Author Topic: Landlords, are you a business?  (Read 13514 times)

sol

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Landlords, are you a business?
« on: October 30, 2014, 12:35:14 PM »
Are any of you people who have rental properties set up as small businesses?

There seem to be a variety of incentives to set up your rental empire as a small business, and then take some of your profit as salary or dividends rather than just as rents paid to you as an individual, which are taxed as income but don't count for things like the EITC.

Especially after retiring from my 9-5, it seems like becoming a "small business owner" who rents and/or maintains rental properties might be advantageous. 

Are there good reasons NOT to do this?

rujancified

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Re: Landlords, are you a business?
« Reply #1 on: October 30, 2014, 01:30:15 PM »
No, but we're in a different circumstance than typical RE investors.

My husband and I own 2 rentals that were originally purchased as owner occupied (one for each of us, prior to marriage). At the moment, the rents we charge cover most expenses and have been rising steadily (rent on my unit just increased by 25% after a short vacancy), so we're holding on to them for the time being.  We asked a CPA if incorporating would be to our advantage tax-wise and he indicated that it would not be advantageous and there would be costs associated with the transaction that would probably offset any positives. That may be because we don't plan to hold these terribly long term (maybe ~5 more years) or because we're phased out of deductions for such things. Something to bring up the next time we speak.

I have another 2 friends who own rentals in the general geographic area who run it as a businesses. I'd consider it in the future if a bunch of factors fall into place the right way.

Commenting mostly to follow and see if anyone strong opinions/rationale.

bugbaby

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Re: Landlords, are you a business?
« Reply #2 on: October 30, 2014, 01:36:32 PM »
No. I have a single rental that I depreciated and claimed property taxes etc.  I think only advantageous because of my 28% tax bracket, single, don't have a primary residence mortgage, eitc or many other itemizable expenses..

brooklynguy

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Re: Landlords, are you a business?
« Reply #3 on: October 30, 2014, 01:47:11 PM »
I assume what you're really asking is whether you should set up a distinct legal entity for your rental business.  Owning your rental units in your individual capacity is still essentially running a business, but as a sole proprietorship.  As rujancified said, there are some costs associated with establishing and maintaining a legal entity that you would need to weigh against the benefits.  My wife and I own our rental unit (which is a part of the multi-family house that we own and live in) in our individual capacity.  Depreciation alone is enough to offset nearly all of the rental income for the time being.  You might get more/better responses if you move this thread to the real estate section.

sol

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Re: Landlords, are you a business?
« Reply #4 on: October 30, 2014, 01:55:29 PM »
The Earned Income Tax Credit in particular would seem a strong incentive all by itself, for an early retiree landlord.  A family with two kids can qualify for like $5500 per year in refundable tax credit if they can show earned income of between about $14k and $23k per year.  But you have to have earned income to claim it, and an early retiree probably doesn't.  Interest and dividends don't count. 

So say you have four rental properties that each net you $300/month in positive cash flow, or $1200/month.  If you put the money in your checking account you pay income taxes on it at your marginal rate, which could be zero for an early retiree.  If you instead collect that money for your business and then pay yourself a salary of $1000/month and dividends of $200/month, your dividends get preferential tax treatment and your $1k/month in salary gets hit with medicare and social security taxes of about 15% (so -$1800) but then qualifies you for $5500 in free money from the government.  And for an early retiree with far fewer than 30 years of earnings, every year you pay SS taxes just raises your eventual SS benefit anyway, so no real harm done.

As a small business owner you also get a variety of other perks, like acess to a SIMPLE IRA and a whole slew of tax deductions.

sol

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Re: Landlords, are you a business?
« Reply #5 on: October 30, 2014, 01:56:35 PM »
You might get more/better responses if you move this thread to the real estate section.

Mods, feel free to help a brother out.

arebelspy

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Re: Landlords, are you a business?
« Reply #6 on: October 30, 2014, 02:25:13 PM »
You might get more/better responses if you move this thread to the real estate section.

Mods, feel free to help a brother out.

Done.

I'm eager to hear the answers, as tax knowledge is one of my weakest points, and I'd love to hear some of our more informed members chime in.
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sol

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Re: Landlords, are you a business?
« Reply #7 on: October 30, 2014, 02:38:30 PM »
As an added bonus, if you are a self-employed business owner with earned income from paying yourself, you also qualify to continue making Roth IRA contributions that would otherwise be off limits to you.  Why would you want to do that, you ask?  Maybe to qualify for the free $2000 in Saver's Credit the government offers to people with low incomes who contribute to retirement accounts.

Hmm, $5500 in EITC plus $2000 in saver's credit is $7500 in FREE government money.  That's a significant chunk of a typical forum member's FIRE budget, equivalent to having to save an additional $187,500 in retirement accounts at 4%.  If you're investing $50k/year, that cuts over three years off of your time to retirement. 

Are there downsides to this plan I'm not seeing?  I get that there will be some paperwork involved in setting up a business and paying self employment taxes, but if that's the price you pay for $7500 (and rising over time?) in free income, I might be okay with it.

edit:  the retirement saver's tax credit is non-refundable, which means you can reduce your tax liability with it, but not buy groceries with it.  Sad.
« Last Edit: October 30, 2014, 02:49:24 PM by sol »

Setters-r-Better

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Re: Landlords, are you a business?
« Reply #8 on: October 30, 2014, 05:06:09 PM »
Seems like most people form an llc and frequently  do their taxes the same way as if they operated as sole proprietors.  Don't know anything about the rest of it. 

arebelspy

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Re: Landlords, are you a business?
« Reply #9 on: October 30, 2014, 05:08:24 PM »

Seems like most people form an llc and frequently  do their taxes the same way as if they operated as sole proprietors.  Don't know anything about the rest of it.

