What is the appropriate entity for real estate investors who buy and sell, wholesale, buy tax liens and deeds, or any other activity that does not require holding on to real estate for more than one year? This question is typically answered as follows – use a limited liability company. This is an entity of choice for many investors but what is not so obvious is how it should be taxed. Depending on who sets up your LLC you will receive different answers.
The Typical Lawyer Structure
Most attorneys focus on the liability aspect of real estate investing and will set up the LLC as either disregarded or treated as a partnership for federal tax purposes. Neither of these choices will produce a desirable tax result for real estate investors engaged in an active business. Yes, the aforementioned activity can be considered and active trade or business. Courts look at seven factors which include:
- the frequency and regularity of sales of real properties;
- the substantiality of the sales and the relative amounts of income taxpayers derived from their regular business and the sales of real properties;
- the length of time the taxpayers held the real properties;
- the nature and extent of the taxpayers’ business and the relationship of the real properties to that business;
- the purpose for which the taxpayers acquired and held the real properties before sale;
- the extent of the taxpayers’ efforts to sell the property by advertising or otherwise; and
- any improvements the taxpayers made to the real properties.
If a court finds your real estate investing satisfies these factors, then your income is considered active and subject to self-employment tax. An LLC, treated as a partnership or disregarded, does not change the nature of the income to the LLCs owner. In fact, an LLC member who actively participates in the business of the LLC is treated as a sole proprietor.
For example, if Freddy Flipper generates $100,000 from the buying and selling of real estate in a single member LLC, his federal tax liability will be approximately $31,000 (regular income and self-employment tax). A CPA looking at Freddy’s situation could easily find a strategy to save him on taxes.
The Typical CPA Structure
CPAs have the tax issue nailed and prefer to set up their client’s LLCs taxed as an S-Corporation. S-Corporation taxation shares many of the same characteristics of partnership taxation in so much as both are considered flow-thru for tax purposes. A flow-thru entity is one where the income or loss passes through to the owner’s 1040. For real estate investors engaged in an active trade or business, the flow thru characteristic of the S-Corporation is preferable to disregarded or partnership status. With an S-Corporation, the portion of the income treated as a distribution is not subject to self-employment taxes.
If we look at Freddy’s situation again but this time with an LLC treated as an S-Corporation his tax situation will be very different. Freddy will take one-half of his $100,000 as a salary (this is subject to employment taxes) and the remainder as a distribution (this is not subject to employment taxes). The net result is Freddy’s taxes are only $25,000. A $6,000 tax savings by electing a different tax status for his LLC.
You might assume the CPA’s plan is the best solution for the active real estate investor. You might be correct if taxes were your only concern. Real estate investors have other interests beyond taxes typically borrowing, i.e., having access to capital. Both the attorney and CPA strategy do not address the impact flow through entities have on a real estate investor’s tax return.
When applying for a loan the lender will ask for your 1040 personal income tax return. If you are running your active business through a flow through a disregarded LLC, the lender will consider you a sole proprietor because all of your income is reported on Schedule C. If you are using an LLC taxed as an S-Corporation, you will have W-2 income and a K-1 with income from your LLC. Upon their discovery of the K-1, your lender will ask to see the LLC’s tax return, its profit and loss statement, balance sheet and possibly its bank statements. In both the attorney and CPA structure, your lender will view you as a higher risk borrower because you run your own business.
Real Estate Investor / Attorney Structure
A good real estate planning firm might recommend you treat your active real estate business as a C-Corporation and receive your profits as W-2 income. The advantage to this approach is your lender does not know you own a business because your ownership is not disclosed on your 1040 (less risk), and you fit into their preferred lending profile – W-2 wage earner. The downside to using the C-Corporation approach is your tax liability will be the same as the single member LLC but with increased access it can be an acceptable trade-off.
I employed the aforementioned strategy to assist one of my real estate clients in accessing the equity in his home. My client earned $150,000 on average from his real estate flipping but lenders, uncomfortable with his source of income, refused to give him more access to the equity in his personal residence, approximately $600,000. To solve this problem, we created a C-Corporation for his real estate business and treated all of his income as W-2 earnings. Within the year, he had access to his equity.
Real estate investing requires studying your objectives from many angles then deciding on a plan that meets your overall objectives. In some instances, it may only be tax while in others it could be the ability to fund a retirement plan or in the case of my client, borrow more money. Whatever your investing objectives, work with professionals who understand investing and not just the tax or legal aspects of real estate.