Investors may look for ways to reduce income, which has the effect of reducing taxes. Investors can do this by claiming expenses and deductions against income. Usually, this process is the result of running a business or being involved in a specific type of investment. In other words, there is some structure over the assets that produce income along with expenses and deductions. This is called a tax shelter.
We’re going to dive into what a tax shelter is, why LLCs are used as tax shelters, and how a tax shelter relates to real estate.
What Is a Tax Shelter?
A tax shelter can help shield your income from taxes. Profits from a business are taxed. A tax shelter provides various expenses and deductions that reduce income and thus taxes. Not all tax shelters shield 100% of income from taxes. In fact, few do.
In a real estate rental property, profits are taxed. Real estate is often considered a tax shelter because it is able to help shield rental income. We can calculate profits by using the following formula:
NOI (net operating income) = Revenue - repairs/expenses (maintenance)
Next, we subtract mortgage interest and depreciation expense (non-cash deduction). This provides the net profit of the business.
Sometimes, profit can be negative. In that case, there is no profit since the business lost money. This will happen if expenses and deductions are higher than income. A loss can carry over to W2 income for those who also work a job. When that happens, real estate acts as a tax shelter for W2 income as well.
Let’s move more into our main topic to see how LLCs act as a tax shelter.
Why Is an LLC a Tax Shelter?
An LLC is actually a legal structure. It is meant to protect assets from legal liability. There are four different types of LLC:
- C-corp — can create adverse tax scenarios (i.e., assets are taxed when moving out of LLC)
- S-corp — flow-through, files Form 1120S
- Partnership — flow-through, files Form 1065, most common for real estate
- Disregarded (doesn’t file a tax return, as if the LLC doesn’t exist)
Let’s say you are 100% owner of an LLC. You receive a Schedule K-1 at the end of the year, which shows your income and deductions from the LLC. The LLC makes $24,000 for the year. You are taxed on $24,000, whether any of it comes out of the LLC or not.
Taking money out of the LLC is called a distribution. Distributions do not equal taxation. The reason is that once the LLC earns income, it is taxable — meaning you are taxed (i.e., the LLC is flow-through). This is an important point to make. If you are considering not pulling money out of an LLC until later for tax reasons, it’s really a moot point.
That still leaves the question — why is an LLC a tax shelter? An LLC provides a protective structure for the assets within that structure. These are the same assets that generate income and deductions/expenses. That is what is meant by an LLC is a tax structure. It still works the same way (minus the asset protections) if the LLC is not there (i.e., sole proprietorship).
However, the LLC provides a way to wrap it all inside a protective structure, along with other benefits such as anonymity (depending on where the LLC is filed) for the owner/investor. Some investors like the anonymity factor because it protects their privacy from the general public and tenants.
With info about tax shelters and LLCs under our belt, let’s bring it all together and see how this works in real estate.
Real Estate and LLCs
We’ll start with an example. An LLC has a rental property in it. The property generates $2000/month or $24,000/yr. You are taking the $2000 out each month. Do you pay taxes on it?
There isn’t a simple yes or no answer. You have to first figure out the NOI (i.e., take out expenses/deductibles). Also, remember that you could end up with a negative NOI, in which case, no taxes are owed.
If the NOI is positive, there is a profit, and the investor will owe taxes. If the NOI is zero or negative, no taxes are owed, and the negative balance can be carried over to the next year or applied to other income.
An LLC is a nice package to wrap a business in. Its benefits are asset protection and anonymity, plus some other benefits. It’s the expenses/deductions on business assets that provide the tax shelter rather than the LLC. Once the LLC is in place, the tax shelter flows through the LLC to the owner.
Working with your tax advisor and finance team can help ensure deductions and expenses are taken, and the benefits of a tax shelter are provided.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. All real estate investments have the potential to lose value during the life of the investment. The ability to generate income or distributions is not guaranteed. The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
