Business entity
The first step in making a real estate investment is starting a business. There are different types of business entities: sole proprietorship, Limited Liability Company (LLC), Series LLC (in certain states only), Limited Liability Company Partnerships (LLP), LLLP, S-Corp, C-Corp. Each of them has advantages and disadvantages. The only true flow through a taxing entity and the most profitable in terms of holding real estate is a Limited Liability Company. A Limited Liability Company allows you to pay for business-related expenses in pre-tax dollars. It is very important to understand that when you are paid and receive your salary, your taxes are already withheld and all your expenses whether they are real estate or business related are deducted on an AFTER TAX basis. When you own an LLC, you take all of the business expenses, deduct them, and pay income taxes on what’s left over. The LLC is the only entity that is NOT subject to a loss limit! An LLC does not require meeting records and minutes. Submission of documents is limited to organizational articles that list LLC members. Tax Advantages: An LLC is a graduated entity and if it is a sole member it is considered waived by the IRS. Corporations are subject to double taxation where not only profits are taxed but distributions in the form of dividends are also taxed. Another advantage is the flexibility in terms of transferring LLC ownership. LLC ownership is guided by an Operating Agreement, which is an internal document. To change ownership all that needs to be put in place is an Operating Agreement and no filings other than an update with the IRS are required for the given tax ID number. It also has fewer filings than S-Corp and is very easy to maintain. If you own multiple properties, own each in an LLC and own one LLC to be your holding company which will own all the other LLCs. For tax purposes, your parent LLC will be the sole LLC member for all others and you only need to file one tax return. In addition to the tax benefits, an LLC also allows you to have a basic level of asset protection.
If your business owns assets, they are segregated from your personal assets and in the event of a lawsuit, they cannot be touched. Please note that an LLC is a BASIC level of asset protection and if the counterparty has a good attorney there are many ways your personal assets can become part of a lawsuit. This is called a piercing corporate veil. For example, you are required to have a separate bank account for the LLC. If your LLC owns your property, then all property-related income and expenses must come out of that bank account. If this is not done, LLC status may be disqualified and your personal assets become part of the lawsuit. Your LLC must be in good standing with the state and you must have adequate information on your articles of organization. Business objectives must be clearly stated without exception and you must submit amendments where necessary. If you buy real estate, you must say that you are buying, holding, renting, or leasing residential real estate; if you are selling, you must certify that you are buying for the purpose of reselling for profit, etc. In some states, the LLC needs to be published in the local paper, and that can be very expensive; in other states like Maryland you will need to pay an annual contribution, which is currently $300 a year. You need to check your state’s requirements and guidelines and always be in good standing with the state.
*RENT DECREASE* for your main Residence. If you own an LLC, you will probably need an office and be quite comfortable in your private residence. Under IRS Code 288G, you are allowed to deduct your office space lease payments at your private residence.
*Depreciation*. This is the most profitable deduction in real estate! While your real estate goes up, you are allowed to depreciate it over the life of the building, which is 27.5 years and take the deduction from your income. However, depreciation is only allowed for buildings, land cannot be depreciated. For example, if you own a house for 100,000, the building may only be worth $80,000 and the land value is $20,000. Thus, you are allowed to take depreciation on the value of the building only.
* Accelerated Depreciation *. You may have heard from your accountant that accelerated depreciation is not allowed on real estate, and that is true, but there are ways to do deductions in prior years and it all depends on how they are classified. For example land improvements such as sidewalks, walkways and landscaping are depreciated over 15 years; private property is depreciated over 5 years. Items considered personal property under IRS code 1.48-1(c) must have one of the following features 1. accessory 2. function 3. transportability. Basically everything that is accessories, functions or moves is real property. If you do your rehab and can install movable walls, you can save 5 years on repair costs. If it cannot be moved, then you will have to take 5-6 times less deductions for repairs in the next 5 years. Make everything you can work, accessorize it, or make it movable! A commercial developer built his office building with movable lightweight walls and was able to deduct $80,000 that same year.
status *DEALERS*. When reversing properties, it is important to avoid “DEALER” statuses. In some cases this can be avoided by flipping the property through a different entity, in some cases by making multiple transactions, but the easiest “investor friendly” way is to state your INVESTMENT OBJECTIVE. If you state that your investment objective is to buy, hold, lease and lease property unless forced to sell under certain conditions such as working capital needs, you can get away with not being considered a DEALER.
*IRS Red Flag*. There are also certain things you should not do that will raise red flags for the IRS and you may end up getting audited. First, don’t report too much lost rental income, there are many costs you can find to reduce your pretax income. Second, don’t overcomplicate your asset protection structure. Having too many business entities on top of one another, or having a domicile headquarters in Las Vegas, NV, a tax haven state can be red flags. Reporting losses for more than 2 years always raises red flags. The common sense behind it: “if you don’t make money why are you still in business?”. Reporting excessive donations, high spending vs. high income can also lead to an audit.
*Property tax*. Real Estate Investors are subject to a number of taxes including property taxes. The appraised value and the market value of the property always have a gap. In 2007 appraised values were typically lower and in 2010 they were 99% higher than real estate market values. Taxes are not always reassessed depending on market cycles and it is your responsibility to dispute them. In the state of Maryland, it’s legal to dispute personal property taxes within 60 days of the settlement date or file before year-end for the following year’s hearing. Although tax is a deduction from income, it is not a tax credit, and the more you can minimize your expenses, the more profit you will make. In order to successfully dispute your tax bill, you will need to show comparable and current selling prices for real estate in your area. You will also need to compare recently sold real estate to yours in terms of structure, number of bedrooms, bathrooms, square footage, amenities, etc.
*Capital Gains Tax*. This type of tax is charged only when you sell the property. The difference between the purchase price and the selling price is subject to this tax. There are exceptions for homeowners who have lived in the property for at least 2 years and profit amounts. There is a way to defer capital gains tax by doing a 1031 Exchange. Make sure you contact the escrow company and do everything according to IRS guidelines. According to these IRS rules, you can sell your property, find another property, submit an offer within 45 days, and complete a new property within 6 months and defer paying capital gains tax. According to IRS tax rules, the property you buy must be “also” property, meaning it doesn’t matter if it’s larger as long as it’s an “investment” like the one you just sold. So you can buy a single family home and buy an apartment building as long as both are investment properties.
The information provided in this article is an overview only and is not legal advice regarding general real estate tax laws. This information may or may not be applicable depending on your state, tax class, and/or other restrictions imposed by the IRS. Please, consult your accountant in your area.
