What is the Right Tax Status for your Real Estate LLC

time for taxes
time for taxes concept on blackboard background

I think many real estate investors can agree; an LLC is the appropriate entity for holding investment real estate long term. Where investors often have a disagreement is electing the appropriate federal tax status for their LLC. If any reader is not aware, an LLC is often referred to as a hybrid tax entity, i.e., the members can elect any tax status for the LLC. Many investors opt to treat their LLC as “disregarded”. This treatment can be beneficial because it eliminates the preparation and filing of costly tax returns. Consider the investor who has nine LLCs, each owning one property, and each owned by the investor and his wife. As disregarded entities, the investor will only file his annual 1040, and each of the nine properties will show up on his 1040 Schedule E page 1 as if he owned the properties outright. The obvious cost savings by not having the LLCs taxed as partnerships may not be outweighed by the increased risk of audit associated with the rental activity.

Savvy investors minimize the audit concern by establishing a “holding LLC” (this is a term with no legal significance for it is just an LLC set up to own other LLCS) in a strong asset protection jurisdiction such as Wyoming or Nevada to own each of their disregarded LLCs. The holding LLC will be treated as a “partnership” for federal tax purposes. Similar to the previous example, each of the properties will appear on the 1065 partnership return filed by the holding LLC as it is the owner of the nine LLCs. The holding LLC will provide the real estate investor and his wife a K-1 for their reportable share of the combined real estate gains or losses. This information will appear on page 2 of their 1040 Schedule E as a line item thereby significantly reducing their risk of audit. I often argue, the benefit of this structure outweighs the added cost of filing one return for the holding LLC.

In some instances, the holding LLC should elect S-Corporation tax status if the real estate investor’s, i.e., the member in the holding LLC, MAGI exceeds $200,000 for a single person or $250,000 for a married couple. The reason for this election is to avoid the 3.8% net investment income tax on investment income. Rents from real estate are considered investment income; thus, for higher income real estate investors avoiding this additional tax is important.

The final point to consider with selecting a tax status is your exit strategy. It is very common for real estate investors to use disregarded entities to hold commercial real estate, multi-family, mobile home park, etc.. Again, this type of planning will reduce your account costs, but it might also impair your exit planning. Consider the investor who purchases a multi-family with the intent to rehab, stabilize and then sell in three to five years. If you avoid the tax return, you may make it difficult for your future buyer to obtain financing. Banks typically want income verification and although your accountant may be really good at bookkeeping it will not carry the same weight as a tax return. Therefore, when planning for commercial property that you intend to sell it is always prudent to have the LLC owning the property treated as either a partnership or S-Corporation for tax purposes.

Here is a video I prepared covering the topic.

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