Part One – Taxes
Everyone who invests in real estate does it for one reason – to make money. Some people think that’s all there is to it. “If I make more money, all of my problems will be over.” Right? Maybe…but maybe not.
It doesn’t matter how many properties you have or how much money you make off of them if they’re not protected. If you don’t protect your assets, they can disappear.
Asset Protection – Tax Laws
Our tax laws allow you to pay your taxes 3 different ways. You can legally pay your taxes:
Really? Let’s take a look at this. If you have ever gotten a paycheck from a job you are paying your taxes now. That is the worst way to pay your taxes because once your money is gone – it’s gone.
If you have a 401K, IRA or some other tax-deferred product, you are paying your taxes later. That means you are hanging onto your money and can make more money.
When you take a tax deduction or tax write-off, you are paying your taxes never. Most of you have been taking tax deductions since you began paying taxes but very few ever take a tax write-off.
Example: If you own a business, our tax laws state that you can buy a vehicle and write off the first $25,000 of the cost of the vehicle. What does that mean in terms of real money in your pocket?
We pay taxes at a 30% tax rate. $25,000 at 30% = $7,500. $7,500 that you would have paid the IRS in taxes that you can now put in your pocket. Congress has established that if you want to slash your taxes to a bare minimum, you will have to do three different things to accomplish that.
(1) Own a business. Why is that? Because business owners get the vast majority of the tax deductions in the tax code while non-business owners get very very few.
(2) Have that business in a properly structured LLC. What business structure cuts your taxes better than any other? Sole Proprietor? General Partnership? ‘C’ Corp? ‘S’ Corp? LLC? Only one of those is going to give you all the tax deductions and all the goodies in the tax laws and it’s called an LLC or Limited Liability Company. This is true only if that LLC is structured correctly. A properly structured LLC can do a couple of things for you.
(a) It can lower your taxes (The problem is most LLC’s don’t do this because of a number of reasons. The first is they don’t lower your taxes because they are not taxed correctly and there are no resolutions in the supporting documents.)
(b) It can protect you from lawsuits, (They don’t protect you from lawsuits because they typically have “cookie cutter” documents with no keywords. This is especially true of those LLC “kits” that are purchased off the internet.) and
(c) It can protect you from IRS audits. ( These are not going to protect you from lawsuits or protect you from being audited by the IRS or give you the correct rate of taxation. Most LLC’s don’t protect you from IRS audits because the LLC documents don’t authorize deductions. These documents are called supporting documents.)
(3) Keywords. Your LLC documentation must contain certain “keywords” in them. Those would be found in the LLC Operating Agreement for tax reduction & liability protection. There must be keywords included for tax reduction and liability protection and these keywords are not automatic. If you have a ‘C’ Corp, those keywords must be included in the ‘C’ Corp minutes and resolutions.
Good news for real estate investors! There are new 2018 tax cuts and real estate investors are reaping the rewards! Under the new 2018 tax laws, owners of “Pass-Through Entities” get a 20% tax cut. A Pass-Through Entity is a special business structure that is used to reduce the effects of double taxation. Pass-Through Entities don’t pay income taxes at the corporate levels. Instead, corporate income is allocated among the owners and income taxes are only levied at the individual owners level.
Pass-Through Entities include most LLC’s, ‘S’ Corps and Family Limited Partnerships. ‘C’ Corps are not included in this list. However ‘C’ Corps also get a tax cut. Their rate drops from 35% to 21%.
Real estate investors should never own real estate in a ‘C’ Corp. A ‘C’ Corp could be used for a management company under certain circumstances. Not true for everybody but appropriate for most.
Corporations can be taxed in 2 different ways. They can be taxed as an ‘S’ Corp or they can be taxed as a ‘C’ Corp. LLC’s can be taxed in 4 ways. They can be taxed as an ‘S’ Corp, ‘C’ Corp, Sole Proprietorship or as a Partnership. You must choose one and that choice has very significant consequences.
When making your decision, remember that the ‘C’ Corp is not a Pass-Through Entity but the others are and they give you an automatic 20% tax cut.
Sole proprietorships are Pass-Through Entities but there are many disadvantages to having an LLC taxed as a Sole Proprietorship.
Finally, an LLC can be taxed as a Partnership. This approach has many advantages. Just to name a few of them:
(1) It is a Pass-Through Entity which gives you that 20% tax cut
(2) There is no self-employment tax amounting to 15.34% on the income going to passive members. That’s a big big selling point for those of you trying to attract investors because they would be passive members and their income would not be subject to self-employment taxes thus saving them an immediate 15.34% in taxes.
(3) Finally, you can allocate both profits and losses which gives you the best tax flexibility.
There are two big advantages you get with going forward as an LLC – Partnership designation.
(1) Great tax savings, and
(2) Excellent lawsuit protection
………..If that LLC is properly structured.
One of the big problems is that many LLC’s are structured in the wrong way and that would be as a Single Member LLC which gives no protection from lawsuits in most states. A single member LLC means there’s only one person I the LLC -1 owner. If this is the case, it’s as if the LLC isn’t even there in the case of a lawsuit in most states.
In most states, if a single member LLC is sued, the lawsuit will pierce the LLC veil and they can take your personal assets. It is strongly urged that IF you insist on using a single member LLC that you use it very carefully.
So to recap, Congress has established that these 3 requirements must be satisfied in order to lower your taxes to the bare minimum:
(1) Own a business
(2) LLC – with correct legal structure and tax method.
(3) Key Words must be contained in the company documents.
The bottom line is that you must have a plan for your money because if you don’t have a plan for your money, the IRS sure does
Our blog next week will continue this discussion with information regarding Asset Protection. Now that you’ve set up your LLC…..how do you protect yourself and your assets from the risk of lawsuits, IRS audits and other risks.
(The information contained herein was obtained through seminars conducted by a licensed attorney. The author of this blog and owner(s) of this site are not licensed attorney’s and make no claims as to the accuracy of this information nor do they intend anything contained within this blog to constitute legal advise.)