Toby Mathis and Jeff Webb of Anderson Advisors answer your tax questions, including which business structure is best for real estate agents. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- What is the 1031 exchange? How is it used and is there any concern that it may go away? Section 1031 allows you to sell an investment property through a qualified intermediary (QI) and then replace that property; there’s no logical reason for the 1031 exchange to go away because it is a tax deferral not a tax avoidance technique
- As a new wholesaler, what is the best way to set up my business structure? Through a corporation because a wholesaler is somebody that gets a property under contract and then sells the contract with a right to close on that property
- How does the tax work on rent-to-own? The non-refundable deposit, monthly cash flow, and the backend? IRS views non-refundable deposit as a lease-purchase option or sale
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Resources:
Infinity Investing: How The Rich Get Richer And How You Can Do The Same by Toby Mathis
Section 121 – Capital Gains Exclusion
Real Estate Professional Requirements
Full Episode Transcript:
Toby: All right, guys. Welcome to Tax Tuesday. Hopefully everybody’s out there alive and kicking. This is Toby Mathis and I got Jeff Webb there on a different cam.
Jeff: Yes sir.
Toby: Let’s dive in. We got a lot to go over. We have people diving into the room. I’ll let you guys come into the room. Let us know by the way if you can hear us, if you could tell us where you are at. Just the city and state would be great.
There’s Atlanta, Titusville, Alaska, San Francisco, […], Westlake, Pennsylvania, Fayetteville, Huntsville, Baltimore, Tampa, Florida, San Jose, Largo, New York, Birmingham, Alabama, Fremont, Louisville. We got people from all over the place.
I would just dive right in. How are you doing, Jeff? You haven’t said anything yet.
Jeff: Yeah, I am.
Toby: You’re all right, Jeff?
Jeff: I’m fine.
Toby: All right. We got a lot to dive into. We got a lot to do, so let’s just jump right in. You can ask your questions. You can ask them live via the Q&A feature on Zoom, so you’ll see the question and answer, not the chat, but the question and answers where you ask your questions. You can always send them in via taxtuesday@andersonadvisors.com.
If you’re needing a detailed response, like a professional response to a specific set of questions that pertain to you, we need you to become a client to do that. If it’s just general tax questions, we just answer them.
What do we say, it’s fast, fun, and educational. We always try to make sure that we demystify this world of taxation and see what we can do. We have a whole bunch of questions. Before we go into the questions, I will say that we have a bunch of accountants that are here to help you. We have Ian, Elliot, Christos, Piao, Dana. You got Jeff and me. You got Patty. You got Matthew and Zander, Alexander, Mr. […] helping us with the tech.
Alexander: Ander is fine.
Toby: Then it says Alexander and I feel bad calling you Ander. I’m just going to call you Alexander since I can be that way. We have a bunch of people there to answer your questions and we can make sure that your questions get answered.
Let’s dive into the main questions for today. As always, we will go through each one of those. I’ll go through all the questions that we’re going to answer and then we’ll go through each one, as well as answer your comments and questions as you go along.
Number one is, “What is the 1031 exchange? How is it used? And is there any concern that it might go away? Seems like the only option if you’re trying to avoid long-term capital gains on property.” We’ll answer that.
“As a new wholesaler, what is the best way to set up my business structure?” We’ll dive into that one too.
“How does the tax work on rent-to-own? How does it work?” How the taxes work is really what I think it is, “The non-refundable deposit, monthly cash flow, and the back end. How were all those things treated from a tax standpoint?”
“I have an SFR,” which stands for single family rental, “that has been passive rental properties since 2003. I have not taken depreciation on my 1040. Now I want to sell the single family residence, take the profits, and pay the long-term capital gains. However, if I have not taken depreciation then there is no recapture, correct? Or will the IRS take depreciation recapture regardless?” We’ll go through that one.
“Does a disregarded Wyoming LLC pay the $800 franchise tax in California? Please advise on any strategies to avoid having to pay the $800 franchise tax in California. By the way, I’m seriously considering moving to Nevada if I can convince my employer to allow me to work remotely.” Somebody is having a lot of fun with California franchise taxes.
“I am a full-time real estate agent with a broker’s license, although I do not currently run my own brokerage. I am planning to begin investing in rental properties as well. Is it a good idea to put together these businesses under an LLC or S-Corporation? Or is it more beneficial to keep things separate?” Good question and we’ll answer that.
“I have a rental and Airbnb on my property, plus I work from home. What part of home repair, landscape, et cetera can I write off?” We’ll jump into that one as well.
“I need to create an entity for my business as a real estate agent. I’m not sure which entity is best for me and pay myself out of my business income separately. Not sure which corp is best?” So we’ll get into that. You got some choices there.
“I have been buying investment properties for the past five years and are under my name. I have a separate personal account where my rental income is deposited. My question is how should I formalize my business structure if they are under my name and my personal account?” Great questions thus far, so we’ll keep answering.
Then the last question is, “I buy and sell vacant land. I typically buy then resell with owner financing, deed of trust, mortgage deed, et cetera. My question is twofold: (1) Would I be considered a dealer given I do 400 properties a year though there are no structures and my intent is to resell on terms not flipped for cash. (2) Would it be possible for me to save on taxes by becoming a limited partner, create a general partner operated by an LLC that my team owns/operates? I just put in the money and stay out of the day-to-day. I’m not very actively involved as it is.” We will go through all of those there. Sounds like we got some good ones today.
So, Jeffery.
Jeff: Yes, sir?
Toby: Here’s the first one. “What is the 1031 exchange, how is it used, and is there any concern that it might go away?”
Jeff: Section 1031 allows you to sell an investment property through a qualified intermediary and then replace that property. You’ve relinquished one property and replaced it with another property. In general, you have to pay more for the replacement property, or at least as much for the replacement property, as you do for the relinquished property.
