All: First, this site has been such a wonderful resource. I thank everyone who has ever responded to my numerous questions. Here is one more…
For tax purposes, does it make more sense to ask the IRS for an EIN and operate as a business as opposed to claiming real estate ventures as investments? I know everyone’s tax situations are different, but in general is one way better than the other or are there specific legalities that determine how I should proceed? I haven’t been able to find anything yet that has helped me make that decision. I am leaning toward the business aspect because I am getting close to the AGI limit of $150,000 in salary in terms of qualifying for the 2% deductions on schedule A.
Thank you!
Bryan
If the entity you propose to form is an LLC, tell us the tax treatment you will elect for the LLC, whether the entity will have employees, and the primary investment activity your LLC will pursue.
it will treated as a disregarded entity…could eventually become a partnership. It will not have employees. Primarily it will be for buying properties to hold long term. Not generally interested in flipping…at least not yet. Plan is to begin with single family units and then eventually move into the 4 plexes.
Bryan
So, you are proposing to use a single member LLC to buy and hold rental property.
The single member LLC is a disregarded entity, and as such is also a pass-through entity. This means that the entity does not file a tax return in its own right, but instead all net income is “passed” through to the member’s individual tax return.
Since you will be reporting all the LLC activity on your personal 1040 anyway, the tax reasons you cited for establishing the LLC won’t be overcome by the LLC.
In your situation, there is no reason to apply for an EIN for the LLC since the LLC will not file a tax return and pay taxes in its own right.
Establish the LLC for asset protection and for other legal reasons, but don’t look to the LLC to shelter income from taxes.
Dave, thank you. One more question then…as I progress with increasing my holdings, can an LLC or other entity be used effectively to shield income from taxes? I am not opposed to giving Uncle Sam his due, just not more than is absolutely necessary.
Bryan
people form C Corporations to split income. C Corporations pay 15% on the first 50k of income. this is a lot lower tax rate than what you would pay if you added 50k to your 150k AGI.
True, a C-Corp is taxed 15% on the first 50K. Then the tax on the next $25K is 25%, and on the next $25K after that the corporate tax rate is 35%.
But a C-corp is not the right business entity for rental property activity. Remember, the investor’s business purpose in this question is to buy and hold rental property – a passive income activity. A C-corp that derives all its income from rental property, is classified as a personal holding company with tax rates that are much higher than the personal income tax rate that would be paid by an LLC treated as a disregarded entity.
OK, but I just needed to clarify that the C-Corp was not the best business entity solution for the investment strategy (buy and hold single family and multiplex property) stated in the question.
Especially, if you consider double taxation on business income withdrawn from the C-Corp, the total taxes paid on an income of $50K would be higher than would be paid by the taxpayer who earned $50K from his (disregarded entity) LLC.
Here is what I mean. The corporate income tax rate on the first $50K of net income is 15%. After paying the corporate taxes, $42,500 would be left to pay out as a dividend. The taxpayer would then pay tax on this dividend at his ordinary income tax rate. If we assume that our taxpayer is in the 25% tax bracket, then that $50K in corporate income will be taxed $7500 at the corporate level, then another $10625 in taxes will be paid on taxpayer’s personal tax return on the dividend he received. The net after taxes will be only $31875 of that original $50K.
If the LLC is only dealing with rental property – a passive income activity – no payroll taxes will be due. The $50K in net rental income will only be taxed “once” at the taxpayer’s 25% rate for a tax bill of $12500. This will allow the taxpayer to net $37500 after taxes.
Dave is correct, as is his habit. Let me add a little:
The determination of whether something is a “trade or business” or “investment activity” for tax purposes is generally not entity driven…rather it turns on the degree and nature of activity involved. The more regular & involved an activity, the more likely it is a trade or business. Sometimes you want to be one, sometimes the other. For example, with rentals, a sufficient amount of activity to be a “trade or business” has at least two possible benefits:
Avoids some of the loss-limitation issues out there (i.e., passive activity loss rules); and
Makes a few extra deductions available. For example, a trade or business can deduct educational seminars, while an invement activity generally cannot.
BUT running a trade or business through your IRA can be a problem and make what is normally a tax-exempt account taxable.