If you want to succeed in real estate, your tax strategy will play a HUGE role in how fast you grow.
A great tax strategy can save you thousands of dollars a year — and a bad strategy could land you in legal trouble.
On today’s episode we discuss some ways to maximize your tax deductions, Little known secrets to take control of your retirement money, clever ways to write off your kids, and so much more.
If you missed our last episode, be sure to listen to the Maverick Mistakes in Real Estate Investing.
Enjoy the show!
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How to Pay Less in Taxes – Amanda Han and Matthew MacFarland
Welcome to Passive Real Estate Investing. I’m your host, Marco Santarelli. Today we’ve got what might be perceived as a boring topic, and that is about taxes. But remember that taxes are your biggest expense throughout your lifetime. Not only do you need to choose your income wisely because your income, depending on how you generate it, will be taxed at different rates. But if you invest wisely, like with real estate for example, you can have some of the best tax breaks available through the IRS code in the United State.
See, the more you earn through your job or through your business, the more you’re going to get taxed. But the system is actually set up in a way that actually punishes people who earn employment income. This is your W9 and, to some degree, your 1099 income. It is designed to reward business owners and investors. Real estate, rental real estate, income producing real estate, falls in that I quadrant. That’s all about investing.
Wage income not only requires hard work but it gets taxed at a very high rate and on top of that, you have to pay what are known as FICA taxes, which have to do with your Medicare. It’s just not the best way to protect yourself from the taxes that will erode and eat away at every paycheck.
How do you protect yourself? The best way is through rental real estate, income producing real estate. Why is that? Because it has many tax advantages, especially over wage income. You got this capital gains rates that, on real estate, caps out at 15%.
Now, that’s assuming you’ve held a property for a minimum of twelve months, but you compare that 15% federal tax rate on the capital gains to the 35% or so that you would be charged on wage income. There’s a huge difference right then and there. On top of that, you have state taxes, and then on top of that, some states even have further discounts on those capital gains income. It really adds up.
Remember that capital gains requires that you hold the property for a minimum of twelve months. This does not apply to flippers. Unfortunately, if you’re wholesaling and flipping property, you lose out on this capital gain benefit.
Now, there’s also that 1031 exchange, which is basically a way for you to roll your profits over from one rental property into another and defer those taxes. You could potentially defer indefinitely. Your tax basis in doing so actually just rolls from one property to another to another. This is the great thing about the 1031 exchange, it’s a tax deferred exchange.
Now, there are some rules you have to follow. You have to close within 180 days and you have to identify those properties within 25 days. We’ve actually talked about this in a previous episode not too long ago. You can go back and listen to that to figure out how this all works.
Rental real estate, income real estate, also provides you an interest deduction. You see, you get to actually deduct the interest you pay on your debt. The beautiful thing about that is it lowers your taxable income. But then that leads into the next item, which is very exciting. One of the most incredible tax breaks or tax benefits in the tax code, and that is depreciation.
When it comes to rental properties, you get this phantom tax deduction for the “wear and tear” that happens to the property. Even if the property increases in value, guess what, you still get to deduct it over 27.5 years with residential real estate. You actually can have a tax break and make money even though on paper, you’re showing the loss. Even though you’re showing a complete loss on paper, on your tax return, you’re actually making and pocketing cash.
Last but not the least, if you structure it properly you won’t pay any FICA taxes. That’s really your self-employment tax withholding, which is 15.3% on the first $97,000 that you earn. Really, this is a Medicare withholding and unfortunately, there’s no way around it. But there are ways that you can structure your tax affairs where you can offset that or defer it or even just not pay it if you have the right entities in place.
Anyway, I’m not a CPA or an attorney and I’m not here to give you tax or legal advice, I just want to kind of just tee up this episode with our two guests, Amanda and Matt. We’ll get to that here in just 20 seconds.
It’s my pleasure to welcome Amanda Hahn and Matt McFarlane to the show. Amanda has over eighteen years of experience as a CPA with a special emphasis in real estate, self-directed investing and individual tax planning. Amanda has extensive public accounting experience with the Big Four firms, servicing clients in the real estate industry.
With her is Matt. Matt has over 20 years of experience in public accounting as a CPA and a tax strategist. He has worked for both the Big Four firms and regional CPA firms. Together, they have co-authored the book on Tax Strategies for the Savvy Real Estate Investor. They’re also the principals of Keystones CPA. With that, Amanda and Matt, welcome to show.
Thanks, Marco. Thanks for having us.
Glad to be here.
I appreciate you guys being on the show. I know you guys are pretty sharp. You have a great reputation. I’ve been following your stuff for a while. I guess towards the end, we’ll provide contact information and whatnot for our listeners. I think it would be great for them to read your material, your website blog and just further educate themselves because education is so critically important. I always love starting my episodes when I have a guest by asking them a simple question. That’s basically, how did you guys get involved in real estate investing?
