LLC Tax Question
I have read some posts, but I am still confused on a couple of things. I have a 2 member LLC with my brother. We own one property and are thinking about renting it out. My questions are?
If we rent out the property how do you figure the depreciation? I saw where is it straightline over 27.5 but is that divided over what we paid for the property or do I have to substract the land value?
IE if we paid 100,000 for land and house do I use the 100,000
if the house was worth 80,000
Land 20,000
At tax time do we just split everything 50/50 and any income is treated as ordinary income?
Yes. That is correct. You can only depreciate the building - not the land. You could also subtract the 'personal property' from the building amount and depreciate this much faster (I believe this is 5 years). Personal property are items like like refrigerators, stoves, portable storage buildings, etc.
If you own your LLC as 50/50 than the net income or loss from operation is split 50/50.
Often even the most profitable property show a loss on paper due to depreciation. In fact, this is the only reason why I am in the rental business - to take advantage of the tax break to off-set some of our W2 income.
So through your rental property you have loss of 5,000. You can then turn around and use that loss to reduce your W2 earnings? If that is correct I can see why some many are in the rental business.
Thanks for the tip on personal property too.
Yep...that is right - the amount of loss will reduce your W2 income (thereby reducing your taxes). There are limits, though. I believe this starts phasing out if you and your spouse earn over $125K (double check this amount, though) in W2 income. You also have to be involved in the running or management of your building.
Do a lot of investors put their personal house in a seperate LLC and fill out a rental application to the company so that they can deduct interest, taxes and deprication?
Is that legal and what are the pros and cons of doing this?
This, I have never heard of and it doesn't sound like it would be on the up-and-up.
For one thing, I am not sure what the real advantage would be? On your primary residence, you can already deduct interest and property taxes. And you are exempt from capital gains so depreciation is somewhat of a non-issue.
This, I have never heard of and it doesn't sound like it would be on the up-and-up.
For one thing, I am not sure what the real advantage would be? On your primary residence, you can already deduct interest and property taxes. And you are exempt from capital gains so depreciation is somewhat of a non-issue.
Question:
Can I deduct a period of vacancy as a business expense/loss under a LLC.
[addsig]
Yes and no. You cannot deduct $1200 because a unit that usually rents for $600 a month was vacant for 2 months. On the other hand, you will have zero revenue for this unit for the vacant period but your expenses will continue which will creat a loss that is deductable.
InvestorNC: I am not sure about the legality of having your personal residence owned by an LLC for assest protection. I am guessing that some other format may work better such as a trust, etc. Perhaps this is a better question for the legal forum or maybe someone with knowledge will post here.
InvestorNC:
You might want to check the LLC laws of your state. I proposed the same kinda question earlier on a different thread. My main concern was not interest deduction on taxes, homestead discount on property taxes or cheaper homeowner insurance it was another concern because the LLC was to own the property free & clear with no mortgage anyway. (You can look through my profile to find that thread to see my question in detail.) But I did some research & found out in most States it is perfectly legal for a LLC to rent, lease or do any legal business with any of its members because they are separate entities and when doing business with the LLC the members are to be treated as non-members(think of your LLC as another person that you created).
Here is how our law in AL. looks:
Section 10-12-19
Business transactions of a member with the limited liability company.
Except as otherwise provided in the operating agreement, a member may lend money to and transact any lawful business with the limited liability company and, subject to other applicable law, have the same rights and obligations with respect thereto as a person who is not a member.
(Acts 1993, No. 93-724, p. 1425, §19.)
Remember this is Alabama’s LLC law & before executing any strategies or methods discussed on any forum, board or website, consult with a competent attorney or CPA!
Thanks for the info. I will be checking the NC version. I beleive Neveda has laxed laws when it comes to stuff like this.
I agree that in most businesses it is a red flag to the IRS to show a loss year after year. I believe that in the real estate rental business, however, it is the norm to show a loss in most years. In fact, I have read (can't remember the source, though) that the tax code was written (allowing depreciation deductions when most likely the property is actually appreciating) as to encourage investment in rental property in order to provide affordable housing.
