Hello, and welcome to another episode of Passive Real Estate Investing. I’m your host Marco Santarelli. Well, I hope you stick around to the end of this episode today, because what is your biggest expense? Your biggest expense is taxes. The less tax you pay, the more money you put in your pocket, and the more you have to work with in terms of spending money and investable capital. So this is something I’m always interested in. I am trying to learn as much as I can and about it whenever I can. And it is a really deep and broad subject, but we don’t have to overcomplicate it because there are professionals out there that you can work with, ask questions of and help you to structure your investing and your business affairs. So you can lower your taxable obligations, the tax impact. And there are many, many, many ways to do that.
The tax code is actually chalk full of incentives, of ways to lower the taxable income that you generate and the tax impact that you have. And that could be so many ways that could be through depreciation. It could be through passive losses, active losses, it could be through cost segregation. It can be through expense. If that’s a real word items, basically expenses to reduce your taxable income. So there are so many ways. And one of the guys who I know who’s very sharp and I’m actually doing some work with his firm personally is a guy that I met many years ago, a young guy, very sharp his name’s Brandon Hall, and I invited a him on the show. Again, he’s a returning guest and I thought I would talk to him today about the passive activity rules, as well as some bonus depreciation and maybe some other questions if I can squeeze it in.
So that is what you are in store for. I think this is well worth listening to right through to the end and possibly a second or third time, because it is just gonna be chalk full of good information that you could use. And so with that, let us get to our interview today.
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Well, it’s my pleasure to welcome Brandon Hall, back to the show. He’s a returning guest. Brandon is the managing partner of hall CPA and accounting and tax services firm for real estate investors and entrepreneurs. Brandon was named 40, under 40 by CPA practice advisor. In 2018. He leverages his personal real estate investing and his big four accounting experience to offer unique insights to his clients. And I am actually one of them. So Brandon, welcome to the show.
Thanks Marco. I really appreciate being back here.
ight on. Well, it’s good to have you back. I love, love what you and your partners do at the firm. It’s always fun talking to you guys and I love your level of expertise and you don’t look like a very elderly per your whole team is like so young. It just blows me away.
Yeah. Yeah. Well, yeah. In accounting. So our, our larger mission that we don’t really talk about much on the real estate side of the, of things with all of our content is we are actually trying to change the accounting industry. So there is just it’s an old, tired, broken model. And I think there’s a lot of young firm owners like myself that are out there that we’re kind abandoning together to try to figure out if we can actually do some damage on changing the industry, how it operates and you know, who’s the face of the industry. So yeah, yeah, yeah. We are a bunch of young, young folks. <Laugh>
I like it. It’s fresh. It’s refreshing. And you put out great content. You have good articles. I like your podcast. I mean, everything you’re doing is great. So keep up the good work.
I appreciate that. Thanks. Thanks. Yeah, the content’s been fun. It’s been a lot of fun. My, my larger mission is to help as many land landlords as I possibly can. And you know, cause I mean we’re, our, our firm is relatively expensive to, to work with, but but I didn’t want that to stop me from trying to help all the landlords out there. Yeah. That’s what all the content’s for. <Laugh>
Cool. Well we’ll touch on that a little more or later. So, you know, taxes is something that is either boring for a lot of people or taxes is something that people don’t want to talk about. They stick their head in the sand because they just don’t like the idea of paying taxes. But the thing is, is one of the, at least I feel one of the best ways to actually put more money in your pocket is to figure out how you can minimize the tax impact because it’s the fastest way to put more money in your pocket. And so for that reason, I actually do like talking about taxes and I do like learning about taxes. And I do like teaching people about how they can save on taxes, which is what you know you do and why I have you on the show. So let’s talk about some stuff that most people don’t typically talk about and let’s start with the passive of activity rules or loss rules let’s begin with, you know, what they are. So investors and people listening to this podcast, understand what we’re talking about. And then we can talk about how do they apply to real estate investors.
Mm. Before we do, I just wanna comment on that, on what you were just saying about liking taxes and stuff. You know, th there are, I think, I think a lot of real estate investors start trying to learn about taxes cause they realize that there’s tax benefits, but you’re, you’re totally right. Like if you, if you don’t like taxes, you, you have to learn how to like taxes because taxes are your number one expense. Like if you pull your tax turn up, they are, you are paying your largest expense is the federal government. And so you should educate yourself at some basic level to understand how taxes work and, and really to have more sophisticated conversations with your own CPA. Like that’s what we try to help people do that are not necessarily our clients. It’s, it’s a look, we just wanna help get you to some basic level of understanding so that you can ask better questions, right?
You don’t have to know the code. You don’t have to know the tax court cases, but you gotta know the questions to ask, to make sure that it’s being done right. And to make sure you’re not missing anything. And know the professionals are not going to cover all of that for you. You can’t outsource this type of stuff. It’s, it’s too important. It’s too important and it’s too big of an expense. So anyway, let’s, let’s jump into the passive activity loss rules. So the passive activity loss rules were implemented in 1986 and they were implemented to stop wealthy people from using rental real estate at, as a tax shelter. Real estate professional status was then later added, I believe in 1993, as a means to allow people who are in real estate full time to use their rental losses, to offset their other real estate business income.
