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Taxes for Real Estate Investors NJ, NYC

LLCs are unique.  Due to the flexibility of tax structure, LLC can file taxes as C Corporation-Tax Form 1120, as Small Corporation-Tax Form 1120S, as Partnership-Tax Form 1065, or as a Sole Proprietorship Schedule C of form 1040. Generally, the LLC is the ideal form of business structure for various forms of real estate businesses.  If you are interested in buying short sale properties, or rental properties for income stream, or just buying properties and holding them for appreciation purposes, LLC structure can be utilized for most advantage tax planning. There are a few reasons for this. Firstly, an LLC provides limited liability protection, which is critical in an industry like real estate, which is prone to law suits.  However, unlike the C Corporation, an LLC can be setup is such a way so it is taxed as a flow through entity; which means, that there is no double taxation like in a C Corporation and the LLC itself does not pay corporate taxes, only the owners or investors pay the tax. There are two pass-through tax classifications: Partnerships and S Corporations. Partnership taxation provides the best tax structure for the LLC at this time.  It’s imperative to have two or more members in the LLC in order to receive preferential tax status of Partnership. The good news is that there is no restriction on who can be a member in an LLC.  It can be any individual, businesses entity such as corporations or partnership or other LLC as well as non-profit organization.

After your LLC selected Partnership tax classification, at the end of the tax year, the LLC issues a schedule K1 to each of its members/investors, which contains each member’s percentage of ownership and their appropriate share of the income or losses that the LLC sustained for that year.  Each member must include his/her K1 schedule on their personal income tax returns.  If the LLC had losses, those losses can provide each member with significant tax benefits.  Specifically, the losses of the LLC can potentially offset gains that a member has on the individual level.  However there are cases where a loss will not be deductible, so please speak to your CPA or Tax Accountant regarding your particular situation.  More importantly, a critical advantage that an LLC has for the real estate investor is the fact that the entire amount of mortgage debt borrowed to finance the purchase of the real estate, counts as part of the investors basis (aka equity) in the real estate.  Since LLC losses are only deductible to the extent of member’s basis in the LLC, a large mortgage increases member’s basis, thus allowing the investor a major tax deduction. This feature of mortgage inclusion in member’s basis is a unique feature of the LLC and is not available in any other tax structure i.e. S Corporation or C Corporation.

Example: Justin B. and John D, two successful real estate entrepreneurs, decided to purchase a new property as an investment for $1,000,000. They invested $100,000 each of their own money as down payment, and the remaining $800,000 was financed by a mortgage.  Because they formed their real estate investment company as an LLC, each one has $500,000 (100K down payment and 400K of mortgage) in basis (equity) in the LLC.  In the first year of business, due to all of their business start-up costs, depreciation and repair expenses, the LLC lost $300,000.  The entire $300,000 in losses in the LLC is passed through to Justin and John.  Thus, each can use $150,000 of losses to offset other real estate gains on their personal income tax returns.  However, had Justin and John set up their business as an S Corporation, only the $200,000(cash that they had contributed as a down payment) of losses would be deductible.  The remaining $100,000 of losses would not be tax deductible for this tax year.  As you can see, only an LLC taxed as partnership can allow an investor to reap significant tax benefits through allowing borrowed money to increase his/her basis in real estate transactions.

In addition, in most cases, real estate investment income can be viewed as passive income (unless several tests are met that are set forth in Treasury Regulation 1.1362-2(c)(5)(ii)(b)). Since the S Corporation has a 25% passive income limitation rule, one can lose the favored pass-through tax status by producing consistent income from real estate that exceeds 25% of the gross income of the S corporation. Once an S Corporation loses pass-through tax status, it reverts to a C Corporation and is subject to double taxation. The LLC however, has no such limitation. For all of the reasons outlined above, the LLC is the natural choice for investors looking to start a business in real estate.

This article was written by TaxBizPro, LLC 2012, all rights reserved ©.

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