So many people have walked away from homes that are hopelessly underwater. With little prospect of recouping their losses, or faced with a difficult personal financial situation, they have made a decision to let the bank foreclose. Prior to 2007 this would have resulted in an income tax liability on the amount of any forgiven debt. Currently the law allows people to walk away from their primary residence without fear of IRS consequences through the end of 2012. Rental properties are another matter. Investors walking away from investment properties are still liable for income tax on the amount of any debt discharged by the lenders.

The real estate bubble lured many neophyte investors into the water with easy money and unsustainable rates of appreciation. When the music stopped many of them were holding multiple properties while drowning in debt. Even experienced investors were feeling the pain. Watching homeowners walk away from their primary residence, seemingly without consequences, led many investors to believe they could do the same. They should have read the fine print.

Debt Relief Act

The Mortgage Debt Relief Act of 2007 allowed homeowners to avoid paying taxes on forgiven debt but investors were specifically excluded from this law. Right or wrong, investors are presumed to be more sophisticated and aware of the risks. At real estate club meetings I have encountered investors talking about “strategic default” and letting the banks have their headaches. When asked about the taxes they would respond that they had lost money so there would be no tax due. When asked about the tax consequences of forgiven debt I would be told that the law forgives it (it doesn’t) or, more often, I would receive a blank stare in response. It was clear that they were so concerned with immediate relief of their debt pain that they hadn’t considered the tax ramifications nor had the consulted a legal or tax professional.

Some investors view bankruptcy as an option. Debts accrued personally and in their business can often be discharged this way. IRS debt? Not so easy. While not impossible, eliminating taxes owed to the IRS is an onerous process. Trying to do so without the aid of a professional is certainly not advised.

Proper Planning

If an investor needs to walk away in a strategic default, or engage in a short-sale of an investment property, proper planning is essential. Investors need a strategy when they begin investing but they also need one for any significant changes that occur in their business. Defaulting on a debt is certainly a significant event. If you are considering strategic default as an option be sure you do so with your eyes open. It is no surprise that investors, especially formerly successful ones, may find the thought of walking away from debt obligations to be humiliating and embarrassing. However, it’s not a time to bury your head in the sand or avoid facing the issue. Swallow your pride and seek the advice of professionals before you act. No one plans to fail, but they often fail to plan ˗ the two are often related.     

 Remember that failure is an event, not a person. – Zig Ziglar

Photo Credit: http://www.flickr.com/photos/notionscapital/2904158944/sizes/z/in/photostream/

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Look Both Ways Before You Walk

We’re in the back stretch of 2011, which bodes well for folks contemplating some tax related moves. Here are some suggestions you may want to put into your own arsenal. Though basic in nature, I’ve learned most tax preparers definitely aren’t proactive in digging for tax savings beyond the normal deductions. You’ll notice a common denominator here.

It’s not difficult to spread many taxable events over a couple different tax years — while gettin’ all the money in the next six weeks.

Some examples for ya.

1. You’ve decided to take the money from your 401k or IRA in order to invest elsewhere. Instead of doin’ it all this year, do half in 2011 then the other half in January. For many this not only spreads the income over two years, but sometimes it also avoids movin’ up to a higher marginal tax rate. 

2. Would ya like to take a capital gain, but the projected tax hit made ya dizzy? Do the same thing. In fact, you can do better in some instances. Let me ‘splain.

Structure the transaction (with a highly competent tax pro, of course) so it closes this year. If you’re carrying the financing, split the down payment. Let the buyer pay half at closing and the other half in January. You can do much the same, only over several years with the note you carried. If it works for your needs, make the payments interest only. Also include regular principal lump sum payments every December and January. This will spread out the note payout over several years, lessening the tax impact even further.

3. The same goes for the sale of any notes you have. Sell them on terms similar to the ones above. The actual structure is limited only by tax rules and the imagination, experience, and knowledge of you and your professional tax guy/gal.