And, and the reason that I say that is we’re gonna talk about real estate professional status through explaining what the passive activity loss rules are. And you may have heard of real estate professional status or through this conversation, you’ll learn about it. And you may think it’s a loophole and I wanna make it real clear. It’s not a loophole. The passive activity loss rules were enacted to stop the loophole, which was I earn a million dollars, W2, I buy three rental properties. I bonus depreciate them. And I wipe my income out. That was the loophole investing in rental real estate was the loophole. So these passive activity loss rules were added in 1986 to stop that from happening. So real estate professional status, not a loophole. And it’s really important to understand congressional intent because then you’ll understand how the IRS attacks it, how the tax court analyzes it.
The passive activity loss rules created two buckets of income. They created the passive come bucket and the non-passive income bucket in my passive bucket is any rental real estate. Unless I qualify as a real estate professional and any trader business that I do not materially participate in. So for the latter, the trader business that I don’t materially participate in, let’s say that I put a hundred thousand dollars into my local hair salon and the use that a hundred thousand dollars as an expansion, they then allocate $10,000 of profit to me every single year. That $10,000 of profit is passive income to me, assuming that I’m not materially participating in the business and I’m not gonna materially participate, I’m not gonna go cut hair. I’m not gonna make business decisions. I’m just putting a hundred thousand dollars down for their expansion and they’re gonna $10,000 a year back.
So that 10K is passive income. It’s a trader business that I’m not materially participating in. So that goes into my passive bucket. All my rental real estate goes into my passive bucket. The other thing that these passive activity loss rules created was the non-passive bucket in the non-passive bucket is my W2 income. It’s my business income where I do materially participate. So for me, that’s my CPA firm income. It’s any capital gain from stock sale interest dividends. Those don’t sound non passive, but with within the, the, these rules, they are so interest dividends gain from selling apple stock gain from selling crypto all considered. So really the only thing in my passive bucket is my rentals in any business that I don’t materially participate in. Everything else is gonna be non-passive. And that is an important distinction to understand because my rental real estate generally produces losses.
So I’ll buy a rental I’ll I’ll cost segregate. It I’ll depreciate. It I’ll end up with a tax loss, even if I have positive operating income, thanks to that depreciation expense that I can accelerate. I’ll end up with a tax loss in that tax loss is passive. Passive losses can only offset passive income or gain on sale from passive activities. So I could use my rental losses to offset my hair salon $10,000 of income, cuz it’s all passive, right? It’s all in the same bucket I can do that. I can use a limited partnership loss if I go and put a hundred K into a limited partnership and it generates $70,000 of losses for me, I can use that to offset my hair salon income so I can use passive losses to offset passive income. I can also use passive losses to offset the gain on sale of rental property or the gain on sale of selling my hair salon steak, cuz it’s all passive.
So I can use rental losses to offset all of that. What I can’t do is I can’t use my rental losses to offset my W2 income, my CPA firm income, my crypto gain income, my stock gain income, my interest, my dividends. I can’t use my rental losses to offset that income unless I can jump my rental losses out of the passive bucket and into the non-passive bucket. And I could do that in a number of ways, but one of those ways is to qualify as a real estate professional. So if I can jump those losses into the non pass bucket, now it’s extremely powerful cuz I could net a million dollars at my CPA firm years to open and I can then go and buy a $5 million multifamily building that generates a million dollar tax loss. And that million dollar tax loss could offset my million dollars of CPA from income. Assuming that I was able to claim that million dollar tax loss from my rentals as non passive. So I’ve gotta be able to move into that non passive bucket, but it’s very lucrative if you can. I mean the tax savings of that example is probably, you know, three 50, $400,000. Mm-Hmm <affirmative> so very lucrative if you can figure it out.
So before we get into the real estate professional status and what that means and how you qualify, cuz I know there’s different qualification criteria there. Why do you not differentiate active income to the non passive income that you’re talking of about what do you mean? Does that make sense? You’ve got passive income and non passive income and why do you not call that non passive income active income?
Good question. So you could call it active income, but for the purposes of section 469, which is the passive activity loss rules, they say that there’s passive and non passive. Now generally speaking, my active income is going to be my non passive income. Like if you, if you use the, the term active income, we’re typically talking about non passive, but there could be points where it’s active income, but it’s actually passive income. You know like, like maybe, maybe I invest in that hair salon and you have a CPA that calls that active income because it’s it’s income from a trader business. That’s that’s like an ordinary activity, right? It’s not rental in the passive traditional sense. So you might have some, anybody call this hair salon investment as they might call it active income. But the reality is is that if I don’t materially participate, it’s considered passive. So for the purposes of these rules, I like to use the terms passive and non passive because that’s what these rules do is they divide your income up between passive, non passive active is not part of the conversation.
So we’re, we’re talking about IRS non-closure, this exactly. Okay. Yes. Even though for the sake of the layman person in conversation, your W2 income is active income, which is also nonpassive income.
Exactly, exactly. And, and for the purposes of like leveling up everybody’s tax sophistication, words and definitions are extremely extreme important when we’re reading the tax code. So what I always encourage people to do is to learn the actual terms and try to use those actual terms whenever you’re talking with your own CPA or with your own tax advisor, because that will clue them in to what sections they should be looking at researching further for you and how to have better conversations with you. So try to use the, a lot of people default to active. I know to switch that to non passive in my head. Okay. If you work with somebody that doesn’t have a ton of real estate investors, they may not make that switch and it could impact you some way shape or form. I’m not really sure how that that would specifically, but yeah. So I always try to use passive, non-passive.
