Can hard money lending be considered a small business, where expenses can be deducted -- just like any other business? I thought this was a given until I started reading about "passive income" and "material participation" I have been keeping track of my expenses (such as traveling to inspect properties, ensuring work is done, education, wiring fees, Title Company visits, paying my minor daughter to do some research for me, etc.). But now I wondering whether I can actually treat this hard money lending activity as a small business. I would like to benefit from some of the tax saving advantages of having small business (self employed 401k, etc.) Can it still be done? What are the limitations or gotchas?
My Scenario: This year, I have made 2 loans. the first with some cash in a savings account, $35k, in June (12% interest paid monthly), the second in August for $65k @14%, interest and loan payable in Feb 2012. This was cash pulled out from a home refinance. Total I have presently invested is $100k for 2011. If things continue to go well, I hope to put another $100k to use in 2012. Just want to make sure I do it right. Presently, I am a sole proprietor.
I would really appreciate any direction from anyone who has been in the same situation -- or knows someone who has. If this topic has already been discussed, please point me there!
Thanks, guys. Love the BP forum, but have been a lurker until now. When I got conflicting replies from 2 CPAs, I decided to register on BP and ask the question here. I know I won't be disappointed.
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
14y
Fern,
I am the accountant. I represent individuals and businesses before the IRS.
Yes, hard money lending may be considered a small business. Usually you could consider the income to just be interest income; however, more often I've had many clients set up an LLC taxed as an S-corp the profits will be ordinary income to the business. This may be done very easily to offer yourself benefits in such a way.
Fern, you may read my posts everywhere on here. I can assist your here and answer any questions you may have regarding the business. This also has no effect on how you are attaining the money (through your equity line or through work).
Flipper/Rehabber · Louisville, KY · Member since 2008 · 1k+ posts · 1k+ votes
14y
Well I am not a CPA or anything close. My first reaction was yes, it can be a small business. However, the fact that you got conflicting advice and the way you described the source of funding, I am not sure at all. I would assume there are more details to exactly what you are doing but it certainly appears you are loaning your personal funds.
Alot of times it comes down to how your business "acts". Are you acting like a business? Business entity, seperating business funds from personal, etc.
I am not so sure you are doing that.
Passive investing issues don't matter if you are acting like a business. If you are operating a business actively, it is active investing...even if the business is money lending which is passive investing on its own.
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
14y
Fern,
I am the accountant. I represent individuals and businesses before the IRS.
Yes, hard money lending may be considered a small business. Usually you could consider the income to just be interest income; however, more often I've had many clients set up an LLC taxed as an S-corp the profits will be ordinary income to the business. This may be done very easily to offer yourself benefits in such a way.
Fern, you may read my posts everywhere on here. I can assist your here and answer any questions you may have regarding the business. This also has no effect on how you are attaining the money (through your equity line or through work).
Accountant · Hyattsville, MD · Member since 2011 · 120 posts · 44 votes
14y
It is a small business. Passive income and Material participation rules only apply to rental properties which is not what you have in this case. Here is the official IRS position: Interest received on notes receivable that you have accepted in the ordinary course of business is business income. Interest received on loans is business income if you are in the business of lending money. Please see http://www.irs.gov/publications/p334/ch05.html
Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes
14y
I agree that it is ordinary income, but every business is subject to material participation rules. Material participation is defined differently but can not be ignored.
A business owner that hires others to do all the work or retires and maintains a salary will be subject to passive activity rules as well because they don't materially participate.
Lender · Tyngsboro, MA · Member since 2009 · 3k+ posts · 2k+ votes
14y
Fern, you didn't ask, but I strongly recommend you check with an attorney who is private lending savvy in your state. This morning I wrote a post about licensing issues for brokers and lenders, you can read it here:
Woodway, TX · Member since 2012 · 1 post · 0 votes
13y
Hi, I have the similar question regarding to whether treat the lending as business or not. My understanding is that if you report the interest income as business income on schedule C, then you can deduct the expenses, how ever the net income is subject to self employment tax which is about 15%. If you just reported as ordinary interest then you just pay ordinary income tax. So it all depends on which way gives you better outcome. Am I right?
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
13y
Ping Liu
That is technically true; however, you may want to consider the possibility or investing through a corporation that way not 100% of the earnings are subject to SE tax.
Vancouver · Member since 2013 · 159 posts · 6 votes
13y
I'm bringing this old thread back to life again!
Could somebody please correct me if I'm wrong! Which there is a good chance I am...
If I lend money, (say $100,000 to make it an easy number), out of a C-Corp and I get 15% interest for the year, I'd make $15,000 before tax.
The $15,000 would then be subject to the C-Corp tax rate of 15% (for any earned income under $50,000) and also Self-Employment tax of roughly 15%.