There are of course, many other applications using this simple principle, but you get the gist. If you’re in a situation you think might be on point, gimme a call and I’ll give you the straight poop. If it seems apropos to execute this strategy, I’ll refer you to a trusted, very experienced CPA for specific guidance.

Though it surely is a simple concept, it’s saved my clients literally millions over the last 30+ years. Consider it just another arrow in your quiver.

Photo: Chris Tolworthy

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Investors: Lower Your Taxes – Here’s How

The Travel Deduction is Often Mishandled by Real Estate Investors
Many real estate investors do not understand the rules and regulations related to the deduction of travel expenses. While real estate investors are allowed to deduct travel expenses, the deduction is limited when compared to business owners.

Real estate investors are allowed to deduct ordinary and reasonable expenses related to investing in real estate; collecting rents, maintaining properties and other reasons related to property management. This can be properties next door, cross country or even in another country. I believe that most investors are aware of this.

The Appropriate Use of the Travel Deduction for Real Estate Investors

An investor is not allowed to deduct travel related to improving a property as a current expense. The cost of travelling related to improving a property must be capitalized as part of the improvement and deducted over the life of the asset. It is possible though, to greatly improve the timing of when you deduct depreciation. So many simply lump improvements as residential rental property which means it will take 27.5 years to fully recover these expenses.

An investor that travels to a region for the purpose of acquiring a rental property will be allowed to capitalize this cost as part of the investment, but this travel would not be a current year expense. An investor that travels to acquire a property in a region, but does not end up purchasing a property in the region will most likely be denied the deduction in any form.

If your real estate activity is a business then the standard for deductible travel is different. Travel in this case must be ordinary and necessary for the business. This is an important distinction. Many more purposes for traveling have a business purpose though they may not necessarily have an investment purpose.

The amount that can be expensed or capitalized will depend on several factors. Travel within the United States is treated differently than travel outside of the United States.

For further information on the travel deduction refer to these publications: Publication 463, Publication 527, Publication 535, and Publication 925

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Can Real Estate Investors Deduct Travel Expenses? Yes, but . . .

One of the least popular tasks for many real estate investors is bookkeeping. Whether or not it is your cup of tea, I have a couple simple tips for automating the process so you can free up your time for some of the other tasks you like better.

This system isn’t quite fully automated, but it’ll certainly make bookeeping easier and save you plenty of time.

3 Components of Semi-Automatic Real Estate Bookkeeping

Separate Bank Accounts

The first, and arguably most important step in automating your bookkeeping is to create separate bank accounts. At the bare minimum you’ll want to have one separate account for each ownership structure under your responsibility.

For example, if you own your properties personally, create a separate account for your real estate investments. Or, if you work with partners, have a separate account for each of the various partnerships or joint ventures you work with. To take things a step further, you may want to create one account for each individual property even if some properties have the same ownership structure.

Pre-Authorized Debit

Most mortgage companies these days use pre-authorized debit. On whatever day your payment is due, your lender will take the payment directly from your account. To further automate the process, why not setup pre-authorized debit for your property tax, insurance, utilities, property management, and any other regular monthly expenses? Sure you need to keep an eye on the transactions each month, but using PAD ensures your bills get paid even when life gets a little hectic. Knowing your business can survive a little longer on its own is usually a step in the right direction.

Tracking

At some point you’ll want to track your transactions by entering them into your system. Whether you keep track of your income and expenses using a simple Excel spreadsheet or favor accounting software for the task, most banks allow you to download a CSV file containing your transactions. Simply copy the transactions you download from your online banking to whatever system you use and your update is complete. Thanks to the separate bank accounts you’ll be using, the transactions will already be separated. At this step you can start to really see the benefit of using one account per property.

Why You Should Automate Your Real Estate Bookkeeping

Be Organized by Default

Most of us prefer to be organized, but when things get busy, bookkeeping and paperwork can get pushed aside and start to pile up. If you setup separate accounts and pre-authorized debit for your bills, the system keeps everything organized for you.