Yes, that's done for liability purposes and has basically no tax benefits, as it's all pass through income straight to your personal tax return.

That's why I'm intrigued by Sol's post - it's not an idea I've heard explained in the real estate world - all the above is the standard, and done for liability protection, not tax benefits.
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sol

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Re: Landlords, are you a business?
« Reply #10 on: October 30, 2014, 05:32:17 PM »
Comments on the MMM article on this topic also mentioned the possibility of opening a solo 401k.  On the off chance that your new business makes you too much money to qualify for something like the EITC, you can always defer the extra into your solo 401k to get your earned income back down to qualifying levels.

expatartist

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Re: Landlords, are you a business?
« Reply #11 on: October 30, 2014, 05:39:12 PM »
Very interesting thread! Thanks for posting, Sol.

sol

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Re: Landlords, are you a business?
« Reply #12 on: October 30, 2014, 05:42:32 PM »
Very interesting thread! Thanks for posting, Sol.

Don't get too excited, this is still all just hypothetical.  I'm fully expecting some seasoned real estate pro to come along and take a giant dump on this idea.

But at first blush, it does seem attractive.

brooklynguy

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Re: Landlords, are you a business?
« Reply #13 on: October 30, 2014, 07:57:03 PM »
The Earned Income Tax Credit in particular would seem a strong incentive all by itself, for an early retiree landlord.  A family with two kids can qualify for like $5500 per year in refundable tax credit if they can show earned income of between about $14k and $23k per year.  But you have to have earned income to claim it, and an early retiree probably doesn't.  Interest and dividends don't count. 

Just did a little research on the Earned Income Tax Credit, and you would need to manage your income in a few different ways to qualify for it.  Having investment income in excess of $3350 will disqualify you.  So not only do you need to ensure that you make enough (but not too much) earned income, but you also have to avoid collecting too much unearned income.  For those of us who will have even relatively moderate amounts of passive investments in addition to the rental property business, that presents a major monkey wrench.  Perhaps even then you can circumvent this problem with some tax-advantaged retirement account gymnastics, but conflicts may start to arise between the eligibility criteria for the various tax credits you are going after.

arebelspy

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Re: Landlords, are you a business?
« Reply #14 on: October 30, 2014, 08:15:02 PM »

The Earned Income Tax Credit in particular would seem a strong incentive all by itself, for an early retiree landlord.  A family with two kids can qualify for like $5500 per year in refundable tax credit if they can show earned income of between about $14k and $23k per year.  But you have to have earned income to claim it, and an early retiree probably doesn't.  Interest and dividends don't count. 

Just did a little research on the Earned Income Tax Credit, and you would need to manage your income in a few different ways to qualify for it.  Having investment income in excess of $3350 will disqualify you.  So not only do you need to ensure that you make enough (but not too much) earned income, but you also have to avoid collecting too much unearned income.  For those of us who will have even relatively moderate amounts of passive investments in addition to the rental property business, that presents a major monkey wrench.  Perhaps even then you can circumvent this problem with some tax-advantaged retirement account gymnastics, but conflicts may start to arise between the eligibility criteria for the various tax credits you are going after.

I'm planning on having 100% of my FIRE income come from rents, and all my equity investments be in tax advantaged accounts.

Seems like the rental income would be unearned income in this case though, so I'd have to take nearly all of it as salary and only a little as dividends, no?
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sol

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Re: Landlords, are you a business?
« Reply #15 on: October 30, 2014, 08:23:23 PM »
Just did a little research on the Earned Income Tax Credit, and you would need to manage your income in a few different ways to qualify for it.

Yes, I'm aware that the EITC has a $3350 limit (for 2014) on investment income including bank account interest, dividends, and capital gains.  I think this is a pretty easy requirement to meet with a little tax planning.  The typical advice is to hold interest-generating assets like like bonds inside of a tax shelter anyway, so it shouldn't be too hard.  If your taxable account is in something like VTSAX with it's 1.83% dividend yield, you could have over $100k in your taxable account and still be safe.  Since anyone utilizing the Roth IRA pipeline is going to be living primarily off of Roth contributions anyway, your taxable account shouldn't need to be too large.  And the recently discussed mega-backdoor Roth, for after tax 401k contributions, provides a very convenient alternative to a taxable account with all of the same advantages.

sol

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Re: Landlords, are you a business?
« Reply #16 on: October 30, 2014, 08:26:18 PM »
Seems like the rental income would be unearned income in this case though, so I'd have to take nearly all of it as salary and only a little as dividends, no?

I'm not entirely sure how the dividends angle would work, but I suspect that if you are running your own company, and paying yourself as an employee of that company, you get to decide how much you pay out as salary and how much you pay out as dividends.  I don't see any reason to pay yourself dividends if you don't want to, especially if doing so jeopardizes a useful tax credit.

But if you have the space under that $3350 cap, and it sounds like you would if you don't have a taxable account, you can shield some of your rental income from taxation by paying it as dividends.

Cheddar Stacker

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Re: Landlords, are you a business?
« Reply #17 on: October 30, 2014, 08:38:50 PM »
Rental real estate by it's nature is a passive activity, no matter how active your are involved in it. If you put in enough time you can designate yourself as a qualified real estate professional. This allows you to treat all your separate holdings as one pool, so losses from one can offset gains from another. Even with that designation I don't believe any of this becomes earned income.

Here are a few real estate related activities that you could generate earned income with:

-a property management company you own/run.
-a maintenance company you own/run.
-flipping houses and being actively involved.

