On this episode we learn how to keep more of what we make and legally pay less tax (or not tax) on our income and real estate!
Our guest is Tom Wheelwright — a leading tax and wealth expert, speaker, and a Rich Dad Advisor to Robert Kiyosaki (author of Rich Dad Poor Dad). Tom is best known for making taxes fun, easy and understandable and is the bestselling author of Tax-Free Wealth.
You can buy his book at most retailers or on Amazon:
Tax-Free Wealth: How to Build Massive Wealth by Permanently Lowering Your Taxes
Visits Tom’s company website (ProVision Wealth Strategists) at www.taxfreewealthadvisor.com
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Rich Dad Advisor, Tom Wheelwright on Tax-Free Wealth
It’s my pleasure to welcome Tom Wheelwright to the show. Tom is a leading tax and wealth expert, a speaker, and a Rich Dad Advisor to Robert Kiyosaki, author of Rich Dad Poor Dad. Tom is best known for making taxes fun, easy and understandable, and is the best-selling author of Tax-Free Wealth. He specializes in helping investors permanently reduce taxes, and that’s the reason I wanted to bring him on the show today. Tom, welcome to the show.
Hey, thanks so much for having me. It’s great to be on your show.
It’s my pleasure to have you. I’ve been actually looking forward to this episode because taxes are one of those things that nobody likes to think about, nor do they like to pay it. It’s been said that taxes are the largest single expense, in fact, that’s a quote from Robert Kiyosaki. I think it’s timely to have you here on the show in January, and I’m pretty excited to talk to you.
I’m always excited to talk about tax. As we were talking beforehand, I am, first and foremost, a tax nerd. I absolutely love tax, I love the tax law. I was actually doing a little research the other day, and I think the Bible has 800,000 words to it, and the tax code, just the law, no ruling, regulation, anything else, has over two and a half million. There’s this famous quote from Albert Einstein saying, “The most difficult thing in the world to understand is income tax.” I just like that quote because it makes me feel good about myself, but I do recognize that it is something that people, like you say, taxes are bad word, it’s a bad thing. But there are so many opportunities to reduce your taxes, that if we can turn it into a good word, then we now have just a lot more money to use to invest and build our wealth.
We’re both very big on education, and I’ve read your book in 2012 when it came out, your book Tax-Free Wealth. One of the things you say in there is that, taxes can make you rich or make you poor, it’s your choice. Let’s start off by talking about what tax-free wealth is. How do you describe that to people?
Tax-free wealth is really a function of understanding how the tax law works and what it really is. Most people look at the tax laws, and in fact, most tax advisors look at the tax law as, this is the government out to get us, and it is completely the opposite. I’ve been a student of taxes for over 35 years. What’s really clear to me is that, there’s only one line in the tax law that actually raises revenue. There’s a line that says, basically, all income is taxable unless we say it isn’t. Then there’s about 29 pages of charts and tables that tell us how much to pay on that income. The rest of the tax law, the rest of the two and a half million words is an instruction guide on how to reduce your taxes. Once we get that in our minds, then all of a sudden … if we’re looking at this as, if I understand this, I can do something about it, which is different than, there’s nothing I can do. All of a sudden, we’re in control of our lives. We’re in control of our taxes and no longer does it have to be your single biggest expense.
Right. This segues to your two rules of money. The first is, it’s your money, not the government’s. Your second rule is, the tax law is written primarily to reduce your taxes.
Right. Here’s what I think most people don’t really recognize, and that is, when you look at the tax law, it’s really simply a series of incentives. That’s all it is. For example, you do real estate, I’m sure we’ll be talking about this, there’s a bunch of incentives for real estate investors. You just have to look at what’s the policy of the government. I’m a big fan of looking at government policy. If you really want to understand the policy of any government in any country, look at their tax law, because I guarantee you that that policy is set out in their tax law. I’ll give you an odd example. In Australia, one of their governmental policies is to encourage the birth rate. They want more kids born into the country. What did they do? It’s an island, fundamentally. They’re so disconnected from the rest of the world, they need to grow their population. They give tax benefits for having more children. You’re just looking at the policy. What’s the policy of your country? What does the government want you to do? If you do that, they’re going to give you a tax break.
It’s like a fundamental unwritten rule. If you want less of something, you tax it more. If you want more of something, you provide tax breaks or tax it less.
Exactly. That’s exactly right.
I have to think, when you’re talking to people about this stuff, what do you find is the most surprising thing people find about what you’re teaching in terms of reducing taxes, either permanently or temporarily?
