Should I form an LLC for investments or remain individual investor?

[sidekickin]

I am going to have farm equipment assets located out of state that will be generating rental income payable from a payer in another state.  The equipment will be purchased new.  It is a passive investment and I will receive a 1099-MISC for rents paid.  The payer has suggested that I may want to look into forming an LLC for the investments in order to take advantage of write-offs and deductions, particularly Section 179 and equipment depreciation.   I've read that Section 179 deductions can only be taken off "active" income from an LLC.  Since this is a passive investment, would this be worthwhile to form an LLC?  What additional deductions/savings/protections will I benefit from having an LLC versus just being an individual investor?  Without the LLC, can I still write off depreciation of the equipment?  Thanks for your help.

[M-MTax]

For starters, you would be in the same position with a single member LLC as you would being an individual investor.....there is no difference because single member LLCs are disregarded for federal tax purposes.

[Carl]

If you would be the sole owner of the LLC, then it offers no real advantage. In fact, even a multi-member LLC would not offer any real advantage if the only assets the LLC will have are those used to generate passive income; and rental income is passive.

If that's the only reason for this, then forming an LLC has nothing to offer you. Stay away from that and just report your rental income/expneses on SCH E as a part of your personal 1040 tax return. Even if you do form an LLC, all the income is still passive and still ends up reported on SCH E as a part of your 1040 return. All that does is just create another layer of paperwork and accounting that provides no benefit and serves no real purpose.

[M-MTax]

Even if you do form an LLC, all the income is still passive and still ends up reported on SCH E 

Not at all true......... @sidekickin said the rental was farm equipment which is not real estate.

Personal property.

Do not use Schedule E to report income and expenses from the rental of personal property, such as equipment or vehicles. Instead, use Schedule C if you are in the business of renting personal property.

[Mike9241]

Even if the requirements explained earlier under What Property Qualifies? are met, you cannot elect the section 179 deduction for the following property.
• Certain property you lease to others (if you are a non-corporate lessor). THAT'S YOU. HOWEVER THERE IS AN EXCEPTION 
Generally, you cannot claim a section 179 deduction based on the cost of property you lease to someone else. This rule does not apply to corporations. However, you can claim a section 179 deduction for the cost of the following property.
1. Property you manufacture or produce and lease to others.
2. Property you purchase and lease to others if both the following tests are met.
a. The term of the lease (including options to renew) is less than 50% of the property's class life.
b. For the first 12 months after the property is transferred to the lessee, the total business deductions you are allowed on the property (other than rents and reimbursed amounts) are more than 15% of the rental income from the property.

179 is limited to business income so if the 179 deduction would result in a business loss the "loss" amount isn't deductible but must be carryforward.

having pointed those things out about section 179, there is another possibility that is not subject to the same constraints as 179. That's bonus depreciation under IRC 168(k)

you should read IRS PUB 946 starting on page 23

HTTPs://www.irs.gov/forms-pubs/about-publication-946 

sometimes taking the maximum depreciation in the 1st year is not the best from a tax standpoint.  your income goes way down that year but then you have no depreciation deductions in future years to offset the income which usually results in paying more taxes in subsequent years than you saved in the 1st year

[Carl]

sometimes taking the maximum depreciation in the 1st year is not the best from a tax standpoint. your income goes way down that year but then you have no depreciation deductions in future years to offset the income which usually results in paying more taxes in subsequent years than you saved in the 1st year

I see and hear about that quite a bit. Mostly from those who wished they hadn't done that when it comes to things dealing with rental real estate.

[sidekickin]

Thanks for all the feedback.  It sounds like if all I have is passive income from investments that there is really no point in forming an LLC since I cannot use the Section 179 deduction.  However, with respect to writing off depreciation on the asset as an individual, if at a later time the asset is sold for the same price as I purchased it for, will I owe back the depreciated amounts I took over the years?

[Carl]

if at a later time the asset is sold for the same price as I purchased it for, will I owe back the depreciated amounts I took over the years?

Yes. A common mistake I see folks make, is thinking that depreciation is a permanent deduction. It's not. When you sell or otherwise dispose of the asset you must recapture all depreciation taken. If you don't depreciate the asset, then you must recapture the depreciation you should have taken, anyway. It's a lose-lose situation. Two things about recaptured depreciation.

1) The recaptured amount is included in your AGI.

2) Recaptured depreciation is taxed anywhere from 0% to a maximum of 25%. Even if your AGI puts you in a higher tax bracket, the recaptured depreciation will not be taxed higher than 25%.

[M-MTax]

there is really no point in forming an LLC since I cannot use the Section 179 deduction

If you can't use the Sec 179 deduction as an individual you can't use it if you form an LLC either.

if at a later time the asset is sold for the same price as I purchased it for, will I owe back the depreciated amounts I took over the years?

