When I was growing up, my family owned a small business. One day, my dad was involved in an auto accident. As a result, he was sued, and years later, when all the appeals had been exhausted, my family lost and had to declare bankruptcy to discharge the judgment. They lost their entire business, their home, and their marriage.
No one likes to think it will happen, but it does. As a real estate investor, you want to set yourself up to create financial freedom, and also protect it.
But what entity structure is best in order to protect your assets and also shelter from taxes? What may be ideal legally can come with tax complications, and vice versa.
First off, since each person’s situation is different, you should consult your own attorney and CPA. We are neither of these.
Sometimes making mistakes can be the best teacher, so here are common mistakes on the legal and tax side we’ve seen over the years of working with real estate investors, to help you avoid them.
Mistake #1: Not Seeking Out Qualified Professionals
Having a trusted attorney, CPA, and insurance agent is the backbone of a strong financial future.
I had a client who was a small business owner and invested in real estate on the side. Over the years he did some small subdivisions, which his CPA classified as capital gains on sale. Years later, the IRS came back and said he was actually a “dealer,” which triggered substantially more tax, along with years of penalties.
Making sure you have the right professional for what you are doing is essential.
Mistake #2: Having a Million Bank Accounts & No Bookkeeping
If you have an LLC for each property, naturally that means each LLC needs its own bank account, right? That can get complicated quickly. Or some investors dump it all into one bank account and then have no idea where the money goes, which leads to losses.
Ideally, an LLC holding company would be the best format, with the holding company LLC owning each individual LLC that holds title to the property. The holding company can host the master bank account.
If you have a third-party property manager, then the ins and outs of each property’s bank account are minimal and can easily be tracked with classes or tags in QuickBooks.
If you self-manage, setting up your own management company is ideal. This acts as a third-party PM to collect rents and pay expenses, operating out of separate bank accounts for the property manager.
A holding company (sometimes referred to as a series LLC) can be a great place to put those other “business expenses” that aren’t directly related to your investments — like that new electric truck you bought for the business, or those great real estate conferences, or professional fees.
As painful as it may be, having good bookkeeping sets you up for success at tax time and provides clarity on how much you are making for all your hard work on real estate investments. Invest some dollars here to do it right.
Mistake #3: Partners
Life happens. If you are going to partner, make sure your legal documents clearly define the roles and responsibilities of each party.
Ask yourself what could go wrong, and then plan for all those things.
Often a group of partners may own an asset collectively in an LLC. When it comes time to sell, some partners may want to do a 1031 exchange, while others may want to cash out. Since a 1031 exchange must be done with the same legal entity going out and coming in, it can be hard to create an out.
There is a solution for this, coined a “Drop and Swap.” In simple terms, a Drop and Swap is where the interest held in the LLC is dropped prior to the 1031 exchange. Using this technique, members not interested in doing an exchange can be given a deeded interest in the property from the LLC while giving up their interest in the LLC.
Mistake #4: Not Planning for Future Value & Financing
Say you bought a property 25 years ago for $850,000. Now it is worth $2.3M because you have improved the property. Now you want to place a nice long-term agency multifamily loan.
When you use Fannie Mae, Freddie Mac, or HUD loans for multifamily financing, one of the key benefits of these loans is the non-recourse feature. This necessitates that the property be in a special purpose entity (an LLC created just to hold the property). If you held title in your own name or a master LLC, you’ll need to move to a new entity, triggering transfer tax, to meet the requirements of the loan.
Another benefit of an agency loan is that it can be assumed by a subsequent buyer. Acquiring LLC shares instead of transferring to a new entity can help keep sale amounts private and reduce transfer tax.
Mistake #5: Putting Your Long-Term Real Estate in an S-Corp
If you are classified as a real estate investor for tax purposes — house flipper, realtor, developer, builder, wholesaler, etc. — then this is for you. You were probably advised to put your “business” into an S or C corp to avoid some of the payroll taxes you owe as an active “real estate professional.” This can be a great strategy for tax savings. If you are a “dealer,” then your real estate can go in the corp as inventory.
However, if you plan to buy and hold real estate, do not put it in an S/C corp. If you do a cost segregation study and want to take all that bonus depreciation as losses, you may be surprised to learn that you cannot take the whole loss, because a loss in an S-corp cannot exceed your basis. If your losses exceed the income inside the S-corp, they remain suspended until there is enough income left in the corp at year-end to take the tax loss.
Mistake #6: Not Getting Started
For all there is to know about structuring entities and taxes, the biggest mistake of all is not taking action and getting started. We have seen people with the simplest plan in the book — just buying one house a year in their own name — become millionaires because of action.
Mistakes will happen, but don’t be afraid to move forward once you’ve done your homework.
Looking to grow your wealth by buying or selling real estate? Contact us today to begin planning for your success.
