ustaxaid.com€¦ · Web viewSo rather than jump right into what’s deductible for your real estate, we’re going to start with a few other steps that will customize your strategy

Your Real Estate Deduction StrategyDiane Kennedy, CPA

“I have real estate. How can I pay less tax?”

I hear that question a lot. Followed by its corollary, “How can I deduct my real estate losses?”

They are related in that they both start with a strategy. That’s what this Home Study Course is about – strategy. It’s easy to get lost in the world of real estate professional status, real estate dealer status, cost segregation studies, tax losses and real cash losses.

Tax strategy simply means doing the right thing at the right time. Or rather, strategy is knowing what to do when and implementation means doing it or actually putting it in place. The combination is what gets you results.

So rather than jump right into what’s deductible for your real estate, we’re going to start with a few other steps that will customize your strategy.

There are actually 8 steps:(1) Separate your real estate investments from your real

estate business,

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(2) Determine your passive loss limits,(3) Understand the 3 deduction types, (4) Deduct direct expenses, (5) Deduct indirect expenses, (6) Determine how much in phantom expenses you should

deduct, (7) Adjust for your pass-through flow through income

reduction, and(8) Determine what ancillary strategies you need to use.

Let’s get started!

Step One: Real Estate Business versus Real Estate InvestmentPlease fully consider this step. Too often real estate gooroos confuse the terms “business” and “investment” and in the process, confuse their students. There is a precise IRS definition for each and the difference can mean a keeping lot of money in your pocket.

You want to get this one right!

So, let’s start right there with a story about a high income couple who realized how they could use the difference to put money in their pocket.


Real Estate Business Means Money in Their PocketsA few years ago, I put on a high-level real estate summit for sophisticated real estate investors. It was for experienced investors only and we talked about leverage, asset protection and tax strategies, of course, but we also exchanged rolodexes. That was probably the most valuable part of the event!

A couple attended the event who were trying to figure out how to take deductions for a couple of their very high-end fix-n-flip properties ($10 million+ price tag). They already had cash buyers for the two properties, but they weren’t going to close until the next year and they wanted to take some deductions in the current year.

What could they do?

As we talked about the properties and the unique market, we talked about the fact that these could be very high-level vacation rentals for a season.

They already had furnishings in the properties and they didn’t expect much wear and tear from some high-end renters. And if they did get trashed, they made sure the renters could afford the repair bill.


The biggest benefit, though, wasn’t the fact that they’d pick up some cash from the rent. The benefit was that they’d get some substantial tax deductions.

Normally, if a client told me they had a bunch of deductions and were renting out their house to take advantage of them, my next questions would be if and how they could take a deduction for the tax loss.

It didn’t matter in this case.

That’s because they had a real estate business and therefore, this would be an active loss. It wasn’t a real estate passive loss, subject to limitations based on income.

This was an important distinction. Their rentals were a business and thus active income or loss. They would not be passive income or losses.

Their activities were defined as a business because the property was rented out for short term stays (average of one week or less) and substantial services were provided. In their case that meant they provided maid service.

If they had been long-term rentals, then the losses would have been passive and not immediately deductible.


A vacation home rental, just like a hotel or motel, is usually considered a business, instead of passive investment. The two key definition differences are: short stay (defined as average one week or less) and providing substantial services such as housekeeping.

If you have a net loss with a business, you need to prove you have basis to take the deduction. In other words, you have recourse debt or, if it’s a business held in an entity, prove you have invested or loaned sufficient money to the business or purchased equity. Other than that additional requirement, it’s pretty easy to take a business loss. That loss can be used to offset other income.

The rules are much more strict if you have a passive loss. We are going to discuss this is in more detail in Step #2.

There are a couple of tricks people have tried use to change a non-deductible passive loss into deductible business losses. They don’t work. Here are some examples.

Just Because You Call it a Business, Doesn’t Mean It’s a BusinessBusiness losses are usually deductible. However, a passive real estate loss is much more complicated.


There are a couple of strategies that taxpayers have tried to take advantage of that fact. Here are two that won’t work:

Mistake #1: Using a business structure and trying to call it something else. FAIL!If you form an S Corporation, partnership or multi-member LLC and hold your property inside that, any passive loss you have will still be a passive loss.

