Before we get on our show here, I want to remind you about our upcoming Memphis Investment and Property Tour that will be on October 6th and October 7th. It’s a Friday, Saturday. This is a great event. If you can make it, get in touch with our investment counselors here. We are offering free tickets, the tickets are normally $450, and we would love to see you and maybe your spouse down there or your business partner. What we are doing is hosting a unique event in Memphis, Tennessee. It will be a weekend of property tours, speakers and networking mixed with a little Memphis culture. Not only will you see great investment properties but the first full day is where we’re bringing together speakers from all over to address various aspects of today’s real estate investing. That’s going to be a breadth of information and topics. We would love to have you down there and see what we have going on in that great market. Again, this is October 6th and 7th. You can come in as early as Thursday, October 5th. I’m not sure if we have an event on Thursday but we definitely have an event going on on Friday evening. It’s a dinner and a networking mixer. Saturday is open-ended on Saturday evening so we can do whatever we want to do unless you want to fly out that night, but I think a lot of people are going to fly out on Sunday. Contact our office or send us an email through our website at NoradaRealEstate.com and we’ll tell you more about it.
Today’s episode is about sheltering your rental income from taxes and maybe some other tax tips. When it comes to taxes, I pay my taxes, it’s not my favorite thing to do, but it’s something we just all have to come to grips with. Paying taxes just seems to be part of the American life now and ever since the Income Tax Act of 1913, there’s really no way around it. There’s a lot of code in the tax code. Unfortunately, you have to pay your taxes for any types of income you make. Fortunately, the US Tax Code has many, many rules that allow rental property owners to reduce their taxes and save money. If you own property, it’s a huge part of your tax strategy because it is the most tax-favored investment that you can get your hands on, that you can put your investment capital into, and the IRS rewards this type of behavior. If you don’t have property, you really should have some because the tax benefits are fantastic.
I’m not a tax professional or a CPA but I do know many people who are tax advisors and specialists in that area and the fact that they are in the niche, that they deal with real estate investors, that really helps in helping educate you through this podcast, through articles as well as clients because we can put you in touch with them to minimize your tax impact or defer that taxable impact or in some cases, even eliminate completely and forever the tax impact of your income. Our show today is about sheltering and reducing your rental income from taxes. I have a great guest on who is a very, very sharp individual, so just stay tuned.
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Sheltering Your Rental Income from Taxes (and Other Tax Tips)
It’s my pleasure to welcome Brandon Hall to the show. Brandon is the owner of The Real Estate CPA. He’s a real estate investor and CPA specializing and providing business advice and creative tax strategies for real estate investors. Brandon’s experience in the Big Four accounting firm and his personal investing experience allow him to provide unique advice to each of his clients. He’s an entrepreneur at heart who happens to be good at taxes. Brandon, welcome to the show.
Thanks for having me, Marco. It’s a pleasure to be here.
I’m glad to have you on. Everybody thinks about taxes and talks about taxes. I haven’t done a show on income taxes and property taxes for a while so I figured it’s about that time. Brandon, why don’t we start off by you sharing with our listeners how you got into real estate investing?
I started my career off at PricewaterhouseCoopers as a Big Four accountant, pursued my CPA and looked at it and said, “This isn’t really something I want to do long-term.” I immediately started trying to figure out how to get out of the corporate world, found BiggerPockets, which was all about rental real estate and started asking a lot of questions there. That ended up leading to me buying my first rental property which was a three-unit down in Hickory, North Carolina. That’s how I started, just standard W2 path and just exploring different real estate options.
When you went to college or university, you were setting out to just be a CPA right from the get-go. It wasn’t that you wanted to be a real estate investor at the time.
I double majored in Finance and Accounting and through my finance degree, I actually took a couple of real estate classes and really, really enjoyed the material. I convinced my parents that real estate was an awesome way to invest and watched them make some investments as my own little case study where I had zero risk involved. After they’ve found some success there, I just realized, “Real estate is definitely a key to wealth building. It’s something that I want to explore later. I don’t know a lot about it but whenever I have the money, I’m definitely going to roll those funds into real estate.” I looked up at the W2 job as more of a way to fund the real estate venture. When I finally had the fund, it was like, “How do we actually do this real estate investing thing? It sounds great. It looks great, but I don’t know anything about it.” That’s where I found BiggerPockets and all those resources.