First of all, I think most people just have never thought of it this way. The context that tax-free wealth gives to the tax law is remarkably unique. I’m actually quite surprised. When I wrote the book I thought, there are other tax advisors promoting this out there and I just haven’t met them yet. What I found was just no, there aren’t. This concept of the tax law being in your favor, if you use it that way, is completely foreign. In fact, most people will go, “It’s my obligation to pay tax and I’m doing something wrong if I avoid taxes.” You’re doing something wrong if you evade taxes. If you evade taxes, you’re going to go to prison and you should because you’re not following the law. Actually, the way you avoid taxes is by following the law. People will say, “It’s unpatriotic to pay for your taxes.” I actually take the completely opposite approach.
Let’s say, if I’m supporting my government, and the government tells me to do something, and I do that, isn’t that more patriotic than not doing it? Whatever I’m doing to follow the tax law and to take advantage of those incentives, it goes back to what you said. The government wants you to do more of something, they’re going to tax it less. Just people hate taxes so much that a little tax incentive goes a long way for the government, and so they get a big bang for their buck by giving a tax incentive. I’ve been fascinated by the Republican debates and the different candidates and their positions. Not the Democrats because Democrats, they get this. Frankly, they get it. They get what the purpose of the tax law and they get what the tax law is for. They’re not trying to simplify the tax law. You don’t see the Democrats saying, “We’re going to go to a flat tax.” They’re not, because they know what it’s for. They understand that we can use the tax law to facilitate government policies. I’m not saying that it should be, I’m just saying it is what it is.
It’s like Robert Kiyosaki always says, “Look, if this is the way things work, why not just take advantage of the way things work? Why are you fighting it? Just put it into place in your own life.” I look at these candidates who want this flat tax, I’m going, okay, so when you have that flat tax, how are you going to get people to follow your policies? Are you going to put them in prison if they don’t? Are you going to penalize them? How are you going to do that? I’m such a believer that a positive reinforcement is so much better than a negative reinforcement, and a positive reinforcement of lower taxes is a really big positive reinforcement.
I agree. I guess that’s an argument against the flat tax with no loopholes, in other words, exceptions to incentivize people.
Yes. Can we talk about this just for a second here? The word loophole is a misnomer. A loophole, when we think about it, is a mistake. I’ll give you an example of a loophole, if anybody has ever heard of this idea of a carried interest, which is basically, the big argument right now is the private equity guys and the hedge fund guys are using this carried interest rule to convert ordinary income to capital gains. With respect to the private equity guys, it’s a loophole. In other words, it was never intended for them. But with respect to your industry, real estate, it was absolutely intended that way. This idea of a real estate developer who goes out and builds an apartment building, and what he does is he doesn’t take money upfront. What he does instead is he says, “Look, I will take a reward on the back-end, should I be successful.”
The government says, “If you do it that way, we’re going to treat that as capital gains at a lower tax rate instead of ordinary income. If you put not just your money at risk, but you’re putting your time and your efforts at risk, we’re going to reward you for that risk by giving you capital gains.” That is exactly what’s that for, so that’s not a loophole. That was intended. That’s an intentional consequence. Whereas for the private equity guys, I think that probably was a loophole. When you talk about closing loopholes, we’re not talking about getting rid of the intended benefits, we’re talking about let’s get rid of unintended consequences, which there always are. I’m off for closing loopholes. I just want to be clear on what we mean by a loophole because to me, if it’s an intended consequence, it’s not a loophole, and so it’s not a mistake by the government. It’s something they actually wanted us to do.
Yes, you’re talking about intended incentives to encourage certain behaviors or growth in particular sectors within the economy.
Exactly.
That makes sense. Let’s get down to some fundamentals here and just build on top of that. This topic about taxes, we could spend hours and hours talking about it and have multiple episodes, each one on different subject matter. We’re just going to touch on a few big things here today and maybe down the road, we can bring you back and have you talk about something in more detail. I think most people understand that there are three kinds of income. There’s ordinary, portfolio, and my favorite, passive, which is the name for our show, Passive Real Estate Investing. Take a second to just define what those three types of income are, and if there’s a way for investors to take advantage of those, then we’ll probably just expand on that as we go.
The thing about ordinary income is something that you worked for. That’s really ordinary income. In other words, it was your effort that created the income, and typically, an ordinary income is going to be taxed at the highest rate. You run your business, I run my accounting firm. My accounting firm produces ordinary income, it’s as a result of my efforts and the efforts of my employees, so that’s ordinary income. It’s something I’m actively involved in, that’s ordinary income. What’s portfolio income? Portfolio income, think of as investment income. This is something that is happening primarily as a function of time as opposed to a function of effort. When you think of portfolio income, you tend to think of capital gains. Why do capital gains happen? They happen over a period of time. I’ve held an asset for a period of time and that’s capital gains. Passive income is unique.