Avoid Commingled Funds

From a cash management perspective, having a commingled fund may seem like the best idea. Pooling all your cash into a single account means you have a larger balance to work with and are less likely to deal with overdraft issues.

The problem with commingling funds is there is no clear separation. With separate accounts you’ll be able to tell at a glance if your property is profitable or bleeding cash. You’ll also be able to tell if you have a healthy reserve fund available for each property.

It’s Easy

Perhaps the best reason to automate your real estate bookkeeping is because its so easy to do. Investors rarely enjoy accounting, so why not make a couple of easy changes to simplify the process and save yourself time and frustration?

Photo credit: o5com

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

How to Automate Your Real Estate Bookkeeping

It would appear the IRS has read Sun Tzu’s “The Art of War” and is applying his strategy of “avoiding what is strong to strike at what is weak.”  Albeit compared to four years ago the real estate market is weak even if it is beginning to show signs of stability.  So who better than to attack then embattled real estate investors who have seen their fortunes and cash flow shrink dramatically?  The first assault began with the Health Care Reform Act and its requirement that real estate investors 1099 any person who is paid more than $600 during the year for service on their property.  Now we find the Treasury General issuing a report encouraging the IRS to perform more audits of individual tax returns that report losses from rental real estate activity.  The report can be found here.

According to the recent report, at least 53% of real estate investors misreported their activity in 2001 resulting in $12.4 billion in misreported income.  Why all the attention? Taxes. The government needs money and who better to extract a pound of flesh from than cash strapped investors. Unfortunately this comes as no surprise given the recent tax court decision that found a real estate investor didn’t qualify as a real estate professional despite over 1000 hours of real estate activities.   

As many of you already know a real estate investor can qualify as a real estate professional, i.e., material participation, if he spends more than 50% of his time in a real estate activity and more than 750 hours of service in such activity.  Basically you do not have another full time job outside of your investing and your spend 750 documented hours on real estate activities.

One key factor in meeting this test is to treat all of your real estate activities as one by making an aggregation election on your individual tax return.  If such an election is made then you may group all of your activities together in order to satisfy the 750-hour test.  Lest you make this election the IRS will apply the 750-hour test on a per property basis.

The benefit of real estate professional status is the ability to deduct all of your real estate losses regardless of income.  (You are not subject to the Passive Activity Loss Rules.)  Unfortunately the rules are not what they appear when you have an aggressive IRS and a sympathetic court. 

Consider the recent decision of Bailey v. CIR.  In this case Pamela Bailey operated a number of rental properties that she owned jointly with her husband, Todd, an emergency room physician. She wasn’t engaged in any other activity besides running the rental properties. For 2004, Pamela spent a total of 1,003 hours on the properties. 324 of those hours were spent running a property called “the Inn” that was offered on a short-term rental basis to overnight lodgers, usually for about three days at a time. The Baileys incurred losses on their real estate properties and this loss offset Mr. Bailey’s income. 

The IRS successfully argued that Pamela’s 324 hours spent on the Inn should be counted for purposes of the 750-hour real estate professional test.  In a perverse ruling the court accepted the IRS’s position based not on the Internal Revenue Code but on its regulations to find that the short-term rental use of the Inn did not count toward the 750-hour requirement.  Thus, Pamela’s hours of participation dropped to 679 which is short of her 750-hour requirement.

Lessons to be learned from this case and recent governmental activity – if you are down and seen as an easy target the IRS will take a bite.  Your best defense is to adequately document all of your real estate activities, however minor, and make the proper aggregation election on your tax return. 

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Real Estate Professional Status: The IRS Has Read Sun Tzu

As we approach April 15, 2011, our call volume dramatically increases.  Individuals desperately seeking to reduce their 2010 tax liability inundate my firm with deduction related questions.  Ironically, like asset protection planning that begins upon notice of a lawsuit, tax planning for 2010 should have begun over a year ago; but alas, such is the individual born with the lifetime subscription to Procrastinators Monthly and unwilling to cancel it.

