For tax planners, taxpayers venturing into the world of investment can make great clients. Investing can be lucrative but also introduces new complexities to your tax plan—and that is where you can offer much-needed wisdom and support. This can especially be true for clients interested in real estate investment. Though a taxpayer does not need to be a pro to begin investing in real estate, they will need the help of a tax pro to ensure their profits are going into the bank instead of straight to the IRS.
One of the biggest decisions we can assist with as tax planners is selecting an entity to hold these real estate investments. Today, we’ll discuss the pros and cons of each entity structure and how to advise our clients on choosing the most tax-advantaged one.
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Structuring a Real Estate Holding Company
Many clients may not even be aware that they need to think about setting up a company. Those who are new to investing might assume they can just purchase real estate as an individual and treat it like any other asset. While this is technically true, as tax planners, we are well aware that this will not be the most tax-advantaged setup for most people. What’s more, owning income-producing real estate as an individual can leave your client unnecessarily exposed to personal liability. After walking the taxpayer through these considerations, the next step is to advise them on what type of legal entity to select based on their tax situation.
Overcoming the LLC Bias
If a client does decide to create a legal entity for their real estate holdings, they will want to employ an attorney who will likely street much of the conversation. While this will be helpful in many regards, it is our responsibility to make sure the tax consequences are not overlooked in the decision-making process. For instance, lawyers often default to recommending an LLC simply because it provides the strongest asset protection. In particular, a single-member LLC benefits from a simple tax reporting process because the entity is treated as an extension of its owner.
These factors may make an LLC an attractive option for some of your clients—but others may be better served by the benefits that come with other entity types. For example, a single member LLC comes with a higher audit risk than, say, a partnership or S corporation. Other entity types might also better support your client’s future goals of expanding their investment portfolio. You will want to ask thoughtful questions and take all these factors into consideration before recommending an entity type.
When a Partnership Makes Sense
Given the nature of partnership, this entity type can be a good fit if your client is already planning on bringing one or more partners into their real estate investment. A major plus of the partnership is that it functions as a pass-through entity. This means your client can skip out on entity-level tax (at least at a federal level) and benefit from the 20% qualified business income deduction (which is currently up for renewal by Congress).
A partnership may also be the best bet if your client and their partners need the entity to be set up in a way that is disproportionate to their ownership interest. Partnerships are unique in their ability to do special allocations and allocate income, losses, tax deductions, and tax credits according to each partner’s tax needs. This may allow the flexibility needed to create tax-free contributions and distributions for each owner.
When a C Corporation Makes Sense
A C corporation may instinctively seem like the most intense and complex option, and there is validity to that. One of the biggest drawbacks of this entity type is the double taxation issue. Under a C corporation, profits are taxed both at the business level and at the individual level. However, this does not immediately disqualify the C corporation as the least tax-advantaged. This really depends on what type of investments your client plans to make and whether other factors might allow them to reduce that business tax, their individual income tax, or both.
First, consider the fact that as an individual your client would have to pay a capital gains tax of up to 20%. On top of this, if their income exceeds $200,000 (or $250,000 for married couples filing jointly), they will also have to pay a 3.8% net investment income tax. By comparison, the corporate tax rate is a flat 21%. Again, if your client has other options to reduce their personal taxable income, this could end up being beneficial.
The taxpayer might also consider a C corporation if they plan to function as a dealer or developer, meaning they are buying and selling the property for profit or managing a whole construction or reconstruction project in order to sell a property. Keep in mind that dealers and developers are not planning to hold onto the property for a long time in the hopes that the value appreciates. Instead, their tactic is to turn a profit based on the property being constructed or reconstructed. With a C corporation, the property can be classified as inventory rather than a capital asset, which means it would only be subject to that 21% corporate income tax.
Your client might also consider a C corporation if they are working alongside foreign investors. Foreign owners typically face more restrictions and higher taxes as a part of an S corporation and partnership. This can make “going corporate” a much better fit.
When an S Corporation Makes Sense
Among all the options, S corporations can pose the most complications. Let’s start with what makes this entity type attractive: as pass-through entities, they are only taxed at an individual shareholder level, and they may be eligible for a qualified business income deduction. These are considerable perks! However, these perks also come with limitations. S corporations are required to have just one class of stock. This means their distributions must be proportionate to each owner’s interest unlike partnerships that are allowed to do special allocations.
S corporations also need to be cautious about generating taxable property distributions. This can happen if the fair market value of the property is higher than its original value when the property is distributed among shareholders. Typically, the entity can offset these taxes by deducting any losses on the property. However, this is another place where an S corporation can run into restrictions. With a partnership or LLC, your client could simply use their mortgage as basis to take a loss, but an S corporation does not enjoy the same benefit. Overall, these limits can mean that an S corporation is less likely to be the right fit for your clients.
Summary
Real estate investment can be a great opportunity, even for amateurs, with enough advance planning. As a tax professional, you can make a major difference for your clients by guiding them on entity choice and helping them factor their investment into their overall tax plan. For a deep-dive into tax planning for real estate investments, sign up to become a Certified Tax Planner today.
Don’t miss the rest of our 4 part Real Estate Investment series!