A W2 income is very important because you need that capital to invest in the real estate. Cash and credit allows you to build that portfolio. Sometimes people ask me, “Should I go into real estate full-time?” That usually means that they’re leaving their job and they’re planning to be a flipper or whatever they plan to be, but that’s not a smart move because you need that income to qualify for financing. That’s a good bridge and I can see how you went from the W2 position to starting your own business and generating income from that and then investing in real estate.
On that note, I just recently closed on a single-family home down in Raleigh, North Carolina as a primary residence, not really as an investment. It was very difficult to underwrite my self-employment income compared to the W2 income. I’ve bought two three-unit properties on W2 income and it was a breeze. That’s definitely one thing to keep in mind if you are thinking about going that self-employed route and giving up that W2 as it gets a lot tougher.
Benjamin Franklin said and I know many people have heard this, “In this world nothing can be said to be certain, except death and taxes.” We’re always looking for ways to not necessarily avoid death, but certainly reduce or eliminate taxes. Let’s start off with this very general, overarching question that could be actually a specific question and that is this: Is there an overall best practices strategy for real estate investors to shelter their rental income?
Overall best practices, I would just say you need to get into a really solid habit of documenting everything and keeping up-to-date financial statements. I know that that’s not a really sexy answer but there’s not a lot that we as CPAs can do if you don’t have appropriate records in place. Sure we can get into the structuring, we can get into all the other tax strategies that rental properties do produce and they do produce a lot of different tax strategies. At the base level, the very first thing that we tell all of our clients as they on-board at our firm is you have to be awesome at documentation. If you’re not awesome at documentation, then we’re just going to continuously talk about it over and over until you too get good at it so that we can move you into the actual strategies. I guess best practices, I would say download applications that help you track things like MileIQ for mileage, Expensify for receipts. Get those things working and rolling so that you don’t miss a single receipt and then get it all into a profit and loss statement, whether it be a simple Excel file profit and loss statement or maybe you’re using Quickbooks Online but the key is to have financial information readily available and the documents to support it.
That’s a great answer but I also assume that that’s really just the starting point because once you have everything documented and all that data captured, now it’s the CPA’s job or your tax advisor’s job to look at that information and strategize with you what the best way forward is in order to reduce, shelter, defer, or eliminate your taxes. Would that be true?
Absolutely. We work with hundreds of real estate investors and we know profitability ratios. We know if you have one rental property in this location, this is roughly how much you should be cashflowing. We know that if you have a multi-family property, your repair expenses should be more 12% versus a single-family at 5%, something like that. When you are documenting your transactions and you have up-to-date financial statements, we can look at those financial statements and say, “Actually, it looks like you’re a little under here. Maybe it’s on repairs.” A classic one is meals and entertainment. People forget that they can deduct meals. “We’re a little bit under on the meals. Do we have meals? Is the financial statement true or we’re just not recording these meals?” Generally, we’re just not recording this. Having up-to-date financial statements that are accurate and the supporting documentation to support those numbers, that’s really the first step because then we’ll go in with a critical eye and say, “Based on what our other clients are doing, these are areas that we can improve on the documentation or areas that we’re missing out.”
I like that. It’s like a frame of reference.
Exactly, benchmarking.
One thing I want to touch on here, which is a bit of a tangent question, is there are three types of deductions that I think some real estate investors get confused. I understand them and they’re very clear but until you actually stop to think about it, it’s not as clear as a lot of people think because a lot of people chunk maintenance and repairs into one category. Although it may be one line item, they’re not the same thing. Can you just briefly explain the difference between maintenance, repairs, and capital expenses?
The IRS defines maintenance as something that is going to occur two times over a ten-year period. Replacing carpeting, that can be considered maintenance. Working on you HVAC unit to make sure that it doesn’t go out, that’s considered maintenance. Two times in a ten-year period. Repairs are going to be made when you have a dysfunctional component. The HVAC system has now gone down. The appliances have now gone down. The carpet is torn up. Some dysfunctional system, it’s not working anymore, that’s what a repair is. A capital improvement is we’re materially improving a unit of property. IRS defines nine different units of property but as an example, we have a structure unit of property which is the building, the windows, the doors, we have an HVAC unit of property, electrical system unit of property. We have all these different units of property but an improvement is materially improving that unit of property. Replacing the HVAC unit, that is a material improvement generally speaking to the HVAC system or the HVAC unit of property. Putting windows on a single-family rental, that is a material improvement to the building unit of property, which is a capital improvement and then depreciate it over about 27.5-year period.