Amidst the fervor to reconstruct last year’s income and expenses into a cogent spreadsheet that in the immortal words of Judge Learned Hand our 10th Supreme Court Justice – "Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.  Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands." However, before donning your Don Quixote armor by taking pen to paper and slashing your income with all manner of possible deductions keep in mind that all deductions must be ordinary, necessary, and reasonable. 

Ordinary Expenses: Are expenses that are typical in your trade or business that are needed to run your business. Ordinary expenses must also be necessary in order to deduct them from your business taxes.

Necessary Expenses: Costs for things helpful and appropriate in running your trade or business. Necessary expenses are not tax deductible unless they are also ordinary expenses.

Example of a Reasonable, “Ordinary and Necessary” Business Expense: Costs associated with looking for real estate e.g., internet subscriptions, software, computer, cell phones, mileage deduction (it is often more advantageous to take a reimbursement for mileage as opposed to deducting your vehicle through your business), mailers, advertising, or other promotional literature being distributed.  Consider deducting purchases of educational courses, books and materials, or other products related to real estate investing.  If you have incorporated yourself and have monthly or quarterly meetings at your house with other investors, your corporation should be renting your house from you and you may be able to exclude the income you receive under IRC Sec 280(a).

Generally speaking, deductions abound if you think about it long enough and can associate the expense with your business. 

Word of note:  The IRS recently released a report indicating their intent to perform more examinations of individual tax returns that report losses from rental real estate activity. The increased scrutiny was triggered by a 2008 report that found at least 53% of individual taxpayers with rental real estate activity for tax year 2001 misreported their rental real estate activity.  The report appears to direct the IRS focus on those taxpayers claiming real estate professional status.  Thus, similar to documenting expenses, documenting your time devoted to real estate related activities is extremely important given the IRS’s intent to look more closely at real estate activities.  The Treasury Inspector’s Audit Report is located at http://www.treasury.gov/tigta/auditreports/2011reports/201130005fr.pdf.

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Considerations for April 15, 2011 Tax Deadline

As a real estate investor, when we hear about selling on contract terms it excites us!  Selling on contract terms opens a whole new buyer pool for our business and allows us to get better pricing for our houses. When we sell on contract, we as the sellers make assumptions on how the taxes are handled on the sales transaction. Let’s take a look at two scenarios to be aware of when facing taxes on “Installment” sales.

Installment Sale: Traditional thinking on a land contract sale would be something like this: We acquire a property for $25,000 in cash, then turn around and sell the property on a land contract for $50,000 with a $5,000 down payment. From a cash flow standpoint, we are $20,000 lighter right? ($25,000 purchase price – $5,000 down payment) Not only that, but we have not realized the gain on the sale or the $25,000 profit between the purchase and sales price. Therefore we can use the Installment Sale method of recording income on the property. The only money received by you, from the buyer, would be recorded on your tax return. This method of installment sales is most effective and makes the most sense when seller financing a real estate transaction. Do too many of these transactions and you enter……

Dealer Status: Dealer Status is when your investments turn into a business. For us real estate investors, that can happen pretty quickly and easily without us even realizing it. For me, the easiest way to think about this is:  If your investments turn into continual work and you rely upon the income for a living, you are a dealer. There are more detailed articles on this topic, and I suggest you talk with your tax professional to understand what side of the fence you are on. This is important as we re-visit our example above. As a dealer you would have to pay the gain on the sale in the year it occurred. In this case the gain is $25,000. Assuming a 35% tax rate, you will owe the IRS $8,750 on the sale. Not to mention, you were already $20,000 in the negative from a cash flow perspective.

This is an important topic that should be addressed as you consider selling on terms to buyers. I have had tax returns with both the installment sale status and the dealer status, and trust me, it is much better have to have the Installment status.  This way you avoid running into to cash flow issues and paying taxes on unrealized gains.  Stay in the installment sale status and your cash flow will thank you!

