Should you create a new LLC for your vacation rental? Eliot Thomas and Jeff Webb of Anderson Advisors answer your tax questions. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- I rent my personal residence and my home office is my primary place of business for my S Corp. Am I a good candidate to take advantage of Section 280A deduction or does that fact pattern disqualify me? No, you’re not disqualified. Keep the areas separate and you are a good candidate to take advantage of 280A and still have the administrative office reimbursement.
- Is it possible to minimize taxes by selling the C Corp, which holds property via a 1031 exchange and then form an LLC to buy the replacement property? Generally, no. If you’re going to have appreciable real estate, a rental, you can’t do 1031 on flipping property. It’s considered inventory.
- I just bought a lake cabin in Wisconsin where we will be renting it out as VRBO as much as possible, but also using it for some personal use for our family. Will I need to create a new LLC to hold the cabin in and how much of it can I write off given we’re unsure about how much it will be rented out, especially the first year? If your personal use exceeds 14 days or 10% of the rental time, it is considered your vacation property and you can’t take losses beyond your income.
- Is there any limit on how long a person should keep tax records? It depends. Most people recommend three to seven years, unless you know you did something wrong. You’ll want to keep all tax records to convince and defend yourself against the IRS.
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Resources:
Qualified Business Income (QBI) Deduction (199A)
Full Episode Transcript:
Eliot: All right. Welcome to our Tax Tuesday here for June 7th. I’m Eliot Thomas, Manager of Tax Advisors here at Anderson. Right now I’m filling in for our Partner, Toby Mathis. This is our Vice President of Professional Services, Jeff, who I’m sure you’re all used to seeing.
Jeff: Yes, howdy.
Eliot: All right, welcome. As usual, we’ll be going through our questions for you guys trying to bring tax knowledge to the masses. That’s kind of our motto here that Toby put into play. We will get started here right away.
First of all, the rules. Ask your questions via the Q&A system through our Zoom feature. That’s where we have a whole group of CPAs and EAs to help answer questions. The chat section itself will be more for just off comments and things like that that you can make, but please put your Q&As through the Q&A section. They will answer as many as they can.
If we can’t get to it, then typically, we will throw it into our pool of questions for the platinum tax group to answer as well. We’ll try and get through all the questions we can. If you should ever need to submit a question, you can email questions to taxtuesday@andersonadvisors.com.
We get to as many as we can through the show but we’re only able to talk about a few on the show. But behind the scenes, they get thrown through our platinum portal. If you need a detailed response, again, you’ll want to become a platinum client so that we can submit them through there or a tax client. The whole idea is just to quickly give you some fun and educational background about tax. We want to help and educate as much as we can.
Jeff: We all know what chat is really for, throwing shade at Toby. But he’s not here today, so we’re not going to do that.
Eliot: Exactly. Yeah, rules? There are no rules here. All right. Let’s see. Let’s go on to the first opening questions.
“I rent my personal residence and my home office is my primary place of business for my S-corp. Am I a good candidate to take advantage of Section 280A deduction or does the fact pattern disqualify me?” I’m going to go through all the questions here. That was the first one.
The second question, “Is it possible to minimize taxes by selling the C-corp, which holds property via a 1031 exchange, and then form an LLC to buy the replacement property?”
Number three, “I just bought a lake cabin in Wisconsin where we will be renting it out as Vrbo as much as possible, but also using it for some personal use for our family. Will I need to create a new LLC to hold the cabin then? How much of it can I write off given we’re unsure about how much it will be rented out, especially the first year?” Good question. A popular question lately.
Next, “My husband and I are on Medicare but we have businesses. Are we too old to set up and contribute to an HSA?” That’d be a health savings account.
Next, “If you set up a holding company as an S-corp, do you have to pay yourself a salary even though you’re not actively running the business? If so, when do you have to start?” That would be paying the salary.
The last on this page, “When completing the purchase of a lease option, how is the basis determined? If the property will be split, partially sold,” I assume partially kept, “how would you recommend it be held?”
Next group, “I receive income from two rental properties, one single family house, another from a studio at my residence. Would my income from these qualify for the IRS QBI 20% deduction, also known as 199A?”
“Are capital gains from stock trades inside an IRA taxable at the end of the year. Is there any limit on how long a person should keep tax records?” That’s always a popular one.
The last two here, “We are moving from Washington, a community property state, to Utah, which is not a community property state. Do we need to change our LLCs in Alaska and Wyoming to single member entities in order to keep them disregarded?” Very good question there.
“How long do you have to keep your primary house a rental in order to 1031 exchange it into something else instead of selling it and paying capital gains on the excess over $250,000 since I’m single?” The old 121 exclusion there. That is it.
Just real quick before we get started. Some ways to connect to social media, we have our YouTube, we can listen to our podcast at andersonadvisors.com/podcasts. We also have watch replays for your platinum portal.
Another thing that I was reminded of, we have another Tax and Asset Protection coming up on June 18th. Not this weekend, I believe, that’d be next weekend. Everyone who wants to be able to take advantage of that, I’m not sure who’s doing it. I know Clint will probably be there. I don’t know if Toby will be or not, but it’s always a good idea to get into that and see. Even if you’ve seen it before, it’s good to get in there and get a refresher on what’s new and things like that. That’s on June 18th.
Jeff: If I was reading the questions and I think I live for doing that, we’d probably still be back on page two.
Eliot: I’ll slow down when we get to the actual questions here a little bit. I was just excited. All right, first question. I believe we’re doing 11 today. “I rent my personal residence. My home office is my primary place of business for my S-corp. Am I a good candidate to take advantage of the Section 280A deduction or does the fact pattern disqualify me?” What say you, Jeff?
Jeff: Let’s look at the factors here. You’re renting the property. You’re not paying the mortgage or anything on that. That really doesn’t matter. It’s still your primary residence, you have control of it. You can use it for what you want.
