What is An Entity and What is the Best Entity for Real Estate Investment? – Videos 1 & 2
Video 1 Transcript
Presenter: We have a number of different ways to hold property. Anybody hold real estate in your own name? Just show a hand. A bunch of people. Anybody have it in a general partnership? Now they’re trying it out of favor. Anybody have it in a limited partnership? Now they’re out of favor. What about a limited liability company? LLC? Few people in the background. Anybody have a corporation? Okay, so mainly LLC. That’s the trend.
Because once you own enough property that you’re worried about losing it or you have enough equity in your primary residence, you don’t want to tie everything together like you are if you own it personally.
If the furnace blows up and the rental kills the family, and you own it personally, all your assets are at risk. That’s the disadvantage of owning real estate individually. With all that being said, there’s special rules for California under Prop 13 and 58 which we will get in to. For California owned property, you may want to own it individually. The current trend is towards an LLC. That’s what’s being used. Can anybody tell my why you’re doing an LLC?
Participant: Asset reduction
Presenter: Absolutely not.
Participant: What? That’s what they told me.
Presenter: Okay, if you have an LLC and you happen to be the manager, the person in charge, who gets to call who gets paid? The manager. Can you give away those membership interests in the LLC to your children? Yes, you can. How much money do they get each year? We don’t know. They’re only paid on profit. Who gets to determine what profit is? The manager. If there’s $50,000 of profit, can the manager say in November, early December, “You know what, I did a really great job this year, and I deserve a what?”
Presenter: Not a raise. A bonus. How much of a bonus are you going to give yourself? $50,000. How much profit is left to share with your children? None. It’s an easy way to do gifting because you’re not giving cash flow. It’s not impacting your lifestyle, but you’re still transferring wealth up to $14,000 per individual. Husband and wife, that’s $28,000 per child. No transfer tax because you’re below the 14. If you give them $14,000? No, why? You’re correct but do you know why.
Participant: No, I don’t. Just say I’d give 13,999.
Presenter: Okay, I wouldn’t recommend that. Because the actual rule, the IRA says it’s $14,000 from January 1st through December 31st. Did you give a $2 beanie baby? Now you’re over $14,000. You owe us 709 gift tax return. What’s the statute of limitations on a 709 gift tax return? Three years. From when?
Participant: When you file.
Presenter: When you file. So if you’ve made gifts for 20 years and you’ve never filed, how many years can they go back?
Presenter: 23 years. By the way, what government agency is totally contrary to everything else where you’re presumed to be guilty until you prove you’re innocent?
Presenter: Isn’t it the smart thing to file the 709 gift tax returns even if you don’t owe money and you below the $14,000 if you’re doing regular gifting. Absolutely.
There’s no tax that’s owed. You’re simply doing it. I can tell you from an eye perspective, they’re looking at us, below $14,000 gone. It’s three years from when you file. That’s the limitation. They can not come after you. Anybody have a single member LLC that are California residents? Good. You know why it’s good? No? You just know not to do it?
Okay. By the way, husband and wife in any community property estate, that’s considered a single member. That’s why I said in California, you have to be careful. The slide says, “Can be used to pay off creditors.” The IRS has determined that if you’re a single member LLC, which is what accountants like because it’s a pass through and it’s just a regular schedule lead. That if you have employees, and if you don’t pay payroll taxes, they can personally attach your individual assets, there is no distinction. There are currently 10 jurisdictions that also say, “There is no creditor protection on a single member LLC.”
So, if you’re in a community property state husband and wife, you do not want to have only husband and wife, which leads you to let who? Children. Now have you started a gifting plan right away, and keep doing that because it doesn’t impact your lifestyle, because it doesn’t impact your cash flow, those are the types that gifts you can give. Now, if you give your children $14,000, how much are they going to keep long-term? If they’re like my kids. Nothing, it’s all going to be gone. If you give them membership units in your LLC or stock in your corporation, how much of those assets are going to be there until you pass away? All of them.
Not only that, when you pass the future appreciation of that asset on to your children, and it’s part of your estate for inheritance taxes. Everybody see that? If you pass the 2% interest in the property in Pittsburgh, and it’s 30 years from now, hopefully it’s gone up a lot. Whatever you have given, that future appreciation is outside of your estate. By the way, what’s that also mean? You don’t own it, creditors can’t get it. Right, you’re doing it for creditor protection. Heck no.
You’re doing it to avoid possible inheritance tax. Everybody understand? Most of the time, asset preservation is the secondary effect, and please remember that, because if you’re on the stand, why did you do this. For creditor protection? What do you think your chances are to actually have creditor protection? Minimal. If you get on the stand, and said, “The people that told me to do this, then they are like 30 or 40 things. I can’t remember them all.” You stand on much better chance of convincing before and the jury, that you didn’t do it solely for creditor protection. That’s when you get into trouble.
Video 2 Transcript
Presenter: Reasons to form an entity. Asset Protection should be the last one. In-law turning into the outlaw. Retirement. Anybody investing in real estate to help them out of retirement? If you’re paying your child or they are in a lower income tax bracket than you and you’re avoiding probate and increasing wealth.