(Disclosure:  I am not a tax professional or attorney.  It is always best to consult your tax or legal professional on these matters)

Photo: James Thompson

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Installment Sales or Dealer Status: Be on the Right Side of the Fence

A common question among many real estate investors I meet is “should I form a C corporation or an S corporation for my short term investing (short term investing is commonly viewed as fix and flips, wholesaling, or just about any investing that does not have an investment intent.)?  My standard answer is almost always a C corporation.

I am sure many of you are thinking that an S corporation is preferable because, according to some myth, it will lower investors’ taxes.  The arguments in favor of an S corporation are persuasive.  Two of the most common are as follows:

1. The S corporation does not get doubled taxed and are flow through entities. 

All income or losses of the S corporation flow through to the shareholders’ return each year based upon ownership percentages of the shareholders.   The recipient shareholder pays tax on his share of the flow through income.  A C corporation, in contrast, must pay taxes at its own rate on its net income.  Any after-tax profits distributed to shareholders will be taxed again as dividend income to the shareholder – hence the “double tax”.

2. The S corporation will save on social security taxes. 

Each individual must pay 15.3% employment taxes on their first $106,800 in active earnings.  On amounts above $106,800, the tax drops down to 2.9% for the Medicare portion (technically, your employer pays one half of the tax, but when it is your business, it is still your money whether it comes from your business or from you individually).  The savings in an S corporation are achieved when you split your corporate earnings between salary, which is subject to employment taxes, and distributions, which are not subject to employment taxes.

Given the potential tax savings, why would anyone choose C corporation tax treatment?

   
Consider two arguments in favor of a C corporation:

1. The IRS has been given the green light from congress to actively audit S corporations that do not pay salaries. 

It has been a longstanding thorn in the side of the service when taxpayers avoid paying employment taxes by utilizing an S corporation to split income between salary and distributions.  By some estimates, the vast majority of S corporations pay no salaries to owners and completely avoid all employment taxes.  As a result, a bill was introduced this year to repeal the availability of S status to business with less than 4 owners.

2. C corporations keep your business affairs private and eliminate many hassles when purchasing real estate. 

As an active real estate investor, I abhor the day my CPA convinced me to convert my business to S corporation tax status.  The small amount of savings I receive by avoiding the 2.9% Medicare tax on my earnings above $106,800 in no way makes up for the hassles I experience as an investor.  Whenever I apply for a loan, I am forced to endure multiple document requests by inexperienced underwriters who believe that through the collection of additional information, their ignorance will culminate in understanding.  The document requests I am referring to were brought on by my S corporation and other entities I participate in that show up on my individual tax return as a K-1s.

Here is how it typically works for me when I apply for a loan:  Initially I am asked to turn over the last 2 years of individual tax returns.  After 3 to 4 weeks, I will receive a 2nd request from the underwriter to produce 2 years of tax returns for every business that shows up on my 1040 in which I own a greater than 20% interest.  After I provide the returns, I am usually contacted in another 2 weeks for a current profit and loss for each business.  In another 2 weeks, I typically receive a follow-up request to explain certain changes in my business from one year to the next.  The process continues until enough paperwork is generated that the underwriter is satisfied they have killed enough trees. 

I have given you the condensed version.  My point is that S corporations can create more problems for the real estate investor than they solve.  Borrowing money is an important aspect to investing and I have found that the more information you provide to an underwriter, the greater chance you will be denied or delayed.  Many of my real estate deals have been delayed because of hang-ups in underwriting.  I typically request 120 days for closing if I am dealing with a lender with whom I have not had dealings.  If the underwriter does not understand your business, then the safest course of action for them is to deny your loan.  You will not have this problem with a C corporation.

With a C corporation, you do not receive a K-1, so nothing shows up on your 1040.  As far as everyone is concerned, you are just a W-2 employee.  I do not want an inexperienced underwriter looking through my business and making a judgment call if my business will pose a risk to the loan.  Some of my business decisions in certain businesses are made to lower taxable income.  From the underwriter’s point of view, this is a negative.  For me, it is a positive.  What you want to avoid is making it an issue that necessitates further inquiry.