So everybody listening to this is now thinking, oh, this is great. How do I get there? What are the ways, obviously the real estate professional status is one way probably the low hanging fruit for most people listening to this. So let’s start with that. And then if you want to add other ways to get there after that, let’s do that. But this is kind of like holy grail. Yeah. In many ways is like, how do I get to this real estate professional status? Because, oh my gosh, can I sure save on taxes?
Yeah. So to start off, let’s explain the benefits. So being a real estate professional allows you to claim your rental activities as non passive, which allows you to claim the rental losses to W2 income against your business income and really to an unlimited effect. So you would be able to eliminate, if you acquired enough property, your income, which would save you tens, if not hundreds of thousands of dollars in taxes during that year, a lot of people do it. It is very possible. It, but it is highly scrutinized. It’s highly litigated. And so if you are gonna be a real estate professional, you have to take it very seriously. We have run into groups online that do a disservice to their members because they don’t teach them the ins and outs of how to actually get this done. And instead they just teach ’em high level.
They’ll, they’ll go over the, the benefits, then everybody in the group’s going, oh cool. We’re all real estate professionals. I’m gonna make my CPA, make this election. And then those are the people that are calling us up 2, 3, 4 years later, to help with an audit. And they always lose. They always lose. I the, the audits that I’ve been a part of where I’ve been called into ’em, it’s almost like a, it’s like a 95% loss rate because they’re just not doing it. Correct. So, so to qualify as a real estate professional, you have to spend 750 hours in real property trade or businesses in which you materially participate. You must also spend more time in those real property trade or businesses than you do anywhere else. So the second piece that more time than anywhere else is going to eliminate anybody with a full-time job.
So if you work 2000 hours, you would have to be able to substantiate that to the IRS and the tax court that you worked an additional 2001 hours in real estate. And though you could physically potentially do it. The IRS in the tax court will not buy it. There’s not been one tax court case where somebody has worked full-time and been able to substantiate the fact that they are a real estate professional. Unless of course they’re working, full-time in a real property trader business. That’s different, right? So if you’re working, full-time not in a real property trader business then you’re not gonna be able to be a real, a real estate professional. But if that’s not you, or if you have a spouse that’s staying at home or a spouse, that’s working a part-time job, your else could qualify as a real estate professional.
So again, to qualify as real estate professional, 750 hours in real property trades or businesses in which you materially participate and more time in those real property trades or businesses than you spend anywhere else, there are 11 real property trades or businesses. I don’t know all of them off the top of my head, but some of them are brokerage operations leasing, property management, construction, reconstruction development, and then there’s a handful of others. So it’s like really kind of think, think of it as like being a landlord that can rental is one of ’em. So being a landlord is a real property trade business. So I I’m like really involved in real estate in some capacity. That’s the time that you’re gonna be able to, to count. If you qualify as a real estate professional, you also have to materially participate in your rental activities in order to make them non passive.
So it’s really important to understand that simply qualifying as a real estate professional does not make your rentals non passive. Your rentals are still going to be passive unless you materially participate in your rental activities and where this hangs people up is, let’s say that I’m a, I’m a real estate agent and I’m a real estate agent for 2000 hours. It’s my full-time job. It’s the only thing that I do. I’m a real estate professional because I spent 750 hours in a brokerage real property trader business. And I spent more time in that brokerage real property trader business than I did anywhere else. So I’m a real estate professional, but, but if I don’t go and materially participate in my rentals, my rentals are still passive. So sometimes we have people that actually qualify as a real estate professional, but their rentals are still passive because they nor their spouse went and materially participated in their rental real estate activities.
So big mistake. So you always gotta come back to the rentals and make sure that you do materially participate. There are seven tests for material participation. The three that we see most often from easiest to hardest are one, your participation is substantially all of the participation. So that means that if you spent 50 hours working on the rental, nobody else did anything. You didn’t have any other contractors. You did everything by hand, property management, everything was you. So of the 50 hours of participation, a hundred percent was yours. You have materially participated cuz substantially all the participation is your participation test number two, the second level 100 hours and more than anyone else. So maybe I have a contractor that spend a hundred hours. I spend a hundred hours, I spend 101 hours. I spend a hundred hours and more than my contractors. That’s the second test.
The third test is to spend 500 hours across my rentals in order. And that’s just kind of like more of a safe Harbor. So if I could spend 500 hours across my rentals, I’m good to go. And this also assumes I, I make a grouping election because material participation is looked at on a rental by rental activity unless I make the grouping election. So assuming that I qualify as a real estate professional and I materially participate in the activity, then I will have a non passive rental activity. So I’ve always gotta come back and hit those material participation tests.
I think that’s where I I’ll. Lot of people lose out on the real estate professional status is they qualify in terms of the hours per year, but they choose. And, and this is true for a lot of our clients, cuz this is what I’m thinking of. As you’re talking about this, a lot of our clients want to be minimally involved. They want rentals that are professionally manage by full service management companies and, and be able to free up their time to do other things. It sounds like that’s where people lose out on this real estate professional status. So first of all, is that true? And second, how can a person who likes turnkey rentals and likes professional management managing their portfolio get into that real estate professional status qualification.
