A CPA Answers: “Do I Need an LLC for My Real Estate, and How Will That Impact Taxes?”
When it comes to legal entities, oftentimes you need to look at both the tax and legal sides of things.
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First, I want to make a full disclosure that I am not an asset protection attorney, and I do not practice law. However, since legal entities often have a tax impact to the owner, I do frequently speak to clients about the pros and cons of different types of legal entities as they relate to the potential tax impact.
One of the most common misconceptions I hear is the need to have a legal entity to write off expenses on tax returns. The truth is that the vast majority of expenses can be written off regardless of whether you have a legal entity or not.
Do I Need an LLC to Write Off My Expenses?
For example, let’s say that you are newbie real estate investor who just purchased your first rental property. After the property is purchased, you realize you are a bit in over your head and decide to enroll in some classes to learn more about investing. It just so happens that the classes you sign up for are in Las Vegas. You hop on a flight and check into a hotel room for the next three nights to attend those real estate classes. While you are in Vegas at the real estate event, you connect with a few fellow investors and join them for dinner and a few drinks one night.
Based on the scenario above, all of these expenses may be tax deductible regardless of whether you have a legal entity or not. The reason is that the IRS does not penalize taxpayers for not having legal entities when it comes to most tax deductions. As long as the expenses are ordinary and necessary as they relate to your real estate business, chances are they will be tax deductible.
Does My LLC Provide Me the Ability to Write Off Every Penny I Spend?
On the same token, if you have an LLC, that does not automatically make all your expenses tax deductible. You would still need to be able to show that the expense are business related. For example, your cousin is getting married in Las Vegas and you are one of the attendees. You fly there, stay in a hotel, and celebrate the weekend with friends and family.
No real estate or other business was conducted while you were there. It just so happened that you opened a new LLC a few months ago that has been sitting empty up to this point. You think to yourself, “If I pay for the cost of these trips with my LLC bank account, I should be able to write off my Vegas trip.” Well, unfortunately, you would be wrong in this case. Since neither the trip nor any of the expenses are related to your real estate or business activities, simply paying for those items out of an LLC does not automatically make them tax deductible business expenses.
These are two clear cut examples of what is and is not a business deduction. But we all know that real life is not always as black and white. In reality, there are likely times when a trip or expense can have both personal and business components. What if you travel to Vegas for business but also take a few days out to have some fun? There are strategies to help ensure that you maximize your tax write offs in these situations. The key is proactive planning to get some documentation in place before leaving for your trip. That way, it is possible to write off 100% of your travel costs, even though a portion of that is spent while you are simply having some fun.
For additional information, you may want to check out “5 Strategies to Make Your Summer Vacation a Real Estate Tax Write-Off.”
So can we know if we need a legal entity or not? Well, that answer will is it depends, and it varies from person to person. Here are a few questions you can ask yourself to get started:
Will It Save Me Taxes?
Is your real estate an active business, such as wholesale or fix and flip? If so, then operating as a legal entity may help to reduce self-employment taxes. If it is purely for long term rental real estate, then odds are that you can get the same tax benefits with or without a legal entity.
Why Do I Need an Entity and How Do I Operate It?
I often come across investors who form legal entities without a clear understanding of what they are to be used for or how to properly use them. Make sure that you fully understand the purpose of your legal entity prior to incurring the cost to form it. Forming a legal entity and not using it properly can provide you with a false sense of security and some unexpected headaches.
For additional information, you may want to check out “Are You Making This Common Entity Mistake?”
How Much Will I Need to Pay?
All entities are not created equal. Certain states have high entity fees, and others have high maintenance costs. Before forming a legal entity, make sure that you have a clear understanding of what the formation and annual maintenance costs will be.
As with anything in investing and business, it is always a good idea to do a cost benefit analysis prior to forming a legal entity. Only form a legal entity for your real estate business after you have a clear understanding of what benefit you will be receiving and after you ensure that it makes sense for your specific situation.
Investors: Did you choose to form a legal entity for your real estate business? Why or why not?
Let me know with a comment.