Working with one or more partners on a real estate deal is frequently a wise decision, if not a necessity. For beginning investors, taking a partner helps offset the risk of even a small investment. More experienced real estate investors may want to take on partners for the same reason, since as the deals get bigger, the risk becomes greater. Furthermore, individual investors can often benefit from the wisdom, experience, and diverse perspectives that partners can bring to the table.
But of course, there are pitfalls to the concept of partnership. Many friendships and even familial relations are ruined due to misunderstanding, negligence, incompetence, or just plain bad luck associated with doing business - not to mention the financial impact of partnerships gone wrong. To avoid these dire consequences, you should always have a formal partnership agreement drafted by an attorney, and you should always establish your partnership as an official, legal business entity.
General Partnership - Just Say No!
A general partnership is established by the simple act of doing business. It does not have to be registered with any governmental body, although it can be formalized with a written agreement. Legally, there is protection for you from the liabilities your partnership creates, which means that your personal assets could come under attack by litigants against your business. Furthermore, your business assets could could be seized for actions related to the misdeeds of your partners. In other words, do not operate as a general partnership if you engage in a continuing business relationship with any partners.
To Incorporate or not to Incorporate?
A vastly superior business entity, easily the most popular, is the corporation. By incorporating, you and your partners establish a legally distinct business entity with its own equivalent of a social security number (called an EIN, or "employer identification number"). In fact, a corporation is technically considered a "fictitious person." Thus, unlike a general partnership, a corporation is legally separate from any and all "partners" - or to be more accurate, "shareholders."
There are many advantages to incorporating. Chiefly among them, corporations provide limited liability. Since they are legally distinct, shareholders cannot be held accountable for the actions of the corporation. In other words, if a corporation of which you're a shareholder is sued, your personal assets are safe. Think about it - if you own stock in Wal-Mart, can you lose your house if the company is sued? Of course not. Your losses are limited to your investment. There are some cases in which a shareholder can be held liable in a small corporation, but in many cases you will be protected from liabilities of the business, and, more important, the misdeeds of your business partners and employees.
Limited Liability Company
The real danger of owning real estate in a corporation is that if one of the shareholders is personally sued for reasons unrelated to the corporation, the creditor may take possession of the debtor's stock certificates. A shareholder's shares are his or her personal property, and thus are at risk. This is why many real estate investors prefer to operate as a limited liability company or "LLC"
An LLC is like partnership in that the business is less formal than a corporation, but it provides liability protection for the owners of the company ("members"). An LLC also provides creditor protection, in that a judgment against one of the LLC owners will not allow a creditor to seize the LLC's asset and potentially ruin an ungoing business.
An LLC does have a federal taax ID number, but it files as a partnership for federal income taxes purposes. For some real estate investors, the partnership taxation model is better than the corporation because of the ability to deduct losses from rental real estate activity. For others, the corporation is better to avoid self-employment taxes on "earned" income from dealer activity, such as flips.
Each investor should consult with a professional tax advisor to determine which is better for his or her own real estate business.
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