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

C Corporation: The Active Real Estate Investor’s Preferred Choice of Entity

Last week I discussed some of the prohibited transaction rules concerning retirement accounts. The point of my post was to make readers aware of the minefields that exist when investing in real estate in these accounts. These rules apply to all forms of retirement accounts, i.e., IRA, 401(k), ROTH IRA, Defined Benefit Plans, ESOP, 401(a), and others. This week I would like to discuss an alternative to the self directed IRA.

The self directed IRA ("SDI") has garnered a lot of attention in the past six years as the investment vehicle of choice for individuals seeking control over their retirement assets. The real estate market explosion in 2004 was a significant factor in the SDI’s popularity. Traditional brokerage firms that hold most IRA monies limit an individual’s investment choices. Taking your IRA funds and investing in an asset not offered by your broker is not an option. Hence, real estate oriented investors turned to those companies that permit such investments through what is referred to as a SDI.

What many investors do not realize is a pension plan (for this post I am referring to a 401(a) plan, i.e., profit sharing plan) offers the same benefits without some of the hassles associated with a SDI.

When investing through a SDI everything is run through the IRA custodian who must sign purchase and sale documents, offers, checks, etc. (The "checkbook IRA" strategy is a solution, but a few concerns exist here so use guidance.) A 401(a) plan does not require the use of a custodian. With this plan you can serve as your own plan trustee. It is the plan trustee who controls the investments and signs on behalf of the plan. Hence, we eliminate the middleman (IRA custodian) and put you in control of your retirement account. Here is how it works:

• An individual establishes a Corporation or LLC for their real estate investing business or uses an existing entity;
• Next he or she establishes a 401(a) plan sponsored by their business and is appointed trustee of the plan;
• An existing IRA (not ROTH) and/or 401(k) monies with previous employers are rolled into a new account established under the 401(a). This account can be setup with several brokers. I use Schwab for my clients. Married couples can pool all of their funds into one account;
• The account will have a checkbook attached to it for control; and the Individual can invest in real estate or any other permissible investments (Note; must adhere to prohibited transaction rules).

The 401(a) in addition to offering greater control also provides for higher contributions ($49,000 each year subject to salary), allows for plan loans of up to $50,000 to participants with adequate balances, and provides ERISA protections if a common law employee is hired (a child will satisfy this test).

A 401(a) plan can be a safer alternative to the SDI with additional benefits. It should be noted that a 401(a) may require an annual tax return depending on the plan value and will come with an annual administrative fee. The annual fees for the 401(a) plan will be comparable or less than the custodian fees for a SDI.

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

An Alternative to The Self Directed IRA

When it comes to asset protection, I always tell my students and clients that segregating dangerous assets from each other is a sound strategy to limit overall risk exposure.  Best practice dictates that each asset should have its own entity.  For many people this could translate into to a multitude of business entities. 

For example, just yesterday I spoke to an individual who owns over 30 properties.  If this investor desired complete asset segregation he should create 30 separate Limited Liability Companies.  This would surely translate into an annual cost of over $6,000 in state fees.   Now depending on your risk tolerance level, $6,000 may be considered cheap insurance given that the cost breaks down to only $200 per property.  For many, this is a bargain given today’s hostile business environment and personally, I would agree.  However, some investors who live in a state with high annual business fees, such a structure may not be financially practical.  Thus, the desired asset protection plan is sacrificed in favor of grouping several properties into to a handful of LLCs.

Is this to say one investor is smarter or savvier than the other?  No, it just comes down to each individual’s risk tolerance level and money.  Now this brings me to the point of my article.  I have been receiving more than usual interest in a relatively new variation of the LLC referred to as the Series LLC.  A Series LLC could be viewed as a possible solution to the cash conscious investor’s dilemma and the “I am entity overwhelmed” investor. 