Now, if you have little or no source of other income and you report loss after loss on your real estate activities, something doesn't add up and an audit would be in order. But even this has me thinking that it would be possible for an individual to continually cash the equity (available due to appreciation) out of each property and live tax free…sure in the end there might be a big problem…
In my situation, my wife and I have relatively high W2 incomes. Quite frankly, without the slight paper loss our rental activity produces each year, it wouldn't be worth the headache for me to continue at the level I am in. In other words, I would either continue with my W2 job and sell off the two properties or quit the W2 job and enter into the rental business on a much larger scale.
I would sure like to hear the opinions of others on the tax code - specifically on the ability to show losses each year mainly due to depreciation.
I agree that in most businesses it is a red flag to the IRS to show a loss year after year. I believe that in the real estate rental business, however, it is the norm to show a loss in most years. In fact, I have read (can't remember the source, though) that the tax code was written (allowing depreciation deductions when most likely the property is actually appreciating) as to encourage investment in rental property in order to provide affordable housing.
Now, if you have little or no source of other income and you report loss after loss on your real estate activities, something doesn't add up and an audit would be in order. But even this has me thinking that it would be possible for an individual to continually cash the equity (available due to appreciation) out of each property and live tax free…sure in the end there might be a big problem…
In my situation, my wife and I have relatively high W2 incomes. Quite frankly, without the slight paper loss our rental activity produces each year, it wouldn't be worth the headache for me to continue at the level I am in. In other words, I would either continue with my W2 job and sell off the two properties or quit the W2 job and enter into the rental business on a much larger scale.
I would sure like to hear the opinions of others on the tax code - specifically on the ability to show losses each year mainly due to depreciation.
Hi c5hardtop:
I am in the first couple years of ownership and have had some major repairs last year and am currently in the midst of a major renovation (windows, siding, roof, heating system, appliances, kitchens, etc.) which involves significant vacancies, so perhaps my losses will only be short lived. The building I am referencing is a 4-plex that I purchased that had deferred maintenance.
I purchased it for $85K and the gross rents are $20K / year. So, on the surface, it was an excellent buy. However, the utilities were not separately metered (will be now). With the repairs, owner paid utilities, and interest on a full mortgage, I am at zero or a couple thousand below. Now with depreciation, I have a significant loss.
Even once things stabilize and the maintenance is brought up to date, and some utilities become the tenant’s expenses, etc. I still don't see how this or most other properties will ever show much of a paper profit (if any at all), especially if an owner keeps a significant mortgage on the property.
Now, my goal is obviously to make money and if I could have a big profit each year I would gladly pay more in taxes. But, the way I see it, I am making money through maintenance catch-up, some appreciation, and principle reduction, and most importantly tax savings. Perhaps the larger properties, where an economy of scale is realized, show profits year after year. But, as I have stated, I don't see how too many small ones ever will, especially if they remain fully mortgaged. Sure they can be a profitable situation in reality but my guess is most are not on paper.
Am I missing something? Are there others that have experience/ examples they would like to share?
Many here seem to use "member" and "owner" interchangeably. Consider using other enities(LLCs or FLPs) as your members to a multi-member LLC. This adds another layer of asset protection. In fact, you could be the sole owner of a multi-member LLC and not be personally listed as a member. Rember, members need not be owners. Members simply have an interest in the company, but that need not be ownership. It can be an entirely non-economic interest. Nevada and Delaware don't collect ownership information when you form an LLC and it need not ever be public information. Ownership in these states is recorded only as an internal company document, if you choose, not with the State.
On properties that cash flow, which makes up the majority of rental income properties that people invest in, its is realtiviely difficult to show continous losses from the rental activity. Cash flow is when rents collected are greater than mortgage service and all expenses/taxes. Note that for tax purposes, the principle part of mortgage service is not an expense, and you can claim depreciation that is a non-cash expense. Implies that for a property to cash flow while showing a legit net loss, decpreciation has to be greater than principle paydown, this is rarely the case long term. Your property should should begin to show gains after you complete your repairs/upgrades. If it doesn't, it was probably a very poor investment. Note that some of the stuff you listed may be considered captial improvments, subject to depreciation rather than a expense right off if done by the letter of the tax code. Its very difficult to lose money long term, unless its a poor investment, or you are continously purchaing and rehabing properties (and expensing this all out).