First of all, it’s unique in that to my knowledge, we’re the only country with this concept of passive income from a tax standpoint. It actually came about back in 1986 when I was in Washington DC, and the 1986 tax hike would not have happened were it not for this change in the law, which basically said that if you have an investment in a business and you’re not actively involved in that business, we’re going to treat that income or that loss as passive. It’s an active business, the business itself is active, you’re just not an active participant in that business, we’re going to call that passive. It’s not portfolio. In other words, you haven’t invested in some kind of fund or some kind of a stock or something like that, and it’s not your own business, it’s in between here. What happens is, is that the beauty of the passive income is two-fold.
From an investor standpoint of course, it means you’re not active and it means you’re not spending a lot of time at it, which is what we all hope for. I like to call it mailbox money. It just shows up in your mailbox, it shows up in your bank account. On the other hand, passive losses, and this is the real reason this law was created, passive losses, you don’t get to use them unless you have passive income. The biggest contributor to passive losses is real estate. If you’re a real estate investor and you’re not actively participating in your real estate, and it throws off losses, which by the way, it should if you’re investing.
If you’re doing it right.
If you’re doing it right, it’s going to throw off tax losses, cashflow positive, tax negative. You’re going to have a passive loss. It’s great because you’re not going to pay tax on your real estate income. What’s not great is, but now I can’t use it unless I have passive income. Then our question becomes, how do I convert some of my income that is otherwise active into passive income so I can use those real estate losses? Because what we want to do is, again, it’s tax-free wealth, it’s not tax-reduced wealth, it’s tax-free wealth. What we’re trying to do is we’re wanting to be strategic about our tax planning in such a way that we don’t just not pay income tax on our real estate cashflow, we actually get a tax benefit to offset our other income from our business or from our job or from our other investment portfolio. We want to be able to use that loss to offset our other income, and that’s where a good tax strategy comes into play.
Strategy is the keyword there, because it’s my understanding that you can’t take passive income and take your passive deductions and use that against active income, correct?
Right. It’s a bucket. Think of it as a bucket. A really easy way for our listeners to think about this is, everybody knows that capital losses only offset of capital gains, right? That’s a bucket. Everybody knows that. We still see lots and lots of people that have these huge carryovers of capital losses on their Schedule D that carryover every year because they only get to use $3,000 a year because they don’t have capital gains. One of our strategies that we use, that we employ is actually to convert ordinary income to capital gain, because if you’ve got big capital losses, that’s an asset you’re not taking advantage of. The same thing is true with passive. Passive losses are a bucket. They go into this bucket and they don’t get to be used up except against passive income. What we’re trying to do, we either want to convert that from passive loss to ordinary loss, because ordinary loss we can use it against anything, or if we can’t do that, we want to convert our active income to passive income.
That’s a whole episode in itself because I know that goes down the road of, how do I become a professional real estate investor and qualify under that particular code and that’s working 750 hours a year in that particular business and there’s all these other criteria. We’ll save that for another day.
We should. Because there’s a thought process, a context here that I’d like our listeners to get, and that is that, when we talk about real estate professional, because a lot of people have heard of that term. What we’re doing is we’re talking about converting our real estate losses from passive to active. One way to do this is to actually convert our losses from being passive losses to active losses. But there’s a whole other way to look at this, and that is, what if we left them as passive losses? What if all we did was convert some of our income from active income to passive income? This is the thought process. Just remember that it’s a bucket, and it doesn’t matter. I can go either way, I can either take my passive losses, move them out of that bucket so that they’re are active losses, or I can take my active income and move it into that bucket so that it can still be offset by those losses.
They just need to be in the same bucket?
They just need to be in the same bucket. Very simple.
Got it. The holy grail of tax write-offs, at least as far as I know, is depreciation.
True.
I think for a lot of people, and including investors, it’s not fully understood, and those who do understand it don’t fully appreciate how powerful it is. Talk about depreciation. Most people I think listening to this program understand what depreciation is. But why is it so amazing for real estate investors?
Chapter seven of Tax-Free Wealth is called The Magic of Depreciation. That actually came up the very first time I run Robert Kiyosaki’s stage, which was about 12 years ago. The very first thing he ever had me do on stage was to explain depreciation. He was very brave because he barely knew me at all, and certainly he had never seen me speak before and didn’t know I had any experience in teaching. I happen to have had 20 years’ experience teaching by then, but he had no idea. A very brave guy. I said, depreciation is just a little like magic, because you have an asset that’s going up in value that you’re getting a deduction for. Tell me another asset that’s like that. Oil and gas doesn’t work that way. Business doesn’t work that way.
Only real estate, only depreciation particularly in real estate works that way. You have an asset that’s going up in value and you’re getting a deduction for it. Now, the reason it’s more magic in real estate, I think, than it is some other places is because, you and I were talking earlier about leverage in using debt for real estate and why that’s so important. Because obviously, you can never get the same returns on real estate if you pay cash for it as you can if you use leverage, if you leverage it and use debt. To me, the two keys to being a successful real estate investor are, one, using debt, and two, using taxes. Those are the two keys. What’s cool about depreciation? We all know that depreciation is basically a deduction for the cost of your investment over a period of time. That’s all it is. It’s just the deduction for what you paid for your investment over a period of time.
