Tax Benefits in Real Estate Investing???

[mja2649]

I am new to this game and would like to find out some information about the tax benefits of investing with regard to depreciation. Also, are there any tax benefits with regard to an LLC or a S-Corp?

I know that I will eventually need to sit down with a CPA for an in-depth discussion. In the mean time though, I need some info to help relief some of the fears that my wife has about us getting involved in real esate investing.

Thanks in advance,

Mike

[Pasquini]

Mike,

Here is a lesson you can carry forward into your investing career. Find out what your wife's REAL concerns are and allay those. What is she really afraid of happening? Your wife probably doesn't give a rip about depreciation, LLC's or S-Corps. Address what she is specifically afraid of instead of trying to sell her on the benefits.

To more specifically answer your questions, depreciation is not a tax saving mechanism, but rather a tax shifting mechanism. You get to take the writeoff now, but it is recaptured when you sell the property. The LLC unless you have a multi-member LLC will be a flow through device taxed as a sole proprietorship. More information about LLC's can be found at My Corporation (http://mycorporation.com/llclearn.htm). More information about corporations can also be found at My Corporation, but at a different page (http://www.mycorporation.com/incorporate.htm)

[dealmaker]

Let me just add an AMEN to what Pasquini said. Beware of anyone who tells you some "investment" has "tax benefits". The way the US tax code is now written about the only way to get a "tax benefit is to LOSE MONEY. If you lose money you will pay lower taxes, but that is NOT a benefit.

Depreciation shifts taxes from this year to a future year. We all hope that in the future we will be earning more, more income equates to more taxes so in theory you're shifting income from a "low" tax year to a "high" tax year.

My suggestion about "bringing your wife along" is to involve her at each step, have her read the posts here and on other sites you frequent. Even if she's not directly involved in the day to day of the investing she needs to know and understand why you do the things you do. Also it give you ready access to someone knowledgeable who you can brainstorm ideas.

Just my $.02.

Good luck

dealmaker

[mja2649]

Pasquini,

Thanks for the info and the link. After reading the link I found that it stated that the IRS can revoke your S-Corp status if you have greater than 25% of your income for 3 years come from passive income sources and specifically stated owning real estate. It also went on to mention that most real estate investors chose the LLC over the S-Corp because of this possibility.

Does anyone have any thoughts on this?

Thanks,

Mike

[Pasquini]

Entity structuring is the least of your worries frankly. I usually counsel people to get busy in their business, and then start worrying about how they are going to structure themselves for world domination. If you pick up a couple of properties without an entity in place it isn't the end of the world.

Regarding S Corps I don't know of a single investor that uses one. Everyone I know uses various combinations of LLC's, C Corps, and Limited Partnerships.

[Aldo]

You need to severely punish yourself if you even think about a C-Corp. Other entities may fit your needs but, unless you have about 500 employees, a C-Corp is out of the question. Out of necessity, I had to do a C-Corp and it's not fun. 28 (yes, 2-8) separate and distinct tax filings each year is one of several reasons. S-Corps are good, but LLC's are the current preference.

[Pasquini]

There is a place for C corps in real estate investing, but it sure isn't for the newbie. I know two different sets of folks using C corps and they are able to do great things with them from a tax perspective. Some of it depends on how you are receiving your income. They are able to zero their taxes and have the corporation take care of a lot of the expenses in their lives which amplifies their income. One of the outfits I know doing this is run in part by a real savvy financial planner type so they've got it seriously dialed in.

Again, not for the faint of heart

[mja2649]

Thanks for all the replies.

Mike

[Just Information]

Back in the olden days when times were simpler and lawyers weren’t as abundant, all you really needed to do to go into business was to hang a sign and tell the world that you were open. Then, when you finally decided to shut the doors for good, you simply didn’t come to work. There was very little distinction between the entrepreneur and his business.

Times, tax laws, and legal precedents have changed, and people going into business for themselves in the 21st century have also had to change how they go about creating a business entity. Simply hanging a sign today will probably result in exposure to taxes and legal liability that shouldn’t apply to you. To select the business entity that best suits your need, new entrepreneurs should first consider what is most important to them.

1. Cost: Cost not only refers to the cost of creating your business entity, but also the cost of maintaining it. In some cases, there are annual fees you must pay to the state so they will continue recognizing you as a business and not just someone illegally collecting money. Other fees may also be required depending on state requirements.

2. Maintenance: This refers to how much work needs to go into maintaining your business. Some entities don’t require maintenance once they have been established. Others require serious record-keeping effort in order to comply with state regulations.

3. Tax Liability: Some business entities will allow you to save money on your income taxes by passing the income directly to the owner. This way, the owner avoids his money being taxed twice (once when paid to the company and once when paid to the owner through a paycheck or dividend.)

4. Legal Liability: Some business entities protect their owners from personal liability when a client has a claim against the business.

5. Ownership: Different entities have different rules for how many owners it can have. This is important to think about if there is a possibility of going public at some point.

Business Entity Types

Today, there are several business entity options available for entrepreneurs. Like anything else, each of them has advantages and drawbacks.