Not to say it can't happen, but its usually from poor investments, or properties that you are expecting to gain from apprication (silly to expect more than inflation rate long term), or from the captial improvments you are making and charging off as expenses.
On a $150k property
deprciation -4727 (value land at $20k)
principle 3568 (on 20yr 100% loan at 7%)
So you can see that depreciation is greater than principle paydown in this case. You can have a property that breaks even cash flow but shows a $1000 loss. Most likely you would be cash flowing $2-3k and showing a tax gain of $1k less than this amount. Note that principle payments would start to rise as loan ages, and you will eventually have to recapture or 1031 exchange out of the depreciation. In this example, in 4.5 years you would be a break even on the depreciation/principle paydown, and for years 4.5-20 you would be showing a greater taxable than cash flow.
Depreciation is an annual allowance that helps you recover on your taxes the cost of the property. Generally, real property never depreciates in value, but since the investment in the property generates income, the tax law allows you to recover your costs against that income through annual depreciation deductions.
For the investor in residential housing, there are four major provisions to consider: (1) depreciation allowances, (2) the rental loss limitation, (3) the tax rate schedule, and (4) the tax treatment of capital gains.
In preparing the annual individual tax return, rental income is totaled for the year, and the expenses associated with the rental operations (for example, depreciation, repairs, insurance, mortgage interest, and property taxes) are deducted to determine the taxable income or loss. Depreciation is a particularly important expense. Each year a percentage of the building's value (but not the land) is taken as an expense to compensate for wear and tear and obsolescence, although this is not an amount that is actually paid "out of pocket."
Those taxpayers purchasing residential investment property after 1986 are only eligible for straight-line depreciation over a 27.5-year period compared to the more rapid 19-year, 175-percent declining balance method available under prior law. Those currently owning rental property must generally keep using the depreciation schedule they began with.
Under the current law, losses from rental property are considered as "passive investment" losses. Losses on passive investments can generally only be used to affect income from passive investments. Accordingly, owners can deduct rental losses only against other rental property income or other passive investment income. Rental losses cannot be deducted against salary, dividends, and interest income. Losses that cannot be deducted currently because of these rules may be carried forward indefinitely to future years and may be used to offset future passive income. Additionally, in the year the property is sold, past, unused losses can be used to offset gain on the sale.
There is an important exception for the small investor, however. Taxpayers with adjusted gross income of $100,000 or less may be eligible to deduct up to $25,000 of passive losses a year against salary and portfolio (investment) income. This maximum of $25,000 of annual losses is reduced or phased out, however, over an income range of $100,000 to $150,000. The available deduction is reduced $1 for each $2 of adjusted gross income above $100,000. To be eligible for this small-investor exception, the investor has to "actively participate" in the management of the property. Property management services can still be used if the owner remains involved in decision making, such as approving tenants, setting rent levels, approving terms of the lease, and approving major expenditures and repairs. At least a 10-percent ownership in the property is also required.
Regardless of when the property was purchased, rental losses that cannot be taken in a given year can be carried forward for use in later years and any remaining loss can be taken in full when the property is sold.
Investors with annual rental losses first use the losses to offset any rental income. Any remaining losses are then applied to offset up to $25,000 of other income for taxpayers who "actively participate" in the management of the property. Any remaining losses are carried forward for use in future years.
You may want to look into tax credits as the IRS grants you special tax credits when you invest in low-income housing or particularly old commercial buildings. The credits represent a direct reduction in your tax bill because you're spending to rehabilitate and improve these properties. The IRS wants to encourage investors to invest in and fix up old or rundown buildings that likely would continue to deteriorate otherwise.
The amounts of the credits range from as little as 10 percent of the expenditures to as much as 90 percent, depending on the property type. The IRS has strict rules governing what types of properties qualify. Tax credits may be earned for rehabilitating nonresidential buildings built in 1935 or before. "Certified historic structures," both residential and nonresidential, also qualify for tax credits. See IRS instructions for Form 3468 to find out more about these credits.
I suggest the following IRS publications to provide a better understanding:
Pub. 527, Residential Rental Property
Pub. 534, Depreciation