My partner and I are just getting started and I am trying to find out what type of protection I should have with my partner. We are going to be purchasing houses, rehabbing, and flipping them. We will not be holding any properties (as of now that is). What type of legal protection should we have and insurance. I have read countless articles and am still not sure if an LLC or what to use. :banghead Please any help and or advice would be greatly appreciated.
Don’t use a partnership. You are on the hook for what he does in the name of the business.
Speak to your insurance agent/broker regarding appropriate insurance.
Sit with a qualified planner and he will advise you regarding the best choices for your situation.
You definitely do not want to invest together without a establishing an entity. If you invested in your own name you would be considered a sole proprietor. When you invest with another person the two of you will be considered a general partnership. In a general partnership each partner has the ability to bind the other partner. For example if one partner decided to order granite countertops for the entire house at a cost of $40,000 both partners can be held jointly and severally liable for the entire amount even if one partner did not approve the purchase. Also, with a general partnership you do not have liability or asset protection.
In your situation I would recommend forming a corporation or an LLC taxed as a corporation. Either entity will help you avoid “dealer status” and provide liability protection. Both of you could own an interest in the entity.
Isn’t a corporation engaged in a property flipping business automatically a dealer? The income is ordinary income, no capital gains tax treatment, no 1031 tax treatment, no installment sale tax treatment. How is this different from “dealer status”?
Thank you for your posts.
AP Lawyer, what is the general cost for filing the paperwork on this or can I find the forms myself online and file myself?
You can use the following link to view LLC fees by state:
For an LLC, you’re concerned with the first two columns. The second column is the filing fee for the initial formation of the LLC. The other is the annual renewal fee. You’ll see some states have very high filing fees. As others have posted, you will need to file the LLC in the state you intend to do business. In addition, you will need to have a registered agent in that state. The registered agent is someone who will be able to have any legal documents mailed to them at a legal address in that state. Don’t just go off of LLC fees for deciding where to do business. I do business in IL which you can see has a very high filing fee. The flip side is that property values in my area are very low and make it very afforable to buy real estate.
You can find the state specific forms online for your respective state’s Secretary of State website. They are easy to fill out and you can file them yourself.
I live in Mississippi but am on the state line of Louisiana. Would that make a difference in my choice? Not due to the cost of paperwork but maybe taxes?
You file in MS and in the state where the property is located. You don’t get a choice in the matter.
While forming the LLC is fairly simple, you DO need to have a formal, written, and properly prepared operating agreement. This is what provides real protection.
Choice of entity/tax election does not make any difference in “avoiding dealer status.” The tax election is determined solely on what makes the most sense for the members/business in their specific circumstances.
With proper documentation dealer status can be determined on a property-by-property basis. Since flips are always ordinary income, dealer status is irrelevant here.
Dealer status is only an issue when you hold both flips AND rentals and you purchase a property for investment (rental) and end up selling it (dealing).
Thank you for your advice Mcwagner!
You can definitely find the forms and file the entity yourself but the real protection comes from the operating agreement itself. The operating agreement should cover such things as who has decision making authority for the business, fiduciary responsibility owed to the company i.e. can an owner find deals for himself or must all deals be first offered to the company, time and financial commitments, etc… My advice is to hire a professional to create your company. If you were investing on your own then a well drafted operating agreement in kit form can be sufficient but whenever other parties are involved you need to be extra careful to flush out the details to avoid dealing with them later on.
On the dealer issue, your company would definitely be considered a dealer provided it is taxed as a corporation. If it is taxed as a partnership the activities of the company will be attributed to the active members individually. Essentially you will be treated as a sole proprietor. The general rule on dealer status is as mcwagner stated that it is supposed to be on a property by property basis however, the IRS does not work that way. If they can paint you individually as a dealer then the default presumption will be all of your property sales are dealer property. Consider the following example of Vinny who sells vehicles instead of real estate.
Vinny owns a BMW dealership in his own name. In addition to selling BMWs Vinny enjoys acquiring vintage BMWs for his private collection. With the increasing popularity of classic vehicles, Vinny’s collection has appreciated significantly over the past five years. Unfortunately for Vinny the economy in his local area experiences a significant downturn when the local highflying technology company decides to move its office to warmer location. Vinny in need of some quick cash must part with several the vehicles in his personal collection. Vinny reports the income from these sales as long term capital gains because he held these vehicles for investment and not in the ordinary course of his business however, the IRS disagreed with Vinny and made him re-characterize the sales as ordinary income. The IRS treated Vinny’s collectable vehicles as inventory.
In Vinny’s situation he thought he could be a collector and a dealer but the IRS thought otherwise. Real estate is the investor’s vehicle. Trying to flip properties under your own name, as a sole proprietorship, or even as a LLC taxed as a partnership in which you participate, will not be much help to you in terms of conducting business as an investor, rather than a dealer.