In any of those instances you could pass the IRS sniff test in calling the profits earned income, or paying yourself a wage via a W-2 or 1099. Short of something like that, I don't see a way for this to work, but I didn't research it and there are smarter tax minds than mine on these boards. Anyone else care to chime in?

sol

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Re: Landlords, are you a business?
« Reply #18 on: October 30, 2014, 08:47:33 PM »
Rental real estate by it's nature is a passive activity, no matter how active your are involved in it

Yes, I was thinking you'd have to hire yourself as the property manager, rather than just funneling rents through a company.  There is work to be done in finding and reviewing tenants, collecting rents, dealing with delinquencies and evictions, filing the taxes, maintaining or updating the properties, and arguably in the pursuit and review of additional properties.  Those are all activities that a real estate business would pay someone to do, so I think you can pay yourself to do them.

And if it's your own damn company, whose to say you can't pay yourself $250/hour to do this stuff?  As long as you don't pay yourself so much that your business doesn't turn a profit, you should be fine.
« Last Edit: October 30, 2014, 08:57:03 PM by sol »

Cheddar Stacker

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Re: Landlords, are you a business?
« Reply #19 on: October 30, 2014, 08:55:32 PM »
Maybe. You can do whatever you want, I'm just not sure it's legal. The IRS has some very strict rules when it comes to related party transactions. And if you own 100%, you are certainly related.

It might be possible, but I've never seen anyone doing it or advised anyone to do it.

They can also assess whether you are paying yourself reasonable compensation. Paying a 50% management fee for instance would not be considered reasonable.

It's an interesting thought. However, I would bet someone else thought of this a long time ago, then did it, then the IRS created rules preventing it, I just don't know those rules well enough. I might research it a bit more when I have more time. Busy week for me.

sol

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Re: Landlords, are you a business?
« Reply #20 on: October 30, 2014, 09:06:56 PM »
I don't know enough about corporate taxes to make any intelligent commentary here, but maybe the problem with this plan is that the business has to pay taxes that you as an individual do not?

An early retiree landlord with $20k in rental income probably pays zero taxes, due to deductions and exemptions and depreciation.  A early retiree who is an employee of his own company is in the same personal tax situation, but his company will have to pay OASDI taxes and maybe also corporate income taxes.  The depreciation of the property would have to accrue to the company, not the individual, but other than that I don't know what kind of deductions and exemptions a corporation would get.  If you have to pay another 15% in taxes on top of the 15% OASDI taxes, then there's a very narrow range of incomes over which paying the tax and claiming the EITC would come out ahead of not paying and not claiming.

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Re: Landlords, are you a business?
« Reply #21 on: October 30, 2014, 09:49:40 PM »
interesting thread. following to see where it goes

brooklynguy

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Re: Landlords, are you a business?
« Reply #22 on: October 30, 2014, 09:50:44 PM »
I don't know enough about corporate taxes to make any intelligent commentary here, but maybe the problem with this plan is that the business has to pay taxes that you as an individual do not?

An early retiree landlord with $20k in rental income probably pays zero taxes, due to deductions and exemptions and depreciation.  A early retiree who is an employee of his own company is in the same personal tax situation, but his company will have to pay OASDI taxes and maybe also corporate income taxes.  The depreciation of the property would have to accrue to the company, not the individual, but other than that I don't know what kind of deductions and exemptions a corporation would get.  If you have to pay another 15% in taxes on top of the 15% OASDI taxes, then there's a very narrow range of incomes over which paying the tax and claiming the EITC would come out ahead of not paying and not claiming.

That problem can be avoided by using an LLC or other pass through entity.  I think it's more likely that the fatal flaw, if there is one, lies in the issues Cheddar raised.

brooklynguy

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Re: Landlords, are you a business?
« Reply #23 on: October 31, 2014, 06:56:18 AM »
Yes, I'm aware that the EITC has a $3350 limit (for 2014) on investment income including bank account interest, dividends, and capital gains.  I think this is a pretty easy requirement to meet with a little tax planning.  The typical advice is to hold interest-generating assets like like bonds inside of a tax shelter anyway, so it shouldn't be too hard.  If your taxable account is in something like VTSAX with it's 1.83% dividend yield, you could have over $100k in your taxable account and still be safe.  Since anyone utilizing the Roth IRA pipeline is going to be living primarily off of Roth contributions anyway, your taxable account shouldn't need to be too large.  And the recently discussed mega-backdoor Roth, for after tax 401k contributions, provides a very convenient alternative to a taxable account with all of the same advantages.

Also, not to derail the thread, but shouldn't anyone meeting these criteria (i.e., someone utilizing a Roth conversion pipeline who has no taxable accounts generating more than $3350 of investment income) already qualify for the EITC without having to resort to a rental business (assuming the Roth conversions in their pipeline fall within the minimum and maximum earned income requirements)?

I suppose this highlights another reason to explore the rental as a small business idea, if you plan on having rental property anyway (because rental income counts as disqualifying investment income, so if you want the EITC you need to find a way to shelter any rental income in excess of $3350).  However, I suspect Cheddar is right that there are rules to prevent you from artificially transforming investment rental income into active earned income.  (Otherwise, why stop with real estate?  Why not make your securities investments a small business too, and pay yourself a salary for your investment management services?)  Cheddar, I'm eager to find out if you learn anything more about this, or if any other knowledgeable folks have any insight.

