Protecting Your Assets
Most beginning investors don’t concern themselves too much with how they hold title to their investment properties. This usually occurs for two reasons; one, new investors don’t know which entity to use, and two, they don’t think that they need to worry about protecting their assets until they have multiple properties.
We will help clarify the differences between the most common entities used for real estate investing and dispel the myth that you don’t need to worry about protecting your assets until you “get large”.
Probably the most commonly asked question is “Which entity should I use”? This is fairly easy to answer - it all depends on what is right for you. There are a number of factors that go into determining which entity will work. Everything from the nature of your real estate business (whether you are an active investor or a passive investor), will the properties be held long term, or do you intend to sell very quickly for profit. Here are some general guidelines to follow, but each situation is different and we recommend you talk to your accountant and attorney regarding your specific situation.
Limited Liability Company’s (LLC’s)
LLC’s are usually the best entity to hold your long term rental properties. When it comes to protecting your assets, most entities (when used properly and you adhere to all corporate formalities) will protect your personal assets from company assets. Having said that, our concerns become more of an income tax issue, the expense to set up and maintain an entity, and the tax benefits derived from each entity.
In most states, LLC’s are inexpensive to setup and easy to maintain, provide excellent asset protection, and can be treated either as a partnership or a corporation for income tax purposes. This is what makes LLC’s so nice, their flexibility. If you intend to hold real estate assets for long term, usually a year or more, then you will want to set up an LLC that is treated as a partnership for income tax purposes. This provides you all the protection of separating your business assets from your personal assets but still gives you all the income tax benefits of being a sole-proprietor or partnership.
Holding rental properties provides the owner of the property benefits:
- Selling and paying taxes at long term capital gains rates
- Depreciation deductions
- Properties can be exchanged for another property of like kind utilizing a 1031 tax deferred exchange paying no taxes on the transfer
- Pay no Social Security or Medicare taxes
With an LLC treated as a partnership for tax purposes, all these benefits remain intact. Your LLC derives the benefits and will then be passed on (or flows through) to you as the member of the LLC.
LLC’s can also be used when flipping properties but may not be the best choice. As we mentioned above, LLC’s are very flexible and provide excellent benefits. The real difference is how LLC’s are treated for tax purposes. In the case of flipping properties, you can still utilize the LLC for asset protection. The corporate formalities are also the same and easy to adhere to, but now we treat income tax matters as a corporation rather than a partnership. Now that we’ve gone from holding real estate in the above example to flipping real estate in this example, the Internal Revenue Service (IRS) treats the income earned differently.
Let’s explain what flipping is for those who don’t know. Flipping properties usually involves an investor who holds a property for a very short period of time, usually less than six months. This gives the investor time to rehabilitate the property after purchase and then turn around and sell it to an end user, typically a homeowner, for a quick profit. Some investors flip properties without ever taking title to the property through the use of an assignment. In this case, an investor has a contract to buy the property. Rather than buying the property, however, the investor assigns his interest in the purchase contract to another investor for a fee which can range anywhere from $3,000 to as much as $100,000 or higher.
Alright, now that you know what flipping is, let’s get back to the tax treatment issue for income purposes. Because the property is owned for only a short period of time, the IRS will not allow the property to receive the benefits as if it were a long-term hold property.
This is where things can be a little tricky so talking with your accountant regarding this next issue is highly recommended, but we want to touch on it briefly. If the IRS determines that you are in the ‘business’ of real estate then the short term profit you make on flipping a property will be treated just like income from your paid occupation. A quick way to determine if you are “in the business” is if you work more than 750 hours a year in real estate, then you can be classified as “in the business”. This means you will pay social security tax, Medicare tax, federal and state income tax, if applicable. There really are no tax benefits to flipping properties if real estate is your business, but the LLC will still protect your business assets from personal assets and the corporate formalities will be easy to maintain.
If you are not in the business of real estate and you flip a property, then the profits will be taxed at short term capital gains rates rather than regular income tax rates. Everything else remains the same, including asset protection and corporate formalities.
