In our last entry we discussed using the LLC as our primary legal entity of choice to hold rental property. To review, here in Georgia the LLC has better statutory protection than a Corp. Costs to establish an LLC do vary by state and can be expensive. The LLC can be taxed as whatever we desire: Partnership, S Corp, C Corp or Disregarded Entity. A disregarded entity means the IRS ignores the existence of the LLC and you are considered a sole proprietor for tax purposes.
So the question of the day is : “what is the best structure to hold Rental Property in”?” We want the income/loss from the rental to ultimately be reported on your 1040. To best accomplish this we use an LLC taxed as either a partnership or as a disregarded entity. Rental income is passive income. It is the least taxed of all income. In fact, often it isn’t taxed at all because on your tax return you actually create what is called a phantom loss. This occurs when depreciation and amortization come into play on the taxes. For example: you collect $12,000 a year in rent, you have $9000 worth of expenses. This leaves you a profit of $3000. Now depreciation of the property comes into play, let’s say $5000. You now have a loss for tax purposes of $2000.
What do you do with the loss? In many cases, you can deduct the losses from your other income. Of course, deductibility depends on your particular situation. Because these deductibility rules are extensive, I will cover them in their own blog entry.
“But Roger isn’t my S Corp a pass through entity? Why can’t I just use that?” Yes. Your S Corp is a pass thru entity. But it is not the optimal solution for Rental Property.
The first problem is there are restrictions on transferability. Meaning there are some hoops to jump through should you ever want to move the property out of the corporation into your own name. To do so requires that you either distribute the property to yourself or sell the property to yourself. The price must be fair market value. If there is a gain you must claim the gain but if there is a loss you may not deduct it.
The second problem is a word called basis. This means how much money have you put in as a loan (debt basis) and how much money you have as stock basis (money contributed as shareholder equity plus or minus earnings). Most single family Rental Properties produce a tax loss after depreciation. As you deduct the losses year after year, you are reducing your basis. When your basis is gone, so is your deductibility.
Now let’s say, that you sell a property and now you’re ready to repay loans you have made over the years with the proceeds. If the payment you make to yourself is greater than the basis that you have in the loan, then you have taxable income from loan payback. How it is taxed depends on how you put the money into the company: sometimes it’s ordinary income sometimes its capital gain!
“What about my C Corp can I rent out of that?” In general, you should never, ever hold appreciating property, such as real estate, in a C Corp. The C Corp has no capital gains rate, it is all ordinary income!
Remember what I said in my earlier blog entries, there are exceptions to every rule! Everything relies on facts and circumstances! You need to consult with a professional before putting entities in place or making changes to existing structures.
In our next entry, we will cover the proper setup for investors with ordinary income.
