If you're a real estate investor, you should be aware of how the tax code and the way you structure your business will affect how much money Uncle Sam takes from your bank account.
For example, the IRS has a lot to say about your Limited Liability Company (LLC) and how taxes for an LLC are handled.
If you don't already have one, it's time to create an LLC. Not only does owning your properties and other investments through an LLC protect you from liability, but it can also save you some serious tax dollars if you make the right elections for your business.
Buckle up! It’s time to learn the basics of how the IRS sees your LLC and what the tax benefits of an LLC are.
An LLC is a business structure that offers its owners limited liability from the business’s debts. That means if you are the owner of an LLC, your personal assets are protected from any debts or obligations incurred by the company. You and your LLC are considered to be separate legal entities.
This type of legal structure is helpful for real estate investors because it's cheaper and easier to create than other entities like a corporation but still offers the all-so-crucial protection from personal liability.
The people or entities that own an LLC are called its “members.” There is no maximum number of members an LLC can have, and most states will allow single-member LLCs, which have only one member, to be formed.
For the purposes of taxes, LLCs are considered “pass-through” entities. This means that LLCs do not pay taxes. Instead, the LLC’s profits are reported on its members’ income taxes. However, depending on the number of members in the LLC and the tax elections chosen for the business, the IRS will treat an LLC as a corporation, partnership, or a disregarded entity.
If you own a single-member LLC, the default tax status for your business is called a “disregarded entity,” which means that the IRS ignores your LLC entirely and just considers its profits to be your personal income. This is the same way that the IRS taxes sole proprietorships. When you file your federal income tax return, you will also need to submit a Schedule C form, which details the profit or loss from a sole proprietorship.
Many states also allow LLCs to be treated as a disregarded entity when the LLC is solely owned by a married couple. However, if you form a married-couple LLC in a community property state, it will be taxed like a multi-member LLC, so it’s crucial that you do your homework before making any decisions.
The IRS will automatically tax multi-member LLCs like a partnership, which means that each member will receive a Schedule K-1 and include their portion of the LLC’s profits as taxable income on their personal income taxes. When LLCs are taxed as partnerships, each member must also include a completed Form 1065 for partnership taxation with their tax returns.
Although the default tax classification for an LLC is either a disregarded entity or a partnership, members of an LLC may choose to be taxed as a corporation by submitting Form 8832 (Entity Classification Election) to the IRS. For tax purposes, there are two varieties of corporations- S-Corporations and C-Corporations.
Like LLCs, S-Corps are pass-through entities, where corporate income, losses, deductions, and credits are passed through to the business’s shareholders for federal tax purposes. With C-Corps, on the other hand, the business itself is taxed, and then each shareholder is taxed again on their earnings when they pay personal income taxes.
C-Corps are generally not the best choice for an individual real estate investor, but, in some situations, an S-Corp can save you a significant amount of moolah on single-member LLC self-employment tax.
While you must pay yourself a reasonable salary from the LLC’s profits, you can receive any income your business makes on top of your salary as a shareholder distribution instead of in a paycheck. Because the IRS considers distributions to be “passive” income, you don’t have to pay self-employment/ payroll taxes on the money you receive as a shareholder distribution.
However, this move only pays off if your LLC makes enough income to support a reasonable salary for yourself on top of shareholder distributions. Generally, this threshold is around $75K annually for a single-member LLC, but this can vary depending on your particular circumstances.
Unfortunately, this is not a question that any blog or article can answer for you. Not even the all-mighty Google can give you advice on this issue. Because everyone’s circumstances are different, we strongly recommend that you meet with a business attorney or tax professional to discuss the tax classification that will save you the most money.
Find out about the tax savings strategies that you can implement as a real estate investor or entrepreneur by taking our Tax Discovery quiz. We'll use this information to prepare to have a productive conversation. At the end of the quiz, you'll have an opportunity to schedule your consultation. TAKE THE TAX DISCOVERY QUIZ
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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