Real estate investment may sound like an arena for moguls and multimillionaires, but the reality is that you don’t need to be a real estate professional and you don’t need millions of dollars to get started. These days, there are plenty of markets across the country that allow you to dabble in investing even as an amateur. Taking that first small step is the best way to get experience while also growing your wealth. 

To ensure your new venture is a boon and not a drain, you need to be aware of the tax planning opportunities available to real estate investors. In today’s blog, we’ll discuss the different ways to structure your real estate holding and the tax considerations for each option. 

Selecting an Entity for Your Real Estate
New real estate investors are likely focused on which properties to choose and how much of an investment to make. Most are not thinking about the tax implications of owning an income-producing property. However, overlooking these details can take a toll on your overall profits. Yes, you can buy a property and pay taxes on it as an individual, but this leaves you exposed to personal liability and is likely the least tax-advantaged option. Instead, creating a legal entity, such as an LLC, partnership, S corporation, or C corporation, to hold your real estate is often the most beneficial move. 

Don’t Just Default to an LLC 

When it comes time to create a legal entity, you’ll find that you have a wide variety of options. Oftentimes, attorneys will drive this conversation, but if you fail to involve a tax planner, you might overlook key factors when it comes to future profitability. Attorneys tend to lean toward creating LLCs because this entity type provides the strongest asset protection. If you form a single-member LLC, this will be a “disregarded entity,” which means that for tax purposes the entity is treated as an extension of its owner. This makes the tax reporting process conveniently simple. 

However, a single member LLC is not the best option for reducing audit risk. If we opt for a formal entity like a partnership or S corporation, our risk of an audit goes down. Other entity types can also come with tax benefits that LLCs do not have. Before setting up a new entity, take the time to explore the tax implications of each option—at the end of the day, the right choice will be specific to you, your current tax situation, and your future goals. 

The Perks of Partnerships 

What are our other options if we don’t want to go the LLC route? Typically, we’re looking at either a partnership or a corporate structure. One advantage of the partnership is that it is a pass-through entity, which means that you are not paying any federal entity-level tax (though some states may have their own taxes). Partnerships also enjoy deductions for qualified business income, a tax break that is being considered for renewal by Congress at the moment. 

Setting up a partnership also allows you to do special allocations where the income, losses, tax deductions, and tax credits can be divided among partners in a way that is disproportionate to their ownership interests. This can provide a simple way to set up tax-free contributions and distributions for different owners. Of course, a partnership does require you to have… well, a partner. This could be a consideration for someone planning on buying real estate on their own.

When to Go Corporate

How about taking the corporate route? If you set up a C corporation, you’re looking at a 21% flat tax rate. This might be a fairly good deal when you compare it to the tax rates you would pay as an individual. Individuals face a capital gains tax on investment earnings, which can be as high as 20%. Those whose income exceeds $200,000 (or $250,000 for married couples filing jointly) will also have to pay a 3.8% net investment income tax. Combined, this exceeds our 21% corporate tax.

However, keep in mind that when you set up a C corporation you have to deal with the double taxation issue: profits are taxed once at the business level and once at the individual shareholder level. So if you opt for a C corporation, you need to have a plan to reduce taxes on one or both of these levels through timing strategies and other techniques. 

So when might you want to go for a C corporation? Let’s say you are a dealer (buying and selling properties for profit) or a developer (managing construction projects as well as selling the property). Dealer status or developer status properties do not have a very lengthy holding period. Rather than holding onto the property long enough for the value to appreciate over time, dealers and developers are counting on profits from the property being constructed or reconstructed. Because of this, dealers and developers can count their properties as inventory from a tax perspective. The good news is business inventory is treated as ordinary income—which means you are just paying that 21% corporate tax. 

Another situation is if you have foreign owners involved in the investment. Other entities, such as S corporations and partnerships, face restrictions when it comes to foreign owners, and these owners often have to pay higher taxes. 

Considering an S Corporation

As pass-through entities, S corporations can be an attractive option: they’re only taxed at an individual level and are eligible for that 20% qualified business income deduction. However, S corporations face some limitations that partnerships and LLCs do not. For instance, partnerships benefit from that special allocations option. S corporations do not have this benefit. In general, because S corporations are required to have just one class of stock, they are expected to make distributions that are proportionate to each shareholder’s ownership interest. 

With an S corporation, you also need a plan for distributing the property among shareholders because that distribution can be taxable. If the fair market value of the property is higher than its original value, that will generate a capital gain and therefore taxes owed. So S corporation owners need to plan out how they’ll handle the property down the road, so they are not surprised by a high tax bill. Typically, one way to lower taxes is to deduct any losses on that property. This is another place where an S corporation can prove tricky—with a partnership or an LLC, your mortgage can give you the basis you need to take a loss, but with an S corporation, that is not the case. 

Though there may be situations where an S corporation is the right choice for a real estate investment, these limitations can make it suboptimal for many taxpayers. 

Summary
Before you dive into real estate investing, weigh your entity options. Choosing the right structure can be the difference between maximum profits and a hefty tax bill. Looking for expert assistance in keeping those taxes low? Reach out to a Certified Tax Planner today. 

Don’t miss the rest of our 4 part Real Estate Investment series!