Entity Choices with Danny Johnson of the Flipping Junkie Podcast

Danny Johnson: I like that. What I wanted to do is guide this just a little bit because I think people listening, the big question I think from a lot of newer ones and we’ve got experienced people listening, newer investors, but whenever it comes time to determine “what is the best entity for me to use?” and I know there’s different legal aspects of everything, there’s the tax planning aspects of the different entities and stuff like that, but let’s do a hypothetical here. Let’s say we’ve got an investor who’s wanting to do some quick-term flip, so he’s buying some houses, fix them up and then selling them, not holding them for very long, maybe the whole process is about 6-7 months in and out of the deal. So you recommend an LLC then for that. You want to speak about the reasons why you would want to do that?

Craig Cody: Well, typically real estate is under most circumstances best held inside of an LLC, and that’s basically for protection-wise and a step up in bases. That’s really the two main reasons. When you’re in a business of flipping, it’s ordinary income; it’s not long-term capital gains, it’s short-term. And if you’re really in the business of it’s actually ordinary income, not even short-term capital gains. So mistakes I see with those kind of investors is treating it like it is short-term capital gains instead of “in the business of”. When it’s short-term capital gains and you have all these expenses that may go into it, your operating expenses not just the cost to remodel but other operating expenses, those are subject to the 2% threshold on Schedule A on your tax return. They’re also subject to alternative minimum tax. So if you make too much money, basically they get added back in and you don’t get the benefit of it so you’re kind of getting squashed. But if you do it properly and you’re actually in the business of like a trader business, then you’re not dealing with those 2% itemized type of deductions and you get the whole benefit and you’re still short-term and ordinary income. So it’s important that you document what you’re doing so you can say “I am in the business of” versus a short-term capital gain. We had a situation like that where we saved somebody $87,000 because they were reporting it incorrectly. So hopefully that answers that part of the question.

Danny Johnson: Yeah, I think so. So you recommend the LLC. I’ve heard the LLC can be taxed different ways. So you can choose to be taxed as an S corp.

Craig Cody: Correct. Typically you want the straight pass-through LLC for real estate. You don’t want to elect to be taxed as an S corp or anything like that because then you’re back to the whole bunch of issues you have having real estate inside of the corporation. Now, it’s not a blanket statement but more often than not you’re better off having your real estate inside of an LLC. I’m not an expert on liability protection but having multiple entities or having multiple pieces of real estate in one entity is probably not the best way to go when you look at the cost of creating separate entities and if you do it right, you shouldn’t be in excessive cost of operations. That’s the way to go.

Danny Johnson: From a tax perspective, why not use a C corporation to flip houses and take advantage of a lot of the benefits of having the C corporation? Why not do that?

Craig Cody: Because when it comes to real estate, I don’t see a whole host of benefits of being inside of a C corporation. Typically a C corporation defers $50,000 is taxed as 15%. But when you go and sell that piece of property down the road, now you’re inside of a C corporation and getting that money out is double taxation. THE NEW TAX LAW HAS CHANGED THIS TO A FLAT 21%

Danny Johnson: Yeah, getting the money to yourself then.

Craig Cody: Right, is double taxation. So it’s not very efficient for that because you pay tax at the ordinary rate and the ordinary rate could be 15% but then in order to get that money out you have to dividend it out to yourself or pay it out on wage, so now you’re looking at at least another 15% and it’s not helping you that much. So C corps are typically not the way to go and if we’re doing planning, a C corp may fit into the planning we’re doing but typically not to hold the real estate. Maybe you’re using it to manage your real estate and taking some benefits that way.

Danny Johnson: So if you are a landlord and you’re picking up rental properties and like you said it’s not probably wise to have a lot of properties in one LLC. So you would recommend multiple LLCs then, just getting more protection into things? We’re not an attorney with regards to that.

Craig Cody: It’s getting more into protection but I have a real-life story to share where I had a client that had a bunch of them and they weren’t even in a single LLC, they were owned personally. She was sued for mold-induced injury. The house was worth about $25,000 and the verdict was 150 or 155 with interest and everything like that. So they went after everything she had and she had a pretty significant portfolio, like that was the garbage that she had in her portfolio.

Danny Johnson: All in one LLC.

Craig Cody: It wasn’t even in an LLC. So it was just owned personal which was just as bad, but if she had 5 inside that LLC, they could have went after all 5 of those. Whereas if it’s in a separate LLC and maybe each of those single-member LLCs are owned by one LLC that’s almost like the mothership, you’re not doing 10 different tax returns, you’re doing one tax return and everything’s protected.

Danny Johnson: Nice.

Craig Cody: Like I said, I’m not a liability expert but I have a real-life story that I see and people say “Well, we have insurance.” Well, apparently which I found out, mold only has a cap on how much you still pay for mold insurance on inside of a policy. That was at $25,000.

Danny Johnson: I’ve got more questions but they all seem to be legal-related so I need to get a follow-up episode to this one with an attorney so we can answer those questions. But going back to tax planning strategies and things like that for investors, so you’ve got three proactive tax planning strategies. Are these three specifically spelled out for different situations?

Get your copy of my book the 10 Biggest Tax Mistakes That Cost Business Owners Thousands here.

Listen to the full podcast episode here.