Separating Real Estate From Your Business

A Common Approach – A Common Mistake

If you’re a business owner who has acquired real estate for your business, you may own this asset within the same entity as your operating business. Many owners do this without giving it a second thought. However, you should consider some of the potential benefits to owning business-related real estate assets in a separate entity from the operating business:

1 Liability Protection

If one of your customers has a slip and fall at your business and is seriously injured, your business could be held responsible. On the other hand, what about other legal issues and liabilities that arise within the business? These risks could result in loss of your property. Real estate has very different liability considerations than an operating business. Separating the real estate into its own entity means any claims resulting from the real estate will be limited to the value of the property itself as well as any accounts held with it to collect rents and pay taxes, insurance and improvements.

Owning real estate separately from your business can shelter a valuable real estate asset from the risks associated with your operating business as well as personal assets or personal actions.

2 Pass-Thru Taxation

Some business owners keep their real estate within their corporation so that expenses tied to real estate could be treated as “ordinary” expenses on the company’s income statement. That may sound like a good idea on the surface, but I if you decide to sell the real estate at some point, any profit will be subject to double taxation. The first layer of taxation is at the corporate level and then at an individual level.

An alternative idea would be to hold the real estate in a separate pass-through entity such as a limited liability company or limited partnership (LLC). The LLC could lease the property back to the corporation. Any expenses generated by the real estate can still flow through to your return to offset income generated from the lease. If you manage the property yourself and make less than $150K annually, you can write off up to $25K in losses.

3 Flexibility For Family Dynamics

The family business is typically one of your most valuable asset. It can face many unique challenges including dealing with active and non-active family members. For example, it may be your intent to pass the family business to the next generation. Let’s say one of your sons, Matt, is very engaged in the business and interested in sticking around for the long haul. On the other hand, your son, Jason, has no interest in the business. Matt’s concern is that he doesn’t have the means to finance the purchase of both the business and the real estate. You’d like to treat your sons equally, especially since the business makes up the bulk of your estate.

If you separate the business from the real estate, you have more options. Matt can buy the business and you can leave the real estate to both sons equally.

Equalizing an inheritance to a mix of active and inactive adult children offers more flexibility if you have more than one asset to work with. If you’d like to gift the real estate, it’s easier to transfer property in an LLC rather than having to record a new deed, thus avoiding fees and taxes. You can just sell or gift an LLC membership interest.

4 More Options During A Sale

Owning the business real estate separately may provide you with more options during time of a sale of the business to a third party. If you sell the operating business but keep the LLC with real estate, you’re able to retain a stream of income to fund your retirement.

When you consider that 50% of business transfers are not planned but due to other factors such as divorce, disability, disagreement, death etc. having more options for how to maintain stable finances can only benefit you.

Final Thoughts

Treating your business real estate like any other business asset can expose you to increased risk and taxes. Creating a new pass-through entity for real estate may allow you to preserve risk, flexibility and taxes in the future. LLCs are relatively easy to set up. While you must follow corporate formalities, such as not commingling your personal assets with the LLC assets, LLCs don’t require officers and directors. You can put buy-sell provisions or other restrictions in the Operating Agreement rather than in a separate contract or irrevocable trust which you can’t modify. Moreover, cash distributions don’t need to flow pro-rata to its members, but are distributed at the discretion of the managing member. Foreign ownership of an LLC is also possible, unlike an S corporation.

Everyone’s situation is different, but holding real estate separately often brings many benefits. Consult with your wealth team to determine an approach that’s most appropriate for your situation.