GREAT STRATEGIES FOR REAL ESTATE INVESTORS
NEVER HOLD TITLE TO REAL ESTATE IN YOUR OWN NAME: The first and biggest mistake you can make as an investor is holding title to your real estate in your own name. It is fine to “take” title in your personal name as long as you transfer the title to a “controlled” entity at your first opportunity. All deeds are public record and free for prying eyes to see. Having property in your own name makes you an easy target for tenants, creditors and attorneys. If a liability is created on your property, the owner is liable (that’s you).
WHICH IS THE BEST ENTITY FOR BUYING, SELLING AND HOLDING REAL ESTATE: This is a much-debated question. Everyone has a differing view on this issue. After all the smoke, mirrors and hype is cleared from the issue, it is our opinion, that:
RECOMMENDED SINGLE ENTITY: if we had to choose a single entity instead of the recommended structures, the entity we would recommend is the tried and true Nevada Series Limited Liability Company (SLLC) for Real Estate investing.
HOWEVER IF A CORPORATION IS USED: There are essentially two types of corporations for tax purposes, “C” and “S” corporations. A corporation is a “C” corporation by default; as the “S” status must be “elected” after incorporation. A “C” corporation files its own tax return and pays taxes on its NET profits. When the corporation distributes profit to its shareholders (called a “dividend”), the shareholders pay additional tax on their personal income tax returns (called “double taxation”). Notwithstanding the forgoing, in smaller “non-publicly traded” corporations (under 2 million in gross income) you will rarely have any dividends and therefore double taxation would not be an issue.
On the other hand, an “S” corporation is not taxed at the corporate level. Like a partnership (or LLC), it files an informational return (IRS form 1120-S) and the shareholders report their share of profit or loss on their personal 1040 income tax returns.
Which Is Better For Real Estate? An “S” corporation is not necessarily better or worse than a “C” corporation, but rather it depends on the investor’s particular tax situation. For example, an investor who has a working spouse may benefit from an “S” corporation, since a loss from the “S”-corporation’s operations can be used to offset the working spouse’s income.
On the other hand, if an investor has a large profit from an “S” Corporation, he/she will pay income tax on all profits, whether or not they are reinvested or distributed.
With a “C” corporation, the individual shareholder is not taxed on profits until they are distributed (the corporation itself pays tax on its income, but the first $50,000 of “C” corporation income is only taxed at the rate of 15%, which is lower than personal income tax rates). In addition, the C”-corporation can provide and “write off” far more deductible expenses that can an S”-corporation, partnership or LLC. Therefore, the “C”-corporation may in fact be able to expense its income down to a zero tax base. None of the other entity choices can provide this benefit.
OTHER IMPORTANT CONSIDERATIONS
Self-Employment Taxes: (IRS Code Section 1402 and Publication 533): Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners. You figure SE tax using Schedule SE (Form 1040). SE Tax is 15.3% of your gross income up to $87,900.
IRS Publication 533 ALSO states the following:
Are You Self-Employed? You are self-employed if any of the following apply to you:
- You carry on a trade or business as a sole proprietor or an independent contractor.
- You are a member of a partnership that carries on a trade or business.
- You are otherwise in business for yourself.
Trade or business. A trade or business is generally an activity carried on for a livelihood or in good faith to make a profit. The facts and circumstances of each case determine whether or not an activity is a trade or business. The regularity of activities and transactions and the production of income are important elements. You do not need to actually make a profit to be in a trade or business as long as you have a demonstratable profit motive. You do need, however, to make ongoing efforts to further the interests of your business.
Sole proprietor. You are a sole proprietor if you own an unincorporated business by yourself. (This designation would include ALL single member LLCs and LLC owned by a husband and wife in a community property state).
Corporate Director, Employee, or Shareholder: This section provides information to help you determine whether your earnings are subject to SE tax if you are a:
Corporate director. Fees you receive for performing services as a director of a corporation are subject to SE tax. It does not matter whether the fees are for going to directors' meetings or for serving on committees.
Corporate employees or officers. Even if you own most or all of the stock of a corporation, your income (salary) as an employee or officer (officers are considered employees) of the corporation is not subject to SE tax.