We kind of had a question like this the other day about, what if it’s not my rental property? What if it’s community property in the apartment complex? That gets into very murky waters. But in this case, it’s property that you’re renting. You have a home office on it. Neither one of those disqualifies you from taking 280A.
You can get the quotes for doing a 280A meeting, make sure they’re reasonable for what you’re doing. You want to make sure you take minutes. Have other people there besides yourself. You can’t have a meeting if you’re the only one there. It really needs to be discussed. What do you typically tell people, strategic stuff or…?
Eliot: First of all, a lot really comes out of this question. It’s a fantastic question because we talked about that home office. Let’s remember in our heads, we’re distinguishing that from the 280A use. As I explain to people, let’s say that you have that home office in the back bedroom, but your 280A is going to be, as Jeff points out, you have other people come for the meeting, that might be up in the kitchen, the family room, basement, what have you where you have people congregate.
You’re able to take advantage of both, an administrative office reimbursement and the 280A. Now, as far as reasonableness and things like that, that certainly goes to the quotes that you get. Don’t get something that’s too high, it’s got to be reasonable. Remember, if your business didn’t make any money, probably it’s not reasonable that we got the 10,000 square foot ballroom or something like that as a quote.
Jeff: Right. Have you seen that?
Eliot: Yeah, so we kind of get the eraser out on that one. I always tell clients, I strongly suggest that they have over third parties that don’t live in the house. A lot of our clients do real estate. That probably is the easiest game in the world.
If you have any friends, family, colleagues, or anyone you know that is a realtor, have them come over and talk business about real estate. Anybody who’s had a property or lived in one knows there’s something about repairs. If you have a family member, colleague, or acquaintance that is a contractor, have them come over and talk about the latest in repairs or what have you. I really recommend you have other people over. I don’t know that it’s necessarily an absolute, but it’s a really, really good idea. We really recommend that you have other people over.
Jeff: One thing I want to say about the home office and the 280A is you can’t use your home office for the meeting because you’re already being reimbursed for that. The S-corporation, corporation, or whoever was in this case, it is an S-corporation. The S-corporation is not going to reimburse you for their home office and then rent the home office from you.
You need to keep them in separate areas. That’s fairly easy to do. You got people over using the kitchen or the living room, such and such. Your office is probably in the second bedroom or something like that.
Eliot: Exactly, right. Just keep the areas separate and you should be good to go. Directly to the question, no, you’re not disqualified. You are a good candidate to take advantage of 280A and still have administrative office reimbursement. It’s really a powerful punch for your S-corporation and just another thing that gives it more value. Great question.
Eliot: All right, number two. “Is it possible to minimize taxes by selling the C-corp, which holds the property via 1031 exchange, and then form an LLC to buy the replacement property?” Jeff, this one kind of confused me because I wasn’t exactly sure of the fact pattern we’re trying to get across here, but I have some ideas on it. Do you have any thoughts?
Jeff: You and I did talk about this a little. Generally, the answer is no. Do you have something different? Did you come up with something?
Eliot: Again, it depends on what we’re really getting into here because I had a lot of ideas that came through because I wasn’t really sure what the question was. Ultimately, if you’re going to have a property, appreciable real estate, rental, or what have you in a C-corp, first of all, we never recommend that, to begin with. You’re only going to put them in there for flipping property, which lends us with a 1031.
Jeff: You can’t do 1031 on flipping property. It’s considered inventory, so you can’t do that.
Eliot: Yeah. If we had that property in there because it was inventory, then it’s a no-go. We can’t do 1031, as Jeff just pointed out. But what if it was a rental property? A C-corp is certainly entitled to do a 1031. We now know after the Tax Cuts and Jobs Act in 2018 that we can only do it with real property.
It used to be in the day, when Jeff and I are older, you could do it with other things, but now it’s just real property, so it’s in the C-corporation. Then we can do it with real property, a 1031. But here’s a trick. If you’re trying to do it amongst yourself as a related party, I think that’s maybe what we’re getting here with forming this LLC to buy the replacement property.
I keep reading this question. Every time I read it, I see it a little bit differently. If we did a 1031 relinquished property in the C-corp, it wasn’t inventory, so it was just a rental. Then you got replacement property put into a disregarded LLC, that’s questionable because you have to have the same title rule with the 1031.
Most QIs, I think, are going to say you have to put it in the name of the C-corp. Later on, you might be able to move it down to a disregarded LLC. But keep in mind, we don’t really recommend having appreciable assets in a C-corp to begin with.
Jeff: Here’s why I don’t think that works. As you said, the disregarded LLC has to be disregarded to that corporation.
Eliot: Yes.
Jeff: If you sell it from the corp and buy it back in this LLC, that’s disregarded to the corporation and you’re trying to dissolve the corporation, you have succeeded in not doing anything.
Eliot: Yeah, I don’t know if we’re going to try it.
Jeff: You’re going to blow your 1031 exchange.
Eliot: Yeah, you don’t want to dissolve the C-corp. Yeah, these things have to stay. These entities have to continue on. Another reason not to do a 1031, often, if you’ve ever been through our Tax and Asset group or listened to Toby here on Tax Tuesday, he often talks about this.
One of the main reasons to ever do a 1031 is if you’re going to swim in those waters, hold it until you die. Because the whole idea is to get that stepped up basis for your heirs so they can redepreciate it over time. Really not a lot of good reason to do a 1031, unless you’re holding forever. As Jeff points out, if we’re ever going to dissolve that C-corp and we did do a 1031, we didn’t do a whole lot for ourselves by doing that.
Jeff: Yeah, as soon as you dissolve the C-corp, you’re going to have to recognize all the gain on that property, including the replacement property. Anything you deferred by using the 1031, as soon as you do that dissolution, you got to recognize that gain.
Eliot: Yeah. I’m just really scared about the principle that we have, appreciable real estate in our C-corp. Maybe it was intended to be a flip, which in case, when we started this question, we can’t do. I’m all worried about where this question is going and what our end goal is here. But hopefully, all that we just threw out will help a little bit on that.