Land doesn’t get depreciated because it never wears out, but everything else does, the building, the contents, the land improvements, the light fixtures, even the garage, even the lighting, even the fencing, all of that eventually is going to wear out, so we’re going to get some kind of deduction for depreciation. But here is the cool thing about depreciation, and that’s leverage. If you think about it and you say, let’s say I’ve got $100,000 of cash. I could go buy $100,000 property. I bet you’ve got a few you could sell for $100,000 or less. I go buy this $100,000 property, and I’m going to get depreciation on probably 80% of that, so let’s say 20% is land, but I’m going to get an $80,000 depreciation deduction over a period of time. That’s not bad. But let’s say I took that $100,000 and I leveraged it. I went to the bank and said, “Bank, would you lend me $400,000 if I put $100,000 of my own money in it?” You’re going to say yes. You got all sorts of banks who will lend 80% loan-to-value on residential properties. Now I’m going to buy a $500,000 property. I still only have $100,000 of my own money into it.
But the great thing about depreciation is, the bank doesn’t get it, you get it. What you’ve done by borrowing is not only have you leveraged your cashflow, but you’ve also leveraged your tax deductions. When I hear people saying, “I have taxable income for my real estate.” The only way you have taxable income from your real estate is because you haven’t leveraged it. It’s the only way because you haven’t leveraged it, either you didn’t leverage it now or you’re not re-leveraging it, because building a real estate portfolio is a function of mass. How much volume of real estate can I have and that volume increases my cashflow, but it also increases my tax benefits. When we talk about tax-free wealth, the reality is that a very serious real estate investor and people who invest on a regular basis can get to zero tax even though they’ve got a huge cashflow. I got to tell you, I met with another CPA just last week, and we had 45 minutes together. She spent the entire time arguing with me. What she was arguing about is she’s arguing about real estate. She goes, “But depreciation, but you’re going recapture it some time.” I’m going, “Why?” “You’re going to sell it.” I’m going, “Why?” If I do sell it, why wouldn’t I just do a 1031 exchange?
Exactly.
“Because you want cashflow.” Why would I take cash on a taxable sale instead of taking that out on a refinance? Why would I do that? But wait a minute, you might not want to manage your real estate. Why don’t I just roll it into a Walgreens? I don’t have to manage that. Why don’t I roll it into something I don’t have to manage anymore? She has some pretty big clients that are real estate developers. I’m going, “Why are you fighting me on this? You should be asking me how I do this for my clients.”
Not all CPAs are created equal, that’s the bottom line. But you make a major point. Real estate is the only asset class where you can come in with as little as 20% down of your own cash, borrow the other 80% and take 100% of the appreciation, 100% of the amortization, 100% of the tax advantages, you keep everything. It’s very powerful. The whole thing about a 1031 exchange, actually that was my next question for you, it’s a loaded question. People will say, “If I sell the property, then I have to recapture taxes and whatnot.” Why do you need to sell it? Just keep doing a 1031 tax-free exchange into more and more and more real estate, keep building your portfolio. You can defer your capital gains taxes forever.
Here’s what happened, you actually deferred them until a certain point in time when you can’t defer anymore, that’s when you die. It’s going to happen to all of us, like it or not. Here’s an interesting phenomenon, when you die, your recaptured goes away, it disappears. The government actually says, “If you’re dead, we’re not going to recapture that tax anymore. That’s our gift to you for dying. Thank you for dying. Here’s your thank you. We no longer have to pay your social security, we no longer have to provide you services. Instead, as our gift to you for coming off of the government roles, we’re going to give you this tax.” I know I’m being a little efficacious about that, but the reality is that we can defer until we make it permanent through death, and so we can defer forever. If we wanted to, we could defer it and then our kids could defer it, and then their kids could defer it. Literally, if you chose not to own the property when you die and you chose to get it over to your kids, they can defer it and they can defer it forever and ever.
The 1031 exchange is powerful, and then with proper estate planning, it’s huge. Now, isn’t there an exception to that? Isn’t there a cap at $11 million?
Right, if you keep it. But here’s the thing, good tax planning Good tax planning includes both income tax planning and estate tax planning at the same time. It drives me crazy when I see income tax planning that doesn’t think about the estate planning, or estate tax planning that doesn’t include the income tax consequences. We have to marry these two. They’re intricately connected. More now than they were before, we have this $11 million exclusion. With this $11 million exclusion, what that means is that if our estate doesn’t rise above $11 million and is never going to rise above $11 million, we don’t want to transfer it out of our estate because we want that step-up in basis. However, to the extent it’s more than $11 million, we want to transfer the rest of it out of our estate, because the estate tax is way bigger than the income tax, than the capital gains tax. We want to get it out of our estate and let’s let our kids deals with that tax down the road. If they want to continue to defer, that’s great. If they want to pay the tax and just cash out, that’s okay too.
