Avoiding self-employment taxes on LLC rental income

Mike Percy · 2017-05-31T03:59:32-07:00

Hello Bigger Pockets community,I am looking into the possibility of investing out-of-state in a buy-and-hold rental property for passive rental income. I am considering a structure of holding the title in a land trust with a single-owner LLC as the beneficiary (see Clint Coons on YouTube for the various benefits of this structure, i.e. here and here). Because it's out-of-state, the LLC would need to hire a property manager to take care of leasing, collecting rents, daily issues, etc.Because I am outsourcing the property management aspect, would this still be considered active income and therefore subject to self-employment taxes or is it possible to classify the income as passive and therefore not subject to those taxes? Would rehabbing the property before renting it out affect active / passive? What if the LLC paid a contractor to do that as well?Unfortunately, I've read that it may not be possible to avoid this tax if the income flows through an LLC to a member of the LLC (see Forbes). Self-employment taxes are around 15% which has a big effect on cash flow so I'd like to avoid paying them while retaining the liability protections of an LLC if possible.When trying to research this specific question, I found a couple of really hand-wavy forum posts from people who mentioned setting up multiple entities (LLC for the property and a C- or S-Corp for the property management) to minimize self-employment taxes on rental income. After many attempts to search on this site and on Google I haven't been able to find a definitive answer on how exactly that works, whether it's necessary, and whether it could also be done with a single LLC in the way I'm describing (outsourcing).I know I will probably need to double-check with an estate attorney and a CPA / EA but I'd love to get some early insights from you knowledgeable folks before I go barking up the wrong tree.Thanks in advance for any advice or links to definitive information on this topic. And good luck with your investments.Mike

Mike Percy

OP

San Jose, CA · Member since 2017 · 30 posts · 10 votes

9y

To add a little fuel to the fire, I also found a recent article by Steve Gorin referencing some recent Tax Court decisions ruling that passive members of an LLC do not owe self-employment tax. I've pasted the interesting portion of the article below.

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The Hardy decision

However, Hardy v. Commissioner, Tax Court Memorandum 2017-16, had a surprising result. Together with seven other equal owners, the taxpayer owned an LLC that operated a surgery center. Each member was also a manager; together they controlled the LLC. They delegated daily operations to an employee, who professionally ran the surgery center. In determining whether the taxpayer's income from the LLC was "passive," the judge focused on actual daily management of the business rather than the taxpayer's legal rights to manage the LLC together with the other equal owners. Based on this focus, the judge treated the taxpayer as a limited partner eligible for the exclusion from SE tax.

This approach appears to contradict the approaches taken in two other Tax Court cases, Renkemeyer, Campbell and Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), and Methvin v. Commissioner, T.C. Memo. 2015-81. As a "regular" Tax Court case, Renkemeyer has stronger precedential value than Hardy or Methvin. Also, in CCA 201436049 (not precedent but a good indication of where the IRS stands), the IRS refused to apply the limited partner exception to an LLC's active owner but implicitly accepted its application to an inactive owner.

Given the state of the law, those who wish to have certainty in avoiding SE tax should consider conducting business through a limited partnership, either directly or through an LLC owned by the limited partnership. However, many tax advisors will suggest taking a risk and directly using an LLC. Whether those who heed that advice will attain the result they seek remains to be seen.

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Linda WeygantPro Member

Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes

9y

Buy and hold properties are considered passive income and are not subject to Self Employment tax regardless of whether you have a property manager in place.

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7 Reply

Alex Deacon

Investor · Pittsburgh, PA · Member since 2015 · 1k+ posts · 1k+ votes

9y

@Mike Percy Mike just to be safe I would speak with 3 highly respected CPAs near you. Get their opinion on the subject. You should hire a very good CPA, Attorney, Agent etc.. Be careful when dealing with the IRS. keep it on the straight and narrow trust me. I do and I still got audited. Fortunate for me my CPA is great and keeps my books in order and me on track and in compliance.

