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Between mortgage payments, repairs, property taxes, and more, the costs of owning a rental property can add up. So when it comes time to form a business entity for your rental property business, you should choose the most cost-effective option while simultaneously providing as much legal protection as possible.
Fortunately for rental owners everywhere, Limited Liability Companies (LLCs) can offer all that and more. Let's explore how you can save and the tax benefits of an LLC for a rental property.
Tax Benefits for LLC Rental Properties
Arguably the most important benefit of forming an LLC is the limited liability protection you receive. With such protection in place, your personal assets — such as your home and car — won't be on the line if your rental property business gets into legal or financial trouble.
But that's far from the only benefit an LLC can offer. When it comes to taxes, LLCs have several time- and money-saving perks:
1. Pass-Through Taxation
Unlike C Corps and S Corps, LLCs provide their owners (also referred to as members) with pass-through taxation. Simply put, that means an LLC's profits are "passed through" to its owners' personal tax returns.
If you have an LLC, your tax paperwork remains relatively simple — your LLC's income is only taxed once, thus making it exempt from double taxation (more on that later).
2. You Can Deduct Your Mortgage Interest
When you purchase a property for the purpose of renting it out, you take out a mortgage to pay for it (unless you pay in cash, that is).
Luckily, the IRS states that "you can deduct mortgage interest you pay on your rental property."
If you pay $600 or more of mortgage interest to any one person or company, they'll send you Form 1098 to document that payment. Then, you can use Form 1098 on your own taxes to demonstrate the amount of mortgage interest you've paid.
3. Separation of Business and Personal Finances
When you establish an LLC, it becomes a separate legal entity from yourself as an individual. This separation allows you to open a dedicated business bank account and business credit card. This helps keep your business finances distinct from your personal finances, making it easier to track income and expenses related to your business activities.
It will help at tax time, and it will also prove to the courts that you're separate from your business if you ever run into any legal issues.
4. Flexible Structure
Thanks to an LLC's lenient rules, you can generally structure yours however you please.
For instance, you could determine each owner's (i.e., member's) share of the business based on the amount of money they contributed, or you could instead determine their shares based on the amount of time they dedicate to the LLC.
This flexibility also makes it possible to determine how much tax each member will be responsible for since a lower ownership percentage means lower taxes. In that same vein, a member who pays a higher tax rate on their income taxes could use the LLC's flexible structure to give themselves more deductible expenses (more on that next).
5. Depreciation Deduction
When an asset loses value over time due to use or becoming obsolete, that's called depreciation. Houses and apartments depreciate, too, since a building that was just constructed is generally more valuable than one built decades ago.
That means the owners of rental properties will see the value of their rentals go down over time. Fortunately, you can deduct that depreciation from your taxes.
In most cases, U.S. rental properties depreciate at a rate of 3.636% per year for 27.5 years. Once you calculate the exact amount you can deduct based on the IRS' guidelines, you'll be able to save money on taxes for decades going forward.
6. Capital Gains Deference
While not exclusive to LLCs, a tax break known as a 1031 exchange can help you avoid paying taxes on the money you make from selling a rental property.
Here's how it works: When you sell a property owned for business or investment purposes (such as a rental property), you have 45 days to identify a replacement property and 180 days to close on the sale of the replacement property.
If you succeed in doing so, you can defer paying capital gains taxes, which are taxes paid on the profits you make from selling an asset.
7. Other Tax Deductions
Once again, these deductions aren't exclusive to LLCs. Anyone who owns a rental property can deduct expenses like:
- Insurance premiums
- Legal fees
- Travel expenses
- Equipment and property rent
- Repairs and improvements
- Routine maintenance
8. Pass-Through Deduction
Like the owners of other entities subject to pass-through taxation, an LLC's owners can benefit from the pass-through business deduction.
If you qualify to use this deduction, you can reduce the amount of federal income tax you owe on your pass-through business income by up to 20%.
To determine how much a pass-through deduction you can claim, you'll need to compare 20% of your household's eligible business income to 20% of its taxable ordinary income. Whichever of those is smaller will determine your pass-through deduction.
