Let’s say you’re an investor who buys and sells properties…wholesales…deals in tax liens or deeds…or engages in other real estate related activities in which you don’t hold onto a property for more than one year. What’s the appropriate entity to use for these transactions? Typically, the answer is an LLC, or Limited Liability Company. Basically, that’s a good place to start. However, where it can get sticky is when you start asking, “But how are these LLC holdings taxed?”
Why? Because depending on what source you consult, you can get totally different perspectives. And different answers about only one aspect or two — if they don’t deal with the whole of your situation — can cost you plenty. Here are a couple of examples of different LLC structures, and what they mean in terms of how you can best profit from real estate investing.
Strategy #1: What the “Legal Beagle” Does
Lawyers are all about liability — and how to escape it! So, they’ll focus on that aspect of real estate investing; they’ll set up the LLC as either of no consequence (“disregarded”) or as a “partnership” for federal tax purposes.
But Here’s the Problem:
Neither of these options produces optimal tax results if the IRS decides your real estate concern is an “active business.” And real estate investment can be considered just that.
What determines that definition? Tax courts examine a collection of factors:
- How often, and how regularly, a taxpayer sells properties
- How substantial the sales are, and what kind of income the taxpayer derives from them
- How long a taxpayer holds real properties
- The nature and size of the taxpayer’s business and how the real properties “fit into” it
- Why the taxpayer acquired and held the property in the first place, especially prior to selling
- Any efforts a taxpayer made to sell the property, such as advertising and marketing
- Improvements the taxpayer made to the real properties
If your real estate investment “business” exhibits these factors, then your income is defined as “active,” and you’re subject to the self-employment tax.
And the Bad News…
An LLC, treated as a partnership or disregarded, doesn’t affect this classification for tax purposes. In fact, if you as an LLC member actively participate in the business, you are considered a sole proprietor.
Let’s See an Example.
Meet our Everyman for these purposes: we’ll call him Freddy Flipper. Under the rules listed above, if Freddy generates $100,000 from buying and selling real estate in a single-member LLC, his federal tax liability is in the neighborhood of $31,000 in both regular income and self-employment taxes.
Yipes! Isn’t There a Better Way?
After Freddy picks himself up off the floor, he decides he’d better talk to his CPA. That’s part of what his CPA does, after all — find him beneficial tax strategies. Fortunately, Chuck the CPA says, “Of course we can do better than that. Let me crunch some numbers and I’ll show you.”
Strategy #2: What the CPA Can Do
Chuck the CPA explains to Freddy that yes, indeed, he can “nail” the tax issue with one simple change: he’ll set up the LLC as an S-Corporation. For IRS purposes, S-Corporations are similar to partnerships in several key ways. One is that both are considered “flow-through” entities — instruments in which income (or loss) passes (hence, flows) through to the owner’s 1040.
Freddy is relieved. This is a much better approach than a disregarded or partnership status when it comes to taxing his active business of real estate investing: in an S-Corporation, the distribution portion of his income isn’t subject to self-employment tax.
What This Looks Like
Now, with Freddy’s LLC treated as an S-Corporation, watch what happens: he takes half of that aforementioned $100,000 as a salary, and the remainder as a distribution. The salary is subject to self-employment tax; the distribution is not. What’s the difference? A cool $6,000 in tax savings. Freddy the Flipper’s taxes are now only $25,000, based on electing a different tax status for his LLC.
Wow! That’s Better!
Yes, it is…on one level. Looking at this, you could be forgiven for assuming the CPA truly did nail the best option for an active real estate investor. And that would be right…IF taxes were your only concern.
But you have other aspects of investing in real estate that you’re dealing in besides tax issues: typically, investors also do some borrowing against their investments, and they want access to capital. For these purposes, neither the lawyer’s nor the CPA’s approach will fully address the impact a flow-through entity can have on your tax return.
There’s an “App” for That
The additional sticky situation comes in when Freddy applies for a loan against his investments. As part of the normal process, the lender asks for his personal 1040 income tax return.
At that point…
- If he runs this active real estate business through a disregarded LLC, the lender will consider him a sole proprietor — remember? — because all his income is reported on Schedule C.
- If he uses an LLC taxed as an S-Corporation, he’ll have both W-2 income and a K-1 with income from the LLC. When they see the K-1, however, Freddy’s lenders go onto a whole other level: they’ll want to look at the LLC’s tax return, profit and loss statement, balance sheet — and perhaps even its bank statements.
The bottom line? In both the attorney-directed and the CPA-advised structure, Freddy ends up being viewed as a higher-risk borrower: after all, he’s self-employed!
How to Escape?
Strategy #3: The C-Corporation Approach
If you sit down with a good real estate planner, you’ll likely hear about a third alternative: treating your active real estate business as a C-Corporation and receiving your profits as W-2 income. This saves you the “dings” of being considered a business owner and/or self-employed. Your ownership isn’t part of your individual 1040, which means there’s less risk for lenders, and you’ll fit into their preferred profile as a W-2 wage earner.
Be aware that this doesn’t make you totally “bulletproof” tax-wise: your liability is the same as in the single-member LLC. But it has enough positives in terms of increased access that it makes a nice trade-off.
How This Works
This is the approach I used to help a client access the equity in his home. On average, this client earned $150,000 from his real estate flipping — but, uneasy about his source of income, lenders balked at giving him access to some $600,000 worth of equity in his personal residence. When we created a C-Corporation for his real estate business, however, all his income became treated as a W-2 “wage”…and within the year, that equity was available to him.
Determining Your Strategy
No one alternative is perfect; there’s no one-size-fits-all “ideal solution” for every investor. Depending on whether you’re more concerned with taxes, funding your retirement, or borrowing, you’ll want to examine your real estate “business” from different angles to find the best route to take. Whatever your objectives are, seek advice from a trained professional who understands the big picture of real estate investment as a whole…not just its legal or tax aspects.