I think for me, I did spent some time in a Big Four accounting firm. I think my first a-ha moment with real estate came when I was probably a couple years in, reviewing an investor’s tax return. It was probably somebody who was in their 60s, retired but just had a bunch of properties. When you look at the tax return and you add back the depreciation like normal nerdy accountants do and you realize how much cash flow the guy was really making. It was just like a holy, you now what.
That was the eye opening experience for me. Then, I left the Big Four. I went to a smaller firm that focused a lot on real estate. We had started Keystone CPA a few years after. It’s just a natural fit that we like real estate, we invest in real estate ourselves and we understand it. It’s something you can tangibly put your hands on. For us, it’s just a natural fit to focus on what we’re good at, which is the tax strategies and emphasize the real estate side.
For me, I’m actually the third generation of real estate investors in my family. I’ve grown up around real estate investing. I was one of those kids that, at a very young age … It’s probably illegal for child labor laws but my grandparents had me go into their apartments for turnovers. My cousins and I would go and help them repaint the property before the new tenants moved in.
Like Matt, I actually worked at the same accounting firm right out of college. It’s the same thing, just being able to see the wealth building as an accountant in terms of real estate investments and also what types of tax advantages that the government brings with all the real estate loopholes.
Once you realize the potential of real estate to help you create cash flow and get you out of the rat race, it just becomes an addictive thing. If I’m not mistaken Amanda, didn’t you read Rich Dad, Poor Dad and that became a turning point for you?
Yeah. Actually I had no idea what Rich Dad, Poor Dad was. Matt was actually the first person who read it. After he read it, this is when we were both still working full time, he turned to me and he said, “Before the end of this year …” Keep in mind this was sometime in August during the year. He said, “Before the end of this year, we should buy some investment properties.”
I honestly looked at him like he was crazy, no idea what he was talking about. I don’t know why I myself would ever want to own real estate. That is how kind of our first introduction. It’s really strange for a lot of people, especially for someone like me who grew up around real estate, was a CPA, but even working one of the largest firms in the world, I didn’t really put the two together in that’s something I should be doing for myself. It was always something that only the clients did and the clients made money. I never thought that that was something that I should pursue. It really was the Rich Dad, Poor Dad book that opened both of our eyes into saying, “Yeah, this is something we can do as well.”
That is a brilliant book. I recommend it to virtually everyone, even if they’re seasoned real estate investors, because it gives you a mindset, it changes your mental perspective and makes you look at assets and cash flow and income and expenses a lot differently. At least a lot differently than most typical people are taught.
The problem is, in our school system, a lot of people really aren’t even taught to balance a checkbook. It’s a common problem I think in most school system. You guys have your own book, the book on Tax Strategies for the Savvy Real Estate Investor. It’s a great book. I haven’t finished reading it, to be completely honest with you, but I did start reading it.
It’s well written because it’s very simple to understand and it’s easy to read. Early on in the book, you talked about what you don’t know can hurt you. It reminded me of a saying that I have, I don’t know if you want to try and answer this. I’ve said it on our podcast here a number of times. Ignorance is blank. What do you think most people say to that?
Bliss.
Exactly. A lot of people say, “Ignorance is Bliss.” I’m whacking my head to thinking, “No. No, it’s not. Ignorance is expensive.”
I was going to say costly.
You’re spot on. Exactly. Ignorance is very expensive because what you don’t know could actually cost you a lot. Why don’t you take a minute and tell us what you meant in the book when you talked about what you don’t know can hurt you?
I think from a tax perspective, one of the biggest reasons, or I guess the most common reasons we see people miss on their tax returns is really as simple as not knowing what is a legitimate tax deduction. That’s where the ignorance part comes in.
I think it’s not really anyone’s fault. The tax code is extremely complicated. Even as a CPA, I think our motto within the firm is we never claim to be an expert. You can never claim to be the expert in all things taxes. From a planning perspective, one of the main things that I always tell people, “The way you take control of your taxes is to really start with a fundamental understanding of what are tax deductible items.”
It’s not to say that as a regular tax payer, not an accountant, to know everything there is to know about deductions. But really starting with at least just the definition of what is a legitimate tax deduction. Really, the IRS has two definitions. One, that it has to be ordinary. Two, it has to be necessary with respect to your real estate business.
Good practice that we tell our clients to do or most investors is, when you’re spending money on something, whether it’s a computer or paper and supplies or taking a trip somewhere, always ask yourself, “Are these expenses I’m incurring, is it ordinary and necessary with respect to my real estate business?”
That is very well said. Obviously, we all want to pay less taxes. Some of us, some people I should say, will pay up to 50% or more of their income in taxes. You can verify this for me. Everybody has a goal of paying less taxes because, for many people, I think their biggest expense year after year and in life will be paying federal, state and local taxes.