A good team is essential to your success,

1 Reply

Patrick LiskaPro Member

Investor · Verona, NJ · Member since 2014 · 1k+ posts · 832 votes

9y

You just heard from @Linda Weygant , A CPA, I have my properties all under different llc's and all my taxes go through my CPA, i have never paid self employment tax, because it is considered a Passive income as Linda said. my Construction business is different, that i pay self employment tax because i am actively involved in it, my PM takes care of my properties and i just oversee them. look at Publication 527

Schedule C (Form 1040), Profit or Loss From Business

Generally, Schedule C is used when you pro-vide substantial services in conjunction with the property or the rental is part of a trade or busi-ness as a real estate dealer.Providing substantial services. If you pro-vide substantial services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C (Form 1040), Profit or Loss From Business, or Schedule C-EZ (Form 1040), Net Profit From Business. Use Form 1065, U.S. Re-turn of Partnership Income, if your rental activity is a partnership (including a partnership with your spouse unless it is a qualified joint ven-ture). Substantial services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For information, see Pub. 334, Tax Guide for Small Business. Also, you may have to pay self-employment tax on your rental income using Schedule SE (Form 1040), Self-Employment Tax. For a discussion of “substantial services,” see Real Estate Rents in Pub. 334, chapter 5.

Passive Activity Limits

In most cases, all rental real estate activities (except those of certain real estate professio-nals, discussed later) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services. For a discussion of activities that are not considered rental activities, see Rental Activities in Pub. 925.

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Mike Percy

OP

San Jose, CA · Member since 2017 · 30 posts · 10 votes

9y

@Linda Weygant Thanks very much for that info! It's great to hear from a knowledgeable CPA such as yourself. I finally was able to find IRS Topic 425 that confirms that rental income is passive even if you personally manage the property:

One thing I am still unclear on is according to IRS Publication 3402 under the section LLCs Classified as Disregarded Entities there is a section on self-employment (SE) tax that states:

Since Topic 425 (passive activities) seems to be at odds with Publication 3402 (LLC member taxation), is there some published guidance on what to do when the two are combined? Based on the Forbes article I linked above that discusses IRS CCA 201436049 it sounds like in certain cases LLC members will be treated as general partners under the tax code (thereby owing SE tax) and in other cases LLC members will be treated as limited partners under the tax code (no SE tax).

@Alex Deacon Thanks for the warning and I totally agree. I will certainly build a good team however at this stage in the game it's all in Excel so I really just want to make sure my numbers are realistic.

@Patrick Liska Thanks very much for the reference to IRS Publication 527. That definitely helps in understanding the definitions of active vs. passive activities. But I am not sure whether it fully resolves the question about taxation of distributions from a partnership.

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Patrick LiskaPro Member

Investor · Verona, NJ · Member since 2014 · 1k+ posts · 832 votes

9y

Mike,

If its a limited partnership then you are taxed on the self level, personal taxes, not as a corporation, there for any money made from the rentals are passive income for you. the money passes through the partnership to you. as long you aren't doing all the work and have a PM in place then the income you make should be considered passive income.

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Mike Percy

OP

San Jose, CA · Member since 2017 · 30 posts · 10 votes

9y

@Patrick Liska This seems to be something of a grey area but I think you are right about that in terms of being extra careful with the IRS. Thanks for your thoughts!

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Linda WeygantPro Member

Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes

9y

Rentals are one of a million different businesses that can be run through the structure of an LLC. In general, when products or services are being provided through an LLC, the profits are going to be subject to Self Employment taxes. That applies to everything from a real estate agent to a sandwich shop to a dog groomer.

Rentals are special. You can run them through an LLC, but the Self Employment aspect won't apply due to their passive nature. (Same goes for making loans out of an LLC or holding tax liens or other paper - it's all passive). Pub 3402 is going to apply to 99% of LLCs. Topic 425 is specific to passive activities and will trump much of the generic information that is in Pub 3402.

As far as how to figure out which information takes precedence when you come across conflicting information - it's tough to hand out a flowchart on. I went to school for 4 years and have 20 years in the industry to understand these types of nuances. It's a bit like asking "how do I know how to program a computer" or "how do I perform an operation on a human being" or "how do I build a rocket ship".

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5 Reply

Caleb Heimsoth

Rental Property Investor · Durham, NC · Member since 2016 · 7k+ posts · 7k+ votes

9y

I'd talk to a CPA. I did that today and It was very beneficial, not to mention with all the tax breaks you receive from Real estate, it's unlikely you'll be taxed, when starting at least. For example, I'm likely going to show a loss from real estate on my tax returns even though I'll technically be making money

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Mike Percy

OP

San Jose, CA · Member since 2017 · 30 posts · 10 votes

9y

@Linda WeygantThank you for the clear explanation! Your analogy is great; I was hoping the IRS had something on this particular issue for the layman but of course they can't do that for every possible situation. We're lucky to have pros like you helping out on this forum!

