Consultant’s Corner: Business Entities for Real Estate Investment
Q. I am a real estate investor. What type of business entity should I form?
Real estate investing activities can potentially have mortgage financing, personal injury, workers’ compensation, debt collection, and other business risks that prompt business owners to form a business entity or entities, to hold their properties. Also, properties are often held in one company or companies and a separate company is formed to manage the properties. With multiple properties, it is common to have properties owned by separate entities in order to give the owners flexibility in disposing the properties, bringing different investors into certain properties, and avoiding any cross collateralization on mortgage and other debts of the properties. In addition, forming separate business entities in different states is effective in some cases.
In terms of entity choice, there is no one best business entity structure for real estate investing activities. While many experts recommend that investors hold their properties through an LLC, an S corporation can also be a viable option, but you will need to make any business entity decision based on your risk exposure, personal financial situation and long-term property investment goals. Corporations (C and subchapter S types), LLCs, and limited partnerships all provide protection of the owners’ personal assets from the business obligations. However, it is more common for real estate investments to be owned by an LLC, limited partnership, S Corp or other business entity that provides pass-through income tax treatment rather than a C corporation, which is subject to double taxation. Also, a C corp’s capital gains are taxed at corporate ordinary income tax rates and are not eligible for the preferential capital gains tax treatment that may apply to gains recognized by individual taxpayers or gains passed through to individual taxpayers from pass-through entities that they own (this tax treatment applies as well to an LLC taxed as a C corp). The following are some tax treatment and other considerations when forming business entities for real estate investing activities:
Passive or non-passive activity status. With real estate investment operations, owners should consider whether they will be full-time real estate dealers or passive investors which affects taxation. Passive income and losses have special tax treatment and limitations on utilizing losses. You can review information on passive activity losses and limits at the IRS website:
https://www.irs.gov/pub/irs-pdf/p925.pdf
Type of real estate investing: rental property for long-term investment which may generate losses due to depreciation expense; or buying and reselling properties for a profit. Generally, the IRS defines a “dealer” of real estate properties as someone who actively buys and sells real estate on a regular basis with the intention of reselling properties rather than holding them for investment. This definition typically includes individuals who flip properties. The formula for determining who is an investor and who is a dealer is subjective, but the IRS will consider several factors which you can review at the following websites:
https://reiclub.com/articles/dealer-issue
If the IRS determines that you are a dealer, your properties are not “investments” but rather “inventory.” Property considered inventory is not eligible for the preferential capital gain tax treatment provided to investment property. Gains on the sale of property considered inventory are taxed at ordinary income tax rates, regardless of the business structure.
The long-term growth plans including capital requirements and additional partners or investors.
Income level from your other jobs or businesses. This affects the amount of self-employment taxes and the ability to absorb losses of the real estate operations.
Other entity comparisons are:
No corporate double taxation on earnings with an LLC not taxed as a C corp and a corporation taxed as an S corp.
With an LLC not taxed as a C corp and a corporation taxed as an S corp, elimination of double taxation when the business is eventually sold.
With an LLC taxed as an S corp and a corporation taxed as an S corp, self-employment tax savings can be achieved in certain situations.
You can review additional discussions on selecting a business entity for real estate investing at the following websites:
https://reiclub.com/articles/choose-proper-entity
https://reiclub.com/articles/limited-liability-company
Also, you can review general business entity comparisons at the following websites:
http://mycorporation.com/business-formations/incorporate.jsp?view=compare
http://www.entrepreneur.com/article/169046
http://www.nolo.com/legal-encyclopedia/llc-corporations-partnerships
Under the TCJA, business pass-through entities, which for the TCJA are defined as pass-through businesses (basically any business not structured as a C corp, including sole proprietorships, partnerships, LLPs, LLLPs, LLCs taxed as sole proprietorships, partnerships or S corps, and corporations taxed as S corps) that have “Qualified Business Income” (QBI) from domestic (U.S.) business activities, may qualify for the TCJA’s 20% deduction for income from pass-through businesses (‘the 20% deduction’). The 20% deduction is the principal tax benefit the law provides small business owners who conduct profitable trade or business activities through pass-through businesses. QBI is defined as the net income of a pass-through business after all business deductions have been claimed. Also, for income to qualify as QBI, the income must be connected to the conduct of a trade or business within the U.S.; as a result, only “business” income is eligible, and only domestic business activities are eligible.
Owners of pass-through businesses who are individuals will claim the 20% deduction on their personal Forms 1040 as a below the line deduction, similar to claiming the standard or itemized deductions, so it will only affect an individual’s federal taxable income and federal personal income tax liability. The 20% deduction cannot be used to reduce a business owner’s net earnings from self-employment, or business profit for Self-Employment (SE) Tax purposes, so it will not reduce a business owner’s SE Tax liability reported on Schedule SE of Form 1040.
With an S corp or similarly taxed LLC, the benefit of the TCJA’s 20% deduction may be less significant because of the IRS reasonable (W-2) compensation requirement for corporate officers of S corps and similarly taxed LLCs. The final regulations on the 20% deduction confirm that W-2 wages paid to shareholder-employees of S corps and member-employees of similarly taxed LLCs count as W-2 wages for purposes of the 20% deduction’s W-2 wage limitation. However, W-2 wages paid to shareholder-employees of S corps and member-employees of similarly taxed LLCs do not count as QBI.
We do not know all the details of your real estate investing activities; however, taxpayers engaged in rental real estate activities, whether they hold their rental properties directly or indirectly through pass-through entities that they own, may be able to take advantage of the 20% deduction if their rental real estate activities rise to the level of a trade or business and generate net income that qualifies as QBI. While not every taxpayer engaged in rental real estate activities may qualify for the 20% deduction as outlined in the articles below, the IRS has finalized a limited safe harbor initially proposed in IRS Notice 2019-07 that would allow taxpayers who are direct and indirect owners in rental real estate businesses to claim the 20% deduction provided these meet the safe harbor’s requirements. The IRS’ final regulations on IRC Section 199A, or the 20% deduction, and the new safe harbor under the regulations for rental real estate businesses are discussed in the article below.
https://whitmanlegalsolutions.com/blog/2019-199a-safe-harbor
Revenue Procedure 2019-38:
https://www.irs.gov/pub/irs-drop/rp-19-38.pdf
The following articles were produced prior to the release of Rev. Proc 2019-38, but provide valuable insight on Section 199A as it pertains to rental real estate businesses:
https://www.cohencpa.com/insights/articles/rental-real-estate-owners-could-qualify-for-tcjas
https://www.bakertilly.com/insights/untangling-tax-reform-final-section-199a-regulations
Due to the various legal and tax implications when starting a new or reorganizing an existing business and forming a business entity, business owners generally use local professionals (CPA, lawyer, and business insurance agent) for help in reviewing their business plans and evaluating business entities, tax, licensing, legal, and risk management issues.
