FICA covered by W2, so does S Corp really buy me much?

Question

Hey Everyone,

I am mainly a buy and hold investor and have purchased our first 6 properties over the past 5 months. I had not intended to flip any but am now considering that given the huge equity we have in them. These are nicer homes that rent in the top range of my market, making it harder to find tenants who can qualify. So my thought was that instead of a refi on a harder to rent home in my area, flip into two or three lower priced homes that rent well.

My question is on tax treatment. I hold all of these in an LLC currently. I've seen several things recently that indicate for flipping, an S Corp could be better to help avoid/reduce self employment taxes. I currently hit the ceiling on FICA through my W2 job, which is the largest part of self employment taxes. Based on limited research, am I right to assume that the only tax advantage for the S Corp vs LLC is to potentially save or reduce the medicare portion of the SET? Since I would not be paying anymore FICA anyway, that was my thinking.

I know I should run this by my CPA and I certainly will. Just asking for some thoughts on this from the team here. Thanks!

John

Steven Hamilton II · Answer

John,

There are a lot of items here.

1. LLCs do not exist as far as the federal government is concerned it is based upon what election or default classification they have.

2. If you have rentals you DO NOT want them in a corporation of any type.

3. Consider the option of a C-corp if you're flipping. The tax free fringe benefits can be great. and then see line 4.

4. You pay yourself a wage and further fund retirement accounts. (no SS if you're over the limit at that point.

5. You can be avoiding Net Investment Income Taxes if you are active in the business can happen with both a C or S-corp.

6. If you're married there are other options to consider such as a partnership but you'll miss out on a large deduction that you'd have if you paid W-2 wages.

7. You need to consult with someone very savvy if you want to succeed.

Just the tip of the iceberg here in this post.

Jerry W. · Answer

@John McAuley, sounds like a nice problem you have. How to avoid paying a lot in taxes because you might be making some big income. I am not an expert in this area, but there are a few things you might check out. First you said yoou bought these over the past 5 months. While your intent in buying them is what counts for purposes oftaxes, the reality is that if you hold them for less than a year the IRS will likely be skeptical of your claim and ask you to prove it.

Next I think 1031 transfers may have time limits on how long you have owned the property. Find out for sure before you try to do one.

Third, get with a good CPA before you try any of the above. Planning in advance is by far the best way to go.

@Steven Hamilton II is extremely astute in this area. maybe he can point you in the right direction.

Dave Toelkes · Answer

@John McAuley,

You purchased these properties with the intent to hold for rental use and are currently holding these properties for production of rental income. You now realize that a couple of these properties will be negative cash flow scenarios and you want to replace them with less expensive properties that have a better chance of producing a positive cash flow as rentals.

Sounds like the perfect 1031 exchange situation. Consider exchanging one high-end property for two or three less expensive rentals. No flipping issues to contend with, and no need to change anything with your entity structure, and no income tax impact either if you are able to do a fully tax deferred exchange.

Consult a qualified intermediary for more specific guidance with regard to your unique circumstances.

Dave Foster · Answer

@Jerry W., There is no statutory holding period before a property qualifies for 1031 treatment. There is only the issue of intent. Intent can be established in a number of different ways. Certainly the length of time is one way. But even the length of time does not guarantee anything.

A person whose business practice is flipping who just happens to hold on to a property for more than a year while a renovation is underway is more likely to be disallowed upon audit than a person with a long term buy and hold business model like @John McAuley who happens to have an "oops" moment on a property.

While longer is preferred, actual demonstrable intent will rule the audit. And an accident can happen at any time where someone may need to sell a property they meant to hold. It only becomes and issue when the accident becomes a pattern!

Dave Foster · Answer

@John McAuley, Echo what @Dave Toelkes just said. It sounds like you've got everyone reinventing your business when all you really want to do is shape your portfolio so it matches your business.

That's where the 1031 can help you without out a lot of artificial entity manipulation. If you were going into the business of flipping that's different and you'd probably want to make some entity moves. But you just had an accident and need to sell these to get rentals that better meet your criteria - 1031!

Steve Vaughan · Answer

I would seriously consider holding as rentals until day 366 before I sold. I'm no CPA or EA, but by holding each of mine for 1+ years, I've effectively had a negative net federal tax rate for 14 years. But I haven't had a w-2 during that time, either.

Well done and good luck with this @John McAuley!

Dave Foster · Answer

@John McAuley, BTW - @Jerry W. is absolutely right. @Steven Hamilton II's one of the best!

Matt Horwitz · Answer

@John McAuley, I believe you're right in that you'd only be saving on the Medicare portion of the SET. Those savings may not be worth the actual cost (and time/opportunity cost) of transferring the property(ies) to the new entity. I also believe there are other mid and long-term things to consider, so would love to hear what you find out after some conversations with CPAs.

John McAuley · Answer

@Jerry W.@Dave Foster

Thank you both for bringing that up and addressing it. I've been reading over the 1031 information for the past hour and found these points addressed but not answered. So the timing is perfect. Completely understood about it becoming a pattern and am used to that in my other businesses for different purposes. Thanks again for all the help here.

John McAuley · Answer

@Dave Toelkes

Great idea Dave. Thanks for putting that out there. I have no idea why I didn't consider this before. I guess I had in my mind that I would utilize 1031s later down the road to "trade up."

These aren't negative cashflow. They just don't cashflow as well because it takes so long to get tenants in this price range plus the turnover on the larger homes are so much more. We got them all at bargain prices (we have about 50% equity in each one, putting 20% of our own money in).

We have been able to roll all the profits right back in and that's what I want to continue doing, building up my buy and hold portfolio. If I can make the timing work though on a 1031, that fits right into my goals perfectly without giving up the taxes. Thanks again!

FICA covered by W2, so does S Corp really buy me much?

FICA covered by W2, so does S Corp really buy me much?

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