Eliot Thomas and Jeff Webb of Anderson Advisors talk about how to maximize tax deductions for your home office and answer more of your tax questions. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- I have an S corporation. Can I institute a health reimbursement account (HRA) plan? Yes, you can have an HRA and an S Corp. The problem is that you cannot benefit 5% shareholders. An HRA can only be for the employees of the company.
- Can a real estate professional status be claimed year to year with yearly gaps on any years that you may not qualify? Yes, this is an annual test. So, you must re-attain real estate professional status every year or possibly experience passive losses.
- If I personally fund my small business, can I deduct all the monies I put into the business from my business taxes? It depends on the type of business and how it is structured. Basically, you are contributing money to your business. So, even if it’s a pass through, if it’s a corporation, it’s not a deduction, but an investment.
- What expenses can/must be kept/recorded in order to get tax reductions or deductions for a home office? All of them, including your utilities, water, trash removal, HOA fees, gas/electric power, property taxes, cleaning expenses, and mortgage interest. Keep any records around those items. Also, calculate for the depreciation to that area.
For all questions/answers discussed, sign up to be a Platinum member to view the replay!
Go to iTunes to leave a review of the Tax Tuesday podcast.
Resources:
26 US Code Section 721 Exchange
Full Episode Transcript:
Eliot: Hello. This is today’s version of Tax Tuesday. I’m Eliot Thomas, manager of Tax Advisors here at Anderson filling in for Toby Mathis, who will be back for the next episode. I’m joined here by Jeffrey.
Jeff: Hello.
Eliot: VP of Professional Services, my boss. Anyway, this is our Tax Tuesday. We come back every other weekend or every other week on Tuesdays. We’ll answer some of the questions that you submitted. We’ll get started on those. First of all, I’m reading them all off here.
First of all, our text today rules, I guess. We’re going to ask that you put in your questions for the Q&A feature in Zoom. We have a whole staff back there. We got CPAs. We got EAs, all kinds of people, bookkeeping managers, et cetera, to answer all those questions through your Q&A. It will be the very best to get through all the questions.
If there are questions that we can’t get, sometimes we’ll ask that you just submit them through the platinum portal for your platinum client. But we try to get all the questions that we can answer. This is not really an exercise where we’re doing tax planning, so please keep your questions as generalized as you can.
You can email questions every time to taxtuesday@andersonadvisors.com. If you need a more detailed response, you will need to become a platinum or tax client. I guess the overall idea is we want to help educate and bring tax knowledge to the masses. That’s Toby’s phrase for it.
Jeff: It’s his registered trademark.
Eliot: Yes, it’s the trademark word. All right, we’ll get started here.
Jeff: If you do have questions, like Eliot said, make sure you put them in the Q&A portion. Do not put them in the chat. If you have just general comments or jibber-jabber, go ahead and put those in. While we’re reading the questions, just to make sure everybody can hear us okay, could you put in where you’re listening from or watching from in this case in the chat portion?
Eliot: Not in the Q&A. Looks like we’ve got one person, Boston.
Jeff: You can see those fair enough.
Eliot: Yeah, we got Florida, we got Tucson, Texas, New York, and a whole bunch of them. I think they can hear us okay. Los Angeles, San Diego. Nome. Oh, yeah, I love Alaska. All right, we’ll get started here.
First of all, again, I’m going to go through all the questions, list them off here, and then Jeff and I will go back and answer them all. First three here we have on the screen. “I have an S-corporation. Can I institute an HRA plan?” We’ll get to that one here in a second. That will be our first one.
Number two, “Can you deduct the renovation costs of renting the basement in the tax year 2021, but you do not have any rental income until the next year in 2022?”
Number three, “Can a real estate professional status be claimed year to year with yearly gaps on any years that you may not qualify?”
Next group, “If I personally fund my small business, can I deduct all the monies I put into the business from my business taxes?”
Then, “Hi. I have two large taxable events for 2022. Are there any tax strategies to offset or mitigate the taxes on the following? (1) 401(k) withdrawals to invest in real estate syndications. I already had the majority of the taxes withheld at withdrawal, but there is still a 10% penalty, which would be about $30,000. (2) We have a selling of the primary residence in 2022. After all improvements and closing costs, as well as a $250,000 exclusion are subtracted, I still have about $100,000 taxable gain there.” Excellent question there.
Next, “I am considering buying a small private plane,” one of our favorites, “With my brother for 100% business travel and potentially written out for other fliers when we’re not using it. Should we create a partnership to own the plane, and then have our other businesses rent out the plane for respective work trips, or should it be owned another way? Advise on the best asset protection and tax strategy here.”
Next, “How long do you have to keep your primary house a rental in order for a 1031 exchange to get it into something else, selling it, and paying capital gains in excess of $250,000 since I’m single. We’ve lived in the primary house for nine years and we’re considering downsizing.”
Next, “I am about to purchase the home where my parents live in New York. It will be listed as a primary home, but I will only visit. The bank is saying that with special circumstances that I’m able to do this as my parents are not able to get a loan. This way, I won’t pay a higher interest rate. How many years should I wait to put it into an LLC? I take care of all expenses. My mom said I should claim all of my taxes, but I don’t feel this is right, because it’s not the reason that I’ve been doing this for the past seven years. They are both retired and don’t work. She said it’s to help me get something back.”
Next, “Please explain the difference and pros and cons between our section 721 exchanges and 1031 exchanges. Why have we never heard of this before? It sounds amazing compared to the 1031 exchange.” A lot of excitement on that one.