All right. Next question, number three. “I just bought a lake cabin in Wisconsin where we will be renting it out as Vrbo as much as possible but also using it personally for our family. Will I need to create a new LLC to hold the cabin in? How much of it can I write off given we’re unsure of how much will be rented out, especially this first year?” Thoughts on that, Jeff?
Jeff: Vrbo is like Airbnb. It’s a vacation rental by the owner. It’s actually an entity like Airbnb that works with people who have cabins, vacation property, and stuff like that. The first thing is your losses are going to be limited to your income. Let’s go back and talk about the personal use.
If your personal use exceeds 14 days or 10% of the rental time, it’s considered vacation property to you. Vacation property goes back to what I was saying, you can’t take losses beyond the income. If you make $10,000 on this property and have $15,000 of losses, those $5000 losses get suspended, I believe.
Eliot: That’s correct, they carry over to next year.
Jeff: That’s part of the problem. You’d have to rent it out for at least 140 days to be able to use it for two weeks or 70 days to use it personally for a week. This is one reason I don’t like mixed-use property because it does have built-in limitations on it.
Eliot: It does. Actually, more than what we could go into in this particular setting where they get into the real details of what is a personal use day, what is a fair market rental day? If you had family or extended family, even I believe, that came in and just was even there for 10 minutes, that’s considered your personal use day. Those add up really fast.
If you, again, have the greater of 14 days or over 10% of the number of days that it was rented at fair market value, then it becomes a vacation, you’re going to be limited on your deductions, and there is actually an ordering system that the code has for how you take those deductions. It’s going to be qualified interest first, property taxes.
If there are any casualty losses and then you get into some operational like advertising commissions, et cetera, finally you get down to others like depreciation and things like that. All those are going to be limited by the amount of total rental income we have.
You can. I don’t want to discourage your family from enjoying the place, but it always causes problems for us. I always get the hint that when I hear people talking about this, they’re kind of tempted to see if they could get away with using it more than what the code says.
Jeff: This is really a case when you have a vacation home that a cost segregation does not pay off.
Eliot: Yeah, no. I wouldn’t do that here.
Jeff: Normally for short term rental, you may be able to write off 30% of the cost of the place, maybe more for a cabin in the woods, or something like that. However, since there is a limitation on how much loss you can take, cost segregation is going to fail here.
Eliot: Yeah, but maybe after we got over the initial year first enjoyment of using it for personal use, the second year is kind of like the boat. Was it the favorite days, the day you bought it and the day you sold it? Maybe you’re not using it so much the second year. Maybe we look at the cost seg then. Reach out to us to see if we can look at it, tear the situation apart, and see what’s going to be in your best interest.
Next, number four. “My husband and I are on Medicare but have businesses. Are we too old to set up and contribute to an HSA?”
Jeff: I looked into this. Everything I’ve read was so wishy-washy.
Eliot: My stuff wasn’t. It was very straightforward.
Jeff: Basically, if you are taking part in Medicare A, B, or D, I think in part A, you have to take it when you turn 65. Otherwise, you have severe penalties for not getting on Medicare.
Eliot: Yeah, that part, I didn’t look into. First of all, there isn’t an age limit on an HSA. However, if you are, as Jeff points out, if you’re taking Medicare A, B, C, and D, if you’re taking any of that, then we can’t do an HSA anymore. If we are in Medicare already, we probably would not be able to contribute to an HSA. But there isn’t a listed age limit to it, other than if you’re required to, as Jeff points out.
Jeff: And why is it like this? Because Congress hates older people like me and you.
Eliot: I’m getting into that club. In doing some research today about reasonable wage, which was just coming up here, I saw some of the statistics in how many billions were missed because people were not paying reasonable wage on their S-corporations back in the early 2000s? I want to see where that goes.
Jeff: I believe we have a question on that.
Eliot: We do. That’s why I was researching it. All right, next. “If you set up a holding company as an S-corp, do you have to pay yourself a salary even though you are not actively running the business? If so, when do you have to start?”
Jeff: Wow, that was amazing.
Eliot: Right? I didn’t even see that.
Jeff: I found this question to be interesting because it was kind of unexpected. You have this S-corporation, you’re not actively managing it. Let’s say it’s a restaurant and you got a manager, do you have to pay yourself a salary?
Eliot: I don’t think you do because it’s passive income typically is the way we look at that. I think you might have the interest of the IRS because you probably are going to take distributions. Usually, that’s one of the key flags they look at. If you take distributions out of an S-corp, generally speaking, you have to pay yourself a reasonable wage.
If it’s all passive, I don’t know that you would have that need. I don’t know that you want to avoid that, though. You might have reasons why you’d want a salary so you could contribute to retirement plans or something like that. Also, depending on the nature of the income coming into the S-corporation, it could be some of the nature like portfolio or what we call separately stated items on an S-corporation.
For those of you who don’t know an S-corp very well, you could have income that comes on to the S-corp return, but it’s not the income of the S-corp. It actually goes through a K-1 on to their 1040, the individual, in a different place. Certainly, I wouldn’t see how you would be responsible for a reasonable wage if that’s all you had, separately stated income. Back to Jeff’s point, if you’re passive about it, I don’t know that you would need to have a wage.
Jeff: You’re right. In the early 2000s, they were really heading this up to like 2008. They were really hitting this hard. Not so much anymore because they don’t want to open up two different title cases.
What I was trying to get at in a roundabout way is that the tests really look at what you’re doing for that S-corporation and what you should be paying yourself for that S-corporation. If that’s nothing, you have a bookkeeper, you have a manager, you’re just cashing checks…
Eliot: You certainly have a good argument for not paying a reasonable salary. Like I said, you might get the attention of the IRS if they were looking at that more because they see a distribution, they see no salary. I think you have a good argument. Well, look, I don’t manage. Why would I pay myself a wage?
Jeff: If you have no employees and no third parties working the stuff, they’re going to determine that you’re managing the company.
