Can capital gains tax be avoided through an LLC & depreciation?

Question

Can you avoid or defer most of the taxes if you have an investment property inside of an LLC by using depreciation or maybe even in conjunction with a self directed or rollover IRA? If so what are the proper steps and pitfalls to be aware of? This case scenario is in the state of Indiana.

I reserve the tough questions for Bigger Pockets. I will not count on any answers being gospel financial advice and will do my due diligence so please do not be afraid to speak plainly. Thanks in advance everyone

Michael Plaks · Answer

@Shawn Long

Plainly, you requested? Sure, I'll oblige. You picked up a bunch of random terms and ideas without having the big picture of where they fit. About as helpful as having a full toolbox without any idea how houses are built.

You do not combine retirement accounts, depreciation and LLCs. So one at a time.

1. SDIRA and other retirement accounts. You can fund them if you have current earned income, like W2 salaries, Realtor commissions that are higher than your business expenses etc. Rent from properties does not count for this purpose. You can buy rental properties inside retirement accounts, subject to many rules and restrictions. You do not care about capital gains, depreciation etc. when holding properties inside your retirement accounts.

2. When you hold properties outside your retirement accounts, the traditional way, then you must take a depreciation deduction while you're holding and renting them. When you sell, you have to pay capital gain taxes PLUS depreciation recapture tax. In effect, depreciation works in the opposite direction from what you imagine: it makes taxes at sale higher, not lower. There're some advanced strategies to deal with capital gain tax, including 1031 exchanges.

3. If you're thinking about flipping instead of renting - then you do not have capital gains at all. Neither do you have depreciation, 1031 exchanges and a lot of other concepts. You have some brutal taxation on your net (after expenses) profit. You can reduce it somewhat by redirecting your profits into retirement accounts.

4. LLCs do not change anything for tax purposes, they are primarily for legal liability protection. They are essentially an extra layer over whatever you use for your properties, and they do not reduce or increase your taxes.

You're not asking tough questions yet, you're asking very basic questions that sound complicated because they are out of context.

Tony Kohnle · Answer

@Shawn Long

As a non Accountant let me rephrase some of what has been written here.

With the IRS it’s pretty much you can pay me now, or pay me later.

A good CPA can help people use strategies that minimize the overall impact of those taxes by controlling the timing. You can’t always mix and match those strategies, they really need to be tailored to an individuals personal needs and situations.

Depreciation. The IRS basically considers an investor owning a house the same as a landscaper owning a backhoe. It’s a piece of equipment they need to run their business. Equipment depreciates, or is worth less over time, so you claim a paper loss of a percentage of the cost of the property each year you own it until it’s fully depreciated. This paper loss can offset actual cash income the property generated in that year, so you don’t pay income tax on it. Nice right?

Well, when you go to sell the house. If it’s worth nothing, you are golden and don’t owe any taxes. If it’s like most houses and is actually worth something, and probably more than you paid for it, then the IRS is going to want back the taxes that were deferred, a penalty for having to wait, and a tax on the properties increased value.

That big chunk can be deferred even longer by using a1031 exchange to reinvest the money back into another property, essentially keeping the money in the business instead of putting it in your pocket. You can do that until you die, and then let your heirs pay the taxes.

Buying a property in a Roth IRA is a great tax avoidance system because it’s set up as a retirement fund. You pay taxes on your normal income then put it in the IRA and any income or value increase is completely tax free.... you just can’t spend it till you retire.

There are other examples, but as you can see, these are long term individualized plans, and the best plan will be different for each investor.

Carl Fischer · Answer

You can read a lot of books and watch videos and talk about swimming but until your in the water it doesn’t mean as much. Work with other investors And professionals, look at their returns and processes. Find a way to “toe dip” before jumping in if you are conservative and have a lot to lose.  Maybe start with your residence, as there are many tax advantages to owning your home.

Carl Fischer · Answer

@Shawn Long

You should have your exit strategy plan figured out before selling- so smart of you to ask. I would have a serious talk with my cpa if I weare you. Not knowing your particular circumstances here is a brief answer that hopefully is thought provoking. The LLC or you individually will pay LTCG tax unless you don’t make much money.  You will also pay depreciation recapture tax when selling (approx 25%.) This can be deferred by using a 1031 exchange and/or using previous tax losses.

A self directed Roth IRA  will eliminate LTCG if no debt financing is used or if the debt is paid off a year before selling. A Roth 401k will also eliminate LTCG taxes. Traditional IRAs and 401ks will defer taxes but basically turn LTCG taxes into ordinary income when distributed. Figuring out ways to lower taxes will definitely improve cash flow and /or networth. It’s worth the money to discuss with a good cpa especially if you have years to implement, utilize, and benefit from the strategies.

Michael Plaks · Answer

@Shawn Long

In Chicago you'd want to reach out to @Steven Hamilton II

Shawn Long · Answer

@Michael Plaks

A suggestion of a good CPA is a strong tool to have in my arsenal. Im well aware of what is required and expected of me as a professional. I am however a directory if you will. And i cannot suggest 3 good CPA's if I don't understand the strategy or my clients position/needs. I am strengthening my role not stepping out of it.

Michael Plaks · Answer

Stay away from getting tax advice to your clients. You're taking a lot of liability doing this, and it's not covered by your Realtor E&O. For tax advice they should not be turning to you but to their tax professionals. And if those professionals disagree, as you mentioned, do you honestly expect to be better qualified than them?

BP books on taxes are OK but not that great, IMHO. Look for books by Stephen Fishman or Sandy Botkin on Amazon.

Allan C. · Answer

@Shawn Long what everyone is indicating is that LLCs have little relevance to tax strategy and are used primarily for liability protection. I hold rental properties within LLCs and also within my personal name, and am able to minimize income tax equally through depreciation shielding.

David M. · Answer

@Shawn Long

There are people that keep properties in their personal name and still don't pay taxes.  Either way, the sum of the income / expenses are still the same whether its in your personal name or company.  Its just a matter of getting the right "deal" and understanding how to do your taxes including depreciation and deductions.

David M. · Answer

@Shawn Long

You might try the BP published Tax Strategies book

https://www.amazon.com/Book-Strategies-Savvy-Estate-Investor-ebook/dp/B01BWDHLTQas well as their second book Advanced Tax Strategies.  I didn't read the first one since I saw too many reviews saying it was too basic.  The second book wasn't really that earth shattering for me.

Good luck.

Can capital gains tax be avoided through an LLC & depreciation?

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