The Series LLC is similar to having multiple LLCs for different properties.  However, the structure is simplified by allowing one LLC to operate numerous other subsidiary LLCs, each of which runs a “single-asset” business. For the real estate investor, this means that each subsidiary LLC owns one property, protecting it from the liability of the other properties.  The Series LLC could possibly simplify things greatly: fewer forms, fewer reports, and a much easier time managing multiple properties than if you had to form a new, independent LLC for each property and not to mention potentially only one annual business fee. 

These benefits have prompted some attorneys and self proclaimed asset protection consultants to hail this entity as the future of asset protection.  However, herein lies the problem with this potentially great entity – how will it be viewed by the courts and the IRS. 

One strike against adopting the Series LLC is the lack of legal precedent.  Only a handful of states, Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah have adopted statutes recognizing this form of business entity.  As such, it is new and untested as an asset protection tool. In point of fact, to my knowledge, the series LLC has only been tested in one case.  In that case, GxG Management LLC v. Young Brothers & Co., No. 05-162-B-K, 2007 U.S. Dist. LEXIS 12337 (D. Me. Feb. 21, 2007), the Court struggled with the series concept and in the end viewed the entity as one LLC.

Second, there is a lot of uncertainty in the federal government about how the Series LLC should be taxed.  On October 13, 2010 the IRS issued proposed regulations that if adopted will remove much of the uncertainty over the tax treatment of series LLCs however, this remains to be seen. 

Third, some states, notably California, have taken the position that each series will be treated as a separate LLC when it comes to annual franchise fees – this will not help the cash conscious investor. 

Fourth, if an investor owns property in different states will the parent entity be required to file in each state as a foreign LLC in order to take title to property in one series?  If so, will that bring every series under the control of the filing jurisdiction even though separate series own property in other states?  

Finally, general business principles require that each series must be treated as a separate legal entity which necessitates separate bank accounts, agreements, letterhead, etc. – this does not help the “I am entity overwhelmed” investor. 

Therefore, creating a Series LLC for real estate and asset protection purposes is still largely uncharted territory and one should proceed with extreme caution.  The Series LLC has there are guidelines for formation, but very little governing business operations, taxation, or legal liability.  I learned long ago that predicting how governing bodies will view a particular strategy or structure is impossible and the risk of getting it wrong is better left to others who have client’s that are willing to put up the money to wage the fight of acceptance.  Many a client has learned the hard way that it is sometimes better to take planning slow and evolve with the law rather than try and chart its course.

I wish you all the best with your business and investing.

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

The Series LLC Experiment – Looking for Guinea Pigs

If you’d like to take a sale on a property, but the tax hit will be painful, do some tax planning via the sale’s structure. This is the time of year when all kinds of slight modifications in a sale’s terms can result in solid tax savings. This year though, it might be problematic due to the scheduled end of the Bush tax cuts. Even if those cuts disappear, it’s still possible, depending upon your specific circumstances, to reduce total taxes owed. What’s not in doubt is your ability to delay the payment of those taxes.

A Real Life Example

Rod had enjoyed a huge 2003, but wanted to back off his work schedule for the next few years. His dad had passed away a couple years back, and now his mom was beginning to show signs of hittin’ a much lower gear. She was still relatively healthy, but at 83 was in need of a closer, and more frequent family presence. Since she was in another state, Rod and his two sisters decided to move her to Colorado, where Rod had lived the last 20 years. He wanted to build a nice one bedroom apartment behind his home, attached by a breezeway.

The problem was not which property to sell, but how best to minimize his taxes. He wasn’t interested in borrowing against it, as it had become his least favorite. Here’s what we did.

Since it was the Labor Day weekend when he first contacted me about this, I immediately knew that the split down payment approach would work to his advantage. We sold it in November (there is a God and he loves me), closing it just after Christmas. It was a fourplex. It sold for just over $500,000 with a net equity of roughly half of that.