There are time frames you have to identify that replacement property within 45 days and purchase it within 180 days. You can actually identify several properties and just choose one or two, whichever serves you.
It gets quite a bit more complicated than that. If you’re going to do a 1031 exchange, the first thing you want to do is go find a good QI (qualified intermediary). They will walk you through this transaction and keep you out of trouble.
“Is there a concern that it may go away?” My personal feeling is this isn’t going anywhere, unlike you hear him talk about wanting to do away with a step-up in basis and things like that. Those are permanent changes that make taxes go away, whereas this 1031 is just deferring when the tax is going to hit. It’s not going to be on this sale but maybe on another sale down the road. I really don’t see a logical way or reason for this going away. What’s say you, Toby?
Toby: I’m kind of the same way. I know that it became part of the Biden platform on taxation that they were saying, hey, we’ll let you 1031 exchange. We’re going to put a threshold limitation on it of a million dollars and things like that. I always looked at that as kind of a red herring. That was a negotiating tactic. I can’t see them making it go away because too many people utilize it. And like you said, it’s not like it’s a tax avoidance. It’s a tax deferral technique.
Now, if you pass away with the replacement property and then you have that step-up in basis, you could avoid paying tax entirely. They’re addressing the step-up in basis. I believe they want to limit it to a million dollars a step up. They even tried talking about a million dollar limitation on the 1031 exchange. I just don’t see it going anywhere.
Jeff: Yeah, I agree.
Toby: The big thing for 1031, though, if you’re somebody who buys properties and you can buy multiple properties. If you want to do a 1031 exchange, you certainly can. You could sell one property and buy 10. You can sell 10 and buy one as long as you’re using a qualified intermediary. There are some pretty tricky ways to use 1031 exchanges, including in conjunction with a 121 exclusion on a home. There are some interesting things you could do there to minimize your tax and to take advantage of multiple provisions.
The other thing is just depending on your scenario, a lot of people get this weird fear of capital gains when realistically, if you spread it out over a period of years, it’s not that big of a deal. They’ll oftentimes run to the 1031 exchange without considering alternatives like an installment sale.
I would just say that if you’re in the real estate world, familiarize yourself with a bunch of the benefits to being involved in the real estate side and that there are other ways that you could defer taxation, including spreading it out over a period of years.
Jeff: Yeah, a really important point of this is when you do a 1031 exchange, you don’t get any cash out of the deal. It goes into your next property. So yeah, I agree with Toby. Maybe the installment method. If you want to sell and get out from underneath the property and cash out, 1031 is not the way to do it.
Toby: Somebody just made a good comment. They just said, “Hey, if I’m under $80,000, is my capital gain rate zero?” Technically, yes. Your long-term capital gains rate would be zero, up to $80,000, and then it goes into the 15% tax bracket. Depending on what your scenario is, what your income is, to whether or not you even need to be worried about the 1031 exchange. You might be shocked that you don’t really have that much tax to owe, anyway, which is why you always do the calculation at a time.
Here’s another one. “As a new wholesaler, what is the best way to set up my business structure?”
Jeff: I got a really short answer for that. I think I would most always do this to a corporation.
Toby: I always say we know what the terms mean so when you say wholesaler, what are you really talking about? A wholesaler is somebody who basically gets a property under contract and then sells the contract. They’re either going to sell the right to close on that property.
For example, let’s say that I got a property under contract for $50,000 and I go to Jeff and say, hey, do you want to buy my right to close? I’ll sell it for $2500, and Jeff says, that’s actually a really good deal. I was looking for a property like that, great, I’d make the $2500. Or I close on the $50,000 and then I immediately turn around and do a double close and sell it to Jeff. In either one of those, and you’re going to have ordinary income that’s hitting you when you’re really going out and you’re running.
When we see wholesalers that are true businesses where they’re going out and they’re dropping a lot of mail, they’re they’re shooting out text messages, they’re using PropStream, and some of these other tools to figure out who’s behind properties, and they’re reaching out, they’re negotiating deals all the time, that individual is going to be some sort of business. It’s going to more than likely be an S-Corp or a C-Corp from a tax standpoint, a corporation or LLC from the state standpoint.
Of course, an LLC can be taxed as an S-Corp or as a C-Corp. It always depends on what it is that you’re doing. I’m with you. I’m looking at this going, you’re a wholesaler, your business, I’m putting it into some sort of corporate structure more than likely an S-Corp to start.
Jeff: Sometimes we have people talk about, well, I don’t want it to be ordinary income. I want it to be capital gain or loss. Actually, you don’t. It’s the same tax rate for both capital gains and ordinary in a corporation. Ordinary losses are of little use unless you have capital gains to offset them. They kind of get trapped there.
Toby: Make sense. If this is the first time you’re hearing some of this stuff, by all means visit our YouTube channel. There are a number of videos on this and our Tax and Asset Protection courses. We always go into some of the good, the bad, and the ugly when it comes to taxation.
Speaking of workshops, we do have the Infinity Investing Workshop coming up on September 11. Just to let you guys know, if you haven’t been doing Infinity Investing Workshop, it’s really straightforward. We go over two types of investments. Specifically, we’re looking at stocks and we’re looking at real estate. We spend a day diving into the appropriate way to invest and how we see our most successful clients investing.
It’s year after year, month after month. It doesn’t matter whether it’s going up, down, or sideways. Our clients, the good investors tend to make money no matter what. We’ll show you what they do and how they do it.
It’s not a difficult process to get involved in. You have to be a little patient because it’s not a get-rich-quick. It’s definitely a mindset and a different philosophy that is a long-term philosophy. If you want to be successful over a long period of time, do what other people that have been successful over a long period of time have been doing and apply the same principles.
