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Anyone have any opinions on what the best business format is for your real estate business?

Sole Propreitership and General Partnership are out to me because of the liability risk.
How about Limited Partnership?
Which Corporate Entity works better for Real Estate? S, C, or LLC?

How does this affect your borrowing ability?

Thanks,
Fool on!!
Matt
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kcmatt wrote: Anyone have any opinions on what the best business format is for your real estate business?

I posted a similar question over on the Tax Strategies board a few days ago but have not yet had a reply, so I'll be watching this thread also.

In the meantime, having been involved with a few small corporations (either as an owner or manager), I'd say that the answer to your question all depends. For a sole owner operator, looking to either A) buy and flip; or B) run a few properties as rentals, and where in neither situation do you expect to draw a paycheck, it doesn't make sense to use a C Corp, since the only way to get the profits out of the corporation and into your pocket is to take a dividend. The C Corp will first get taxed on its earnings, then you will get taxed on the dividend. Very bad on a scale of good to bad.

That leaves an S Corp or a LLC, both of which are more attactive from a tax standpoint. I expect there might be some differences that would push a decision one way or another, so hopefully others will post.

Scot
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Here are my thoughts on this section of your response Scot--

In the meantime, having been involved with a few small corporations (either as an owner or manager), I'd say that the answer to your question all depends. For a sole owner operator, looking to either A) buy and flip; or B) run a few properties as rentals, and where in neither situation do you expect to draw a paycheck, it doesn't make sense to use a C Corp, since the only way to get the profits out of the corporation and into your pocket is to take a dividend. The C Corp will first get taxed on its earnings, then you will get taxed on the dividend. Very bad on a scale of good to bad.

If I wanted to minimize my taxes (in the ST) wouldn't I be in the best shape if I used a C corporation and ran all the profits through that? This way I would only pay 15% taxes on the first 50K, whereas with an S or LLC I end up paying my current rate (already 28% and only going up). Then I can keep the profits and re-invest them into more properties. And keep 13% more of the profits because of the taxes. Perhaps even more if I pay myself a small salary, but keep my personal income in the 28% range. I don't need the profits for myself in any way so they can just keep rolling over in the business. This is one of the reasons why I think a C corp might be the best choice for me. Although books specifically say "Don't use a C corp for Real Estate".

Perhaps I'm off base??

Confused Matt in KC
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I don't need the profits for myself in any way so they can just keep rolling over in the business

Eventually you'll want to take some of those profits - probably as a salary. Maybe as a "dividend".
At that point I think you'll have to pay all the individual income taxes.

So all of your profits will be taxed once at the corporate rate. Then as I see it, they'll be taxed again at your indiv. income rate.

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Matt - -

I don't understand why you wouldn't just want to use a sole proprietorship and get an umbrella excess liability policy. This helps eliminate the "liability" risk.

Could you provide some clarification as to why you don't want to do something like that?

Winston
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I don't understand why you wouldn't just want to use a sole proprietorship and get an umbrella excess liability policy. This helps eliminate the "liability" risk.

That's how I do it.
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I don't understand why you wouldn't just want to use a sole proprietorship and get an umbrella excess liability policy. This helps eliminate the "liability" risk.

Sometime "helps" isn't enough. If you have a claim that exceeds the umbrella limit, you are personally on the hook with a sole proprietorship. To me that's an unacceptable risk because there are lots of people out there who do stupid things then look for someone to sue. Remember that person who dumped hot coffee on her body then sued McDonald's because they didn't tell her that hot coffee could burn? The more assets you have the more attractive you are as a target. The deep pocket theory: sue the person with the most bucks.

There is much better protection with a corporate entity. I believe that the only way that the corporate veil can be pierced is if it is determined that shareholders treated corporate assets as if they were their own.

Having an S corp to stand between your personal assets and your rental assets is a minor inconvenience and minor expense. I assume an LLC is similar, but don't know for sure. The last time I incorporated the cost was somewhere around $1200 all up. Then there are annual tax returns, corporate reports and, in California, a minimum corporate franchise (income) tax of $800. I maintain my books using Peachtree and a CPA prepares the annual reports and tax returns. CPA costs me $800 annually.

Scot
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Having an S corp to stand between your personal assets and your rental assets is a minor inconvenience and minor expense.

And possibly minor protection from what I've read...
(At least I'd be worried about proving in court that a corporation I completely owned and completely controlled was really separate from my personal assets.)

I maintain my books using Peachtree and a CPA prepares the annual reports and tax returns. CPA costs me $800 annually.

What about the annual corporate meetings and minutes?
(Or are you one of the people I've read about that *thinks* they have a corporation, but since they don't keep minutes of an annual meeting they likely have forfeited their corporate status?)