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Re: Landlords, are you a business?
« Reply #24 on: October 31, 2014, 08:30:20 AM »
The strange thing about this is in my experience everyone does everything they can to go the other way, trying to make earned income passive. This is a new wrinkle. If I don't respond again next week someone post here as a reminder.

sol

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Re: Landlords, are you a business?
« Reply #25 on: October 31, 2014, 09:51:51 AM »
shouldn't anyone meeting these criteria (i.e., someone utilizing a Roth conversion pipeline who has no taxable accounts generating more than $3350 of investment income) already qualify for the EITC

I don't think so, just because the EITC requires earned income and an early retiree without another side gig wouldn't have any.  Roth conversions, like as part of a pipeline, don't count.  Anyone can make Roth conversions, even people without earned income.

Quote
(because rental income counts as disqualifying investment income, so if you want the EITC you need to find a way to shelter any rental income in excess of $3350)

I don't think it does, at least not for EITC purposes.  Things like child support also don't count as disqualifying income. 

brooklynguy

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Re: Landlords, are you a business?
« Reply #26 on: October 31, 2014, 03:02:32 PM »
shouldn't anyone meeting these criteria (i.e., someone utilizing a Roth conversion pipeline who has no taxable accounts generating more than $3350 of investment income) already qualify for the EITC

I don't think so, just because the EITC requires earned income and an early retiree without another side gig wouldn't have any.  Roth conversions, like as part of a pipeline, don't count.  Anyone can make Roth conversions, even people without earned income.

Having done some more research on this, I believe you are correct.



Quote
(because rental income counts as disqualifying investment income, so if you want the EITC you need to find a way to shelter any rental income in excess of $3350)

I don't think it does, at least not for EITC purposes.  Things like child support also don't count as disqualifying income.

But on this point, I think you are incorrect.  Worksheet 1 in IRS Publication 596 (on page 6 of the pdf linked to below) includes rental income from Schedule E in the determination of investment income for purposes of the EITC. 

http://www.irs.gov/pub/irs-pdf/p596.pdf

sol

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Re: Landlords, are you a business?
« Reply #27 on: October 31, 2014, 08:54:49 PM »
Worksheet 1 in IRS Publication 596 (on page 6 of the pdf linked to below) includes rental income from Schedule E in the determination of investment income for purposes of the EITC. 

Yea, we totally need an accountant here who specialized in small business taxes.  This community is great, but I'm sure there is a more appropriate one to be asking these kinds of esoteric questions.  Anybody have any suggestions for where I might look?

If you're right, and I have no reason to dispute you because I'm an ignorant buffoon, then the business would have to retain the majority of the profits.  That income would still accrue to you eventually, but it would require some shenanigans like paying yourself a small salary plus dividends from company profits.   Or having the company reinvest its cashflow into more properties or paying down the mortgages.  Or something.

brooklynguy

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Re: Landlords, are you a business?
« Reply #28 on: November 01, 2014, 06:11:45 AM »
Yea, we totally need an accountant here who specialized in small business taxes.  This community is great, but I'm sure there is a more appropriate one to be asking these kinds of esoteric questions.  Anybody have any suggestions for where I might look?

If you're right, and I have no reason to dispute you because I'm an ignorant buffoon, then the business would have to retain the majority of the profits.  That income would still accrue to you eventually, but it would require some shenanigans like paying yourself a small salary plus dividends from company profits.   Or having the company reinvest its cashflow into more properties or paying down the mortgages.  Or something.

The problem with conventional resources for tax advice is that they don't look at things through the lens of extremely early retirement.  I think this forum is actually the single best place around to ask these kinds of questions (even the esoteric ones), due to a unique combination of attributes:  (i) it is populated by some of the smartest people on the internet (who are well-versed in a range of relevant topics, including tax), (ii) it is focused on FIRE matters, and (iii) it has a sufficiently large number of active participants for the marketplace of ideas to weed out bad information.

Once we get some consensus here, I think that's the point when it makes sense to go off and confirm the approach using appropriate due diligence (which may involve consulting with a bona fide professional) before acting on it.  (Unfortunately, the IRS doesn't accept the "I read it on the internet so it must be true" defense.)

Maybe we can exploit the kindness of Cheddar and add this to his workload (i.e., confirming whether rental income ordinarily counts as disqualifying investment income for EITC purposes).

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Re: Landlords, are you a business?
« Reply #29 on: November 03, 2014, 10:39:35 AM »
Sol, I didn't real all the responses in detail, but are you talking about this venture after retirement? As CheddarStacker said, I don't see any way of getting past the passive activity issue, certainly not while you still have your traditional job. No matter how you organize yourself (individual, LLC, S Corp, etc.), it's pretty well impossible to get past the IRS definitions of passive activity for residential real estate. Even as a retiree, unless you're a real estate professional (as defined by the IRS with minimum hourly requirements), all rental activities will be considered passive, and will likely thwart your plans for having that income considered as coming from a business.

Standard disclaimer: I am not a tax professional, just someone who read the IRS regs in painstaking detail when trying (and was unable) to get around the passive income issue. I also had an LLC with me as the operating manager (for other real estate purposes), and that did not matter.


sol

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Re: Landlords, are you a business?
« Reply #30 on: November 03, 2014, 02:35:25 PM »
Yes, I'm talking about after retiring,  when you have no other income.