Okay, “What expenses can or must be kept recorded in order to get tax reductions or deductions for a home office?”
“My W-2 income triggers high taxes to my current paycheck,” I think that’s RMDs, required minimum distribution. “Social Security, et cetera. How can I decrease this for this year and next year by starting an Airbnb info to questions submitted? I’m a physician by profession and have decreased work hours from 20–25 hours per week.” I guess that’s it.
All right. Just before we begin, just a reminder that you can reach us on YouTube. Subscribe into our YouTube channel at abalink/youtube. We have a podcast through Google and Apple. Lastly, we have replays on your platinum portal for this show.
Jeff: We are broadcasting on YouTube right now, I believe.
Eliot: Yes, I think we have Dana over there. She’s usually our YouTube expert. All right. Again, questions, when you want to send them in, send them to taxtuesday@andersonadvisors.com. You can just get us on our primary website, andersonadvisors.com.
All right, first question. “I have an S-corp. Can I institute an HRA plan?” What say you, Jeff?
Jeff: An HRA is a health reimbursement account. Yes, you can have an HRA and an S-corp. The problem is that you cannot benefit 5% shareholders. If you’re doing this only for the shareholders of the S-corporation, this is not going to work out. The HRA can only be for the employees of the company.
You could reimburse insurance. Actually, you don’t want to reimburse it. You actually want the S-corporation to pay the insurance for you. You can get a benefit from that health insurance. That also includes reimbursing for Medicare if you’re 65 or older.
That reimbursement does get included on your W-2, but it’s also a reduction of income from the S-corporation, so it balances itself out. Where the advantage comes in from that is on the other deductions, what we call above the line deductions, you can take a deduction for self-employed health insurance.
Eliot: Yeah. As Jeff pointed out, if you have your S-corporation pay for your health insurance, and we’re just talking about premiums here, it is added into your W-2, but remember that the S-corporation gets a deduction for that. It is subject to federal and state income tax withholding, but that portion is not subject to employment tax, so you get a little bit of a break there.
When we put that over on to your 1040, what we call adjustments to income, and the bottom is just pointing out, you get the deduction back, if you will. You’re coming out a little bit ahead that way, just a smidgen. But it’s not the same as the HRA, which is the original question there, because if you are probably an owner, you probably can’t take advantage of it, but your other employees could.
Jeff: Correct. This is also going to apply to any family members. Your dependents, your lineage, direct siblings, and so forth, would also be prohibited from participating in an HRA within your S-corporation. With the C-corporation, you can own it 100% and still get reimbursed for the corporation for your out of pocket health costs.
Eliot: Absolutely. It’s one of the reasons that we like C-corporation so much. As Jeff pointed out, the IRS and Congress caught on to, well, what if I have my wife work as a W-2 employee, and yet I’m 100% owner? We can’t get around the rules here that way, because you’re a related party. All right. Excellent question.
Next, “Can you deduct the renovation costs of renting the basement in tax year 2021, but you don’t have any rental income until tax year 2022?” I think I’m going to make some assumptions here. I assume we’re talking about our personal residence and maybe we’re just renting that area of it out, maybe the basement. You can. There’s an element of depreciation that would go in here.
What really is going to happen as a renovation cost, Jeff pointed that out a lot. He’s really good at always picking this up. You’re going to have some direct costs to that area, and then some of that might be kind of added to the overall basis of the whole house. It’s possible that you have a business in 2021, that if it was available for rent, that might be an option where you would be able to deduct it. Perhaps, in 2021 to have at least some deduction, but then actually, weren’t able to get it rented out until 2022, and then it would carry on there.
Jeff: Yeah. Looking at this, because you say you didn’t have any income in 2022, but were you seeking to rent it out in 2021, but just couldn’t find anybody to move in. In that case, it would be possible to take some of these expenses in 2021. But if it wasn’t available to rent until 2022, then you’re going to have to hold off to take any deductions on that basement rental till 2022.
Eliot: Yeah, and you’re going to have to have some way of proving that it was available for rent that you had it out there. It was publicized, it was available on Craigslist, or whatever you’re advertising. The real problem is if someone actually calls you on it and to try and rent it, you can’t really turn them away then if you’re not ready, which brings up another reason. We’ll leave it at that for tax purposes.
Jeff: There’s what I call separate structure rules, which goes back to what you were saying about the renovation costs, what they’re for, and so forth. At a minimum, you have to have separate entrances, separate facilities, no community areas, to be considered a separate unit.
For example, this basement apartment. I know when we use the term basement, my mother has a basement type like this that’s all decked out. It has a kitchen down there and everything. It has a separate entrance. She could do something like this and possibly separate her living area from the basement area.
Eliot: Yeah. It’s got to be kind of an independently operating area in order to consider it a separate rental area, assuming that’s not what was meant in the question, though. We’re just talking about our house and we just have this area that we’re renting out a little bit, maybe occasional Airbnb or something like that, then we’re going to have to piecemeal the costs out.
Jeff: When you have this combined property and you are carving out a section for renting out, don’t you feel like you’d still have to look at the value of the entire property to actually segregate what the costs are? That also goes back to what you were saying about, I may have finished out the basement so I could do this. But then you have to determine, does the cost go towards the rental portion or does it actually increase the entire value of the home?
Eliot: Yeah, there’s going to be some direct costs there, undoubtedly, that will have to be attributed just to that area, like in a home office. We’ll get to that question later on. Then there are portions that will go to the whole house, I would think usually in renovation. All right. A lot to think about on that one.