That’s true even if you combine the real estate with a regular business you already have. The passive income/loss is reported separately from the business income/loss. You can’t combine them unless the real estate is used for the business.

In other words, a business structure doesn’t change the character of the income. If it’s passive, it’s passive. And that means a passive loss that flows through to your personal return from a business structure is still a passive loss when it hits your tax return.

The one exception is if you have a C Corporation hold your property. In that case, the C Corporation doesn’t have the same passive loss restrictions. However, there are other reasons why you probably shouldn’t have a C Corporation hold your property.


Appreciating property will end up having a lot more tax when it sells if it’s held inside a C Corp. Effective 2018 and the Tax Cuts and Jobs Act, the new C Corp tax rate is 21%. That’s not much more than the highest capital gain tax rate for individuals. On the surface, it may look like it doesn’t matter. But, that’s not where it ends.

What now? How do you get the money out of the C Corporation? If you take it as a dividend, you’ll pay tax personally and there is no deduction for the C Corporation. That’s double taxation. If you’re in this spot, it will take some more sophisticated planning to try to get you out and avoid the double tax. Best plan is to just never get there in the first place. Don’t put appreciating property inside a C Corp.

To sum it up, you can’t run a real estate passive loss through a flow-through entity like an S Corporation, LLC or partnership and expect it to be different. It will still be a real estate passive loss.

Mistake #2: Setting up a “property management” company for your own property. In this illegal tax scheme, the taxpayer sets up a business for property management. On the face of that, it’s completely legal. You can set up a property management business and it’s taxed


just like any other business…provided you have clients other than yourself.

If the only client you have is yourself, then all you’ve done is try to move expenses off your Schedule E (rental property reporting) where the loss would be a passive loss. Again there is nothing wrong with that either, as long as the loss from your property management company is treated like a passive loss.

If you have other clients, you’ll need to be properly licensed within your state to act like a property manager. The part of your business that works with other clients will be a regular business and taxed as such. The work you do for yourself still needs to be treated as passive income or loss.

You can’t change the character of your passive losses by using another schedule or form.

Self-RentalIf you have a business now and rent a property for the use of the business, that can be a smart use of real estate. But the income of loss from the rental to your business is called a “self-rental” and is not a true passive income or loss. It would be business income or loss, but without the self-employment tax.

Summary of Step One


Separate out your real estate investments from your real estate business or “other” categories. For purposes of this Home Study Course, we’re only going to be talking about the passive income or loss from your real estate investments.

Step Two: Determine Your Passive Loss LimitsThere is just one question for this step. It might seem simple, but it’s not.

In fact, your whole real estate investment tax strategy hangs on this.

How much passive loss can you take on your tax return?

If your adjusted gross income (the last line on page 1 of your Form 1040) is under $100,000 and you actively participate in the property(ies), you can deduct up to $25,000 in real estate losses against your other income each year.

If your adjusted gross income is over $150,000, the losses become suspended and you can’t deduct any of the real estate passive losses.

The deductible amount phases out when your income is between $100,000 and $150,000.


If you or your spouse qualify as a real estate professional (provided you are married and file jointly), then you qualify to deduct an unlimited amount of real estate loss which can be used to offset your other income.

For now, this is the most important thing to know and you need to know it before year end.

How much can you deduct?

If you aren’t sure if you can qualify as a real estate professional, make sure you ask about it during your next coaching session or ask your CPA. We also have a Real Estate Professional Home Study Course that can help you put together a bullet-proof strategy to make sure you can legally and safely utilize this important loophole.

Summary of Step Two Determine how much of a passive loss you can deduct on your return. This is based on your personal circumstances and your adjusted gross income.

This is typically done by looking at your adjusted gross income on your tax return. The one exception is if you’re a real estate professional.


Step Three: Understand the 3 Deduction TypesFor purposes of this Home Study Course, there are three types of tax deductions you can take against your passive real estate income.

The more real estate deductions you write off against your other income, the lower your taxable income will be. That means lower tax.

These categories are:(1)Direct expenses,(2)Indirect expenses, and(3)Phantom expenses.