The more you could do to reduce that, the more you’re going to keep in your pocket. It’s a direct … I don’t know how you guys call it in your lingo. It goes directly to the bottom line, does it not?
You’re absolutely right. There was actually a survey that came out a couple of years ago and it’s really eye opening, that the average American is spending more money on taxes than they do on food and clothing and shelter combined. Think about that for a second. Some people’s biggest items, they’re spending more on taxes than those other things.
Going back to the ignorance question, it is really important because not just knowing what you can deduct, but also just planning ahead. So many times, we remind our clients that before you do a transaction, before you buy a property or sell a property, give us a call because you may not think it’s a big deal, you may not think there’s anything you can do, you may not even think it’s a tax issue.
If you just made a quick phone call or quick email or something, then we can identify something you’re not thinking about, then maybe that ignorance becomes less costly to them down the road.
You rely on your team, your professionals to avoid making mistakes. Having the right CPA, the right attorney, the right real estate agent or right property manager, all those people as part of your team, will help you avoid landmines and pitfalls and make more money and then of course, save more money. Saving taxes is a way to cut your expenses and put more in your pocket.
If we were to frame this conversation, because I like this whole theme of how to pay less taxes. This is really a softball question for you guys. Just at a high level, what are the tax benefits of real estate investing?
I think one of the ways we like to look at … I guess first off, a lot of people like to compare it to other tax investments. A very common one obviously is stocks, bonds and mutual funds. One of the huge benefits of investing in rental properties is the depreciation deduction you get to get.
If you buy a rental property for $100,000, you get to write off a big huge chunk of that purchase price over time. Whereas you spend $100,000 on stocks, you don’t write that $100,000 off until you actually sell the stock down the road.
The other benefit is the cash flow we’re getting from real estate. As you’re getting cash flow in your pocket, if you’re using depreciation and some of the other strategies that are out there to reduce your cash flow on paper, the goal is to get cash in your pocket but have zero positive income on your tax return related to that rental property, if not even a loss, that you might be able to utilize against other sources of income. From our perspective, that’s one of the huge benefits, is appreciation. It’s a Christmas gift that keeps on giving from the IRS, if you will.
It’s incredible. The fact that the IRS allows you to depreciate residential property over 27.5 years, even though the property maybe increasing in value, is incredible. The term escapes me, but basically you don’t have to spend a penny to get that deduction. It’s a non cash deduction, I think is what they call it.
What’s really interesting about depreciation that sometimes people aren’t very clear on is … As a real estate investor Marco, you know that one of the ways to super charge wealth building is through leverage. Depreciation calculation is based on actually the purchase price of a property and not the cash amount that you invest.
In a very extreme example that Matt was talking about, let’s say that I buy a rental property for $100,000 with no cash down, 100% leverage, my depreciation deduction is still calculated based on that $100,000 purchase price. It’s something that’s very, very powerful. If you buy stock, there’s not that ability generally to leverage, as you have in real estate, on top of the depreciation.
I think something else that’s really great about real estate investments, maybe for those investors who don’t really have other sources of income. Maybe it’s someone that’s working a full time job that’s starting to do real estate on the side, whether through turnkey properties or just other passive investments. One of the greatest benefits of being an investor is that for the first time, you can legitimately turn some of these otherwise personal expenses into legitimate business deductions.
Some of the most common ones that we see a lot would be maybe you start to use your car for real estate, whether going to look at properties or meeting with realtors, going to deposit rent checks, going to local real estate meetings. All those things now become tax deductible to offset the rental income and potentially the W2 income that you’re earning. It’s a really great tool to super charge the deduction side of things.
You bring up a great point. That’s a good segue to the whole concept of running your own business. The lovely thing about real estate is that you’ve got this powerful tool called leverage. You can put zero down, you can put 20% down, but what you get is 100% of the benefits, 100% of the cash flow, 100% of the depreciation, 100% of everything.
There’s really no other asset class out there that you can do that. In fact, you can’t even come close to what you can do with rental income producing real estate. Depreciation is huge. I think most people underplay how big of a benefit that can be.
If you combine that fact with the tax savings, to think about it another way is for every dollar that you’re saving on taxes, assuming you’re putting 25% down, that could equate to $4 of a new investment. For every $25 you’re saving, that’s another $100 of rental property you can buy.
That’s what we help our clients focus on too, is that when you’re saving the taxes, you can turn around and use that to reinvest and generate more cash flow and more wealth as you continue on in the cycle.
Definitely. You mentioned this being a business. Real estate is a business and should be treated as a business, which means now you have deductions. I think the goal for most people is to maximize those deductions. I don’t know if it’s harder to find what you can deduct versus what you can’t deduct. Very few people ask the question, “What can I not deduct?” Is that a fair question to ask? If so, what would be an example of that?