That IRS regulation or rule of the two per year, wouldn’t that fall into repairs, not so much maintenance? The reason I asked that is because it’s my understanding that maintenance has more to do with things like lawn care, snow removal, things that have to be done on a regular basis but it’s not technically repairing the property and nor is it adding value to the property so it’s not a capital expense.
Yes. This is something that a lot of clients think. From a practical perspective, you’re right. It’s definitely considered a repair.
You mean maintenance?
Yeah. Most maintenance expenses are definitely going to be considered repairs, not maintenance. Maintenance is going to be the snow removal, the lawn care, things like that. From a technical perspective, if we are classifying different repair items as maintenance, then what we get is the ability to use the maintenance safe harbor at a future point in time. Let’s say that you go and you repair, we’re just going to call it repair, you repair the HVAC system. You have a maintenance tech comes out, he looks at it, and he says, “These five things on the HVAC system need to be repaired.” A normal person would say, “These are repairs,” but we would want to actually classify that as maintenance because it was a result of the maintenance call when the HVAC tech came out to take a look at it. The reason we want to do that is because we can then classify those repairs under the maintenance safe harbor rule, which allows us to deduct them in totality without regard to cost. There is a little bit of a technical difference but from a practical perspective, you’re totally right. A repair is a repair. Maintenance is going to be snow removal, lawn care, that type of thing.
If you deduct them that way, you’re saying you could write it off in the same year but if you take them as a repair, it would have to be amortized or depreciated overtime?
No. A repair item is still going to be deductible in the first year. I guess the difference would be, let’s say on the HVAC system, the motor in the HVAC unit went out but we found that the motor was about to go out due to preventative maintenance that we had conducted on the HVAC system. Once that motor goes out, if we have that preventative maintenance, we can classify the repair as maintenance under the maintenance safe harbor. Even if the motor costs $10,000, which I know is absurd for an HVAC unit but just go with me here, if we didn’t have that preventative maintenance, then we have to classify that $10,000 motor as a capital improvement. It would then be depreciated over 27.5 years. That’s the difference. It’s purely semantics.
From a tax perspective, is it the same or is it just a matter of you being able to write it off all in one year?
From a tax perspective, if we are able to classify it under the maintenance safe harbor, then we get to write it off in the current year. If we can’t classify them under the maintenance safe harbor, then we have to depreciate it over 27.5 years.
This is why I don’t like taxes. There’s never a simple answer. That’s why we have guys like you. Now it’s a little more clear to me but I wanted to clarify maintenance, repairs, and capital expenses for people there so I think that’s as clear as mud now. Let’s talk about depreciation for a moment. I think most people listening here understand depreciation. With residential investment property, you can depreciate the improvements above the ground, in other words not the dirt but the improvements for 27.5 years. I’ve heard some people say or even ask the question, “Should I depreciate the property?” I’m not even sure if this is an option or a choice. What do you say to people that ask you if they can or should depreciate their property?
We actually get this question a lot from new investors or from investors that have gone to one of those guru seminars, which I have nothing against those, those can give a lot of information, but we find that sometimes they produce wrong information. One of those points is depreciation. Some people will tell you that you do not have to depreciate your rental property, which is not true. You absolutely always have to depreciate your rental property. The reason that you have to depreciate it is because when you sell that property at the end of the hold period or whenever you get tired of holding onto it, you sell that property, you have to pay something called depreciation recapture taxes and it’s generally going to be at an amount of 25%. It’s going to be based on how much depreciation you’ve taken or how much depreciation you could have taken. That latter part, that could have taken, that really can trip a lot of people up if they didn’t take depreciation for whatever reason. Maybe they don’t want to pay those depreciation recapture taxes whenever they sell, but the IRS is going to tax you as if you took depreciation even if you didn’t. That’s why we say you might as well go ahead and take it now. You might as well benefit from it now. Then we can generate passive losses to offset other income sources. Definitely, you have to take it regardless of who tells you that you don’t have to take it.
Advice there is just take it because you really don’t have a choice.
Absolutely.
The next thing really won’t apply to everyone unfortunately, but the Holy Grail for real estate investors is this designation or classification as a real estate professional and we can probably take an entire episode on this topic. Let’s start off by just explaining what this real estate professional designation is and why it’s, in my opinion, considered the Holy Grail for real estate investors?
