Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal or financial advice related to individual situations. Consult with your own CPA, attorney, and/or other advisor regarding your specific situation.
Create a property management company, so you can deduct more rental expenses—have you heard this one before?
Jim owned a small portfolio of rental properties, all of which were owned in his personal name. He met with his attorney, and his attorney suggested two action items:
- Form an LLC to hold title to your rental properties.
- Form a second LLC to be the property management entity.
Jim’s attorney suggested the “Rental LLC” to hold title to his rentals in order for him to get asset protection, and he suggested the “Management LLC” because he would be able to write off more deductions and save more on taxes.
So, Jim took his attorney’s advice and formed “JJ Management LLC” to be the manager of his rental properties. This LLC collected the rental income, paid the rental expenses, and earned some management fee income from Jim’s rental properties. Jim also formed “JJ Rentals LLC” to hold title to his rentals.
Jim paid some fees to his attorney to help form the entities and also did a lot of paperwork to get them up and running. But life got busy, and Jim forgot to transfer title of his rentals into JJ Rentals LLC. So, by the end of the year, his rentals were still in his personal name.
But Jim did open up bank accounts for both of his LLCs and was good about paying management fees from his rental LLC to his management LLC, as advised by his attorney.
Before we discuss the tax side of this advice, what was wrong with this structure from an asset protection standpoint? We are not attorneys, but since the titles of the rental properties were never transferred from his personal name to the name of JJ Rentals LLC, presumably Jim isn’t receiving the asset protection that he spent money and a lot of time trying to get.
Now, putting on our CPA hat, what was wrong with this advice from a tax perspective?
Do You Need an Entity to Deduct Expenses?
The answer is no. Things like rental expenses, the business use of car, travel, marketing, and BiggerPockets subscription fees can all be written off against rental income with or without a legal entity.
So, the management LLC in Jim’s situation did not allow for “additional deductions” or for him to “save more on taxes.”
Paying management fees to yourself could result in HIGHER taxes!
How Paying Management Fees Could Result in Higher Taxes
Paying management fees to your own entity may be a costly mistake! The reason is because management fees are the type of income that is subject to self-employment taxes, while rental income is not.
Self-employment taxes are the same thing as the Social Security and Medicare taxes you pay as someone else’s employee. The difference being is that when you work for yourself (i.e., in the capacity as a property manager), you get to pay both the employee portion of these taxes, as well as the employer portion. So, this can add up to an additional 15.3 percent in taxes on the management fees received.
Again, rental income is not subject to self-employment taxes. So, for example, by having your rental properties pay $10,000 of “management fees” to your management LLC, you have in essence shifted $10,000 from one bucket to another bucket. The issue is that the income now resides in the bucket that is subject to the extra 15.3 percent self-employment taxes.
So, in this example, you’ve created $1,530 of additional taxes out of thin air! Probably not what you were trying to accomplish.
It is not uncommon for investors to manage their own properties. The good news is that the IRS does not require you to pay yourself a property management fee. So, for those of you who manage your own rentals, you can avoid the self-employment tax simply by not paying yourself a property management fee.
Are You Subject to the Passive Activity Loss Limitations?
If you are subject to the Passive Activity Loss (PAL) rules and limitations, then you may be hurting yourself even more.
Generally, someone is subject to the Passive Activity Loss rules for their rentals if they do not qualify as a Real Estate Professional for tax purposes and if their rental properties combine to generate a net loss for tax purposes.
If you have a net loss from your rental properties, you are not a real estate professional, and your adjusted gross income on your tax return is greater than $100,000, your ability to deduct the entire current year net loss from your rentals on your tax return may be limited.
If you find yourself in that situation, paying yourself a management fee from your rentals would just create more deductions from your rentals—i.e., a larger net passive activity loss. So, if you couldn’t deduct your entire PAL before the $10K, you’ve essentially just created a bigger loss that also can’t be used in the current year.
This extra loss can be carried forward to a future year, so it’s possible that you’ll be able to deduct it in a future year. But what about this year?
Take a second to think about what you would have done. You would have created a deduction that you can’t use in the current year. You would have also created income on the other side that is subject to both income tax and self-employment taxes this year. So, income goes up on one side, but deductions don’t go up on the other side!
Does It Ever Make Sense to Pay Yourself a Management Fee?
Of course. There are always exceptions to general rules. There are two situations that come to mind when it may make sense to do this. But as always, you should consult with your own tax advisor before running out and creating new entities.
The first situation that comes to mind has to do with retirement accounts. If someone is interested in starting their own Solo(K) or SEP-IRA to contribute additional money to retirement, then that person would need self-employment income to do so. And as we discussed, receiving management fees for services rendered would be self-employment income.
There are a couple of caveats here:
- The income you receive needs to be enough to create cost/benefit analysis when comparing the income tax savings from the retirement plan contribution vs. the additional self-employment taxes you would pay.
- There needs to be non-tax business purposes for paying yourself these management fees.
So, assuming you can get past both of those hurdles, then it could possibly make sense in your situation to do this.
The second situation that comes to mind is if you are planning to be a property manager for other people’s properties. If you are going to do this, you are obviously going to get paid property management fees for doing so.
So, if you generate enough income from serving as a property manager for other people, and you are going to contribute to your own Solo(K) or SEP-IRA, then we generally only recommend paying yourself additional management fees if it will help you contribute more to retirement and if the cost/benefit that we mentioned in the previous paragraph adds up.
Often times, tax and legal strategies work in unison and other times adjustments may be needed. If your attorney wishes to have a management company for asset protection purposes, consider whether it would be appropriate to do so without the need to shift a larger amount of management fee income into that entity.
Some of our clients’ attorneys are of the opinion that you do not need to “pay” management fees to your own management company. If that is the case, then that helps to solve the tax problem.
Other attorneys definitely want you to pay a management fee to your own entity to create a more valid transaction. In those circumstances, work with your legal and tax advisors to see what the least amount of management fees can be shifted that makes sense. By shifting lower management fees and increasing expenses of the management company, that may help to eliminate or reduce the tax burden of the structure.
Also, look at the cost/benefit of creating and funding your own retirement account to see if that can help with the additional tax burden from this structure.
Asset protection and tax savings are an extremely important part of any investor’s overall plan. Make sure to bridge the gap by working with your advisory team so you can achieve the best possible scenario for your unique situation.
Look for more tax advice from Amanda Han, CPA, in her latest title The Book on Advanced Tax Strategies: Cracking the Code for Savvy Real Estate Investors, available for pre-order February 5.
Let’s talk below!