Eliot: Yeah, you have to have a paid manager, someone that you set up. If I had my S-corporation and I was completely hands-off, I’d have to pay Jeff or somebody to be the manager of it.
Jeff: Maybe not like Jeff.
Eliot: Yeah, probably Toby, not Jeff. All right, next. “When completing the purchase of a lease option, how is the basis determined? If the property will be split or partially sold, how would you recommend it be held?” I thought this was a really intriguing question because a lot of people have options. First of all, maybe they don’t understand what’s really going on. Is there actually a sale or not a sale? Any thoughts on that?
Jeff: Generally, the IRS has been saying, if you got a lease option, it’s probably a sale.
Eliot: They’re going to look at the totality of the facts. But if you have these lease payments that are above normal rent, you take the cost of those over time, and now this option, payment, whatever it is, if those kind of add up to what the fair market value of the property is today when we sign the agreement, IRS is going to say, you effectively sold it. There’s an economic sale there, so you’re going to have to recognize taxable income. Maybe you can get by with an installment sale, perhaps, then it’s sold.
What happens with the basis? It’s going to be dependent on what our sales price is today. That’s what we would have to basis. If we’re split, partially sold, I don’t know what the other part is, maybe we kept the other part. Maybe it was a duplex?
Jeff: Going back to the lease option payment that you paid, the IRS has generally considered that you’re doing an installment sale and that is your down payment on the property. Then they will bifurcate that payment as to what it is. You’re right, that’s usually going to fall into basis somewhere.
Eliot: Yeah, we’re going to throw that amount in there. That’d be their basis. Your basis would be your adjusted basis when you really originally purchased plus—
Jeff: They did say the purchase of a lease option.
Eliot: Yeah, okay. Your purchase will be based on the fair market value of the house that you got it at, and then any improvements or depreciation over time will change that. But the split parts will be split and partially sold. I guess, if you’re selling off part of it, like I said, what came to mind was a duplex situation or something. Then yeah, I think the best word is bifurcate. You would allocate or ratio out those amounts accordingly.
Jeff: Would you have to do a division of parcel?
Eliot: I think so because usually, a duplex, it is. They’re separate tenants. I’ve heard that in some places that they have a different ability to separate out. If you have a four-story building and each floor is separately contained autonomous areas, that can be done. I have seen that in certain towns.
I honestly don’t know if that’s a state and local thing, I would imagine it is. You’d have to kind of check to see what the local rules are. I think, certainly, you’d have to have some kind of designation that splits out these areas.
Jeff: Yeah. Typically, I’ve seen when they’re duplexes, side by side. In some places, it’s all one property. In some places, they’re each separate properties. I think that would first need to be determined because I don’t think you could sell half your property if it’s part of one parcel.
Eliot: Yeah, we’re going to have to bring in the real estate attorneys to figure out or the local boards that determine that type of thing. That is very much a state and local specific issue. As we often say, here say, well, 50 different states, 50 different answers. Although unfortunately, most of them typically follow one or two other similar patterns, you’d have to look at them and see what’s appropriate for your area.
Jeff: You started talking about lease options. If you’re the seller, you’re the landlord, and you receive a lease option, how are you treating that?
Eliot: If I’m the one selling it?
Jeff: Yes.
Eliot: I’m going to have to go back and look to see if it is actually a sale, which typically Jeff and I are saying would be. Then I’m going to look at my original basis, again, plus any improvements, less any depreciation. That gives me my adjusted basis. I subtract that from the sales price. If I’m getting the payments over time, we now are looking at an installment sale situation, where I only have to recognize a little bit of gain for each payment I receive, we do that on the sales ratio.
Jeff: Okay, let’s look at something else. I give you a $5000 lease option. I never follow through with it. How is that treated tax-wise to me and how is that treated tax-wise to you?
Eliot: You never paid?
Jeff: I gave you the $5000. It’s a non-refundable lease option, yet we’d never completed the sale.
Eliot: Yeah. I suppose I would have to give it back. It depends on the agreement.
Jeff: Yeah, let’s assume it’s non-refundable.
Eliot: I think I’d still have to call that income. Whether it’s capital gains or not, I don’t know about that. It certainly would be income to me because I’m retaining it, I just got free money. I don’t know.
Jeff: That sounds like you said before that a portion of it would be taxable income under the installment sale rules. But you’re saying if the sale never happens and you get to keep the money, that’s income to you?
Eliot: Yeah, I’m going to say 100% […] there. As far as your side of it, I don’t know if you can call this a lost deal or something like that of that nature. I’m not sure if you could get away with maybe a short term capital loss type thing.
Jeff: It’s probably going to be lost money that you’re never going to be able to deduct, collect, or anything.
Eliot: Yeah, so we’d have a tough situation. All right. Just great questions all the way around.
“I receive income from two rental properties. One a single family house, another from a studio at my residence. Would my income from these qualify for the IRS QBI (Qualified Business Income) deduction 20%, otherwise known as 199A?” It could.
Jeff: The single family residence definitely would if you’re making money, of course. What about the studio?
Eliot: Both of them have to be considered a trader business. That’s the key. The big debate when this came out was, is rental activity a trader business? That had been resolved sometime before. The question was whether or not that still was applicable to 199A back in 2018. It looks like it was.
One could argue having a hard problem or maybe a tougher time arguing that it’s a trader business if you had just one rental, but most practitioners that I know would still consider it as such. Back to the studio residence, you’re going to have to run it like a business, keep it separate, and have all your detailed documents. You could if you treat it as a trader business. Especially, because you’ve already set a precedence of having another rental unit, then you’d probably have a stronger argument for it.
Jeff: Yeah. Another thing to keep in mind is there’s an aggregation rule that applies to 199A, the QBI deduction. That is if my single family residence makes me $5000 in a year, but I lose $6000 on the studio. I have to combine those and end up with a $1000 loss and I get no deduction for that.