Sole Proprietorship

A sole proprietorship is a business entity that is virtually indistinguishable from its owner. The cost to create it is frequently only a small one-time fee to the state or county officials to register a fictitious business name and the cost of placing an ad in your local paper to notify the public that you are doing business under that name (i.e., Joe Public is now doing business as "Cash 4 Real Estate"). You may also need a state, county, or city business license, so check with your local authorities to ensure compliance.

A sole proprietorship has few recurring costs. Since the business and the individual are identical, there is no special maintenance required to keep the business alive, so there should be few recurring costs beyond any state business license fees and fees to maintain your fictitious business name. As long as you continue to call yourself a business, you are one.

There is a price for this easy set-up, though. Sole proprietorships cannot take advantage of special business income tax rates since all income is considered individual income. Sole proprietors are also not protected from personal liability if they get into trouble with a client. If an upset client decides to sue, they sue the proprietor personally. If the proprietor must declare his company bankrupt, he files for bankruptcy (http://www.sellanyhousequick.com/bankruptcy.php) personally. And, by definition, a sole proprietorship can have only one owner, and that owner must be a "natural person" (i.e., not a corporation, trust, LLC, or other such entity.) Finally, a sole proprietorship cannot be sold or passed to one's inheritors.

General Partnership

General partnerships are formed by two or more legal entities (any kind of legal entity can be partner), and each of those entities are individually responsible for the partnership. This means that each partner is personally liable for the partnership’s debts and legal liabilities. If one rogue partner makes an enemy of a third party, all partners will come under fire.

For tax purposes, all partners are considered self-employed and claim their share of the partnership’s income on their individual tax returns (the partnership itself pays no taxes). General partnerships are relatively easy and inexpensive to create and maintain, although the state where the partnership is established usually requires annual renewal filings and fees. A partnership agreement usually accompanies the formation of a general partnership, though it is not legally required. Partnership agreements generally cover topics like transferability, duration, and management control.

Limited Partnership

A limited partnership is much like a general partnership in structure. The main difference is that in a limited partnership, there are two different kinds of partners: general and limited. A limited partner does not take part in the management of the partnership and is not liable for any more than his individual capital investment. This distinction is made to encourage investors to become limited partners and so they can share in the profits but not lose more than their own contribution.

"C" Corporation

A "C" corporation is a standard state-formed corporation. It is a legal entity once it is formed, so it files its own taxes and is responsible for its own dealings. A "C" corporation can have unlimited numbers of shareholders, and those shareholders can be any kind of legal entity.

Corporations are the most expensive kind of business to begin and maintain. Not only do they require significant annual filing fees (which, in some states, can add up to several hundred dollars per year,) but also they require a good deal of effort on the part of the director(s) to maintain. A board of directors must be elected, annual meetings must be held, minutes of corporate meetings must be kept, and stock must be issued. And all this applies even if you are the only shareholder in the corporation. If these formalities aren’t followed, you run the risk of losing your personal liability protection if a court decides that your corporation was just an alter ego of yourself created to keep you safe (sometimes referred to as "piercing the corporate veil").

Additionally, since corporations are taxed on their income and shareholders have to claim dividends as taxable income themselves, shareholders of a "C" corporation are "double taxed" on their dividend income. One way to avoid this is to not issue dividends and simply re-invest your income back in the company. Spending your income on items that are tax-deductible is another way. You could also look into forming an "S" corporation.

"S" Corporation

An "S" corporation is much like a "C" corporation in that it is also its own legal entity, protects its shareholders from legal liability, and requires a significant amount of effort and money to start and maintain. However, an "S" corporation allows shareholders to claim their share of the corporation’s income directly on their personal tax return. This gets around the "double taxation" problem of a "C" corporation. The only drawbacks of an "S" corporation are that they may cost a little more to form and they are generally limited to a maximum of 75 shareholders. This makes going public with an "S" corporation practically impossible. However, if your intention is to keep your business relatively small, this is an excellent option.

Limited Liability Company

A limited liability company (LLC) is essentially a hybrid of a corporation and a partnership. An LLC provides the same kind of tax and liability benefits as a corporation, but has the same management structure as a partnership. In the past, LLC's have had more restrictions on them than corporations. For example, at least two people were needed to form an LLC and an LLC’s duration was specifically limited. However, in the last few years, states have started loosening these restrictions.

Forming an LLC is about as complicated as forming a corporation. The LLC comes into existence when the Articles of Organization are submitted to the state (and the appropriate fee is paid.) The LLC members must also have an Operating Agreement, but it is not necessary to file it with the state. In fact, in most states, it can be verbal.

It’s as easy as one, two, and three

Regardless of the entity you choose, the steps to forming it are essentially the same:

1. Decide which state you want to form your company in. Some states are more business-friendly than others. You’ll need to either be physically present in the state you choose, or hire a registered agent who is.

2. Choose a name for your company. You’ll need to pick something that isn’t already taken in the state you have chosen. It’s probably a good idea to also check with the Patent and Trademark Office http://www.uspto.gov/ to make sure that your company name doesn’t infringe on someone else’s trademarked catchphrase.

3. Follow the instructions for your state to form your company!

[mja2649]

Thank you JohnMichael,

Mike

[GoodLife]

Yeah, thanks for that clarification regarding the different kinds of entities.


Ray