Making the Proper Tax Election for your Rental LLC

Mike: Welcome back to flipnerd.com REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now let’s meet today’s expert host.

Clint: Hi, Clint Coombs here with Anderson’s Business Advisors and Host of the REI Classroom. In this particular segment we’re going to talk about making a proper tax selection for your rental limited liability company.

Mike: This show was sponsored by passiverental.com.

Clint: When it comes to creating limited liability companies for rental real estate, most people are unsure how to tax their LLC. Now the beautiful thing about LLCs is you can choose any form of taxation. You can have them set up as C-corporations, disregarded entities which means that they’re not even looked at for federal tax purposes although the gains, losses flow down to the owner of the LLC. They can be set up as a partnership where you actually file a partnership tax return and they’re split based upon ownership interests amongst the members in the LLC. Or you can have it taxed as an S-corporation.

Now, when we’re looking at how to tax an LLC, some of the things that you need to consider, number one is, how many LLCs do you have? Many times if somebody is starting out with only one rental then of course you’re only going to set up possibly one LLC, maybe two if they’re looking for an additional asset protection shield such as using a Wyoming or Nevada holding LLC to hold their rental LLC.

If you have multiple LLCs then most definitely you’re going to be looking to treat those LLCs as disregarded entities, that is, why have seven LLCs and have to file seven tax returns because they like you to have them setup as partnerships or corporations. Whenever I run across a real estate investor who has set up an LLC for their rental real estate, then I see that they’ve elected partnership treatment or corporation treatment, I know right away their CPA set it up for them based upon how many returns they have to file on an annual basis.

So what I always look at when I’m setting up an LLC is the number of companies you tend to establish. My rule of thumb is that I like to set up LLCs in the state where the property is located, have that LLC disregarded so it doesn’t have to file a tax return, down to a holding LLC that is set up either in Nevada or Wyoming because both of these jurisdictions offer excellent asset protection. Now it is that holding LLC that is very important in determining how it should be taxed.

Now right off the bat, you never want to have it taxed as a C-corporation. We don’t want to do that because we’re dealing with rental property and we want to preserve our capital gains treatment on the income from either the sale of the property or we want to preserve the flow-through treatment for the rental depreciation and deduction that comes from owning property. So C-corporations are out of the mix.

Disregarded? That’s an option. You could choose this entity and treat it as disregarded entity. The only drawback to that tax status is then all your real estate will appear on your Schedule E, page 1. Now, why don’t I like this? Well, it increases your risk of audit. The more that the IRS sees that you have, the more likely it is that they’re going to audit you. And they have already come out and said that they are going to audit real estate investors.

If you set it up as a partnership, the advantage to that is that all of your properties will not show up on your Schedule E, page 1. They show up as a line item on Schedule E, page 2. Again the benefit there is that you’ve removed yourself out of the audit pool. You don’t throw yourself out there and say, “Hey, IRS, just look at me. I have a lot of real estate. I’d be the one you want to audit.” So partnership taxation for your holding LLC is a great election to make, especially you’re going to have to do it if you have more than one owner.

Now the last one is S-corporations. Now most CPAs will tell you never elect S-corporation status because there are some drawbacks that come with it. Mainly that if you pull an asset out of an S-corporation that has depreciated that is a taxable event. However if you utilize my strategy with a holding company and have your real estate in separate LLCs, that’s never going to be a concern because you can move money around and assets around without ever having to take it out.

But why would you choose an S-corporation status? It has to do with the net investment taxable income. That is the Obamacare tax. Additional 3.8%. If you earn over $200,000 as an individual or $250,000 as a married couple, you will find that your rental income will be subject to this as an additional 3.8% if you choose any other form of taxation other than S-corporation tax status for that holding LLC.

I can’t tell you how many real estate investors have been surprised to find out that get tagged with this additional 4% because their holding LLC was set up as either a partnership or disregarded entity. Don’t make that same mistake. Check your rental and ordinary income to make a determination then as to how to have that entity set up from a tax standpoint to save yourself money.

My name is Clint Coombs with Anderson’s Business Advisors and I’ll see you next time.

Mike: Passiverental.com is your source for turnkey, done-for-you rental properties. If you’d like to be an investor and not a landlord, please visit passiverental.com to learn how to purchase cash-flowing, professionally-managed rental properties in the hottest rental markets across the country. We can also help connect you with financing for your next property. Invest the easy way today and get started by visiting passiverental.com. Please note, the views and opinions expressed by the individuals in this program do not necessarily reflect those of flipnerd.com or any of its partners, advertisers, or affiliates. Please consult professionals before making any investment or tax decisions, as real estate investing can be risky.

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