How do you figure? You're buying farm equipment and leasing it to someone else, right? It's a bit unrealistic to think you're going to be able to sell the asset for the same price you paid for it "years later". You've taken depreciation deductions but because that's a cost recovery system. "Years later" you should only be able to get a fraction of what you paid for the asset when you sell it.

[M-MTax]

A common mistake I see folks make, is thinking that depreciation is a permanent deduction. It's not.

You're right......it's NOT a permanent deduction....it's a cost recovery system. 

You're also thinking about it wrongly because you're fixated on depreciation deductions for real estate which almost always goes up in value over time. You need to consider personal property which almost always goes DOWN in value over time. If you buy office furniture for a suite of offices for your business you'd depreciate the furniture over 7 years BUT you'd be hard pressed to find someone to pay more than a paltry sum if you tried to sell the stuff after that amount of use. So your "recapture" would be next to nothing.

[Opus 17]

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@sidekickin wrote:

Thanks for all the feedback.  It sounds like if all I have is passive income from investments that there is really no point in forming an LLC since I cannot use the Section 179 deduction.  However, with respect to writing off depreciation on the asset as an individual, if at a later time the asset is sold for the same price as I purchased it for, will I owe back the depreciated amounts I took over the years?

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You always owe recapture, whether you are a sole proprietor, LLC, or C- or S-corp.

[sidekickin]

There are some additional details that are pertinent to this situation which will explain why I am asking about this.  In the contract for the lease, after the initial 5 year term the payer has extended the option to purchase the equipment for the full amount that I paid for the equipment.  However, if I continue for subsequent lease terms (5 years each), that option is no longer on the table and I would be lucky to receive MAYBE 50% of the original purchase price if I sold the equipment.  The reason they are putting this option in the contract is because the company expects to be bought out by another company within 5 years and is doing this to protect me as an investor.  So, with this additional information in mind, if I allowed the payer to buy the equipment for my original full purchase price at the end of the initial lease term (or the company is bought out and they fulfill the terms of the lease agreement), would I have to pay back any depreciation I deducted over that 5 year period?  Are there any other things to consider in this type of situation?

[M-MTax]

 if I allowed the payer to buy the equipment for my original full purchase price at the end of the initial lease term (or the company is bought out and they fulfill the terms of the lease agreement), would I have to pay back any depreciation I deducted over that 5 year period?

New farm machinery and equipment has a recovery period of 5 years under GDS. So if you sold for the same price you paid for the equipment after 5 years your entire purchase price would be the amount of depreciation recapture on the sale......assuming you did not assign any salvage value.

[Opus 17]

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@sidekickin wrote:

There are some additional details that are pertinent to this situation which will explain why I am asking about this.  In the contract for the lease, after the initial 5 year term the payer has extended the option to purchase the equipment for the full amount that I paid for the equipment.  However, if I continue for subsequent lease terms (5 years each), that option is no longer on the table and I would be lucky to receive MAYBE 50% of the original purchase price if I sold the equipment.  The reason they are putting this option in the contract is because the company expects to be bought out by another company within 5 years and is doing this to protect me as an investor.  So, with this additional information in mind, if I allowed the payer to buy the equipment for my original full purchase price at the end of the initial lease term (or the company is bought out and they fulfill the terms of the lease agreement), would I have to pay back any depreciation I deducted over that 5 year period?  Are there any other things to consider in this type of situation?

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Roughly speaking:

Suppose a $100,000 tractor, depreciated over 5 years.  The lease is in place for 2 years, during which time you take $40,000 depreciation expense.  Your adjusted cost basis is now $60,000.   If you sell the tractor for $100,000, you have a taxable capital gain of $40,000 (sales price minus adjusted cost basis).  In this case, since all the gain is due to depreciation, it is taxed as depreciation recapture, and not at the more favorable capital gains rates.  

You deducted $40,000 in the past, now pay tax on the $40,000.  It's a wash (in one sense) but it benefits you in another sense.  $40,000 of taxable income 3 years from now is less real money (purchasing power) due to inflation, so it's still financially to your advantage to deduct the depreciation now and pay the tax later.

Your situation is odd; normally it would be more common to keep the equipment until it was no longer usable and then sell it for scrap or sell it used, either of which would create recapture, but much less than the original full price. 

And also, very important.  You must recapture depreciation you took or could have taken.  So if you think that you will just not bother reporting depreciation to save paperwork, and therefore not report the recapture as taxable income, that's a huge mistake if you get caught.  

[sidekickin]

@Opus 17 

So, I really have no choice but to depreciate the asset whether I want to or not?  If I don't depreciate the asset, it would seem to me that there is nothing to recapture and thus no taxable income on it.  I never saved any money if I didn't depreciate it.  Is there a reason they require this?  Is there some hidden added revenue they get through the depreciate/recapture process?