That’s a good question. I want to first just clarify. We talked a little bit about the real estate business. One of the most common myths out there is that I think a lot of taxpayers equate the term business to a legal entity. Time and time again, we’ll come across investors who say, “I know we can deduct business expenses but I don’t have an LLC yet. I own my rentals in my personal name or I just started doing real estate.”
I just want to clarify, when we say business, real estate investing itself is a business activity. For investors, you’re generally getting the same deductions, whether you hold your rentals in an LLC or corporation or simply just in your personal name.
What is tax deductible? The IRS really looks to say, “If you’re spending money on something, how can you substantiate that it is reasonable and necessary for your real estate business?”
I guess to go to an extreme example of what is and is not deductible. I guess for someone who owns rental real estate, is it’s reasonable to assume that they would go to local real estate meetings or they would take investors or brokers out to lunch and dinner and shows to try to raise money or to improve the real estate investment. Those are probably something that’s going to be more reasonable.
Gosh, to think of something that’s unreasonable as a business deduction, I guess if I just took my five year old to Disneyland, just the two of us, that might be something that’s unreasonable to say how that is actually helping out in my real estate business.
It needs to be justified and it has to provide some sort of direct or maybe indirect benefit to the business. The example I always think of is if you go on a trip, a business trip, and you happen to go and look at real estate while you’re on your vacation, that doesn’t necessarily qualify because the planning, the event itself was a vacation. You just happen to be looking at real estate, not the other way around.
It really does need to be the other way around. Planning ahead, documenting, making sure you’ve got meeting schedule ahead of time, you’ve got correspondence. Then when you happen to go to, I don’t know, Disney World while you’re in Florida looking at properties, then so be it. At least the trip, majority of those expenses on the trip would be deductible at that point.
To your point Amanda, it sounds like with people thinking that you need an entity in order to have a deduction, it’s not just about the entity. It has more to do or a lot to do with the act or an event, not just the entity itself to be a deduction.
You’re exactly right, Marco. If we go through an example and say I formed an LLC this year for my rental properties. I took my son to Disneyland, just the two of us. I used the LLC to pay for my Disneyland ticket. That does not make the trip deductible.
On the other hand, I don’t have any entities but I bought a really wonderful tax book on Bigger Pockets. That would still be a tax deduction, whether or not it was paid from my particular LLC. It is looking exactly at the expense itself and how does that relate to your real estate income activities.
On the theme of deductions. I don’t know if this was last year or this year, but I think I read or heard somewhere that the rules for having a home office changed. The reason I’m asking you this question is because a lot of real estate investors run their business from a home office.
They don’t actually have an executive office suite, especially here in Orange County. Such a large percentage of our population here locally work from home. They have thse home offices. I think there’s some confusion on the home office rules that apply. Any comments on that?
It’s a great question because there was actually an article that came out few years ago that stated that about 50% of Americans actually have a home based business of some kind now. It’s definitely relevant. It’s out there. It used to be red flag when it first came out years ago.
When we actually ask that question when we do speaking events, people still think it’s a red flag to claim their home office. Believe it or not, there’s still people out there that that’s what they think.
The IRS is actually making it easier to take the home offices deduction. That’s just another one of those strategies that gives you the ability to convert what is usually non deductible personal expenses into at least a percentage of those now becoming tax deductions.
As investors, we all know we can deduct our mortgage interest and property taxes on our primary residence. But it’s that other stuff. It’s the insurance, the utilities, repairs, maintenance, HOA fees you might be paying monthly, security cost and everything. All that stuff kind of adds up. Like I said, it’s usually nondeductible.
A home office gives people the ability to at least take a deduction for a percentage of that. The way the IRS is making it easier, they’re trying to … I think because it’s time consuming for them maybe to audit it, so they made it easier where people can now take a flat standard deduction for the home office, if you will, where it’s a flat dollar. The maximum ends up at about $1,500.
They also still give you the ability to do your regular calculation. If the regular calculation adds up to more than $1,500, you can take the greater of the two. But if your regular calculation would have been $500 but the standard deduction works out to be $1,200 or $1,500, you can still take that amount.
I think they’re just trying to make it easier and simpler and less time consuming maybe for the tax payer and the IRS auditor and maybe even hopefully the tax repair.
One of the chapters in your book made me laugh. A large percentage of our clients are definitely in the passive real estate investing category. The reason for that is the big common denominator they have is time, or lack of thereof. They have full time jobs and careers, they have a family, they have obligations and then they have their kids. Their kids have piano lessons and soccer games and this and that.
Your chapters on how to write off your kids. At first I thought, “Geez, that’s not something I want to do.” I’m thinking about it as a deduction now.