The buyer was adamant about putting down 30%, a position on which he simply wouldn’t budge. Not a problem. We split the down payment, chronologically, into three parts. 10% at closing — 10% on or before January 10th, 2004 — 10% on or before January 10th, 2005.  The buyer would pay the largest penalty allowed by law for prepayment. This was handled through the terms of a note/trust deed carried back by Rod. (And yeah, good luck finding a lender these days who wouldn’t laugh you out of his office for even proposing this out loud.)

This gave a large portion of the transaction, installment sale status. Rod didn’t pay anything on the $100,000 note in the year of sale. He then paid taxes in 2004 on what the IRC formula showed as return on capital, plus 2-10 days of interest. In 2005 he repeated that sequence. Recall that Rod had already decided to throttle back on his work efforts, so his ordinary income for ’04 and ’05 were significantly less than his banner year, ’03.

The buyer liked the fact that the note he executed in favor of the seller called for no payments, and just 7% interest. Also, since he had no payments on the junior note, the property’s month to month performance was unaffected. It didn’t hurt that not only was the buyer a pretty good guy, but that his broker was a highly experienced pro, who contributed immensely to the success of the transaction.

Rod loved the results. Still, we had to deal with all the cash, and therefore capital gain the new purchase loan was gonna generate in 2003. Though he didn’t like it at all, he went along with my advice to execute a partial tax deferred exchange. He only needed about $50,000 to build Mom’s apartment. He would have that and a bit more, after taxes, once the first January payment was made, only a week or two after closing.

We exchanged the remaining equity so that the new loan on his upleg (newly acquired property) was about equal, or at least not much more than what he’d left behind. This was made easier by the fact that his local market sported a much better price/rent ratio, generally speaking, than had his fourplex in San Diego. Sweet. He still wasn’t happy about doing the exchange, but admitted it was much preferred over the alternative of an onerous tax bill. Duh.

With the help of his sisters, he moved Mom into his home the week we took the listing. She moved into her new place, if memory serves, some time before Memorial Day. She turned 90 recently and is still in relatively good health. Rod’s contemplating the addition of a bedroom to her apartment for a live-in nurse when the time comes.

It’s all a matter of having a Plan and doin’ things on Purpose.

Photo: JD Hancock

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

Lowering Cap Gains Tax Bills Via Property Transaction Structure

In the off chance you missed your IRS draft notice I thought I would remind everyone of their new responsibilities. As you know, the United States has run up a huge deficit and spending is no where near under control. In an effort to appear as if steps are being taken to to address the deficit (you will not I did not write "spending") Congress is poised to increase taxes in 2011 by letting the Bush Tax Cuts expire and increase the burned on business and real estate investors.

The current tax law requires businesses to provide information returns, such a 1099s, to each payee that the business has paid $600 or more for the year in their ordinary course of business.  Until now investing in real estate was not considered to be a business. In one of my earlier posts I wrote of an investor who was denied the ability to deduct several real estate related expenses on his 1040 because the IRS considered him an investor and not a "trade or business." Interestingly when it comes to deductions real estate investing is not considered a trade or business; (Note: you must do more than purchase a few rentals) however, when it comes to assisting the IRS in its collection efforts, starting next year it will be for the limited purpose of reporting.

Effective for 2011, the 2010 Small Business Act provides that solely for purposes of filing information returns, a person receiving rental income from real estate will be considered to be engaged in a trade or business of renting property.  Thus, recipients of rental income from real estate generally are subject to the same information reporting requirements as taxpayers engaged in a trade or business. In particular, rental income recipients making payments of $600 or more to a service provider (such as a plumber, painter, or accountant) in the course of earning rental income are required to provide an information return (typically Form 1099-MISC) to IRS and to the service provider.

Translation – beginning next year every investor better maintain great records and issue timely 1099s to those with whom they work. Failure to do so will result in substantial penalties.

This Article is Copyright © 2004-2011 BiggerPockets, Inc. All Rights Reserved.

2010 Small Business Act: You Have Been Drafted by the IRS