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option8

Flipping vs. Assignments

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Am I missing something here?

Gene,

 

Yes, you are missing quite a bit here.

 

First, let me state for the record that I never did respond to the original question posted by Option8. His question was posted in the Legal Forum and answered there. Meanwhile MichaelC sent me a PM with a different (but related) question. My responses to Michael got appended to this thread, and then this entire thread got moved to the Tax Strategies Forum.

 

So, for the record, let me say that the tax treatment for assignments and for flips is the same. In the absence of a corporate business entity, they are both reported on Schedule C and self-employment taxes are computed on Schedule SE.

 

The thread then digressed into which business entity to use and why you might want to use two separate entities for your rental activity and for your flip activity. The responses contained the general guidance that an LLC is best for your long term rental holdings, and an S-Corp is usually best for your flip activity. This same suggestion was confirmed for you by the CPA which addressed your local REI Club meeting.

 

What was probably left out is the LLC structure (this is a big part of what you are missing). The organizational structure you elect is determined when you form the LLC. The structure you elect, determines the LLC's tax treatment. An LLC is organized as one of the following

  • Corporation
  • Partnership
  • Disregarded entity

Rental property activity is a passive income activity. Depreciation expenses are allowed, capital gains tax treatment is allowed, 1031 exchanges are allowed, and the taxpayer is allowed to use up to $25K in net passive losses to offset other ordinary income. Additionally, passive income is not subject to self-employment taxes. If you want to operate your rental activity from within an LLC, you want to elect an entity structure that preserves all these tax advantages. Because a partnership and a disregarded entity are both "pass-through" entities, an LLC organized as a partnership or as a disregarded entity will preserve all the tax advantages of rental property ownership in your own name.

 

On the other hand, property flipping is an active income activity. Capital gains tax treatment is not allowed, 1031 tax treatment is not allowed, your net income is taxed at your ordinary income tax rates, and your net income may also be subject to self-employment income taxes. If you want a business entity to conduct your property flip activity, then a corporation gives you more opportunities to take reasonable and ordinary business expenses against your income and reducing your tax burden. You can elect a Subchapter C Corporation or a Subchapter S Corporation. The C-corp brings double taxation issues into play, but allows you to write off health care insurance premiums, corporate "keyman" insurance policy premiums. The net income earned by the C-corp is taxed at corporate rates beginning with 15%.

 

The S-corp is more restrictive about corporate writeoffs, but you don't have the double taxation issue to deal with. Unless your S-Corp pays you a reasonable salary, all of your net income from your S-Corp flows through to you and is taxed at your ordinary income tax rate (whatever your marginal tax bracket happens to be). Additionally, your net income from your S-Corp is subject to self-employment income. You can reduce the self-employment income tax effect by taking a reasonable salary. Your salary is subject to the self-employment income taxes, but the corporate share of these taxes is a deduction to the business. The balance of the S-corp net profit can then be taken as a dividend. The dividend passes through to your Schedule B and is taxed at your ordinary income tax rate, but is not subject to self-employment income taxes.

 

By the way, a LLC organized as a corporation, defaults to a C-Corp. You have to make a separate election to convert your C-Corp to an S-Corp.

 

There is not a single answer to your question about the best business entity to use. The answer depends upon your personal financial statement, your estate planning requirements, and your ability to use corporate writeoffs. The best entity for you might not be the best entity for me. This decision should involve your tax planner, your estate planner, and your CPA.

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Dave T:

 

Thank you very much for the informative post. I sincerely appreciate you taking the time to answer my question thoroughly.

 

Gene

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Dave,

Just for clarification... Are you saying 2 different entities for the best protection or one entity with 2 (or more subaccounts) is sufficient.

Thanks

option8

 

This is good stuff. I needed this. I have an LLC now but will also form a S-corp for handling my flips and L/O's.

 

My CPA feels the same way. I should have an S-corp for the flips and LO's and always a separate LLC for each rental property.

 

 

Thanks..for the clarification.

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My local REI association met last week and one of the speakers was a CPA.  One main topic of her presentation was entity selection.  I left this meeting feeling very confused.  This confusion was due to my assumption that an LLC was the proper legal entity for my lease purchasing business.  The speaker stated that LLC’s are good for holding rental properties long term and S-corporations are better for quick flips or l/o’s.

