The damage to the economy as a result of the COVID lockdowns have significantly reduced tax revenues. The government is now looking to increase taxes or create new taxes to cover the shortfall.
In a previous post, I outlined the various methods that you can use to protect your real estate investments from litigation. However, given the current environment, it is just as important to reduce tax liability on your income and property while maintaining your asset protection from lawsuits.
As of this writing, the USA is less than a week away from the presidential and congressional elections. Although the polls show Biden with a significant lead over Trump, the outcome is anything but certain.
In the event that Biden should win the presidency and the Democrats maintain their majority in the House and gain the majority in the Senate, it is more than likely that the Trump tax cuts will be repealed and to further add injury, tax rates will be raised to a higher level than they were before Trump’s tax reforms. Capital gains taxes are likely to be raised significantly and there is also a possibility that the 1031 exchange provisions will be eliminated.
Even if Trump is elected for another 4 years, there will likely be no respite from higher taxes on the state and local levels. Many states and municipalities have experienced significant losses in tax revenues and will likely raise taxes and implement new taxes.
The Wealth Tax
A great example of this is the current discussion in California to implement a wealth tax.
The tax will be initially imposed on those with wealth exceeding $30 million. However, just as the introduction of the income tax was promised to only affect the rich, it has progressed to affect everyone. Don’t expect anything less from a wealth tax. There are just not enough taxpayers in California worth $30 million or more to cover the budget shortfalls.
How to Reduce Tax Liability
If you currently own investment property personally, the net income after expenses and depreciation is added to your personal income via Schedule E on your 1040 tax return and taxed at the marginal rate. If you own multiple properties, you will have to provide an income statement for each property.
Not only do you forgo the ability to deduct certain expenses, but you also run the risk of being subjected to an IRS audit.
Should you currently own your investment property personally, it would be prudent to transfer ownership to another legal entity. Consult with an attorney to determine the best method to facilitate this transfer.
By simply transferring title, there can be unintended consequences such as additional document stamps, and the triggering of the due on sale clause in your mortgage.
Limited Liability Corporation (LLC)
While an LLC by itself can protect you from lawsuits, it offers no protection from the hungry tax man. This is especially true in states where the shareholders or members must be registered with the state.
One method to avoid scrutiny is to set up an LLC in a state where you can maintain anonymity. There are essentially two types of LLC’s that you can set up;
Member Managed LLC
Under this LLC any or all the members can manage the LLC.
Manager Managed LLC
With this structure, only the appointed managers manage the LLC. The members or owners have nothing to do with the operation of the LLC.
In some states, it is a requirement to register the name of the manager. In that case, it makes sense to register the LLC as a member-managed LLC in the state where the property is located.
To further obfuscate ownership, you can set up an additional LLC in another state as a manager-managed LLC and appoint a manager or agent. It is important that this LLC be listed as a member of the LLC where the property is located. It is important that this LLC is set up first.
Therefore, if the state where the property is located should ever inquire as to the ownership of the LLC, you, as the actual owner will never show up in the files. As such, it is difficult for the state government to assess a wealth tax if you happen to live in the state where the property is located.
Inside vs. Outside Protection
The whole point of an LLC is to protect your assets from liability. There are 2 forms of protection.
In the event that the owner of the property, the LLC, is sued, you as the owner are protected against personal liability. Only the assets within the LLC are at risk.
Should you happen to be sued personally as a result of a car accident for example, and a judgment is entered against you, in some states the law allows the plaintiff to seize your interest in the LLC.
In other states, your interest in the LLC is protected. All the plaintiff can do is file a lien against your interest in the LLC in the form of a charging order. What does this mean? If you should choose to take a distribution from the LLC, the lien will compel you to pay that distribution to the plaintiff. Needless to say, you will never take a distribution under those circumstances.
Given that situation, you want to locate the parent LLC in a state where your LLC interest is protected.
How Many LLC’s Should You Have?
Some real estate investors choose to set up a separate LLC for every property they own. If you own one or two properties, this is not an issue. However, if you own 10 or more properties, having each property in LLC can be an administrative nightmare.
It makes more sense to group properties in terms of value. This is a combination of the amount of equity in the property and the ROI. You want to group the properties of high value in one LLC and the properties of lower value in another LLC.
From the perspective of asset protection, it is extremely important that every LLC have its own bank account. Cash distributions must flow through the structure of ownership which reinforces the ownership structure in the case of a lawsuit.
Investor vs. Dealer
If you are flipping properties and you are not structured properly, this could be very expensive from a tax perspective.
Should you be using a BRRR strategy, then this is much less of an issue. However, if you flip several properties per year, the IRS will likely deem you to be in the business of flipping properties and all profits earned from your flipping operations will be treated as ordinary income.
This is not a problem if you are selling outright for cash and the buyer is arranging his own financing. However, if you paid cash for the property and sell it to a buyer and choose to hold the mortgage, this could create a tax issue. Let me give you an example.
The property is sold and you as the seller accept a down payment of $10,000 and you hold the mortgage for the balance of $170,000 for a period of 10 years.
If you are deemed to be in the business of flipping properties, in other words, a dealer, this sale will be regarded as an installment sale. You will have to pay tax on the entire profit of $63,700, even though you only received $10,000 in cash.
In the event that you do this several times per year, you are likely to be taxed at the top rate of 37%. Therefore, just on this deal, your tax liability is $23, 569. You will have to pay the additional $13, 569 out of your own pocket.
Your best option is to set up a C Corporation and hold the property under that corporation. The net profit will be taxed at only 21% instead of 37%; a difference of $10,192.
The Bottom Line
It is important to protect your real estate investments, not only from the lawyers but also from the tax authorities. This requires setting up the proper structures and you should do so BEFORE you purchase the property. Attempting to restructure after you have purchased property can trigger unexpected taxable events and legal issues.
Do not attempt to do this by yourself. Have an experienced real estate attorney and tax accountant set up the appropriate structures for you. Be sure to follow the rules that the structure requires in order to maintain its integrity. The expense of setting up the structure will be more than offset by the taxes and legal fees you will avoid in the future.
The information provided here is for educational purposes only and is not to be construed as professional legal, tax, or financial advice. Every situation is unique and you should consult with an attorney, tax accountant, or financial adviser to determine the best options for your personal situation.