Great question. So the first part, yes, it’s definitely true. If, if, if you are outsourcing property management, there is an extremely low chance that you would be able to substantiate to the IRS and tax court that you are materially participating in those activities because you’re not the one that’s the real estate professional, right? Marco is the real estate professional. He’s the one that’s running everything and your team is running everything. So your team could be real estate professionals assuming that they own, I think it’s at least 5% of your company if they’re W2 employees. So and we, we can just skip over that. We don’t need to go into that any further, but the point is is that if outsource the management, you are not gonna be able to use the hours associated with that rental as material participation or real estate professional status type hours.
Those will be considered investor level hours because you’re not involved in the day to day management. So to answer your second question, well, how could I be a turnkey investor and still benefit from all of this? There are two ways. One the first is to give the real estate professional status game up and to simply go with the Warren Buffet approach to investing, which is over time, I’m gonna build CA tax advantage, us income streams. And you know, today it’s not gonna make a big difference, but 10 years from now when I’m cashing $20,000 a month, and my depreciation expense is $18,000 a month, I’m gonna end up with $240,000 of cash, but I’m gonna get to tell the IRS that I only earn $20,000 or $24,000, right? So my effective tax rate on that might be 4,000 bucks on $240,000 of income.
My effective tax rate is extremely low, cuz all I’ve done is I’ve just bought great income producing assets that are also highly tax advantageous. That’s the way that I would encourage anybody listening to go long, regardless of what you do short term long term, it’s gotta be a focus on acquiring real estate, acquiring cash flow streams that I don’t pay tax on either the full income stream or, or I even get a tax loss as a result of this income stream, even though I’ve actually earned money. So that’s option number one, option. Number two, you could build out a portfolio that is local to you and you could self-manage that portfolio like, like if, if turnkey was a really big part of my investment strategy and I called you up Marco and I was like, all right, I’ve got 500 K to deploy.
We’re gonna buy however many homes, 20 homes, probably not today. Maybe I don’t know no what 15 homes whatever, whatever the going rate is, we’re gonna buy a bunch of home and, and we start acquiring start acquiring. I can’t use any of the hours that I spend with you for material participation or real estate professional status, but I could acquire two or three homes local to me, local being, you know, 15, 30 minute drive. It’s gotta be something that, that I can visit frequently. I could rehab those homes. I could self-manage homes and I could probably justify potentially that I spent 750 hours managing those homes. And if I spent 750 hours managing those homes, guess what? I’m also gonna hit that 500 hour material participation test. So I’m also materially participating in my own properties, right? My own two to three properties maybe, or maybe five there’s no bright line test.
You could do it with one. There are tax court cases where people have one with one property, they have one real estate professional status with only one property. It’s not about the number of properties. It’s about the time that it takes you to manage the properties. So I could, let’s say I buy three properties, local and I self-manage them. And I do hit 750 hour. So I qualify as a real estate professional on my own three properties. I materially participate in my own three properties and you’re managing 15 properties for me. Well, what I do is I make something called the nine election. This is found in treasury regulation, section 1.469-9G. So I make this election and what it does is it groups in all of those rentals that you’re managing into my three rentals that I’m managing. And basically it says, I am materially participating on the entire portfolio.
So now all 15 that you you’re managing are now non passive as well. So I could, if I really wanted to get around it, that’s how I would get around it. I would buy local rehab me self-manage and then I would make this nine election to group all those others in. And I don’t have to do this every single year, right? Maybe it’s just this year that I need a big spike and depreciation. So this year I’m gonna self-manage everything and I’m gonna tough it out on my local three rentals. I’m gonna make that nine election. And then next year I’m gonna hand it to a property manager. My local rentals I’ll hand to a property manager, cause I don’t really wanna manage the day to day. So you don’t have to, you know, stick with it forever, but that’s how I would get around it.
So that’s interesting. Let me take your example and stretch it a little further. Sure. What if you don’t want local properties like me as an example here, I’m in orange county, California. There’s nothing I want locally. It’s just too expensive. Can you make that same example or achieve the same result by having material old participation in properties that are elsewhere, but not necessarily your entire portfolio. So somebody listening to this, maybe they have 10 properties. They’re gonna materially participate in one or two of those, but they’re not in your backyard as they say.
Yeah, So you can. Yes. you can certainly materially participate at a distance. It J us depends on your activities. So you would need to manage all communications with the tenants, basically the entire setup of rent collection and payment. You would need to be the one that calls on the contractors to get them out to the property. If you’d got any sort of rehab upfront, we would wanna see you actually go to the property and spend time down there, either doing the rehab or monitoring the rehab and doing all the inspections. So you gotta be like, you gotta be involved. You probably not be able to materially participate again, if you have property management. So that’s automatically out. But if you are self-managing at a distance, yes you can. If you structure it right, you probably have to manage more at a distance. Then you would locally just cuz you’re gonna be subbing out all that contract labor, but you can do it. You, you can do it. We have some clients that do it. It is definitely something that like, if, if you were working with us and you were trying to justify that it would be something that we would scrutinize and we would just make you do a little bit more of your own substantiation in terms of the hour logs that you’re, that you should be keeping and what notes we wanna put down and stuff like that because the IRS will scrutinize the heck out of it if you’re audited. But it can be done.
