Minimization of Individual Tax Liability in Real Estate Investment
In the world of investing, in general, one question is often the most challenging to answer. How does an investor grow their nest egg without losing the majority of their gain to the IRS as income tax? This question is even more challenging in the area of real estate where one’s tax liability is drastically increased by just the sale of one property. This simple transaction can increasing the investor’s ordinary income if the property is a short term investment (investment is less than 1 year) or increasing their capital gains for long term investments (over 1 year). Surprisingly, there are several easy ways to drastically reduce tax liabilities with some planning and basic knowledge of the IRS tax code. There are several tools at their disposal including utilizing Internal Revenue Service Section 1031 (1031 Exchange), using pretax income to form a self-directed IRA, or by forming a limited liability company (LLC) to protect their investment.
The 1031 Exchange began as the idea that two individuals could trade one property for another and, as a result, there was no gain or loss realized. In 1979 the Internal Revenue Service (IRS) came to the realization that it was not as common to find someone who wanted to trade real property in this manner. As a result the IRS modified the Law allowing an individual or corporation to sell property and purchase another property as long as specific guidelines were met. This created a very important tool that investors could use to minimize or even completely remove any tax burden. “The most important advantage of 1031 exchanges is the fact that you can defer all capital gains indefinitely. The other deferral tools available usually only allow a deferral period” (Williamson 2003, 46). This is what sets the 1031 exchange apart from all other tools. By understanding and following the rules of the program closely an investor can effetely make his tax liability virtually disappear. There are three main rules one must follow in order to take advantage of this tax benefits. These are the use of a qualified intermediary, like property requirement, and time restraints. The use of a qualified intermediary means that a third party, usually a title company, must hold the proceeds from the sale of the first property and pay out directly to the seller of the new property. Also all of the proceeds from the first sale must be completely used to purchase the new property or properties. In other words the new property or properties must be more expensive. Next is the like property requirement. This requirement is not as rigid. Author Jack Cumming explains “like property” as: “In essence, you can exchange property held for trade or business with the same kind of property, or investment property for other investment property” (Cummings 2005, 63). The property cannot be land, real property lived in by the investor, or be located outside the United States. Last is the time restraints. Both time restraints begin on the date the property being sold closes. A list of potential properties must be compiled within 45 days of closing and one or more, from that list, must close within 180 days of closing. The 1031 exchange is a great way to manage an investors tax issues but it limits their options in terms of the timing of buying and selling of property. Unfortunately some investors might not have the after-tax capital on hand, but might have one or more individual retirement accounts (IRA) or other pre-tax accounts (ROTH) which can be combined into a self-directed IRA.
A self-directed IRA functions similar to a traditional IRA, as they can defer gains until the owner is in retirement and therefore pays much less in taxes. Of course there are some differences as explained by author Casey M. Murdock:

All retirement accounts are maintained in the name of a custodian. A custodian exists, in part, to assure the IRS that you have not tapped into your accounts during the year (thus triggering taxes and, possibly, penalties). A few custodians, however, offer what is called a self-directed IRA. In this case the custodian withdraws its fiduciary responsibility and allows you to choose the investments that you think are appropriate, such as investment property. (Casey 2013, 168)

At first glance the self-directed IRA can seem like the perfect way to leave the stressful world of the stock market but the seemly endless rules can quickly change an invertors mind. Furthermore if an investor knowingly or unknowingly breaks one of the many rules they could be audited by the IRS and if caught the entire IRA becomes immediately taxable as ordinary income. The most important rule is that the investor must keep his personal funds separate from their IRA funds. Most professionals agree it is important to consult an attorney and a CPA to facilitate the creation of a self-directed IRA. For the investors who fell the risk of an IRS audit is too great and are looking for more protection of their other assets, if they find themselves involved in a lawsuit, the formation of a Limited Liability Company (LLC) might be a better option. The existence of LLC’s didn’t occur until 1977 as author John Balouziyeh explains here:

Corporations and partnerships have traditionally served as the forms of organization from which business owners could choose. Recently, state statutes have begun to recognize a new form of business organization, the limited liability company (LLC). First recognized by state statute in 1977, the LLC is a hybrid organization that combines the advantages of the partnership with those of the corporation. In many ways, the LLC bridges the law governing both entities. (Balouziyeh 2013, 99)

In reality a LLC can take on one of two forms. The default status is as a pass through company or if it chooses to, “File Form 8832, Entity Classification Election to, elect classification as a C corporation” (IRS 2014, 3). As the default company all profits and losses “flow through” to the owners through a form 1040 - Schedule C, or through a form 1065 with K1’s, for partnerships (more than one owner). In this situation gains or losses must be recognized regardless of the individual owners’ tax situations. The major advantage being that income is only taxed once at the individual level. The ideal choice would be to elect to function as a C corporation. This election would allow the corporation to operate as a stand-alone entity and refrain from paying owners, similar to an IRA, until the owner chooses to, for example, is in retirement and pay much less in taxes. The disadvantage is that income is taxed at the corporate level (although at a lower rate) and again at the individual level. The idea is that the corporation is taxed while the investor’s individual tax bracket is high therefore saving ordinary and capital gains taxes over a long period.
The 1031 Exchange, self-directed IRA, and forming a LLC are just some of the many tools available to real estate investors used to minimize both ordinary and capital gain tax. In each situation there are many rules, some not mentioned here. It is very important to consult a CPA and/or an attorney when planning or executing any of these tax programs. By not fully understanding all of the rules an investor can find themselves in a very costly, or possibly, illegal situation.

Works Cited
Balouziyeh, John. 2013. A legal guide to United States business organizations the law of partnerships, corporations, and limited liability companies, 2nd ed. Berlin: Springer Accessed 11/30/2014. http://utdallas.primo.hosted.exlibrisgroup.com/UTDALMA:UTD_ALMA51173736010001421
Cummings, Jack. 2005. The tax-free exchange loophole: how real estate investors can profit from the 1031 exchange. Hoboken, N.J.: John Wiley & Sons Accessed 11/31/2014. http://utdallas.primo.hosted.exlibrisgroup.com/UTDALMA:UTD_ALMA21122155800001421 United States Internal Revenue Service. 2000. Tax issues for limited liability companies. Washington, D.C.: Dept. of the Treasury Accessed 11/30/2014. http://utdallas.primo.hosted.exlibrisgroup.com/UTDALMA:UTD_ALMA51171751610001421

Murdock, M. Casey. 2013. Tax insight for tax year 2013 and beyond, 2nd ed. New York: Apress Accessed 11/9/2014. http://utdallas.primo.hosted.exlibrisgroup.com/UTDALMA:UTD_ALMA51179403040001421

Williamson, Richard T. 2003. Selling real estate without paying taxes a guide to capital gains tax alternatives. Chicago: Dearborn Trade Pub. Accessed 11/9/2014 http://utdallas.primo.hosted.exlibrisgroup.com/UTDALMA:UTD_ALMA51152657580001421