When I was growing up, my family owned a small business. One day, my Dad was involved in an auto accident. As a result, he was sued, and – years later when all the appeals had been exhausted – my family lost and had to declare bankruptcy to discharge to judgement. They lost their entire business, their home, and their marriage.
No one likes to think it will happen, but it does. As a real estate investor, you want to set yourself up to create financial freedom – and to protect it.
But what real estate entity structure is the best? What will protect your assets while also sheltering from taxes? What may be ideal legally can come with tax complications, and vice versa.
Before we dive in, it’s important that I mention that each person’s situation is different, so you should consult your own attorney and CPA (we are neither).
Sometimes, making mistakes can be the best teacher, so here are some common mistakes that we’ve seen over the years of working with real estate investors. Keep these legal and tax issues in mind to help you avoid losing everything.
Mistake #1: Not seeking out qualified professionals
Having a trusted attorney, CPA, and insurance agent is the backbone of having a strong financial future.
I had a client who was a small business owner and invested in real estate on the side. Over the years, he did some small subdivisions, which his CPA classified as capital gains on sale. Years later, the IRS came back and said he was actually a “dealer”, which triggered substantially more tax and years of penalties.
Making sure you have the right professional who is knowledgeable on the work you’re doing is essential.
Mistake #2: Having a million bank accounts, but no bookkeeping
If you have an LLC for each property, naturally that means each LLC will have its own bank account, right? That number of real estate entities can get complicated quickly. Or, some investors just dump everything into one bank account, but then they have no idea where the money goes – leading to losses.
Ideally, an LLC holding company would be the best format for your real estate entity, with the holding company LLC owning each individual LLC, which then holds the titles to each individual property. The holding company can then host the master bank account.
If you have a third party property manager, then the ins and outs in each property’s bank account are minimal and can easily be tracked with classes or tags in QuickBooks.
If you self-manage, setting up your own management company as part of the real estate entity is ideal. This acts as a third party PM to collect rents & pay expenses, operating out of separate bank accounts for property management.
Having a holding company (sometimes referred to as a Series LLC) can be a great place to put those other “business expenses” that aren’t directly related to your investments. Expenses like that new electric truck you bought, or the exciting real estate conferences you’re attending, or professional fees.
As painful as it may be, having good bookkeeping sets you up for success at tax time and provides clarity on how much you’re making for all your hard work on real estate investments. Invest some dollars and time here to make sure you do it correctly.
Mistake #3: Confusing Partnerships
Life happens. If you’re going to partner with anyone for your real estate entity, make sure your legal documents clearly define what the roles and responsibilities of each party are.
Ask yourself what could go wrong, and then plan for all of those things.
Often, a group of partners may own an asset collectively in a real estate entity. When it comes time to sell, some partners may want to do a 1031, while others may want to cash out. Since a 1031 exchange must be done with the same legal entity going out and coming in, it can be hard to create an out for those who don’t want to participate.
There is a solution for this, though, coined a “Drop-and-Swap”. In simple terms, a drop-and-swap is where the interest held in the LLC is dropped prior to the 1031 exchange. Using this technique, members not interested in doing an exchange can be given a deeded interest to the property from the LLC while giving up their interest in the LLC.
Mistake #4: Not planning for future value & financing
Say you bought a property 25 years ago for $850,000, but in your name instead of a legal real estate entity. Now, it’s worth $2.3M because you have improved the property. So you want to place a nice, long-term, Agency Multifamily Loan.
When you use Fannie Mae/Freddie Mac/HUD loans for multifamily financing, one of the key benefits of these loans is the non-recourse feature. This necessitates that the property be in a Special Purpose Entity (an LLC created just to hold the property). If you held title in your name or a master LLC, you will need to move to a new entity, triggering transfer tax, to set up for the requirement of the loan.
Another benefit of an agency loan is that it can be assumed by a subsequent buyer. Acquiring LLC shares instead of replacing a new entity can help keep sales amounts private, as well as reducing transfer tax.
Mistake #5: Putting your long-term real estate in an S-Corp
If you are classified as a real estate investor for tax purposes – a house flipper, realtor, developer, builder, wholesalers, etc. – then this is for you!
You were probably advised to put your “business” into an S-Corp or C-Corp to avoid some of the payroll taxes you own as an active “real estate professional”. This can be a great strategy for for tax savings. If you are a “dealer”, your real estate can go into the S/C Corp as inventory.
However, if you plan to buy and hold real estate, do not put your business in an S/C Corp. If you do a cost segregation study and want to take all of the bonus depreciation as losses, you may be surprised to learn that you cannot take the whole loss. A loss in an S-Corp cannot exceed your basis. Thus, if your losses exceeded the income inside the S-Corp, it will remain suspended until there is enough income left in the Corp at the end of the year to take the tax loss.
Mistake #6: Not getting started
For all there is to know about structuring a real estate entity and associated taxes, the biggest mistake of all is not taking action to get started. We have seen people with the simplest plan in the book, just buying one house a year in their own name, who have become millionaires – because they took action.
Mistakes will happen, but don’t be afraid to move forward once you have done your homework.
Looking to grow your wealth by buying or selling real estate? Contact us today to begin planning for your success.