I think you just started to answer my next question. And that is how do you prove that you’re spending time self-managing or being materially involved in your business or your rentals?
Yep. Great question. You do have to have a time log. The time log can be whatever, whatever suits you, you can, it could be handwritten. It could be on Google calendar. A lot of our clients use Google sheets just cuz you can put, you know, a spreadsheet anywhere on your phone, but it has to detail the date. The amount of time the pro operating was four. And then you want notes. You, you want notes that are good notes, not like I sent in received emails or I did emails. That’s not a good note. And the reason it’s not a good note is because these audits are not gonna happen for multiple years. I mean, think three years into the future. Now they come and audit you and they start asking about your time log. They’re gonna scrutinize and you need to, you need to be able to very easily and quickly remind yourself of what you did so that you can give the context and tell the story.
Otherwise the auditor’s gonna ask you more and more and more questions and that’s how people will lose these real estate professional audits that I’ve been a part of is they just, they’re making the time logs up. They’re making ’em up retroactively. They really have no idea what they did on these days because they many notes. So if you take really good notes you’ll, that’s, that’s the biggest piece of, of substantiation. So I emailed with Brandon and his team about that takes two more seconds to write or maybe five more seconds to write, but now you’ve protected yourself in the, in the future.
Okay. So maybe my last question about real estate professional status and that is, is it retroactive? In other words, if somebody makes that election now in March of 2022, will that apply going forward or can that apply to last year?
So the real estate professional status is actually not an election. It’s really just a reporting mechanism. Every time that we file to act returns and it is on an annual basis. So, you know, we could be deciding if we wanna be a real estate professional, October 15th, 2022, four year 2021 tax returns because that’s the filing deadline, right? So we have up until then to really say yes or no, but if you want to qualify as real estate professional, you should make that decision proactively and you should start recording time now.
Here’s my last question about it. There are a lot of websites and I’m not gonna mention any of them here. There are a lot of tools online that allow real estate investors to self-manage their properties, which means they don’t have a property manager, but they have tools where they can communicate with tenants, collect payment and dispatch people as needed. If there’s a service request or whatever it may be. If you manage your properties through these tools, these portals, would that still qualify you as a real estate professional?
Yes. Because you would effectively be the property manager at that point, but okay. You just, you have to be realistic with the time that you log because the IRS and any sort of tax court judge that might be looking at your situation, they’re gonna apply their own experiences to life. And these guys own rent to real estate too. Like they’re, it’s not like they’re, they’re total noobs at this stuff. And so a good way to put it is like, you know, I, I have a beach hum and I’ve got it on Airbnb and VRBO and I use hospitable to to self-manage it. And I do self-manage it. But like after the initial fix up, I changed out all the fixtures. I’m a pretty, I’m a pretty handy guy, even though I’m a tax guy. But I, I changed out all the fixtures.
Did, did some of this upfront work. I mean, after that, it’s pretty chill and this is even people coming on a weekly basis because my communications are answering maybe, you know, four questions from somebody during the week. And then and then just communicating with my cleaning crew, my linen crew at over, and it’s not a significant lift. So that’s why I say like, if you’re, if you are self-managing especially at a distance and you’re using these tools yes. Your time, like in these tools, managing them, dispatching people to your property. Yes. That time can count, but you probably need a lot more property at that point. Then something that I’m managing locally a little bit more or rudimentary, not as tech forward not as modern.
Interesting. Right. So you mentioned short term rentals. How do the passive activity rules apply to short term rentals? Is it just the same or is it any different?
It’s a great, great question. So if your average period of customer use is seven days or less, which is most short term rentals then you actually do not have a rental activity under section 469 of the internal revenue code. And section 469 is the passive activity loss rules that we just went over and they say, all rental activities are passive unless you qualify as a real estate professional and any trader business that you don’t material participate in a is passive. So if a short term rental is not a quote rental activity, this is why I said definitions that are important. If you don’t have a rental activity, then you don’t have to worry about qualifying as a real estate professional because only real estate professionals, only rental activities are passive unless you qualify as a real estate professional. Right? So if I don’t have a rental, I don’t have to worry about real estate professional status.
All I have to worry about is material participation. So what this means is I can have a full-time job, a full-time W2 job. I could, I could be running this CPA firm full time and I could buy rental. I could buy short-term rentals and I could make those non passive through material participation. And I could use those losses to offset my W2 income or my CPA firm income without having to qualify as a real estate professional, cuz remember real estate professional status is the hangup for real estate investors. It says 750 hours, but it also says more time in real estate than anywhere else. So it’s that more time in real estate than anywhere else that hangs everybody up. So if I don’t have to qualify as real estate professional, I don’t have to worry about that more time than in real estate than anywhere else.
All I have to worry about is material participation. So I could, self-manage a short term rental. And if I do all the work myself, you know, I could book 50 hours and if it’s 50 hours divided by a total of 50 hours by all participants, then my participation is substantially all the participation. In theory, I have materially participated, even though I spent 50 hours on the activity. Now don’t go run away from this podcast thinking you can only spend 50 hours. There’s no bright line test. We don’t actually know how many hours that substantially all test actually requires. And so talk with your CPA first. But we definitely know that if I spend 110 hours managing my short term rental and my cleaners spend 103 hours cleaning it, we definitely know that I have spent 100 hours and more than my cleaners. So I am materially participating in that instance. And since I’m materially participating, my short-term rental activity is now non passive. You know, I could buy a million dollar beach home. I could cost segregate. It create a $250,000 tax loss in the current year, offset that with my CPA firm income yield 112K in tax savings, you can do it with short-term rental, lot more flexibility, a lot more flexibility.