We’re not going to be doing anything that’s crazy. It’s going to be here’s mathematical certainty. The easiest way to look at it is we don’t want to be gamblers, we want to be the casino. We’ll show you how to be in the casino. You can, by all means, join us; it’s absolutely free. We’ll hopefully get Patty to share out that link with you all if you’d like to come in and join us.
It’s actually fun. If you’ve never spent a day learning about investing, it’s actually kind of a blast because we bring in some really great people. Pia Washington, Nicole, Ambrosia, Aaron Adams, just great people who just have a ton of knowledge and a lot of success so they do a really great job.
All right, “How does the tax work on rent-to-own? The non-refundable deposit, monthly cash flow, and the back end?” What say you, Jeff?
Jeff: This would seem to be an easy answer, but it’s not because of the way it’s treated and the way the IRS looks at it. The non-refundable deposit you mention is typically what we would call a lease purchase option. That can be treated one of two ways. The IRS is going to either look at that as an unexercised lease purchase option or it’s going to look at it as a sale at the time the option’s paid.
The two main factors they looked at is have you increased the rent. Are you asking for more rent payment than it’s fair market value, fair rental value? The second factor is that back end, that closing price or sales price, is that a bargain rate? If they’re seeing those two things where you’re asking more for rent, but you’re asking less for that purchase price than is expected, they’re going to consider this a sale. That non-refundable deposit will be a down payment on the property. A portion of those monthly cash payments are going to be considered part of the sales price gain on that.
The other side of that is if they don’t do that, that is if you’re just getting fair market rent, it’s just a future, say in the next five years they could exercise this deposit or this lease option, they could do that. It’ll be treated just like a normal rental. It’s just that once you trigger certain things that you start triggering income like a sale.
Toby: You’ll hear it called a land contract, or contract for deed and things like that, where they call them different terms and what you have to figure out is what the relevant rights are between the parties because all of those things would be an installment sale. Is it a lease with an option? Or is it an actual lease-to-own where you’re in essence making a partial payment every month on that deal, on that purchase.
If I see a rent to own, I’m almost always wanting to see two agreements. I want to see the lease and I want to see an option. If they put down money on the option then until they exercise it, then that money hasn’t been earned yet. The way option money is earned is the expiration of the option or somebody actually exercised it. If they never exercise it, then you’d have a taxable event.
We’ve seen this so many times. There are folks out there that have some pretty interesting interpretations of the tax law. They’ll take option money and they’ll think it’s never taxable including when the person moves out or they said, hey, I’m not going to exercise the option, well that just became taxable, too, and you’ll have people argue with you that no, no, no, it’s not. No, it’s like what? You just get free money? Did you pay tax on it when you received it? No, it was an option.
Options are taxable upon exercising it when it expires. When it expires from either a time or whether you walk away and you say I’m going to abandon it or sell it. It’s no different than options are in the stock market.
When you do a rent to own, you do need to be careful as to how it’s treated. The non-refundable deposit, if it’s for the option, then we would have to look and see what rights were triggered. Is it the right to have the option? Because in that particular case, it’s not taxable, too.
If you’re receiving monthly cash flow, then is it under the lease? Or is it a payment that is being made? So is it rents and upon exercising that option is all of a sudden a portion of that attributed towards a purchase price? Again, you have to look at what the rights are inside of those contracts regardless of what you call them.
Jeff: We talked about rent-to-own and I prefer, like you were saying that lease option, you actually have to exercise that lease option rather than you’re buying a little equity with every payment you make. I think that makes it a lot more complicated.
Toby: It does. That’s why we always have to take a look at it. People are always like, hey, I’m doing a lease option. It’s okay, but can we see the documentation? Then it’ll end up being a disguise sale. Like, hey, that’s not exactly how it works. I don’t care what you call it, I care about the rights that are between the relative parties.
All right. “I have a single family rental that has been passive rental property since 2003. I have not taken depreciation on my 1040. Now I want to sell the single family rental, take the profits, and pay the long-term capital gains. However, I have not taken depreciation. Then there’s no recapture, correct? Or will the IRS still hit you with the recapture?” Jeff, what do you think?
Jeff: There are actually a couple of issues here. Not only will there be recapture, your basis will be lower. Let’s say that you had this for 27½ years and it’s fully depreciated. Your basis would be zero in the sale.
What you want to do is find a good CPA, EA, tax preparer, somebody who knows what they’re doing, and if you’re selling it this year, you need to do a change of accounting method this year. It will allow you to take all the depreciation in the current year. You’re still going to be subject to recapture but I would rather pay the recapture and have that deduction.
Toby: Chances are they’re going to put the passive loss when they take the depreciation. Then that will be released as ordinary loss when they sell the property. You definitely want to make that change of accounting method.
To answer the question here, the real specific question is if you haven’t taken depreciation, you still have to pay recapture. The way Congress words that is you may take depreciation but you shall recapture. You’re going to have to pay recapture no matter what, whether you took the benefit or not.
I’m 100%, with Jeff saying, you’re going to get hit here. It’s a good thing you’re asking now before the tax year is over and before the sale is done because what we want to do is make a change of a tax election before you file your final return or before you file your return in the year of the sale.
We want to capture this in 2021, for sure, and make sure that we are getting the benefit of all that depreciation and then fire the accountant that you’ve had since 2003 in the meantime. This is well enough known.
You see this all the time with people that will have a second property or a third property, and they’re renting it out. They’re like, oh, I’m just renting it out a little bit. It doesn’t matter. You have to make sure that if this is an investment property, that you are taking that depreciation because then they will make you pay taxes, though you did. Anything else on that one, Jeff?
Jeff: If you look at the form where you calculate this gain, it actually says depreciation allowed or allowable. Meaning either you took it or didn’t take up what should have.
Toby: Yup, not very nice. Definitely not very nice. Let’s see, I sent over a question via email yesterday. Will you answer it in this call? I’d probably not. Guys, we get about 400 questions a week. Our guys will go through and answer them and then we pick about 10. Somebody’s like, hey, I just sent it. When are you going to hit it? You could always ask the question in the Q&A if you want.