Next, “Can a real estate professional status be claimed year to year with yearly gaps on any years that you do not qualify?”
Jeff: This is a good question. The answer is yes, this is an annual test. The question was asked, can you? The question really is more of must you. Each year, I’m a real estate professional, I own all these properties. I qualified in 2019, I qualified in 2020. Then, 2021 came about and I didn’t spend as much time.
I didn’t make 750 hours. I was working full time because I needed more money or whatever. I’m not going to qualify as a real estate professional now. One of the little promises is aggregation. I’m no longer a real estate professional for at least 2021, but I made an aggregation election to aggregate all my properties together into one activity. That election stays in effect forever, until you sell what?
Eliot: Substantially, all.
Jeff: Substantially, all of your activities in that aggregation. That is one thing to consider. I don’t think that’s normally a big deal. Let me ask you this. I didn’t qualify as a real estate professional in 2021. With that mean, any losses I had in 2021 would be passive.
Eliot: Yeah. This is a really good question, because a lot of our clients have real estate professional status who were thinking of getting there. You had it, and then all of a sudden, you don’t. It just goes back and reverts back to all the passive loss rules with the exception, as Jeff points out, that you’ve now aggregated, so they’re all stuck together like cement.
You’re just going to whip up a bunch of passive losses that get suspended that year. Unless you have other passive income, they’ll just sit there. Let’s say the next year, you get back to real estate professional status. You’ve now effectively blocked those passive losses for that one year, and they’re isolated until you find some other form of passive income.
It surely won’t be real estate, because as Jeff pointed out, you aggregated, so you’re stuck there. The end of the world doesn’t happen. They don’t take your properties away or anything like that, but you do have this passive loss issue you have to work out that one year.
Jeff: Here’s what we sometimes see. I qualified to be a real estate professional, as I said, in the past couple of years, but in 2021, I didn’t. I may have intentionally worked more outside of real estate, because I know I’m selling one of my properties and want to free up those losses. The aggregation election prevents me from freeing up those passive losses, they stay suspended until I get rid of virtually everything that’s aggregated together.
Eliot: Substantially, all.
Jeff: Yup. However, any gain from the sale of that property is still passive gain, because it’s coming from a passive activity. It’s just your suspended losses, you can’t free up like that.
Eliot: Yeah, they’re really stuck unless you find some other investment that’s going outside of real estate that’s going to give you passive income. Then you could offset it with that, perhaps, down the line. Directly to the question, yes. You can have a real estate professional in one year, and then not the following year, and then all of a sudden, re-obtain a real estate professional in the third year.
Jeff: We actually had that. We had a professional who took some time off. She wanted to have a family. She took some time off from her career. The family was a real estate professional. Then a year or two later, she quit being a real estate professional to get back into her profession.
Eliot: Yeah. There are some times where it’s a good move that we might be able to pick up for a year to get some bonus depreciation and cost-seg going. Then if we go back to work, and we had a property we were still looking at and really want it, maybe we can do that short-term rental plan that we always talk about, which would be unrelated to real estate professionals. There are things that can be worked with just more advanced tax planning.
Jeff: We’ve probably talked about this before when we talk about aggregation. In 2019, I made that aggregation election to put this property, this property, and this property. I aggregated them all in one election.
What happens in 2020 when I buy another property? That property is automatically sucked into that aggregation group. Every property I buy after that, as long as I have any of those properties, they will still keep accumulating into that aggregation.
Eliot: Yeah, any rental activity will be thrown in there, absolutely. It sucks it all in.
Jeff: Including things like syndications and so forth. If you have a partnership that’s also doing rental real estate, that will get pulled in also, but short-term will not.
Eliot: That’s right. short-term rental is the thing we always have to caution. short-term rental true, when I say tax code short-term rental, it’s not rental activity at all. You’re basically a hotel, so it’s not related to rental activity at all.
Jeff: People love when we say short-term rentals aren’t really rentals.
Eliot: Yeah. It’s a poor choice of words by the IRS, but nonetheless. All right. Next, “If I personally fund my small business, can I deduct all the monies I put into my business from my business taxes?” Jeff, start it. It depends what our business is and how it’s structured.
Jeff: You and I start a business, Eliot. We each put $50,000 in. Is that a deduction to you?
Eliot: No.
Jeff: That’s what we call a capital contribution. We are contributing money to the business. Even if it’s a pass-through, if it’s a corporation, it’s not a deduction period, it’s an investment. The S-corporation and partnership, even the sole proprietor, is still treated the same way. You’re investing in your business. If it’s one of the latter three, the partnership, S-corp, or sole proprietor, you are getting deductions from the business for expenses of the business.
Eliot: That’s right. It’s how the business spends it. If it spends it on buying a new laptop, that’s where you’re going to get your deduction. As Jeff points out, it’s a sole proprietorship, partnership, and S-corp. That’s going to flow through to your personal return. You get the same effect as if it, kind of in a sense, was. You’re taking the deduction, but it really threw your business. But what happens on the C-corp?
Jeff: The C-corp is its own entity. The C-corp either has the tax, or doesn’t have the tax, or the income and loss. But it also has what we call 1244.