@Caleb Heimsoth I totally agree with you!

Thanks again.

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Jocelyn Canfield

Easton, PA · Member since 2013 · 42 posts · 14 votes

8y

Originally posted by @Linda Weygant:

Rentals are one of a million different businesses that can be run through the structure of an LLC. In general, when products or services are being provided through an LLC, the profits are going to be subject to Self Employment taxes. That applies to everything from a real estate agent to a sandwich shop to a dog groomer.

Rentals are special. You can run them through an LLC, but the Self Employment aspect won't apply due to their passive nature. (Same goes for making loans out of an LLC or holding tax liens or other paper - it's all passive). Pub 3402 is going to apply to 99% of LLCs. Topic 425 is specific to passive activities and will trump much of the generic information that is in Pub 3402.

As far as how to figure out which information takes precedence when you come across conflicting information - it's tough to hand out a flowchart on. I went to school for 4 years and have 20 years in the industry to understand these types of nuances. It's a bit like asking "how do I know how to program a computer" or "how do I perform an operation on a human being" or "how do I build a rocket ship".

Linda, I currently own 8 rental units and have a full time self employed business doing something else. I am getting my real estate license so that I can show myself properties of interest for investment and also for disposition of my primary residence this year. I was also considering an LLC structure for the rentals for greater protection and to ensure I am eligible for the 20% income deduction from the Trump tax plan. My accountant feels I am potentially exposing myself to self-employment tax assessments on rental income as well as ineligibility for preferential long-term capital gains tax treatment on dispositions. Thoughts?

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Linda WeygantPro Member

Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes

8y

@Jocelyn Canfield

1. You'll want to keep your passive income (rentals) in a separate LLC from your other active income (agency + something else business).

2. Simply pushing rentals into an LLC has no bearing on SE tax, nor on capital gains. I'm a little concerned that your current accountant may not be the right accountant for you if that was their first comment to you as it shows kind of a big lack of understanding as to how LLCs work in association with rentals.

3. If you said that you were thinking of combining your rentals into your regular active business, then your accountant is definitely barking up the right tree with concern about messing up the passive nature of your rentals. Owning rental properties in an S or C Corp is generally not a good idea except under a very specific set of somewhat rare circumstances.

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Michael PlaksPro Member

Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes

8y

@Jocelyn Canfield

I second what @Linda Weygant said, adding one more comment.

LLC also does not have any effect on your eligibility for the new 20% deduction. Besides, this deduction is calculated off of the NET income: rent minus all expenses minus depreciation. For most properties with mortgages, this number is negative, so the 20% deduction is a non-issue.

1 Reply

Jocelyn Canfield

Easton, PA · Member since 2013 · 42 posts · 14 votes

8y

Originally posted by @Michael Plaks:

@Jocelyn Canfield

I second what @Linda Weygant said, adding one more comment.

LLC also does not have any effect on your eligibility for the new 20% deduction. Besides, this deduction is calculated off of the NET income: rent minus all expenses minus depreciation. For most properties with mortgages, this number is negative, so the 20% deduction is a non-issue.

thanks to both of you. I would never combine my primary business with the rentals. I only have one mortgage on the rentals and the rest free and clear so I do have net income and he does not seem convinced that I am eligible for the 20% because the rentals are investment and not an entity. I said that a sole prop is pass through. he is waiting guidance on this since it isn't relevant this tax year. I have been considering LLC for rentals but see so many mixed opinions it is hard to decide. as to real estate agent, that would be 1099 income but unsure if I need an entity as I would be being paid by brokerage. I guess that would just go on separate schedule C.

I am wondering same about new accountant more versed in rental props. but I have been with him close to to years

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Jocelyn Canfield

Easton, PA · Member since 2013 · 42 posts · 14 votes

8y

Originally posted by @Linda Weygant:

@Jocelyn Canfield

1. You'll want to keep your passive income (rentals) in a separate LLC from your other active income (agency + something else business).