And I don't need to make all of my rental income into earned income, just some small portion to be paid to myself as salary for managing and maintaining the properties.

arebelspy

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Re: Landlords, are you a business?
« Reply #31 on: November 03, 2014, 05:06:43 PM »
Will you be doing 750 hours of real estate annually?
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Re: Landlords, are you a business?
« Reply #32 on: November 03, 2014, 05:22:45 PM »
Not sure if this is relevant to most, but Antioch here in Ca has a measure on the ballot for tomorrow to force landlords to register as a business and pay a tax ($250 per household or $150 per condo) to make landlords "pay their fair share" not thinking that they would directly pass this cost on to their tenants.

http://www.contracostatimes.com/contra-costa-times/ci_25848583/antioch-landlord-tax-measure-will-find-home-november

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Re: Landlords, are you a business?
« Reply #33 on: November 03, 2014, 05:38:12 PM »
Perhaps some of the best books on the subject are John T Reed's Aggressive Tax Avoidance for Real Estate Investors...

http://johntreed.com/

generally speaking he advises people to just stay a sole proprietor unless you have partners or investors. He also advises to never have partners or outside investors. :-)

sol

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Re: Landlords, are you a business?
« Reply #34 on: November 03, 2014, 07:20:00 PM »
Will you be doing 750 hours of real estate annually?

The 750 hour test is for declaring yourself a real estate professional and thus exempt from the passive income rules. 

It would be a stretch for only a handful of properties, even accounting for things like attending a week-long RE conference and two weeks of training per year.  Would still have to average like 12 hours per week on the management side, which probably means at least six properties under management. 

But I think it misses the larger question.  I'm suggesting that you give up ownership of the properties, like quit claim them to the company.  Corporations are distinct tax entities separate from their owners.  The company would own the properties.  It would incur all profit and loss from owning the rentals.  You would be an employee who draws a small salary from the company.  Can't a CEO draw a salary from his company in the same way any other employee can?

In this case the corporation is not just a pass-through entity because the profits and losses incurred are not yours, they are the company's.  You would have no income (passive or otherwise) except for the salary you draw from it.  I'm thinking of it kind of like being an employee of a private REIT that you also invest in.

Am I living in a fantasy world?  Is the IRS going to hunt me down?

brooklynguy

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Re: Landlords, are you a business?
« Reply #35 on: November 03, 2014, 08:45:33 PM »
The 750 hour test is for declaring yourself a real estate professional and thus exempt from the passive income rules. 

It would be a stretch for only a handful of properties, even accounting for things like attending a week-long RE conference and two weeks of training per year.  Would still have to average like 12 hours per week on the management side, which probably means at least six properties under management. 

But I think it misses the larger question.  I'm suggesting that you give up ownership of the properties, like quit claim them to the company.  Corporations are distinct tax entities separate from their owners.  The company would own the properties.  It would incur all profit and loss from owning the rentals.  You would be an employee who draws a small salary from the company.  Can't a CEO draw a salary from his company in the same way any other employee can?

In this case the corporation is not just a pass-through entity because the profits and losses incurred are not yours, they are the company's.  You would have no income (passive or otherwise) except for the salary you draw from it.  I'm thinking of it kind of like being an employee of a private REIT that you also invest in.

Am I living in a fantasy world?  Is the IRS going to hunt me down?

If you can do it with real estate, can I do it with index funds?

My guess is that, as Cheddar suggested, the IRS may be able to look behind the form at the substance and disallow you from artificially transforming passive income into earned income.  I don't know enough about this area to speak all that intelligently, but I do know that in the business world there are times when the absence of a legitimate business purpose can cause a transaction to cross the line from acceptable tax avoidance to illegal tax evasion -- that is, if a transaction is conducted for no legitimate reason other than the reduction of taxes, it may be illegal (even if the transaction is legal in all other respects).  And this is starting to sound like that.

DoubleDown

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Re: Landlords, are you a business?
« Reply #36 on: November 03, 2014, 08:46:28 PM »
Will you be doing 750 hours of real estate annually?

The 750 hour test is for declaring yourself a real estate professional and thus exempt from the passive income rules. 

It would be a stretch for only a handful of properties, even accounting for things like attending a week-long RE conference and two weeks of training per year.  Would still have to average like 12 hours per week on the management side, which probably means at least six properties under management. 

But I think it misses the larger question.  I'm suggesting that you give up ownership of the properties, like quit claim them to the company.  Corporations are distinct tax entities separate from their owners.  The company would own the properties.  It would incur all profit and loss from owning the rentals.  You would be an employee who draws a small salary from the company.  Can't a CEO draw a salary from his company in the same way any other employee can?

In this case the corporation is not just a pass-through entity because the profits and losses incurred are not yours, they are the company's.  You would have no income (passive or otherwise) except for the salary you draw from it.  I'm thinking of it kind of like being an employee of a private REIT that you also invest in.

Am I living in a fantasy world?  Is the IRS going to hunt me down?

Yeah, unfortunately I think that's a fantasy, although I don't know if they'll hunt you down. First, I don't think you can avoid the 750 hour-test just by structuring things as a business and placing ownership of the properties with the company. That is, the IRS does treat the company as a pass-through entity for tax purposes. The IRS has foreseen what you are contemplating, and I'm assuming specifically set up the passive activity/real estate professional test in order to prohibit exactly what you are proposing. How the properties are owned is really immaterial to how the IRS deals with the taxes on you.

Secondly, transferring ownership of properties to a corporation is great in theory, but then you encounter all kinds of difficulties like obtaining a mortgage, getting insurance, etc. They aren't insurmountable problems, but definitely add a wrinkle.

I mean, definitely read up on it and see if you can find any reasonable way of making it work, but after looking into it myself I recall finding no way to do what you are proposing without becoming a "real estate professional" and spending lots of hours at it in order to meet the IRS criteria. Being a company doesn't matter unless "the company" is spending at least 750 hours at it every year (and is not doing any other work more than that).

Bobberth

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Re: Landlords, are you a business?
« Reply #37 on: November 04, 2014, 03:04:07 PM »
I'm going to start off saying I don't know but I'm thinking some things out loud.