The QBI deduction is based on the aggregation of all trades of businesses. If I have Toby’s pizza shop and my single family rental, we’ve seen it where rentals are typically run in the negative. They run at tax losses. If I have income in the pizza shop and a loss in my single family rental, they have to offset each other first. I could possibly not get any QBI 20% deduction from my pizza place because of my other losses.
Eliot: Yeah, it’s an ongoing tally, almost like our passive loss rules. To just point on the aggregation, please do not confuse that with aggregation for real estate professional purposes. That’s a whole different ball game, but an unfortunate use of the same terms. That’s our tax code.
Jeff: They do that a lot.
Eliot: Right, exactly. Safe harbor is another one they love to throw off your left, right, which they have the safe harbor for this as well.
Jeff: Passive income is one that means something for Section 469, something different for foreign income, so completely different.
Eliot: If you ever go out there trying to research some of the stuff and you say passive income, you’re going to get things from financial institutions talking about interest and things that you don’t actively work out. That’s different from what the IRS is talking about with passive income often. They call that portfolio income, so vocabulary becomes kind of critical.
Jeff: Let’s say that I aggregate all my trades and businesses and I have a $2000 loss in 2020. I go to do my taxes in 2021 and I have $5000 of income in my trader business. Does that mean I get a $1000 deduction? No because that prior year loss carries forward and gets aggravated with all your trades and businesses once again.
Eliot: There’s a sheet that you should fall on your 1040. If you don’t have it, probably your tax preparer does on their copy. That’s going to track all these carryovers, your traditional ones or net operating losses, capital losses carryover. Now we have this whole sheet dedicated to 199A purposes of carryover or just that purpose.
Jeff: One thing I wanted to bring up while we’re talking about QBI Section 199A, the 20% deduction, whatever you want to call it, and going back to the S-corp salary subject, this is really a balancing act. You’ve heard Toby say the one rule is calculate, calculate, calculate. Because by paying myself a salary, I’m lowering that QBI deduction because that QBI deduction is based on the income from my S-corporation. If I made $100,000 in my S-corporation, I’m going to get a $20,000 deduction. Okay, just checking my math.
Eliot: More salary, you have less taxable income, but then you’re going to add employment taxes and things like that. It’s a very difficult thing to find that perfect area where the two meet.
Jeff: Right, because we’re also talking about you mentioned retirement plans earlier. You got to have compensation to do retirement plans. You may have medical insurance being supplemented by your S-corporation, which an S-corporation can do. That’s one medical expense they can deduct, but comes back to your salary. You really have to look at this 20% deduction like, am I paying myself enough? Am I not paying myself so I can get a bigger deduction?
Eliot: It’s a challenge. You almost need the new quantum computers to put all these factors in and get it right. It’s not easy.
Jeff: One more thing about the reasonable salary. If my company makes $100,000 and I don’t pay myself a salary, I have $100,000 of taxable income, correct? And we’re going to ignore the 199A, the 20% deduction. If I pay myself $30,000 in wages and ignore payroll taxes, I’m still going to have $100,000 of income on my 1040. I’m going to have $70,000 from the S-corp and $30,000 in wages.
Why this matters to the IRS is they’re chasing that small percentage of payroll taxes. They want you to pay Social Security. They want you to pay Medicare. They want you to pay federal taxes. You’re going to pay the federal taxes regardless.
Eliot: Yeah. Fed taxes state income taxes, that is. The IRS, in fairness to them, they’re doing what they’ve been mandated to do, go out there and shore up retirement. Everybody’s worried about retirement. Well, maybe if people pay their reasonable wage and their S-corps, we’d probably don’t know how far that would move the needle down, but it would have been adding to it.
Jeff: I paid a reasonable wage for myself. Get off my back.
Eliot: I actually have friends I tell about this and they’re just like, yeah, you know what, I don’t do the returns. I don’t think I need to pay that much a reasonable wage. It’s something that we always have to wrestle with, especially when you throw in that 199A.
Jeff: That’s a good point. But if you’re my friend and you asked me to do the tax return here, you’re no longer my friend.
Eliot: I’m not doing it either. I’ll stay away from family and friends because of those.
All right, next. “Are capital gains from stocks traded inside an IRA taxable at the end of the year,”
Jeff: I get this question frequently.
Eliot: Yeah. It’s kind of neat that we get this because people are thinking they’re worried about capital gains, but they’re forgetting it’s in a retirement account. What happens?
Jeff: Nothing.
Eliot: Exactly right. Because if your stock can go up, up, up, up, Bitcoin, two years ago, 80,000, all that gain, if it was in your retirement plan, there’s no tax until you retire. Even if you sell it, there’s no gain. It grows tax-free until you distribute it to yourself. That’s where the hammer comes down with taxes. Not a problem here at all from gains, as long as you haven’t distributed anything out of your plan.
Jeff: Yeah, realized capital gains mean nothing inside of an IRA. Any kind of QRP, it also means nothing inside a nonprofit. The one disadvantage, and it’s just a slight disadvantage, is capital gains to you personally, if they’re long term capital gains, get taxed at a much lower percentage. When you pull all these capital gains out of your IRA, you’re pulling at your regular tax rate, not the lower capital gains rate. It’s kind of a trade-off.
Eliot: As far as tax planning, that’s always that big issue. Do I think rates are going to be higher when I retire or lower? Toby gets hit with that. I know all the time because I see it tax-wise and all that and here with Jeff on Tax Tuesday.
Should I do a Roth or whatever? You’re always playing that game of, do I think taxes are going to be higher or not? We don’t have that crystal ball, but I believe Toby often talks about it. He’s done a lot of research and cracked a lot of numbers.
Often, if you’re older, there’s probably no use to going into the Roth. If you’re trying to do a conversion in a Roth, it’s probably not worth it because you have to make that backup, that amount of tax you’re paying. Just some thoughts, but directly to the question. You just have gains and you haven’t taken anything out of your IRA, that all grows tax free until you take it out later on in retirement.
Jeff: What is the one time that I’m going to have to pay tax in my IRA?