If you want to discuss further contact me offline.
I respectfully disagree.
your company would definitely be considered a dealer provided it is taxed as a corporation
Choice of entity does not factor in to the dealer status question.
however, the IRS does not work that way
Dealer status can be determined on a property by property basis as long as sufficient documentation is kept regarding the intent and purpose for each purchased property.
Vinny’s problem still exists whether he purchased the vehicles in a corporation, LLC, partnership or whatever. Vinny’s salvation would have been records indicating that he purchased additional insurance for his personal collection of vehicles, or did not report them to his insurance company as “inventory.” Perhaps his personal collection was stored at a more secure location than his inventory vehicles. He kept records of what vehicles he advertised for sale, which vehicles were taken for test drives. His collector’s vehicles were registered with the Antique Auto Association. With proper documentation a strong case can be presented for capital treatment of the sale of his personal collection.
Likewise, if you purchase a property, acquire landlord insurance, advertise it for rent, accept rental applications, keep records of prospective tenant interviews and showings, then you receive an offer to purchase the property that’s too good to refuse. You have a strong case for capital treatment of the sale.
Since we don’t plan on holding any properties all of our profits will be taxed as ordinary. Now later on down the road if we start holding properties how long would I have to hold them in order to receive capital treatment.
My point on dealer status is a corporation traps the dealer activity at the entity level. A flow through entity like a partnership disregarded or under a partnership election will taint the members with the activity of the entity. I believe we agree that you can build a case on a deal by deal basis for why one deal was held for investment and why another is deal property; however, why place yourself in a defensive posture where you must provide ample evidence to rebut the dealer presumption. My approach has always been to completely separate dealer activity from the taxpayer. This was my point with Vinny, don’t conduct your investment activity where you conduct your dealer activity - keep them separate. Because the taxpayer will favor investor status keep the dealer status locked in an entity that insulates its owners from entity level activity.
completely separate dealer activity from the taxpayer
This works fine until you enter the real world…
where your flip property over in your entity won’t sell at your needed price, and you’re forced to put in a tenant for a year or two and WHOOPS all your planning is for naught because you have an investment property in your dealer entity.
Your investment property suddenly receives an offer you can’t refuse and suddenly WHOOPS your dealing a property that’s over in your investment entity.
My point is: the only certain method to avoid these issues is a strong grasp of the facts and good documentation. Entity segregation is almost impossible to achieve in the real world.
You are correct in your statement the real world is not perfect. But please explain your thinking a bit more because in an earlier post you said “dealer status is determined on a property by property basis”. This statement seems to conflict with your most recent post that takes an all or nothing approach to this issue. I often explain to my clients that in business things do not always work out as planned and tax motivated transactions are red flags that only serve to undermine credibility in the face of a comprehensive field audit or even worse a TCMP audit.
If I keep all my flip properties under one LLC and my rental property under another in the event one of my flip properties doesn’t sell and I have to place a tenant in it could I transfer the property to the other LLC. I"m not sure how I would do that I guess sell it to the other LLC. Is that a possible scenario?
Without knowing how your LLC’s are taxed e.g., partnership, disregarded, corporation, - I can’t give you a definitive answer. However, you are structing yourself to keep your deals separate so this is a good thing but don’t put too many properties into your holding LLC. After 4 or so you should consider establishing another LLC. The only other issue is pulling the flip property that does not sell out and moving it to your holding LLC. I would reccomend you create a different LLC to hold these questionable properties. The IRS will look at your motiviation in holding the property prior to sale and if it is waiting for the right price then it might be considered dealer property.
This statement seems to conflict with your most recent post that takes an all or nothing approach to this issue.
where did I say (or imply) this? I have said the opposite: trying to put all your dealt properties inside an entity (an “all or nothing” approach, no?) is impractical. Better to fully document exactly what you do with each property so that each property’s status can be properly determined when sold.
My point is that choice of entity has no bearing on dealer status. A corporation can be a dealer just as easily as an individual, and faces the same hurdles with rental properties.
A further point is that any attempt to segregate properties in an “all or nothing” scheme will fail if you are forced to (or benefited by) holding a property you planned to flip, or dispose of a property you planned to hold. How many times has this happened to someone on this forum?
Dealer status depends on the nature of the business in relation to the nature of a specific property that is sold. If your business is flips, a single rental will be considered “incidental” and will not be capital when sold unless you can substantiate that you intended to purchase that specific property as a rental investment from the beginning or converted the property to investment due to market conditions, etc. With proper documentation you can take advantage of favorable capital treatment even if your business is flipping.
With your method, this rental house would be in the “wrong” entity and you would lose favorable capital treatment.