All Forum Posts by: Michael Plaks

@Chris Howard

1. Yes, the income is taxed differently. While it is possible to have all moneys in one company and split it into two buckets for tax preparation - it's much easier to do when they are already naturally separated between two LLCs.

2. Besides simplicity and clean separation, the flipping entity might decide to choose a different form of taxation (S-corporation). You do not want to hold rentals inside an S-corp however.

3. You will be able to bring in a partner for a flip while keeping all rentals to yourself - or the other way around, Or different partners for different projects.

4. The new tax law created a so-called 20% deduction on "qualified business income." Unfortunately, we do not yet have enough clarity on how it will be implemented, but it is quite possible that separating flips and rentals will help you maximize this new deduction.

5. Separation can sometimes simplify borrowing money, depending on the type of funding you're using. 

6. Legal liability should be discussed with an attorney, which I'm not. But generally, the more things are separated, the better for legal protection, as far as I understand.

7. Last but not least. We accountants will be able to charge you for one additional tax return. :)

PS. Agree with @Costin I. that assigning the beneficial interest to yourself eliminates liability protection provided by LLC. But our opinions are pretty much worthless, since we're not attorneys.

Finally, I found a chance to disagree (kind of) with @Brian Schmelzlen :)  Usually I just nod and vote for his answer.

@Isaiah Williams and @Reid Hanley - my advice is to never decide on either kind of corporation, C or S, until your business is established. You don't know what will be best for your business until you see what kinds of deals you're working and what kind of numbers you're generating. Jumping the gun and choosing the wrong entity can backfire.

So keep it simple and stick to the default choice: sole proprietorship. You might change it later if warranted.

Reid - even though yours defaulted to the partnership, you will most likely be filing it as a disregarded entity / sole proprietorship anyway, i.e. no separate tax return. The best thing is of course to discuss it with your accountant.

@Account Closed mentioned, there could be situations when a business entity creates additional problems, as well as some rare instances where an entity can help - but, as a rule, you cannot defeat limitations on losses with an entity.

Lastly, you mentioned liability issues. To address those, you normally create an LLC. It should, in combination with good insurance, provide liability protection, while not changing anything on taxes. The details of how LLC can legally protect you is a question for an attorney, and I'm not one. (Not being an attorney never stopped anybody from giving an advice on LLCs though - but their opinions are worth exactly as much as the price you paid for them.)

@Jeff Berkowitz

Browse tax questions asked by people on this forum. They are usually answered by one or more of us tax experts. This very question has replies from FOUR of us! And you can easily find another 10-15 of our colleagues on this forum by looking at other questions.

Read what we say, choose who you like and contact privately. (If you click on the person's photo, it will lead you to a page that gives you contact information, and some experts list that information at the bottom of their posts.)

@Michael Batshon

Actually, putting it into an LLC will make it worse. You will become liable for the $800 annual tax for the LLC - another perk of being a Californian. You can't avoid paying CA, sorry. They tax everything.

Come to Texas, my friend.

@Jamie Engledow

you are only partially correct. Yes, 2 out of 5 years, but it's only one of the rules.

If, like in your first example, you move out and then move back in, another rule kicks in - which will result in losing part of the exemption.

@Andrew Varney - this does not apply to you, you're good to go on the 20th. Also, depending on the circumstances of your move, you may be able to sell it earlier. If you had some real good reason, other than just moving to a cheaper location.

Yes, 1031 after that many years of renting is probably the right approach. However, first check how much of the actual tax impact you will have. Sometimes, it's much less than you think and may not even warrant avoiding the tax. Have a competent accountant specializing in REI run the numbers for you.

@Sean Ratcliff

Spare the messenger, you will not like the message. 

Yes, you do have to pay taxes on recapture of all past depreciation. Much worse, you do NOT escape capital gain taxes by moving back for 2 years, contrary to popular misunderstanding.

You only have a small partial exclusion, and the formula is based on dates. Let's say you moved back at the beginning of this year. You will live there for all of 2017 and 2018. Then you look back all the way to 2009 (the year when this rule was introduced) - and you have 10 years to count.

Out of those 10 years, 8 were rental years and 2 homestead. You only get to exclude 2/10, or 20% of your capital gain. The 80% of capital gain is taxable PLUS 100% depreciation recapture.

Sorry for busting this nice dream, but it's the law. Which, by the way, was specifically designed to destroy this strategy. It worked prior to 2009, but not anymore.

@Tyler Galdes

Your terminology needs more clarity.

When you start a loan, you create an amortization schedule or amortization table. This table shows how each monthly payment is split between interest and principal. Initially, almost the entire payment is interest, with minimal principal. Gradually, a bigger portion goes to principal, and the interest portion starts shrinking. Also gradually, the remaining principal balance of the loan goes down. Very slowly at first, and it gets faster as the loan matures.

If this is what you were referring to, then the interest is the only tax deduction. There is no deduction for the principal portion of your payments. (Instead, there is a depreciation deduction which is not based on the loan - a very different topic.)

There is another amortization: amortization of the loan costs, such as origination fees, points, appraisal etc. Those are evenly divided over the length of the loan, and it is an additional deduction.

@Tim Ivory

These are good questions eventually, but it's the wrong focus for now. 

1. To your specific question: flips are taxed as business income, same as contract jobs or commissions. This is the most brutal taxation: ordinary rate plus SocSecurity/Medicare tax, also known as self-employment tax. Together, they can be as high as 40%. A good rule of thumb is plan to pay 1/3 of the net profit.

2. The net profit concept is critical. It's whatever money is left from the flip itself after everybody (except you) got paid MINUS all business operational expenses: driving, marketing, technology, supplies and whatnot.

Example: you bought it for $90k, put in $20k in repairs, $15k in interest and taxes and sold for $150k with $10k closing costs. Your profit from the flip itself is $15k. 

If you spent another $10k on driving and marketing - your net profit is only $5k. Your taxes are calculated on $5k.

3. Why I said wrong focus? Because making this $5k from my example is much tougher than it looks on TV and seminars. Approximately 95% of first-time flippers lose money, not make money. Their taxes are zero, but so are their bank accounts. How do I know? I prepare their taxes.

The initial focus should be on how to make money. Taxes are something way down the road. Don't worry how you are going to pay for college for your future kids when you're on your first date. ;)

4. That said - capital gains, long or short, and 1031 exchanges do not apply to flips, period. They are for rental properties. What @Dave Foster alluded to is that you could change your business model and hold to these properties longer and possibly rent them before 1031. Yes, it can work, but it's a fundamentally flawed approach to build your business model based on taxes, particularly early on. Later on - maybe.