Eliot: You can build up losses there. If you have overall losses and basically dissolve your C-corporation, there’s a process you have to go through, but you can get a loss up to $100,000 married filing joint, $50,000 filing single against ordinary income on the stock loss, which normally, that would be a short-term capital loss, which means you’re limited to $3000 each year until you eat up all that, which would be 33 years in case of $100,000. It can be quite a nice deduction there, and then it’s meant to encourage business. It’s there for a purpose.
Jeff: You and I had a total of $100,000 into this partnership. We brought in $20,000 of revenue and spent $80,000 because we’re not very good at what we do. We have a net loss of $60,000. That will pass back to us.
Eliot: Yeah, pretty much 50/50 if that’s our arrangement.
Jeff: Our investment in the partnership or if it’s an S-corp will still be $40,000. That’s the difference. $20,000 for him and $20,000 for me, so we still have money in there. One thing else I want to talk about was that I mentioned 1244. You will read and see that 1244 also applies to S-corporations.
Eliot: It does, but it’s more challenging. The reason why is because, usually, your loss got through or flowed through onto your 1040, so there isn’t any loss there.
Jeff: Yeah, I don’t think I’ve seen an S-corporation yet where we’ve been able to use 1244.
Eliot: I did one. That was my first year at Anderson. I haven’t seen one since, because it is very rare. It was a unique set of circumstances.
Jeff: What if we don’t get our $20,000 back?
Eliot: Again, depending on the type of business, you would probably have a capital loss, I would imagine, on the business.
Jeff: Especially on a C-corporation.
Eliot: Yeah. 1244 aside, if we’re not getting the 1244, then it’s going to be a capital loss limited to the capital loss rules.
Jeff: Yup.
Eliot: All right. Next, “Hi. I have two large taxable events for 2022. Are there any tax strategies to offset or mitigate the taxes on the following? (1) 401(k) withdrawals to invest in real estate syndications. I already had the majority of the taxes withheld at withdrawal, but there is still a 10% penalty, which would be about $30,000. (2) I sold my primary residence in 2022. After all improvements and closing costs, as well as the $250,000 are subtracted, I still owe about $100,000 taxable.”
There are certainly things that we can do. A lot of it will depend on what’s going on in your return and what kind of investments you get into. Anything hit you, Jeff?
Jeff: There are certain exceptions to the 10% penalty. One, of course, is you meet the age requirement, 59 ½.
Eliot: I believe so, yeah.
Jeff: I get the rules 50, 55, 59 ½. I’m past all them, so it doesn’t matter. There is that rule. There’s a first time homebuyer exception. There’s the medical events exception to the 10% penalty. That one in particular says, whatever you show on Schedule A is deductible for medical. That’s how much you can exempt from your 401(k) or IRA distributions.
Some of the rules apply to the IRAs that don’t apply to 401(k), and vice versa. However, in this case, I don’t know of any exception that’s going to get you out of the 10% penalty.
Eliot: Yeah, no real estate syndication exception, but we would look for other things. You got a syndication, so that tells me you’re into real estate. You did a withdrawal. To me, that means that you bought it in your personal name, so we have other real estate things? Can we pick up a short-term rental?
Do we have at least one or two long-term rentals, where we might get a real estate professional? I guess you’re single, so that’d be unlikely if you have a W-2 job. Those are things where we might get some great depreciation deductions or something like that. We might have to really start scraping out everything here.
You got a 401(k). Assuming that you still have it, make sure you’re deferring as much as you can into that. If you have stocks, any capital losses out there, try and take advantage of those. I guess it’d be limited to $3000 in this case.
Jeff: No, that’s a good point. We may not be able to do anything about the 10% penalty itself, so what else can we attack? What other taxes can we attack? He said something I wanted to go back to, 401(k) withdrawn to invest in real estate syndications. Was there possibly another way to do this? Maybe invest within the 401(k)?
Eliot: Absolutely.
Jeff: What I was thinking is you invest inside the 401(k) into real estate syndication. We see it all the time with IRAs and stuff like that. You just have to get your 401(k) plan approved as an accredited investor. You invest inside your 401(k).
Couple of good benefits from that is (1) You don’t pay the taxes or penalties on the withdrawal. (2) We always hope these syndications go up significantly in value. We’re not there for the rent or anything. We’re there for appreciation and the real estate. It goes up by 20%, 30%. None of that gain is taxable to you.
Eliot: Right. That’s an excellent play. Those opponents will say, but then you don’t get any benefit from the depreciation write-offs against your income on your personal return. That’s correct, because it’s all isolated in your retirement account. Still, as Jeff pointed out, any growth is tax free. Free is the best word in tax.
There are things there. But when we couple up with number two here, sell the primary residency, that $100,000 is going to be capital. There, I guess, would be more to the point. If you bought bitcoin when it was a lot higher, you might have some capital losses. That could be used to offset.
You might want to sell off some capital losses to conquer that $100,000 because that is capital. It still is not going to help us with number one, because that’s going to be considered ordinary on the taxes on that.
Jeff: We’re going to have a question about this later. You could consider turning your primary residence. You already sold it, so that’s not even an alternative. You could consider turning it into a rental for at least some period of time before you exchanged it into another property.
Some of the things like that can be expensive, especially when you’re talking about primary residency, because you do have to have someplace to live. You have to have the cash to do so. The last thing we want to do is pull more money out of your 401(k) so you can buy another residence while you’re waiting for this one.
Eliot: More penalty then. Yeah, we’d be going backwards on that. What you did with the extra cash from the seller, your primary residence might be a clue if we can get into some kind of investment that would give you deductions. Real estate’s always a great one.