 

This thread addressed some very good points.  However, I wonder if the original question was completely satisfied.  Option8 asked “What is the tax implication difference between a flip and a assignment?”  Dave T. clarified the question stating that it is really a dealer issue.  Bottom line…dealer property is not eligible for the same tax benefits as investment property.  The thread then veered over to a discussion of how to keep investment and dealer property separate so that the IRS does not tax all transactions as dealer transactions.

 

I am wondering what entity will best satisfy our financial needs related to the dealer issue.

 

It is my understanding that an LLC will still be liable for self employment tax, where an S-corporation would not.  SE tax is approximately 15% and this is in addition to the ordinary income tax that would be applied to our profits.

 

Does an LLC have other substantial benefits that outweigh the self employment tax issue?  Am I missing something here?

 

Gene

 

If I can revisit this...I currently only have a LLC. According to the posts, my LLC automatically defaults to a C-corp. If this is the case should I elect for S-corp status if I will be only doing lease purchases, CA's, and wholesale flips?

 

ALSO, when stating "long-term investment holdings" are we referring to rental properties that are purchased using conventional terms. No lease purchase, CA's etc or....

 

I would like to get more clarification on investment holdings vs. dealer transactions. Is a lease purchase a dealer transaction or a long term investment? I hope this doesnt sound off the wall.... :D I just want to make sure that I elect the right status.

 

Thanks much...Your answers are greatly appreciated.

 

Akin

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If I can revisit this...I currently only have a LLC. According to the posts, my LLC automatically defaults to a C-corp.  If this is the case should I elect for S-corp status if I will be only doing lease purchases, CA's, and wholesale flips?
It depends upon the tax treatment you selected when you filed your paperwork. If you elected to be treated as a corporation, then the default is a C-Corp. A separate tax election needs to be filed with the IRS to convert your C-Corp to an S-Corp.

 

ALSO, when stating "long-term investment holdings" are we referring to rental properties that are purchased using conventional terms. No lease purchase, CA's etc or....

 

I would like to get more clarification on investment holdings vs. dealer transactions.  Is a lease purchase a dealer transaction or a long term investment?  I hope this doesnt sound off the wall.... :D I just want to make sure that I elect the right status. 

Long term investment holdings are properties you intend to keep for a long time either for the production of income or for future appreciation. The acquisition method does not matter, as long as the property is one you plan to hold. The LLC organized as a disregarded entity or partnership preserves all the tax advantages you might derive from investing in a passive income activity in your own name while giving you the limited liability protection you need to shield your personal assets from a lawsuit. The corporation should be reserved for your active income activities in which your income is taxed as ordinary income.

 

The active/passive income tax treatment depends upon your exit strategy. If you purchase property to resell for profit, the active income tax treatment applies. Your income is active income taxed at your ordinary income tax rate and subject to self-employment income taxes, too. Purchase the property to hold (perhaps forever) for the production of income, you are engaged in a passive income activity.

 

The sandwich lease option and CA deals are active income activities, in my opinion. To classify the lease option exit strategy, I need to know your intent. If you purchase a property to rehab and sell, then you have an active income activity. The fact that you use a lease option to facilitate the sale does not change your intent to sell for profit even though it may take a couple years for the option to be exercised. In this situation, an S-Corp is a better business entity than an LLC treated as a disregarded entity.

 

On the flip side, let's say you purchase a property to hold in your investment portfolio for long term rental use. After a couple of years of straight rental use, you find yourself in a soft rental market and a prolonged vacancy. You decide to sell the property, and use a lease option to facilitate the sale. The rental income in this situation is passive income, and the profit from your sale is taxed as a long term capital gain. Here, the disregarded entity or partnership LLC allows you to take maximum advantage of the passive income and capital gains tax treatments to which you are entitled.

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DaveT brilliant advice...

 

I happen to have had long conversations with Glenn W, a Tax guy in Santa Barbara California, regarding this very issue... BTW Glenn is known as the go to guy for real estate investors.. Some of the nation’s big boys and girls use him. He tells me that the little word "Intention" can be manipulated... Although I disagree with him and believe a dealer is a dealer, he indicates that a for rent sign and a Polaroid can clear the issue of dealer status... But Glenn is also a guy who goes and looks at houses for sale on every vacation... Documents it with property flyers in a binder.

 

personally if you sell houses for a living you’re a dealer. Seems simple to me. Have two separate Corps for your passive income and dealer income...

 

 

Michael Quarles

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