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(At least I'd be worried about proving in court that a corporation I completely owned and completely controlled was really separate from my personal assets.)

It depends on if you treat it as a third party - all transactions at arm's length. But don't take my word - ya really have to talk with an attorney. Mine have told me to keep the relationship formal: no co-mingling personal and corp assets, no personal use of corporate funds, etc. I don't take "loans" from the company - everything taken out is either pay or dividend.

Yes, the annual meeting is important and I do have minutes. If one goes to the trouble of setting this up, it doesn't pay to be sloppy in the details.
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Wolf et al--

I'm considering some type of entity for my real estate holdings for 4 main reasons.

1.) Liability issues--If someone gets sue-happy it only affects my company, not my personal affairs.

2.) Security--If something happened and my business started to go down the tubes (god forbid) it would only affect my corporation, not my personal assets. This way I can keep creditors out of my personal credit when the business is the cause of the problem.

3.) I believe I can get a lower tax rate from a corporation than I can from running it through my personal tax rates. Corporations can be run very tax efficiently, but it would be hard to do that with my personal tax rate.

4.) It allows everyone to see my business and myself as two seperate entities. This makes life easier in my opinion.

These are my thoughts on the reasons why to incorporate.

Fool on!!
Matt
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3.) I believe I can get a lower tax rate from a corporation than I can from running it through my personal tax rates.

Can you provide an example of how this is true?

I'd believe you'll usually pay more taxes... Once at the corporate level, once at the individual level.

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I'd believe you'll usually pay more taxes... Once at the corporate level, once at the individual level.

Let's use an extremely simple example and you must remember that I have stated multiple times that I don't want the money for my personal use.

Let's say I have a business with 100K in net income and it has 50K in expenses. Here is how they would look:

C Corp LLC, S corp, GP, LP, Sole Proprietership
100K income
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Sorry about that. I hit the wrong button.

I'd believe you'll usually pay more taxes... Once at the corporate level, once at the individual level.

Let's use an extremely simple example and you must remember that I have stated multiple times that I don't want the money for my personal use. I want to leave it in the business to roll over and keep using.

Let's say I have a business with 100K in net income and it has 50K in expenses. Here is how they would look:

C Corp LLC, S corp, GP, LP, Sole Proprietership
100K income 100K income
50K in expense 50K in expenses
50K in pre-tax net income 50k in pre-tax net income
7.5K in taxes due (15% corp rate) 14K in taxes due (28% my rate)
42.5K in after tax income 36K in after tax income

The simple differance in how I choose to report my business structure has increased the worth of my business by 6.5K!! And this example doesn't include any self-employment taxes or state or local taxes. Just federal taxes. Since I'm not issuing dividends to myself I don't have to pay taxes on that part of the leftover income. You only pay taxes on that part if you issue dividends, and I'm choosing to set up the corporation as a non-dividend paying entity. On top of that if I set up another corporation correctly, and this one also, I can pay dividends to that second corporation and still not have to pay much in taxes (compared to individual rates). Imagine how this 6.5K can roll over from year to year. (Eventually you do have to pay taxes on your Retained Earnings though)

See what I mean? Now of course there is the bad side that I can't get the money if I need it. But what about paying myself a bonus? Or using the corporation's income to pay for my medical expenses, car, food, housing, etc, and reduce my taxes even further? And leave me more money to personally spend on fun stuff.

From what I can tell there is a lot of fun stuff you can do with a C corp that you can't do with other business formats.

Fool on!!
Matt
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The simple differance in how I choose to report my business structure has increased the worth of my business by 6.5K!! And this example doesn't include any self-employment taxes or state or local taxes. Just federal taxes

But this is real estate. The income is defined as "passive income" (which is a real hoot, especially considering the amount of work that I do to get it) and is not subject to self employment tax, if I take it as myself (rather than taking it into a corporation then collecting a salary.

As a practical matter, although I pay a lot in property taxes, after the depreciation allowance is figured in I haven't paid any Federal or State tax in a decade. I periodically have to pay local taxes in various municipalities, but I then work to restructure to make those particular properties into after-depreciation losers so that I don't have to keep paying the local tax.

The way I have managed this has been to periodically do cash out refinancing, which alternatively funds expansion of my business and funds some really nice vacations, etc. Consequently, I have tapped the asset base for cash, while not having any genuine income - as defined by the IRS.

The downside to this approach is that when times get bad, I am leveraged and risk running out of cash under circumstances that make it difficult for me to raise money against properties. The strategy then is to sell off properties, as required, and purchase again when times improve.