It is the Holy Grail. Let’s first explain what it’s not. It’s not a title that you put on LinkedIn. It’s not something that you can get a license like a real estate license then call yourself a real estate professional. A lot of people get that confused too. For me as a tax advisor, it’s funny, because people are like, “If I put that I’m a real estate professional on LinkedIn that counts, right?” It does not. Think of this as purely a tax election, which it is. It’s just purely something that the IRS has said, “Here are rules. If you meet these rules, you will be able to elect, to be qualified, or classified as a real estate professional for tax purposes only.”
What you have to do is first, you have to qualify as a real estate professional and that’s two-fold. You have to work 750 hours in real estate. It doesn’t matter what you’re doing in real estate. You can be leasing, selling, managing contractors, managing a construction property, renting out your properties. It just has to be real estate-related activities. We have to spend 750 hours in those real estate related-activities. The second part of that is that we have to spend greater than half of our time in those real estate activities. The greater than half of your time rule pretty much automatically throws you out if you have a full-time job, because you’re going to be working on that full-time job for 2,080 hours and I don’t know about you, but working an additional 2,081 hours on real estate would be really hard to do. Your weekends would be very boring at that point. No sleeping at all. If you can hit the 750 hours and the greater than half of your time, then you are qualified as a real estate professional, but there’s a second part to this.
Generally, people want to qualify as a real estate professional so they can deduct their passive losses irregardless of how much income they earn from other sources. We often see real estate professionals as the spouses of the people that are earning a high amount of income. Let’s say that you have a breadwinner earning $300,000 a year. That person can’t be a real estate professional, but their spouse can be qualified as a real estate professional assuming that they meet those criteria. The benefit is that the passive losses generated from their rental real estate portfolio can then offset the $300,000 income from the other spouse. If you don’t qualify as a real estate professional, that same $300,000 household, would not be able to deduct any of their passive losses unless they also had passive income which with rental real estate, it could be the case but is generally not the case.
Going back to the real estate professional, 750 hours, greater than half of your time, that’s step one. Step two is showing or demonstrating that you have materially participated in your rental real estate activities. Generally, material participation is showing that you have worked 500 hours in your rental real estate activities. You could be a real estate agent and only do real estate agent things like leasing, buying, selling, and earning commission income. You would be qualified as a real estate professional. However, if you don’t participate in your rental real estate activities for 500 hours then you would not be considered to be materially participating, thus you would not be able to actually deduct your passive losses against your ordinary income. Two steps: real estate professional then material participation. If you can hit both of those steps, you qualify as a full-blown real estate professional and you can deduct all your passive losses against your other ordinary income without any limits on the passive losses.
In order to qualify time-wise, does that have to include direct property management? Most investors I know, including myself, don’t actually manage the properties. We have professional property management companies doing that for us. We could be “managing the manager” which is not a time consuming task by any stretch. Does that need to include property management or could it be made up of anything that’s related to managing those properties or managing your real estate business outside of property management? Does that make sense?
Yeah. The way that it works is the 500 hours, we can aggregate all properties together and we can spend 500 hours on the portfolio rather than 500 hours on each rental. We do that a lot. It’s called a grouping election, but you still have to demonstrate that you spent 500 hours managing the portfolio. The question would be, “Marco, if you have ten rental properties and you have a property management firm managing all ten of those rental properties, how much time are you really spending working on that rental portfolio?” You might be able to justify 500 hours but the IRS is going to fight pretty hard and say, “No. You’re definitely completing investor activities here. The property manager is the one that’s materially participating and you’re just sitting here collecting checks and collecting the financial statements on an ongoing basis.” That would be hard for a CPA to come in and say, “No. He’s definitely a real estate professional.” If you are going to have professional property management or even I guess not professional property management, it makes it much harder to justify material participation, that 500-hour rule, unless you have a really large portfolio. We’ve got guys that own 100 of units. Those guys are real estate professionals even though they don’t actively manage the properties themselves. They have professional teams in place but they just spend so much time on the portfolio that it’s very easy to argue that they’re a real estate professional.
I would assume it’s easier to qualify for this if you’re an active real estate investor, meaning that you are fixing, flipping, rehabbing. You’re involved in a deeper capacity.
You mean if they go and they fix up their rental and then rent it out?