Eliot: If we do different types of investing, we’re talking about capital gains here. What if it’s something that didn’t create capital gains? What if it created ordinary active income like a real business? Take Toby’s famous pizza shop. If you invest in something like that, an active business, you could have what’s called unrelated business taxable income or UBIT. Sometimes, you can turn the I and T around.
There you’re going to get hit with heavy taxes. The brackets aren’t much higher than regular, it’s just that they rise really fast. By $10,000 of income, you’re at a 40% tax bracket or something and it’s critical. The whole idea is to punish those who invest in that kind of thing because the IRS needs a level playing field or the Congress wants a level playing field between Toby’s pizza shop that’s out in the private world and if someone’s investing in one through their retirement plan.
Jeff: I have a couple of investments in my portfolio. Not my retirement portfolio, my regular portfolio, Sunoco Limited Partnership, All American Pipeline, and a couple of others. These are almost all publicly traded partnerships. They usually have limited partnership in their name.
I’m not giving investment advice on this. They tend to pay pretty decent dividends because of the nature of the business, but they also generate exactly what you said. They generate ordinary income, sometimes ordinary losses, which is not a big deal.
If I have the Sunoco in my IRA account and it’s generating ordinary income, these limited partnerships send out K-1s even though they’re traded on the stock exchange. I have to report that ordinary income as unrelated business income, which gets taxed. What’s the percentage of that?
Eliot: Again, it is bracketed, but it grows really fast. It’s on, I think, trust rates. I don’t know the exact brackets, but I believe the highest is 40%, 37%, or something like that. It’s up there. But again, it takes very little time to get up there, like $10,000, $15,000, or something like. It grows very fast.
Jeff: My advice is if you have anything in your retirement accounts that say limited partnership, I know you bought it on the New York Stock Exchange or whatever, Kinder Morgan’s another one. You may want to dump those puppies.
Eliot: Yeah, unless you’re making a ton of money. If you’re making a ton of money and you’re getting taxed for it, you’re still gaining.
Jeff: I don’t think people even realize what they bought until they’ve already bought them.
Eliot: How often do I get to say that?
Jeff: Yeah, that’s the one time you may have to pay tax out of your IRA. The other time is the qualified interest one, the financing one.
Eliot: Unrelated debt-financed income, which is really considered a subset of UBITs, but it’s directly related to when you have debt involved. Do you want to go into that further?
Jeff: From what I’ve seen—you can disagree if you think I’m wrong—I’m getting income from this entity that was paid for by financing. They went out and got a loan for the $100 million and then paid out distributions to their partners or shareholders with that money. That income becomes taxable.
Eliot: It’s a ratio between the amount for the project that was financed with cash from the investment and how much was from debt. You have this ratio and the amount. Let’s say you get $100 of income. We’ll say it’s 60/40, 60 cash, 40 debt. Forty percent of that income or $40 will be subject to this UDFI, which is that same super accelerating tax bracket. At $40, you’re already taxed at some crazy amount like 25% or something like that. It takes a little time to get up there.
I believe if you look through and you do enough research, I don’t know why anybody would, but I think UDFI is really just a subset of UBIT. It’s just that UBIT’s the most popular one. You don’t hear as much about finance, but it happens a lot, especially with the clients in our realm who might be going into investments in real estate where they’ve taken on a lot of debt to build maybe a syndication or something like that. They did it with an IRA. They did the investment there. It could be an issue, something to be aware of.
Jeff: And UDFI only affects IRAs, not 401(k)s, correct?
Eliot: My understanding is that you can get in these very narrow circuits where you might get hit with it in a solo 401(k), but it’s far more unlikely that you run into UDFI there. Just different rules and different kinds of things going on with the solo 401(k). The IRA is the one that really gets hammered with it, typically.
Jeff: If you’re investing in your typical common stock, preferred stock, bonds, if you’re doing options, all of that’s going to be non-taxable while in the IRA. All that typical trading stuff, it’s just a few of the weird items that can get you into a bit of trouble.
Eliot: Yeah. Again, coming all the way back around. Capital gains, typically, no problem. Then your IRA, we want those. They just grow and grow and grow tax-free, unless you get into some kind of investment that has unrelated debt taxable income or unrelated debt-financed income, or you might get some tax on it at a very high rate.
Next, “Is there any limit on how long a person should keep tax records?” I love this one.
Jeff: What say you?
Eliot: Everyone disagrees with me. I’ll just say this upfront. First of all, you have to understand, the real crux of this question is, how long do you think you need to hold them? Generally, you’re going to hear three years because that’s typically how far the IRS would normally go back for an audit. But that’s not always the case, is it?
If you have over 25% of gross understatement of your income, which could be from things like just the income itself you understated or maybe you overstated basis on a sale on something, then they can go back six years. Or in the case of you’re really bad, you have a fraud, there isn’t any limit. If you really want an answer to this, I don’t think there’s any time that the IRS will say, just throw your tax records away. But as a rule of thumb, people usually say three to five years.
Jeff: I usually say seven years. All the statutes that use the six years or all of them that use a six-year statute of limitations, they’re all considered tax crimes. You’re going to probably have somebody from the criminal investigation team or maybe even the fraud team come visit you.
Eliot: The Madoff people coming your way with that orange jumpsuit.
Jeff: If it’s just a substantial underpayment of tax, you’re probably not going to be in any kind of criminal trouble. There will be a substantial fine, usually 10% of the understatement, $5000 or 10% of the understatement. It could eat up a lot of money.
Eliot: But in today’s world of digital, how hard is it to keep tax records for the last 1000 years on a little drive? I don’t see it as that big of a deal. If you have paper records, scan them or whatever. I think you want to keep them for a while because what are you going to defend yourself with? Not that you went out and committed fraud, but…
Jeff: Let’s say I keep my last seven tax returns and they think I’ve been up to no good and they come and audit me for 2015.
Eliot: Back in your crazy days?
Jeff: Yeah, because I think I was up to no good. But also I’ve kept it as my tax returns. Does that do me any good, if I haven’t kept more of my backup, my substantiation?