Jeff: Short-term?
Eliot: Yeah, short-term would probably be the easiest. We often talk about short-term rentals, because it’s just a lot easier for real estate professionals in some cases, so it might be a thought.
Jeff: We do understand that some of the short-term rentals are being looked down upon by metro areas. I know the Las Vegas area had some issues for a while, because there were a lot of party houses. The neighbors didn’t seem to like that.
Eliot: I remember reading articles about the guy who brought grenade launchers or whatever.
Jeff: Oh, my gosh.
Eliot: Yeah, real stuff. This was all in the news. It was on the whole country. Anyway, not my neighbor’s.
Jeff: RPG, rocket-propelled grenades.
Eliot: Yup, exactly. Jeff knows this.
Jeff: Also, we talked about this frequently with a $100,000 of gain if you don’t want to pay tax on that. See what losses you may have elsewhere, capital losses that you can harvest. My favorite place to harvest losses right now is crypto. For a couple reasons, I can take those losses today on that $60,000 bitcoin I purchased that’s now worth $22,000. Go ahead and take the loss, and I can turn around and buy that bitcoin back again tomorrow.
Eliot: No wash rule.
Jeff: No wash rule.
Eliot: Yeah. That’s a really great one. I get that loss. Take it to offset your $100,000.
Jeff: You can also do that with your stocks. Just keeping in mind that you cannot buy them back in the next 30 days after your sale, that same stock. If I sell Boeing, I can’t buy Boeing back until day 31, I believe.
Eliot: Correct. All right. Next, “I am considering buying a small private plane with my brother for 100% business travel and potentially rent it out to other fires when we’re not using it. Should we create a partnership to own the plane and then have our other business rent out the plane for respective work trips or should it be owned another way? Advise on the best asset protection and tax strategy here.”
Jeff: When I first started reading this question, my first thought was, oh, no. Actually, what you lay out here is exactly what you want to do. I’ve had clients that have had jets and so forth. I had another client. He was a doctor and he had a couple different planes that he used for business.
You want to do that. I would put it in a separate entity. I would keep pristine flight logs. I would mark what each is for, which each slide is for, when is business, when is personal, and so forth. Charge rent for these when you’re flying for third parties. I’m assuming either you or you have a pilot of your own. If you’re renting a small private plane to other parties, I would get a ton of insurance on it, liability insurance.
Eliot: I got an LLC. You’re going to want every kind of protection you have.
Jeff: Yeah. This is exactly how I would handle this. These things often run at losses. You know what just the fuel costs. Basically, the airport service cost and how much they can be. Every time I land somewhere, somebody wants to charge me something.
Definitely in an LLC and only have the plane in there, or anything that directly involves the plane. You could do the rental from that, like I said, keep the flight logs. You want to log every hour that the plane’s engines are spooled up. Get really good insurance to protect you. I’m thinking more along the lines of umbrella insurance at this point.
Eliot: Yeah. I think anything that says the word insurance, I’d be looking at.
Jeff: In a case like this, would you actually do two umbrella policies, one for the LLC and one for you personally?
Eliot: It wouldn’t be a bad idea. Your insurance provider will be able to tell you that and they won’t have any problems telling you what they can. That might not be a bad plan. They’re an inherently dangerous thing, obviously, for so many reasons and inexpensive to maintain, as Jeff pointed out.
I remember a long time ago, a friend used to drive a Blackhawk helicopter, and he was telling me something, it’s like, $10,000 a blade hour to run one of those. That’s, I think, far less expensive than a plane, but I don’t know for a fact.
Jeff: They don’t call them heavier than air for no reason.
Eliot: Right? Exactly. It completely goes against the laws of nature. But the asset protection, I think you got to write in. Certainly in an LLC, partnership, probably because of the ease of putting assets in and out as opposed to say an S-corp or a C-corp.
I think, probably, despite your best efforts to rent this out, you probably are looking at a loss. There’s business savvy to be done in this type of thing, where you could make a go of it if you had it available for enough business renting. It sounds like you’re going to do some personal things there. That’s going to cut back on what we can do for deductions, unless you paid yourself market rate for it.
Jeff: When I was at IRS around 2010, 2012, IRS was heavily targeting these, because they knew people were not doing things the way you intend to. You really want to make sure you’re doing things the right way that you’re doing things on the up and up, because I think you can get it in a particular event, where you think you’re doing it on the up and up. But if you’re not documenting things properly, you’re going to get nailed by the IRS.
Eliot: It’s too late to document then. You do the best you can. I think your ownership is a good idea. Keep that away from everything else, as far as don’t put any other assets in it as Jeff pointed out. Your tax strategy is really going to be operating as a business by keeping very good logs for your personal use.
Jeff: You know what, this is similar to people who want to buy a car in Turo, things of that nature. You run into the same type of liability and all that all you need is somebody who went out partying in your rental vehicle, got drunk, killed somebody, and they’re going to come looking for you. You want to protect yourself as much as possible. Hopefully nobody’s flying, your plane dropped. I don’t see that happening, except maybe on airlines.
Eliot: Get as protected as you can. All right. Next, “How long do you have to keep your primary house as a rental in order to 1031 it or change it into something else, instead of selling it and paying capital gains and access to the $250,000 since I’m single? We’ve lived in the primary house for nine years, and we’re considering downsizing.” Yup, it brings up a couple of issues here.