Going back to depreciation for a sec, Tom. Depreciation is on a 27 and a half year schedule, and then after that, the depreciation is gone unless you do something to the property. Do you have a strategy or what do you recommend investors do after 27 and a half years to reset the clock? Refinance?
Totally. Buy more property.
Buy more property?
First of all, 27 and a half years, you’re talking about residential property. Commercial is 39. Just so we’re clear. I think investors should be on a constant evaluation of their property and acquisition. Because here’s what’s going on, if you’ve held that property for 27 and a half years, you got a bunch of equity in there. Don’t just buy another property, but leverage that equity, because at the same time, like you said, you get the depreciation but you’re also amortizing your loan down over that probably same 27 and a half years, the same period of time. At this point, now you got a bunch of equity in there, why don’t you go leverage that equity again and buy more property? That’s the key. You become a bit of an investment fanatic where you’re, it’s probably not the right word to use, but it kind of is, Ponzi. You’re taking that money and investing it more. You’re continuing to build and grow and build more volume. That’s actually one of the arguments I was having with the CPA. She goes, “Then you have to keep buying more real estate.” I’m going, “Yes, and what’s wrong with that? Why wouldn’t you want to keep buying more real estate?”
To your point, as a property appreciates and you gain more equity over time, I laugh at some investors that talk about their “return on equity”. You can do a math calculation on that, but the fact is there is no return on equity. It’s dormant or dead equity, it’s not doing anything for you. You have to redeploy that into more real estate in order to convert that equity into another income producing asset. Now, you actually have a return, it’s called cashflow and you can measure that. What you’re saying makes a lot of sense, and I think that’s the way to do it, is just keep building your portfolio.
The more real estate you have of course, the lower your equity is compared to your total real estate, and so the higher than return on equity is. That’s how you keep your return on equity keep going up and up and up, is by continuing to refinance and buy more property.
Converting it into income producing assets. Just on a tangent here, from a tax perspective, what’s the difference between flipping and holding property? Obviously, we’re not promoting flipping, that to me is a transactional business. It’s exactly that. It’s a business and it’s a transaction. It doesn’t produce checks in the mail every month. But from a tax perspective, can you just summarize what the difference is for those people who are listening that are saying, “I need to “invest in real estate”, I’m going to start flipping.” No, that’s not investing. At least it’s not to me.
It’s not, that’s a business. That’s ordinary income, and that’s taxed twice as much, at least twice as much as buy and hold. I don’t have any objection to people flipping priorities, as long as they recognize that it’s not investing, it’s a business and you treat it for what it is. It’s a business. Everybody knows who Dave Ramsey is. I was on a radio show with him not too long ago, and offline we were talking about how he only uses cash. He invests in real estate but he does cash investing. I’m trying to understand, why is that? Because he got caught flipping with using leverage to flip. Using leverage to flip is a highly risky thing to do. Using leverage to buy and hold is a very low risk thing to do. You’ve said it a number of times and thank you for saying that, as long as you have strong cashflow.
The reason people got in so much trouble in 2007, 2008, and 2009, is because they had bought real estate betting on the market going up. That’s called speculation. That’s what that is. That’s speculation. Speculating, you know what, I’m sorry, but you speculate, you kind of get what you deserve. It’s a bit like buying lottery ticket. Your chance of winning is the same whether you buy the lottery ticket or not. That’s the challenge with that. Flipping from a tax standpoint, you’re paying twice the tax rate, that’s basically what it is. You’re going to pay twice as much tax on the same income from flipping as you do from buy and hold, and that’s assuming that you pay tax at all. The reality is, what normally happens, a good real estate investor, like we said, will never pay tax on their cashflow or their capital gains, whereas a flipper will pay as much as 40% to 50% on their income from flipping their properties. It’s a big, big difference. ¬
Just to be clear, there’s nothing wrong with flipping, it’s just not what I consider investing. If you’re going to flip and make $10,000, $20,000 or $30,000 on a flip, take that, use it as a down payment and buy some income producing real estate where you’re building a portfolio. That’s, I think, the smartest thing to do with that income.
I agree with you from the standpoint that if you see it as a business, then that’s fine. Just treat it as a business. Don’t look at flipping as investing. It’s no more investing than consulting is investing, it’s not. It’s a business and just treat it that way, that’s fine. If what you want to do is take that $30,000, to me you’ve got a choice. You can put it back into the business and buy more properties, to flip more properties, and that’s one road to go. The other is, take that money and go put it in buy and hold. I don’t think one’s right and one’s wrong. I think that there are certain people that if they have a really good business, buying and turning over properties and improving them and flipping them, that’s great. That’s your business. If on the other hand you’re an investor and you buy to hold your properties, that’s great. But you’re absolutely right, one’s a business, one’s investing.