Direct expenses – These are the expenses directly related to the property. These are the same expenses that you accounted for when you do the cash on cash return calculation (COCR).

Cash on Cash Return (COCR) Calculation COCR is used as a quick review to see if a real estate

investment makes sense. Calculate the annual cash flow (gross rent minus direct

expenses)


Divide the annual cash flow by the total amount of cash you put into the property. (Typically the down payment and fix-it expenses)

Does the COCR meet your criteria for investments?

Indirect expenses – These are expenses that are part of you being in the business. They are expenses not directly associated with any one particular property.

Phantom expense This is depreciation. You don’t need to actually spend cash flow to get this deduction.

Each of these deductions require different strategies. But first you need to understand what each of them actually is.

Summary of Step ThreeGet your bookkeeping caught up so you can identify all possible direct and indirect expenses. At this point, don’t worry about phantom expenses. That’s something you and your CPA will discuss with your tax returns are prepared.

Step Four: Deduct Direct ExpensesDirect expenses are the most easily tracked expenses. They are the ones that go along with owning a property. These include some of the following:


Mortgage InterestProperty TaxHOA DuesInsuranceUtilitiesProperty Management feesRepairs, andOther expenses that you wouldn’t have if you didn’t own this property.

There are two things to consider about direct expenses.

#1: When did the property go into service?Just because you own a property doesn’t mean that you immediately get to start taking deductions. You need to either rent it out or show that you were legitimately trying to rent the property.

If you buy a property and immediately start to repair, rehab or improve it, it is not in service. That means nothing is deductible immediately. The direct expenses must be capitalized and later depreciated when the property is rented.

The secret here is to put the property in service as soon as possible. If you later improve it or rent it, that’s okay. Just get it in service first.


#2: Is an expense a repair or an improvement?There is no quick explanation here. The IRS issued “Tangible Property Regulations”, 150+ pages of rules regarding when you immediately expense a repair or when you have to capitalize the cost and then depreciate it over time.

If you have big costs and are concerned about this, talk to your CPA first.

There are a few exceptions to know right away:

#1: If the invoice is under $2,500 you can expense it. #2: If the property value is under $1 million you are not subject to some of the really tough reporting requirements. #3: If the expense covers less than 50% of the physical space and is less than 50% of the total value of the entire property, you can probably take an immediate deduction.

In order to take advantage of exception #1 (invoice below $2,500 can be expensed), there are even more rules: You must have a written policy in place at the beginning of

the year that states that assets purchased below a certain threshold can be expensed.


If your threshold is $2,500, then any expense under $2,500 will be expensed. You can’t pick and choose. If that is the policy, you must follow it.

The $2,500 limit is applied on a per-invoice basis, unless the assets are separately listed on the invoice, in which case the limit applies on a per-asset basis. You could conceivably buy 40 computers at $2,000 each and deduct all $80,000, even without an applicable financial statement, provided the computers are separately listed on the invoice.

Remember, amounts deducted under the safe harbor do NOT count against your Section 179 limitation, as the cost was never treated as capitalized.

Most importantly, remember that the safe harbor election is an annual election, meaning you must make the election under Reg. Section 1.263(a)-1(f) again this year, even if you made it last year.

Section 179 expensing is allowed for qualified non-residential rental improvements. It is not allowed for residential improvements. Generally, “qualified” means improvements that are personal property, not real property. If you add on a room to your building, the framework, siding, windows and the like are real property. The floor covering, HVAC, cabinets, lighting and other items like this are personal property.


Effective with 2018, you are allowed to take bonus depreciation of 100% for both new and used purchases that have a class life of less than 20 years per the IRS rules. However, the property must be put in place first in order to take that deduction. Detailed information on class lives is listed in Appendix B of this IRS publication: https://www.irs.gov/pub/irs-pdf/p946.pdf

Direct Expense BookkeepingTrack the direct expenses per property. If you use QuickBooks, make sure you have the version that allows you to track by property. You need to track the income and the direct expenses for each property. That’s the whole purpose of direct expenses. You must show the expenses directly against that property.

Strategy for Direct ExpensesAlways deduct all of your direct expenses on your tax return, even if that means a loss. The loss is suspended and can eventually be used against future passive income, used up at $25,000 per year if your adjusted gross income dips below $100,000 or added to basis when your property sells.

