How to hold it: LLCs, partnerships, and your building

My ever-changing views on LLCs, partnerships, and direct personal holding, after a decade buying real estate.

First try: Cornercase I LLC (2011)

As I want to do real estate investing seriously, My first Step is to create a Real Estate LLC for Tax benefits and legal protection. - BiggerPockets‍

In 2011, I was the guy above. I wanted to "invest in real estate", so I created a "Real Estate LLC".

Wrong.

I was 26, living in Seattle, and Drew and I had decided to “invest in real estate”. I’m a big nerd; Drew's even worse. I still remember getting the scoop on the "massively underpriced Tesla bonds" from Drew, in line for the bathroom at my brother's wedding. We were a pair of middle-class guys who'd met in college after growing up a few miles apart in Chicago’s South Suburbs, who'd spend a couple hours on the phone every month or two discussing housing starts, interest rates, whatever.

We'd both bought plenty of stock, and decided jointly it was time for the next adventure—directly purchasing a building, somewhere away from the expensive coastal cities where we both lived. Like the guy above, we got started by creating "a Real Estate LLC”. Ours was called Cornercase (a programming reference) and we did All the Things—bank account, operating agreement, yada yada.

Looking back, it wasn’t a bad start—we already talked about this stuff, why not "make it interesting" (use real money)? And in fact, this is how a lot of investment clubs operate: monthly meetings, with presentations, discussion, and investment using a single pooled brokerage account, by vote.

And yet, by 2011, this already felt dated, something from the 1960s my grandfather did after a research trip to the library, with his VFW buddies, some Old Style, and a couple cigars. (Sidenote: my dad loved these trips, and still talks about them.) Even into the 1990s, small accounts were getting taken to the cleaners—$200 or more to buy 100 shares (1-2% of $10,000), so it paid to be big. Though Robin Hood was yet to come (2013), by 2010 it was clear trading would become free, with including Zecco, Sharebuilder, and TD Ameritrade showing the way. Investment clubs would be forums for discussion, but rather than fighting over this or that trade, each member could go home and trade his or her account however he saw fit.

Cornercase was going to be different: we were going to find a private deal, something not available "on the screen". But after months of searching, including a couple out-of-state trips, we wrapped up the LLC without ever finishing a deal.

This was my first experience doing any kind of investing away from an exchange, and I learned something fundamental: it's difficult. Mr. Market shows up every day; driving around, getting on planes, and orchestrating 10 or more individuals toward closing, is something else entirely. For real estate in particular (a super-localized market), you'd better either live there, or find an agent you really trust.

So don't bother with the LLC until you've found your building. And if you’d rather just trade "on the screen" (stocks, REITs, etc), you don't need an LLC at all.

Going solo: buying an apartment (2019)

It took eight years, but I finally got around to buying an apartment.

By 2017, I’d moved to California and was running Shortbar, my software contracting company. I’d lived in three time zones, writing a decade's worth of rent checks to "Vanguard Properties", “LCB Associates”, "Equity Advisers"—placeholder names that meant nothing. So it caught my attention when the guy taking my check requested it made out to him personally: "Ted Dang".

Holy crap, I thought. Kids have bicycles; apparently some adults have 50,000 square feet near city hall. There was a lot to learn here, if you paid attention: a 30-year veteran of real estate, running dozens of buildings worth well over $100 million, who'd tell you nearly anything if you asked—particularly if you came with a check, and didn't trash the place. He didn't try to hide ownership: no LLCs with registered agents, no "I'm just the manager". He had a management company (Commonwealth) and could've had the checks made to them, but didn't. Ted also understood that, even though everyone says they want a nice office, what most people really want is cheap rent. And finally, I remember asking if he was worried about slip-and-falls, or getting sued: "I've got insurance" (general liability). The results spoke for themselves.

So when I got the apartment, I used my own name. I'd strongly recommend this as "Plan A" when going solo—it's simple, requires no paperwork, and if you want more structure later, it's easy to quit-claim, or transfer into a partnership without tax consequences. If you're in business thinking about buying the building, consider that the buyer may not want the real estate, and/or you may want to continue receiving rent. Keeping the building out of the business (separate) makes all of this easier.

The main lesson: keep it simple; complexity is the eternal enemy.

Partners: Unchecked Capital (2019)

Obviously, everything is different with partners. That's Unchecked Capital, my 2.0 "do-over" of Cornercase. I'd learned my lesson: we were buying a distressed property at auction, but waited until after we'd won to create the LLC. We ended up with three members (owners), and partnership (the multi-member default), in California where the three of us lived.

I got that right. But without knowing better, I'd set up in the wrong state.

Venture capital vs real estate

A quick aside on real estate, technology firms, and LLCs. I've mostly worked in Silicon Valley-style startups (venture capital-funded technology firms), which are overwhelmingly (a) corporations (not LLCs), (b) set up in Delaware.

Venture firms prefer corporations because ownership gets complex: hundreds of employee-owners, each with multiple share grants at various dates and prices. Also, these firms are designed for investment from outsiders, often several "rounds", years apart, each with negotiated payout seniority and control rights (e.g. who gets board seats). The rigid, standardized rules of corporations (directors, meetings, share classes) ensure things stay orderly, and ultimately, predictable.