We’re not saying just write them out of your life.
Exactly. I had to read that twice. Briefly speaking, how do you write your kids off?
The technical term in the tax world is called income shifting, which probably sounds a little bit more polite than writing off your kids. The concept of that is to be able to shift income from your higher tax bracket down to a lower tax bracket or maybe even a zero tax bracket for your kids.
A common question we get a lot is, “I spend a lot of money on kids. My son has car payments I pay for, or football jerseys. How can I write these off? How can I make it a business deduction?”
Generally, if you want to buy a car for your kids or give them money to go to the movies, those are just personal expenses. The strategy is instead of just giving them money to pay for these things, that you hire them to help you out in your real estate business.
Maybe you have a teenager who’s going to be helping you out with painting, kind of like what I did with my grandparents, except I was actually not paid for those. If you want to hire your kids to help you with make ready expenses or maybe if you have a child who can help you with bookkeeping for your real estate properties, entering things into Excel, driving to deposit checks.
If they’re helping you out in your real estate business, then you could pay them a reasonable salary or amount for the pay and those become tax deductions. The thought process for that, on the side of the IRS, is if I wasn’t hiring my daughter to do my bookkeeping, I would’ve had to pay, to hire someone else to do bookkeeping anyways. That’s a reasonable deduction.
By doing so, if I paid my daughter to help me with bookkeeping, that’s a business deduction to me. She can then use that money to go and use as allowance to go to the movies or pay for her car. Now, depending on her age and how much other income she has, it’s possible that she would pay taxes on the money that we pay her.
It’s something that we have to be careful from a planning perspective, is we don’t just haphazardly say, “Pay your kids and take a deduction.” We have to actually run the numbers and figure out how much should we pay them so that we’re, as a family, still getting more deductions than what the kids might be picking up in terms of taxable income.
I don’t think a lot of people know this or even understand it. Is there a minimum age that makes it legal and if it’s within the IRS regulations to qualify for that income shifting?
It’s such a great question. I guess it depends on how you look at it. You think about those kids that are in diaper commercials. They’re getting paid. They’re six months old, maybe a year old, two years old. It is going to depend on what the work that you’re doing.
Now, obviously, we’re not attorneys, but certain states are going to have their own child labor laws. I think there’s certain industries that kids can’t work until they’re a certain age. We tell people to check with their employment attorney or labor law attorney in their local state.
As a general rule, the IRS doesn’t have a minimum age. They just want to sure that the amount that you’re paying them is reasonable for the work that they’re doing. Again, an extreme example, is it reasonable for your five year old to be your IT consultant? Probably not. Maybe if a twelve year old is better at computers than you or I are, that maybe that is reasonable. There’s no minimum age. It just needs to be, whatever you’re paying them needs to be reasonable for the work that they’re doing based on their skill set, obviously.
I never heard of a two year old getting a 1099 statement.
You know what’s interesting too? Just in today’s demographics, income shifting, the most common example we use is with kids. But the reality is it really could be anyone that’s related to you or even not related to you that you are maybe giving money to already, which would be non deductible.
In today’s demographics, what we’re seeing a lot is we have a higher population of aging parents. If you’re someone who’s working your real estate business, you have a mom or dad or both of them are now retired who have very little, if any, income, those might be people that you can hire to help you out in the real estate business and you can shift income to them in their lower tax brackets.
We have clients who maybe have a significant other whose boyfriend, a girlfriend, grandkids. All those types of people could be ideal for income shifting strategy. The one person that, for the most part, we don’t recommend shifting income to will be to spouses. That’s because generally husband and wife would file either as married separate or married joint returns.
There are a lot of circumstances, there’s not really a benefit to income shifting between a spouse. In some extraordinary circumstances, we do recommend income shifting between spouses maybe in order to find retirement accounts or take advantage or certain types of special tax deductions.
Plus, it’s probably way out of the scope of this particular episode, but on the whole theme of income shifting, it doesn’t have to be a person. It could be an entity. There are probably ways to reduce your tax burden and defer it through income splitting with some of your legal entities, not just people in your household.
Definitely. There’s income shifting between tax years. You could be looking at, if you sell a rental property and pay tax or you do a 1031 exchange and defer that tax for the next ten or fifteen years. There’s a lot of ways to utilize that strategy, for sure.
This is why you shouldn’t be your own attorney, and at the same time you shouldn’t be your own accountant or tax strategist. You need the right people on your team. People like you and people who write books to educate people on this particular topic is so important.
I think most people listening to this are probably paying more taxes than they should be and they can certainly reduce it. Education’s important, but having the right people to work with is also very important.
Here’s a question about legal entities, if I can throw this out. We keep talking about legal entities. From a tax perspective, why do you guys suggest having a legal entity for your real estate? Then maybe I’ll throw in, what type of legal entity is best?
