Help regarding upstreaming of income?

Question

I am yet to make my first investment- but have been doing my homework and saving, and I'm "almost ready".  I work in a secure, full-time employed position, and I love my job. To be clear, I do Not intend to quit anytime soon to run into the real estate investment world. That said, my benefits at work are restricted to what my employer provides. 
I learned about defined benefits plans, and how I can create this benefit under certain corporate entities. Then I learned a bit about upstreaming between entities, which, on paper, sounds like a good tax-saving idea. I'm having a much harder time trying to model the tax savings under my circumstance. 
Specifically, I don't see how this scenario could work when the bulk of my income still comes from my employment rather than my investments. My job-earned income funds the purchase of assets that are held in a corporation. I've already paid income tax on all the money I'd use to fund any corporate spending (it's all my earned income from my job), so it seems like the second entity is redundant. I'd be upstreaming just to get a write-off to avoid being double taxed on transactions that are passed through an unnecessary second corporate entity. The whole situation would be avoided if I simply had one corporation that owned the investment property and provided a defined benefit plan for it's executive board, wouldn't it?
Can anyone explain to me how upstreaming works in the "real world"? I'm sure there's a way to optimize that flow for non-self-employed people, but I just can't see it yet. 
Thanks,
Doug

Jon Holdman · Answer

I must respectfully disagree.  The tax benefits of owning real estate are, IMHO, overhyped.  The claim is the passive lost from (usually crummy) real estate investments can be used to offset ordinary income.  This can be done, but the ability is limited.  If your AGI (married or single) is under $100K, you can use up to $25K in passive losses to offset ordinary income.  If you AGI is over $150K, you cannot.  In between, the limit drops by $1 for each $2 of income over $100K.  You can carry forward these disallowed passive losses and use them when you sell a property.  These can offset gains on the property that's being sold. And it doesn't have to be the same property that generated the disallowed losses.  So, you could have a portfolio of rentals, all generating disallowed passive losses and sell one and use the losses to shield the gain.

Rental income, OTOH, does have very favorable tax treatment income.  The interest and depreciation deductions can be used to reduce taxes on the rental income. Even if your AGI is over $150K, you can still apply these deductions against the net rental income (i.e., collected rent less actual expenses.)  So, rental income is, in a sense, more valuable than ordinary income because of this preferential treatment.

A kicker in all this that's often overlooked by those promoting the "tax benefits of real estate" is this:  you have to pay it back! Actual expenses (i.e., paying a painter or a plumber) and interest are money you actually spend.  Depreciation is not.  But you still get to deduct deprecation from your income to get to taxable income.  Depreciation seems like free money.  But as your taking the deprecation (or even if you don't, it doesn't matter), the basis on the property is going down by that same amount.  So, when you sell, you gain is higher.  And, you will owe a higher tax rate on this unrecapatured depreciation part of the gain than the rest.  So, if you have a gain of $50K on the same, but have taken (or could have taken) $20K in depreciation, you will owe the recapture tax (currently 25%) on the $20K and then long term capital gains (currently 15%0 on the remaining $30K.

"Tax benefits" are, IMHO, often used by those selling crummy investments as a way to put some lipstick on a pig.  "Sure, this actually loses money, but with depreciation, it has a big passive loss.  You can use that to offset your other income."  That may or may not be possible, depending on your AGI.  And even if you can do this, it will come back to bite you when you sell.  Now, if you're in the 33% or 35% bracket, or even 28%, there is a benefit because of the lower 25% rate on the recapture tax.  But this is more like a deferral than truly avoiding the tax.  Better to buy more profitable properties and use the favorable tax treatment to pay less tax on the rental income.

James Vermillion · Answer

You are focusing way too much on the structure of the business you have yet to start.  In my opinion you should go see a lawyer when you are ready to start invesing and they can help you set up an entity with your goals and personal situation in mind.  For now, I would worry more about learning your market, devising a solid business plan and getting started in investing and leave the rest to the legal experts.

Jon Holdman · Answer

That's the first I've heard of the term "upstreaming".  Sounds like a guru-ism.  Do you have a reference?

Corporation entities seem to provide few benefits unless you're trying to take advantage of tax deductions for medical insurance or similar expenses.  I think many of these complex entity structures only make sense if you're self-employed.  If you have income on a W2 and benefits from that employer, the ability to leverage these complex structures is limited.

Michael Lauther · Answer

Owning real estate as an investment provides individuals like yourself (who perhaps are in the upper tax brackets) outstanding tax deductions against ordinary income to begin with. Concentrate on investment value and seek guidance form tax and legal professional about how to structure investments to maximize tax benefits and limit liability.

Bill Gulley · Answer

I'm not familiar with the book you mentioned but I understand your delima. Take for example a doctor who is employed at a hospital, high income on a W-2 basis. While you can shift so much to retirement plans, that doc will be paying taxes.

Setting up holding entities won't help much for such income and only assist in income from the subsidiary entities. One strategy is to get with an employer and have the employer contract for professional services to a corporation at a lower cost for the employer. The employee or even a group of employees can fall under the corporate structure and provide the same work by contract. Hospitals do this with medical clinics, engineers, accountants and attorneys may work in such a manner. Something to consider if the employer is willing and able to do so.

Don Konipol · Answer

Forget all the structural non sense.  Learn what you can that will enable you to make your first deal so that you will have the money to utilize the structural formations.  Most salaried people, small investors and small business owners will do just as well with an LLC.  When you have multiple properties and multiple businesses then you can worry about separate entities, etc.

Doug G. · Answer

I'm still learning, so perhaps it is a guru-ism, I honestly don't know. I can reference a few investment books and multiple websites that use the term, but I cannot speak directly to their validity (Robert Kiyosaki discussed it in length in Own Your Own Corporation, as do Diane Kennedy and Drew Miles on their respective websites). Learning in the Internet Age can be a tricky business- you've gotta be selective about your sources! :)

The corporate structure for me is a tool for asset protection. I work in a litigious field, and the less I personally own, the better off I am. Tax savings and any other benefit I can wrangle from owing a corp is just icing on the cake.

Help regarding upstreaming of income?

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