I would think that if this was possible, it would be beneficial for high tax bracket individuals to set up a separate corporation for an individual property and maximize the low initial corporate tax rate.  My guess is that it is not possible as a straight rental corp. 

Don't forget that when you convert passive income to earned, you now have to pay 15.3% FICA tax on it.  You could deduct health insurance premiums.  Most business setups that I've seen are a C corp owns the business for the deductions and an S corp owns the real estate and charges enough rent to keep the C corp in the lowest income bracket.

My guess is that if this is even possible, it would have to be set up as a multi-member corporation in the least.  I think if you set it up as a single member (or even with your spouse or close family) that the IRS would pierce it and you wouldn't gain anything.

EastCoastMike

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Re: Landlords, are you a business?
« Reply #38 on: November 04, 2014, 04:37:39 PM »
I've been wondering the same thing for when I start accumulating rentals.  Tax advantages aside, I like the idea of separating the rentals from personal assets.  I'm not comfortable with the idea of exposing all my personal assets to any potential lawsuits.

johnhenry

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Re: Landlords, are you a business?
« Reply #39 on: November 05, 2014, 09:43:04 AM »
The strange thing about this is in my experience everyone does everything they can to go the other way, trying to make earned income passive. This is a new wrinkle. If I don't respond again next week someone post here as a reminder.

I've done quite a bit of research on this over the years.  I'll admit I've forgotten most of what I've learned since it never has panned out.  We have several rentals that generate passive income on our Schedule E and each time we've investigated moving to a C-Corp or LLC/S-Corp the numbers not only don't make sense, but we realized that claiming the income as we do is already a sweet deal.  We have been motivated to look because we are young and FIRE and were hoping to find creative ways to show some more earned income for the purpose of funding SEP IRA or Solo 401(k).  But it turns out, even if there is a way to turn RE income from unearned to earned (and I'm not sure there is), you wind up signing up for more new taxes that you avoid.

Since the RE income is all unearned/passive, we only pay federal/state tax on it.  No FICA, self-employment, or local for us.  Any strategy that "shows" this income some other place will likely incur those taxes right off the bat.

Where a C-Corp is concerned.  It seems (from memory) that if it showed under $50K it's tax rate remained lower, but there were also some points against every holding RE within a C-Corp.  Even if there is a C-Corp that does other (non RE) business, it's often wise to hold any business RE in a separate LLC and have the C-Corp pay rent if it's using the building, or if it's getting paid rent, have the rent paid to the LLC/individual.

From memory, C-Corps pay capital gains at their normal rate.  So you wouldn't have the option of unloading the property in a no/low income year to avoid capital gains tax.  This is moot if you choose to 1031 exchange, but it's a good part of an exit strategy that you lose if it's held in a C-Corp.  Also, property transferred from C-Corp to individual doesn't have the benefit of transferring on a stepped up basis.  Another point against for long-term holding and exit strategy options.

With C-Corp off the table as an option, it seems that LLC/S-Corp was the other possibility.  It's possible to run money through an S-Corp and then pay some of it to the owner as salary and some as dividends instead.  But I think this option would only be worth exploring if the income in question was earned and not passive RE income.

Not an expert, but interested in this thread and finding out if others have creative ways to hold RE for tax advantage.




johnhenry

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Re: Landlords, are you a business?
« Reply #40 on: November 05, 2014, 09:53:58 AM »
I forgot to mention, if you do show earned income as a sole proprietor or as a business/employee you are going to wind up paying both the employer AND employee portions of those taxes that were avoided before.

Again, not saying that you can even claim passive RE income in that manner, but if you were trying to.... that would be an obstacle you'd be up against.

mooreprop

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Re: Landlords, are you a business?
« Reply #41 on: November 06, 2014, 10:20:44 AM »
Good answer, John Henry.  I am not a tax professional, but I think most of what you said is what I recall from when I investigated this.  I keep having to tell my husband every year that we do not need to set up a corporation to have tax advantages, and that the liability protection can be obtained using alternate methods.  Since I do all the paperwork, he thinks this sounds great.  lol  By the time you pay both the employer side and the employee side of the equation, I would have a lot of work for little money.

Another time I can think of that the additional work might be worth it is if you have kids in college and can qualify for more financial aid in addition to the tax perks.  I am not sure if they count real estate held by a corporation as personal assets on the FAFSA, however.  I considered it when I was facing two kids in college at the same time, but they both got full-ride academic scholarships luckily.

Cheddar Stacker

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Re: Landlords, are you a business?
« Reply #42 on: November 06, 2014, 11:06:21 AM »
Ok, so I stayed out of this thread for a while to keep it in my "unread replies" and to think on it a bit. I was unaware sol was hinting at making this a C-Corp until reply #34 and that explains a lot.

My answer after thinking through it all - johnhenry summed it all up pretty well there, but I'll add a few things.

C-Corp notes:
- You lose the ability to offset losses (if any) against other income on your 1040.
- The net income is taxed at 15%-39%, < $50K is 15% which isn't much different than a 1040.
- If you leave profits in a C-Corp they are taxed when you take those profits out in the form of dividends.
- Big exception to note, I see no reason why these would not be qualified dividends which are currently taxed at 0% if you are in the 15% bracket or lower.
- Everything above still generated no earned income, to do so you must pay yourself a wage for running the business.
- When you pay yourself a wage as JH mentioned you are now subject to SE/FICA and local earnings taxes where applicable. This is a tough hurdle to get over as it's a 14% ish hit (15.3% less the deduction for the ER portion).
- If you pay a wage you could then have a 401k, solo 401k, SEP IRA, whatever, but any contributions do not reduce the SE tax. Your benefit of deferring would have to exceed 14% at least to make it worth your efforts. If this is possible, maybe it makes sense, but it seems your effective tax rate would need to be > 15% which might be tough, particularly for you sol since as you point out you have $60k of free tax space right now.

