To Entity or Not to Entity

While the decision to establish an entity such as a corporation, trust or the most common for real estate, a limited liability company, in which to make real estate investments, may seem like a prudent decision to an investor. It is important for investors to understand the ramifications of such a move in the current market environment.  As with many decisions in life, awareness of potential unintended consequences up front can help minimize headaches in the future.

Certainly, the appeal of the anonymity and liability protection afforded by making real estate investments in entities are real and do not need to be reviewed here.  Many real estate investing gurus have profited from selling video tapes, compact discs, and seminars espousing these very benefits. Those advocates rarely take the perspective of a lender or other skeptics, and point out the potential downfalls of such a move.  They include:

  • ACCESS TO LOANS: The universe of lenders that have an appetite for Non-Owner Occupied Real Estate is small.  It becomes even smaller if the property is owned in an entity.  The exception is blanket commercial loans that typically are for larger dollar amounts and warrant the time of the bankers due to their size.
  • LOSS OF DEALS: Deals can be lost if, for example, a purchase contract is originally executed in the name of an entity but a lender refuses to make a loan secured by the property unless the contract is in the name of an individual.  These days, inflexible sellers such as banks, HUD or Fannie Mae/Freddie Mac typically refuse to amend contracts and would rather sell to the next bidder than go through the brain damage of modifying your deal.
  • COST OF LOANS:  The cheapest money in today’s market is Fannie Mae and Freddie Mac compliant loans.   If you can find a bank that will provide financing for non-owner occupied property held by an entity, it will cost significantly more.
  • COMPLEXITY:  The very liability-shielding attributes of investing via an entity may spook lenders if those entities lack long and well-established track records.  If lenders decide to lend directly to the entity, the individual owner(s) of the entity usually end up having to personally guarantee the loan anyway.  The days of non- or limited-recourse lending are a distant image in the rear view mirror.
  • ADDITIONAL COSTS: It is easy to undermine the underlying purpose of establishing the entities if people who use them are extremely vigilant, but it takes thought, time and money.  To have the desired liability-shielding effect, operating in an entity requires extra costs and hassles, such as formation of entity, distinct set of books and financial statements, tax returns, bank accounts, checks, and the like. 
  • LEGAL: The use of an entity may take away an individual’s ability to represent himself in small claims court or for real estate tax complaints.  For example, if an individual owns a four-unit in the name of his entity and seeks to evict a deadbeat tenant, a judge would not likely allow the landlord to appear in court without an attorney.  Why?  Because not doing so would be considered unauthorized practice of law in most states since as an individual (who is not an attorney) cannot represent a third party in court.  Even if the individual owns 100% of the entity which owns the building, the entity itself represents a discrete third party in the eyes of the court.

All hope is not lost, since certain goals can be achieved through alternative means.  For example, to the extent owning real estate in entities helps shield individuals from potential liability, such as the mailman slipping and falling, protection against this can be obtained through proper landlord policies and an umbrella insurance policy.

In short, be sure to think through all of the potential ramifications of whether to make your real estate investments in the name of an entity or as an individual.  Notwithstanding what the gurus say (and sell) in their tapes and seminars, always remember The Golden Rule.  And if the folks with the “gold” who are making you a loan to buy properties take steps to undermine the effect of your entity, then the use of it may turn out to be more hassle than it’s worth.