No, if they’re rehabbers and flippers. In other words, this doesn’t apply only to passive real estate investors, people who just hold the portfolio and do other things. It’s probably a lot easier to qualify for this if you’re both an active and a passive real estate investor, meaning that you’ve got your passive portfolio but you’re also actively involved in finding deals, fixing them up, managing contractors, all that stuff related to fixing, flipping or finding, fixing, and buying a property.
If real estate is your business, that’s your primary source of income, it’s going to be pretty easy to qualify you as a real estate professional. That said, just because we qualify you as a real estate professional, we still have to hit that second step of material participation in your rental activities. We can have a flipper that does 100 deals a year but he’s got three rental properties that are managed by professional property management company. That guy, it would be difficult to say he’s spent 500 hours managing his three rental properties when he has a property manager doing it for him. Thus, if we don’t hit that material participation threshold, we wouldn’t be able to take those passive losses. With our active guys, with our guys that do real estate as their main source of income, it’s just all about structuring. How do we structure the facts and circumstances to yield the real estate professional status?
What are the pitfalls with this?
The one pitfall is if you group your rental properties. Let me explain the grouping. Going back to that material participation, let’s say you have ten rental properties. The material participation rule says you need to spend 500 hours in each rental activity, which means that if you have ten rental properties, you have to spend 5,000 hours on your portfolio in order to justify that you materially participated. What we do instead is we group those ten properties into one rental activity, meaning that we can now spend 500 hours on all ten properties combined and what will be considered materially participating in the portfolio. The pitfall there is that if you were to sell one of those properties, you’re theoretically selling 10% of the entire portfolio and 10% is not a material portion of the portfolio. What that then leads to is the fact that if you do have suspended passive losses, you can’t use them because you did not liquidate a material portion of your rental activity, instead you only sold 10% of it. That’s the number one pitfall to the real estate professional election and the grouping election. Other than that, there’s not really a pitfall to it. You just need to make sure that your documentation is in place if the IRS will go back a couple of years and see if the facts and circumstances were the same and you just didn’t record or for whatever reason didn’t elect a real estate professional status. It is an annual election. The pitfall has really revolved around the grouping that I just talked about and then documentation.
The reason we’re talking about this is tied to our theme of sheltering your rental income from taxes. We might have glanced over this, but why would someone want to be a real estate professional? What is the key benefit of having that designation with the IRS?
The key benefit to being a real estate professional is that you do not have any limits on the passive losses that you’re allowed to take. When you buy a rental real estate, if you structure your facts correctly and you structure your work correctly in terms of rehab and repairs, you can pretty much end up with a passive loss every single year until you sell the property. Those passive losses can be very valuable if you can take the passive losses currently against your ordinary income. Without a real estate professional election, you cannot take the passive losses against your ordinary income unless you are earning less than $150,000. Between $100,000 and $150,000, there’s a $25,000 passive allowance that gets phased out and it’s completely phased out when you earn $150,001. You can no longer take any passive losses. The idea is that you become a real estate professional and therefore, you no longer have any limit on the amount of income that you can earn and the amount of passive losses that you can take.
Going back to that example where I was saying, one spouse might be earning $300,000, will say that they generate $50,000 in passive losses every year. If the other spouse doesn’t want to qualify as a real estate professional, then what’s going to happen is that $50,000 in passive losses is going to be suspended. It’s going to be carried forward until it can be used by offsetting rental income or passive income. What we see happen is these folks that do earn a lot of income, that $250,000, $300,000, $400,000 range, they generate tons of passive losses. We had guys with $400,000 of passive losses that had been suspended because they don’t have anybody that can qualify as a real estate professional. The idea is to qualify as a real estate professional and take that $50,000 of passive losses that you’re generating annually. You take that in the current year, offset your $300,000 of income and you don’t have to worry about any limits on the amount of passive losses that you can take.
That’s why it’s the Holy Grail because there’s no cap to the passive losses that you can take in a year against your ordinary income, which greatly reduces your taxable income.
We’ve had guys get high, high, high five-figure refunds once they go to real estate professional route.
It’s a little complicated to understand and wrap your head around if you’ve never heard this before or you don’t understand this real estate professional designation or election. It might be a little bit beyond the scope of this particular episode but people can always contact you. Just speaking of suspended passive losses, those passive losses that people can’t take, let’s say there are people listening to this and they do not qualify for real estate professional status, which I would assume is a lot of people, probably the majority. If they have suspended passive losses, how can they tap into that without qualifying as a real estate professional or is that even possible?