If you can do it with real estate, can I do it with index funds?

My guess is that, as Cheddar suggested, the IRS may be able to look behind the form at the substance and disallow you from artificially transforming passive income into earned income.  I don't know enough about this area to speak all that intelligently, but I do know that in the business world there are times when the absence of a legitimate business purpose can cause a transaction to cross the line from acceptable tax avoidance to illegal tax evasion -- that is, if a transaction is conducted for no legitimate reason other than the reduction of taxes, it may be illegal (even if the transaction is legal in all other respects).  And this is starting to sound like that.

All of this is true, to an extent. You can manufacture some legitimacy here. For instance I will share that our firm has a client organized as a private, family owned C-Corp. Dad owns a big chunk, and so does his revocable trust, and so does his daughters, and a few other trusts. The C-Corp's sole purpose is investing, so it's sort of along the lines of Brooklyn's question about doing this with index funds. (side note-owning marketable securities in a C-Corp is a fool's game since you can't carry back capital losses more than 2 years and you can't carry them forward more than 5 years. I've had to bail out this client, and one other one, with extremely creative "sales" of investments to utilize their losses from big market declines)

The guy who put the capital in (the president-aka daddy warbucks) runs the C-Corp's investing activities and pays himself a hefty salary for doing so, and in our eyes it's completely legitimate. The business purpose for the C-Corp is to invest and the income earned by the president is very well earned. I wouldn't advise doing this at all for various reasons. One of them is a form of triple taxation on dividends which is a very crazy rule. I'll post about that next as this is already way too long of a reply.

In summary, it doesn't make sense to me, but it can be legitimately done. Successfully done for a tax profit is TBD by whoever analyses their own circumstances.

Cheddar Stacker

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Re: Landlords, are you a business?
« Reply #43 on: November 06, 2014, 11:14:42 AM »
Triple Taxation

I own a C-Corp.
My C-Corp invests in other C-Corps.
Other C-Corps pay my C-Corp dividends from their profits which have already been taxed on their tax return. Tax#1
I report those dividends on my C-Corp tax return.
I do receive a "dividends received deduction" of 70%, so my C-Corp pays tax at the appropriate tax rate * 30%. Tax#2
My C-Corp is profitable and out of the net income I pay dividends to the stockholders.
The stockholders report the dividends on their tax return and pay their proportionate taxes. Tax#3

Crazy huh? But it happens a lot. The 70% dividends received deduction is a nice little favor from the IRS, but why not 100%? And at the 1040 level if you are in the 10% or 15% bracket your tax is currently $0. So it's not 100% triple taxation, but you get the idea. This is one very good reason not to do what brooklynguy asked.

brooklynguy

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Re: Landlords, are you a business?
« Reply #44 on: November 10, 2014, 10:47:11 AM »
Thanks johnhenry and cheddar for your insights.

Sounds like the upshot is that it is very unlikely for this scheme to result in a net positive from a tax perspective.  And even if the stars appear to be aligned to make this worth doing under some individual's particular circumstances, I would be afraid of unintended consequences stemming from both (i) the issues we are not thinking of and (ii) changes in individual circumstances and/or tax laws that change the analysis.

But getting back to sol's original question in its broadest sense, let's not forget that landlording is in fact a business.  So while you may not be able to structure the business in a way that allows you to hack your way into receiving the EITC or establishing a SIMPLE IRA, you do get the more plain vanilla benefits associated with running a business, like tax deductions for a wide variety of expenses related to the business.  Personally, one less-obvious benefit I get from my rental apartment is that it qualifies me for business credit cards that I use in the miles game.

arebelspy

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Re: Landlords, are you a business?
« Reply #45 on: November 10, 2014, 01:20:51 PM »

But getting back to sol's original question in its broadest sense, let's not forget that landlording is in fact a business.  So while you may not be able to structure the business in a way that allows you to hack your way into receiving the EITC or establishing a SIMPLE IRA, you do get the more plain vanilla benefits associated with running a business, like tax deductions for a wide variety of expenses related to the business.  Personally, one less-obvious benefit I get from my rental apartment is that it qualifies me for business credit cards that I use in the miles game.

Yeah but you get that regardless of if you set up the business like sol's describing or not - even if done in your own name. So it's not super helpful - it's the basic already happening. Something like this would actually go above and beyond to really useful.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
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brooklynguy

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Re: Landlords, are you a business?
« Reply #46 on: November 10, 2014, 02:01:55 PM »
Yes, that's the point that I was trying to make -- that even though it may be difficult or impossible to achieve what sol proposed, that doesn't mean the answer to his initial question is that landlords are not a "small business."  We are still entitled to the regular garden variety benefits that come along with owning a business (with no fancy structuring necessary).

johnhenry

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Re: Landlords, are you a business?
« Reply #47 on: November 11, 2014, 08:06:57 AM »
Yes, that's the point that I was trying to make -- that even though it may be difficult or impossible to achieve what sol proposed, that doesn't mean the answer to his initial question is that landlords are not a "small business."  We are still entitled to the regular garden variety benefits that come along with owning a business (with no fancy structuring necessary).

