All Forum Posts by: Brian Schmelzlen

No, it is something else.  Most people who are full-time real estate investors probably won't run into it because they would need to own a separate business.  The best way I can describe it is through an example.  Lets say you own a manufacturing business, and you decide to purchase the property that you use to run your business.  However, the manufacturing business does not purchase the property; you purchase it as an individual.  Then the manufacturing business rents the property from you.  That is self-rental because you own both (you- as the manufacturing business- are renting it from you- as the landlord).  There are special rules that apply to it; probably why it was carved out. 

For the past 8 months, tax professionals have been studying Section 199A (the 20% pass-through business deduction) and trying to position their clients to best be able to maximize their deduction.  However, we have been operating without any regulations providing guidance on how the deduction will operate.

Because of last minute changes made to the Tax Cuts and Job Act (the 2017 tax reform law), many assumed that rental real estate would qualify for the Section 199A deduction.  However, that was just an assumption, and yesterday the IRS finally issued proposed regulations providing clarity.  The bad news: under these proposed regulations most rental activities will not qualify.

Here is the problem: the deduction applies to qualified business income from a qualified "trade or business".  We were waiting to hear how, for purposes of Section 199A only, the IRS would define a trade or business.  Rather than coming up with a new definition that would be helpful for real estate investors, they decided to use Section 162 of the Internal Revenue Code to define it.

There has been quite a few court cases over the years defining a "trade or business" under Section 162, and in a lot of cases rental real estate does not qualify.  The courts will look at a lot of factors, but to oversimplify things if you report the activity on Schedule E of your individual tax return rather than on Schedule C, it doesn't count.

Now, some of you may be wondering about if you own a significant number of rental properties and operate them like a business.  Even in that case it probably won't help.  The issue is that the IRS indicated that each property would be evaluated independently, not in the aggregate, so having more properties doesn't help.  Additionally, the IRS did not provide an exception for those it classifies as real estate professionals.

There is one carve-out, and it is for self-rentals.  If a business is renting property, and there is a common owner to both the business and the property, that activity qualifies for the deduction.

So, this is bad news for buy and hold investors.  However, it is not bad for all real estate investors.  My understanding is that flippers and short-term vacation rentals (that operate more like a bed and breakfast, rather than a pure rental) will still qualify for the deduction. 

Hi @Tracey Hamilton,

By default, your LLC is taxed as a partnership. If you choose, you can elect to have it taxed as a corporation going forward.

It hasn't been discussed yet, but as a flipper you (meaning the entity doing the flips) are considered to be a "dealer".  The IRS defines a dealer as anyone who purchases real estate and sells it to customers in the regular course of business".  Therefore, the real estate is inventory to your business, and as inventory upon sale it is taxed at ordinary income rates (not capital gains).

That is not a problem for your business; that is the correct treatment.  The problem is if you also have rental properties.  You want to be able to depreciate your rental properties, and eventually when they are sold have the sale count as a capital gain and not be taxed at ordinary income rates.

Therefore, you want the dealer status to be contained within your entity. An LLC won't do that; the dealer status will attach to you as an individual. However, as an S-corporation the corporation itself (as a separate legal entity) would be the dealer, not you.

There are other advantages to operating a flipping business as an S-corporation. The main one has to do with self-employment taxes. You don't have to worry about self-employment taxes with rental real estate so an LLC is fine for that, but ordinary income through an LLC would have self-employment taxes. Therefore, you might want to consider setting up an S-corporation and paying yourself a "reasonable salary". That salary would be subject to payroll taxes, but any additional distributions would not.

Not exactly what you asked, but I hope this helps.

Hi Charles,

I like @Alan Brown's suggestion of house hacking. If you are not planning on staying in Seattle, you should look into the option in the area you want to move to. You don't have to have 20% down if it is owner-occupied; you may have to pay PMI but build that into your costs when looking at the deal.

Regardless of whether you want to house hack or not, I would recommend getting into the habit of analyzing deals.  Pick out your target market (it sounds like Montana, but you may want to narrow it down further).  Look at major employers, economic trends, etc.  Then just run numbers on a number of houses until you become good at it.

I would consider reading a few books on commercial real estate before paying for any classes or training.

Hi @Alec McGinn,

I agree with the general advice of comparing your projected cash on cash return of investing versus the interest rate you are paying on your debt.  Generally the cash on cash return of investing will be higher, but it does depend on the deal.

There are a few other factors to consider.  1) Would a bank find you more appealing to loan to if you pay down more of your student debt?  If paying down some of your debt now does make you more appealing, then you may qualify for better loans (i.e. higher amounts, possibly with better terms).  That might mean that you could eventually (in a year or two) be able to invest in properties with an even better cash on cash return.  2) What do you think about the market in the area that you are about to invest in?  Do you think prices are at their peak, is there still room to grow, or is your market fairly stable?  I generally don't advise trying to time the market, but at the same time I never ignore the first rule of investing "Buy Low, Sell High".

Hi @Zeb Getrost,

How to get started investing should have less to do with your age and how much money you have, and more to do with why you are interested in real estate in the first place.  Figuring out your "why" can help you decide where you want to end up, and that makes it easier to figure out your first step.

If your reason for investing leads you down a fix and flip path, I would start off by trying to get a job in construction.  You will learn a lot that will help you either do the work on your own properties in the future, or (even better) that will help you manage contractors on your jobs.

If your reason for investing leads you down a buy and hold path, I would consider getting a job either as a realtor or as a property manager.  Both will help you gain valuable skills that will make you a better buy and hold investor.

Having those skills will also make it easier to partner with someone else (who has money) since you will be bringing valuable skills to the partnership.

Of course, getting paid to learn will also help you save up your own money to begin investing in properties.

Hi @Maria Gonzalez,

Having a separate LLC for each investment property provides additional asset protection, but it may be overkill. I would talk to a New York asset protection attorney about that.

You also need to consider whether it is worth the additional cost. New York charges an annual filing fee for each LLC ($500 minimum, unless each LLC is treated as a single-member LLC in which case it is $100 annually).

Everyone's situation is different, so that level of asset protection may make sense for you. However, it may also make sense to put all 3 properties in the same LLC, and have a large insurance policy covering that LLC.

While cash flow is a very important factor to consider (especially making sure that it is not negative cash flow), it is not the main thing I consider when evaluating commercial property investments.  My main concern is how quickly I can get my cash back, and my main strategy to do that is through a cash-out refi.  Therefore, I am looking at properties with the most value-add opportunities, and not necessarily immediate cash flow.

Hi @Aaron Wortham,

Welcome to BiggerPockets.  Although we are on opposite ends of the county, feel free to reach out if you ever want to get together to talk about investing (or how California still might tax you for out of state investments).