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Tax Saving Strategies For Real Estate Investors
The first step in any real estate investment is to start a business. There are different types of business entities: Sole Proprietorship, Limited Liability Company (LLC), Series LLC (in some states only), Limited Liability Partnership (LLP), LLLP, S-Corp, C-Corp. Each of them has its advantages and disadvantages. The only true flow-through tax entity and the most advantageous from the point of view of owning real estate is a limited liability company. A limited liability company allows you to pay your business expenses with pre-tax dollars. It is very important to understand that your taxes are already withheld when you get paid and receive a paycheck, 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 of your business expenses, deduct them, and pay income tax on what’s left over. The LLC is the only entity NOT subject to loss limits! The 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 it is a single member, the IRS considers the entity to be disregarded. The company is subject to double taxation, where not only profits are taxed, but also distributions in the form of dividends. Another advantage is flexibility in terms of transferring ownership of the LLC. Ownership of an LLC is governed by an operating agreement, which is an internal document. If you want to change ownership, all that needs to be done is an operating agreement and no applications are required other than updates to the IRS for a given tax number. It also has fewer filings than an S-Corp and is very easy to maintain. If you have multiple properties, hold them in an LLC and have one LLC that will be your holding company that would own all the other LLCs. For tax purposes, your main holding LLC will be the sole member of the LLC for others and you will only need to file one tax return. In addition to tax benefits, an LLC also provides you with a basic level of asset protection.
If your company owns the assets, they are separate from your personal assets and cannot be touched in the event of a lawsuit. Keep in mind 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 piercing the corporate veil. For example, you must have a separate bank account for an LLC. If your LLC owns your property, all income and expenses related to the property must come from that bank account. Failure to do so may disqualify your LLC status and make your personal assets part of the lawsuit. Your LLC must be in good standing with the state and you must have proper formation information. The purpose of the business must be clearly stated without exception and you must file changes if necessary. If you are buying real estate, say that you are buying, owning, renting or letting residential real estate; if you are selling you must state that you are buying with the intention of reselling for profit etc. In some states, an LLC must 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 should check your state requirements and guidelines and always be in good standing with the state.
*RENT AMOUNT* in your primary residence. If you have an LLC, you may need an office, and it’s convenient enough that it can be in your personal residence. You can deduct rent for your office space in your personal residence under IRS code 288G.
*Depreciation*. This is the most favorable deduction in real estate! While your property is growing, you can depreciate it over the life of the building, which is 27.5 years, and deduct it from your income. However, depreciation is only allowed on the building and land cannot be depreciated. For example, if you own a house that is worth $100,000, the value of the building may only be $80,000 and the value of the land may be $20,000. Thus, you can consider depreciation costs only from the value of the building.
*Accelerated depreciation*. You may have heard from your accountant that accelerated depreciation is not allowed on real estate, and it is true, but there is a way for improvements to be deducted in earlier 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 over 5 years. Items considered personal property under IRS Code 1.48-1(c) must have one of the following characteristics: 1. Accessory 2. Function 3. Movable ability. Basically, anything that is a utility, function, or chattel is real estate. 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 pay 5-6 times less for improvements in the next 5 years. Make everything you can either work, be an add-on, or make it moveable! One commercial developer built his office building with lightweight movable walls and was able to shell out $80,000 that same year.
Status *MERCHANT*. When flipping properties, it’s important to avoid “DEALER” status. In some cases it can be avoided by flipping properties between different entities, in some cases with a few transactions, but the easiest “investor friendly” way is to simply state your INVESTMENT INTENT. By stating that your investment purpose is to buy, own, lease and rent real estate, unless you are forced to sell under certain conditions, such as the need for working capital, you can avoid being considered a DEALER.
*IRS Red Flags*. There are also some things you shouldn’t do that will alert the IRS and they can audit you. First, don’t report too much loss of rental income, there are many expenses that can reduce your pre-tax income. Second, don’t overcomplicate your asset protection structure. Having too many business entities on top of each other or being based in Las Vegas, NV, a tax-free state, can be a red flag. Reporting losses for more than 2 years always triggers warnings. The common sense behind it: “if you’re not making money, why are you still in business?”. Reporting excessive donations, high expenses compared to high revenues may also result in an audit.
*Property Taxes*. Real estate investors are subject to many taxes, including property taxes. There is always a gap between the assessed value and the market value of the property. In 2007, the assessed value was usually lower, but in 2010 it was 99% higher than the market value of the property. Taxes are not always reassessed based on the market cycle and it is your responsibility to challenge them. In the state of Maryland, personal property taxes can be challenged within 60 days of the settlement date or filed before the end of the year for a hearing in the following year. Although taxes are a deduction from income, they are not a tax deduction, and the more you can reduce your expenses, the more profit you will make. In order to successfully challenge your tax bill, you should show comparable and recent property sales prices in your area. You will also need to compare properties that have recently sold to your property in terms of structure, number of bedrooms, bathrooms, square footage, fixtures, etc.
*Capital Gains Taxes*. This type of tax is only charged when you sell the property. The difference between the purchase price and the sale price is subject to this tax. There are exceptions 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 tax with a 1031 exchange. Make sure you contact the escrow company and do everything according to the 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 “equal” property, meaning it doesn’t matter if it’s bigger, as long as it’s an “investment” just like the one you just sold. So you can buy a single-family home and an apartment building if both are investment properties.
The information in this article is only a general overview and not legal advice on general estate tax law. This information may be different or unusable depending on your country, tax bracket and/or other restrictions imposed by the IRS. Please consult your accountant in your local area.
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