C-Corp tax rate of 15% = 15,000 x .15 = $2250 paid in tax.
Since I'd like to re-invest all of the money I made, I'd pay myself the minimum salary allowed to hopefully avoid an audit. (I've read varying opinions, roughly 40% of income made).
Does that mean on the $15,000 made, I'd pay Self-Employment tax (roughly 15%) on the $6,000 I took out in salary, (40% of $15,000) which equals about $900.
So the total tax I paid (not including deductions to keep it simple) of the $15,000 I made would be $900 for SE Tax and $2250 for the C-Corp tax rate for a grand total of taxes paid of $3150...?
Also, if this is correct (which it might not be) and I was to make over $50,000 in income from lending, would it be best to open a second C-Corp to lend out of to keep the same tax rates at 15% again?
Lender · Tyngsboro, MA · Member since 2009 · 3k+ posts · 2k+ votes
13y
@Taylor Green, I'm definitely going to leave your question to the tax professional. I wouldn't lend out of a C-Corp in the first place, maybe Steve can better address the whys, whynots, and the above questions.
Real Estate Investor · Northeast TN, TN · Member since 2008 · 516 posts · 361 votes
13y
Not quite right @Taylor Green :) Corporate earnings are NOT subject to "self-employment tax" - corporations are not self-employed. The wages that you take from the corporation would, however, be subject to the usual payroll taxes and withholdings.
So the money I have to take as a salary from the corporation would be then subject to self-employment tax on my personal return? The corporations only tax would be the regular tax rate?
Also, could I leave the rest of the money in the corporation as retained earnings?
I'm bringing this old thread back to life again!
Could somebody please correct me if I'm wrong! Which there is a good chance I am...
If I lend money, (say $100,000 to make it an easy number), out of a C-Corp and I get 15% interest for the year, I'd make $15,000 before tax.
The $15,000 would then be subject to the C-Corp tax rate of 15% (for any earned income under $50,000) and also Self-Employment tax of roughly 15%.
C-Corp tax rate of 15% = 15,000 x .15 = $2250 paid in tax.
Since I'd like to re-invest all of the money I made, I'd pay myself the minimum salary allowed to hopefully avoid an audit. (I've read varying opinions, roughly 40% of income made).
Does that mean on the $15,000 made, I'd pay Self-Employment tax (roughly 15%) on the $6,000 I took out in salary, (40% of $15,000) which equals about $900.
So the total tax I paid (not including deductions to keep it simple) of the $15,000 I made would be $900 for SE Tax and $2250 for the C-Corp tax rate for a grand total of taxes paid of $3150...?
Also, if this is correct (which it might not be) and I was to make over $50,000 in income from lending, would it be best to open a second C-Corp to lend out of to keep the same tax rates at 15% again?
The corporation should be paying you a reasonable salary. The corporation would withhold your half and pay their own SS and Medicare taxes.
The C-corporation would be subject to 15% tax on your $15,000 of income. One issue with a C-corporation is that you do not want it to receive interest income; however, that changes if it is in the "Business of lending money". If it is not in that business a C-corporation has more than 60% passive income it will be treated as a Personal Holding Corporation. (30% tax rate) unless the income is distributed to the shareholders.
There is however, an exception. If the corporation is in the business of lending money. IE Hard money lender etc.
Now, if you are looking at paying a $6,000 salary, you will pay 6.2% Social Security and 1.45% in Medicare. The Corporation would pay the same amounts and Unemployment taxes as well.
IF taxed as a PHC and you did not distribute the income, you would pay an additional: $1,281.15
Totaling: $2,562.3
Personal Return:
Plus $6,000 income as wages on Line 7.
You would receive pay check for $6,000 minus $459 SS and Medicare minus any federal and state taxes withheld.
IF you only have one loan out of it, then it becomes difficult to justify that it is a one and done loan for the year.
"c) Exceptions The term ''personal holding company'' as defined in subsection (a) does not include - (1) a corporation exempt from tax under subchapter F (sec. 501 and following); (2) a bank as defined in section 581, or a domestic building and loan association within the meaning of section 7701(a)(19); (3) a life insurance company; (4) a surety company; (5) a foreign corporation, (6) a lending or finance company if - (A) 60 percent or more of its ordinary gross income (as defined in section 543(b)(1)) is derived directly from the active and regular conduct of a lending or finance business; (B) the personal holding company income for the taxable year (computed without regard to income described in subsection (d)(3) and income derived directly from the active and regular conduct of a lending or finance business, and computed by including as personal holding company income the entire amount of the gross income from rents, royalties, produced film rents, and compensation for use of corporate property by shareholders) is not more than 20 percent of the ordinary gross income; (C) the sum of the deductions which are directly allocable to the active and regular conduct of its lending or finance business equals or exceeds the sum of - (i) 15 percent of so much of the ordinary gross income derived therefrom as does not exceed $500,000, plus (ii) 5 percent of so much of the ordinary gross income derived therefrom as exceeds $500,000; and (D) the loans to a person who is a shareholder in such company during the taxable year by or for whom 10 percent or more in value of its outstanding stock is owned directly or indirectly (including, in the case of an individual, stock owned by members of his family as defined in section 544(a)(2)), outstanding at any time during such year do not exceed $5,000 in principal amount;"
Vancouver · Member since 2013 · 159 posts · 6 votes
13y
@Steven Hamilton II thanks for breaking that down for me. I find it unbelievable you find stuff like that fun!! You made that so much easier for me to understand...