Summary of Step FourKeep track of your business deductions with a good accounting software program. The direct expenses will be categorized by each property.

Step Five: Deduct Indirect Expenses


https://www.irs.gov/pub/irs-pdf/p946.pdf

Indirect expenses are legitimate tax deductions that aren’t directly related per property. These are the expenses that are most often missed.

Indirect expenses include home office, office furniture, computer, printer, cell phone, ISP, cell phone plan, business travel, business meals, tools, software, education programs, investing books, accounting and business software, legal, accounting, and tax preparation fees and even the the cost of USTaxAid Coaching and Home Study Courses.

Find Your Hidden DeductionsDirect expenses are usually easy to track. Those are the ones you have to pay when you own a property.

Indirect expenses are also known as general & administrative (G & A) expenses. They are the expenses that have to do with the “business” of managing your properties. I want to be clear about something first, though.

Just because we call these G & A expenses, they aren’t treated as business deductions by the IRS. They are still expenses related to your passive activities, so they are passive deductions. If they create a loss, it’s a passive loss. Throughout this section, I may refer to these as business deductions or that this is part of the business of having real estate, but please don’t get confused.


These are passive expenses and subject to all of the passive loss restrictions. They are not business deductions that are deductible against your other income, no matter what you may call them or the business structure you may put them in.

The IRS tells us that an expense needs to be “ordinary” and “necessary” to the production of income. Those are two important definitional words when it comes to determining indirect expenses.

I don’t recommend going out and spending money just for the deduction in any case. You spend dollars and receive back cents in the form of tax savings. That’s especially true when it creates passive losses. The losses from the expenses may not even be deductible.

Instead, look for things that you currently spend money on and then consider whether the expenses are ordinary and necessary for the production of income.

As with businesses, you have to first make sure you have an active real estate investment portfolio. You can’t take a bunch of deductions for education and travel and not have any properties. You can, however, take a limited amount of deduction for education if you already have property.


Watch out for this deduction, though. It could be considered a red flag by the IRS. If you spend thousands or tens of thousands of dollars for a real estate coaching plan and only buy 1 or 2 small rental properties, the IRS may challenge that deduction.

The same is true for travel. It is perfectly legitimate to write off the cost of travel to other areas to check out properties, as long as you buy a property outside of your geographic area at some point.

Accounting for Indirect ExpensesThe indirect expenses are typically recorded in just one group, as if they were a separate property. You could call this “general”, “administration” or actually any other name that clearly denotes that these are indirect and general expenses.

When it comes time to report this on your personal tax return, the totals can be divided among the properties or just shown as a separate “general” schedule.

Some of our clients like to set up a separate LLC for the general expenses. There is no tax advantage to doing that. It’s just to keep track of the indirect expenses and avoid having to allocate the costs among properties.

Strategy for Indirect Expenses


Indirect expenses, just like direct expenses, should always be fully deducted on your tax return. Even if you have a loss already, report the legitimate deductions you have. Reporting these will allow you to carry these forward for use later even if you can’t currently take the deduction.

You can’t later go back and pick up the expenses from years you didn’t include the expenses unless you file an expensive and cumbersome amendment. And if your return is past the statute of limitations you may not even be able to take the deductions with an amendment.

Summary of Step FiveTrack your indirect expenses in a good software program. Any education could be a deduction if it is ordinary and necessary to the production of income. Remember that these expenses will still impact your passive income or loss. They do not become business deductions.

Step Six: Determine How Much in Phantom Expenses You Want to DeductThe phantom expense is best of all. It’s depreciation. You can take normal “MACRS” depreciation, you can front end load depreciation with a cost segregation study, you can take straight line depreciation, you can catch up depreciation and you can postpone depreciation. There are seven proven strategies with to


use with depreciation. You can create deductions when you want and, to a certain extent in the amount you want. It’s really that simple.

In the case of direct and indirect expenses, I recommend that you always take all of those deductions even if it creates a real estate loss that doesn’t currently help you. In the case of the phantom expense of depreciation, I recommend you make sure you determine what you want first.

Let me say this again because there is a lot of misinformation about depreciation and your tax return.

