Are you an investor engaged in real estate flipping? Do you deal in tax liens or deeds or engage in investment activities in which you never hold on to property for longer than a year?
You’re probably wondering what sort of entity I recommend for such transactions. If you guessed an LLC, you’re right. But it's not as simple as it sounds.
One of the issues flippers will struggle with is how these LLCs are taxed.
This is an issue that can make or break your business. So you need to consider your needs as a whole to come up with the right entity for you.
Let's get down to the meat and bones of setting up the right entity for flipping properties.
Your attorney will, more often than not, focus on liability and how to avoid it. Most attorneys aren't savvy real estate investors themselves (although we at Royal Legal Solutions are). But an "average" lawyer will likely advise you to set up the LLC as a partnership for federal tax purposes.
But there’s a problem with this approach: You’re left exposed to the IRS. If they decide your real estate investment is actually an “active business,” you’re toast. You’ll be subject to self-employment tax. Even worse, this judgment about whether your investment is actually business is at the discretion of the Tax Court.
At this point, you’re probably thinking a CPA will solve all the problems you’re likely to face with the Taxman. After all, they’re the number cruncher.
Your CPA may suggest that you can dodge the issue with Uncle Sam by setting up the LLC as an S-Corporation. The IRS treats S-corporations the same as partnerships. They’re both pass-through entities where income passes through to the 1040 of the owner. This way, his or her income is not subject to self-employment tax.
I’m sure you’ll agree this is a much better prospect. But we still have a problem.
On the surface, everything looks hunky-dory. But upon closer inspection, you will realize that the advice from the CPA only protects you if taxes were your only problem. Unfortunately, this is not the case with most real estate investors. You will need to raise money at some point.
And here’s where both the lawyer’s and CPA’s approach will fail. When applying for a loan via a disregarded LLC or an S-Corporation, the bank will treat you as a high-risk borrower if you’re self-employed.
Talk to someone with entity and tax chops (like us!), and they’ll know about this third alternative. It involves setting up a C-Corporation to handle your active real estate business while receiving your profits as W-2 income. This way, you won’t be considered self-employed or a business owner since your ownership is not part of your individual 1040.
There’s really no one-size-fits-all approach for flippers. Every investor has to pick what works best for their unique situation. Your choice will be based on whether you’re more concerned with funding your retirement, borrowing, or minimizing your taxes.
Interested in getting more details? Check out our article Selecting the Best Entity for Real Estate Flipping.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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