Q: Tax Playa, I plan on having several rental properties over the next several years. Should I hold them as an individual, get an LLC, a corporation, an S-corporation, etc.?
BJ, Washington DC
A: It is almost always better to hold and manage real estate investments as an indivdual for two very good reasons. First, you may be able to deduct rental losses of up to $25,000. Second, you benefit from lower personal capital gains taxes.
For those interested in this topic, they should first read two articles I have written on different types of business entities, and the basic tax rules on rental properties.
This is a question that I get a lot, and it stems from a misunderstanding about how LLCs and corporations work.
An LLC is a disregarded tax entity. That is, its activities are taxed the same way the members of the LLC are taxed. If an individual owns an LLC and has trade or business activity, it's reported as a sole proprietorship. If he has rental activity, it's reported on the Form 1040, Schedule E.
An LLC can elect to be taxed as a non-disregarded entity, usually a corporation or an S-corporation. Alternatively, a business can be incorporated in its own right.
People ask if this is a good way to invest in real estate (as opposed to doing so as an individual).
First, there is a practical problem. Real estate investing requires getting mortgages. Unless they are super-liquid, companies normally cannot qualify for mortgages. Even if they do, the terms are usually less favorable.
There are also two very good tax reasons not to invest in real estate in anything other than an individual capacity:
1. Passive Losses May Be Allowed
Real estate investing is considered a passive activity. The tax law does not permit losses from passive activities to be deducted against non-passive income. Any remaining losses are suspended until future years, when they can cancel out future passive income. If the asset is disposed of, suspended losses can be taken in full.
Two important exceptions exist for this. First, if you actively and materially participate in the rental activity (basically, don't turn the property over to a management company and never deal with it), and your AGI is less than $100,000 you can take a rental real estate net loss of $25,000. This loss phases out between $100,000 and $150,000 of AGI.
Another exception to the passive loss limitation rules is if you are a "real estate professional," defined as spending at least 750 hours per year in real estate. In this case, the passive losses are always fully-allowed.
Corporations (or entities taxed like corporations) are not allowed to realize passive losses net of passive income. The suspension rules described above are airtight.
2. Capital Gain Rates Are Lower.
For corporations, income is income. There are no separate capital gains tax rates. When it comes to real estate sales, the amount of gains can easily push a corporation into a higher tax bracket. Any gains over $75,000 will result in a marginal corporate income tax rate of 34%.
By contrast, there are two low capital gains rates that individuals benefit from.
The first is on any depreciation that must be recaptured. Depreciation, you may recall, is a provision that allows investments to be slowly-deducted over time (in the case of rental real estate, either 330 or 468 months, depending on whether it is residential or non-residential). If that asset is sold for a gain, part of that gain is getting the cost basis of the asset back up to the original depreciable basis. This is considered a capital gain.
However, this gain is not taxed as ordinary income (which can get as high as 35%). Rather, it is taxed at a flat rate of 25%.
The second capital gain is the more familiar one. If a property is bought for $100,000 and sold for $130,000 there is a $30,000 capital gain. Provided the property is held for longer than a year, it qualifies for the long-term capital gains tax rate of 15% (as opposed to the ordinary income rate which can go as high as 35%).
For these reasons, I would generally advise people to conduct real estate activities as individuals, not under corporate tax rules.
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