As you can see, an LLC is a very useful entity due to it’s low initiation costs, easy corporate formalities to maintain, and the flexibility to treat the LLC as a corporation or a partnership for tax purposes. Based upon you and your accountant’s determination of your needs, it’s your choice how you utilize an LLC. One word of caution though - if you intend to hold properties and flip properties (as we do) and you choose to use an LLC for your flipping activities, we would recommend that you set up two LLC’s. One LLC will be treated as a corporation for tax purposes for all your flipping properties and the other LLC will be treated as a partnership for tax purposes for all your long term rentals. In addition, because of the low cost to initiate an LLC, we would also recommend the following: you should use more than one LLC if you are planning on holding multiple rentals, or a stand alone LLC if you have a large property, like an apartment complex or strip center, etc. This way if a transaction between two parties becomes a legal issue (in our litigious society this is a realistic possibility), then they may be awarded some of your assets but they won’t get them all.
Corporations may be the best entity to use for flipping properties.A better entity for flipping properties may be an S-corporation or a C-corporation depending on your income. Again, we recommend you talk to your accountant and attorney who can help you make this decision. First, we will need to distinguish between an S-corporation and a C-corporation. Both corporations are virtually identical from an asset protection stand point, as they both have corporate formalities to adhere to, but they vary widely when it comes to tax treatment.
An S-corporation produces income that flows into the company in which all expenses are paid. Expenses can include salaries to corporate officers as well as all normal business deductions. After expenses are paid, profits are left over. (We’ll assume there was more income than expenses, which is why we are in business). The profit that is earned is not taxed at the corporate level but “passes through” to the shareholders. The shareholders at the end of the corporation’s tax year receive a K-1 statement which is then added to the income the shareholder earns from other revenue sources, and is then taxed at their personal income tax rate. This is a huge benefit as the profits are only taxed once, at the personal level.
In addition, because the income is profit and not salary, it is not considered earned income by the IRS and not subject to social security or Medicare tax, you receive a benefit of 15.3% for S-corporation shareholders. This assumes the shareholder took a reasonable salary as defined by the IRS. The downside to an S-corporation is that if the profits are not paid out to the shareholders but remains in the company, the shareholders will still get a K-1 statement showing the profits earned and have to pay taxes on the profit even though they did not receive the money. Let’s use an example to show the tax difference and why choosing the correct entity can be so important.
UbidProperties.com, Inc is an S-Corporation that had gross revenue of $500,000 but paid out $450,000 in expenses leaving a $50,000 profit. The expenses included two salaries of $75,000 each payable to the two shareholders. Because UbidProperties.com is an S-Corporation, there are no taxes that UbidProperties.com has to pay but rather the two partners (shareholders) each receive a K-1 statement from UbidProperties.com showing a $25,000 profit to each shareholder. The two partners earned a salary of $75,000 plus a $25,000 profit for a total taxable income of $100,000. The $75,000 salary was subject to social security tax, Medicare tax, federal and state income tax. However, the $25,000 profit was only subject to federal and state taxes and did not have to pay social security or Medicare tax on the profits. This is because the two partners took a ‘reasonable salary’ and therefore could take the profits as distributions rather than salaried income.
Below is an example of the taxable difference created by choosing the correct entity. You can see in Example 1 the income difference that each partner would receive if they were in an S-corporation or if they were in an LLC. The first column represents the income to one shareholders since UbidProperties.com is an S-corporation. The second column shows what one partner would receive if they were set up as an LLC. The difference of $3,750 goes into your pocket not to the IRS.
- Example 1:
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* Tax is based on a 35% federal rate and a 15% social security rate. This example does not take into consideration the marginal tax rate nor state taxes.S-Corporation LLC Salary $75,000 $100,000 *Tax (50%) 37,500 50,000 Net $37,500 $50,000 Profits $25,000 $0 Tax (35%) 8,750 0 Net $16,250 $0 Take Home Pay $53,750 $50,000
A C-corporation works the same way as an S-corporation, income flows into the company and then all expenses are paid including salaries to corporate officers. But this is where everything changes. We’ve all heard the term “double taxation” but how many of us truly know what it means or how it works? Well, we are going to tell you. As we previously mentioned, expenses are paid from the income earned resulting in a profit (we’ll assume there was more income than expenses again). However, the C-corporation is not a flow through entity and therefore profits are taxed at the corporate level. C-corporations have marginal tax rates just like individuals. Once the corporation has determined its profit the corporation then pays a tax based on that profit. Here’s where the double taxation comes into play. If the corporation decides to pay the balance or a portion of the profits out to shareholders, the money the shareholders receive will be taxed again at the shareholders tax level. Double taxed, once at the corporate level then again at the shareholders level!
