I have a job where I make good income, I'm in the highest bracket with my regular wages. I'm about to start buying some rental properties and am not excited about the prospect of all of my business earnings being taxed at the highest tax bracket (or paying self-employment tax).
Because of this, and the fact that I'm just getting started so most of the income is going to go back out to the business for quite some years, I'm looking at a C corp so that I can retain the earnings in the business and not be fully taxed on rental income.
My question is regarding how C corps are taxed in regards to income. To make things easy, if I buy a 100% financed property (0% equity) and my expenses are $500/month, and my rent is $600 a month, at the end of the year I have $1200 in income. If I roll this $1200 into an equity payment on the loan for the same property, do I still pay corporate taxes on it? What if I roll it into a down payment on new property, is it still taxed?
What if I build a property and have instant equity. Do I pay taxes on that equity gain or only after I sell it? I guess I'm trying to find out how much I can keep reinvesting in the business without paying corporate taxes and what's considered "income." Ideally I would not distribute any dividends or salary for several years as I would want to continue growing the business and won't really need the money for personal use.
@Bob Sackameno I'm not an accountant, but my understanding is that retained earnings are taxed in a C-corp. Then, shareholders are taxed on whatever income they receive from the C-corp.
Do a quick google search on "C-corp double taxation".
In an S-corp or LLC, the company is not taxed on its income. Taxes are paid by the members or shareholders when they receive income as regular income tax.
You've got a lot of questions in here, so I'll do what I can to answer them.
My question is regarding how C corps are taxed in regards to income. To make things easy, if I buy a 100% financed property (0% equity) and my expenses are $500/month, and my rent is $600 a month, at the end of the year I have $1200 in income.
Your first misconception is this calculation here. Part of your $500/month of expenses is your mortgage payment, part of which is principal and part of which is interest.
Let's say that of your $500/month of expenses, $350 of that is your mortgage payment. Breaking that down further we see that approximately $320 of your payment every month is interest and the other $30 is principal.
Now your income is calculated like this:
$600 - Income
$320 - Mortgage Interest Expense
$150 - Other deductible Expenses (repairs, taxes, insurance, utilities, etc).
$130 is your Operating Income, so your annual income is actually $1560.
But wait, there's more:
Let's say you bought this house for $50,000. You also get to depreciate this asset (for simplicity sake, I am leaving out land value). You get to take $1818 per year as a depreciation expense.
This makes your taxable income -258 (a loss) and so no tax is due.
But let's say you bought the house for only $20,000. Your depreciation is then $727 per year, so you'd have a profit of $833 per year.
The corporation pays tax on the $833/year.
If I roll this $1200 into an equity payment on the loan for the same property, do I still pay corporate taxes on it?
No - As I demonstrated above, pay down of the principal of a loan is not an expense. It is simply a reduction of a liability and there is no tax effect of paying down the loan.
What if I roll it into a down payment on new property, is it still taxed?
No. Buying a new property is the purchase of an asset, which is not immediately deductible. Instead, you take an annual depreciation expense on the purchase price.
What if I build a property and have instant equity. Do I pay taxes on that equity gain or only after I sell it?
No tax due if you have instant equity. Taxes are due when the gain is realized.
I guess I'm trying to find out how much I can keep reinvesting in the business without paying corporate taxes and what's considered "income." Ideally I would not distribute any dividends or salary for several years as I would want to continue growing the business and won't really need the money for personal use.
Further investing does nothing for your tax burden. The key is to structure the rental so that the depreciation eats up your taxable income.
As long as you don't personally pull any money from the corporation, this will have no tax issues for you, although your corporation may pay taxes once the mortgage interest reduces over the last half of the loan period.
However, in any year where you do pull money from the corporation, the corporation will pay taxes on its income, then any amount you pull will be taxed to you as Dividend Income (the famous Double Taxation of Corporations you hear so much about).
I would also heavily caution you against holding property in a C-Corp. There are very few instances where this is an ideal tax situation and you should research very carefully the consequences of selling real property within a C-Corp as it loses it's Capital Gain status and gets taxes at much higher regular income rates within a C-Corp.
A C-Corp is also more heavily regulated than other forms of ownership - you are required to have a full roster of corporate officers (usually) as well as have a formal board and a formal board meeting each year.
It's not a casual decision and you should consider the tax and legal ramifications very carefully before moving forward.
@Linda Weygant wow thank you so much that was extremely informative. I'm trying to figure out why I've heard people say C corps are bad for holding property. My rationale is that I am at the highest tax bracket, any income I receive will be taxed at 35%.
If I hold in an LLC or S-corp, 100% of my income is taxed at 35% (plus employment tax). I don't need the cashflow now, so I feel like this is wasted.
If I hold it in a C-corp, I would presumably not take any distributions for some time (rolling cash into new investments). Therefore, my thought is that I would only pay tax on income at 15%? I've also heard that you can create an LLC for your labor services and deduct it from the C corp as a business expense, thus reducing the double taxation on salary if I needed it.
I don't have an issue with the administration I've managed nonprofits before so don't have an issue with the corporate bureaucracy if it will save me significantly in taxes.
Thank you for your time.
You're part way there.
The first $50,000 of corporate income is taxed at 15%, from there it graduates (much like the personal tax brackets) to 25%, 34%, 35%, 38% & 39%.
So yes, your corporate taxes will be lower than your personal taxes and if you aren't going to be pulling any funds, then you'll be ok.
The issue is that when you go to sell the property, if you leave it in your personal name or an LLC, your long term capital gains will be taxed at 0%, 15% or 20% (depending on your total income that year). Those are the only brackets (as of now - Congress can always change their minds).
Those capital gains brackets are lost in a C Corp because there is no differentiation between Capital Income and Ordinary Income, so if you profit $100,000 when you sell the property, you'll be paying somewhere between 34 and 39% in ordinary income on that whereas if you held it in a pass thru, you'd pay, at a maximum, 20%.
So it depends on your strategy.
Putting it in a C-Corp nets you lower taxes now but possibly much higher taxes later whereas holding in your personal name or an LLC gets you higher taxes now, but lower taxes later. If you're buying in a high appreciation market or you intend to hold for a very long time, this may not be viable.
So it really just depends on what your goals are, when you think you'd be selling, what your other income is at the time you sell and whether or not you think you want to 1031 your gains later or just cash out at some point.
Charlie MacPherson, thank you for posting this question. While not all your questions were relevant to me now, however at some point down the road it will be very relevant.
Linda Weygant, your advise/expertise is greatly appreciated. I am in the process of considering creating a new LLC to do business with quite a few 1099 business associate who will function as fellow Real Estate Investors. I will be submitting payment to each associate (All associates are paid as 1099) based on an agreed percentage of all ROI.
I will be pulling funds out of the LLC to pay myself, so I was wondering if you see this as an sound approach to minimize taxes and protect myself legally?