We’re talking about real estate being a business, we’re talking about holding property, we’re talking about transactions, all these things play into entities. There are a lot of promoters out there, and even attorneys that sometimes are giving bad advice or misinformation on tax saving entities. It took me years to figure this out because I heard all this information and misinformation and I didn’t know when to use an LLC versus an S corp versus this and that. I finally have figured it out as of recent years on what the best entity is. But again, this is a big, big topic. You can just give me your two-minute version of entities and what investors should use or maybe not use from a tax perspective when it comes to their real estate.
It actually goes back to the conversation we were just having. Certain entities are good for investing and certain entities are good for business. If what you’re doing is a business, most people will end up being taxed as an S corporation. If what you’re doing is investing, most people will not want to be an S corporation because there are some big downsides to being an S corporation if you’re an investor. Instead, what you want to do is be taxed either as a sole proprietor as a partnership. But you do use the term LLC, which is of course limited liability company. In most cases, for most people that will want to use a limited liability company, either way. Limited liability company, just to be clear, is not a tax designation. It is a state law designation. You can have a limited liability company that is taxed as an S corporation. You’re going to have a limited liability company that is taxed as a partnership. You’re going to have limited liability company that’s taxed as a C corporation or that’s taxed as a sole proprietorship. You can have a limited liability company.
One limited liability company might be taxed as a general partnership and another one taxed as limited partnership. There’s a lot of different tax designations. The reason people like limited liability companies is for the limited liability. It’s to protect your assets. That’s a legal question, that’s something you have to be talking to your attorney about, is how do I protect my assets? What you want to talk to your accountant about is how do I protect not my assets from somebody who’s going to sue me, but how do I protect my assets from the government? That’s called tax protection, and that’s a function of how is it taxed. That’s a really difficult distinction for people to understand but a very important one.
When I talk about an S corporation, I say, “You should be an S corporation for tax purposes,” I’m not saying you should be a corporation. I’m saying you should probably be a limited liability company taxed as an S corporation, because for LLCs we get to choose how we’re taxed. I may want that for asset protection but still get to use it for tax purposes. But the fundamental difference is that, I don’t want real estate that’s investment real estate, not flipping, but investment real estate, I don’t want it taxed in a corporate form. I don’t want tax as an S corporation or a C corporation. That’s bad. If your advisor is telling you to do that, run away. Go get another advisor. Because investment property should, almost without exception, and I just say almost because there’s always the exception out there, almost without exception be in an entity that’s taxed either as a sole proprietorship or a partnership.
There’s always two sides to this question when it comes to entities. There’s the tax side and the legal side, and they do go hand in hand. You do want the protection from an asset protection perspective, but you always have to ask the question, how are the taxes going to get treated on that? Is it going to be flow through to my personal tax return? Is it going to be double taxed? You really have to look at both of these things. I like S corporations for one particular reason, when it comes to transactional businesses. I like LLCs for the asset protection and have it as a disregarded entity with the IRS so things flow through, and then I just reported on another tax return at the end of the year and I don’t have to file a tax return for that LLC. It can be simple.
It can. Here’s a little hint for our listeners, and that is that a partnership is going to have much less chance of being audited than if you report it on your Schedule E. I do like investment property being held in an LLC that’s going to be taxed as a partnership. I actually think there’s some pretty significant advantages. Let me explain. Husband and wife, that’s a partnership, so you don’t have to go outside of your family. I’m not suggesting you have an outside owner. I’m just suggesting that I think there are some real advantages to being taxed as a partnership and it’s worth the little amount of money that it costs to file a tax return for it. You end up with a balance sheet, you end up with better reporting, you end up with a less chance of an audit, you end up with a better tax consequences. I think there are a lot of advantages to that. I’m not a big fan of the disregarded entity at least for the holding company. We can do that another time, talk about holding companies. Your choice of entity, by the way, when we do a tax strategy, it takes us typically three months to get somebody’s taxes down by 10 to 40%. But when we do that, I’ll tell you, about 50% of your tax savings comes from your choice of entity.
That’s a huge difference. 10 to 40% is a massive difference. If you think about that as rate of return, where are you going to get rates of return up to 40%?
It’s a tax free rate of return too, because you’re reducing your taxes and you didn’t get deduction for those taxes. Now, our goal as a CPA firm is that we are the best investment that anybody ever makes. That’s our goal.
You need the right team, there’s no question. Here’s a softball question for you. I know this is kind of a sore spot for a lot of people. When it comes to 401Ks and IRAs, you have no control. You lose advantages of debt and taxes, and a lot of people don’t understand that. I’m going to throw this over to you and just ask you this softball question. What do you think of 401Ks and IRAs as a tax advantaged vehicle?
