Rental Property Investor · Cleveland, OH · Member since 2015 · 1k+ posts · 880 votes
I have searched for a while before posing this question, but couldn't find exactly what I was looking for.
I recently put my latest flipping project under contract and have been going back and forth on whether to keep and perform the flip under my current LLC (which has all my rentals) or start a new LLC for flipping. I'd like to hear the pro's and con's from the experienced BP nation on why I should or shouldn't do this. Our business plan is to ramp up the flipping for 2016 to do about 6 next year.
A few things that I have thought about already:
Pros:
Asset protection for my rentals during renovations and immediately after sale of flip.
Separation of rental operations and flipping operations where LLC could get labeled a dealer and put future sales of long-term holds at risk for higher taxes
Cons:
Multiple paperwork, maintenance fees, bank accounts, tax returns, accounting records for having multiple LLC's
I'm interested in the thoughts behind doing one way versus the other.
@Matt Motil from a tax perspective, it makes the most sense to separate the businesses. If you have a great year flipping houses, you'll likely want that entity taxed as an S-Corp. If rentals get tied up in that S-Corp, you'll have tax problems - mainly the fact that you can't get the rentals out of the S-Corp without creating a taxable transaction, even if you want to move the property back into your own name.
On top of that, if classified as a dealer, you may subject your rental portfolio to the dealer status if they are also under the same entity. Now, "intent" is evaluated at the property level, but there have been instances where "flipping intent" bleeds over to rentals under the same entity. The burden will then be on you to prove that the rentals are maintained with "investment intent" - not fun.
From a business perspective, it often doesn't make sense to co-mingle different "departments." Each department will use a different set of accounting procedures and analytics. It's easier to keep them separate.
@Matthew Kreitzer can speak in depth on the legalities, but in my non-legal opinion, why subject one business's liabilities to another? Flipping is inherently more risky than landlording. I wouldn't want my rental portfolio to be subject to legal liability caused by my flipping activities.
@Matt Motil from a tax perspective, it makes the most sense to separate the businesses. If you have a great year flipping houses, you'll likely want that entity taxed as an S-Corp. If rentals get tied up in that S-Corp, you'll have tax problems - mainly the fact that you can't get the rentals out of the S-Corp without creating a taxable transaction, even if you want to move the property back into your own name.
On top of that, if classified as a dealer, you may subject your rental portfolio to the dealer status if they are also under the same entity. Now, "intent" is evaluated at the property level, but there have been instances where "flipping intent" bleeds over to rentals under the same entity. The burden will then be on you to prove that the rentals are maintained with "investment intent" - not fun.
From a business perspective, it often doesn't make sense to co-mingle different "departments." Each department will use a different set of accounting procedures and analytics. It's easier to keep them separate.
@Matthew Kreitzer can speak in depth on the legalities, but in my non-legal opinion, why subject one business's liabilities to another? Flipping is inherently more risky than landlording. I wouldn't want my rental portfolio to be subject to legal liability caused by my flipping activities.
@Brandon Hall, OK, I knew you were going to go that route since we'd already talked a bit. Next question then...
Does it make sense to have them be completely separate entities or have one own the other? or does it not matter from a tax standpoint? The only thing I really question is taking funds from one entity to fund the operations of the other.
Although I defer to Mr. Hall on the tax issue, there are some concerns I would have if you were to operate them as subsidiary LLCs. Normally I tell people to go talk with a local attorney, and I will tell you to do the same, but I want to highlight in this particular instance why I am recommending this.
I'm sure you're aware of the basic concepts of "piercing the corporate veil". You've heard the words before from other investors, and I am sure you have a familiarity with the idea that even if you are incorporated, people may be able to reach your assets.
According to preliminary research, Ohio's Supreme Court passed a landmark decision just this year on "piercing the corporate veil". As such, there is much debate and many law reviews talking about the legal quagmire that leaves us in.
If your chief concern is protecting your assets and not maximizing your tax estate, you should seriously consider bringing up your ideas with a local attorney. It gets much easier to make accounting or paperwork mistakes with a wholly owned subsidiary. They are more likely to get overturned and pierced in a court of law generally speaking.
There may be other vehicles available to you for asset protection as opposed to traditional LLCs. There may even be strange, statutory trusts or LLC structures available to you in your state.
@Brandon Hall I, with the help of my CPA, have been taking advantage of the long term and short term capital gains on my flips for many years. They are in a sole member llc. Why would you recommend an s-corp. I understand there are some trades between the 2 entity types, but from a tax saving advantage the llc is the winner. Right? I would like to add, that I am not interested in collecting on social security. Am I missing something? Thanks.
@Steve Vaughan Yes. My mistake. I am aware you can elect to be taxed as a S-corp. I still have the same question. I guess my concern is that my CPA is sending me in the wrong direction. I had asked about dealer status being forced on individuals, and he said that it is highly unlikely given the volume of around 20 flips a year.
Sure. I figured as much @Account Closed. I'm not an accountant, but an s-corp tax election helps reduce or remove self-employment taxes as far as I know. My s-corp is for mgt only and owns nothing. I have it for anonymity and the SE benefits.
Great question. I'll preface this by saying that that flips are generally going to be considered inventory and therefore not subject to capital gains, short or long term, so if you flip a property and hold it greater than 12 months, it's still subject to your ordinary income rates and SE tax unless it's a one-off flip.
An LLC offers no tax advantage or disadvantage . You're tax position will not be better off if operating under an LLC.
An LLC taxed as an S-Corp allows you to reduce your SE tax liability. SE stands for Self-Employement and is made up of SS and Medicare taxes, both the employee and employer side.