Eliot: It becomes difficult for you. Again, it’s on their side to show that something was done wrong on the return. They have the burden. But if they reach that burden, you have nothing to defend yourself with. It’s a tricky business, but really this is for your criminal attorney.
Jeff: Yeah, just keeping your tax returns really does you no good if you don’t keep the backup for it, if you don’t keep your W-2s, your 1099s, everything you used to come up with your expenses and so forth.
Eliot: Yeah. Not exactly. It’s kind of an it-depends answer. But I think seven years, you’d probably be looking really good, unless you knew you did something wrong. It would be very difficult for you to get into a situation where they call fraud on you and you had no idea. Usually, you have an idea if you’ve done something that bad. You kind of know you went down the wrong path. Then maybe you want to keep your records in case you have to defend yourself.
Jeff: If they’re looking past seven years, don’t worry about it because you can’t keep your tax returns in Leavenworth from what I remember.
Eliot: I can’t take on using the staples to break out.
Jeff: This goes back to one of the things we’re always preaching about, substantiation. You don’t have to prove it to your tax preparer what your deduction is necessarily, but you may have to prove it to the IRS, so always be able to substantiate everything you want to deduct. Don’t worry about substantiating your income because the IRS will do that for you.
Eliot: Yeah. I often tell clients, look, I’m not the one you have to convince. A preparer will require that you are stating that you do have backup for anything that they put on the return, so then it becomes the taxpayer’s burden and responsibility.
Jeff: You know what’s funny about this question? The IRS just got busted for destroying 30 million backup items.
Eliot: Yeah, a lot. That is a shred job right there. That puts the White House to shame.
Jeff: They got nothing on Arthur Andersen.
Eliot: No. What kind of shredder does that? All right, next. “We are moving from Washington, a community property state, to Utah, which is not a community property state. Do we need to change our LLCs in Alaska and Wyoming to single member entities in order to keep them disregarded?” What say you, Jeff?
Jeff: Let’s see if our answers line up. They may not. I’m of the opinion that once I move out of that community property state into Utah, it’s no longer community property. My LLC will have to file as a partnership if both me and my wife own that LLC.
Eliot: Correct. It becomes an issue, potentially. We run into this a lot, where we’re talking about 1031s. I did a 1031 back in a community property state, and now I moved with my spouse into a non-community property state, turning something into a partnership, also destroying our 1031 because you’re not in the same title if you come into a partnership.
In this situation, if you want to keep it as single member, probably just one of the spouses off it so that there’s just one spouse on these. It keeps it disregarded when you move into the non-community property state.
Jeff: You and your spouse have unlimited gifting to each other. They could gift their interests and you could gift your interest to them to keep this so you would only have one owner. You can also fill in a little estate planning to make sure they get their share of it, they get it if you should pass, make them a beneficiary, or something like that. The Alaska one, they have a few strange entities in Alaska.
Eliot: I don’t know if strange is the word.
Jeff: Strange compared to other sets.
Eliot: The thing that’s neat about Alaska, well, there’s a lot of great things. I actually love Alaska. I went there a couple of times. They have, I guess, a quasi where you can kind of pick whether you want community property or not when you’re there, so that’s really unique.
As far as different types of entities, I’m sure they have some different things. But strictly to the LLCs, even if it’s a different type of entity, the IRS is going to have a rule for how they’re going to tax it, and that’s what matters. If there are two people on it or more than one member in it, it can’t be disregarded once you leave that community property state.
Jeff: No. One advantage of turning this into a partnership is if you’re planning on growing the number of properties you hold, you’d rather have these properties in a partnership because it gets reported on page two of Schedule E rather than page one of Schedule E for rental properties. The banks tend to give you more credit for the income generated from those properties.
Eliot: That’s right. You’re more lendable or higher amount that can be lent for having a partnership. Generally, Clint would beat us both. Clint talks about this all the time in Tax and Asset Protection. One of the great attributes of the partnership is that lenders will give you more. Of course, they have their own rules, their own limitations of what they can lend, but that’s certainly one of them, something they’ll look into. If you can get more of that money to work with, better investments, more growth, is just a win-win.
Jeff: What are some of the disadvantages of moving from Washington to Utah now that I’m in a non-community property state? You’re going to have to pay for another tax return. It’s not going to change your annual registration fees.
Eliot: Probably not. With the states, no.
Jeff: Because you’re registered in Alaska and Wyoming, you’re going to pay the same thing already.
Eliot: Correct. You’re going to, again, have another tax return. And in the case of the 1031, it could have issues if you have a property that already went through a 1031, that might be an issue.
Jeff: But it’s the same entity, though, isn’t it?
Eliot: Not when it becomes a partnership, that’s the whole problem. A partnership, LLC is not the same as you take that same jettison with the partners and become disregarded. They’re not the same thing in the eye of the IRS.
Jeff: No. I’m saying if we take a husband and wife disregarded entity and we move in, they’re now a partnership because of the rules. Same entity, same EIN. It’s just the tax filing is now a partnership.
Eliot: The problem is it’s the partnership. In the case of the 1031, that owns the property, not the individuals in a disregarded LLC. So no, you still have an issue. You got to be very careful with 1031s.
It’s one of those things that’s not easy, but can be worked with. You’re going to have some tenants in common arrangements and things like that. They’re a little more advanced or a topic for another time, I should say. There are things that can be done to work with it.
The sky is not falling if we’re in the situation, we just need to work it out properly. Sometimes we need to work it out a little bit in advance. That’s always the key. Try and get it done first early before we do anything drastic like move to a community property state. I think that’s it for that one.
Jeff: Tax law is hard.
Eliot: Taxes are hard, just in general. “How long do you have to keep your primary house, a rental, in order to do a 1031 exchange to exchange it into something else instead of selling it and paying capital gains on the excess $250,000 since I’m single?” I think we have to look at 121 first on this, maybe, just to get an idea on what that even means. Any ideas on what that is?
