Michael Bowman, Esq. covers four effective strategies for protecting wealth from taxes and lawsuits.
Updated August 20, 2020
Whether you buy and hold, fix and flip, invest with your retirement account, or a combination thereof, real estate investors are exposed to more liability than those who invest elsewhere. There are inherent risks to property ownership that you won’t encounter investing in stocks. Additionally, real estate investors who don’t understand the Tax Code will be doomed to overpay year after year.
To address these myriad threats against wealth accumulation, use entities. Entity structuring involves using one or multiple entities to create an entity structure that shields your assets from personal and business creditors, as well as unnecessary taxes.
One of the first objections I often hear when discussing the risks associated with real estate investing is probably what many of you are thinking right now: Well, I have insurance. I’m here to tell you that, unfortunately, insurance is not enough. The average judgment in real estate is over $1 million, but the average insurance payout is only $500,000. Plus, read your policy closely: there are tons of exclusions. Insurance is imperative, but don’t be under any delusions when it comes to how much insurance actually covers.
Individuals vs. Businesses
Entities are useful for multiple purposes; one of their most attractive benefits is that entities allow individuals to utilize the business Tax Code. This is a major advantage since the business Tax Code is much less restrictive than the individual Code.
As we all know, the individual Tax Code operates like this: earn – tax = spend. After your earnings are taxed, you can spend what’s leftover. Looks familiar, right?
The business Tax Code is quite different: earn – spend = tax. Businesses only pay taxes on the money left over after spending.
Entity structuring allows individuals to access this preferential business tax treatment.
Long-term Real Estate Strategies
With long-term buy-and-hold real estate investments, the main concern is maximizing the owner’s privacy and asset protection. One of the important things to consider regarding asset protection is charging order protections.
Charging Order Protections
When it comes to protecting your buy-and-hold real estate investments, many will suggest “just put it in an LLC.” However, where your LLC is set-up and how your entities are structured are crucial.
A charging order is basically a lien against interest. If you are sued personally and there’s a judgment against you, a charging order protects your LLC’s assets from that creditor. Instead of being able to seize your LLC’s assets, the creditor’s only option is a charging order, which entitles the creditor to any money distributed from your LLC. And since you’ll be in charge of your LLC, you won’t distribute any money.
As the law was originally intended, charging order protections prohibit creditors from:
- Becoming a partner in your business
- Demanding income from your business
- Forcing you to distribute assets from your business so the creditor can get paid
- Participating in the management of your business
Unfortunately, over time, many states have weakened their charging order laws. Nevada and Wyoming, on the other hand, have strengthened their charging order protections. This makes an LLC in one of these states an essential component of your entity structure.
Considering this, you’ll want to use a Nevada or Wyoming holding LLC to own each of your in-state LLCs. Each property should be held in a separate LLC created in the same state as the property. Each property-holding LLC should then be owned by your Nevada or Wyoming holding LLC.
From there, you can incorporate and add a corporation into the structure. The corporation is your workhouse: its income-producing activities are active. Your corporation should manage each of the LLCs. The LLCs can even pay a management fee to your corporation, decreasing their taxable income.
Short-term Real Estate Strategies
If you invest in fix-and-flip properties, one concern should be avoiding dealer status with the IRS. Whenever you hold an asset for less than one year before selling, this could be considered being a dealer. Moreover, the IRS test for this is intent-based, meaning it doesn’t matter how many flips you do. You could only do one flip in a full year and still be tagged as a dealer if your intent was to sell in less than one year.
Being tagged as a dealer by the IRS means losing significant tax benefits, including:
- 1031 exchanges
- Depreciation deductions
- Long-term capital gains tax rates
- Passive income
All these benefits will be lost if tagged as a dealer. Since your real estate activities aren’t considered passive, that means an additional 15.3% tax you wouldn’t otherwise have to pay.
There is an entity structure to mitigate all these concerns. Create an in-state LLC to hold the property. You should take title, buy, rehab, and sell property from this LLC. Assign the LLC to your corporation so the activity of the LLC doesn’t show up on your personal tax return. Make sure to create separate LLCs for each property.
This structure also allows you to access the corporate Tax Code, which provides significantly more deductions along with a host of other benefits, including the ability to fund retirement plans.
Retirement Planning and Real Estate Investing Strategies
Using entity structuring, you can establish your own qualified retirement plan (QRP), which will allow you to be your own trustee. To do this, follow these steps
- Create a corporation or LLC taxed as a corporation
- Create a QRP sponsored by the business
- Fund your plan by rolling over your existing retirement plans
Being your own trustee means that you won’t have to work with a mediator to make deals. As your own trustee, you have much more freedom to invest with your retirement account:
- Buy and sell real estate
- Hold real estate
- Buy and sell options
- Tax liens
- Deeds of trust
Additionally, you can borrow from your plan, pool accounts, and make annual contributions.
Real Estate Dynasty Planning Strategies
After you’ve worked so hard your entire life to accumulate wealth and protect everything you’ve earned, shouldn’t you also make sure your life’s work is preserved?
You can protect your heirs from themselves as well as from excessive taxes by creating a living trust. Living trusts are “living” entities, meaning they live on after your passing. Living trusts avoid probate and the court system entirely, saving the 18-24 months that probate usually lasts and the tens of thousands of dollars it costs on average.
In addition to saving money and time, living trusts also allow you greater control over the distribution of your estate. You can individually plan for your beneficiaries or create a distribution schedule that protects beneficiaries. For instance, my living trust is set up to distribution certain percentages to my son when he reaches certain ages. You can stipulate the distributions however you choose — that they must be used for certain purposes (like education or travel), or distribute at certain points in time, for example.
Your living trust should hold title to all your assets. This includes your short- and long-term real estate structures, banking LLC, vehicles, personal residence, and corporation.
This is only a fraction of the multitudes of options that open up to you as an investor when you utilize entity structuring. Not only do you protect yourself and your life’s work from potential creditors and save thousands in taxes, the right structure can also increase your financing options and make yourself look more attractive to lenders.
If you’re interested in learning more specific strategies for entity structuring, I highly encourage you to attend our 3-day Tax & Asset Protection Workshop. We cover these strategies in much more detail, as well as a lot more. If you’d like to discuss the best entity structure for your unique investing situation, I invite you to sign up for a complimentary consultation with one of our advisors. You can schedule your consultation online or by calling 800.706.4741.
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