When it comes to taxes, there’s a big tax difference between a real estate investor and a real estate business owner. We’re seeing interest from both types these days, especially from folks wanting to set up a business structure to protect their personal assets, as they come back into the market. But it’s important that you get into the right structure, or you could wind up overpaying your taxes.
The difference between the two is (fairly) simple. A real estate investor buys properties to hold and rent out. If you’re an investor, you’re in it for the long haul. You’re going to hang onto that property for several years.
A real estate business owner, on the other hand, has a different goal in mind. If you’re picking up properties with the intention of moving them on in a relatively short period of time (1 year or less), or if you are developing land, then you’re a real estate business owner.
Both of these classifications relate to the IRS, and how the income you earn is taxed. With long-term investments, the income is passive. That means you pay income tax, but it’s not money you have to treat as salary, and pay Social Security or Medicare taxes on. When (and if) you sell the property the income will be treated as a long-term capital gain for tax purposes. So, it’s best to use a structure that gives you good passive income treatment. If you’re into long-term investments, LLCs electing either partnership or, if you are the only owner, disregarded status, are best here.
With short-term investments, the IRS looks at the income as being active, earned income. Even if your income comes from buying and reselling properties, it’s not passive unless you hold the property for over a year. If you own it for less than a year, the profit from a sale is considered a short-term gain, which are taxed at regular tax rates. Your best bet here is one of the active tax classifications – either S or C Corporation tax. That way you can stream your income, by taking part as a salary and part as a profit distribution. Only the salary portion will be subject to payroll taxes (in most cases). But because you’re still going to be holding assets in the business structure, you want the LLC asset protection. So, an LLC making either a C or an S Corporation election is going to be your best choice here. Which one you choose depends on where you’re at financially, and what you’re using the income from the business for. If you’re living off the real estate income, an S Corp is probably your best bet. If you’re using the real estate as a way to accumulate income, and don’t need it to live on, there are great opportunities for you with C Corporation taxation.
But wait! You’re investing money into real estate with the intent of making a profit. Aren’t you an investor regardless of what you’re doing with the properties? And the answer is yes! It’s really two sides of the same coin. In the grand scheme of things, you’re still an investor. The question is, HOW do you invest in real estate. Knowing the answer will help you to make sure you get into the right business structure.