Tax Implications Behind ‘Subject-To’ Financing & Similar Strategies
October 17, 2023
The W-2 Employee’s Guide to Legal Tax Reduction: Save More in 2024!
November 8, 2023

October 31, 2023

Mastering LLCs – The Guide to Efficient Real Estate Entity Structuring

Introduction

One question that consistently emerges at real estate conferences is that of entity structuring. Real estate investors are often perplexed about how to structure their entities correctly. Some people go to extreme lengths, investing thousands of dollars in elaborate structures involving offshore trusts, multiple LLCs, and C corporations.

While complexity has its place, it’s essential to balance it against the administrative burden it brings. This episode delves into some key aspects, including why simplicity is often best, the role of tax strategy, and specific scenarios in which particular types of entities might be suitable or unsuitable.

Why Simplify?

The more complex your entity structure, the more administrative work you have to manage, from annual filings and fees to managing separate EINs and bank accounts.

This complexity often leads to mistakes or oversights, which can be costly. Therefore, while protection is critical, the question to ask is whether a complex structure provides significantly more protection against high-likelihood risks than a simpler structure.

Tax Considerations

S Corporations and Real Estate Investments

S Corporations are generally not advised for holding rental properties for two main reasons:

    1. Taxable Events: Removing a property from an S Corporation can trigger a taxable event, as if the property was sold to a third party. This is problematic if the property has appreciated significantly.
    2. Basis Issues: S Corporations limit the amount of losses you can claim to the extent of your “basis” in the corporation. This is not the case with partnerships, which allow for what is known as Qualified Non-Recourse Financing (QNR) to increase your basis and consequently, your ability to claim losses.

When is an S Corporation Suitable?

An S Corporation may be an appropriate choice for real estate investors who are in a real property trade or business, like flipping or wholesaling properties, or working as a real estate agent or consultant. The main advantage here is that you can mitigate self-employment tax by paying yourself a “reasonable salary,” with the remaining profits not subject to self-employment tax.

Reasonable Salary: A Caveat

The term “reasonable salary” is critical here. Paying yourself zero or an unreasonably low salary to avoid self-employment tax is an audit risk. Therefore, determining a reasonable salary involves a nuanced analysis, often requiring consultation with tax professionals.

Questioning Entity Structure

Entity structuring is not a one-size-fits-all situation. It varies based on individual circumstances, risk tolerance, and the type of real estate investing you are engaged in.

Therefore, it’s crucial to consult with multiple professionals, including tax strategists and attorneys, to tailor a structure that suits your specific needs while also considering the tax implications.

What is the Best Entity for Rental Property?

If you’re going to be the sole owner of the property, a Single Member LLC taxed as a disregarded entity is likely the most tax-efficient structure for you. This type of LLC is simple to manage, as its activities are reported directly on your 1040 tax return.

Tax Implications of a Single Member LLC

Contrary to popular belief, the tax implications of a Single Member LLC are virtually none. The LLC is primarily used for asset protection purposes rather than offering any additional tax benefits. If you’re deducting business expenses, a Single Member LLC doesn’t give you an edge. It simply acts as a pass-through entity for tax purposes.

Addressing Misconceptions

Despite the buzz about LLCs, especially among influencers on platforms like TikTok, an LLC doesn’t make you a more effective business owner. Additionally, it doesn’t offer more deductions than operating as a sole proprietor.

When You Have Partners

If you have multiple owners of the property, you should consider a Multi-Member LLC (MMLLC) taxed as a partnership. This structure comes with more complex tax implications, including the necessity to file a separate tax return (Form 1065).

Operating Agreements

When setting up a Multi-Member LLC, an operating agreement is crucial. This agreement should align with what you and your partners expect tax-wise. It’s essential to consult both your accountant and attorney when drafting this document to avoid future misunderstandings and legal complications.

Tax Flexibility

One of the benefits of a partnership structure is the flexibility it offers in terms of asset management and tax allocations among partners. But it’s vital to ensure that your operating agreement and tax return are in sync to avoid complications down the line.

Partnership with Spouse

If you’re setting up an LLC with your spouse, you may be surprised to learn that you generally need to file a partnership tax return, unless you’re in a community property state. This comes with additional compliance costs, so be aware.

Key Takeaway

Before you dive into a complicated entity structure, step back and ask yourself: Is this complexity truly necessary, or is there a simpler way to achieve my objectives while still mitigating risks effectively?

Remember, the aim is to protect your assets, but not at the expense of creating an administrative nightmare.

Interested in optimizing your tax strategy for real estate investments? Feel free to reach out for an initial consultation.

Listen to this podcast episode here.