So Brandon, I don’t know if you answered this, but for someone who has a small portfolio, you know, anywhere 3, 5, 10 houses, one of those properties being a short term rental and they choose to self-manage the short term rental only and have property management on the rest. Can they meet the thresholds, managing that short-term rental to qualify as a real estate professional?
Great question. The tax court will tell you no. So the tax court thinks that short-term rentals are completely separate they’re on their own island. Sometimes literally in long-term rentals are in a different, you know, bucket. So the tax court says our spent on short-term rentals will not count towards real estate professional status and will not count towards material participation on your long-term rentals. So that whole grouping thing that I was talking about earlier, you can’t group short-term rentals with long-term rentals.
That’s too bad. It
Is too bad. Yeah.
That sounded like an easy out.
I think, I think that somebody is going to successfully argue at some point that that’s not the way that it should actually work, but that’s what we currently have in the tax court.
Well, that’s, that’s a bummer because that sounded like an easy way to go <laugh> yeah.
Oh yeah, yeah. Yeah.
Okay, before we leave the topic of real estate professional and passive activity rules. Is there anything else you want to mention about it? Because I think we covered a lot, but I’m not sure if we missed anything that’s significant.
Yeah. Yeah. So a couple things for material participation purposes, you and your spouse can combine your time. So my spouse and I, like I could spend 25 hours. She could spend 25 hours combined. We have 50 hours, our participation substantially, all the participation. We are materially participating, but for the purposes of the real estate professional status tests, one spouse has to meet those two tests, 750 hours more time than anywhere else completely on their own. So real estate professional status and material participation is a little bit different in terms of who or how you can combine time with spouses. But if one spouse is a real estate professional, the way that I like to think about it is your tax return is now a real estate professional status to hacks return. So both spouses get to benefit from the real estate professional status election.
And the last thing that I’ll say is I probably engage in a conversation once a month, about how losses from one passive activity cannot offset income from another passive activity or gain on sale from a passive activity. And I just want to give everybody a little tip. If your CPA or tax advisor tells you that you cannot use your syndication losses to offset your rental income or that you cannot use your rental losses to off from one rental to offset your rental income from another rental, or you cannot use your rental losses to offset the gain on sale from a rental activity ask them to prepare form 8, 5 82 or ask them to prepare a proforma form 8582, which is just a projection. And they will very quickly realize that they are incorrect and they can get to that conclusion without looking anything up in the code.
If they look it up in the code, they will confirm that they’re incorrect. But that is what I tell people to ask their CPAs to do because a lot of times the CPAs simply just don’t understand section 469, it’s very complex to learn once you learn it, it makes total sense, but it’s very complex to learn initially and truly understand. So I just, I just encourage people to, to, to ask your CPAs prepare form 8582 and then they will realize all passive losses can offset all passive income and all gain on sale from passive activities.
Interesting. So for the benefit of those listening to this, that don’t qualify for the real estate professional status, you mentioned a little while ago that the alternative route to saving taxes is just to build a portfolio and take advantage of whatever deductions there might be. And you didn’t mention it, but I, I would imagine that we’re talking about the depreciation on those rentals.
Yes.
So is that the strategy for someone who just simply cannot qualify real estate professional status is just to build a portfolio as big as they possibly can and just use the given depreciation schedule to lower that?
Yeah. Yeah. And I mean, you can even still do cost segments. Like I, I just bought a I bought 10 duplexes with my parents and and I’m, I’m passive, right? My dad is a real estate professional, but I’m passive. So we’re gonna do a cost segment and my parents are gonna benefit today. I will receive probably 200 or so maybe $180,000 of losses that I will not be able to claim, but I also have a rental property in my portfolio. That’s got about $200,000 of gain built into it, thanks to the recent run up in real estate prices. So if I have 180K of losses coming from one portfolio or, or these 10 properties, then I can, I can liquidate this other property and not have to worry about a 1031 exchange. Right. So you can still accelerate losses. Like I don’t, I don’t want people to come away from this thinking that they just have the straight line depreciation.
Like you could still accelerate, you could still do the cost egg. It it’ll produce losses that are suspended that you can use in the future. But it does give you flexibility. But yes, to answer your question, absolutely. I mean the name of the game, it, at the end of the day, we wanna build wealth through real estate, right? Like, like taxes should all always be secondary. If you can understand the tax game, you can, you can further optimize that wealth building, right? You can, you can make it happen faster. But a lot of people when, when they listen to my real estate professional status talks, cuz in, in certain groups like whenever I’m talking to it’s like brand new people who have been in these like different guru groups or these different Reiss that, that hype ’em up about real estate professional status.