The first thing I’ll say as far as that time period, there’s nothing in the code that says. It’s not a matter of time, it’s a matter that you ran it as a trader business. That’s what is required in a 1031. What does that mean? If you go on enough commentary, and look out there online, and things like that, you’re going to see a lot of two years.
That’s not what the code says, though. The code says it has to be used as a trader business. When have you established that, that’s anybody’s guess, but kind of a lot out there. A lot of people would say, probably two years.
Jeff: I’d like to say, report it on two different tax returns maybe less than a year, maybe more than a year. What do I base it on? Like you said, there’s really nothing, I don’t think there’s anything that’s been adjudicated really.
Eliot: I haven’t found it yet if there is.
Jeff: What tends to happen is, if it goes before the Sixth Circuit, they may come to some ruling if it goes before the night that may come the different one on the […] and so forth. Until something like this, for some reason, will come before the Supreme Court, I don’t think there’s going to be a tight decision, unless the Treasury comes out with some ruling.
Eliot: What’s going to happen when that does happen, if it gets up there, some law clerks are just going to google it and find that everybody says two years, so that becomes our law. Going with that, I like having it on two returns, because it shows you definitely we’re running it as a rental. Make sure it’s at a fair market rate, too. Don’t try and just put people you know in there and say, please stay here or cut the rent down or anything like that. The IRS will look right through that kind of thing.
Jeff: What’s the maximum amount of time I can hold this as a rental?
Eliot: You mean, and still take advantage of the 250?
Jeff: I do.
Eliot: Yeah. The rules with the 250, you have to have owned it and treat it as a primary residency for at least two of the last five years. You’d be able to do it for theoretically up to three years, but you really kind of close it so everything will work if you get into that close to three years.
Jeff: Yeah, this is really a case where two years works. Once you go beyond that, it starts getting iffy. One thing to keep in mind with any 1031 exchange is, at least in this past market, it has been very easy to sell your house and it has been very difficult to find a replacement property. We talked about the identification period of being 45 days in a 1031, either 45 days before 45 days after the sale. Honestly, if I’m planning on doing a 1031, I’m looking hard before I ever sell my property.
Eliot: Yeah, in this market, I’d be looking six months ahead at least trying to find something that might apply, which probably won’t be there. But at least it gets me into the mode of seeing what’s out there and what I can realistically expect. Good question.
All right. “I am about to purchase the home where my parents live in New York. It will be listed as my primary home, but I only visit. The bank is saying that with a special circumstance, I’m able to do this. My parents were not able to get the loan. This is why I won’t pay a higher interest rate. How many years should I wait to put it in as an LLC? I take care of all expenses. My mom said I should claim them on my taxes, but I don’t feel right doing so, because that’s not the reason I have been doing this for the last seven years. They’re both retired and don’t work. She said it helps me get something back.” By taking the expenses is what’s being referred to there.
Jeff: Let’s talk about primary residence—primary home. I’m assuming that this is for the bank’s purposes saying it’s your primary home. The reason I say that is this house would never ever qualify to be your tax primary home. Basically, what the rules say is you have to have at least, I believe, 180 nights per year in this home to make it your tax home. You’re also going to need to be licensed in New York, have your voter registration in New York.
Eliot: It’s a difficult situation from a tax standpoint, because it’s not your primary residence probably. There, you almost look at best, maybe calling it a second home, in which case you get the mortgage interest and the property taxes, perhaps.
Jeff: You can deduct the real estate taxes on this home if you own it. You can deduct the real estate taxes on any real estate you own. The problem is, if you also live in New York and have New York withholding, you’re not going to benefit from that.
One of the alternatives is to take the mortgage interest, the real estate taxes, and then any other expenses, maybe HOA fees, and just plow them into the investment, the basis of this property, which you can do. There’s an election to do that, saying, I’m just going to capture all these costs as the investment and not deduct the expenses. That way, while the value of the property goes up, hopefully, your cost basis is also going up, probably not as fast, but help you out down the line.
Eliot: Good point.
Jeff: What about putting it in the LLC, though?
Eliot: If we determine that it’s an investment at that point, then yeah, you can go ahead and put it in there. I don’t know. Again, the whole primary residency thing, that’s going to be on the lender. They’re calling this a personal loan for your primary residence. You’re going to want to be careful with that, because some lenders get in trouble with that if they turn around and use it for commercial. But you’re not renting it out to anybody, you just want to make sure you’re satisfying them that you’re using it enough personally to qualify for whatever their qualifications are. But then, as far as the tax aspect, once it becomes an investment, I assume, then put it into the LLC, I would think.
Jeff: Yeah. If this is an investment, could they deduct the mortgage interest on this property as investment interest?
Eliot: I know if they were renting it, yes, they obviously could. But just as an investment, I’m not sure. I know they could do the taxes. Like you say, you can always deduct those. But the interest, would that be an investment […] or you’re limited to the…
Jeff: Limited to your investment income, yes.
Eliot: Interest income, yeah.
Jeff: I agree with you about putting in the LLC. Normally, I would say don’t worry about it. But since the bank is classifying this as your primary residence, I’m kind of surprised that the underwriter was willing to do that.
Eliot: Not here to question that.
Jeff: Just the facts, man. I would normally say go ahead and put it in LLC. But in this case, I think I would wait to put it in the LLC. There’s not a tremendous amount of liability here. I don’t think your parents are going to sue you.
Eliot: Just have regular insurance on it or whatever. Talk to your insurer about it. Make sure they’re covered, you’re covered, et cetera. But maybe two years of investment would be, I would think, plenty. Then you’re probably to where you could go ahead and call it an investment.