I’m going to surprise you a little bit. They have their place, not for your listeners, but they have their place. As far as for real estate, bad idea. Two things happen if you invest in real estate through your IRA. One is you lose all the depreciation deductions. You’ll never get them. I don’t care if you’re Roth IRA, I don’t care. You’ll lose your depreciation. You will never get that back. Number two is, you’ll lose your leverage, and that’s a bigger issue actually than even the tax consequence. Because banks’ general rule, you cannot guarantee that loan. If you invest, let’s take your IRA money and you invest in real estate, you cannot guarantee that loan, that’s a prohibited transaction, it will blow your whole IRA.
It has to be non-recourse.
It has to be non-recourse. Banks don’t like non-recourse loans on residential property and on smaller properties. They require you to sign on that dotted line and you’ve got to sign personally for them to lend you the money, so they don’t. What you end up with is instead of an 80% of loan to value, you’re probably ending up with a 50% loan to value. Think of that. That means that if you have a $100,000, think about how big this is. A $100,000 to invest, if you do it inside your IRA, you can only buy $200,000 of property, but if you did it outside your IRA, you could buy $500,000. Now, let’s say that what you did instead was you actually pulled the money out. I’ve run this number a hundred times. You pulled the money out. Let’s say you had to pay taxes and penalties, so you actually went from $100,000, you paid taxes and penalties, you’re down to $50,000. That $50,000 will still get you $250,000 property, which is more than the $200,000 you get inside your IRA.
Here’s another thing, don’t think that now I have more equity in my property. No, I don’t, because here’s what happens. You take that $100,000 and you buy a $200,000 property, you have a $100,000 in equity. But when you pull that money out, you’re going to pay tax on $200,000. You’re still going to give up, you’re going to pay off your bank, and you got to pay your taxes. Here’s what’s going to happen. You pay off your bank, now you’re down to $100,000, you pull the money out, you got $50,000 left. You’re in the same place, only the difference is that now, you haven’t been able to leverage over the years. Frankly, I tell people, if your wealth strategy is to do investment real estate, why would you ever do it in an IRA? Pull the money out, pay the tax, pay the penalty, don’t worry about it. You’re done. Now you have control over it, now you can go invest.
It is a very rare situation that I would ever see anybody, even if they’re investing through a partnership, invest through their IRA. It just makes no sense. Any CPA, by the way, who does have a lot of clients with a lot of real estate, they will always tell you just never do it inside an IRA. Like I said, if you’re going to invest in the stock market and you’re going to do that long-term buy and hold, and you get a 100% match by your employer, and you’re not going to pay attention to your money anyway, so you’re just going to put a mutual fund or an ETF or whatever, go for it. I actually think sometimes the numbers work out there. But the reality is, if you’re going to be an active investor, take control of your life, you’re actually going to go out and take advantage of the tax laws as they exist. You would just never do it through an IRA or 401K.
Have you actually ever advised a client to pull funds out of their 401K or IRA and use it in real estate if that’s what they wanted to do?
Of course, I do it all the time.
Interesting. You’re the first guy who actually admit it. That’s good. We talked a lot about strategy. Just wrapping things up here for today, what would you advice real estate investors specifically, what would you tell them to do in terms of a starting place to start working on their “tax-free wealth strategy”? Where does one begin? Or maybe if they’re already a seasoned investor, they have a small portfolio, what’s the next step?
There was a book years ago. I don’t subscribe to a lot of things in this book, but it was a New York Times best seller called The Millionaire Next Door.
I’ve read that.
The one thing that I really like about that book is that the author was absolutely right when he said, the most important person in your life from an investment standpoint will be your tax advisor. He was absolutely right, because like you said, taxes are the biggest single expense. You must find the right tax advisor. You must find somebody who understands the law, and more importantly, understands your situation. What drives me crazy is when I’ll hear somebody in a class I’m teaching or a seminar I’m doing, and then they’ll say, “My CPA never asks me any questions.” I’m going, “Why do you have them for your CPA?” One of the rules about taxes is if you want to change your tax, you have to change your facts. Anything could be deductible, for example. Almost all expenses can be deductible under the right facts and circumstances. I’ve got to understand, as your tax advisor, I have to understand what your situation is and what your future situation is going to be. I have to have a crystal ball, I have to be looking at all aspects of your life in order to understand how do I reduce your taxes. If I’m not asking you those questions, I’m not doing my job.
