The most intimidating concern of real estate investors is how do I protect my property, reduce taxes and what entity if any should I use? First, you must have a very good tax and legal team who understands real estate and investors.
If you are an investor who does rehabs, fixer uppers, option contracts, developments, consulting and services or you are a real estate agent or broker you are facing self-employment tax which is upsetting. The rate is 15.3% which is the difference of the 7.65% that an employer withholds for social security and Medicare and then matches. As a self-employed individual, you receive no match and pay the entire 15.3%.
If you're paying elevated self-employment tax, you are a sole proprietor. Often a client can optimize their situation by using an entity but which one will do the trick? By now you've probably been racking your brains on this very question and heard of the C-corp., S-corp., Limited Liability Company (LLC), and Family Limited Partnership (FLP). The C-corporation is sometimes effective by typically not a good fit for most because it creates a double taxation. The S-corp is generally best for a company raising capital or going public. However, sometimes a C Corporation may be appropriate for other operations because its initial tax brackets of 15% and 25%. For example, if you're in an individual tax bracket of 25% or higher, then there could be an opportunity to eliminate taxes by shifting some of your income to a C Corporation. This has a nice application because of the shifting of income to a taxpayer (your C Corporation for instance) in a lower tax bracket than you personally.
The S-corporation makes great sense for those who are doing consulting, rehabbing, fix & flips, developments and services because it is a flow through entity. Because of this flow-through capability you can eliminate capital gains tax without a dividend tax but you have to take a “reasonable salary” and create a payroll which is probably the biggest intricacy. There are no hard and fast rules on the salary and is a subjective analysis. My team and I have devised a spit that is prudent, yet reduces tax. This salary/dividend split is the number one strategy for ordinary income. Remember when dealing with real estate investing we may have passive or ordinary income and for each type of income there will be a different strategy that in combination, slays some of the tax and provides protection.
Some of the difficulties with the S-corp. if you want to really nitpick are, it is inflexible in moving long-term real estate in and out and you have to do a quarterly payroll. The payroll is simple to deploy but you need to find a cost-effective tax preparer who will do it or use a payroll company and it should not cost an arm and a leg to get done but the savings will substantially offset this expense. A good rule of thumb on when it makes sense to have an S-corp is around $50,000 or more of ordinary income.
If you're not doing anything but buying and holding then you'll want to consider a limited liability company (LLC). You will not get the abatement in self-employment tax but you have liability protection and an opportunity to do some creative estate planning to avoid future estate taxes. Owning a small business for rental real estate is an excellent strategy since it may convert personal expenses to business expenses that will offset income even if you are currently an employee receiving a W-2 from an employer. The LLC also limits a creditor to a charging order which is an assignment of income and many LLCs do not distribute or can elect to not distribute thereby making this a hopeless remedy for the creditor. Contrariwise, a limited partnership can be foreclosed upon by statute in California.
Sometimes clients are told to use an LLC and have their S-corporation be the general partner of their family limited partnership (FLP) and this can create vulnerabilities to the stock of that S-corporation by a lawsuit that occurs outside of the LLC activities. The strongest portfolios seem to be those that have a combination of active real estate investing e.g., fix & flips, rehab, and passive in the form of rental real estate which can then be used to offset income of the active investing, however, this requires use of two entities.
In closing, clients are often confused where the best place is to set up there entity because they hear all the radio ads about Nevada. If you are a resident of California, you will not save any taxes by forming your entity out of the state. There other states that have stronger protection (e.g. Delaware) and under the Supreme Court Doctrine of the Internal Affairs, a corporation will be governed by the state of incorporation but any disputes arising will have the law of the jurisdiction where the dispute occurs applied. For example, if you are incorporated in Delaware and hold Texas property and encounter a challenge in Texas, Texas law will be applied but how the corporation is run and its structure should be preserved under the state of incorporation which would be Delaware.
If you have any questions about setting up your real estate investing business you need to find a great team for the tax and legal strategies. The best is usually an attorney and CPA who are also investors and understand the merits of owning real estate. This is only a broad brush stoke on the possibilities and each persons circumstances are different so you would need to be evaluated, as one size does not fit all.