Investors are often advised to use another separate corporate entity to manage the properties. The legal reason for this is that the separate entity will act as your rental property management company as a decoy in dealing with tenants, contractors, vendors, etc. In the event of a legal dispute or action from one of these (tenants, contractors, vendors, etc.), the management company (acting as a decoy) is a separate and distinct entity apart from you. Presumably, any legal action will be brought against this managing corporation and not against you, or not against whatever entity owns the property (such as an LLC). This management corporation will have little assets to attach in the event of the legal action. This is why it may give you additional asset protection. But, on the legal side, for this asset protection strategy to work effectively, the management corporation must do all of the managing. If you, in your capacity as an individual or as a real estate LLC member, do any management at all, then claimants could bring a legal action against you or your real estate LLC, instead of the management corporation. A smart attorney may be able to prove that you or your real estate LLC did at least some management (or were somehow responsible) and therefore liable to the claimant (tenant, contractor, vendor, etc.) and thus not even bother suing the decoy (limited asset) management corporation. So, legally, this asset protection device could be flawed and is potentially collapsible.
On the tax side, there too is a potential significant pitiful. One of the most expensive tax traps for the uninformed real estate investor is the passive loss limitations depriving investors the ability to currently deduct their property loss deductions against their other ordinary income (W-2, business income, etc.), with the resultant loss of tax savings and decrease in after-tax cash flow. If this separate rental management entity does too much management (when legally it’s suppose to do all managing), then you may be too passive and thus may not be able to currently deduct rental property losses because of the passive loss limitations of IRC 469. Reason: In order to bypass these limits and deduct losses you or your spouse must perform a certain amount of management functions, especially landlord-tenant activities. These functions must be performed by you or your spouse (individually or as a manager-member of an LLC that owns the properties), not another entity, even if it’s your entity. Understand that the management company (corporation or another LLC) is a separate, distinct entity apart from you and your spouse. Thus the management company’s performance of these activities is not attributable to you. Because of this, there are several tax courts cases where real estate owners, using separate management entities, were denied current property deductions costing them thousands of dollars in current savings. Moreover, top tax experts throughout the country agree with these conclusions of the courts based on IRC 469.
You do not need your own management corporation, along with its legal and tax disadvantages because there is an excellent cost-effective solution where you can protect multiple property equities in one entity called Equity Stripping which is discussed in the prior track.
If you want to benefit from certain C-corporation deductions (such as fringe benefits), instead of making the C-corporation the primary entity owner of the real estate or a management company, make the C-corp a minority non-voting member of your real estate LLC, with a low ownership percentage. In this scenario, besides the tax benefits, having the C-corp as an LLC member augments asset protection via another state-registered entity as a corporate member enhancing the LLC-partnership as an entity, separate and distinct from its member-owners with the shield of limited liability.
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