Course 2: Asset Protection and Entity Formation for Real Estate Investing

Transcript:

Adam:

Welcome to another edition of Wealthy and Wise. I'm your host, Adam Kintigh. And today we decided to unpack this mystery about how real estate investors should really set up and operate investing business. We have a lot of clients who will be doing wholesaling and rehabbing, tax liens, and tax deeds. They also are doing long-term investments as well.

So I thought, why don't we bring in the smartest guy in the world, especially in this topic, Mr. David Vanlandingham. David, thank you so much for being here today.

David:

Absolutely. I'm the smartest guy in the world. That's fantastic.

Adam:

One of the smartest people I know. So, David, there's always this big question about, alright, should it be an S corp for flipping, an LLC for flipping? How we really want to structure it and the whys. And all the time we have people that, especially in today's market, you might buy a property, you're in the middle of a rehab, and it's not selling as quickly, and it makes sense to refinance it and hang it on to it as a rental. We call that the BRRR, the buy, rehab, refinance, and rent.

And there's always this question about how we do that and what's the best way to do it. So I figured if I brought you in you could just share with us. In our audience of what we do and why we do it, that would be great. So start with your flipping business, wholesaling, rehabbing. If I'm a real estate agent, what's your best structure for those folks?

David:

So, and it is a mystery, a lot of people get conflicting information, right? And that kind of paralyzes people and keeps them from moving to do anything actually. So, the important aspect of it is we look at a couple of different things. We look at the liability and we look at taxation. Those are the two things.

So when we talk about liability, we want to look at, not mixing liabilities of one liability impacting another. We look at the tax side of it because that's how we get paid and that's who we pay the taxes to. So really simple, the active income, which is really your flipping and wholesaling, those are activities that take less than 12 months are going to be in an LLC taxed as an S corporation, what's beneficial about that is that you can control the amount of income that you take. The IRS says you must take a reasonable salary, but they don't tell you what that reasonable salary is. U They will tell you, however, what's unreasonable if you don't take enough.

Our CPA says to take a minimum of 30 percent, so if you make 100, 000 a year, take 30 percent of that, 30,000. That 30, 000 is now drawn as a W2 salary, and it's subject to self-employment tax. If you're doing this as a sole proprietor, you'd be paying up, you know, on 100 percent of that, so 15,300. So that's, that's really how we want to position that side of the business, but we often get people that will rehab a property, and then all of a sudden they decide, hey, this is kind of nice, I think I'm going to make it a rental.

How do we pivot that? What's the exit plan? Or the birth strategy, as you mentioned. So, I've got my nifty little iPad here, so if we can Take a look at this. So when we talk about the S Election, the other benefit that S Election brings is another tax return. So if you're doing this as a sole proprietor, all of that would go on your personal return, which sooner or later loading up all those deductions, probably going to cause an auditor or somebody to start peeking into your tax.

Adam:

I was just talking to a really good friend and he said, Adam, if you look at the audit risk of filing a Schedule C, The good old U. S. Inspector General does a report card every year. What is your audit risk with a Schedule C? It is 1 in 20, which is crazy. It's 6%. LLC taxes on S Corp, that drop to less than one-quarter of 1 percent for the lowest audit risk. So, in addition to those tax savings, significantly less audit risk doing the LLC taxes on S Corp.

David:

And then there are also some benefits that come up. If you're electing to be an S Corp, there are additional benefits you can have as well. So Some people look at it as like, oh, no, I don't want another tax return.

Well, it's not really just another tax return. It's another way to get additional deductions. So with the LLC, with the S selection, that's where all of the wholesaling and rehabbing takes place. You'll notice on the other side, completely separate from that is going to be your rental structure for passive income.

And that is called a disregarded LLC. The reason we call it disregarded is because, for IRS purposes, it's disregarded and does not file its tax return. So if you currently have rentals, and at the end of the year that you're preparing your taxes or having them prepared, all of your rental income goes on your Schedule E.

The same thing is going to happen with a disregarded tax election here on the rental side. It's not really complicating anything for the rentals. So, the difference is, when we have the disregarded here we have a lot of flexibility with your investments as far as if you want to do a single family, multifamily, not up to commercial, but four units and down.