Would there be any reason not to lend out of a C-Corp? I've read a lot of people are doing it out of an S-Corp...
Also, if your lending business makes $75,000 profit. Would you want to form a second C-Corp to keep the tax rate at 15%?
@Steven Hamilton II thanks for breaking that down for me. I find it unbelievable you find stuff like that fun!! You made that so much easier for me to understand...
Would there be any reason not to lend out of a C-Corp? I've read a lot of people are doing it out of an S-Corp...
Also, if your lending business makes $75,000 profit. Would you want to form a second C-Corp to keep the tax rate at 15%?
Other than the PHC issue, there isn't really a problem that I foresee, granted that can depend upon the state lent to.
No, you cannot open another C-corp for the same function. As closely held corporations will run you a great amount of risk. Depending upon your current income level, an S-corp may make more sense. Like I said, it all depends upon your situation.
Then after that point you want to look into alternative structure that is beyond the scope of this post.
Lender · Tyngsboro, MA · Member since 2009 · 3k+ posts · 2k+ votes
12y
@Bill JONES , they might not. But then again, if the borrower claims the interest as a deduction, and the IRS doesn't find a corresponding 1098, they might go looking for it. I have no idea how likely this scenario is, but since intentionally not declaring income is considered tax evasion, I believe, I wouldn't think it's worth the risk of opening that whole can of worms. Since there is no limit to how far back the IRS can go in the case of fraud, that opens up all the tax returns your have ever filed.
Not my idea of a good day. Maybe @Steven Hamilton II can weigh in if I'm wrong
A CPA told me once that one of the first things they ask for in an audit are bank statements. It may not show on your tax return but it will show on the statement.
How would the irs know you even have income on a hard money loan.. can anyone answer this question.. the mortgages are not sent to the irs.. right?
First of all to deliberately not report the income is fraud. Second, the penalties can be severe.
The IRS will see the other person did not receive a 1098. From there the IRS will issue a letter to said person. This person will submit proof of their loan and interest. You then receive a nice lovely audit letter from the Fed looking for unreported income.
New York City, NY · Member since 2016 · 3 posts · 0 votes
9y
@Taylor Green I'm looking at doing something similar as well. Create an LLC and elect to be taxed as a C-Corp. Were you able to do it? Did you have any issues with the Personal Holding Company tax?
It is a small business. Passive income and Material participation rules only apply to rental properties which is not what you have in this case. Here is the official IRS position: Interest received on notes receivable that you have accepted in the ordinary course of business is business income. Interest received on loans is business income if you are in the business of lending money. Please see http://www.irs.gov/publications/p334/ch05.html
Thanks Ebere, although this forum thread is 5 years old, it's still pertinent in 2016 tax filing. I'm in the same situation as Fern. Thanks for sharing information from IRS publication.
I am the accountant. I represent individuals and businesses before the IRS.
Yes, hard money lending may be considered a small business. Usually you could consider the income to just be interest income; however, more often I've had many clients set up an LLC taxed as an S-corp the profits will be ordinary income to the business. This may be done very easily to offer yourself benefits in such a way.
Fern, you may read my posts everywhere on here. I can assist your here and answer any questions you may have regarding the business. This also has no effect on how you are attaining the money (through your equity line or through work).
-Steven the Tax Guy
Your guide to IRS laws, rules, and regulations.
Thanks Steven for your take on tax issue particularly relating to private lending as a business as posted by Fern five years ago. I'm sort of in the same boat as Fern but I will need to set up an LLC and taxed as an S-Corp for 2017 tax return. The borrowers sent me 1099-INT. Question is, can they sent me 1099-MISC instead?
San Diego, CA · Member since 2018 · 5 posts · 0 votes
8y
I have a question. I have not seen anywhere any information on how to handle a loan that goes bad. How is a loan treated that is written off as bad and uncollectable? Can you write off the loss to ordinary income? If the loan was made out of a business llc can it be written off towards ordinary income or does it have to be written off as capital losses and applied only to capital gains? I don't have any capital to write it off to so I'm trying to find out how to write off $165k.