Decoding real estate entity lingo provides clarity beyond a balance sheet.
A common mistake I see with real estate investors is the failure of their local professional to truly understand their entity needs. Most real estate investors are told to create LLCs for their investing for asset protection. When it comes to the tax treatment most investors are advised to have their LLC treated as an S-Corporation or disregarded for tax purposes.* Sound familiar? Don’t get me wrong, an LLC is a truly great entity, but before you create an entity you should know whether the entity will help or hurt your overall investing goals. This is only determined by first understanding your current or future investing challenges and only then choosing the appropriate entity structure to solve it. This is exactly what I did for Brad, a fix-and-flip investor who, with the help of a local attorney and CPA, was creating an entity structure that did not solve his real investing challenge.
Brad’s attorney told him to set up an LLC because the LLC would protect him should anything happen with one of his flip properties. “Is this correct?” Brad asked.
I told Brad his attorney is 100% accurate. An LLC will protect you in the manner in which you describe. If a buyer later sues or someone is injured while working on the flip, the LLC will keep these liabilities contained and your personal assets should be beyond the reach of creditors.
Brad then told me his CPA said Brad’s income is all active income. “I’m basically self-employed in the business of buying and selling homes, and that’s why I file a Schedule C every year. He said my biggest problem was I overpay in taxes. To fix this problem I should have my LLC taxed as an S-corporation. That way, I will easily save five- to six-thousand dollars a year in employment taxes. Is this correct?”
Again, 100% accurate. With by election S-Corporation tax treatment you will avoid employment taxes on distributions you take from your LLC. Based on Brad’s income of $175,000 a year this will save him several thousand in taxes.
I explained to Brad that his real problem is not asset protection or tax reduction, it’s having access to money from traditional lenders.
“As I see it, you should seek a solution that addresses the issues raised by your local attorney and CPA but that also breaks your ties to private and hard money lenders to fund your deals, that is, 10-12 percent.”
His 1040 tax return showed he was paying an enormous amount in interest expense while only flipping three to four properties per year. I said, “Look, you have a home with over $800,000 equity and I am sure at some point in the past you have attempted to access this equity for an ultra-low interest home equity loan to fund your flips, but lenders won’t work with you because you’re a sole proprietor who flips real estate. They’ve been burned too many times.” It makes sense from the lender’s point of view. They don’t want to lend money to another naïve real estate flipper who went to a seminar or watched an episode of Flip This House. It’s just too risky.
Brad just stared dumfounded as I proceeded to explain he should think of real estate investing like a three-legged stool. Each leg represents a different aspect of investing: one leg is asset protection, one is taxation, and the other is the business itself. Most professionals focus on only one leg of the stool. In Brad’s situation, his attorney was looking at finding a way to minimize the risk associated with investing, his CPA was focused on taxes, but neither understood the real need — look better to lenders so you can qualify for traditional financing.
Brad asked, “Ok so what should I do? Neither of my advisors brought up the horrendous interest I pay to put my deals together.”
I told him to set up an LLC but elect to have it taxed as a C-corporation.
Readers may be thinking (as did Brad) does this guy know anything about real estate and taxes? Most know a C-corporation is the last entity a person would want to set up because of the dreaded double taxation. I get this objection 70 percent of the time when I recommend this approach. I explained to Brad if he follows the advice of his CPA there is no denying he will save on taxes, but it will not help him advance his investing and isn’t that what a good plan should ultimately provide?
Brad is in need of a structure that looks good to lenders, so he can access the equity in his residence to self-fund his deals saving him $18,000 to $22,000 a year in interest. These savings in 10 years will amount to over $180,000. Brad will never get there with an LLC taxed as an S-corporation because the very same pass-through benefit extolled by the CPA for saving Brad $6,000 in employment taxes will give a traditional lender heart burn.
When Brad attempts to take out a loan, the activities of his LLC taxed as a S-corporation will appear on his personal tax return via a K-1. Brad’s lender will notice the K-1 then ask for the LLC’s tax return, recent profit and loss, balance sheet, business purpose, and quite possibly recent bank statements. Brad will provide all of this information and ultimately find himself back at square one — working with private and hard money lenders.
Brad is making his tax return complicated and not masking the fact he is involved in real estate flipping — heartburn for lenders. A C-corporation is the antacid because the corporation’s business activity does not appear on Brad’s personal tax return. A C-corporation is a separate tax-paying entity. Thus, to create a business-friendly structure, we need to recognize underwriters are paper pushers. They like to check the boxes and do straightforward lending. A complicated tax return means a complicated loan. With Brad, we made it easy for the bankers. We separated him from his business. We created a C-corporation — let’s call it F&F Enterprises — for his real estate flipping, named him president, and let the corporation pay him a big salary so he could show his lenders a nice, fat W-2. Yes, Brad will pay more in employment taxes, but wouldn’t you rather pay $6,000 more in taxes to save $18,000 in financing costs every year? Brad did.
Creating entities for your real estate investing should begin with the understanding you are building a business and there are other concerns beyond just asset protection or tax planning. Issues such as borrowing, title, banking, and future selling are just some of the problems that plague real estate investors who fail to look at their structuring with a business mindset.
*A disregarded LLC does not have to file a tax return, all income/loss is carried on the member’s personal 1040.