As a tax accountant who has spent most of my career specializing in working with real estate investors, I have seen a lot of rookie tax mistakes from new investors on their real estate investing taxes.
Whether you just started your investing business or not, keep these Dos and Don’ts for your taxes in mind during tax season!
Define What Type of Investor You Are
When you get started in real estate investing, the language is very clear for anybody who is in the real estate business. The problem is that Uncle Sam does not understand what you are saying. To Uncle Sam there is no such thing as a real estate investor.
For Uncle Sam there are two completely different types of real estate investors. There are landlords and then there is everybody else. When people start getting into real estate, they essentially cover the whole spectrum of what real estate investor can do. This is all great, but when it’s time to look at that from a government perspective, you need to define exactly what you do. Are you a landlord or are you any other type of investor?
One Way to Simplify Your Real Estate Investing Taxes
When it’s time to prepare tax returns, there are different rules and different forms. If you are just starting as a real estate investor, I would recommend that you choose one strategy and stick to it initially. Then you can add to your toolbox. That could be just doing wholesaling and nothing else that year. If you try everything in that first year (wholesaling, rental properties, etc.), then according to the IRS you are starting two businesses, not one. If you start two businesses, you need to keep everything between those two businesses separate.
“…I would recommend that you choose one strategy and stick to it initially.”
Is Creating an LLC Right for You?
Your first order of business should not be to run out, form an LLC*, and start all of these formalities. You are not going to hurt yourself by doing that, but it’s really not necessary if you are starting as a wholesaler.
The primary goal of creating an entity would be for legal protection. I’m not an attorney so I’m not qualified to render legal advice, but for legal protection, you need to have exposure. You need to have risk. For a wholesaler, the questions are: What is your risk? Where are you exposed and what are you going to lose if somebody actually goes after you with a lawsuit?
It seems to me as a non-attorney that as a wholesaler you don’t have much of either… Not a whole lot of exposure and not a whole lot to lose if you are in legal trouble. Therefore, creating an LLC is not an emergency step you need to take, from a legal perspective. But, check with your attorney.
The Tax Benefits of an LLC
Creating an LLC will create absolutely no tax benefits for you as a new wholesaler. It might eventually. And by eventually…I mean when your wholesaling business becomes seriously profitable. At that point, setting some kind of structure might help, but not when you start.
If you are a new wholesaler, you are going to have a lot of expenses to get that business going. This includes marketing and you may not immediately see income from the business. What you are taxed on is the difference between your income and your expenses, which is called net income.
If your net income is $50,000 (after all expenses), then setting up a business entity for your wholesaling business makes more sense, tax-wise. Then an S corporation** would be considered for tax reasons. My 20 years experience of working with investors tells me that very, very few new wholesalers will hit $50,000 net profit in the first year.
Don’t: Try to Look like a Big Business
We have people who actually come with no deals, have done absolutely nothing, and they talk to me about arranging office space for their business. We have people who are starting out and one of the first things they do is go on a purchasing spree. They try to get an office, buy furniture, buy technology, and set themselves up. All of that is great except you just spent $20K, and there is absolutely no business benefit for that other a feeling of importance. This is not something a new investor should be spending money on.
“Whatever money you have as a new wholesaler, put it in marketing, not into setting up your business presence.”
Based on my 20 years of experience and looking at hundreds of investors and seeing who is successful and who is not, my advice would be…
Whatever money you have as a new wholesaler, put it in marketing, not into setting up your business presence.
Do: Immediately Establish Focus as an Investor
It’s important to immediately establish a focus. If you don’t, you will not be distinct from anybody else, and will be competing against hundreds of other investors and probably lose that competition because there are too many. You can succeed if you establish a specialty.
From day one choose an area, choose a type of the property, and choose a type of investing. Start building your reputation as a specialist in that particular area with those kinds of properties. Then anybody who is looking for that will soon learn that you are the person to go to for that.
Do: Establish a Marketing System
It is also important to pick one marketing strategy when you get started as an investor. Marketing is not cheap and trying to spread your money between several ways to market your wholesaling business is very quick way to spend all your money, run out of cash, and have nothing to live on after that. Choose one method of marketing and stick with it consistently. Learn how to do it efficiently. Whatever that method is, there are 10 different ways to do it and some ways are way more efficient than others. Create a focus, and create an efficient marketing strategy.
Start These Bookkeeping Habits Today
Get into two habits to simplify your life when it comes to bookkeeping and real estate investing taxes:
The first one is to separate business money from personal money. The simplest way to do it is to create two accounts at your bank. It doesn’t even have to be business account. It can be two personal accounts but designate one account for business, one for personal. Everything you need to pay for your business, pay out of your business account. Get into that habit. If there is not enough money in that account, transfer money from your personal account into that business account. Just make sure that everything business related is paid out of one account and never pay anything personal out of that.
“Everything you need to pay for your business, pay out of your business account.”
The second habit is to get an app on your phone that tracks business expenses and business mileage. There are tons of those apps. Get one from day one and get into a habit of using it because not everything will be paid out of your business account. Sometimes you have to pay cash. There is no record of that. In these apps, you can put a note in that says, “I just paid $7 for parking for an investor meeting in cash.” When the time comes to do your real estate investing taxes, that app will be a huge help because everything will be recorded there as well as mileage. If you go to a networking meeting, record the mileage. When it comes time for taxes, this will be helpful.
*LLC: A limited liability company (LLC) is the United States-specific form of a private limited company. It is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. LLCs do not need to be organized for profit. In certain U.S. states (for example, Texas), businesses that provide professional services requiring a state professional license, such as legal or medical services, may not be allowed to form an LLC but may be required to form a very similar entity called a professional limited liability company (PLLC).
**S Corporation: An S Corporation is a closely held corporation (or, in some cases, a limited liability company or a partnership) that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. In general, S corporations do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.