So that's more so for the long term, short term, we'll have another session on that because that's a little different, but for the long term side of it, what we're going to be doing is taking our properties, individual properties that we own. So in this case, we have three rental properties and we're going to put those individually into a real estate privacy trust.

That's a fancy word for land trust, by the way, so a lot of people have never heard of it. Oh, it's a land trust. So the Real Estate Privacy Trust does many things. It allows for a structure that is financially efficient because you're not going out and setting up an LLC for every rental property.

We do hear about that quite a bit and that, that can be a little cumbersome, 30 LLCs, 30 checking accounts, 30 record books, 30 renewal fees. So to be more financially efficient, we're going to set this all up under the disregarded LLC over here on this side. So what we do is we take each property and place it into its own Real Estate Privacy Trust.

We get to rename that Real Estate Privacy Trust. So if you have a rental property and your name, it's in Adam Kintigh's name, what we're going to do is, is typically name it after the street that the property is on. So if we're going to name this the Fort Apache Privacy Trust, Adam's name comes off, and it goes into the Fort Apache Privacy Trust.

What's unique about that type of trust is because of the 1982 Garn St. Germain Act, it allows you to take an encumbered property, place it into this qualified inter vivos trust, and avoid the due on sale. Because we have a lot of people who say, well, I got a rental property, I know it needs to go into an LLC, but I heard the boogeyman out there and they're going to send me a bad letter.

And do you hear much about that?

Adam:

I hear about it. I just heard the question this morning. It's always a concern. I got a mortgage. We put it into an LLC. We violate the mortgage agreement. The bank can call the note too. So you're saying the trust that can't happen.

David:

It can't happen. And the reason it gets caught most of the time is because a lot of mortgages get sold off, right? So if they sell off a mortgage that's in Adam Kintigh’s name. And all of a sudden they go look at that and it's a different LLC name, that's where they catch it, or sometimes in an internal audit. So we just don't like those surprises, so this better suits and prepares us not to have to deal with those things.

So, benefit number one is we can retitle the asset, we can avoid the do-on-sell. We protect the different investments from each other. So if we had three LLCs, or three properties inside of that LLC, and one is sued, everything is up for grabs now. By separating each property into its own real estate privacy trust, an action that happens to one does not involve the other two.

Adam:

So, it's a great way of separating the liability. The real estate privacy trust, the land trust, has no bank account, no tax return, and no renewal fees. Very simple to set up, and very simple to maintain, one LLC is going to collect rent, pay mortgages and taxes, and whatever is left over you write yourself a check.

Now I want, to cover one thing that was really important is, oftentimes we will have people that have done the birth strategy, they bought the house, they refinanced it, and they, the bank said, hey, we have no problem with you keeping it in the LLC, the S corp. What is the danger of having rental properties inside of that S corp?

David:

Well, I mean, that's the reason why there are four different types of LLCs. Everything has its own little place to be. So when you start doing your passive in a structure that's really meant for active income if you continue that structure over a three-year period and the rental income is 25 percent or more of the income of the LLC taxes and S Corp. Now what can happen is the IRS steps in. Tap you on the shoulder and say, Hey, you're not doing this right. We're just going to default this and now make it a C corp, which is kind of the death blow.

Adam:

Yeah. You have a fake problem.

David:

Fake problem. Yeah, so there are ways that we do, or we are able to utilize both of these structures working in concert together. And that's if, and I'm just going to draw here, right in the middle of the screen, I'm just going to put another R E P T here. And we're going to put it in the center here. So let's say you went out and bought a property and your original intent is to rehab the property and sell it. And then we decide, Hmm, maybe I'm going to keep this property.

Maybe the cash flow is good on it. Maybe just fell in love with it. Right? So now what we're going to do is we're going to take the property that's in here and move it over to the real estate privacy trust. From the S corp into a land trust. And then we're just going to reassign that beneficial interest over here to the disregarded LLC.

So now it falls into that whole strategy over here. And this would be more sometimes what people would do with the BRRRR as well. Sometimes people don't want to do the BRRRR in this structure over here on the disregarded side. Because for liability reasons, what happens if somebody gets hurt?