Then somebody was asking about the capital gains. The way it works is long-term capital gains are going to be 0%, 15%, or 20% depending on what your income is. If you are married, filing jointly, and you’re below (I think it’s) $80,000 this year, then you were in the 0% long-term capital gains rate.
The easiest way to think about it is if you are somebody who’s making $50,000 a year, then you do have long-term capital gains, you have about $30,000 of long-term capital gains that you can use up at the zero rate.
Why is that important? Because you can adjust your basis if you’ve owned certain stocks for a long period of time and they’ve popped up. Let’s just say that COVID dealt you a low blow and that you didn’t have a great earning year. It might be this is the year where you sell some things to recognize capital gains and buy them right back. All you’re doing is resetting your basis so that if you sell them in the future, you don’t have any gain.
Is the gain included in the $80,000? Yes. So if I made $70,000 and then I had $50,000 long-term capital gains, $10,000 of it would go in the 0% and the remainder would be in the 15%. It is utilized towards that figure.
Jeff: That $80,000, that’s for married filing jointly. The single is for $40,000, married filing separately is 40,000, and head of household is like $54,000.
Toby: Yup. Then somebody just said, hey, I heard Toby saying the wholesaler questions he’d recommend an S-Corp to start. Clint sometimes says C-Corp. It’s always going to be based off of your facts. If it’s a wholesaler and living off the money, I’m probably going to start them with an S-Corp.
If they are not necessarily living off the money, or they’re going to take it all out as salary, and you want to qualify for loans, then that would be something where I’d probably look at the C-Corp depending on what your scenario is. There are a lot of moving parts there so there’s not a hard and fast rule.
What I look at is if somebody is making money, active income that they need, the S-Corp is almost always going to save you money as opposed to just doing it as a sole proprietor. If you’re living off of that money and that money is coming out to you, you’re going to be better off as an S-Corp from a tax standpoint.
What would push us to this side of saying, hey, maybe we should be a C-Corp? Lots and lots of medical bills, lots of expenses that I can’t write off necessarily as an S-Corp that might be a factor, and also, if I am trying to qualify for a loan and I don’t want them to have to go through my S-Corp. But in the case that I just gave you where somebody is making their living at it, they’re almost always going to have to.
Again, usually you’re sitting down and doing your weighing test with somebody who says, all right, what type of activity are you engaged in? What are you going to be doing over the next four or five years? Is it something where we should start off to where it’s easy access to the capital, or should we add that little bit of extra complexity via the C-Corp because you’re building up a portfolio of property? That’s what we’re looking at.
You’re doing a little bit of balancing, you’re doing a bit of weighing. This is the only rule. This is like, hey, here’s the considerations that we’re looking at. Again, if somebody who’s working, I want to make it easy for them to get their money. That’s usually where we’re going to start. No matter what you do, you’re not stuck.
Quite often, every corporation pretty much starts off as a C-Corp, but then you make the S election. Sometimes we’re looking at it going, hey, this beginning year will be a C and then we’ll make the S maybe next year, or let’s just see how we’re doing money wise. It’s not like if you have a gun to your head and you say, hey, you have to make this decision right now and it’s forever. No, it’s not like that. We can go back and we could change things up as needed.
“Does a disregarded Wyoming LLC pay the $800 franchise tax in California? Please advise on any strategies to avoid having to pay the $800 franchise tax in California.” Then it says, “By the way, I’m seriously considering moving to Nevada if I can convince my employer to allow me to work remotely.” They must not like their taxes in California. What do you think, Jeff?
Jeff: The Wyoming LLC is set up to avoid taxes in California because the presumption is that the Wyoming LLC is not doing business in California. It’s doing business in Wyoming where it’s organized. It can sometimes get pulled into California. The most notorious way is California says, well, your shareholders, members, whatever, all live in California. They’re doing all the work for the Wyoming LLC.
When we set these up, we try to set them up in a way that does not draw California’s ire. I don’t know that I would move to Nevada just to avoid the $800 of tax. But if you’re paying, like I was, a serious amount of personal taxes in California, that’s a good reason.
Toby: A lot of this depends on where you reside. It sounds like this individual resides in California. It used to be, as long as the LLC was owned by a trust, we would win these and the Franchise Tax Board would tell you, you didn’t have to pay it if the trust was the member. Then they went back and said, oh, no, if it’s a living trust or if you’re the grand tour, then it’s still the individual. We want the LLC to pay the Form 568 as a foreign business doing business in California saying, hey, since you’re the member as the trustee of the trust, or they would always concoct some, hey, you’re ultimately in control, therefore, we think that the LLC is doing business in the state of California.
Obviously, it sounds neat for the Franchise Tax Board, but from a legal standpoint that doesn’t necessarily meet the constitutional requirements of doing business in a state. Then you end up with lots of Franchise Tax Board court cases and it’s all over the place.
Here’s what we do. There’s a way to avoid it completely. There are two really easy ways right now. Number one is you use a California disregarded limited partnership. That is still a viable option. It sounds weird, but the Franchise Tax Board recognizes that it is not a taxable entity from a tax standpoint for franchise tax, and it’s called a disregarded limited partnership. It’s a limited partnership in which, in essence, you are controlling both the limited partnership and the general partner interest, more than likely doing it through an LLC. So that if you have multiple properties, let’s say we have a bunch of properties and you’re using limited partnerships to hold them, you might have one entity that’s ultimately taxable in the state of California so that you can avoid paying multiple $800.
That’s not our favorite. Our favorite right now is the Wyoming statutory trust where it’s considered a grantor trust. It’s not taxable for franchise tax purposes. It’s still given the same protections as the limited liability companies. What you’ll oftentimes see us doing now is going for the Wyoming statutory trust, as opposed to using the LLC or the limited partnerships.