Exactly.  That's the way I look at it as well.  Sol was right to ask the question whether this strategy could make sense.  It's unfortunate that it probably doesn't.  It would be interesting to see someone post a tax consequence comparison for an early retiree.  Someone who was say 35 or 40, to see how their taxes would differ if they had a side gig that made (net) $20K (earned income) vs. $20K from rentals (unearned income).  Then for both cases, assume $10K in unearned income from traditional investments.  Using the 1% rule and the 50% rule, assuming the depreciable property was 85% of the total value, you could calculate what the annual amount of depreciation claimed would be for the rental business.  Of course an estimate would need to be made for the depreciation of any property for the side gig making earned income.  Depreciation being a key factor, because it determines how much income can be deferred.

To expand on Brooklynguy's way of thinking.... If you are FIRE or approaching FIRE, don't discount RE rental just because it doesn't allow you to have earned income and thus fund Solo 401(k)s, SEP IRAs and the like.  Instead give extra consideration to RE because income is unearned and thus subject to less tax upfront (for those with smallish incomes under the threshold at which FICA tax stops). 

This is especially powerful for those of us who do most of the repair, maintenance, and PM ourselves.  It's said a lot on this forum that if you do the work yourself, you shouldn't include all the profit in your "investment return" but instead realize that some is being paid to yourself for labor.  Well that is one way to look at it.  But another way to look at it is:  Owning a RE rental business, where much of the work is done by the owner, not only saves the premium one pays to another for-profit entity, BUT allows the owner to use his labor to generate unearned income!!  In short, if you are able and willing to spend your labor there, that may be the best place for it.

Of course in the real world, people are also taking into consideration how much of their business can be done in cash, because that has nice tax consequences too!! :)  It's probably a little easier to run a side gig making earned income where you make $30K, but claim $20K.  I'm not advocating that behavior, but I know lots of small business owners (farmers, plumbers, dirtwork guys, computer repair) who also own RE rentals and I don't know any that don't deal with some unreported cash.


Cheddar Stacker

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Re: Landlords, are you a business?
« Reply #48 on: November 11, 2014, 08:42:44 AM »
Another good post by johnhenry. I like the way you think (except the tax evasion part, can't condone that).

The most important take away for me from your post is earned vs. unearned income during retirement. The former implies a lot of effort and work, and the latter does not. For that reason alone, I prefer the latter for generating income post FIRE.

And if I can find some time I may run that $20K comparison and circle back here to post it. So many variables though, this could be tough. EIC, Savers Credit, AFA subsidies state by state, IRA's, dependents.....Gaaaah!

Cheddar Stacker

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Re: Landlords, are you a business?
« Reply #49 on: November 11, 2014, 10:36:37 AM »
Right, so I made time. This stuff just intrigues me so I had to. Very interesting results, but make sure you read these assumptions first:

1) Don't have any investment income > $3,350 or you are disqualified from the EIC; I used $3,300 Q Divs.
2) Don't earn too much income or you will be disqualified from the EIC.
3) Roth IRA withdrawals do not count against the EIC.
4) T. IRA withdrawals (and conversions from T to Roth) add to gross income and count against the EIC.
5) If you see IRA distributions, then less Roth portion, all that must be Roth principal for this to work.
6) If you don't see less Roth portion, it came out of a T.IRA (assume it's a T to R conversion).
7) This is 2013 tax data because it's the best available resource to me to calculate this all accurately.
8) This ignores states.
9) This ignores the AFA subsidies since they weren't around yet.
10) IRA contributions didn't help anything since there is no federal tax, so I left them out. If you make more this could come into play, and you might get a savers credit. But earning more might boot you out of the EIC, depends on deferrals.
11) The earned column assumes the $20K is wages or a schedule C, the passive column assumes the $20K is rental income.

Sorry about the formatting, I'm still working on this skill. The first 2 columns are a DINK couple. The next 3 columns are a married couple with 2 kids (which is my situation, so I used it). I used the standard deduction across the board.

DINKMFJ 2 Kids
EarnedPassiveEarnedEarnedPassive
Business Income20,00020,00020,00020,00020,000
Qualified Dividends3,3003,3003,3003,3003,300
IRA Distributions30,00030,00030,00015,00030,000
Less Roth Portion-30,0000-30,0000
1/2 SE Tax-1,4130-1,413-1,4130
IRA Contributions00000
Standard Deduction-12,200-12,200-12,200-12,200-12,200
Exemptions-7,800-7,800-15,600-15,600-15,600
Taxable Income1,88733,300-5,9139,08725,500
Federal Tax03,61105782,441
SE Tax2,82602,8262,8260
Total Tax2,8263,6112,8263,4042,441
Earned Income Credit00-5,372-2,4230
Child Tax Credits00-2,000-2,000-2,000
Balance Due (Refund)2,8263,611-4,546-1,019441

My take away from this: If you are going to shoot for the earned income credit, which is obviously a nice little benefit but only realistic with kids, you lose the ability to roll over your T.IRA into a R.IRA in a tax efficient manner. I created two versions of the "Earned" column to illustrate this under the 2 kids scenario. In one you are drawing only from Roth, and in the other you are drawing nothing from Roth but converting $15K from T to R which cuts your EIC and adds $3,527 to the balance due (24% effective tax). 

Sol, I think you have 3 kids so this option looks appealing on the surface. If you are already Roth heavy it could be worth it. If you have a lot deferred it might hamstring your ability to convert everything into Roth before RMD's kick in. I see this as a temporary strategy if you get a side gig making a few dollars shortly after retirement. Or, maybe a long-term thing if you never deferred a lot to begin with for some reason. In any case, it seems to only make sense if you do everything you can to qualify for the EIC.

And lastly, I'm still not sure it would be worth owning the rentals in a C-Corp in order to generate earned income via a wage, because if this is a temporary strategy you would use for a brief time. Once the dependents disappear this loses a large part of it's appeal anyway. And for you DINKs, keep it passive, this strategy likely won't help you much.