Real Estate Investments

Structuring Ownership of Real Estate Investments / Business Entities

Many investors simply own rental real estate personally in their own names. Others feel the need for the protection of a business entity, like an LLC. Some investors use a separate business entity for each real estate property for maximum liability protection. Even with a business entity, attorneys typically recommend liability insurance.

The most common business entities to own rental real estate are the Limited Liability Company (LLC) and the Limited Partnership (LP). LLC’s have special tax problems in California and are less common here than in many other states. If an LP is used, a corporation (often an S-Corporation) is typically used as general partner to complete the liability protection. Trusts can be used in the right circumstances and can avoid the California $800 minimum annual tax. Corporations, including S-Corporations, are typically not used because the owner(s) cannot get the property out of the corporation without incurring tax liabilities.

When a real estate investor simply owns the property in his or her own name, there is no separate income tax return for the property – it is simply included on the owner’s personal income tax return on Schedule E. When a business entity owns the property, the business entity must file its own income tax return.

Switching from Residence to Rental Real Estate

In past years investors have converted properties from residences to rental properties and vice versa, taking advantage of the Section 121 exclusion of up to $500,000 of gain from principal residence and Section 1031 Exchange tax-deferral. New rules recently came out making this more complicated and risky. Consult with an experienced real estate tax professional to make sure you understand critical tax issues, such as:

  • Section 1031 and the new rules
  • Section 121 and the new rules
  • How Section 121 and Section 1031 work together

Real Estate Flipping vs. “Long-Term” Real Estate Investing

Flipping real estate is very different from long-term real estate investing. Get advice from an experienced professional to make sure you avoid pitfalls and understand critical tax issues, such as:

  • Capital Gains vs. Ordinary Income
  • Self-Employment Tax
  • Section 1031 Exchange of “Flip Property”

Real Estate Investment Analysis

Real estate is a financially complex investment to evaluate because of the many factors affecting cash flows to the owner. Characteristics that distinguish real estate investments from typical “portfolio” investments (stock/bond/mutual fund) include very high leverage (debt), less volatile market value, high cost of purchase and sale transactions, and the many unique tax benefits mentioned above. We can help you analyze potential real estate investments by using sophisticated software to illustrate the financial results under varying assumptions (what-if scenario analysis).

Tax Benefits of Real Estate Investing

We will outline some key tax rules on real estate. Real estate investing has long been an excellent tax strategy, primary because of depreciation deductions, Section 1031 Exchange, and special real estate depreciation recapture rules.

  • Tax law allows a deduction for “depreciation” of rental real estate buildings. This is generally considered a non-cash deduction and contrary to economic reality, since the value of the structure generally goes up, not down, over time. For a cash-flow positive property, some or all of the net positive cash flow is not taxable in the year received, but instead many years later. Some experts call this “phantom income”. For a cash-flow negative property, depreciation results in deductions greater than cash paid each year for rental property expenses. Some experts call this “phantom deductions”.
  • Net losses from a rental activity can be deducted in full against net income from another rental activity or passive investment (K-1), or, subject to the following limitations based on modified adjusted gross income, against other income. ◾Less than $100,000: can deduct $25,000 of rental real estate losses against other non-passive income.
  • Between $100,000 and $150,000: can deduct between zero and $25,000 of rental real estate losses against other income.
  • Over $150,000: all losses are suspended.
  • If net losses are not deductible in the year incurred, they are suspended and carried forward indefinitely until either there is positive income against which they can be deducted or the property is sold. If the property is sold, the suspended losses are ordinary losses which first offset other ordinary income that year before offsetting any capital gain from the property sale. Even with suspended real estate losses, the taxpayer is essentially creating capital gain income and ordinary losses in the year the property is sold.
  • Unlike most other investments, real estate can be sold without taxable income through a Section 1031 Exchange.
  • The ultimate tax strategy is to die owning real estate with large unrealized gains built in. Unless you die in the year 2010, the unrealized gains disappear when your heirs inherit the property with a cost basis equal to the Fair Market Value at date of death.
  • Benefits also apply for Alternative Minimum Tax (AMT).

We offer a free initial consultation for real estate businesses. Call us today at 714-533-2600 and to schedule a mutually convenient time to meet.


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