The limited partnership has been on their target since. I want to say it’s been about a year-and-a-half since the Franchise Tax Board came out with their opinion on it. We think that the legislature is going to address it by saying, hey, we’re either going to make it something that this definitely applies to because they need the funds. We think that’s the route they’re going—they just haven’t done it yet—which leaves the Wyoming statutory trust as our best friend.
Yes, you could use other states if you really wanted to. We find that Wyoming is very effective and very economic. It’s like, why spend thousands of dollars a year doing something in Delaware when you could do it for a couple of hundred in Wyoming? That’s where we end up going. Hopefully that answers that question.
You don’t have to move, but if you do, just make sure that you’re not doing the pretend move of, hey, I bought a condo in Nevada and now I’m saying that’s my residence. Now you actually have to move and you have to spend more time in Nevada. You have to make sure you’re registering your cars here, register to vote here, and all that jazz, to make sure that it’s legitimate. Otherwise, California would more than likely be giving you a look-see.
Jeff: California gained a lot of notoriety over their $800 fees, but it wasn’t because they had the highest fees in the country. It was the tenacity that they went after very tenuous relationships with California that really got them in hot water. Even the courts had to tell them that they needed to back off on certain relationships.
Toby: Hyatt v commissioner. They actually followed somebody into Nevada. Here’s the other one. People always assume that if I leave California, the taxes don’t follow me. That’s not true. If you had gains that it’s unrealized capital gains. If I owned shares in a company that gains substantial value and then I leave, California could still follow me around and say, whenever you sell that, I want my piece.
That’s ultimately what happened in the Hyatt case and a few others. They’re following somebody who sells after they are no longer a California resident, but a big portion of the growth was why they resided there. California says we’re entitled to our tax, and they usually win those. It’s just one of those weird things.
Somebody says, “I think California still wants taxes on 1031 deferred gains.” Absolutely, Bill. You just hit a nail on the head. They actually say like, going back to our very first question today about the 1030, so it’s a deferral. They want you to track it if it’s from California property. Even if you go into another state, they still want you to track it in case that ever becomes taxable because then they just raised their hand and say, hey, the portion that was deferred for California pay up now. We call them vampires because they can smell that. They can smell that money wherever you may be, they follow you around, and they’ll just latch on.
All right, “I am a full-time real estate agent with a broker’s license, although I do not currently run my own brokerage. I am planning to begin investing in rental properties as well. Is it a good idea to pull together these businesses under an LLC or S-Corp, or is it more beneficial to keep things separate?” What do you think, Jeff?
Jeff: I would prefer to keep all of these separate. Ideally, I keep each property separate and I don’t mingle them with my real estate business. I’d hate to be held personally liable for something that happens to one of these properties and then have to hand over my commission to somebody and make good on an accident or something on one of my properties. Ideally, I keep all of these in their own entity. Could you group them as all disregarded LLCs under an S-Corporation or something like that? Yeah, you probably could. Do you see any danger with doing something like that, Toby?
Toby: Yeah, I wouldn’t put the rental properties under an S-Corp just because if I ever have to take it out to rebuy it, it’s appreciated. I would get smacked with the tax. Your point is taken. Just because you have a separate entity doesn’t mean it’s a separate taxable entity. For example, this particular case, this person’s real estate agent. This goes back to the same question about the wholesaling. If I have an active business where I’m making my living out of it, I’m going to start with an S-Corp.
In your state, it probably requires an S-Corp. In other words, they want to know who the owner of the brokerage is. The only way they can know that is if it’s going to be an S-Corp or an LLC taxed as an S-Corp, because then they can see who the actual owners are on the 1120-S that gets filed. That’s always where we’re going to start there. On the rental property side, it’s a little different because rental property is presumed to be passive, which means you don’t have to worry about taking a salary out of it.
You could literally set up a disregarded LLC if you wanted to do it that way, or you could set it up as a partnership as an LLC, and you can have all your properties and sub-LLCs underneath that one LLC. You could have a hundred pieces of property going on a single tax return. There are reasons that you do that.
The big ones are from a lending standpoint. There’s a big difference between being on page one of Schedule E and page two for the amount of credit they’ll give you for the revenue. They’ll give you 70% of page one, they’ll give you 100% of page two. There are reasons that we do that.
There are reasons you do it also if you’re selling properties. But in any case, we want to keep those activities completely separate. Like Jeff said, if you have a liability occurrence on one of your rental properties, it doesn’t follow into, hey, I have three closings this month, and all of a sudden you have some lawyer trying to attach those proceeds. You’re like, gosh, bless it. If only I had listened to Jeff and kept it separate.
No, it’s not hard to do to keep your rental property separate from your active business. It’s absolutely essential in many cases. That’s the route I would go. I would keep those separate if I was you. Anything else on that, Jeff?
Jeff: Some of you were saying about the S-Corp for the real estate for a breach because they need to know who you are, who’s actually doing that. On the other hand, putting those rental properties in a partnership, each under an LLC, you can have anonymity there, but you may not be able to have an S-Corporation.
Toby: Absolutely. Great point. Again, if you’re a successful real estate agent and you’re putting your face out there, obviously, in advertising, do you want somebody to be able to pull up every property that you own and say, let’s just see? Here’s Jeff Webb, realtor, let me see what Jeff owns and I find 20 properties. Sometimes it’s begging for an issue. We’re big privacy buffs. We see that not a lot of people get sued when you can’t find out what they owned.
Just back to the matter, it usually takes the impetus of someone to chase after you, but we’ve had plenty of clients have frivolous suits when they were easy pickings. If we can, we want to make sure we avoid that if possible.