It is possible. It takes a little bit of creativity but it is definitely possible. There are three relatively ways. The easiest way to tap into the passive losses is to sell your property. If you sell your property, you unlock all of your suspended passive losses and you can unlock suspended passive losses from other rental properties. Let’s say, I have four rental properties. They are all producing passive losses. I sell one for a $100,000 gain, that property that I sold throughout the hold period generated $20,000 of passive losses. My other three properties throughout their hold periods have generated $30,000 of passive losses. Combined, I have $50,000 of those that have been suspended. I can use the entire $50,000 to offset my $100,000 gain. That’s the easiest way to unlock suspended passive losses. It’s just to liquidate a property that has a nice gain built in.
The second way is to buy better properties, which is easier said than done. If you buy properties that are cashflowing better, then you won’t have passive losses that then becomes suspended because you’ll be producing higher cashflow, you’re producing net income. The key is getting over the net income after depreciation and amortization, which can be very difficult to do especially if you have a property with a high basis that has a nice depreciation write-off every year. The con to this is that after you’ve used all of your suspended passive losses, you now have a real estate that’s generating taxable income because we don’t have enough write offs anymore to shelter it. That could come back to bite you but picking a better real estate is generally a good way to go.
The third way to do it is a little bit more, I guess creative, some of our clients call it the sexier method, is to invest in businesses that are generating passive income. You would invest as an equity holder, not a debt holder. As a result, your investment would generate a portion of the net income from the business we paid out to you. Your investment is going to be generating passive income. That passive income can be offset by your suspended passive losses from the rental real estate.
You just need another asset class in order to apply those passive losses to.
I tell our clients too, “Don’t get too spawned up if you have passive losses that are being suspended. It’s really not the end of the world.” We get a little concerned when we see $50,000 of suspended passive losses that have accumulated over a period of maybe three to five years. Let’s say, you buy an apartment building and as a result of everything that you’ve done, you generate $50,000 in passive losses in the first year. That I wouldn’t be too worried about because that apartment building might actually be generating passive taxable income even after depreciation in future years and it’s going to just eat up its own suspended passive losses. We like to dig in to the more creative routes or options whenever we see $50,000 of suspended passive losses being generated over a good period of time. If it’s been generated over a short period of time or you have less than that, I really wouldn’t worry too much about it.
Just quickly to touch on this, I’m wanting you to explain why multi-unit properties like duplexes and even fourplexes are more tax advantaged, if that’s the right word, than single-family detached homes? A lot of people just don’t know this or think about this.
A multi-family property is going to be broken up into multiple units, that’s why it’s called a multi-family. The key is that, when you make repairs to a multi-family property, you’re generally making repairs to a unit or the repairs compared to the property as a whole. For instance, let’s say you have a four-unit. We replaced all the floors in one unit. That is theoretically 25%. We replaced 25% of the floors in the entire property because we have a four-unit property. If we’ve repaired 25% of the floors in the entire property, an argument could be made that that might not be a material improvement to the building structure. Whereas, if you have a single-family property and you replaced all the floors in that single-family property, you’ve now replaced 100% of the floors, meaning that you have materially improved the building structure. There’s not really an argument there.
The multi-units, it allows us to jump into the gray of playing with what is a material improvement to the unit of property being affected. Before we started, we were talking about HVAC systems, same thing. If you have a four-unit property, you have four HVACs and you have four systems of ductwork. The ductwork and the HVACs, they all make up that property’s HVAC system. If you replace one HVAC unit, again theoretically, you’re replacing maybe 22% to 23% of the HVAC system. Is that a material improvement to the HVAC system? That would be the question you have to answer. If it’s not a material improvement, then we get to expense that replacement cost. If it is a material improvement, then we have to capitalize it. On a single-family home, we have one HVAC unit, we replace that HVAC unit, we’ve materially improved that HVAC system, and we have to capitalize and depreciate.
That’s the difference between the capital expenditure that you depreciate over time versus taking the entire expense in one year, the first year.
