When it comes to taxes, investing, business, and real estate, it seems as if the terms are never-ending.
Being a smart business owner, real estate investor, or overall financially smart individual takes research and education.
Oftentimes we try to self-diagnose and find ourselves in a Google vortex. When you’re feeling ill, googling your symptoms will only cause you more trouble due to the never ending answers you get.
The same goes for how we manage our money and business moves. The same can be said for our financial decisions. Why do we get such different answers and responses?
The key is, none of them are absolutely right or wrong.
What truly matters is the perspective one has for each situation.
Everyone cannot have the same exact issue, nor can someone be the answer to all your issues if they do not have all the facts about your situation. The best we can do is stay informed, educate ourselves, and do the right research with the right people.
Speaking with a tax strategist can be an important way to get a hands on, detailed view of your best options.
The following information is to inform potential or active real estate investors of specific ways certain business entities can affect your business and financial plans.
Before you read!
Here are some key terms you may or may not be familiar with:
Flow-through entity: A flow-through entity is an entity that is treated as a partnership, not taxable as a corporation, a grantor trust or disregarded entity for U.S. federal income tax purposes or subject to treatment on a comparable basis for purposes of state, local or foreign tax law.
Workflow management: Workflow management is the administration of multiple steps or tasks within a business process.
Limited Liability Corporation: A limited liability company (LLC) is a corporate structure in the United States whereby the owners are not personally liable for the company’s debts or liabilities.
S corporation: S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.
Schedule K-1 A Schedule K-1 is a tax document used to report the income, losses, and dividends of a business’s partners or an S corporation’s shareholders.
If you own real estate, there are so many options and each with its own outcomes. The following is information for those who own real estate, or may be interested in owning real estate:
A Flow-through management company:
Flow-through management companies are recommended for clients who own real estate and may be receiving a lot of profit from their real estate. This would also be a good idea if real estate owners are out of depreciation and want to get other write-offs that are not specifically tied to the piece of real estate.
💎 Speaking of Real Estate: Let’s define a schedule E: When you own rental real estate and you are on a 1040 individual tax return, your rental real estate is going to get reported on the schedule E. So when we say schedule E, we mean that an individual is filing a 1040 return.
If you are in a flow-through entity, like in an LLC , it is going to be on a similar form that looks like a schedule E, but it’s inside of your flow-through entity. They may look similar, but they are different things. Due to this, many folks make the mistake of mixing up where the expenses are put. This is not good because when it gets to the IRS, they are going to see expenses that should not be there and will flag the file. We always want to make sure that everything is where it belongs and done in a legal, accurate way. The reason why we recommend the flow-through management company is so that you can pick up expenses that may be auxiliary to you owning a rental property and get a write- off for it without flagging a return for audit. This is a legitimate write-off and is being placed in its proper location.
Limited Liability Company (LLC):
Everyone has different reasons for buying real estate, whether that be for creating wealth, leverage, cash flow, appreciation, or reducing a tax burden. However, real estate can also come with its own risks such as lawsuits from tenants. Our main goal is to try to protect these assets, and in order to do so we may go inside of a Limited Liability Company (LLC). You are able to get write-offs within the LLC. However, if you want even bigger write-offs, we are only going to put in your rental property with the normal expenses that go with the rental property such as mortgages, insurance, property taxes, repairs, etc. Your other expenses, however, are going to be thrown into a management company or S-Corp. The reason for the flow through management is because other write-offs will not look normal inside of an LLC that is holding real estate.
💎TIP: As a rule of thumb, you would not use a C corporation to hold real estate. The C corporation is the mother liability protection. It is the best to have, but not for when you’re holding real estate.
What is K1?
When you work a W-2 job, you receive a W-2, right? When you work for an employer, you get a W-2 at the end of the year. When you own an entity, that is a flow-through. When we use the words flow-through, think of it like this: Here is the entity over and here’s you. The entity will file a tax return and maybe pay an $800 minimum tax. But the income, the net profit, is going to flow- through and come to your personal income tax return. The document that makes sure that income comes to you is the K1 form.
Why do I need liability protection if I have an umbrella insurance policy?
Some may think that just because you have insurance on a particular property, that it may not need to have a Limited Liability Company. Ask yourself this, what is the main point of insurance? Insurance does not actually protect you from important, drastic factors such as being sued. Limited Liability Companies are limiting the liability only to the asset that sits inside of that entity. Your personal assets, home, and retirement account are all still tied to your finances and need to be protected. When someone sees that you have an LLC, they will see that you are someone who is informed and in charge. The fact of the matter is, if you have a rental property, you should have an LLC.
Do I have one rental in an LLC or do I have multiple rentals in an LLC?
If you have more than one rental property, how should you go about LLCs? The key to this question would be to access all of your properties and create a strategy for them. When you have multiple LLCs, you’re going to file multiple returns. You’re going to pay multiple. If you’re incorporated in California, you’re going to pay multiple $800 minimum taxes, so you have to do a cost-benefit analysis. This is why evaluating your options and outcomes is so important. Think critically about what you’re doing. Try not to be impulsive because sometimes it’s costly to undo things that have already been done.
What if I am a single member LLC?
Should I be a single member LLC? If you are by yourself and there is no one else to partner with, you are going to automatically default to a single member LLC. So if you set up an LLC as just you with just your name, it is going to be a single member LLC, and it’s going to go inside of your own personal income tax returns.
What works well inside of an LLC?
There are two types of businesses: Passive and Active.
An active business needs to run and be worked on a daily basis.
A passive business is the opposite.
Rental real estate would be considered a passive business since it does not require work everyday to generate revenue. Other examples of a passive business include portfolio income, interest income, dividend income, and royalties. Passive businesses work well inside of LLCs and inside of partnerships if you choose to do that. When you have active income, you really want to drill down and determine the entity that you need to be in due to the taxes that can come from the self-employment tax when you have a net profit.
💎TIP: If you are a licensed accountant, a licensed engineer, or a licensed architect, you have to be in a professional corporation. By law you have to sit in a Limited Liability Company, LLP— basically any professional company.
💎 Major Takeaway: You want to choose an entity based on the income you’re making, the benefits you want to have, the tax you’re willing to pay, and the social security you may think you don’t need later in life.
What about holding real estate in an S -Corporation?
If you are a regular real estate owner, most likely not due to the taxes. However, there are particular situations in which this would be ideal. Some of these would be if you have a management company or may be flipping real estate. You probably want to flip inside of an S Corp because when you flip properties, you can be considered a dealer. You’re no longer a real estate investor when you’re holding real estate. This would be considered an active business, and active income gets hit with self employment tax. If you are in an LLC and are flipping houses, you could potentially run into Social Security Medicare tax, have to pay that on your flips, plus the gross receipts tax, in addition to the Flow -Through Income Tax, federal and state.
What to take away from this information:
As mentioned before, there are many ways business entities can affect your taxes, income, and plans. Most of these tips are for those of you who may want to start investing in real estate, or already do. There are endless possibilities regarding your taxes and business. Here at Capital V Solutions, we want to educate and inform our readers. However, everyone’s situation is different. We highly recommend speaking to a tax strategist who can take the time to go through your history, future plans, and determine the best course of action.
I know that every individual situation is different that is why I am offering my readers complimentary Tax Strategy Session for a limited time.
During this strategy session we will discuss:
1. Your current tax situation and analyze it
2. How we can find hidden deduction opportunities you might be overlooking
3. Strategize to see how we can get you into the right tax bracket so we can keep more money in your pocket ethically
4. Review your past tax returns and see if you left any money on the table and strategize how to get it back.
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Talk to you soon! 🙂
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