There are many angles to consider when you are seeking the best choice of entity type for your real estate investing activities. There are liability and creditor protection concerns, tax consequences, ease or difficulty of use, length of ownership in your investments, purpose or type of real estate investments, and even privacy concerns to worry about!
Whether you are just starting out as a real estate investor, or whether you already have a head start, or even if you already have an entity formed and are wondering what you can do with it from a tax perspective—we can help! This article gives you a preview of some of the considerations we’ll walk through with you. But since there are always exceptions to the rules, it is advisable to seek out individualized advice from a qualified business tax CPA.
Let’s start with what S Corporation’s and LLC’s have in common….
Extra liability and creditor protection when you hold your investments in an LLC or S Corp. (Visit with your attorney on the entity structure to maximize the protective attributes.)
Separate business bank accounts and credit cards are recommended to maintain a clear separation of your business activity from your personal accounts. Paying investment-related expenses and receiving investment income only through your business bank accounts--and not blending your personal and business accounts--helps to preserve your liability protection.
Both entity types provide extra privacy in the form of an EIN (Employer Identity Number) to use on required forms. For instance, if your property manager sends you a 1099-MISC in January to report the rents you received last year, you may provide the property manager with your business’s EIN rather than share your Social Security Number with them. Likewise, if you are required to issue any 1099’s to another individual or company, your business name, address, and EIN would appear on the form, rather than your personal information.
Both entity types are considered “pass-through” entities, where the taxable profits and losses from the business flow through directly to the owners rather than being taxed at the entity level. Once the pass-through entities pass their profits and losses to the owners, the owners are then taxed on the gains or benefit from the losses. This prevents double-taxation, like you may see sometimes with a C Corporation.
If a property had ever been a personal residence, the possibility of a personal residence gain exclusion is forfeited upon moving the property under an entity.
Then, we should compare the differences….
Long-term rental properties held for more than one year are generally considered a Passive activity. Short-term fix-and-flips are generally sold within a year and would qualify in that case as an Active activity. But, as you would imagine, there are also several exceptions to the Active versus Passive classification for real estate investments. Here are some exceptions that would qualify an activity as Active that we see with our clients:
The rental property is considered a self-rental, where the owner of the building rents space to another of the owner’s Active businesses.
The owner meets the tests to be considered a Real Estate Professional.
Fix-and-flips might be so numerous that they rise to the level of a trade or business, in which case, the properties would be treated as Inventory.
The average rental period of a property is less than seven days.
Significant other services are provided to a tenant as a part of the rental.
The rental properties are grouped with other Active activities.
Active or Passive activities have their applications and benefits, depending on the taxpayer’s tax situation. A good tax planning CPA can help you devise the best benefits from your overall tax situation and will be able to give you a clear idea of what type of entity works best. We’ll consider the length of time you plan to own the investments, the types of activities you’ll have, and how they play into your overall tax situation. If you’re thinking of forming or changing an entity for your investments, set an appointment or give us a call today!
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