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The Importance of Forming a Business Entity for Real Estate Investments

Written by Alex Reuter on August 21, 2020 Category: Business Formation and Organization

With very few exceptions, real estate is one of the most widely available assets that one can expect will appreciate over time. As a result, many investors and entrepreneurs utilize real estate to grow their wealth and diversify their portfolio. However, owning real estate for investment purposes is not without its risks. In particular, and in addition to inherent market fluctuations, there are risks associated with contractual and other legal obligations that arise in the course of purchasing and maximizing the return on the real estate investment.

For example, if the real estate is being purchased as a rental property, an investor will be subject to liability under several contracts, starting with the purchase agreement and extending to the lease. If either of those agreements are executed by the investor in his or her individual capacity, the personal assets of that investor will be subject to liability in the event of a breach. However, if the agreement is entered into by an entity (as opposed to an individual) the personal assets of the investor will, with limited exceptions, be shielded from liability (i.e., collection). This liability shield is afforded to several different types of entities, including corporations and limited liability companies. But when it comes to singular purpose entities, such as the type used in the real estate investment industry, it is the later that is most efficient and most employed.

The liability shield that is provided by the use of an LLC essentially limits liability to only the assets of the entity, thereby operating as a shield for the personal assets of the investor. This liability shield is especially important when investing in property that will eventually be rented out to residential tenants. With the gambit of statutory provisions and common law obligations that are imposed on Michigan landlords (including but not limited to the Anti-lockout Act; the Landlord and Tenant Relationship Act; the Truth in Renting Act; and the Michigan Consumer Protection Act) there are a multitude of claims that tenants can assert against a landlord. And if the landlord is not an LLC (or other protective entity) the investors personal assets will be left wide open to liability.

But the benefits of using an LLC to invest in real estate is not without limitations. For starters, when it is necessary to obtain financing for the purchase of the investment property, most mortgage lenders will require a healthy credit history, which a newly formed LLC will not be able to provide. As a result, there will likely be some personal obligation tied to the loan; typically in the form of a personal guaranty. Another limitation to an LLC is when an investor disregards corporate formalities, such as failing to file annual statements or maintain separate financial records and accounts. Similarly, the liability shield of an LLC will be “pierced” (rendered ineffective) where an investor commits fraud or other intentional tortious acts. Having experienced legal counsel will help an investor avoid these pitfalls.

The business attorneys at Dalton & Tomich have years of experience representing investors in the formation of business entities (from filing articles of organization or corporation with the Department of Licensing and Regulatory Affairs to preparing operating agreements and bylaws), as well as in the negotiation of real estate purchase agreements and mortgage loans and in preparing the necessary rental documents for both commercial and residential rental properties. Call us today to set up a consultation for your future real estate investments.

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The business and employment attorneys of Dalton & Tomich take your business just as seriously as you do. Attorneys Zana Tomich and Noel Sterett are trusted by closely held family businesses and others across Michigan and Northern Illinois as invaluable partners and counselors. We guarantee all your calls and emails will be returned within one business day so you can focus on what you do best: running your business.