If you don’t plan accordingly for your investing goals and choose the correct entity structure, the taxes will definitely hurt your bottom line in a big way. As a real estate investor, you need to stay updated on which entities are on the IRS hit list. Recordkeeping also plays a big part in wealth building. Done the right way, you can save yourself a lot of headaches and money come tax time.
Entity Definitions
1. LIMITED LIABILITY COMPANIES (LLC’S): An LLC is an unincorporated business entity filed under state law, in which all owners (called “members”) have limited legal liability. It is a hybrid entity that combines some of the major legal advantages of corporations and the excellent tax advantages of general partnerships. The owners in an LLC are called members or managers.
Tax Status: As a separate legal entity, an LLC can be taxed as a sole proprietor, as a partnership, or as a corporation. But for real estate ownership, an LLC should elect to be taxed as a partnership and thereby be governed by the favorable tax benefits of partnership tax law.
2. PARTNERSHIPS: A partnership is an association of two or more legal persons (or entities) joined together in a business.
Tax Status: It is fairly inexpensive and simple to form a general partnership, plus there are no state filings. They can be done informally and verbally (although not recommended). General partnerships are not recommended for real estate transactions, due to the liability exposure.
3. LLC-PARTNERSHIPS: An LLC-partnership is both a legal entity and a tax entity with at least two members. An LLC partnership is the ideal entity for most cases of real estate ownership. They are generally the best for real estate.
Tax status: On the tax side it is a partnership with the favorable tax benefits of partnership tax law, including a lower IRS audit profile.
4. LIMITED PARTNERSHIPS (LP’S): An LP is a separate legal entity formed under state limited partnership statutes with at least one general partner and one limited partner.
Tax status: On the tax side an LP is a pass-through entity, filing partnership tax forms and has almost all of the same partnership tax advantages. Limited partners are totally subject to passive loss limits and are therefore not entitled to currently deduct rental property losses against other types of income.
5. CORPORATIONS: A corporation is a legal, artificial person that is separate, distinct, and apart from the owners.
Tax status – C and S Corporations:
(a) C-corporations – A C-Corporation has its own tax rate schedule and pays its own corporate taxes. It is taxed separately with a tax rate of about 40%.
(b) S-corporations – Unlike C-Corporations, S-corps do not have their own tax rate schedule and usually do not pay their own corporate taxes. Instead, income and losses (within certain limits) pass through to the shareholder’s individual tax returns. S-corps offer the same limited liability as a C-corp, yet do not have the disadvantage of double taxation. I recommend S corps for Short Term Cash strategies with significant income. This way, you can pay yourself a salary that is subject to self employment taxes, and the rest of your income will not be subject to self employment taxes but the regular taxes.
Generally speaking, the LLC is the ideal entity to start your real estate investing with. If you decide to hold on to the property, stay with the LLC. If you flip or rehab and flip you will want something with S Corp tax treatment. So either elect S Corp for your LLC or start a new company. Here we’ll look at the definitions of various entities.
The State Where You Operate – My Choice
Incorporating in the state of operation is the least complicated and least costly choice. In addition, if you were to get sued, the local laws will govern. So your entity should have legal standing in the state where you intend to operate your business.
Delaware
Delaware is very popular as an incorporation state with thousands of start-up companies in the US. Delaware has low incorporation fees, low taxes, and management flexibility making it an attractive option.
Nevada
Again, Nevada is attractive to new companies because of its favorable corporate laws such as low taxes, low fees, and corporate privacy laws. But, like Delaware, it is larger corporations who have the most to gain from incorporating in Nevada. Similar to Delaware, smaller corporations may find more disadvantages than benefits to incorporating in Nevada.
Tips on Good Record Keeping
The importance of having a good record keeping system for your taxes cannot be underestimated. The key to superior recordkeeping is to make a habit of it. Recordkeeping should be done every day or every week and at least every month. Record keeping allows you to obtain every possible tax deduction, which is another way of cutting expenses. It is also one of the best ways to tell what does and does not work for your business as a real estate investor.
As a real estate investor, you will have a lot of transactions and documentation related to your deals. You must organize this information because you will need it when to comes to filing your tax return. If you don’t have a system in place, it will cost you time and money, and in some instances – a lot of money.
Here are some tips for keeping a good record for tax time:
• Check your records every month, week, and quarter.
• Double check, and make sure all the facts and figures are accurate.
• Make sure you have your cash flow mapped out so you know exactly what you have available.
• Use an easy to understand system like Quick Books
• Alternatively, you can use a simple Excel spreadsheet.
The important thing is to set up the right system and manage it properly. If you need help, hire a bookkeeper, or find someone qualified to teach you how to manage your own system.
The Burden of Proof
At the IRS examination level, the burden of proof remains with the taxpayer. The burden of proof concerning an audit only shifts to the IRS in tax court. To qualify for this shift in the burden of proof, these conditions must exist:
1. You must maintain all records required by the Internal Revenue Code.
2. You must produce these records at the audit.
The IRS’s best defense is to reshift the burden of proof to you and assert that you did not have adequate records.
Here’s a recent question from my blog:
QUESTION: I‘m about to sign a sale contract for my 1st flip. I have the option to close at the end of December this year or begin of January. From a tax perspective what would you recommend? To note that I’m holding the property since August.
ANSWER: It really depends on which year would be more favorable from a tax rate standpoint. Do you have other expenses this year that can offset the flip income? I usually advise my clients that these scenarios are best dealt with through a year end tax planning analysis. And there are Do it yourself kits out there as well as professionals that can do this analysis for you to determine which one is better.
QUESTION: Can a person take 1031 exchange monies and partner with another investor on a like property? If so, how would this look and be set up? Say I have to 1031 and want to buy a property with a partner that also brings in $100k to invest.
ANSWER: Yes you may. Partial interests qualify for exchange within the scope of Section 1031 of the Internal Revenue Code. However, if your interest is not in the property but an interest in the partnership which owns the property, your exchange would not qualify. This is because partnership interests are excluded from Section 1031. But don’t be confused! If the entire partnership desired to stay together and exchange their property for a replacement, that would qualify.
Another caveat, those individuals or groups owning partnership interests who desire to complete an exchange, and have for tax purposes, made an election under IRC Section 761(a) can qualify for deferred gain treatment under Section 1031. This can be a tricky issue!
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. You can get more information at Wealth Building Plan