I know that my job is to bring everybody down <laugh> so I will remind them how, how incredibly hard it is to qualify as a real estate professional. And you look around the room and you see all these de it looks right. And they’re all, they’re all thinking like, man, I wanna invest in real estate and I wanna use the tax losses, but this guy up here is telling me that I can’t do that. So what the heck’s the point of investing in real estate, but I just wanna be clear that, Hey, I can buy a hundred thousand dollars home that cash flows $4,000, but I depreciate it $3,700 a year. So I’m, I’m getting $4,000 of cash that hits my pocket and I’m telling the IRS, I only made $300. So I’m paying tax on 300 bucks, I’m paying $30 in taxes on a bad day, you know?
And so I’m paying $30 in taxes on $4,000 in earnings. If you can, 10 X that now it’s $40,000 of, of actual income. That’s hit my pocket and I’m paying $300 in taxes, right? And then if you can 10 exit again, now it’s $400,000 of cash. Then I’m paying $30,000 in taxes on. And the equivalent there is like earning a $700,000 W2 wage. Okay. If I can net 400 K and basically not pay to acts on it it’s as if I earned a $700,000 W2 wage. And so that’s the real that that’s, that’s what everybody should really be targeting is how do I net 1, 2, 3, 4, $500,000 in cash flow. But I don’t tell the IRS that that’s what I netted. I tell the IRS something significantly, if not negative, because if I can do that, then I will truly have this, this wealth building down.
I will accelerate my wealth building. I’ll accelerate my freedom number, my financial independence number or getting there. And I’ll just be freaking crushing it. And one of the reasons that I got into real estate, like, like way back, 20 15, 20 16, I was like, should I niche in real estate? And I had a bunch of CPAs say, no, there’s no money in real estate. And they were all lying cuz there is. But they were like, there’s no money. Like don’t, there’s all just a bunch of landlords. They’re all cheap. Yada yada, yada, you guys are cheap by the way, but that’s no that’s okay. CPA’s are really cheap too. One of the reasons that I wanted to get in it was I wanted to see does real estate genuinely provide a path to wealth building and and I have confirmed that it 1000% does.
But the other cool thing that I’ve seen is we have clients that net two, three, $400,000 a year and they do not pay tax on that income. And that is really cool to see. So it’s not like it’s, you know, before actually seeing it, it’s always like, eh, it’s just somebody just telling me, you know, whatever. That’s not, it’s not CA I’m not capable of it. There’s no way I’m gonna get there. But then you actually see it on these tax returns and you actually see the results and then you talk to the client and they’re just, you know, just some Joe Schmo driving a Toyota, a Corolla, there, nothing, nothing, nothing exciting. Nobody knows that they’re net in 400K a year and they’re not paying tax on it.
And that that’s just through the depreciation. You’re not factoring in cost segregation
Just through the depreciation. Yeah.
So, okay. We’ve, you’ve mentioned cost segregation multiple times here. I think it would be a mistake not to line what it is and who should use it and who should not even worry about it.
So a cost segregation study is the act of, or it is the science, I guess, of relocating value away from 27 and a half year property and into a five, seven and 15 year schedule. So been basically when I buy a rental property, I depreciate the building value. I can’t depreciate land, so I gotta figure out the land value. And then I just kind of set that aside, but I depreciate the building value over 27 and a half years. Why 27 and a half no idea. This is what Congress says. So it’s 27 and a half years is how long I depreciate the building value. So a hundred thousand dollars pro acquisition, maybe $90,000 is add is improvements divided by 27 point a half should be like $3,300 a year. That’s my annual depreciation that I get to claim every single year. Now cost segregation study says, it’s kind of like based on the premise of, Hey, you have things inside of this property.
Like, like the property’s not just build there’s stuff inside of that building that will wear out a heck of a lot faster than 27 and a half years. Some will last five years, some will last seven years, some will last 15 years think of your carpet, your appliances fixtures, things like that, all that, all those things are not gonna last 27 and a half years. So a cost segregation study is the practice of taking value out of this 27 and a half year building bucket and allocating it to 5, 7, 15 years. And so if you think about it, if I take like let’s say I take $27,000 out of my 27 and a half year bucket. So it was providing $1,000 of annual depreciation expense. I take 27,000 and I allocate it to five year property instead. Well, now I’m gonna get $5,000, roughly $5,400 of annual depreciation expense for five years.
And if you’re a tax person listening, I know that’s not exactly how works, but you know, we’re just, we’re just going high level here. So I’m, I’m taking 27 K depreciating over five years, $5,000 a year. So instead of getting $1,000 a year for 27 and a half years, I get $5,000 a year for five years. And then I get zero after that cause I’ve fully depreciated it. But for those first five years, I’ve increased my depreciation expense fivefold that just allows me to offset more cash flow. So, and with the time value of money theory, you do want to do that because the cost of, of everything rises and you want to take your tax benefits outta this property as quickly as you can so that you can reinvest those tax benefits today versus getting the tax benefits on your 27. And inflation has just completely eroded the value of those tax benefits, which is a separate conversation, but with this five year property.
So I can also 100% bonus depreciate five, seven, and 15 year property. So in this example, when I allocate value away from when I allocate this $27,000 out of the 27 bucket, I put it in the five year bucket. I could depreciate 5k a year for five years and get that increase in my annual depreciation, or I could 100% bonus depreciate it and take $27,000 today. So $27,000 of expenses now today, and that is extremely powerful when we’re talking about that time value of money theory. And that’s what a lot of people are are doing right now is they’re taking that full value today. A hundred percent bonus depreciation will phase out starting next year. So next year it’s gonna be 80% in 2023, then it’ll be 60% in 24, 40%, 25, 20% in 26 and zero in 27. I expect that there’ll be some sort of act in Congress to delay the sun setting or or, or expanded or something like that. But right now it’s a hundred percent. So you, you get that cost done. You can generally immediately write off 20% or so of the purchase price in the first year of ownership.