That’s a really good question, Marco. That’s actually probably one of the most common ones we get from real estate investors. It’s a little bit tricky. I think in answering that question, the first step is to divide real estate into two different types of businesses. I think a common misconception is real estate is real estate, so whether I’m flipping, wholesaling or doing rental real estate, it’s all the same.
That’s actually incorrect. Under the IRS, real estate is really divided into two general buckets. One is the rental bucket. Rental really includes renting out single family, multi family, commercial, self-storage, all those are under the rental bucket.
The other big bucket would be the active real estate. Those are generally going to be fix and flip, wholesale, realtor commissions. Those are the ones that are defined as active because you’re more likely to be actively involved in running the day to day operations.
Starting from the more simpler side of it, which is the rental real estate, for rental real estate, actually purely from a tax perspective, we don’t really have a preference in terms of whether you hold your rental properties in an LLC or if you hold it directly in your personal name. The assumption of course is that this is just going to be long term rental.
The reason we don’t have a preference of LLC or not is simply that you get the tax deductions, the same benefits of depreciation, 1031 exchange, income shifting, writing off the expenses. You get all those whether you have it in an LLC or if you have it in your personal name. Really, when you’re talking to investors whose advisory team says, “We want rentals inside of an LLC,” those are generally for asset protection reasons.
The one thing when it comes to rental real estate that I will say, from a tax perspective, is that we generally do not recommend holding rental real estate in any kind of a corporation. That would apply to C corporations or S corporations.
The reason for that is that if you’re holding rentals inside of corporations, you may have unintended tax issues in the future if you were ever to transfer title of that property outside of an LLC or a C corporation. Those are the general reasons in entities in terms of rentals.
The caveat, before we go any further on the active side, legal entities just like any other tax strategy that we talk about today, are very tax payer specific. One thing that we like to say is there’s not a one size fits all. These are just general broad strokes in terms of what type of entity makes sense for a particular investment or investor.
I think the other reason, which is actually a non tax reason that we look at to help our clients evaluate any of this structuring for the rental properties is just from an asset protection standpoint.
Again, they should consult with their own asset protection attorney, but the issue of if somebody slips and falls and they’re going to sue the owner property. If the owner property is you personally, then theoretically, your personal assets might be a risk to that lawsuit.
Whereas if the LLC own the property, they sue the owner, which is the LLC. Only the assets of the LLC might be at risk. Assuming, there’s a lot of assumptions there. That’s a general rule. That’s another really big reason why people look at entity structuring for rentals.
On the side of the more active real estate that we talked about earlier, commissions, fix and flip, wholesale, that type of stuff. There is a tax reason to sometimes operate those inside of a legal entity.
For active income, again, this is a very broad statement, but assuming someone doesn’t have another job or other types of business income, all they’re doing is active real estate. A lot of times what we look at is a LLC/S corporation structure.
Generally, the benefit of that is to do what’s considered, one of the terms you used earlier, income splitting. Being able to take out some of the money as dividends, some of the money as payroll. Essentially, with the key goal of minimizing self-employment taxes from an entity perspective.
That’s huge. I think that’s where the S corp comes in handy.
S corps sometimes are great. For other investors, sometimes a C corporation is great. It depends on what their overall tax rate is going to be. As a very general example, if you’re someone who’s flipping real estate, you made $100,000 this past year and you don’t have any other type of income, operating in an S corporation versus in your personal name could very well save you anywhere from $4,000 to $7,000 on average per year. It could be a fairly significant amount of tax savings for those involved in the active real estate.
I know there’s exceptions to every rule, but as a general rule, I don’t think it makes sense to do business of any kind as a sole proprietor. You may disagree with me on this, but my personal feeling is that no matter what you’re doing, if you’re actively flipping property or wholesaling and you have a transactional business, or if you’re a landlord, you own properties and you hold them in LLCs for asset protection, you always separate yourself as a person from your business endeavors. This is why I’m not believer in having anything as a sole proprietorship. Do you feel the same way or am I off base on that?
No, I think that’s a really great point. I will say though, one of the most common mistakes we see are investors who form a legal entity in the understanding that they have asset protection, but then proceed to not use the entity and continue to maybe flip or get commissions in their personal name.
Same with rental real estate, there’s a large percentage of new investors that I talk to throughout the year that will tell me, “I have these three or two entities but I titled my rentals to my personal name. The rent checks are still coming to me.”
It’s very important to not just form the entities for asset protection reasons but to really work with your attorney on how to make sure you’re operating it in the way it was intended to be operated.
Good point. Wind it down or wind it up by talking about retirement accounts and funding your real estate using your retirement accounts but maybe with a tax perspective as a spin on this.