Now, I am entering another leg of the cycle and at this point I am more interested in paying down balances than in expanding. So I am now focusing on increasing the revenue stream to the point where I can start working off some of my carry-forward losses (which I don't lose and which will shelter me from taxes for the indefinite future).
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Many thanks to wanderer0692 for the link to the AICPA doc. The moral of those stories is that it pays to have experts provide advice on tax and legal matters as those areas are far too complex for a non-professional (and even professionals) to ever remain current.

And now... kcmatt writes: Now of course there is the bad side that I can't get the money if I need it. But what about paying myself a bonus? Or using the corporation's income to pay for my medical expenses, car, food, housing, etc, and reduce my taxes even further? And leave me more money to personally spend on fun stuff.

Warning, Will Robinson! I hope you've discussed this with a CPA or tax attorney. Not being either of those, I don't know one way or another, but the article that wanderer0692 provided (read the part about the Veterinarian) discusses the issue directly and it seems to me that you have a good chance of being on the wrong side of the tax law. Yes, it is possible to pay many of those things you mention, but there are limitations and/or you still may be liable for tax on those as a fringe benefit.

IMO too many people with small businesses try to go it alone on legal and tax matters and end up getting burned, sometimes badly. Poorly informed mistakes are small f foolish when good advice from a professional is readily at hand. I had the good fortune of running a small business early in my career for a group where one of the owners was an attorney. After having been involved with a family business where professional advice was sometimes looked upon with disdain, it sure was an eye opener.

Once a fool, now a Fool,
Scot
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jiml8,

Was interested in your comment about cashing out some of your equity in order to get cash that the IRS does not consider income. I understand that part, what I want to know is how you handle the increased interest on your new loan? It seems that you can only deduct "purchase money" mortgage interest or if you use the proceeds from the larger loan to improve the rental property. In other word, when refinancing a rental property mortgage for a larger amount, the deductibility of the interest depends on how the proceeds are used, not the fact that the colleratal is a rental property.

Do you just not take the higher interest deduction on your taxes?

TIA

Terry
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But what about paying myself a bonus?

What about it?
You'll then have to pay taxes on it.

Or using the corporation's income to pay for my medical expenses, car, food, housing, etc, and reduce my taxes even further?

Seems to me like the IRS would be inclined to disallow such things. Or at least consider them as income to you if they aren't justifiable as true business expenses (which they probably aren't)

Of course if you can show me why it'd work, I'd be interested - I'm always interested in saving money.

I don't want the money for my personal use. I want to leave it in the business to roll over and keep using.

If that is all, then it seems to me that it is just deferring taxes until a latter point, but paying some taxes upfront for that privilege, and more taxes overall, as eventually you want to use the money for something...
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I've come a little late, so most of my retorts have already been used, but...

(1) You can get RIDICULOUS amounts of excess coverages - - $1MM, $5MM, $10MM, etc. An added bonus to this type of coverage is that you also have all of the insurance attorneys on your side. They are going to be the ones handling the claims. You don't think that they want to shell out the entire expense, do you? The umbrella policy is a relatively nominal expense, even when considered it for 1 or 2 properties.

(2) I agree with jiml8 in regards to taxes. Read some good books (JTReed comes to mind), get a good r/e tax attorney, whatever - - you shouldn't be paying much in the way of annual taxes on the r/e income, as there are too many ways to decrease the reported income. I've done several scenarios with cash cows that I still can report little-to-no income.

In the end, I don't think you need to set up a corporation. You may have added comfort in one and that is obviously what matters in the end (for you), but I think you'd be throwing unnecessary down-payment/closing cost funds out the door.

Winston
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So I am now focusing on increasing the revenue stream to the point where I can start working off some of my carry-forward losses (which I don't lose and which will shelter me from taxes for the indefinite future).

Jim,

Can you describe this strategy in more detail? How and why do you do it?

InParadise
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I understand that part, what I want to know is how you handle the increased interest on your new loan? It seems that you can only deduct "purchase money" mortgage interest or if you use the proceeds from the larger loan to improve the rental property. In other word, when refinancing a rental property mortgage for a larger amount, the deductibility of the interest depends on how the proceeds are used, not the fact that the colleratal is a rental property.

Not according to my accountant, and not according to my understanding of the tax law. While this restriction is true when it is your home, it isn't true for other things.

Besides, those cash-outs go everywhere; replace a roof, repave a couple parking lots, go to Hawaii, buy a building, buy a minivan. Let IRS figure it out.
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But what about paying myself a bonus?

What about it?
You'll then have to pay taxes on it.


Correct. But according to IRC #74 I can pay myself an Achievement and Longevity award of $1,600 each year. If I pay cash I have to pay taxes, but if I buy something and award it as a gift to myself for this reason then I get it with no taxes.