Jeff: Yeah, I would probably get landlord insurance on this and also have my parents purchase rental insurance on it to cover their goods. I’ve seen where somebody was living with their significant other and they weren’t an owner of the house. The house burns down. They cover the owner stuff, but they wouldn’t cover any of the significant other stuff, because they consider her a renter, a tenant, more of that nature. If your parents are having lots of wild parties with elderly people, you may want to get a little more insurance.
Eliot: All right, “Please explain the difference, pros and cons, of our section 721 versus a 1031 exchange. Why have we never heard of this before? It sounds so amazing compared to the 1031 exchange.”
Jeff: There are like and they’re not alike. We talked about the 1031 exchange. Eliot wants to sell his rental property. He goes through a Qualified Intermediary, who actually does a sale for him, and holds the proceeds. Then when Eliot finds the replacement property, purchase the replacement property, Eliot gets rid of one property, and ends up with another property. It doesn’t pay any tax on the gain.
Section 721, where I’ve seen most use is in real estate investment trust, in REITs. What you’re doing there is you are exchanging your investment property with the limited partnership, typically the REIT, in exchange for an interest and all the properties for the REIT. Again, it’s a tax deferred exchange. It’s called 721 exchange because all the 700 codes are for partnerships. That’s how that typically works. You got anything else on this?
Eliot: You asked for pros and cons. You do enough research on these. One of the big pros is that you get an interest in a lot of different varied commercial or whatever type of properties. You’re spread out a little bit more, as opposed to just one single property that will make it or break it. That’s a real pro to it and probably less for you to deal with than having another rental property.
I can’t tell you how many times I hear clients like, hey, man, real estate’s done fantastic for me, Eliot, but I met the agents. I just don’t want to deal with it anymore. This could be fantastic for them. They believe in real estate. They can get into this type of thing. That might work very well for them.
There are dividends that come out, and those are taxable. In order to meet these REITs standards, those are very specific. They have to pay out as much like 90% of all their income and dividends. That would be taxable income, I believe, is my understanding.
You have that. In certain circumstances here, you lose the control over that interest. They could sell your property, which could create capital gains. There are other issues depending on the type of REIT you’re looking for.
Jeff: A couple of pros. You’re no longer managing a single property. You’re getting a portfolio managed by a professional company, but do this for a living. One of the cons is finding a REIT willing to take on your property. The rate you may be looking at may only invest in apartment complexes, or a particular type of homes, or things of that nature, even office buildings.
I don’t know if I’ve seen this or not. I think some of them are probably willing to purchase a property from you to get into the REIT, and then they turn around and sell that property right off right away.
Eliot: Yeah, and your replacement interest is really the investment in the REITs or the UPREIT, sometimes they call it.
Jeff: You talked about the dividends and all. Have you ever gotten one of those 1099s from your broker that are correct at four months after the end of the year? This is why. REITs are not required to have their 1099 completed until I believe May 15th.
Eliot: Yeah, already after the fact to begin with.
Jeff: Yeah, your broker already knows how much dividends you got from the REIT, but then the REIT comes out with their 1099 to the broker that reclassifies everything and corrects everything. That’s why you often see those corrected 1099-Bs.
Eliot: This, more than anything else, might be one of the best examples of why you always extend your 1040. There’s just no other reason, because you’re going to have to amend. You can wait until the correct one comes out after May 15th or whenever they get out, the REITs get them out.
Jeff: I think you pointed out something really good. It can be a pro, it can be a con. If you want to manage your real estate, then you want to do a 1031.
Eliot: Yeah, he wants to be hands-on there.
Jeff: If you don’t mind giving up control and you’re getting a K-1 every year, then maybe section 721 is for you. What you said about I’ve had clients that have had their own little portfolio and I’m tired of this, I am so over this, and they’ve pushed it off on the REITs or they’ve sold off what they can, and did the 721 exchange. Again, it’s a tax free exchange, like the 1031 exchange is. With both of them, depreciation is also deferred, depreciation recapture or so.
Eliot: But you do lose a little bit of control on the 721 that you would have with the replacement property at 1031.
All right, “What expenses can or must be recorded in order to get a tax reduction for a home office?”
Jeff: All of them.
Eliot: Yeah. That’s pretty much the right answer, right there. I always think of administrative use of a home when I see a home office through reimbursement through a corporation, because that’s what we preach probably the most here. Certainly, you’re going to want to have all the basics, your utilities, water, gas, power, electric, property taxes, mortgage interest.
You’re going to want to have a calculation for the depreciation to that little area of your house over 39 years because it’s commercial. Then taken by your percentage of office space area, so you know how much that is and any records around those items. We get asked a lot about, what about the maintenance of the yard and things outside?
Jeff: Typically, if it’s outside your four walls, it doesn’t count. You get the inside of the house or paint it. That’s a repair. That counts into the calculation. You get the outside payment, you get none. Your pool outside doesn’t help you any, but your utilities do. Did you mention that?
Eliot: Yup.
Jeff: HOA fees.
Eliot: Trash removal, woodworking, that’s hopefully outside.
Jeff: Yes, but landscaping won’t, repairs to the outside won’t.
Eliot: However, the landscaping outside areas will work if your office is where you meet clients on a regular basis. I don’t mean once every week. I mean you have five clients come in every day, where it is actually your office and that’s your storefront, you’re outside, then the IRS does well on that.