The reason I like this topic is because there are trillions of dollars out there trapped. I like to say it’s trapped in 401Ks, IRAs, self-directed IRAs and different types of retirement accounts.
I think some people really understand how to leverage that and use it properly. But my experience, most of the time when I talk to someone who’s got funds in a retirement account, first of all, they don’t even realize that they can self-direct it.
Then when they do realize they can self-direct it, they really don’t know what the benefits and the power is of being able to do that. I guess, that’s a matter of taking control. How do people take advantage of their retirement accounts and how can they save in taxes by doing so?
You have a great point. I would agree to that. I think a lot of people don’t know that they, not only can they self-direct, but as a general rule, a lot of people don’t know that they can use their retirement account to invest in real estate. This has been allowed for decades.
For probably the majority of the people listening to this podcast, they understand real estate, they’re interested in real estate. If you’re looking at what you’re going to invest your retirement money on, why not invest in something that you understand and you know and that theoretically you could touch, versus some of the other investments out there, stocks, bonds, mutual funds, whatever it is.
That’s one of the things that we talk to our clients about, is that if you do have a passion for real estate, then why not direct your retirement funds to investing in something that you at least understand and have an advantage on?
I think the traditional brokerage firms and using retirement for real estate is just something that most people are familiar with. It’s almost second nature for people to just default to leaving money in the stock market. Nine out of ten clients that we speak with when we do tax planning, one of our questions is, what’s your retirement money invested in? The follow-up question is, are you happy with the returns?
Nine out of ten times, the answer is no, they’re not happy with the money in the stock market or mutual funds but just not knowing how to really move that over. Unfortunately, I think there’s a lot of misinformation out there.
We’ve had clients who talk to their CPAs or their financial planner, or maybe their CPA is their financial planner. A lot of times, they’re scared half to death because their advisors will tell them, “I don’t recommend you do self-directed investing. It’s extremely risky or it’s illegal.” Sometimes they’ve been told that, “If you were to move into real estate, you’d have to first pay taxes and penalties on that.”
All of those are, unfortunately, incorrect information that’s flowing out there to people who are looking to self-direct. The truth is that the IRS really doesn’t have any preference in terms of whether your money is in the stock market or it’s in a note investment or it’s in a turnkey property. It doesn’t matter to the IRS.
As long as it’s in a retirement account, that money should still continue to grow either tax deferred or tax free. The key is that if you’re someone who’s thinking, “Gosh, I’m not happy with my money in the stock market or the mutual funds,” then talk to your CPA or talk to an advisor who’s familiar with self-directed investing and ask them, “How can I move money from the stocks and the mutual funds to self-directed investing via a tax deferred or a tax free mechanism?”
A lot of the times, the key term for that is using a rollover. If you have IRAH, you have 401K that’s in the traditional accounts, what you can do is you can do a rollover, a direct rollover, from Charles Schwab or Mary Lynch into a self-directed custodian. Once it’s at the custodian’s account, then you can basically start shopping for investments.
The way an investor is paying less in taxes is they’re in effect deferring the taxes they would be paying today by funding their retirement account than using those funds to acquire real estate, correct?
Yeah, exactly. For the self-employed people, people in the real estate market, there’s a lot more options in retirement accounts than just the annual traditional or Roth IRA. What you said is exactly right.
We talked to clients about it, we get a lot of push back like, “I don’t want to necessarily put $20,000 in a retirement account because I want to use that money to go out and invest in real estate.” Why not do both? Why not put the contribution in and get a deduction from putting the contribution in and then turn around inside that retirement account and invest in real estate?
A very typical and a powerful example is somebody that’s self-employed, earning some sort of active income in the real estate market. Whether it’s fix and flip wholesales syndication fees, that kind of thing.
Or even a doctor who’s earning income.
Right. They can take advantage of various retirement accounts, either self IRAs, solo 401Ks, whatever it might be, to really super charge and build their retirement nest egg and still get tax deductions for it and still invest in real estate.
Like you said, there are other very powerful vehicles to do that. We actually did an episode with Dimitri from Sense Financial. We spent a fair amount of time talking about the solo 401K, which is just amazing because you can fund, I don’t remember the number, close to $50,000 a year and defer your taxes on a pretty significant amount. It’s almost ten times what you can put into a traditional IRA.
Not knowing that is where it goes back to the whole ignorance is expensive thing. If you don’t know these tools and vehicles are out there for you, you’re missing out. You’re paying too much in tax today and you’re not going to have enough in returns to live off of tomorrow. This is why it pays to educate yourself and to work with people like yourself and just other sharp advisors.
Think about it too, like you were saying, that $50,000 number. What if it’s a husband and wife that could put $100,000 in every year? That just adds up and adds up.
