Since they first arrived on the scene back in the 1970s, limited liability companies — known as LLCs — have become an extremely common and useful business tool, particularly in the context of commercial real estate. Understanding what LLCs are, when they should be formed, and the different purposes they serve across the CRE industry is essential for those looking to successfully navigate today’s marketplace.
But because an LLC’s owner is not a matter of public record in most states, LLCs often present a challenge to commercial real estate brokers and appraisers looking to contact a building’s owner. Below, we’ll take a look at the distinct advantages LLCs present those who form them, the ways in which those advantages can be abused, and why full transparency is essential.
The LLC Advantage
An LLC is a corporate structure whereby the members of the company cannot be held personally liable for the company’s debts or liabilities. According to Investopedia, limited liability companies are essentially “hybrid entities that combine the characteristics of a corporation and a partnership or sole proprietorship.”
While some businesses and building owners do use LLCs to intentionally obscure their identities, LLCs are not by nature criminal, and are in fact quite useful in organizing complex ownership structures while protecting personal assets from liability.
Perhaps the most distinct advantage LLCs hold over traditional partnerships is that the liability of each member of an LLC is limited to that individual’s financial investment. Should the worst happen, the owner can’t lose more than the assets held by the LLC. This shields external assets in case of lawsuit, bankruptcy, or foreclosure.
Another significant benefit of the LLC is known as pass-through taxation. Under the default tax classification rules, the IRS classifies a real estate holding company with one owner as they would a sole proprietorship. As a result, income and capital gains from the LLC pass through directly to the owner, who can then pay taxes as an individual while still enjoying the protections offered by the LLC liability shield. This allows owners to avoid double taxation on both the rental income generated by the property and the appreciation in value of the property upon disposition.
Real estate holding companies that have several owners are known as “multi-member” LLCs and are generally taxed by the IRS like partnerships, meaning that the LLC files an “informational” tax return, but does not actually pay taxes itself.
For CRE investors, LLCs provide an opportunity to safely diversify. For example, a building owner might use one LLC for a residential unit they own in San Francisco and use another for a commercial property in Washington, DC. If an accident were to occur at the San Francisco property, an ensuing lawsuit would not impact the owner’s DC asset. For this reason, LLCs are the logical choice for many CRE investors.
A Bad Reputation
Despite the many legitimate, legal ways to use LLCs to help conduct business, there remain those who abuse the system for their own personal gain, taking advantage of what is in many ways a legal gray area. Because an LLC’s owner is not a matter of public record in most states, anonymity has allowed the questionable practices often associated with LLCs to flourish.
The Los Angeles Times reports that LLCs have recently come under “close scrutiny” following the release of the Panama Papers scandal, which revealed how wealthy individuals and public officials were able to hide their identities and assets using shell companies — offshore LLCs — that were run by a Panamanian law firm. In the world of commercial real estate in particular, the Times notes that “wealthy investors have acquired high-priced real estate through LLCs that have obscured their identity,” with experts advocating against them arguing that “LLCs and shell companies often are used to obfuscate the source of ill-gotten cash or cover up illegal activity.”
This article originally appeared on reonomy.com