Well, that LLC is connected directly to those rentals. So let's do that activity of the rehab over here, where that's typical what that is set up for in the first place.

Adam:

Now I was thinking about two more problems. So the 25 percent rule for passive income inside an S corp was one of them. Number two, all the time I have this happen where people want to refinance a property, it is in an S corp or an LLC taxes an S corp, and the act of moving the property from the LLC back to their name now becomes a taxable event.

And in order to refinance the property, oftentimes the bank says, hey, you got to put that back in your name. We'll fund the loan and then you can do what you want. That act of moving it from the LLC to, your own name, becomes a taxable event for that client.

David:

It can be constituted as a sale too, as the way to look at it. So really there are two issues here. Either it can be constituted as a sale or in addition to a transfer tax. Now, Real Estate Privacy Trust does not eliminate transfer taxes in all states, but in most states, we'll say that. We do our work first, that's why you consult with us so we can tell you if your state's one of the ones that is not as friendly, or if they have certain restrictions.

So in that way, yes, absolutely, you could take a property out of the Real Estate Privacy Trust, refinance it, and then put it back in. Most often you're going to avoid transfer taxes by doing that.

Adam:

Now the third thing I was thinking about is the danger of having rentals inside the S corp being tagged as a dealer. Tell us about that.

David:

Yeah. So here's what's called an investor-dealer argument with the IRS as far as what activities constitute. So your dealer is more short-term flipping wholesaling, things of that nature, whereas your investor is disregarded. That's where your long-term capital gains are being applied here.

So when we talk about putting that inside of there, now you've got another case of liability because if you have a rental inside of this LLC here, and you've got a rehab going on inside this LLC here, and something happens in the lawsuit, now what's the asset that's at risk? The rental property. Everything.

So, we really look at the class of liability. We look at the taxation and we look at it as a whole. Sure. We want to be flexible in our schedule, making sure that you have the pivots. You have the exit plans based on what your goals are. And we sometimes we'll change our minds on things. Like I said, so we want to have that flexibility, but we also need to be aware of where not to put it, and that's just as important.

Adam:

So I had a client that a few years ago. I've been doing the rehabbing and the rental properties under one sole proprietorship and the IRS came back and said, you are a dealer.

All of her passive income was being offset by passive losses, they said, yeah, we consider that active income because you bought and sold more than one property in a year and you have rentals. You were a dealer and all of her passive losses got out a lot, disallowed. They said, no, we now consider the rent to be active income, which now you also owe social security and Medicare.

Oh, and by the way, none of those depreciation losses count in that WACTR for 70, 000 was that one year. And we knew it was coming because they don't, they never give you the notification the year it happens. It's always three or four years later. So we saw that audit. I think that was back in like 2013, 2014.

And we know what's coming next. We've got at least two or three more years of some pain coming. So we always keep these separate. It avoids those dealer possibilities.

David:

Yeah, absolutely. And if you looked at that particular incident and what the cash flow was on that rental property, and then you figure there's going to be penalties and on top of that re-grabbing, recapture that 15.3%, your cashflow is probably negative at that point.

Adam:

Yeah, it was a devastating blow. So she, and you can argue with the IRS all you want, but at the end of the day, they have rules in place that they have to follow. And so we just have to know what those rules are so that we can follow them equally as well.

David:

Yep. And, and it's not the same for everyone. And this is why when we do our consultations, it's so important to understand what your intent is and how to build in this flexibility in case that changes. We just can't all of a sudden have a property in the LLC taxed as an S Corp that was a rehab, now you finished it and just leave it there. We've had that happen before. Not a place to park it. That's for sure.

Adam:

Right. I wanted to cover this with a visual today so you can see exactly how these rental structures fit in place. And there's always a lot more to it. But we want you to know that as a client of NCH, even if you're not a client of NCH, call and talk to one of our experts like David.

Let us help you navigate the field and decide what structure is best for you and your family and the situations that you're dealing with. So thank you so much, David. I really appreciate you flying all the way from Orlando, Florida just to be here on the show with me today. I sure appreciate it. And safe travels home.

Absolutely. Thank you.

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.