2. Simply pushing rentals into an LLC has no bearing on SE tax, nor on capital gains. I'm a little concerned that your current accountant may not be the right accountant for you if that was their first comment to you as it shows kind of a big lack of understanding as to how LLCs work in association with rentals.

3. If you said that you were thinking of combining your rentals into your regular active business, then your accountant is definitely barking up the right tree with concern about messing up the passive nature of your rentals. Owning rental properties in an S or C Corp is generally not a good idea except under a very specific set of somewhat rare circumstances.

Linda he was suggesting that I need to be a formal entity to get the 20% and when I was talking about real estate LLC I think he was suggesting that being a licensed agent could jeopardize the passive nature of the investing. is there risk of that?

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Michael PlaksPro Member

Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes

8y

@Jocelyn Canfield

Don't mix the two issues:

1. LLC. LLC or no LLC - there is no difference under the new law. You neither gain nor lose anything. You may have good reasons to create an LLC for your rentals (legal protection) - but taxes is not one of them. It is true for your Realtor income, and it is also true for your rental business.

(For full disclosure: there're some rare scenarios where creating an LLC could make a difference on taxes. Not in your straightforward case though.)

2. Eligibility of rentals for the 20% deduction. I agree with your accountant on this one: nobody knows for sure at this point. The new law is NOT clear on this provision. We tax professionals have a decent guess of what the Congress meant, and we believe that rentals where you are personally involved will qualify. One day we may be able to say it with certainty, but not today yet.

PS. "I've been with someone for 10 years" is not by itself a compelling reason to stay in a relationship if it's not working - both personal and business relationships.

3 Reply

Linda WeygantPro Member

Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes

8y

Originally posted by @Jocelyn Canfield:

Originally posted by @Linda Weygant:

@Jocelyn Canfield

1. You'll want to keep your passive income (rentals) in a separate LLC from your other active income (agency + something else business).

2. Simply pushing rentals into an LLC has no bearing on SE tax, nor on capital gains. I'm a little concerned that your current accountant may not be the right accountant for you if that was their first comment to you as it shows kind of a big lack of understanding as to how LLCs work in association with rentals.

3. If you said that you were thinking of combining your rentals into your regular active business, then your accountant is definitely barking up the right tree with concern about messing up the passive nature of your rentals. Owning rental properties in an S or C Corp is generally not a good idea except under a very specific set of somewhat rare circumstances.

Linda he was suggesting that I need to be a formal entity to get the 20% and when I was talking about real estate LLC I think he was suggesting that being a licensed agent could jeopardize the passive nature of the investing. is there risk of that?

No, I don't think there's any risk there. He's going down the road of real estate professional which is an election you can make. That election allows you to write off passive losses against active income if/when your income is up over $150,000. But if all of your properties are free and clear, then you're likely making profits, not losses, so the real estate professional designation is not one you would consider electing, even if you qualified for it.

Being a real estate professional does not change the nature of the rental income from passive to active. It simply allows you to deduct the passive losses as I described above.

I agree with Michael Plaks when he states that right now, all tax professionals are guessing about the 20%. However, it is a fairly educated guess based on how the new bill was worded and past experience. Essentially the bill stated "all non C-Corp", which would include pass thru entities such as LLCs and Sole Proprietors and Individual Schedule E filers.

However, the IRS has issued exactly zero guidance on this, so we're all in a Wait and See mode. Even then, we'll have to wait until a couple of cases have made their way through tax court before we truly know how this will end up.

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2 Reply

Adriana Balley

Member since 2020 · 2 posts · 1 vote

6y

Hello Linda,

I got my real estate license back in 2018 since I wanted to sell my house and I wanted to buy another one for my family in another town. In the mean time I had three rental properties over the years. Will holding a real estate license raise an eyebrow at an auditor when it comes to self employment tax. I do receive a 1099 from my broker in a particular year if I sell any property which commison is always less than 10k a year since I do not practice it every single day if a family member buys a property then I get a lead but I do not practice being a real estate agent every day. Will this license make me pay self employment tax on my rental profits. I currently file them under schedule E and I would prefer not to file them on schedule C since then I would have to be 15% on top of all profits. Please advise and by the way you do seem very very knowledgable.... I have been reading your posts and you seem to know all your stuff really well! A+++ to you :)

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Avoiding self-employment taxes on LLC rental income

Avoiding self-employment taxes on LLC rental income

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