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Tax Saving Strategies For Real Estate Investors
The first step in real estate investing is starting a business. There are different types of business entities: Sole Proprietorship, Limited Liability Company (LLC), Series LLC (some states only), Limited Liability Partnership (LLP), LLLP, S-Corp, C-Corp. Each of them has its advantages and disadvantages. The only real flow through the tax entity and the most advantageous in terms of holding real estate is a limited liability company. A limited liability company allows you to pay business-related expenses in pre-tax dollars. It is very important to understand that when you get paid and receive your pay stub, your taxes are already deducted and all of your expenses, whether real estate or business related, are deducted on an AFTER TAX basis. When you have an LLC, you take all the business expenses, deduct them, and pay income tax on what’s left. LLC is the only entity not subject to loss limitation! LLC does not require records and minutes of meetings. Filing paperwork is limited to the articles of organization that list the members of the LLC. Tax Benefits: An LLC is a pass-through entity, and if there is a single member, the entity is considered disregarded by the IRS. A corporation is subject to double taxation, where not only profits are taxed, but distributions in the form of dividends are also taxed. Another advantage is flexibility in transferring ownership of the LLC. LLC ownership is governed by an operating agreement, which is an internal document. In order to change ownership, all that needs to be done is an Operating Agreement and no filings are required other than updates to the IRS for that tax identification number. It also has less filing than an S-Corp and is very easy to maintain. If you have multiple properties, hold them each in an LLC and have one LLC as your holding company that would own all the other LLCs. For tax purposes, your main holding LLC will be the only member LLC for the others and you will only need to file one tax return. In addition to the tax benefits, an LLC also allows you a basic level of asset protection.
If your business owns property, it is separate from your personal property and cannot be accessed in the event of a lawsuit. Please note that an LLC is a BASIC level of asset protection and if the opposing party has a good attorney, there are many ways your personal assets can become part of a lawsuit. It’s called the piercing corporate veil. For example, you must have a separate bank account for the LLC. If your LLC owns your property, then all income and expenses related to the property must come from that specific bank account. Failure to do so may disqualify your LLC status and your personal assets become part of the lawsuit. Your LLC must be in good standing with the state and you must have sufficient information on your Articles of Organization. The purpose of the business must be clearly stated without exception and you must submit amendments if necessary. If you are buying real estate, you should say that you buy, hold, rent or lease residential real estate; if you are selling, you must state that you are buying to resell for a profit, etc. Some states require LLCs to be published in the local newspaper, which can be very expensive; in other states, such as Maryland, you must pay an annual fee, which is currently $300 per year. You must check your state requirements and guidelines and always be in good standing with the state.
*RENTAL ACCOUNT* in your primary residence. If you have an LLC, you may need an office, and conveniently enough it could be in your personal residence. Under IRS Code 288G, you are allowed to deduct rent payments for office space in your personal residence.
*Amortization*. It’s the best deduction in real estate! While your property appreciates, you can depreciate it over the life of the building, which is 27.5 years, and deduct it from your income. However, depreciation is allowed only for construction, land cannot be depreciated. For example, if you own a home worth $100,000, the building value may only be $80,000 and the land value $20,000. So you can only take depreciation against the value of the building.
*Accelerated Depreciation*. You may have heard from your accountant that real estate is not allowed accelerated depreciation, and that is true, but there is a way to take improvements deducted in previous years and it all depends on how they are classified. For example, land improvements such as curbs, sidewalks, and landscaping are depreciated over 15 years; personal property is depreciated for 5 years. Things that are considered personal property under IRS Code 1.48-1(c) must have one of the following characteristics: 1. accessory 2. function 3. mobility. Property is essentially anything that is a fixture, function or movable 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 deduct 5-6 times less improvement deduction over the next 5 years. Make everything you can either function, be an accessory, or move! One commercial developer built his office building with lightweight movable walls and was able to deduct $80,000 that same year.
status *DEALER*. When flipping properties, it is important to avoid the “DEALER” state. In some cases this can be avoided by going through properties through different entities, in some cases by doing multiple transactions, but the easiest “investor friendly” way is to simply state your INVESTMENT INTENT. If you state that your investment intention is to buy, hold, rent and lease properties, unless you are forced to sell them under certain conditions, such as the need for working capital, you can get away with not being considered a SELLER.
*IRS Red Flags*. There are also certain things you should not do that would raise red flags for the IRS and you could be audited. First, don’t overstate the loss of rental income, there are plenty of expenses you can find to reduce your pre-tax income. Second, don’t overcomplicate your asset protection structure. Having too many business entities above you or being based in Las Vegas, NV, a tax-exempt state could be a red flag. Reporting losses for more than 2 years always raises red flags. The common sense behind it: “if you’re not making money, why are you still in 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 tax. There is always a gap between the appraised value and the market value of the property. In 2007, the assessed value was routinely lower, and in 2010, it is 99% of the time higher than the property’s market value. Taxes are not always reassessed depending on the market cycle and it is your responsibility to question them. In the state of Maryland, you are allowed to file a personal property tax objection within 60 days of the settlement date or file by the end of the year for next year’s hearing. Although taxes are a deduction from income, they are not a tax credit, and the more you can minimize your expenses, the more profit you end up making. In order to successfully dispute your tax bill, you would need to show comparable and recent sales prices of properties in your area. You will also need to compare a property that has 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 the property is sold. The difference between the purchase and sale price is subject to this tax. Exceptions are for homeowners who have lived in the property for at least 2 years and the amount of the profit. There is a way to defer capital gains taxes by doing a 1031 exchange. Make sure you contact the escrow company and do everything within IRS guidelines. Under 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 taxes. According to IRS tax rules, the property you’re buying must be “like” property, meaning it doesn’t matter if it’s as big an “investment” as the one you just sold. So you can buy a single family home and buy an apartment building if both were investment properties.
The information provided in this article is only a general overview and not legal advice on general estate tax laws. This information may vary or may not be applicable depending on your state, tax bracket, and/or other IRS-imposed restrictions. Please consult your accountant in your area.
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