Investor · Los Gatos, CA · Member since 2010 · 25 posts · 5 votes
Its LLC entity, will issue K-1 for each partners.
Passive income for passive partners - Should it be categorized as ordinary income just as the active partner, or should be short term capital gain? The project is a flipping project.
Investor · Sarasota, FL · Member since 2008 · 18k+ posts · 17k+ votes
13y
If there are multiple passive investors giving you money that you're pooling to buy investments, you should be careful -- you may be violating SEC regulations, as the investment would likely be classified as a security.
Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
13y
Originally posted by J Scott:
If there are multiple passive investors giving you money that you're pooling to buy investments, you should be careful -- you may be violating SEC regulations, as the investment would likely be classified as a security.
If you enter into an agreement where one or more persons put in their money and the success or failure depends mainly on the active member, then you are most likely in SEC territory. If the project fails or the results are not as promised, the investors can demand their money back and the SEC can prosecute for selling an unregistered security.
Jon Holdman,
The passive investor investing in an LLC is not investing in RE even though the LLC is. This would not be considered ordinary income. In our LLC's the returns to the investors are considered return of capital and is not taxed until initial capital is returned and then it would be taxed as dividend income, at a lower rate.
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
13y
Sorry, Jeff Greenberg, I don't fully agree. Perhaps our resident CPA, Steven Hamilton II will chime in.
Unless different tax treatment is elected for the LLC, its a partnership. The profit and loss is distributed directly to the partner's tax returns.
Now, the LLC could elect to be taxed as an S-corp or C-corp, which could convert the distributions into dividends (or whatever the correct term, I was corrected on this w.r.t. an S-corp in another post recently.)
Selling units in an LLC would indeed be a security. Best to do that with Reg D paperwork and a proper operating agreement and private placement memorandum. The alternative is to structure it as a loan. Some would argue even that is a security. And interest income is subject to ordinary income tax.
I'm quite sure than none of the proceeds from flipping can be converted into capital gains, even short term capital gains.
Richard Z., this seems like something you should be discussing with your LLC's CPA.
Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
13y
Richard Z.
Jon Holdman,
J Scott,
Jeff Greenberg,
Jon, I am an Enrolled Agent licensed by the Department of the Treasury in Tax and to represent all types of taxpayers before all levels of the IRS. As far as taxation goes my credentials hold more weight to the IRS than that of a CPA. I'm working on becoming a CPA.
http://www.irs.gov/Tax-Professionals/Enrolled-Agents/Enrolled-Agent-Information
I represent tax payers before the IRS. Specifically I represent many real estate investors before the IRS.
Passive income from flipping is ordinary income. It WILL NEVER be short term capital gain.
The is the exception of the accidental flip or the it came across and I decided to sell it capital transaction.
If you enter into an arrangement to flip a property it is business income. It is ordinary income bottom line.
Jeff,
You are wrong about the short term gain. It will not be subject to Self employment tax for the limited partner or passive partner; however, it will be subject to tax at the ordinary rate just as short term capital gains are; however, it WILL NOT be offset by any prior capital loss carryovers.
It will be on Schedule K-1 Box 1. Ordinary Income.
It will pass It will flow through to the Form 1040 to Line 17.
The LLC will default to be treated as a partnership as there is more than one shareholder UNLESS all parties agree to have the entity taxed as an S-corporation(Form 2553) or a C-corporation(Form 8832) as long as it is timely filed.
S-corporations and Partnerships issue distributions. C-Corporations issue Dividends.
Units in an LLC are in fact a security and selling securities to friends and family members with whom you have a prior relationship with or those who are sophisticated in the invest type.
Investor · Los Gatos, CA · Member since 2010 · 25 posts · 5 votes
13y
J Scott,
Jeff Greenberg,
Thanks for the reminder of security regulation thing, but right now my operation mainly w/ friends and family members so it should be fine. As more passive investors pooling I do need be cautious about not crossing the line.
Jon Holdman,
My LLC CPA has been out of country these couple of days, I do want to get a few things clarified before he comes back.
Steven Hamilton II,
Thanks for the clarification!
Regarding the passive income from flipping, this question is raised up by my passive partners from time to time, so I really would like to get it clarified. In Fact, the CPA I work with did had put it into right category – Ordinary income per previous K-1 for passive partners.
As for the LLC partnership, I do keep it only to friends and family members I have prior relationship with or those who are "sophisticated investor". The LLC units are not allowed to be sold, transferred or assigned etc. per the operating agreement.
I do have one more question regarding the security thing, since the LLC is formed with all the partners at the very beginning, does that constitutes any sale of security?
Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes
13y
Yes. This is how this typically happens. All that documentation - the operating agreement and private placement memorandum and any necessary filings protect you. The "general partner" in old partnership terminology. If things go sideways, that paperwork helps protect you if the limited partners file suit.
These private placements are ALWAYS limited to people you already know and have an existing social relationship with, whether accredited (a SEC term with specific meanings) or sophisticated (a less specific set of criteria, which all of your investors should meet if they're not accredited). Any sort of public offering (shares or units sold to strangers) is a much bigger deal. So, the fact these investors were your friends doesn't eliminate the need for the proper paperwork.
Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
13y
Sale of shares or units in an LLC as previously described is considered sale of a security. You can sell your security without a license, but don't sell someone else's security. Your investors can sell their shares after a one year hold, but within the PPM it states that there may not be a market.
You do need to have a significant pre-existing relationship with the investors before you discuss an investment opportunity. Even with friends and relatives you need to know that they are suitable for the investment being offered. Using Uncle Bob's 100,000 life savings on a high risk investment would not be viewed favorable by the SEC if the deal goes bad.