What I always tell people is, the job of an advisor is not to give answers. The job of an advisor is to ask questions. You think about the last time you went to see a doctor. What was the most important thing they did? They diagnosed your illness, didn’t they? They asked you a bunch of questions. They didn’t say, “Here, go take this pill. I don’t know what’s wrong with you but go take this pill.” They would lose their license over that. Yet, what do we have? We have financial advisors, tax advisors, legal advisors all the time going in there and saying, “Here, go do this,” without asking the questions. The reality is, just like with the doctor, you have all the answers, you know where it hurts, you know what it feels like. All they can do is interpret your answers to say, “Okay, then here’s what we need to do.” The same thing is true, and if he’s not asking the right questions, he’s not going to help you. The same thing is true with the tax advisor. If they’re not asking you the right questions, they can’t diagnose the problem and they can’t give you a good answer. It’s really a function of the questions, not the answers, when it comes to, I think, any advisor and more particularly a tax advisor than anybody else.
I was going to ask you the question on how you go about finding the right tax advisor, but I think you’ve answered that question. It’s someone who actually listens to your situation and asks questions to figure out where you are and where you need to go.
It is. You want somebody who is diagnosing your situation. When we work with a client to create a tax strategy, we’re diagnosing their situation. We’re going, “Where are you today? Where are you going to go?” Based on that picture, what is it that we need to do? But until we’ve diagnosed the situation, to give you any kind of advice or any kind of ideas whatsoever is beyond general education, like we’ve done on this program. Anytime you go beyond general education then I think you’re into a pretty scary area.
Thinking back about what our investment councilors do, they do the exact same thing. Nobody ever calls us saying, “Look, I’m looking to buy a real estate and build a portfolio,” and then the first thing we say, “Purchase three properties in Indianapolis.” We always start off, “What are your goals? What’s your strategy? What’s your criteria?” If we don’t understand that, we can’t make any recommendations. That makes sense. I want to make a comment about that book. I read it many, many years ago. I actually thoroughly enjoyed that book. I think another problem with that book today is that a lot of those people that were case studies within that book accumulated their wealth through savings. They were investors too. But savings doesn’t work today because the currency is being debased so much that, as Robert Kiyosaki said, “Savers are losers.” You just can’t save yourself to wealth anymore, you have to invest.
That’s right. You used to be able to. Robert makes a point of that. Prior to 1973, prior to going off the gold standard, you could actually save yourself to wealth. That’s where The Millionaire Next Door came from. It’s the idea of you could do it back then. You cannot do it anymore. You can leverage your way to wealth. You can reduce your taxes to wealth, but you have to do something different.
I totally agree. Is there anything else that you’d like to share with our listeners before we wrap up or something I didn’t ask you that maybe I should have?
Like you said at the beginning, we could go for hours and hours and hours, and I hope it’s clear by now that I can go for days on this stuff. I think there’s so much to learn. What I love about the tax law? I like that there’s two and a half million words in the tax law. It means that there’s two and a half million opportunities to use the tax law to my benefit. It means that there’s so much that you can take advantage of and the key is understanding that. I applaud you for doing this show. I applaud you for the right kind of financial education. There’s a lot of bad financial education out there, so I want to thank you for that. I just want to encourage you, keep it up.
Thanks, Tom. I appreciate that. I personally know people who use ProVision, your company, for their tax strategy and tax advice. I guess in closing, tell our listeners how they can find you and your company, about your book, the websites that you have, so they can get more information and look into their own personal situation with your company.
Just go to TaxFreeWealthAdvisor.com, that’s the easy one to remember because it’s the name of the book. You can also call our office, the phone number is 866-467-5809. The book of course, it’s on Amazon, anywhere you can get an e-book. There’s e-books, there’s paper copies, we have an audio book. I read it myself, for 15 hours I read that book, to get it on to an audio book. You want to hear my voice for 15 hours, that’s fine, do the audio book. I love it when people read the book because the whole point of the book is to change your context and your thought process. It’s a Rich Dad advisor book. Many of the listeners know Robert is one of my clients. I wanted it to be consistent. He’s all about context. Change the way you think about something, it will change the way you behave. If you can change the way you think about taxes, it will change the way you could behave about taxes, and then you can make that serious reduction in your taxes at that point.
One of the biggest things we hear about Rich Dad Poor Dad, the book, from people is that it changed the way they think. It changed their context. That’s a huge thing. The one thing I will say about your book is that it does change your context. When I read it, it just made everything so easy to understand and so simple. It’s the analogy of the glass and pouring water in the glass. It gave you the shape of a glass. Now when you start pouring the water in, which is the content about taxes, you know exactly where it fits and how it relates to everything else. That’s the most powerful thing about the book.
That was the intent, so I’m glad to hear that.
If nothing else, if people don’t even contact you or your company, at least read the book because it will just help you understand something that you’re going to spend more money on in your lifetime than virtually everything else.
Read the book, have your tax advisor read the book. Make sure they’re not fighting you over the book. Seriously, having advisors that share your context and your values is really important.
Tom, you are a wealth of information and knowledge, so I really appreciate you spending the hour here today. We certainly would look forward to having you again later this year as a guest.
I’m happy to do so and thanks for having me.
Thanks, Tom.