So when you take bonus depreciation or you do a cost segregation, if you can’t use it all, can you carry it forward? Whatever you don’t use?
Yes you can.
So you never lose it. So there’s no loss or downside to doing a cost segregation or doing bones depreciation today. You have nothing to lose you, you use what you can and you carry forward. What you don’t use.
The only downside is going to be when I pay $3,000 for a cost segregation study. And I create like, let’s talk about a real example, right? On these 10 duplexes. The downside for me, Brandon Hall is that this cost segregation study will cost $3,000. My ex my half of that’s 1500 bucks. So I’m gonna pay $1,500 in fees to get $180,000 of losses that I cannot claim. So it’s gonna be $180,000. That’s suspended if my portfolio consistently produces losses and I’m never able to claim the 180 K. And then if we later sell the, the 10 duplexes and I can claim the 180K then against the 10 duplexes, but it’s like, the gain would be smaller if I never took the 180 K in the first place. So it just, it’s a wash that’s when it’s not beneficial, because I was, I was never able to actually claim the 180 K and the benefits associated with it and reinvest those benefits today. But I would say that it’s not beneficial, maybe 5% of the time. So of all the studies, maybe be five of them, don’t actually pan out to be beneficial. So for the most part, you’re correct. Even if it’s gonna create large losses, you should really understand what your investment philosophy it looks like. And, you know, you can use those losses to offset future income
And you can carry them forward. And definitely until you actually use them, there’s no expiry on that.
Yes, absolutely.
So if I wanted to do a cost segregation or a bonus depreciation, do I work with you as my CPA? Or do I have to hire a third party?
Good question. We require our clients to go through third parties. Okay. And there’s, there’s several ’em out there. We don’t have like, you know, anybody in particular that we refer to, we want the separation of duties. If that makes sense. Like, we, we want, wanna be the tax firm. We wanna advise you on it, but we want the actual cost segment folks to actually do it. Cuz they have a ton of data. That’s the thing like they’ve been doing it for decades. They have a ton of data as to what things should actually cost both internally. And then also through these publications that they subscribe to. And and we just think that that’s a much more powerful audit protection tool than using us as your cost seg person.
Very cool. Brandon, we’re not even gonna touch on business loss rules and other stuff I had here. We’ve gone long enough. So let us wrap this up, share with my audience here, how they can get ahold of you, your firm, whatever information you wanna share, please, you know, let us know.
Yeah. Two ways. So if you’re interested in exploring a client relationship you can check us out at the realestate cpa.com, www.therealestatecpa.com. We’ve got a whole lot of content on there. Our podcast is on there. You can check out too, but there’s a big orange button that says get started and you can start filling out that form caveat that we are expensive. We are, you’re gonna be several thousands of dollars in every single year to work with us. And if that is too much, that’s totally fine. My larger mission in life is to help every single landlord out there. Save money on taxes by working with their own CPA in a more sophisticated manner. So we created a group called tax smart real estate investors. You can find it on Facebook. I believe it’s facebook.com/groups/taxsmartinvestors. So go there, join the group. It’s a free group. You can ask any question you want. And myself, my team and other people in the group who have gone through our courses and our education, it’s actually surprising me. They’re coming back and they’re answering questions too, and they’re doing it in a really good way. So come join that group, cuz we’ve got a lot of really good questions flowing through there and we’ve got about 9,300 people in the group today.
That’s awesome. All right. Good stuff. Well, we’ll put all that in show notes so people can click and link and find it and it’ll be super easy. But I would like to have you back on here in the coming months to continue this conversation and talk about some of the stuff that we didn’t get to today. So it’s been very helpful.
Sure thing. Happy too, thanks for having me on Marco. I appreciate it.
All right, Brandon, have a great day and thanks again.
You too.
Well, that was literally a great episode. I know this stuff can be a little bit dry at times, but the thing is it’s important to understand what your options are and the ways that you can lower your taxes. Because as Brandon mentioned, you know, your biggest expense are the tax bills you pay to the federal government and the state. So learn how to reduce your taxes. If you want to put more money in your pocket, it’s really that simple. And that is the ball line. All right, well with that we’re gonna wrap it up here for today. We went a little bit long. I think we went about 52 minutes. Download your free guide on our website. The Ultimate Guide to Passive Real Estate Investing, It is available to you at both of our websites at noradarealestate.com and passiverealestateinvesting.com. And if you want to speak to my, team about real estate investing and building a portfolio, you know, sign up for your free strategy session.
It is no cost, no obligation. My team is here to help you and answer your questions. Speaking of questions, if you have questions for me, I am going to be doing more Ask Marco episodes and you can just submit those to me from the passiverealestateinvesting.com website. Just click on Ask Marco. That is it for today. Remember to subscribe takes you two seconds, just click on the subscribe button on your computer or smartphone, help us spread the word, visit us on iTunes, leave us that rating and review. We greatly appreciate it. And that is it for today. Thank you for listening. We will see you all on our next episode.
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