Let’s skip through some of the Q&A. I could see that the guys and gals that are professionals are absolutely knocking it out of the park. There are over hundred answered questions in writing thus far, and they’re just pumping through it. If you have a question, this is the day to do it. These guys are on fire right now. Dana, Christos, and Ian, they’re just doing a great job, Eliot. Piao’s killing it. I could just see all these guys knocking on waysides. That’s awesome. I’m just going to go jump right into another question.
“I have a rental and Airbnb on my property, plus I work from home.” This is your type of question, by the way, Jeff. Whenever I look at these, I’m always like, Jeff will break this down. “What part of home repair, landscape, et cetera can I write off?”
Jeff: I’ll be honest. When I first read this question, I was like, wait, what? You have a rental and an Airbnb. Apparently, it’s your primary residence, too. How do you see this working, Toby?
Toby: Let’s just break it down into little pieces. It’s where they live. It’s their home. Maybe they house hack and they have Airbnb. Maybe they have a long-term tenant that stays upstairs. Let’s pretend it’s three levels. The upstairs, they have a rental that somebody is there for the long haul. Then on the second floor, it has a beautiful view, and they Airbnb it, and people come in all the time because it looks out over those. On the first floor, they have where they reside, but one of the rooms is used as their home office, too, their administrative office of their home.
Then the question becomes, what portion of the home is rental? What portion of the home is this Airbnb, and is it rental or is it not rental? It gets kind of fun. Then what portion of the first floor can they get reimbursement for? There are a few little question marks there.
Let’s knock out the easy one first. You have a rental upstairs and let’s just say they’re using up a third of the square footage on the rental, then we would get depreciation. We would be able to write off the property, the real estate taxes. We’d be able to write off any expenses and repairs associated with that area, number one.
Then we go to number two and say Airbnb. The question is, is the Airbnb rental or is it ordinary income? In order to do that analysis, you have to figure out how many days the average rental is. If it’s an average Airbnb, it’s three days, and you’re providing some sort of service—whether cleaning, or coffee, and things like that—that’s not rental income anymore. That’s a hotel.
You’d still get your depreciation, but it’s no longer a rental income. So we wouldn’t bunch it with the rental upstairs. It would be its own little creature. Let’s say that you were the one that was managing that, it would be active ordinary income. It would be subject to self-employment tax, too. But you could take a ton of depreciation on that third of the house.
Technically, we could accelerate that depreciation and I could write off a big chunk of my house in that first year. It’s going to end up being a huge positive. Then we look at downstairs and we say, all right, we had some landscape and things like that. Was the landscape required for the Airbnb? Was it something that was necessary?
If you have a home office, are you meeting people there? For example, let’s say that you were managing your Airbnb at your home and they were coming in. Yeah, I would write that off. I’d write that off in a heartbeat. I’d say, yeah, it’s necessary because that’s where people come in.
Anyway, that’s how I’d be breaking it down. I would have a few questions for this individual to get some more clarity on what it is exactly they’re doing. Just off of that, I’m thinking that Airbnb is going to be their ticket to getting a nice deduction. On the same token, we have a passive rental income and passive loss that’ll probably be coming off of the part of the home that’s used for that.
Then I still have my home office, which again, it really depends on whether you have another business or whether you’re able to do an administrative office in the home, because you might find yourself in a really, really great situation from a tax standpoint operating your business this way.
Jeff: Sounds good. I like the way you set that up.
Toby: With the Airbnbs, there are some things that we oftentimes do and this might be one of those cases. It just depends on how their numbers line up. Quite often, you’ll have a rental property that is a long-term rental, you’ll have the Airbnb which isn’t. You can just rent it to a corporation that acts as the host. Quite often, what you’ll do is you’ll have an individual create a corporation, and you’ll rent—again, I used a third, a third, a third—that 1/3 to the Airbnb corporation and let it be the host.
The reason I would do that, would it really be because I don’t want necessarily to have a huge chunk of losses coming out to me, but also because I want to be able to offset the income via deductions, something like the administrative office. Maybe I’m not too worried about the tax bill. I might be making my living off of this.
Maybe I don’t want to take all the accelerated depreciation in one shot. But that would be something where guys like Jeff do a really good job of just, here’s option number one, here’s option number two. We get to break it down. Don’t you love questions like this? It’s like, we can just make them do whatever we want.
Jeff: I have so many other questions.
Toby: I know. There are a ton of questions coming in, too. Our guys are killing it today. All right, “I need to create an entity for my business as a real estate agent. I’m not sure which entity is best for me and pay myself out of my business income separately. Not sure which corp is best.” I think we’ve talked about this a couple times today, but what do you think?
Jeff: I’ll go back to what we said earlier. For a real estate agent, I like the S-Corporation.
Toby: I think you have to, in many cases.
Jeff: I think there are going to be some states that may allow you not to be, but I still think the S-Corporation is the best choice. It has an easier way of getting money out of that S-Corporation. You put it in a corporation, you’re either going to have to pull that money out either through salaries, which is okay, or dividends, which is less okay. I don’t know that you’d want to do this as a partnership. I’m going to settle for S-Corporation because I can’t think of a better way to do it.
Toby: Somebody says, “Well, some states won’t pay the commission to an entity and it must be paid to an individual.” Yes, but there’s a way to get that over there, Justin. There’s actually an IRS case and it’s not nominee. Actually, if you show and you give to your broker, for example, that you’re under the exclusive control and you have an employment agreement with your S-Corp, then even if they pay it to you, you could reassign it over to the S-Corporation.
You have to show those two things. You need to have an employment agreement and you need to make the payor (who is going to pay you individually) aware that you are under the exclusive control of that S-Corp. I always screw up the case on it. I want to say it’s like the Fitzgibbons, or Fitzgerald case, or something like that. There’s actually a case on it.
Usually you’re going to look at your state laws and say, hey, what kind of entity can I be? A lot of real estate agents start off as a sole proprietor for some unknown reason. I say that bad taste is timeless. The reason I say that—I say that in jest—is that your audit rate is about 800% higher as a sole proprietor and you lose—no joke—94%–95% of the time. No, I don’t want that.