IRC#79 says you can receive up to $50K from the company in paid for life insurance.

IRC#105 and 106 discusses medical plans and options regarding a corporation.

IRC#129 says a corporation can provide it's employees up to $5000 year in dependent care expenses tax free (child care costs). All employees have to be eligible, but if you are the only employee...

IRC#132 says the company can pay for fitness equipment and expenses if the BOD says that it's a perk for the employees.

IRC#243 discusses how your company is treated for capital gains and dividends. Depending on how much of that other company is owned by the corporation up to 100% of the dividends are tax exempt, but at a minimum 79% are tax exempt. This could be significant tax savings.

Other codes discuss company sponsored pension plans and automobile reimursement for exectuives. Other codes also state that the company can pay for all meals that are provided on company premises, and if you run your business from your home wouldn't that be the company premises? All this is predicated on setting everything up correctly.

If that is all, then it seems to me that it is just deferring taxes until a latter point, but paying some taxes upfront for that privilege, and more taxes overall, as eventually you want to use the money for something...

I agree, but compounding this money pre-tax should eventually lead to larger amounts of money for me to use. The longer I can defer the taxes the more I have to compound, and thus the more I will eventually have. This is the basis behind "buy and hold" with stocks.

Of course I advocate discussing this with an Attorney or CPA. I am not considering this without the input from those two parts of my business team.

If you are interested I would recommend reading the book "Inc and Grow Rich" by CW Allen and others. This is where I got most of this information and I'm verifying this with my CPA and Attorney as we speak.

Fool on!!
Matt
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I believe if you check those code sections you will find they are based on receiving wages. If the corp pays you a bonus or wage you pay BOTH income tax of x% plus Social Security of 15.3% (both "or" and "ee" portion.
Very few rentals show income after depreciation and by putting in corp you loose the cap gains.
I have spent over 30 + years trying to keep clients from puttin real estate in corps and when they do a few years later they say, "Why did you let me do that?"
Please also remember the old tax planning adage, "Pigs get fat and hogs get slaughtered."
JMHO
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I am a beginner real estate investor also interested in these issues.

Here are my thoughts:

1. It seems like there are all kinds of traps in a C-corp:
Double taxation unless you are careful.
No ability to write off losses against your income.
Having to pay tons of $$ in SSA/FICA.
Then, in the end, you can't get your assets out easily.

There are lots of benefits in terms of taxation (unless you do things badly and fall into the traps). Of course, you can go public too, if you ever want to do that. The liability protection is top-notch (to the extent you can be protected).

I would say, go for it, if you understand all these issues and have a good exit strategy in mind. If I were going to do this, I would always be thinking "how am I going to get that money out...".

I know you said you don't need it now and you think you can defer most of your tax liability. I've just seen this work out _badly_ many times (fortunately other people's mistakes :-)

2. How about a S-Corp:

This seems like the winner. Here is what I like:
* Some liability protection (my CPA advises that it is not like immunity, as any lawyer with any brains will sue you personally as well as your entity).
* Pass-through income (you might be able write off the loses in early years --- watch out for passive activity limitations)
* No problem getting assets out (not taxable event).
* Well tested in the courts and established precident.

3. How about a LLC:
* Its just like an S-Corp, it seems to me, except that starting an LLC is REAL easy...it takes one form in my state.
* My CPA advises that it is not well tested in the courts and state laws vary in how they are treated.
* My CPA again warned to not assume that liability was truly limited to the amount i've invested.

4. How about Sole Proprietor:
* The advantage here, it seems to me, is the simplicity. You don't have to keep independent records, etc. You can constantly rob-peter-to-pay-paul. No assets or income issues.
* Problem: no liability protection (maybe OK if you have good insurance).
* Problem: tax treatment is not as nice (I can't figure out how to write off as much as I could with a company of some type). If I want to write off my home office, can I do that as a sole proprietor in the real estate biz? What about general tax and legal advice ? As an individual the later is limited by the 2.5% AGI rule.


Please consider all this the ramblings of an amateur. I honestly don't know which structure I will choose. I definitely will not choose a C-Corp...the others are all possibles.

Rob
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If I want to write off my home office, can I do that as a sole proprietor in the real estate biz? What about general tax and legal advice ? As an individual the later is limited by the 2.5% AGI rule.

Talk to your CPA & read the IRS 1040 forms....

But I *think* as an individual you're looking at an itemized deduction (Schedule A).
As a sole proprietor I *think* those items can go under a different form as a legit business expense, provided they're for the business.

Disclaimer: I'm practically guesssing - I haven't looked at the schedules other than Schedule A & D (itemized deductions and cap gains) in 10 years or so...


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