Yes. Let me explain why that’s extremely important to understand. A dollar today is worth more than a dollar tomorrow. We want to get our savings as quickly as we possibly can and we want to reinvest that capital in different opportunities whether it be real estate or not. If we have to collect that tax savings over a period of 27.5 years, we’ve really shot ourselves in the foot in terms of an economic perspective. The other big con to depreciation is, going all the way back to what we’re talking about earlier, when you sell a property, you have to pay a 25% tax on your depreciation, generally it’s 25%. If you’re in a 10% tax bracket or at 15% tax bracket, you pay 10% and 15%. For most people, we’re paying a 25% recapture tax on depreciation we’ve taken. If I have the option to write off $10,000 this year and save $3,000 or capitalize $10,000 and get that $3,000 tax savings over 27.5 years and then whenever I sell it, I didn’t get taxed on the $10,000 of depreciation, I’m going to try to write off as much as I can.
That can add up to be a lot. That makes complete sense. Sometimes people want or need to sell their property. We make the case that you should never sell. You can move your equity and maintain your portfolio but not sell for the sake of selling. There are several techniques here. You can do a 1031 exchange, in other words, a tax-deferred exchange. There are all kinds of other techniques that you talked about. How do you reduce your taxes when you sell if you need to sell? I guess there are different assumptions that need to be made here, whether the sale is a 1031 exchange or you’re flat out just selling it, moving off, and doing something else.
First, you should really understand what your goals are. If you want to get out of real estate, we don’t recommend 1031-ing because you’ll be right back in the real estate. If you want to get out of real estate, we recommend owner financing. With owner financing, you get to spread the recognition of capital gains out over the period of the note that you’re holding. Just in case somebody doesn’t know what owner financing is, it’s like if Marco sells me a property and then Marco takes back the note rather than me going to the bank, Marco is then owner financing the property. He gets to recognize the capital gain on the property that he sold me over a period of time rather than all upfront, which can be very beneficial especially with all the extra things that we have in the days, tax code, the net investment income tax, and all that great stuff.
If you want to get out of real estate, owner financing is a good way to go potentially. If you want to stay in real estate, which is most of our clients, you want to look at what are your options for liquidation and what is the tax impact going to be? The first thing that we look at is do you have suspended passive losses? Going back all the way to that conversation, if you have suspended passive losses, you might not have to do a 1031 exchange because after your suspended passive losses offset the gain that you have, you might not have that much of a taxable gain left. If that’s going to be the case, then we don’t want to jump through the hoops of a 1031 exchange. We should just liquidate and call it a day. That’s the very first thing that we look at is what are your passive losses? Can we potentially tap into those?
The next thing is looking at a 1031 exchange and a 1031 exchange just means that the gain on today’s property that we’re selling, we’re rolling all that into the next property. 1031 exchanges are good, however what people tend to forget is that your basis is going to remain the same when you roll it into the next property unless you put more money into it or unless your mortgage notes are drastically different. Your basis is going to remain relatively the same. What this means is that, let’s say you start off with $100,000 property and you 1031 that into a $200,000 property, then you 1031 that into a $500,000 property, then you 1031 that into a $1 million property. Now, you have $1 million property producing cashflow that a $1 million property produces, but you have a basis of a $100,000, that original property that you purchase. What this means is that your depreciation is so low that you’re going to be crushed with taxes. In a 1031 exchange, one of the big cons is the fact that your basis erodes over time just because you’re not adding, again going back to that example, we don’t have a $1 million property with a $100,000 basis. We do push 1031 exchanges. You can save a ton of money with them but we have to be very cognizant of what happens to our basis over time. One more option would be instead of doing a 1031 exchange, we liquidate and then we buy a property maybe an apartment complex and we do a cost segregation study. The cost segregation study just increases your depreciation that you write off every year for the first five years. We could theoretically boost our depreciation to help offset some of the gains.
That sounds it’s a bit of an eye opener for some people who are doing a 1031 exchange or thinking about doing a 1031 exchange. I would imagine that the right decision is to compare what would happen if I did do a 1031 exchange versus looking at suspended passive losses or other strategies. I would assume there’s probably some other strategies here. To do that, someone would need to talk to their tax advisors or someone like you and then compare scenario A to scenario B to scenario C. Is that the process you would take them through?
Yeah. We do it all the time. We actually love it because what some people don’t realize is that you can actually take cash out during a 1031 exchange. If you structure it correctly and if you have suspended passive losses, then we can take just that amount of cash out. Let’s say you have $20,000 of suspended passive losses and you’re 1031-ing that $200,000 property, if we structure it right, you can take $20,000 out of that 1031 exchange and not pay any taxes on it. You can definitely get pretty creative with 1031 exchanges. It’s not as cut and dry as people write about. If your tax advisor does think it’s cut and dry, I recommend maybe getting a second opinion because you can definitely get really creative with how we structure this.