A specialist industry has developed within the United States legal profession catering to Delaware corporations, and since most of these firms operate across state lines, there's little benefit to setting up in one's "home state"; it's easier using what everyone knows (Delaware), and getting permission to operate everywhere else (foreign qualification).

Real estate, by comparison, is an intensely local industry, with entirely different problems. Real estate assets (buildings) are mostly held using limited liability companies (LLCs), flexible "asset containers" created when members (owners) sign a contract called an operating agreement. Their flexibility is a double-edged sword: appropriate for close holding by a small number of owners, who don't trade in and out, or raise successive rounds of outside capital.

Unchecked ended up as a California LLC owning a building in Illinois. "Easy", I thought, "We'll just get foreign qualification in Illinois". It never occurred that we should just set up in Illinois, which was silly.

With thanks to my lawyers:

1. Having the LLC in California means we'd have liability protection for economic activity in California—we got that part right.
2. However, a lot would also happen onsite, at the building in Illinois. When the inevitable slip-and-fall, tenant issue, or car accident happened, we'd get sued, and it would be filed in Illinois.
3. The Illinois court would decide whether it was appropriate to hear the case—a yes/no decision. "No" because, what business does an Illinois court have with a California LLC; "yes" because there's enough "in Illinois" to satisfy the doctrine of minimum contacts.
4. The Illinois court would probaby hear the case, and without foreign qualification, a California entity is an "unincorporated association"—a bunch of people acting together with unlimited liability—BAD.

So the only two options were moving the LLC to Illinois, or registering there as a foreign (California) LLC. For now, we stayed in California, but it's something I'd like to change in the next few years.

Is this even investing??

The bigger question: why are we worrying about slip-and-falls and leasing? Aren't we supposed to be investing? It turned out to be a good question.

Buying a building is for sure "investing", but it's other things, too.

One is property management—leasing, rent collection, dealing with clogged toilets, "running it". Broadly, you either do this yourself, or outsource it. Most business owners do it themselves, which isn't surprising because great property managers are rare, and charge a lot. (We hired one for Unchecked, and ended up firing him.)

Buying a building is also asset management—constructing a portfolio. Determining what's worth buying and at what price, going and getting it, and arranging financing. Financing is interesting for two reasons: one, it requires navigating tradeoffs between too much debt (risk) and too much equity (bad returns), and also, it ends up "financializing" illiquid assets, making them easier for small investors to own in their account at Schwab. ETFs, mutual funds, and REITs are all the work product of asset managers; these folks do a lot to facilitate "Robin Hood"-style investing, small accounts trading in and out easily for almost nothing.

Merritt Growth: What’s next (2023)

I was tempted to call this section the "Conclusion", but judging from history, I've definitely got a few things wrong. I just don't yet know what.

But this is what I believe today.

First, if you want to invest and a brokerage account won't cut it, use a general partnership (not an LLC). GPs typically require nothing more than a signed contract between members (many states don't require registration); Bivio's partnership agreement is a decent place to start. The partnership should buy limited-liability securities, things like shares, and bonds. Not buildings.

Second, the partnership should have a written investment objective—growth, income, whatever. If some folks want growth and others income, just set up two different partnerships.

Third, recognize that buildings are businesses—not brokerage assets—they have customers, loans, lines of credit, even inventory (cleaning supplies). Buying a building (or a property for Airbnb) isn't "investing in real estate"—it's operating an asset-heavy small business, more like a place that rents construction equipment, than clicking "Buy" on Apple stock. Running a building require customer service, a roster of specialist tax, legal, and trade professionals, and bookkeeping/cash management. In addition to management, learning how to price any private asset takes a long time—years.

If you really want to own a building for investment:

• Use an LLC in the state where the property is located.
• Consider a Series LLC, especially if you'll own multiple buildings in the same state. Not all states have them; they're a newer form of LLC that allows slicing a single LLC into different "divisons" or "cells" (called "Series"), each a mini-entity with its own bank accounts, loans, and ownership. This is perfect for owning a bunch of buildings, but keeping them separated from each other.
• Take advantage of single-member LLCs. If an LLC has just one member (owner), it's "disregarded", meaning the IRS pretends it doesn't exist—its owner claims everything itself. For individuals, this means holding property in an LLC where you're the sole owner, and leasing it long-term, is just another line on your Form 1040, Schedule E. We use a parternship, which means even with a separate LLC, it all ends up on our partnership's Form 1065. This is a nice way to cut down a lot of paperwork and expense, while still keeping everything separated for liability purposes.

And finally, recognize that asset management is a business—specialist work that requires time, specific knowledge about a particular type of asset, and relationships (the best deals are sometimes the one where they call you).

We aren't yet here, but the diagram above summarizes where we're heading:

• Everything to the left of the line is paper assets: limited-liability securities, held in a general partnership.
• Operational stuff happens on the right, in limited-liability entities (corporations, LLCs, etc.), walling it off from the partnership.
• Two buildings owned by an Illinois Series LLC.
• Management by Sweet Home Chicago LLC ("SHC LLC"), a specialist property manager.

I started off telling you to keep it simple. It's OK for things to get complex, but it should happen slowly, and intentionally.

Thanks for sticking with this long post, and check back here as we continue building the systems to make self-management easier.