We had fun at another seminar. We tried to think of reasons. We came up with 35 reasons in four minutes of why you use an entity. To keep family money together. If all the family money is an entity or multiple entities, can you get better deals than the banks? Absolutely. You have a larger capital to pull from so you can buy larger projects.
Can you have retirement planning in that entity? Yes, but you have to do one thing. What’s that? Rents. Earned or unearned income? Unearned, which means you cannot count any of that revenue towards retirement. You have to do what? Pay yourself a W-2. If you pay yourself a W-2 you can do a 401(k). You can do profit sharing plan and you can do a DV plan. With the right ages, you can put hundreds of thousands of dollars away for retirement and not pay any income tax on that money today but you have to have earned income, Yes?
Participant 1: You’re saying if you write yourself a W-2, you can create a solo 401(k)?
Presenter: You could but I wouldn’t recommend it.
Participant 1: Got it.
Presenter: The reason being a solo 401(k), SEP IRA are not covered under ERISA which means it’s not creditor-protected unless you file for BK. With all that being said, you have to judge the risks. We have a lot of clients that want to pull some of the money out, put it in a self-directed IRA to purchase real estate but it’s a way to be able to transfer money outside of an unprotected vehicle into a protected vehicle.
Participant 2: Then 401(k) if you can hold up, they all stay in 401(k). 401(k) is protected versus IRA.
Presenter: Correct because 401(k) is under ERISA. 403(b), ESOPs and two other things are all under ERISA.
Participant 2: You just specifically said W-2 income can also be 1099?
Presenter: You could but they are looking at why you’re paying the 1099 from your own company. Is that reasonable compensation for the work you’re doing? Typically we use a W-2, it’s easier than the 1099. Yes?
Participant 3: Is that through you employment and SSI tax?
Presenter: Absolutely. How much is that total? 15.5%? Anybody here paying more than 15.5% in income tax? I would trade any day not paying income tax to pay the 15.5% because typically between the state of California and the IRS you’re at 28% to 35% at the drop of a hat. To save 35%, to pay 15% I’ll take that deal any day. That’s why the IRS is looking at reasonable compensation because people that have corporations they’re taxed as a Sub-S, want to do what? Avoid payroll taxes. They want to save the 15.5%. So they’re pooling at all these profits.
It gets really ugly if you’re not paying yourself reasonable compensation. That’s what the service is looking for. We also have other people that their job description probably would generate maybe $100,000 but they’re paying themselves $250,000. That happens to be the magic number for getting the maximum money into a defined benefit plan which is the old pension plan. The IRS is looking at both ways.
Everybody understands the slide, one of a multitude of things is asset protection. Gifting income tax purposes, inheritance tax purposes, generation-skipping transfer tax purposes. If you are in the state of California possibly prop 13, prop 58, those are all legitimate reasons for putting assets, especially real estate inside an entity. Or I have a gifting plan that I wanted to transfer- let’s say I’m 50 and I have life expectancy of 30 years. Somebody do the math for me. $40,000 times 30 is what?
Participant 1: $520,000
Presenter: $520,000 I can transfer over my lifetime $520,000. Is there a gift tax? No. Is there an inheritance tax? No. If I can do it with memberships and identity where I control the cash flow has an impact to my lifestyle? I’ve taken because the IRS is at 40% right now, on inheritance tax, I’ve saved possibly 40% of what I transfer. That’s per child. I have three. That’s a million half. Oh, I forgot my wife.
That’s another million. That’s $3 million you transfer. The issue is, most people don’t have cash to be able to transfer cash. What can you transfer that doesn’t impact your lifestyle? An entity is of absolutely great purpose.
Why multiple entities? if you own 15 rental properties and they’re each worth $200,000, I should pick easy math for me. Is that $3 million?
Presenter: $3 million, thank you. The furnace blows up in one of the 15 properties, how much is that risk?
Audience: All of it.
Presenter: All $3 million. I can personally tell you, I’m not comfortable having all of them in one entity. I really don’t want to lose $3 million. I’d be much more comfortable at half million to a million. If I had it in three separate entities, the first blows up and the property in that entity, what am I subject to losing? The million dollars. The other two are protected. Quick question for you. If a child comes and you have the $100,0000, “Mom, dad, I need $100,000 for down payment on a house.” Are you going to say yes if you have the money? Are you going say yes? I only ask tricky questions. What’s answer?
Presenter: No. What are you going to do Instead?
Participant 3: Loan the money.
Presenter: You’re going to loan the money, get a promissory note and a deed of trust. If there’s a divorce, who gets paid back first?
Presenter: You do because you have a note and a deed of trust plus the interest? Then the next day, can you turn around and loan the same money to your child to buy another house? Two ways to get the same thing. One protected and one not. That’s what asset preservation is. How can we do it? Have a legitimate reason. I want my child to be able to afford a house in the Bay Area and how can I do it to protect them? As an aside, my children will never inherit anything from myself nor my wife. Let me say it again. My children will never inherit anything from myself or from my wife. Why is that?
Participant 3: Because you don’t own it.
Presenter: If you don’t own it, hence, my children don’t own it. It can’t be taken away from them. Lifetime trust for my children. That rolls out of my revocable living trust when both my wife and I are done. Simple.