“S” corporation shareholder and officer. If you are a shareholder in an “S” corporation, your share of the corporation's earnings are not subject to SE tax, even though you include them in your gross income for income tax purposes.
NOTE: If you are a shareholder and also an officer of an “S” corporation and perform substantial services to the corporation, you are considered an employee of the “S” corporation. Your payment for services is subject to withholding of social security and Medicare taxes and is therefore not subject to SE tax, regardless of what the “S” corporation calls the payments. Basically this same rule would apply to a “C” corporation as well.
Additional information worthy of mention from publication 533:
Real Estate Rent: Rental income from real estate is not included in earnings subject to SE tax unless either of the following applies to you.
1. You are a real estate dealer
Real estate dealer. You are a real estate dealer if you are engaged in the business of selling real estate with the purpose of making a profit from those sales. Rent you receive from real estate held for sale is subject to SE tax. However, rent you receive from real estate held for speculation or investment is not subject to SE tax. NOTE: This would NOT apply to you if you are operating your real estate business through a “controlled” entity.
2. You provide services for your tenants (you personally manage your properties).
NOTE: Starting in the 2003-tax year, the IRS (and many states have started to follow suit) has been attacking individuals in the real estate business by arbitrarily tagging them with a “Dealer” Status Designation. A dealer is an individual who regularly buys, sells and holds real estate as a business. If an individual is tagged as a “dealer,” the income from his or her sales of property is subject to self-employment tax. Notwithstanding the forgoing, buying and selling real estate through an entity, can avoid the “dealer” status.
WHAT ABOUT CAPITAL GAINS?: Because the business of the corporation is buying and selling real estate, the income generated from renting or the sale of real estate owned by the corporation would be classified as “ordinary business income” that can be spent by the corporation to pay its normal business expenses as well as benefits for you. Should any “taxable” NET income be remaining at the end of the year, the corporation would be required to pay taxes only on the amount remaining. Should that amount NOT exceed $50,000.00, the corporation would be taxed at 15%. However, the corporation could “ZERO OUT” its net income and pays NO taxes at all.
IF YOU USE A CORPORATION FOR YOUR REAL ESTATE BUSINESS YOU COULD Sell The Corporate Stock And Not The Property: If you are holding a single property in a corporation as the only asset in the corporation, (and the corporation is operating as a real estate or investment business), you could sell the stock of the corporation when you are ready to sell the property. You are essentially selling the entity’s business, which contains the property. If you had “reified” and “stepped up” the cost basis, then you will have little or no capital gains from the sale of the stock in the corporation.
Why would anyone want to buy the stock and not just the property? The answer is simple; for the same reasons you originally transferred the property into the entity in the first place; tax write offs and asset protection.
Should you choose to sell the stock, the usual escrow closing and settlement costs can be minimized if not totally eliminated. The sale of the corporate stock then becomes a simple transfer of stock certificates, the corporate book, and a name amendment on the property with the lender and a signatory name change on the bank account for the entity. You only need to execute a stock subscription agreement and corporate resolutions, in order to reflect the change of owners of the entity, when you sell the entity.
One final thought ABOUT SELLING STOCK: By selling the stock you can set up an “owner carry back” type of financing with the buyer. Your risk becomes minimized because you are selling the stock over time (and reducing the corporate and your taxable income stream to a minimum). Should the buyer fail to pay, he/she simply owns the amount of stock already purchased as though they were any other investor in your corporation. An additional process would be to utilize a lease with option to buy in conjunction with the sale of the stock. In this way, the buyer is actually leasing with the option to purchase. There is more to the actual implementation of this concept but I think you have the basic “drift” of this strategy.
THE ABSOLUTE BEST STRUCTURE FOR REAL ESTATE INVESTORS
In reality, it is our opinion that there is no single entity that is best for buying, holding and selling Real Estate. The optimum structure for this endeavor is to utilize a Series Limited Liability Company (SLLC) as the beneficial owner of the properties with a Nevada Limited Liability Limited Partnership (LLLP) as the owner of the SLLC. You can maintain control with minimum ownership interest by positioning yourself as the General Partner (with a 2% ownership) and have your Living Trust as the Limited Partner (with a 98% ownership). This “recommended” entity structure would provide the best mix of asset protection, tax savings and flexibility.
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