Real estate is an immensely sought-after investment venture (having recently hit $10.5 trillion in value) that, unfortunately, has several idiosyncratic risks. These risks should not deter investors away from this market but merely inform them of the precautions they should be taking to safely capitalize on their investments.
While often the first thing that comes to mind, insurance is not the most effective safeguard that investors can employ to protect their real estate portfolio. That title goes to holding companies, which not only mitigate risk but also grant several other fringe benefits.
After explaining what a holding company is, and how it’s structured, this article will explore the reasons it is used for real estate portfolios.
What Is A Holding Company?
In the context of real estate portfolios, holding companies are entities designed to contain several subsidiaries, each of which is responsible for a single, specific asset (i.e. a property) of the owner. The purpose of the holding company is merely to hold all of these other subsidiaries responsible for each property of the owner.
Furthermore, holding companies will not get involved in the daily undertakings of each of their subsidiaries to maintain a separation of the risks of each business. It is common for holding companies to be formed as an LLC in a business-friendly state such as Nevada or Texas.
Limited liability companies (LLCs) have become more popular as holding companies than corporations since the latter is far more complicated to manage and is less adaptable to taxation.
Why Use Holding Companies
Since the IRS views holding companies used for real estate purposes with a single owner as equivalent to a “disregarded entity” (such as a sole proprietorship or general partnership), it benefits from the tax advantages associated with these structures. Namely, they are subject to a reduced form of tax called ‘passthrough taxation’ since any capital gains and income tax the business would be liable for is only paid by the owner instead, rather than both.
On top of this, if the holding company chooses to organize itself as an LLC (which it is recommended they do, not least because there is no extra tax associated with this decision) it is able to avoid double taxation too. This would mean that neither the rental income of the property nor its raw value can be subject to tax penalties.
In fact, mortgage interest on the property is tax-deductible for owners of single-member LLC holding companies. That being said, the IRS takes a slightly different approach with multi-member LLCs, which are considered more similar to partnerships if anything.
Insulates Against Economic Downturn
Establishing a holding company in order to manage all the properties on your real estate portfolio is an extremely effective measure to insulate oneself against the effects of an economic downturn on properties.
Since property values are highly volatile and, to quite a large extent, determined by the state of the economy itself it is important for real estate investors with multiple properties to use holding companies to protect themselves most effectively from a drop in the value of one or several of their properties as a result of an economic downturn.
- Precludes Personal Liability
It is well known that real estate investment can yield great returns, due largely to the pure amount of capital involved in single deals. Because of the size of this capital, and the highly volatile nature of the housing market, it is paramount that real estate investors use holding companies in order to protect their personal assets (i.e. their liquid, car, house, etc.).
Holding companies are able to provide this protection because they are normally either LLCs or corporations – both of which curb a business’s liabilities to the business itself. This stops the owner’s personal assets from being drawn upon to cover business debts in the event the business becomes bankrupt or is subject to a lawsuit.
As such, only the holding company’s business assets would be at risk in the case of these events, so the owner can rest easy that their personal assets are not on the line with every investment.
Association LLC Benefits
Since holding companies are very often established as LLCs, they get to share in a number of additional benefits associated with this structure, primarily its:
- Cheapness – LLCs are by and wide much cheaper than corporations to maintain, the starkest example of this is the difference in fees each business structure has to pay for its authorized number of shares. That being said, the cheaper state registration fees of LLCs do not go unnoticed either.
- Transferability – ownership of LLCs is fairly simple to transfer, which perfectly suits the needs of a holding company as the owner can use this as a way to ‘gift’ the LLC to their heirs every year to avoid some taxes without the need to sign a deed.
- Straightforward nature – LLCs are far simpler to manage than corporations because the latter is mandated by law to have appointed directors while no such requirements are present for LLCs. This means that it is much less of a headache to apportion responsibilities and roles between owners (or even a third party) at an LLC
Since holding companies can be LLCs, owners who do not wish their ownership of the company to be public knowledge can establish it as an anonymous LLC. This is a specialized way of registering an LLC which means that the owners of the LLC do not need to be publicly recorded by the state in a database of some sort.