#1: You do NOT have to take a depreciation expense. If someone tries to tell you that you must take them, tell them that the law changed in 2004. That’s right! This possible depreciation concern was cleared up by the IRS over a decade ago.

Or, better yet, if someone tells you that you have to take a depreciation deduction, just say “thank you” and move on. They’re wrong. If it’s a tax advisor, just know that they haven’t kept up on this particular part of the tax code. Keeping up to date on this part of the tax code is critical for you as a real estate investor.


#2: You CAN accelerate depreciation. The IRS has made that a little more complicated, but it’s still possible.

Let’s look at why this works by using a single family home residential property as an example.

The property clearly has land, real property and personal property. Personal property are the items that can be removed and include items such as an HVAC system, garbage disposal, lights, flooring and the like. It also includes hard outside surfaces like the concrete in the driveway.

If you buy a property for an amount, say $100,000, then a portion is allocated to the land, a portion is allocated to the real and a portion is allocated to the personal property. The land is not depreciable. The real property would be depreciated over 27.5 years. The personal property will most likely be depreciated over 5 to 18 years,

The IRS requires a very specific form for the calculation and reporting of the allocations. This is called a Cost Segregation Study. There are a couple of options now. You can hire a firm to do a Cost Segregation for you. My firm does not recommend that because we believe we can show you how to do it and you’ll do it just as well as any expert will and you’ll save a lot of money in


the process. The guys doing the Cost Segregation Studies usually charge a lot. That makes sense if you have a big commercial property. But if you have a residential property, especially a single family home, it probably doesn’t make sense to pay the high fee.

If you’re interested in getting more information on our Home Study Course and Cost Segregation Studies, please check out the shopping page at USTaxAid.

#3: You can catch-up depreciation. You can also catch up depreciation if you’ve skipped a few years. You use that with Form 3115. Use an experienced real estate tax CPA for the preparing and filing of this form. It’s tricky.

With these three tools – stop, speed up, catch up – there are 7 proven strategies. We’re not going to go through them in depth during this Home Study Course. You can review that with your CPA provided he or she has experience with real estate tax. Or we can talk about it during the next coaching session. Or you can pick up the Home Study Course at USTaxAid.com.

100% Bonus DepreciationEffective in 2018, you are allowed to take a 100% bonus depreciation for any improvement, new or used, made to a property already in service. This is allowed as long as the class


life of the improvement is 20 years or less. You aren’t required to use the bonus depreciation. You can instead depreciate the items over the normal depreciable life.

How Much Depreciation Should You Take?How much depreciation should you take? The amount depends on what you came up with earlier. How much can you deduct?

Use phantom expense to make sure you don’t have taxable passive income. If you can use the deduction and it makes sense in your strategy, then take the depreciation loss. In fact, you may even want to use accelerated depreciation. This is all part of the tax strategy you and your CPA need to develop. Also, remember that you can change strategies each year. As your circumstances change, your strategy changes.

And finally, you can wait until tax filing time to determine what’s best for that year.

Summary of Step SixThe phantom expense of depreciation is a choice. You can stop depreciation, you can speed it up and you can catch it up. There are a lot of possible strategies available. Pick one that works best for you. As your circumstances change, your strategy can change.


Step Seven: Adjust for Your Pass-Through StrategyThe Tax Cuts and Jobs Act has added one more wrinkle to most tax strategies. Determining your deductions is no exception.

The pass-through tax change means that there is a 20% pass through income reduction in certain cases.

The first step is to determine your taxable income. This is not the same test as the AGI (adjusted gross income) test to determine if your passive real estate losses can be used against your other income. The taxable income is your AGI less either your itemized deductions or your standard deduction.

If your taxable income is less than $315,000 (married, filing jointly) or $157,500 (single), you will be able to reduce your taxable income from pass-through entities. Most real estate is held inside pass-through entities, so this will impact most real estate investors. You can reduce your taxable income that is related to ordinary income or rental income, but not your capital gains income.

If your taxable income is over that threshold amount, you may still be able to take at least a partial deduction and this is where depreciation and expensing can get complicated. The amount of income that may be reduced is limited by either 50% of the


wages paid from that entity or 25% of wages paid from that entity plus 2.5% of assets, still being depreciated.