If I am an S-Corp, I will save money. Even though I’ve done the numbers, even just straight across,—apples-to-apples—even at $25,000, you save about $1500 a year as an S-Corp. Even at $25,000. If you’re at $100,000 it’s close to $10,000. It’s right around the $8000–$9000 mark. That’s without even giving all the other tax incentives that come along with having an accountable plan, which is only possible through an S-Corp.
In other words, if I want to do an administrative office in the home, I have to have an S-Corp. S or C, and if I’m in real estate, chances are, I have one choice. I’m going to be, from a tax standpoint, an S-Corp. It could be an LLC taxed as an S-Corp, don’t get me wrong, but from a tax standpoint it’s going to be that S-Corp.
There are lots of other benefits. Not only is the accountable plan there, but also, I could still do a 401(k). I’m paying a small salary, which I could dump straight into my 401(k). There are lots of other bells and whistles. But when I just look and I say, here’s my S-Corp, here’s sole proprietor, you’re making $50,000, if I did nothing else.
We know that the S-Corp gets a whole bunch of their benefits, but if we didn’t even take advantage of them, all we did was use this as your money comes in, and we pay a small salary, and the rest of the money comes out.
If that’s all we did with the S-Corp and kept it super simple, you’re still going to save yourself somewhere around $4000–$5000 a year being the S-Corp. I’m still shocked people want to be sole proprietors. Stop that.
The answer to your question is, as a real estate agent, I would immediately go right to an S-Corp to start. If you get really big, we have guys that clear seven figures on a monthly basis, not on an annual basis, but we have some that are some big hitters.
That’s when you add some complexity, that’s when you define benefit plans, that’s when you might have a management company, that’s when you’re starting to do other activities in real estate to create losses that can be offset. If you can qualify as a real estate professional and things like that, there are lots of other ways to lower the tax bill. Then at the end of the day, I always say to people, look, if you have a tax problem, that’s a great problem to have.
It means you’re making a bunch of money. Quit whining about it. Minimize it, but be happy that you have that issue because there are a lot of people out there going, boy, I wish I had a tax problem. Sorry, Jeff. I just go off sometimes.
Jeff: It’s very interesting.
Toby: Do you whine on that?
Jeff: No. I’m thinking about it very well.
Toby: All right, you can follow Anderson on social media. The one I would drive you to guys, the one that is where we have so many people get a lot of use is out of that YouTube, aba.link/youtube, or just go to YouTube and look for us.
All right. “I have been buying investment properties for the past five years and are under my name. I have a separate personal account where my rental income is deposited. My question is, how should I formalize my business structure if they are under my name and personal account?” What say you, Jeff?
Jeff: My suggestion route for this would be to form a partnership. I would have a corporation be the general partner, and maybe the limited partner, or limited member. I would then put the properties. I would contribute the property, see the partnership. Going back to what we always say, one LLC per property if you can do that. If you can’t, you just need to consider what your risk level is.
I have all my properties in the partnership. The corporation is responsible for running them. We can pay them a management fee to help manage how much income is coming to me personally. The one thing I wonder about is if we’re looking at substantial losses, do we want to consider a real estate professional here? In that case, maybe we don’t put up a partnership. But we could still have a corporation managing these entities. I’m going to ask you, what do you think about this?
Jeff: In its most simple phrases, just because you own it individually now doesn’t mean that you can’t put it into a separate LLC. Depending on how much equity you have in the properties, the best advice, the best practice is to separate each property in a separate LLC. Unless you just don’t have a whole bunch of equity at home and then there’s some argument that maybe you could divvy them up.
Personally, at this point, I’m always just a separate LLC. Why mess around with it? Just keep the best thing for you because those properties are all income generators. You don’t want to lose the income off of a property because you decided to play cheap on an LLC, or you want to avoid the $100 fee or whatever it was every year with the state, so don’t do that.
It’s not that difficult. It’s very, very common. Even though you have your own separate bank account, nobody cares from a standpoint of the IRS or asset protection. If it’s in your name, it’s in your name. It’s like, it’s in my right pocket versus my left pocket versus my back pocket. They don’t care. It’s all you.
What we want to do is set up separate boxes to hold on to those assets. If anything happens to them, you don’t lose all of your assets. The same thing with you. If something happens to you, you don’t lose all your properties as a result. If one of your kids gets into a car accident or whatnot, you just don’t want these to come into play.
We tend to use LLCs. Jeff mentioned having a singular LLC that was a partnership that held the other LLCs. That singular LLC that would be taxed as a partnership, nine times out of 10 is going to be in Wyoming so that they can never take it from you. Because Wyoming says, hey, creditors can’t take it, the most they can get is a charging order, which is a lien. It keeps you from having to worry about the asset disappearing.
I wouldn’t worry about it for two seconds. Everybody, generally, has to start off buying things in their name. I remember 20 years ago, you couldn’t get a loan in an LLC. You had to get it individually and then at closing, you’d put it in the LLC. It wasn’t that uncommon nowadays. They’re far more likely to let you close directly in the LLC.
In some cases, if you have a traditional loan, the bank’s going to say, hey, Jeff, could you put it in your name so we can close and then we’ll put it back? All right, you know, that’s still not that uncommon. Don’t think this is not fixable. There we go. Thank you.
All right. “I buy and sell vacant land. I typically buy then resell with owner financing, deed of trust, mortgage deed, et cetera. My question is twofold. One, would I be considered a dealer given I do somewhere around 400 properties a year, even though there are no structures and my intent is to resell on terms, not flip for cash? Would it be possible for me to save on taxes by becoming an LP, created GP operated by an LLC that my team owns and operates? I put in money and stay out of it.” What do you think, Jeff?