Jeff: Section 121 says you have to have held it for two of the last five years. He mentions the $250,000 exclusion that goes along with Section 121. It sounds like he’s going to turn this into a rental. I don’t know. What do you usually say when you’re asked this?
Eliot: What we’re trying to do here is take advantage of both 121 and 1031. As Jeff just laid all the groundwork there, 121 says that you have to have it two of the last five years of not just used, but ownership as a primary residence.
Let’s just say we have our house and this individual has used it as their primary house two of the last five years. Now they want to get some kind of 1031 going. They can’t do it at that moment because at 1031, as Jeff always has to remind me, is only for a property that’s been put in a trader business and we don’t have that here. That’s a personal house.
Let’s say they rent it out, as they mentioned here in the question, so now they’re going to rent it out. Let’s say they rent it out for a year or two, but how long do they have to rent it out? Nobody knows. It’s not in the code. You ask 100 different people, you’re getting 100 different answers.
Typically, a lot of the more conservative answers say maybe two years of rentals. Some will say, and I’ve heard Toby say this, it just has to be a trader business, so that might be a shorter period of time. I’m not going to put words in Toby’s mouth, but there isn’t anything in the books to tell us. You just have to prove that it’s a trader business.
Let’s just say it is a year or maybe two years that you hold it, then, because you still have the 121 aspect that you have had it as a personal residence two of the last five years, you can take off or exclude $250,000 capital gains, and then you 1031 the rest. The calculation will have to be done on that and you’ll be able to defer the rest of the capital gains.
Jeff: Here’s my opinion on this and it’s not quite as conservative. I do agree. I like the one-year holding period as a rental property. I do not want to see a primary residence, rental property sale in the same tax year.
Eliot: Yeah, no.
Jeff: They’re just asking for trouble at that point.
Eliot: I would agree. Yeah. Try and have a year of solid rental income showing on your return. It might be a good idea that you do have rental income. Don’t just say it was available for rent. I think you really do want it showing that it was rented.
Jeff: Even if you have rental income saying 2021 and some in 2022, all the IRS sees is that you’ve rented it out in two separate years.
Eliot: Unless they look further, but they probably won’t.
Jeff: Yeah. A lot of it is perception. We’re not trying to get around the rules. Because as you said, there are no rules for this. There are no guidelines.
Eliot: There’s no rule for a reasonable wage on S-corporations or we start all the way back in the beginning on this. Sometimes, it’s a gray area.
Jeff: It all depends on whether your judge had a good day that day.
Eliot: Yeah, or the auditor.
Jeff: But yes, it’s a perfectly reasonable thing to do. Another thing we sometimes suggest, I’m going to go with the S-corp, you sell the property to your S-corporation. Now you’re going to have to recognize the gain, but you can 1031 it. Wait, I’m doing something wrong here.
Eliot: We went through a 1031 right now, but you can sell your S-corporation if you really wanted to keep that house and still recognize the $250,000 here. As Jeff pointed out, you’re going to have to pay the taxable gain upfront. Even if you’re being paid by the S-corp for the house on installment, if you sell it to your S-corporation, it pays you back, you’re going to recognize all the gain in the year that you had that sale because it’s a related party.
We can do installments as far as you receive income over time, but you have to recognize all the gains in the case with a related party like you sell it into your S-corporation. Down the line, though, you could do a 1031 exchange. The benefit of the S-corp, what it does is that against the S-corp stepped up basis to fair market value, and you can do all this magic with depreciation there, cost seg, bonus depreciation.
Jeff: I’m going to backtrack a little bit. Right now, if Toby was here, he’d be looking at me like I got three eyes. If you want to defer all the gain, not pay any gain in the current year of sale, you need to do the 121 and the 1031. You need to do the primary residence exclusion and the like-kind exchange.
Eliot: Yeah, no S-corp. Again, the original question is, how long do they have to keep it as a rental? Enough to show that it was a real estate trader business and there isn’t anything that will tell us. Well-intended, very educated tax people will tell you different things about that. I’ve heard anywhere from six months to a year to two years. There just isn’t anything definitive out there.
Jeff: Let me ask you this, and I know we’re running up against time. If I turn my house into a rental but I only offer a six-month lease and then sell it when that lease is up, do you feel like that’s evidence that I intended to sell this house right away anyway?
Eliot: Yeah, it depends what side you’re arguing. I’m going to argue that, yes, that is exact evidence that you had every intent of doing all this. But you’d have to come back with a counterargument. I was just ringing it, and then during that time period, I decided to sell. It becomes a facts and circumstances thing, which you never really want to get into, unless you have a lot of facts and a lot of circumstances that are in your favor.
It’s really easy to sit here and try to ask these questions, but they’re very difficult to answer because there’s so much, and as Jeff points out, it depends on what kind of day the judge had. Also, a lot of factors that go into that are under the circumstances.
Jeff: I frankly like to think about when we’re answering questions like this that I am always subject to audit. The percentages may be very low right now, but I don’t know that I want to play those odds.
Eliot: Yeah. You never want to get into that conversation. I think there’s a low chance of an audit. That’s not the reason to do something tax-wise. We want to keep within the rules so we can all sleep at night and not do anything crazy. You didn’t do anything wrong if you just rented it in six months. It’s just that you may have an uphill argument.
Jeff: Yeah. Anytime you’re pushing the envelope, that doesn’t mean you’re wrong. You just need to make sure you have an argument to go along with that.
Eliot:: They call it passing the laugh test. It doesn’t mean you’ll win, but at least you can show you didn’t have fraudulent intent. All right. Again, thank you for your time. Thank you for joining. I don’t know if Toby will be back for next Tax Tuesday or not in two weeks.
Jeff: I don’t know. It might be me and Eliot again.
Eliot: Oh, boy. Anyway, if you have questions, please email them at taxtuesday@andersonadvisors.com or visit us at andersonadvisors.com. Last reminder, June 18th, I believe it is, the Tax and Asset Protection coming at you from Anderson. Be sure to look into that. Thank you so much.