Common Questions About LLCs for Rental Properties
We know you have crucial questions about the tax benefits of an LLC for a rental property. So, to get you the answers you need, we consulted with the experts, and here's what they said:
What Type of Business Is Best for Rental Properties?
The differences can be nuanced when comparing LLCs vs. sole proprietorships for a rental business.
"Submitting your business as an LLC, as opposed to operating as a sole proprietorship, doesn't inherently provide tax savings," says Mike Jesowshek, CPA and the founder and host of the Small Business Tax Savings Podcast.
"In fact, a single-member LLC and a sole proprietorship are taxed identically," unless the business's owner elects to have their LLC taxed as an S Corp.
"However, consulting with an attorney can reveal numerous legal advantages associated with using an LLC for your rental properties, such as enhanced asset protection. It's crucial to understand these benefits when considering the most appropriate structure for your rental business."
Can You Write Off Your Mortgage in an LLC?
"Yes, but it is limited and the treatment depends on how the LLC is taxed," says Crystal Stranger, Partner and Chief Operating Officer at Cleer Tax & Bookkeeping.
"If [the LLC is taxed as] a sole proprietorship, [mortgage interest can be deducted on Schedule E" of Form 1040, she explains. "On a partnership return," though, "this will be reported on Form 8825."
"Losses for real estate investments are passive income, so they are limited as to how much you can actually deduct," she goes on. "And the limit is on the individual tax level, so it isn't applied per investment, but per individual or couple filing jointly."
How Do LLC Profits Avoid Taxes?
"First off, you should never try to 'avoid' taxes," cautions Stranger. "That is seen as tax evasion, and any decisions made with this intent create criminal liability."
"However, it is perfectly legal to optimize your tax position by applying strategies to offset income to future dates and maximize deductions available," she clarifies.
For example, using the inherent flexibility of an LLC, you can elect to be taxed as an S Corp and save money on self-employment taxes. Similarly, you can strategically divide expenses among your LLC's members to control the tax write-offs each member gets.
Can You Write Off an Investment in an LLC?
According to Stranger, this "depends again on the taxation of an LLC, and if it is [a] passive or active income source." In other words, it depends on whether the income you get from your rental properties is ordinary or unearned.
Why? "LLCs are flexible for tax purposes," she elaborates, and while they're taxed as a sole proprietorship or partnership by default, "with an election, they can be converted for tax purposes into a C Corp or S Corp. The best structure depends on the nature of the business or investment activity. Losses then are limited if the investment is passive, but if active, then these limitations are waived."
So then, the solution is to ensure your investment is active, right? Stranger says it's not so easy.
"To be deemed 'active' in a real estate rental activity is tough," she says, "as there are specific rules that have to be met [by] the IRS."
For instance, the IRS states your rental activities can only be classified as "active" if you're a real estate professional. To qualify as a real estate professional for tax purposes, you must do the following:
- Perform more than 750 hours of services during the tax year in real property trades or businesses
- Materially participate in each of those trades or businesses
- Dedicate more than 50% of the personal services you perform to those trades or businesses
If you don't meet all of these qualifications, the income you earn from your rental business will be viewed as passive income. As a result, the losses you can deduct from your taxes will be limited.
How Does an LLC Avoid Double Taxation?
Double taxation is an expensive reality for C Corps but not for LLCs.
As Stranger explains, unless an LLC has elected to be taxed as a C Corp or has a foreign owner, "there really isn't any risk of double taxation for an LLC." That's because "an LLC is a pass-through entity by default."
Protect Your Assets (and Simplify Taxes) With an LLC
Although the IRS may treat LLCs the same as sole proprietorships, the truth is that an LLC can provide far more value to a rental property owner than a sole proprietorship ever could.
So if you like the sound of pass-through taxation, powerful asset protection, and adequate separation of your business and personal finances, an LLC is likely the best business entity type for you and your rental business. And when you're ready to form your LLC, our $0 LLC service is here to help.
Carrie Buchholz-Powers is a Colorado-based writer who’s been creating content since 2013. From digital marketing to ecommerce to land conservation, she has experience in a wide range of fields and loves learning about them all. Carrie is fond of history, animals and beauty in equal measure. In her free time, she enjoys knitting, playing video games and exploring Colorado's prairies and mountains with her husband.
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