Let’s switch gears and say that UbidProperties.com is now a C-corporation and we’ll use the same numbers that we did in Example 1; $500,000 in revenue minus $450,000 in expenses leaves a $50,000 profit. But because UbidProperties.com is now a C-corporation, the company must pay taxes on the $50,000. The marginal tax rate for corporations who earn up to $50,000 is 15% or $7,500 in federal tax leaving $42,500 in after-tax profits paid to the shareholders. If there are still only two shareholders and they choose to take the after tax profits, then each shareholder would receive $21,250. As you can see each shareholder lost an additional $3,750 at the C-corporate level that did not have to be paid out at the S-corporate level. In addition, the shareholder still has to pay taxes at the personal level. Example 2 details the tax structure as a C-corporation.
- Example 2:
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C-Corporation Profit $50,000 *Tax (15%) 7,500 Net Profit (42,500/2 shareholders) Shareholders Profit 21,250 Personal Tax (50%) 10,625 Net Shareholder Cash 10,625 Salary $75,000 **Tax (50%) 37,500 Net Salary 37,500 Take Home Pay $48,125 *Corporate marginal tax rate up to $50,000 profit.
**Tax is based on a 35% federal rate and a 15% social security rate. This example does not take into consideration the marginal tax rate nor state taxes.
Now that you know the difference between these two corporations your probably asking the million dollar question: Why would I ever want to be a C-corporation? It is a valid question and here is why it might make sense. First, if you are a high income earner you can leave up to $50,000 in your C-corporation and only be taxed at 15%. That money can then be used for other ventures rather than paying it to the shareholders as long as they don’t need the money. If you don’t take the money as a shareholder, you are not taxed unlike the S-corporation, where you’re taxed on the money whether you take it out of the corporation or not. Second, the income of a C-Corporation can often be reduced substantially by creative means to return money back into the shareholders hands (i.e. the Corporation rents equipment from the shareholders, the shareholders own the building individually and the Corporation rents the building from them, earning salaries, etc.) The IRS also offers C-corporation benefits that S-corporations cannot partake in such as medical plans, retirement plans, tuition and childcare reimbursements just to name a few. Again, check with your attorney and accountant who can help you decide the best choice.
Nevada Corporations. We have often been asked if it is wise to incorporate in Nevada. The answer is simple - if you live in Nevada, yes. If you live in any other state, then it probably will not matter if you incorporate in Nevada or not. Most individuals and the companies that sell Nevada corporations will tell you that the benefits of Nevada are wonderful; no income tax, no disclosure of officers, etc.
However, here’s the problem; if you incorporate in Nevada but do business in Arizona, your corporation is domiciled in Nevada and you have no legal rights in Arizona. The only way to have rights in Arizona while being incorporated in Nevada is to file as a foreign corporation in Arizona. If you are thinking that you just won’t file foreign status in Arizona, hold on. If you are doing business in Arizona and your corporation is in Nevada and you are sued (i.e. a tenant is hurt on your property, or there is a lease agreement dispute) you will absolutely lose. You will have no rights, and no rights means you can’t win! Ouch!
Once you file the foreign status in Arizona, any private information that Nevada doesn’t disclose isn’t revealed, but in Arizona you must disclose what is requested. Arizona is like almost all other states, privacy isn’t private! The worst part about all of this is that you are now paying annual incorporation fees not in one state but in two!
In addition, if you live in Arizona and you do business in Arizona you will pay Arizona State Tax, plain and simple. If you have a Nevada corporation, you may not have filed a foreign status in Arizona, but you live and do business in Arizona you will pay Arizona tax. Please understand, state laws must be followed and consulting with a knowledgeable attorney and accountant is the best plan of action.
Before you decide to incorporate in Nevada, confer with an attorney and accountant in your state. They may tell you to incorporate in Nevada but then again they may tell you that you are wasting your time because all the benefits do not apply when you live in another state.
