize their return.
A typical scenario for a real estate project may include an individual who owns bare land and one or two investors who are willing to lend funds to develop the land. The investors in many cases will be passive investors, and they likely will want to limit their risk on the project. While forming a general partnership (as many people do when developing property) is probably the easiest thing to do, it will not limit the investors' risk, as partnerships are treated the same as a sole proprietorship for liability purposes. While the investors can limit their risk by just lending money to the landowner at an aggressive rate of return, the downside is that interest earned on the note is taxed as ordinary income, and the amount of interest that can be charged is limited by law. Choosing the proper business structure can address these issues.
A real estate project may be lawfully operated by a variety of different business structures including a sole proprietorship, a C-Corporation, an S-Corporation, a land trust, a Limited Liability Partnership ("LLP"), a General Partnership, a Limited Partnership ("LP") or a Limited Liability Company ("LLC"). Choosing the appropriate business structure involves considering who is going to be involved in the project, to what capacity they will be involved, timing for repayment of investors, and an analysis as to the risk the investors are willing to accept. While each of these business entities offers certain advantages in certain situations, under the scenario outlined above, and with most real estate development, the preferred business entity is an LLC.
The preference for an LLC is based on the fact that while LLCs and corporations both limit the liability of their owners, an LLC allows for substantially greater flexibility with respect to structuring the ownership interests of its members, and it offers greater flexibility with respect to tax matters. With respect to ownership, an LLC allows for members to disproportionately allocate profit and loss between members without requiring the creation of separate classes of stock. For example, the members could provide that until the investors are paid off, the land owner will not be entitled to any payment other than a base salary for operating the project, and that upon the investors being paid off, all members could then share equally in any profits. This type of special allocation is more difficult to structure in a corporation.
An LLC also has significant tax flexibility. The formation and liquidation of an LLC is generally tax free, and debts of the LLC, regardless of whether they are recourse or non-recourse, are added to the members' individual bases. Further, profits earned by a non-managing member of an LLC are not subject to self-employment taxes. Finally, upon sale of the project (assuming the LLC is not treated as a "dealer" and that the project is held for at least one year), all profits from the sale of the project would generally be subject to capital gains tax treatment instead of ordinary income.
While an LLC will not be the best business structure for every real estate project, in most cases it should be the first consideration given the flexibility outlined above and the limited liability protection it offers investors. While many people successfully develop land as a sole proprietorship or partnership, the flexibility and ease of operation most people desire can be accomplished through an LLC while protecting the members' assets.