According To Irs What Is A Flow Through Entity Tax Saving Strategies For Real Estate Investors

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Tax Saving Strategies For Real Estate Investors

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The first step in any real estate investment is starting 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. Each of them has its advantages and disadvantages. A limited liability company is the only real flow through taxing entity and the most beneficial in terms of holding real estate. A 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 deducted upfront and all your expenses whether real estate or business related are deducted on an after-tax basis. When you have an LLC, you take all business expenses, deduct them, and pay income tax on what’s left. An LLC is the only entity not subject to a loss limitation! LLCs do not require records and minutes of meetings. Filing of documents is limited to articles of organization that list LLC members. Tax Benefits: An LLC is a pass entity and is considered a disregarded entity by the IRS if it is a single member entity. Corporations are subject to double taxation where not only profits are taxed but distributions in the form of dividends are also taxed. Another benefit is flexibility in terms of LLC ownership transfer. LLC ownership is guided by an operating agreement, which is an internal document. A change of ownership requires only an operating agreement and requires no filings other than updates with the IRS for a given tax ID number. It has fewer filings than an S-Corp and is much easier to maintain. If you own more than one property, place them in each LLC and have one LLC as your holding company that owns all the other LLCs. For tax purposes your main holding LLC will be a sole member LLC for others and you will only need to file one tax return. In addition to tax benefits, an LLC also allows you a basic level of asset protection.

If your business owns assets, they are separate from your personal assets and cannot be touched in the event of a lawsuit. Please note that an LLC is the basic level of asset protection and there are many ways your personal assets can become part of a law suit if the opposing party has a good attorney. It is called piercing the corporate veil. For example, you must have a separate bank account for the LLC. If your LLC owns your property, all property income and expenses must come out of a specific bank account. If this is not done, the LLC status may be disqualified and your personal assets may become part of the lawsuit. Your LLC must be in good standing with the state and you must have adequate information about your articles of organization. The purpose of the business should be clearly stated without any exclusions and you should file amendments when necessary. If you buy real estate, say you buy, hold, rent or lease residential real estate; If you sell, you must state that you bought with the intention of reselling for a profit. Other states, like Maryland, require you to pay an annual fee, which is currently $300 per year. You need to check your state’s requirements and guidelines and always stay in good standing with the state.

*Rent reduction* on your primary residence. If you have an LLC, you may need an office and it may 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*. This is the most profitable deduction in real estate! As your real estate appreciates, you are allowed to depreciate the building over its 27.5 year life and take a deduction against your income. However, only depreciation is allowed against the building, land cannot be depreciated. For example, if you own a house worth $100,000, the building may only be valued at $80,000 and the land at $20,000. Thus, you are only allowed to take depreciation expense against the value of the building.

*Rapid Depreciation*. You’ve probably heard from your accountant that accelerated depreciation isn’t allowed against real estate, and that’s true, but there is a way to deduct improvements in prior years, and it all depends on how they’re classified. For example, land improvements such as curbs, sidewalks, and landscaping are depreciated over 15 years; Personal property depreciates over 5 years. According to IRS Code 1.48-1(c) items considered personal property must have one of the following characteristics: 1. Accessory 2. Function 3. Mobility. Essentially anything that has accessories, functions or is movable is real 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 movable, you will have to take 5-6 times less deduction for improvements in next 5 years. Make everything you can either work, be an accessory or make it movable! A commercial developer built his office building with lightweight movable walls and was able to deduct $80,000 that same year.

*Dealer* Status. It is important to avoid the “DEALER” position when flipping properties. In some cases this can be avoided by flipping assets through different entities, in some cases doing some transactions, but the easiest “investor friendly” way is to simply state your investment intent. You can get away with not being a dealer if you state that your investment objective is to buy, hold, rent and lease assets without being forced to sell them under certain conditions, such as working capital requirements.

*IRS Red Flag*. There are also things you shouldn’t do that will raise red flags with the IRS and could lead to an audit. First, don’t report a loss of income with too much rent, you’ll find plenty of expenses to reduce your pre-tax income. Second, don’t overcomplicate your asset protection structure. Having multiple business entities on top of each other or domiciled in Las Vegas, NV, a tax-exempt state, can be a red flag. Reporting a loss for more than 2 years always raises red flags. The logic behind it: “If you’re not making money, why are you still in business?”. Excessive donations, high expenses and high income can also lead to an audit.

*Property Tax*. Real estate investors are subject to several taxes, including property tax. There is always a gap between the assessed value and the market value of a property. In 2007 the assessed value was generally lower and in 2010 it was 99% higher than the market value of the real estate. Taxes are not always reassessed with market cycles and it is your responsibility to dispute them. In the state of Maryland, it is allowed to dispute personal property taxes within 60 days of the settlement date or to file before the end of the year for a next year’s hearing. Although taxes are a deduction against income, they are not a tax credit, and the more you can reduce your expenses, the more profit you will make. To successfully dispute your tax bill you need to show comparisons and recent sales prices of real estate in your area. You will need to compare your property with recently sold properties in terms of layout, number of bedrooms, bathrooms, square footage, amenities, etc.

*Capital Gains Tax*. This type of tax is levied only when you sell the property. The difference between the purchase price and the selling price is subject to this tax. Homeowners who have lived in the property for at least 2 years and the profit amount are exempt. One way to defer capital gains taxes is by doing a 1031 exchange. Make sure you contact the escrow company and do everything according to 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 months and defer paying capital gains tax. According to IRS tax rules, the property you’re buying must be “just like” property, meaning it doesn’t matter how big it is as long as it’s the same “investment” 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 overview and is not legal advice on general real estate tax laws. This information may or may not apply depending on your state, tax bracket and/or other restrictions imposed by the IRS. Please consult your accountant in your local area.

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