business entity

The first step in making any real estate investment is starting a business. There are different types of business entities: Sole Proprietorship, Limited Liability Company (LLC), Series LLC (certain states only), Limited Liability Company (LLP), LLLP, S-Corp, C-Corp. Each of them has its advantages and disadvantages. The only true flow-through-tax entity and the most beneficial in terms of real estate ownership is the Limited Liability Company. Limited Liability Partnership allows you to pay for business-related expenses with pre-tax dollars. It is very important to understand that when you get paid and receive your paycheck, your taxes are already deducted and all your expenses, whether real estate or business related, are deducted AFTER TAX. When you have an LLC, you take all business expenses, deduct them, and pay income tax on what’s left over. LLC is the only entity that is NOT subject to stop loss! LLC does not require records and minutes of meetings. Document filing is limited to articles of organization that list the members of the LLC. Tax advantages: LLC is a pass-through entity and if it is a single member, the IRS considers the entity disregarded. A corporation is subject to double taxation in which not only the profits are taxed, but the distribution in the form of dividends is also taxed. The other advantage is the flexibility in terms of transfer of LLC ownership. Ownership of the LLC is governed by the Operating Agreement, which is an internal document. To change ownership, all that needs to be done is the Operating Agreement and no filings are required other than updates with the IRS for the given tax ID number. It also has fewer filings than an S-Corp and is very easy to maintain. If you have multiple properties, have each one in an LLC and have one LLC to be your holding company that would own all the other LLCs. For tax purposes, your primary holding LLC will be a sole member LLC to others and you will need to file only one tax return. In addition to the tax benefits, LLC also allows you to have a basic level of asset protection.

If your company owns the assets, they are separated from your personal assets and, in the event of a lawsuit, cannot be touched. Keep in mind that LLC is a BASIC level of asset protection and if the opposing party has a good lawyer, there are many ways your personal assets can become part of a lawsuit. It’s called piercing the corporate veil. For example, you must have a separate bank account for an LLC. If your LLC owns your property, all income and expenses related to the property must come from that particular bank account. If this is not done, the 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 must have adequate information regarding its article of organization. The purpose of the business must be clearly stated with no exclusions and must be amended when necessary. If you buy real property, you must say that you buy, hold, rent, or lease residential real property; if you sell, you must state that you are buying for the purpose of reselling for profit, etc. In some states it is necessary to list the LLC in a local newspaper, and it can be very expensive; In other states like Maryland, you must pay an annual fee, which is currently $300 per year. You should check your state’s requirements and guidelines and always be up to date with the state.

*RENT DEDUCTION* on your principal residence. If you have an LLC, you may need an office, and it could conveniently be at your personal residence. Under IRS Code 288G, you are allowed to deduct rent payments for your office space at your personal residence.

*Depreciation*. It’s the most beneficial deduction in real estate! While your real estate is appreciating, you are allowed to depreciate it over the building’s useful life, which is 27.5 years, and take the deduction against your income. However, depreciation is only allowed against the building, the land cannot be depreciated. For example, if you own a house that is worth $100,000, the value of the building might be only $80,000 and the value of the land is $20,000. Therefore, you are allowed to take depreciation expenses against the value of the building only .

*Accelerated depreciation*. You may have heard from your accountant that accelerated depreciation is not allowed against real estate, and it is true, but there is a way to make improvements deducted in prior years and it all depends on how they are classified. For example, land improvements such as curbs, sidewalks, and landscaping depreciate over 15 years; personal property is depreciated in 5 years. Items that are considered personal property under IRS code 1.48-1(c) must have one of the following characteristics 1. accessory 2. function 3. mobility. Basically everything that is an accessory, function or piece of furniture is immovable property. If you are rehabbing and can install movable walls, you can deduct the cost of the improvements over 5 years. If they are not mobile, you will have to deduct 5-6 times less for improvements over the next 5 years. Make everything that can work, be an accessory or make it mobile! A commercial developer built his office building with lightweight movable walls and was able to deduct $80,000 that same year.

Status of *DEALERSHIP*. When changing properties, it is important to avoid the “DEALER” state. In some cases, it can be avoided by exchanging properties through different entities, in some cases doing a few transactions, but the easiest way to be “investor friendly” is to simply state your INVESTMENT INTENT. If you state that your investment intent is to buy, hold, lease and rent properties unless you are forced to sell them under certain conditions, such as the need for working capital, you can get away with not being considered a DEALERSHIP.

*IRS Red Notices*. There are also certain things not to do that would raise red flags for the IRS and you could get audited. First, don’t report too much lost rental income, there are many expenses you can find to reduce your pre-tax income. Second, don’t overcomplicate your asset protection structure. Having too many business entities on top of each other, or being headquartered in Las Vegas, NV, a tax-exempt state, could be a red flag. 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 expenses versus high income can also trigger an audit.

*Property taxes*. 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 the appraised value was normally lower and in 2010 it is 99% of the time higher than the market value of real estate. Taxes are not always reassessed based on the market cycle and it is your responsibility to dispute them. In the state of Maryland, it is permissible to dispute personal property taxes within 60 days of the date of assessment or to file before the end of the year for next year’s hearing. Although taxes are a deduction against income, they are not a tax credit, and the more you can minimize your expenses, the more profit you’ll make. To successfully dispute your tax bill, you will need to show recent comparables and sales prices for real estate in your area. You will also need to compare real estate that recently sold to your property in terms of structure, number of bedrooms, bathrooms, square footage, amenities, etc.

*Capital Gains Taxes*. This type of tax is imposed only when the property is sold. The difference between the purchase price and the sale price is subject to this tax. There are exemptions for owners who lived in the property for at least 2 years and the amount of the gain. There is a way to defer capital gains taxes by doing a 1031 Exchange. Be sure to contact an escrow company and do everything within IRS guidelines. Under this IRS rule, you can sell your property, find another property, make an offer within 45 days, and settle in a new property within 6 months and defer paying capital gains taxes. According to IRS tax rules, the property you’re buying must be “equally,” which means 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 only a general description and not legal advice on general real estate tax laws. This information may be different or not applicable depending on your state, tax bracket, or other restrictions imposed by the IRS. Please check with your accountant in your local area.