Jeff: Doing 400 properties a year, I would say you’re a dealer of land. You’re selling on terms, which I’m assuming that means seller financing. But you’re not going to be able to use the installment method to recognize gain on these. You’re basically selling inventory. It’s going to be at ordinary income rates. If you sell 400 properties this year, you’re going to have to recognize that income all this year when you file this tax return.
Would it be possible for me to save taxes by becoming an LP? If you’re doing this many sales in your own name, that’s probably a really bad idea. Something is bound to go wrong. I would at least put these in an LLC. What about an S-Corporation, Toby, rather than an LP?
Toby: I think you bring up a good point. When you’re buying and selling any property, it’s an active business. If people weren’t following you close enough, the installment sale is not available to you if you’re a dealer in real estate. A dealer is somebody who buys property to sell it. It doesn’t matter whether you’re doing terms or not. Did I buy that property to hold it as inventory and sell it? It’s no different than being a car dealership.
Just like in a car dealership, when the car dealership sells the property, they may get financing for you, but they have to recognize all that income, whatever they received, immediately. That’s the same thing here. Going down the path of using limited partnerships, I don’t see that being something that’s necessarily relevant here. You are in an active business of buying and selling inventory.
What I would be looking at is, how do I isolate off my liabilities on those properties? Depending on the value of the land that you’re buying, I might put separate LLCs together, depending on the area of the country or if there are any distinguishing features so that if something bad happens in one area, it doesn’t take out my entire business. I might even systematically close them periodically as I buy and sell. I might be doing that through a separate LLC for each tranche, so that when I’m done, I can close down that LLC and my liability goes with it.
I’ve seen, 15 years after a sale, somebody coming after, people that were in the chain of title. It’s not something you want to see. I actually had a land dealer, somebody who did exactly what you’re doing up in Seattle. They came in, and I think it was 11 years after the sale. What happens is, if they ever discovered a defect, they just associate it with everybody that had previously owned it and then assert the claim against them all and fight it out.
Jeff: One thing. The question asked is to become a non-LP, create a GP operated by an LLC that my team owns. Is that the best way to give some ownership to your management team, or would an LLC do the same thing?
Toby: It’s the same thing. They’re just using the vehicle limited partnership. I’m saying here, the general partner is this other group and they’re in control of everything. I would never advise a client to give up control, unless it was something where I said, hey, you know what, if this is really them, then maybe you should be doing participating loans.
Maybe you should just be a lender, a hard money lender to them, and let them make their money and your money. At least that way, it’s still ordinary income. It would be portfolio income, but you wouldn’t be subject to self-employment tax. That’s the only thing I could think of.
Whenever I see this type of thing and they say, well, I’m not really doing anything. Yeah, you’re probably in control of the whole thing and you control the purse strings. Everybody else is going out and doing this, which again, just because we’re saying, hey, this is a regular business, that’s not a bad thing. Again, it’s like being a really successful car dealership, except instead of selling cars, you’re selling land.
I would treat it identically, then make it an active business. But I’d make sure that I’d probably be looking and saying, how much income is being generated on a consistent basis, and should I be using things like defined benefit plans? Would I be better off saying, since I’m in real estate, maybe I need to start accumulating some, and becoming a real estate professional, and using that to offset the income that I’m going to be forced-fed over these installment sales?
Because the installment sale does not work for dealers. Specifically, it’s 26 USC 453. It specifically says except in the case of a dealer. You don’t get to spread it out over a period of years. You’re going to have to recognize that income. We probably want to deploy some tax strategies to offset that. Real estate happens to be the best game out there for those types of benefits. Good questions, guys.
Hey, there’s Infinity Investing again. I’m just going to throw that back up at you. If you guys want to join us on September 11, we’re going to have a really good group. PO Washington will be in the house teaching the stock market landlord. Nicole DeBlasio will be going over real estate, and I’m sure a lot of Aaron Adams is sticking his head in there too because there’s so much cool stuff going on in the real estate market.
If you haven’t been paying attention, real estate’s going nuts. It doesn’t look like it’s slowing down, although, I wish I had a nickel for every day if somebody said, oh, it’s going to crash. Not in the numbers I see. It might flatten but it’s definitely not going down.
I’m going to keep going on. There’s YouTube. Said, if there was one area that I would go and spend some time, that’s where I would go. Let’s see. Are there any other questions that you saw out there that you want to answer?
Jeff: I did not see any others that I wanted to answer.
Toby: Perfect. If you guys like this information, if you like Tax Tuesdays and you like a little bit of brain food, I guess this is the best way to put it, andersonadvisors.com/podcast. Please go in. We actually have a really good listening base. We are looking at the year over year numbers and you guys are good. You guys go and you guys are watching even if you can’t be here.
You guys are really good about popping on, but you’ll see that we’re always throwing different guests and we’re having some fun talking about finances, tax, and all that good stuff. If you’re a platinum member, you can go and watch Tax Tuesdays. There’s always a kick in the pants. If you want to ask questions, just email us, taxtuesday@andersonadvisors.com.
Our guys today between Dana, Piao, Eliot, Christos, Ian, Ander, and Patty, they’ve already answered 185 questions in writing. You can always just pop in and ask us a question. I’m just going to tell you guys that I’m not aware of anybody else out there that’s an attorney or that’s an accountant that would grab their staff and answer these types of questions just live. Most people are too scared.
They always want to go back in and read up on everything and I’m like, no, let’s just do the best that we can, share information. Every now and then, Jeff and I screw something up and you know what, there’s always a CPA out there that says, hey, guys, you screw that up, here’s this. Like, oh, it’s a good thing we have people listening. That’s great.
Anyway, somebody says, love these things, I’m a customer and it helps me to be a better customer. Thanks, guys. I will just say, Jeff, have a great day and thanks for being willing to jump on the Zoom. All right, guys.
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