Should Small Business Owners Also Be Real Estate Investors?

There is an interesting and very hypothetical question on Quora, I’m an entrepreneur and made $2 million this year with my business. I wanted to invest in real estate to avoid taxes but my accountant says to wait till next year…What should I do?, which could potentially give some insights for those looking at long-term success as both a small business owner and active real estate investor.

A very interesting and potentially insightful answer was put forth by Michael Lantrip an author of several books including, “Tax Cuts And Jobs Act For Real Estate Investors.” (The Tax Cuts & Jobs Act also created Opportunity Zones and the potential for real estate investments in these new areas.)

One thing to note about his answer, he does open it with, “Your question is obviously fake, but as a HYPOTHETICAL, there is a very interesting answer. Let me show you how to pay Zero Taxes on the $2M…”, but the potential 10-point strategy he lays out is filled with gold.

But here’s what you can do to keep the entire $2M:

1.) Create a single-member LLC.

2.) File Form 8832 electing to be taxed as a corporation.

3.) File Form 2553 choosing Subchapter S status.

4.) Find a commercial shopping center selling for $6M.

5.) Contribute $1,500,000 of the $2M to the LLC.

6.) Use the $1,500,000 as a Down Payment (25%) and enter into a Contract for the LLC to buy the shopping center.

7.) Before you close, do what is called a Cost Segregation Study.

8.) Now you close on the shopping center and operate it until the end of the year.

9.) When you file your S Corp tax return for the shopping center, let’s say it shows an operating profit of $700,000.

Now, here’s the kicker.

I recommend reading his response in its entirety, it’s definitely worth the time even if to come up with some questions to ask your personal financial advisor or CPA.

An interesting part of the strategy he lays out is the necessity of the Cost Segregation Study. He provides additional insights on the strategy within his answer, but for those real estate investors unfamiliar with what exactly a Cost Segregation Study is, Ernest & Wills provides an excellent definition. From their website:

Cost Segregation is the practice of identifying assets and their costs, and classifying those assets for federal tax purposes.

In a cost segregation study, certain commercial building costs previously classified with a 39-year depreciable life, can instead be classified as personal property or land improvements, with a 5, 7, or 15-year rate of depreciation using accelerated methods. Residential buildings, including multi-family buildings are subject to a 27.5 year life.

An “engineering-based” study allows a building owner to depreciate a new or existing structure in the shortest amount of time permissible under current tax laws.

Michael’s answer also sheds some insight on how the changes to the Tax Cuts and Jobs Act can have significant benefits for real estate and business owners. The IRS has an update from April 9th, 2018 – New rules and limitations for depreciation and expensing under the Tax Cuts and Jobs Act. 

Businesses can immediately expense more under the new law

A taxpayer may elect to expense the cost of any section 179 property and deduct it in the year the property is placed in service. The new law increased the maximum deduction from $500,000 to $1 million. It also increased the phase-out threshold from $2 million to $2.5 million.

The new law also expands the definition of section 179 property to allow the taxpayer to elect to include the following improvements made to nonresidential real property after the date when the property was first placed in service:

  • Qualified improvement property, which means any improvement to a building’s interior. Improvements do not qualify if they are attributable to:
  • the enlargement of the building,
  • any elevator or escalator or
  • the internal structural framework of the building.
  • Roofs, HVAC, fire protection systems, alarm systems and security systems.
  • These changes apply to property placed in service in taxable years beginning after Dec. 31, 2017.

Temporary 100 percent expensing for certain business assets (first-year bonus depreciation)

The new law increases the bonus depreciation percentage from 50 percent to 100 percent for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. The bonus depreciation percentage for qualified property that a taxpayer acquired before Sept. 28, 2017, and placed in service before Jan. 1, 2018, remains at 50 percent. Special rules apply for longer production period property and certain aircraft.

The definition of property eligible for 100 percent bonus depreciation was expanded to include used qualified property acquired and placed in service after Sept. 27, 2017, if all the following factors apply:

  • The taxpayer didn’t use the property at any time before acquiring it.
  • The taxpayer didn’t acquire the property from a related party.
  • The taxpayer didn’t acquire the property from a component member of a controlled group of corporations.
  • The taxpayer’s basis of the used property is not figured in whole or in part by reference to the adjusted basis of the property in the hands of the seller or transferor.
  • The taxpayer’s basis of the used property is not figured under the provision for deciding basis of property acquired from a decedent.

As you can see there are a number of provisions and factors that influence how the deductions can be used. As a savvy business owner or real estate investor, it is best to consult with your tax and investment professionals to determine how best to structure your real estate investment as a business owner or as a business owner who recently divested.