Real Estate Tax Strategies And Forming An LLC
The 1st step in doing any real estate investments is to start a business. There are different types of business entities: sole proprietorship, Limited Liability Company (LLC), Series LLC (only in certain states), Limited Liability Partnership (LLP), LLLP, S-Corp, C-Corp. Series LLC can be set up in following states: Delaware, Iowa, Oklahome, Tennesee, Utah, Wisconsin.
Each of them has its advantages and disadvantages. The only true flow through taxation entity and the most beneficial in terms of holding real estate is Limited Liability Company. Limited Liability Company 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 they are real estate or business related are deducted on AFTER-TAX basis. When you have an LLC, you take all business expenses, deduct them, and pay income tax on what is left over. LLC does not require records and minutes of meetings. Filing paperwork is limited to articles of organization that lists LLC members. Tax Advantages: LLC is a pass through entity and if it is a single member the entity is considered disregarded by IRS. A corporation is subject to double taxation where not only the profits are taxes but also distribution in the form of dividends are taxed as well. The other advantage is flexibility in terms of LLC ownership transfer. LLC ownership is guided by Operating Agreement, which is an internal document. In order to change ownership all that needs to be done is the Operating Agreement and no filings are required besides updates with IRS for given tax ID number. LLC is the only entity that is NOT subject to loss limitation! It also has less filings than an S-Corp and very easy to maintain. If you have multiple properties, have them each in LLC and have one LLC to be your holding company that would own all the other LLCs. For tax purposes your main holding LLC will be a sole member LLC for the other ones 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 business owns the assets, they are separated from your personal assets and in case of a law suit they can not be touched. Please, note that LLC is a BASIC level of asset protection and if the opposing party has a good attorney there are many ways how your personal assets can become a part of a law suit. It is called piercing corporate veil. For example, you are required to have a separate bank account for an LLC. If your LLC owns your property, then all property relates income and expenses have to come out of that particular bank account. If this is not done, the LLC status can be disqualified and your personal assets become part of the lawsuit. Your LLC must be in good standing with the state and your must have adequate information on your article of organization. The purpose of the business must be clearly stated with no exclusions and you must file amendments when necessary. If you buy real estate, you should say that you buy, hold, rent or lease residential real estate; if you sell, you must state that you buy for the purpose of resale for profit, etc. In some states it is necessary to publish LLC in a local newspaper, and it can get very expensive; in other states like Maryland you need to pay annual fee, which is currently $300 a year. You need to check on your state requirements and guidelines and always be in good standing with the state.
Primary Residence. If you have an LLC, you might need an office and conveniently enough it could be in your personal residence. According to IRS Code 288G, you are allowed to deduct rent payments for your office space in your personal residence.
Depreciation. It is the most beneficial deduction in real estate! While your real estate is appreciating, you are allowed to depreciate it over the life of the building, which is 27.5 years and take the deduction against your income. However, depreciation is allowed only against the building, land can not be depreciated. For example, if you own a house thats worth 100,000, the value of the building might be only $80,000 and the value of the land is $20,000. Thus, you are allowed to take depreciation expense against the value of the building only.
Accelerated Depreciation. You might 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, sidewalk, and landscaping are depreciated over 15 years; personal property is depreciated over 5 years. Items that are considered personal property according to IRS code 1.48-1(c) must have one of the following features 1. accessory 2. function 3. movability. Basically everything that is an accessory, functions or movable is real property. If you are doing a rehab and can install movable walls, you can deduct the cost of improvements over 5 years. If they are not movable, then you will have to take 5-6 times less deduction for improvements in the next 5 years. Make everything you can either function, be an accessory or make it movable! One commercial developer built his office building with light weight movable walls and was able to deduct $80,000 that same year.
DEALER status. When flipping properties it is important to avoid “DEALER” status. In some case it can be avoided by flipping properties through different entities, in some cases by doing a few transactions, but the easiest “investor friendly” way is to simply state your INVESTMENT INTENT. If you state that your investment intent is buy, hold, lease, and rent properties unless forced to sell under certain conditions like need for working capital, you can get away with not being considered a DEALER.
IRS Red Flags. There are also certain things you should not do that would raise red flags to IRS and you might get audited. First, do not report too much rental income loss, there are plenty of expenses you can find to reduce your pre-tax income. Second, do not over complicate your asset protection structure. Having too many business entities on top of each other, or having domicile headquarters in Las Vegas, NV, tax free state could be a red flag. Reporting losses for more than 2 years always raises red flags. The common sense behind it: “if you do not make money why are you still doing business?”. Reporting excessive donations, high expenses vs high income can also cause an audit.
Property Taxes. Real Estate Investors are subject to a number of taxes including property taxes. Assessed value and market value of the property always have a gap. In 2007 assessed value was normally lower and in 2010 it is 99% of the time higher than market value of real estate. The taxes are not always reassessed depending on the market cycle and it is your responsibility to dispute them. In state of Maryland it is allowed to dispute personal property taxes within 60 days off settlement date or file before the end of the year for the next year hearing. Even though taxes are a deduction against income, they are not a tax credit, and the more you can minimize your expenses the more profit you will end up with. In order to successfully dispute your tax bill you would need to show the comparables and recent sales prices of real estate in your area. You will also need to compare the real estate that was 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 you sell the property. The difference between purchase price and sales price is subject to this tax. There are exemptions to homeowners who lived in the property for at least 2 years and the amount of profit. There is a way to citizenship by investment in turkey defer capital gains taxes by doing a 1031 Exchange. Make sure that you contact an escrow company and do everything within IRS guidelines. According to this IRS rule you can sell your property, find another property, make an offer within 45 days and settle on a new property within 6 month and defer paying capital gains taxes. According to the IRS tax rules, the property you are buying must be “likewise” property, meaning it does not matter if it is bigger as long as it is “investment” just like the one you just sold. So you can buy a single family house and buy an apartment building as long as both were investment properties.
What is essential to know before setting up an LLC?
The NAME. Your business should be in the name of your LLC. Most companies name LLC by the street address, for example 17 Lexington Ave LLC…I prefer to name them by the number and street name only without St..Ave..Ct.etc For example 17 Lexington LLC. It is just easier to remember and shorter to write. When you get a number of LLCs set up it starts getting confusing which one was St or Street or Ave, and the correct spelling of the LLC is essential in absolutely everything you do.
CHECKING NAME AVAILABILITY. Once you pick the name, you need to check the name availability with the Secretary of State Office. In many states in could be done online, and if you go to Secretary of State Office, they can check it there for you as well. I like to go in person to file all paperwork just because I can get everything done right there and get all paperwork in my hands the same day. In state of MD it costs extra for expediated service but it is worth paying because you need to get your bank account and everything else straightened out right away.
ARTICLES OF ORGANIZATION. Articles of Organization is the name documents that lists members and managers of the LLC. It does not have to be registered with the state, at least in MD and NY.
REGISTERED AGENT OR RESIDENT AGENT. An LLC requires a resident agent to serve on behalf of the LLC. It can be a business entity or individual that resides in the state where LLC was formed. For example, if you live in state of New York, you can list your name and address as a registered agent, or hire a company to represent the LLC. If the LLC is formed in another state, it is necessary to have a registered agent in that state.