Very quickly. Absolutely. Guys, we can go on forever. There’s just so much more material that we can cover as it relates to taxes and finance that it just seems to be an endless topic. Maybe what we should do is just plan to have you back on a future episode to go into some other topics, maybe something more seasonal.
Anyway, having said all that, before we give out your contact information or whatnot, is there any question that I didn’t ask you that maybe I should have in today’s episode?
I think the one thing that I would just like to share is, we talked about these different strategies and things you can do and things that as investors, we can learn about. One of the key things that I hope people take away is to really try to be proactive in the planning process.
If you’re calling your CPA after you sold a property for a huge gain, that might be too little too late. April 15th is the first time you’re looking at last year’s taxes, that might be a little bit too little too late.
The way that you get the best tax result is really keeping your tax advisor informed throughout the year. We tell clients this all the time. It doesn’t always have to be a one, two hour discussion about everything there is to know about taxes, because I know not everyone is as passionate about taxes as we are.
It could be as simple as sending an email to your CPA saying, “I’m thinking about selling this property or I’m thinking about moving out of California. I’m thinking of sending my daughter to college or I’m buying a rental property where my daughter’s going to live in while she’s at college.”
These little things that, as life happens, if you keep your CPA informed, then they’ll be able to help you with strategizing on what potential things you could be doing before you actually do it to help reduce your taxable income.
I think from my perspective, the other thing is, we alluded to it earlier, but it’s one size doesn’t fit all. You’re listening to the podcast or … I think Marco, you’ve probably had these type of events too where somebody’s at the front of the stage yelling, “Run at the back of the room and create these five companies or do this, do that.”
That might be good and all for somebody but it’s not going to be good and all for everybody. Whatever strategy you may hear today or you take away, this is not a do it yourself thing, as you were talking about earlier. It’s about your team.
Go talk to your advisor about, “I heard about this. I heard about that. Does that work in my situation? If not, why not? Is there something I can do to tweak my fact pattern? Would it be beneficial to tweak my fact pattern to get it that way?” Those kind of things. Education is great. It’s just making sure your utilizing your team to put it in action.
Well said, guys. It’s funny because today is November 8th, Tuesday. It’s Election Day, and we’re here talking about how to pay less in taxes. Interesting thing, the United States never had income taxes for the longest time. They imposed income taxes briefly during the Civil War and then in 1890s. It wasn’t until 1913 that the US tax code was put into place on a permanent basis. Coincidentally or ironically, that was exactly the same time that the Federal Reserve came into play.
Nobody likes to pay taxes. We all want to learn how to reduce our tax burden. The smart way to do that is again, work towards educating yourself and working with a team life yourself. I want to thank you guys for your time. It’s been very informative. I would love to have you guys back on, if you are so inclined.
We’d love it.
Thank you so much.
I’m going to encourage our listeners to get your book, The Book on Tax Strategies for the Savvy Real Investor. Maybe you can tell everyone where they can get the book and how they can find out more about you guys.
Sure, our book is available on BiggerPockets.com. It’s also available on Amazon, Amazon Online. Check out both of those resources. What I love about the book is we’ve given that book to a lot of our clients and what happens is after our clients read the book, typically what they’ll do is they will email me a very, very long list of questions that they get from reading this story and that story.
That’s what we really hope that all readers will do. Again, I don’t expect everyone to become CPAs or tax experts from the book. The book is really designed to help prompt questions for you and to open up that dialogue for you to have with your CPA.
Our website is KeystoneCPA.com. For those of you on the podcast that’s never visited our website, I do encourage you to take a look. We have tons of free downloadable resources to check out as well as the latest in the tax world.
Matt, did you have anything to add to that?
No, that was perfectly summed up.
Great. A closing thought for our listeners here. If you want to give yourself an instant pay raise today or this year, the best way to do that is to lower your taxes.
I like that.
Absolutely. It’s instant and it works. Most people can do it. Anyway, you guys, I appreciate it. Amanda and Matt, thank you for your time. We’ll get this out here shortly. We’ll have you back on the show in the near future.
Sounds good.
Thank you, Marco.
Thanks.
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About Our Guests
AMANDA Y. HAN, CPA
Amanda has over 18 years of experience as a CPA with special emphasis in real estate, self-directed investing, and individual tax planning. Amanda has extensive “Big Four” public accounting experience in the Lead Tax Group servicing clients in the real estate industry. She provided tax consulting and tax compliance for companies engaged in land development, residential development, medical facilities, and conglomerate shopping malls. Subsequent to her work at Deloitte, Amanda served in the Corporate Tax Department for an international Fortune 500 Company in the high tech industry and was responsible for quarterly provisions and various aspects of SEC reporting. Amanda has numerous years of experience in working with international companies in terms of federal and multi-state tax planning as well as audit representation and resolution.
MATTHEW T. MACFARLAND, CPA, MBT