As an example, let’s assume you and your spouse are over the threshold. You have net income from your rental properties of $100,000. You didn’t pay any wages from your business, so now your possible reduction is limited by 2.5% of depreciable assets. If everything has been expensed already, you won’t get any reduction.

Of course, most people won’t have that kind of net income from properties due to depreciation. If you’ve previously accelerated your depreciation and used a lot of bonus depreciation, you could possibly be in that position. In some ways bonus depreciation and accelerated depreciation can be a great strategy for the present, but not such a great strategy for later years.

The solution if you start an aggressive depreciation type of strategy is to be prepared to keep buying more property every 5 years or so. This will add more depreciable basis. Otherwise, be prepared for changing strategies in the future.

Summary of Step SevenReview the implications of accelerated depreciation and bonus depreciation on your long term real estate holdings. Are you prepared for less depreciation in the future?


Or, instead, are you prepared to continue to buy real estate in the future?

Step Eight: Determine What Ancillary Strategies You Should UseThroughout this Home Study Course we discussed some ancillary strategies you may want to consider. Here is a summary of some possibilities. Does it make sense for you to look at these in more detail?

Real Estate Professional StatusYou have a limit on how much real estate passive loss you can take against your other income. The exception is if you or your spouse (if you file jointly) qualify as a real estate professional.

At first glance, the qualifications for this seem straight forward:

Test #1: You must have 750 hours in qualifying real estate activities and more hours than you spent in any other trade or business. Test #2: You must materially participate in the property.

Test #3: Each property must individually qualify.


But it’s not that simple. Here are 10 questions to consider right away:

#1: Do your activities qualify as real estate activities according to the IRS?

#2: What if your trade or business IS real estate?

#3: What if you’re an employee in the real estate field?

#4: What qualifies as material participation?

#5: What is the difference between active and material participation and why is that important?

#6: What if you have a property manager? Can you still pass the test?

#7: Can you aggregate your properties so you only need to qualify once for Test #3?

#8: What’s the downside of aggregating properties to avoid Test #3?

#9: If you’re married, which one of the tests can you jointly pass?


#10:Can I just get a real estate agent license and be a real estate professional? (answer = no)

We have a whole Home Study Course on qualifying for the Real Estate Professional and being able to satisfy any kind of IRS inquiry if you are audited while taking it.

This is an IRS audit area, but if you follow the rules, you’ll be fine.

Seven Proven Depreciation StrategiesYou have 3 options with depreciation: stop it, accelerate it or catch it up. With those 3 options, you have actually 7 different strategies.

Which is right? It depends on your own personal circumstances. Some of the things we want to consider is whether you or your spouse is a real estate professional, how much suspended loss you have, do you plan to sell or exchange any properties, how much of a passive loss do you have, how much is your adjusted gross income, among others.

There is a lot that goes into determining which is the best depreciation strategy. We have a Home Study Course about that.


In this case, I especially recommend that you also attend the coaching class that covers this subject matter.

There are currently 18 separate real estate modules. We go through these one by one and they do eventually repeat. The Real Estate Accountant in a Box, due out Spring 2018, includes ALL 18 modules and also includes coaching. There will be a special offer for this product for coaching students and for anyone who has recently purchased one of the Home Study Courses. Keep watch for the email announcement of this special offer!

Cost Segregation StudyWhen should you consider a cost segregation study? Only after you’ve done two things:

(1) Determined that you can take more passive loss or have passive income you can offset with depreciation, and

(2) Determined that you need more than the normal depreciation.

If you don’t need the extra depreciation and/or can’t use it, don’t do this. You don’t want to do a Cost Segregation study too soon. You can always do one and catch up depreciation at the right time.


SummaryDon’t get ahead of yourself with worrying about phantom expenses. Your job now is to get a system in place to provide current and accurate financial statements. If you have the skills, time and interest to do the bookkeeping yourself, do it! But, if you don’t have the time and put off the entries, hire a bookkeeping company to help you. It won’t cost much compared to the tax savings you’ll get.


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ustaxaid.com€¦ · Web viewSo rather than jump right into what’s deductible for your real estate, we’re going to start with a few other steps that will customize your strategy