This can get a little bit more in depth. It doesn’t need to be complicated but we do quite a few 1031 exchanges. We’re not an accommodator. We don’t do the 1031s but we have clients that are doing 1031 exchanges. For those of you listening, if you’ve got questions about that, contact your investment counselor here to discuss that. For a deeper conversation, either reach out to your tax advisor or give Brandon a call and get into that conversation because you don’t want to jump the gun and make a decision that is an advantage for you but there is a better way to do it. Consider your options before you actually make that decision. Brandon, just a couple of quick questions. Some people might laugh at these but I’m going to call them miscellaneous tax tips. Can someone write off a firearm?
No. We actually get this question a lot. There was one time where I was like, “Maybe,” but he other instances, generally no. In order to write anything off, the expense needs to be ordinary and necessary. If you’re a real estate agent and you’re in Detroit, no offense to those guys, you might say, “A firearm is necessary.” Then the IRS is going to say, “Yeah, but is it ordinary for real estate agents to have a firearm?” The answer is really going to be no, so I’m going to go with no.
What about travel? A lot of people travel for their business especially our clients who are out-of-state investors. They may live in California or New York, an expensive market, but they have properties throughout the Midwest down through Texas out towards the southeast and they travel from time to time. Is that a write-off?
We can have another podcast just on travel. It can get really, really crazy. At a high level, yes we can write off travel but you need to have a rental property or a business relationship in the area that you’re travelling to. I guess the example that I gave is, if the IRS didn’t have this rule, you could take trips as many times as you wanted during the year to Hawaii, to Virgin Isles, the Caribbean, wherever you wanted to go, and you could say, “This was a business trip.” The idea is that no, it’s not a business trip unless you have a rental property there, unless you have prior business relationships there and it actually justifies the trip.
Is that the litmus test or the rule of thumb?
That’s the rule of thumb. We get a lot of clients and a lot of new clients too that say, “I went to Hawaii for a vacation and I went and looked at couple of rental properties. I’m going to include those travel expenses,” which I go, “No, you’re not. If you want to, we’re not doing them. We’re not writing them off for you.”
It sounds like shopping doesn’t qualify but shopping that leads to a purchase could.
Shopping that leads to a purchase could, even if you buy the property a couple of years later. That same person that travels to Hawaii that doesn’t buy anything, they should keep track of those expenses because if they do buy something in the future, then they can add those costs to the basis of the property.
Brandon, you’re wealth of knowledge and you’re right, some of these topics could be episodes on their own. We may have to just do another episode in the future, focus on one of these topics that are pretty in depth. In the meantime, I want to thank you for your time. Do me a favor, tell our listeners how they can find you and/or get more information about you.
I appreciate it, Marco. Anybody can find me at www.TheRealEstateCPA.com. You can contact me there. You can set up a consultation if you’re interested in hearing more about what we have to do. I also run my own there and have a pretty extensive You can connect with me on LinkedIn. I like to talk about the flaws of the corporate world on LinkedIn. I tend to get a lot of good feedback there. Some people really like connecting with me on LinkedIn, but anyone of those methods work.
We’ll let our investment counselors know about that as well. We’ll make sure that you get some questions directed your way. Brandon, I really appreciate your time today. Thank you for everything you’ve offered.
Thanks, Marco. I appreciate you inviting me on.
There you have it. Who you said that taxes weren’t fun? I hope this was educational and helpful. If some of it was over your head, by all means reach out to Brandon or give your investment counselor a call and we can help clarify some of this at least hopefully. If you haven’t downloaded our free report The Ultimate Guide to Passive Real Estate Investing, go ahead and do so. You can find it on both our websites, just head over to PassiveRealEstateInvesting.com and you can download that report from the link in the middle of the page.
If you are actively looking for rental properties, we offer a free strategy session. Why not take advantage of it? Let’s spend some time and talk about what your investment goals are, what you’re trying to achieve, what you’re thinking we can help create a strategy and a plan around that for you and certainly help you build that real estate portfolio at whatever speed make sense for you. If you have general questions about real estate investing, click the Ask Marco button on our Passive Real Estate Investing website and I will cover those in an upcoming episode of Ask Marco.
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