If one has, for example, an apartment building that has a positive pre-tax cash flow of $40,000, is there a way(or place) to put that income so that you will not be heavily taxed on it (income taxed) i.e. invest in more real estate, etc?
I know that a 1031 exchange works for selling/buying similar investments without capital gains but I’m curious as to whether or not there is something like this in effect for income that income properties generate.
this is a good problem to have.
with this kind of cashflow, I would guess that these properties are employing you close to full-time. At this point, the business should be providing you benefits that would be deductible for the business, but not count as income for you. Specifically I would look for a business auto and insurance / 401(k) benefits. This allows you to receive “stuff” that isn’t income to you, but is deductible (and therefore lowers taxes) to the company.
You’re also getting over the passive limits, so you should be considering taking a portion as salary, and receiving the rest as a distribution of S-corp profits. With a reasonable salary, S-corp distributions may avoid self employment taxes on the distributed portion.
Mark,
Please explain the “passive limits” reference. I was not aware that there is a limit on passive income.
Please tell me that DC Group’s $40K annual rental income is still passive income, so, no need to worry about SE taxes, right?
Generally, rental activities are passive activities even if you materially participated in them. However, if you qualified as a real estate professional, rental real estate activities in which you materially participated are not passive activities.
You are considered a real estate professional for the year if you met both of the following requirements:
More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
At $40,000 of rental income, I would imagine he’s getting close to being considered a real estate professional, and losing passive status. 750 hours is a pretty low threshold.
Are you implying that multi-family rental buildings should operate under S-corp entities?
IF your income is not passive (and therefore subject to SE) then you should seek other ways to avoid excessive SE tax. S-corp salary/distributions are one way to do this. As long as your income is passive, it’s a non-issue.
I C. I was under the impression that rental property performs the best under an LLC.
but you can choose to tax your LLC as sole proprietor, partnership, S-corp or C-corp.
Rental income is not subject to SST/SET, even if you are an “RE Professional”. The latter designation only applies to the issue of passive activity loss limitations and can only help you by eliminating the passive loss rules as far as your rental losses are concerned.
Putting rentals in an S-Corporation is almost always a terrible idea. Some reasons: losses are likely to be limited (“outside basis” rules, very boring, trust me), properties generally cannot be removed from the entity (e.g., to refi) without paying income tax (General Utilities doctrine) and the entity is generally much less flexible than an LLC.
Running “earned” income through an S-corp (e.g., income from managing rentals or engaging in flips) can be a good idea to reduce SST/SET…not an issue with “unearned” rental income. You could convert unearned income to earned income by paying a salary…not generally a good idea unless you have a very specific reason to do so (e.g., need to have “earned” income to qualify for IRA’s and the like).
How to generate losses to offset income is a VERY broad question, so here are some broad answers:
John Hyre
Uhm… no.
if you qualify as a real estate professional, rental real estate activities in which you materially participate are NOT passive activities.
this is NOT the same as a passive loss limitation.
Pub 925 is a good reference.
The “real estate professional” designation arises from IRC Code Section 469(c)(7), which is a subsection of 469, the Passive Activity Loss Section. It essentially states that RE Professionals are not subject to the Passive Activity Loss Rules of Section 469. It makes no reference whatsoever to social security or self-employment taxation. The fact that the income is not “passive” for purposes of Section 469 has no bearing on social security/self employment taxation.
Self Employment Taxes are covered in Code Section 1402(a), which taxes net earnings from self-employment. Treasury Regulation 1402(a)-4 clarifies the Code Section and states “(a) In general. --Rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares) and the deductions attributable thereto, unless such rentals are received by an individual in the course of a trade or business as a real-estate dealer, are excluded. Whether or not an individual is engaged in the trade or business of a real-estate dealer is determined by the application of the principles followed in respect of the taxes imposed by sections 1 and 3. In general, an individual who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales is a real-estate dealer. On the other hand, an individual who merely holds real estate for investment or speculation and receives rentals therefrom is not considered a real-estate dealer. Where a real-estate dealer holds real estate for investment or speculation in addition to real estate held for sale to customers in the ordinary course of his trade or business as a real-estate dealer, only the rentals from the real estate held for sale to customers in the ordinary course of his trade or business as a real-estate dealer, and the deductions attributable thereto, are included in determining net earnings from self-employment; the rentals from the real estate held for investment or speculation, and the deductions attributable thereto, are excluded…”
A real estate “dealer” and real estate “professional” are NOT the same thing. The latter is relevant only for Section 469 Passive Activity Loss purposes and has NO bearing on self-employment taxation at all. If you hold properties for investment (as opposed to holding as a dealer), you do NOT pay SE taxes. Pub 925 says nothing to contradict any of the above - and if it did, it would have to give way to the law. As such, an S-Corporation is not appropriate for rentals, because there is no SE Tax to reduce and the many deficiencies of S-Corporations would impair owner’s ability to take losses, distribute properties, etc. If it’s any consolation, Holmes F. Crouch confused “not passive” with “taxable for SE purposes” in his book entitled “Rental Real Estate”. A careful read of the law thankfully dispels that link.
John Hyre
I see what you’re saying, but…this is not what I was taught, nor is it what the IRS tells us to do.
you’re saying “real estate professionals” should use Sch E, and though the income is not passive, SE doesn’t apply, nor does the $25k loss limitation.
as opposed to real estate professionals report rentals as a Sch C business income, subject to SE.
interesting. any case law to back it up?