You say you don't plan on collecting SS in retirement and going based on that, I'd strongly strongly encourage you to review prior tax returns to first determine if your flipping activity was reported correctly (should be on Schedule C) and if so, how much you are paying in SE tax. Because without the S-Corp election, you pay SE tax on 92.35% of your earnings. So you are paying into a system (SS) that you stated you don't want to utilize. Conflicting interests.
On top of that, if you review and choose to go the S-Corp route, open a new entity to do so. Never place rentals into a corporation. It creates massive headaches and tax issues.
Perhaps you should link up with a real estate CPA just for a second opinion.
**edit- just saw you are doing 20 flips a year. I highly, highly recommend that second opinion. Many investors have been tagged dealer for less.
@Brandon Hall Thanks. Well up till the last 6 months I was working a 9-5 job, and had been prior to investing. Would you think the capital gains approach is safe for an investor who is working a full time job, on top of investing?
@Brandon Hall Thanks. Well up till the last 6 months I was working a 9-5 job, and had been prior to investing. Would you think the capital gains approach is safe for an investor who is working a full time job, on top of investing?
Yes, absolutely. But with the volume you are pushing, I'd say you're reporting quite aggressively. Now that you are doing this full-time (I'm assuming) there's very little basis to substantiate passive activity.
Generally speaking, chances of audit are low. But if you get audited, I'm not so sure I'd feel comfortable defending that position. Now, I don't have all the facts and it does require a holistic look. But if you lose the audit, they will reclassify all those passive gains to active income and now you are paying back taxes, penalties, and interest.
@Brandon Hall Thanks. Well up till the last 6 months I was working a 9-5 job, and had been prior to investing. Would you think the capital gains approach is safe for an investor who is working a full time job, on top of investing?
Yes, absolutely. But with the volume you are pushing, I'd say you're reporting quite aggressively. Now that you are doing this full-time (I'm assuming) there's very little basis to substantiate passive activity.
Generally speaking, chances of audit are low. But if you get audited, I'm not so sure I'd feel comfortable defending that position. Now, I don't have all the facts and it does require a holistic look. But if you lose the audit, they will reclassify all those passive gains to active income and now you are paying back taxes, penalties, and interest.
@Brandon Hall Well that stinks. Thanks for your help tonight. I will def raise these issues with my cpa.
That is more on the side of fire your cpa. Not to mention the tax benefits you could have been taking advantage of before this utilizing an entity such as an S-corp.
@Steven Hamilton II Hey Steve. Well up to May of this year I was working full time for an employer so I was treating all home sales as either short or long term gains. I guess now that I am a full time investor I should treat at least some of this income as normal income, and the remainder as a dividend via a s-corp tax approach.
What are your thoughts? Do you think its unacceptable to invest full time and still report income as short/long term gains.
@Account Closed and I are implying is that your CPA has given you really bad advice. If you work a full-time job and flip one or two homes, we may have a case for capital gains over ordinary income. But you've been flipping 20 homes per year. Treating those profits as capital gains is inexcusable and your CPA may have set you up with a fat penalty if you are ever audited.
I don't say this with intent to scare you, but rather spur action to speak to new CPAs and potentially form a new relationship. We have 20 days left in the year so now it's crunch time to make last minute adjustments which I'm confident you will benefit from.
@Brandon HallThanks Brandon. I just want to add, I did not mean any disrespect in asking John as well. I appreciate and value your advise:)
I just talked with my CPA and he said there is no requirement to treat the income as ordinary unless I got into development. I only mention it in passing and not as an argument. I just moved to a new area and will seek new financial help.
Great artical. So let's say I made 100k on 4 flips. How much could I pass as dividends in an scorp tax approach. Why do stock investors not have this issue?
Great artical. So let's say I made 100k on 4 flips. How much could I pass as dividends in an scorp tax approach. Why do stock investors not have this issue?
You would pay yourself a reasonable salary based upon the amount of work you put into the business. You may also want to pay higher to fund a 401k plus matching contributions up to 53k(58k if over 50) for the year.
The rest is taxable to you even if you don't take it out of the business. So if you paid yourself 35k as a salary because you only did administrative work and someone else found the deals etc, you could distribute the remaining funds to yourself not subject to Social Security and Medicare. You can even pay a spouse or child to fund a retirement account etc.
Stock investors are not active in those specific businesses. You are putting in sweat equity essentially and the task involves more than just picking and looking up a stock.
Thanks guys. I have done a bunch of reading, inspired by Brandon's article, and can only conclude just about any person who is regularly buying and selling houses and has no other income would be a dealer. I wish things could be easier.
Its not a bad thing though since it sounded like you are a high earner. Take advantage of the ability to help offset a vehicle cost, pay for your phone, home office if applicable, FUND RETIREMENT ACCOUNTS FOR YOU AND YOUR SPOUSE. You could contribute a great deal and avoid taxes on the funds.
In a former life I practiced in US Tax court and handled several cases before the IRS Appeals Division
The dealer vs. investor has been highly litigated area of the law. It's one of those vague rules says something like if the asset is held in the ordinary course of business, and irs to consider the total facts and circumstances of the transaction and amount of time spent in the activity related to your other activities. It's funny if you lose money irs wants you to be an investor so you can only write off 3k a year of your loss, but if you make money they want to classify you as a dealer. I've read court cases where IRS argued that "book keeping and research" was not a business activity but an investor activity when a day trader lost 100k in the stock market. Then IRS argued that "book keeping and research" was a business activity when a taxpayer made over a million flipping pre construction contacts on condos, back in the boom.
That said it would be hard to argue that you are an investors with 20 flips a year, In my opinion you would probably loose the issue in an audit, but since this issue is mirky and you relied on professional tax advice you would not owe any accuracy related or fraud penalties. You would just owe the tax and interest, and you may have a claim against your tax professional E&O liability insurance.