Jeff: Yeah. When we started, we talked a little bit about separate detached buildings. That gets into a whole different ball of wax, where you may be able to, let’s say you turn the garage into an office, and that’s all it’s used for, then you can bifurcate that and depreciate that entire office building inside and outside. That’s one time. I’ve also seen people. I worked with a guy who had a fabulous office. He had a cleaning lady, and the cleaning and expenses would go for that, and so forth.
Eliot: We’d let that be for cleaning expenses. That would certainly be a part of it.
Jeff: This is really a case where you can over record. You’ll be told if no, we can’t deduct that. But if you under record, you’re going to miss out on deductions, possibly.
Eliot: Yeah, get everything, especially the things that are directly related, because we can 100% that if it’s directly related to the officer. I used to give an example about the home office deduction, where they made the mistake of inviting me into their house to show me their office with their nice white carpet. They gave me a fruit punch Hi-C that I spilled all over the carpet. If they have to replace that carpet itself directly in there, that’s 100% right there, as opposed to if I dropped it on the way into the office, where it’s outside, and then we just get a percentage.
Jeff: You get a new desk, bookshelf, stuff like that. Those are all called direct expenses, and are deductible 100%. You don’t have to allocate it between the whole house.
Eliot: The legal fee is to keep Eliot out of the house going forward. All right. Hopefully that helps. Another great question there. Let’s see what we got next. Is that it? Oh, one more thing.
“My W-2 income triggers high taxes due to current paycheck, AMT, Social Security, et cetera. How can I decrease this for this year and next year by starting an Airbnb info to questions submitted? I am a physician by profession and decreased work hours decreased from 20–25 per week.” I think the key here is we’re cool with Airbnb. We have all this income coming in. What do we do, Jeff?
Jeff: We start at Airbnb. I’m going to say this one. I don’t think I’ve said it. I like having separate property to do my Airbnb. I don’t like using my personal property where I live for it.
You want to materially participate in that activity. You want the average state of being seven days or less. Those two items are critical to getting any kind of deductions out of this. I know you said you’ve reduced your work hours to 20–25 hours per week. That actually doesn’t play into this the way it does in the real estate profession.
Eliot: Exactly. It’s kind of a red herring. It doesn’t really matter here. It would if we’re real estate professionals. But if we’re true short-term rental, and I always use that phrase, we’re by the tax code when it considers a short-term rental, then we don’t care about the hours that you have, and your other jobs, or anything like that. We typically recommend over 100 hours, and you do more than anybody else on that short-term rental.
Jeff: We talked about substantial services. That may be how many cleaning person come in every day, empty trash, make beds, and leave.
Eliot: Yeah. Change up the linens.
Jeff: By substantial services, we mean for the tenant while they’re staying in there, putting water in the refrigerator.
Eliot: Also, if you go into a hotel, they always have the coffee makers tea, changing those out. I had a friend who used to bring in fresh cut flowers. He and his spouse would change that out all the time. Just little things like that to show you’re more like a hotel. Why? Because of what Jeff and I talked all the way back earlier. This is a short-term rental, which has nothing to do with rental.
You’re trying to emulate a hotel, which is an active business. It’s not like long-term rentals. If we do that, if we materially participate, then we’re going to get that great deduction of cost seg, hopefully, and things like that.
Jeff: Yeah, I didn’t mention that, cost segregation.
Eliot: Yeah, we got to have that. Bonus depreciation.
Jeff: And then the year that you make it to short-term rental. One other thing I wanted to bring up, I know you said you reduce your hours to 20-25 hours a week. Let’s suppose you’re married and I don’t know that that’s the case, you could still be working 100 hours a week. As long as your spouse qualified and had enough time into this Airbnb, they could be materially participating, and you jointly would get that deduction.
Eliot: That’s right. A lot of flexibility here with the short-term rental. It’s usually a little bit easier to get into than the real estate professional, especially if you don’t have one building. It’s very difficult with one rental to get into real estate professionally. It says you have to have several, really, and then of course, as you pointed out, reduced hours.
Jeff: Eliot, I bought this nice property that I’m doing short-term rental. I’m going to do short-term all through 2022. I know I’m going to get into 2023. By then, I’m going to be tired of this. Have you tried the long-term rental?
Eliot: Absolutely, yeah. It’s not stuck as a short-term rental. We can go ahead and turn it into a long-term rental later on. If you wish to pursue real estate professional status at that time, you certainly can.
Jeff: But it did cost segregation while it was short-term rental.
Eliot: That’s okay. The bill is the bill and the depreciation is depreciation. It will just continue on. All right. I think that’s it for questions. Just a reminder, you can listen to us on YouTube, our podcast, and watch the replays for the platinum portal. I think we’ll be back in two weeks, probably with Toby back. I think so, I hope so.
Jeff: Eliot does a great job and I appreciate him being here while Toby’s out.
Eliot: It’s fun. It’s good to have Toby back. Anyway, thank you so much. We’ll see you in two weeks. If you get questions, throw them into taxtuesday@andersonadvisors.com or visit us online at andersonadvisors.com.
Jeff: Thank you and have a good two weeks.
As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, a great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets.
Additional Resources:
- Claim your FREE Strategy Session, and learn how Anderson Advisors can protect your assets.
- Join our next Tax & Asset Protection event to learn more advanced tax minimization & entity structuring strategies
- For all things investing, check out the Infinity Investing YouTube channel
- Subscribe to our YouTube channel to make sure you never miss the latest strategies & updates
