which scenario pays less taxes?

General Real Estate Investing
1

Hello all. I have a hypothetical scenario I was hoping to get some clarity on. Which situation would pay more taxes and roughly how much would they be paying in taxes?

Scenario 1:
John’s Consulting LLC – John pays himself $60,000 annually consulting for other companies. The LLC is taxed as an S-Corporation.

Scenario 2:
John Real Estate Investing LLC – John has a rental property valued at $100,000 with $60,000 of net equity in it, after the closing costs. John does a cash-out refi and pulls the $60,000 out of his LLC and into his bank account for personal business. 1 year later, John sells this property at a breakeven price because of certain market conditions. He only paid off the mortgage with the sale. John’s total time spent owning the property was 1 year and he maintained a breakeven cash flow the entire time.

Scenario 3:
John Real Estate investing LLC – Same scenario as in #2, but instead of a cash-out refi, John sells it after a year and nets $60,000 from the sale.

(I knew this would sound silly so that’s why I warned you it was hypothetical. I’m just interested in the face value taxes of each scenario, not including all the different tax reduction strategies, depreciations, or debt pay down calculations.)

Here is my series of questions:

All scenarios net John $60,000.

  1. How much in taxes would scenario 1 pay and what tax rates / different taxes would John be subject too? (ie. Payroll tax, self-employed, marginal tax rate)

  2. How much taxes would scenario 2 pay and what tax rates / different taxes would John be subject too? (long term capital gains? how much that rate is)

  3. How much taxes would scenario 3 pay and what tax rates / different taxes would John be subject too? (long term capital gains?, what that rate is? etc)

  4. What election for taxation would be best for the LLC’s in #2 & #3?

  5. Which scenario would be the most beneficial?

I’d appreciate any feedback. I understand that these questions sound very strange and contain a lot of variables. I tried not to miss any necessary information. Please provide rough answers and/or fill in the blanks of any info I failed to give based on the state of Florida. Thanks in advance for humoring me on this.

2

you didn’t give quite enough information for a complete answer, so I have to make some assumptions.

two and three are no different, since what you owe has no relationship to your gain on the sale. in both cases he sells it for 100. assuming that “breakeven” means his basis was 100, then he has no gain, and pays no taxes. he keeps the 60k either way, since that represents 60k that he put into the deal in some form when he bought it (otherwise, how did the property have 60k equity going in?).

if, on the other hand, he bought it for 40, valued at 100, then in both scenarios he has a 60k capital gain. this flows through to his personal return as a 60k cap gain, taxed at 15%. No SE

The salary from the LLC will be W-2 income to him personally, and both he and the LLC will pay social security and he will personally pay income tax. assuming that the LLC reports zero income after all this, he’s done.

the total tax bite is the same if the LLC reports 60k income, passes thru to him on the K-1, subject to income and SE tax. only difference is that as W-2 employee, the LLC pays half the FICA/medi. total tax bite is around 40%

almost always better to take cap gain.

3

All responses address federal income taxes. State tax liability, if any, is in addition to the federal taxes.

1. How much in taxes would scenario 1 pay and what tax rates / different taxes would John be subject too? (ie. Payroll tax, self-employed, marginal tax rate)

John’s consulting income is subject to ordinary income taxes at his marginal tax bracket rate, AND, self-employment income taxes at 15.3%.

2. How much taxes would scenario 2 pay and what tax rates / different taxes would John be subject too? (long term capital gains? how much that rate is)

If John’s cost basis in this property is $40K (property valued at $100,000 with $60,000 of net equity in it, after the closing costs). John’s taxable profit is the sale price minus the cost basis, or $60K. The mortgage amount is immaterial to the profit calculation.

If John’s cost basis is $100K, then there is no taxable profit resulting from this sale.

Since the sale occurs exactly one year after purchase, the sale profit is taxed as a short term capital gain. The tax rate is the same as John’s marginal tax bracket rate for his other ordinary income. If John sells at least one day later, so that his holding period is one year and one day (or longer), then the long term capital gains tax rate would apply. Currently, the maximum long term capital gains tax rate is 15%.

3. How much taxes would scenario 3 pay and what tax rates / different taxes would John be subject too? (long term capital gains?, what that rate is? etc)

The tax treatment for scenario 3 is identical to the tax treatment for scenario 2. The presence or absence of mortgage financing is immaterial to the taxable profit calculation.

4. What election for taxation would be best for the LLC’s in #2 & #3?

If the LLC is a single member LLC, then disregarded entity is better than corporation. If the LLC is a multiple member LLC, then partnership is better than corporation.

5. Which scenario would be the most beneficial?

If you mean which scenario results in the highest after tax income, then scenario 2 and scenario 3 are better than scenario 1, if the taxable income in all cases is $60K. Scenario 1 is a consulting business, not a real estate related business, with active income taxed as ordinary self-employment income. Scenarios 2 and 3 are real estate activities with passive income that is not subject to self-employment income taxes. Sort of comparing apples to oranges.

4

Thank you very much I appreciate it. I have a couple other questions. Where can i determine what the different tax rates are for social security (FICA?) for both the personal level and LLC level, and where can I go to determine the marginal tax bracket? Thanks again for your feedback

5

There are not different rates for social security. The social security tax is 12.4% of the first $90K in earned income. Typically, the employer pays half and the employee pays half. If you are self-employed, you pay both halves (you are both the employer and the employee).

Medicare tax is 2.9% of all earned income without limit. Typically, the employer pays half and the employee pays half. If you are self-employed, you pay both halves (you are both the employer and the employee).

Look at IRS Publication 17, and find the Tax Rate Schedules. Identify the Schedule for your filing status. For your taxable income, the Schedule will tell you that your tax is
[list]$X + Y% of the amount over $Z[/list]
Your marginal tax bracket is Y%. In the 2005 publication, the Tax Rate Schedules are found on page 262.

In other words, your marginal tax bracket is the tax rate that will be applied to the very next dollar you earn.

6

hello mcwagner and dave-t,
I really don’t have any questions, I just wanted to tell you guys thank you for sharing you expertice in this great forum of knowledge.

7

I’ll second that! You two guys are GREAT! I hope you don’t mind me refering other posters to seek you out!

Keith