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When Trying to Grow Your Rental Portfolio, Which Real Estate Entity Should You Choose?

Your business entity matters. Although it is often a mere afterthought, choosing the right entity for your rental business is the foundation of your property investment future. Similar to the foundation for a house, if the proper entity isn't selected, the entire structure could be weak—or even collapse, given the wrong circumstances. The good news is that even if you own four, five, six, or more rental properties, it's not too late to select a business entity in Dallas.

An essential examination of the details around four entity options will help you make a financially sound decision. We're going to look at sole proprietorships, partnerships, C corporations, and limited liability corporations (LLCs). We'll discuss the tax ramifications for each entity—so you can figure out how to save the most money—as well as some of the other benefits.

Sole Proprietorships and Partnerships

For tax purposes, sole proprietorships and partnerships are essentially the same. All money made by the business is income for those who own the company; funds will incur taxes like ordinary income.

Rental Property

Benefits of Sole Proprietorships and Partnerships

  • Simple structure: There is no separation between you, your partners, and the business. Therefore, you don't form a new entity.
  • Easy to set up: Although the initial process and expenses depend on where you are, getting things rolling is easy and cheap.

Drawbacks of Sole Proprietorships and Partnerships

  • Your assets and income are exposed: If the business gets sued, you get sued—and you could lose everything.
  • There are no options available to help you get extra tax savings: Although you can deduct expenses, there are no special business tax protections in place if you have a sole proprietorship or partnership.

C Corporations

When you form a C corporation, your Dallas business turns into an entity. This classification means it gets treated like it's a person with taxes to pay. It also means that if the company gets sued and loses, it pays for the loss with its own money—not yours. Here's a closer look at the tax situation faced by a C corporation:

The corporate entity can enjoy a flat rate of 21% on its profits. If a person makes between $19,050 and $77,400 each year, they're only paying 12% in taxes. If that's the case with you, you would be paying 9% less than what the corporation would be paying. However, assuming you make more than $77,400 each year, you're paying at least 22% in taxes. So if you make more than $77,400 each year, it would appear that forming a C corp would be a great idea! Not so fast—you have to take into account double taxation.

Double taxation occurs when the corporate entity gets taxed, and then you get taxed when you take some of the money the corporation makes. The payment you receive is considered a dividend.  As a result, if the corporation makes money and you take some, the amount you take is taxed at the rate set for dividends.

The income you make from your rental corporation—if it's $77,200 or less—doesn't incur a dividend tax. Any amount between $77,201 and $250,000 gets taxed at a rate of 15%.

If your rental corporation pays you an amount between $250,001 and $479,000, you pay an extra 3.8% Medicare tax on top of that, which results in an effective tax rate of 18.8%. And if you receive $479,001 or more, you pay 20% plus that same 3.8% Medicare tax for a total of 23.8%.  

Benefits of a C Corporation

  • Low taxes: If you live a simple life with low expenses, less potentially taxable money is taken from your C corporation.
  • Your property and other assets are protected: If the business gets sued, it can lose—but you can escape most of the damage.
  • Fringe Benefits: When you work as an employee of a C corporation, you have access to fringe benefits that the C corporation can deduct from its income. Some of the fringe benefits include health and other insurance, medical expenses, deferred compensation plans, and company-owned cars.

Drawbacks of a C Corporation

  • Double taxation: You can get taxed twice; once when the C corporation makes money, and once when you take money out because it's considered a dividend.
  • No pass-through tax deduction: If you have an LLC, you can deduct 20% of the LLC's income from your taxes. This isn't possible with a C corporation.
  • More record-keeping: You may have to keep records of the meetings you have.
  • More tax paperwork: You have to file taxes twice; once for you, and once for the C corporation.

Limited Liability Corporations (LLCs)

An LLC is often seen as the structure of choice for a rental business. It is considered a "pass-through" entity, which means its profits and losses pass through to the owners. Owners get taxed according to these profits and losses. You also get to protect your personal assets if the business gets sued.

LLC?

How the Pass-Through Deduction Works

An LLC has a chance to pay 20% less on its net income. If you form an LLC, and you're in the 24% tax bracket, you may only have to pay a tax rate of 19.2%. If you had formed a C corporation, you would have paid more—21%.

Benefits of an LLC

  • Tax savings: With the pass-through deduction, you are in a good position to pay less money in taxes than you would as a sole proprietor, partner, or owner of a C corporation.
  • Protection of your assets: Personal assets sit comfortably behind the shield of the LLC structure.

Drawbacks of an LLC

  • Can be costly to set up: The amount you pay differs depending on where you live, but it can be several hundred dollars a year. However, in Dallas, you pay a setup fee of just $100.
  • More recording work: You have to keep records of the meetings you have.
  • More tax paperwork: If you have multiple members, you have to file taxes twice: an LLC tax return and a partnership tax return.

Why Many Investors Choose an LLC for Their Dallas Investments

Considering the protections an LLC offers, the relatively low setup cost, and the tax savings, it's no wonder why LLCs are a popular option for property investors in Dallas! However, to make the best possible decision, you should sit down with your accountant and go over the numbers. Regardless of which entity you choose, if you do so thoughtfully, you are putting yourself in a position to build a strong financial foundation.

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