Tax Tuesday Episode 144: Estate Planning

Jeff: And I’m Jeff Webb.

Toby: And we’re here to answer a lot of your questions and we’ll go through a whole bunch of good ones today. If you’re out there, just let us know you’re alive. Just go to chat and say, I’m alive. Let us know where you’re at.

Howdy. DC, howdy from Florida. I’m alive. “Yo,” from KC. Santa Barbara, Galveston, Georgetown, Grand Rapids, Lehigh, oh, I’m jealous. Long Beach, New Orleans, Houston, […], Dallas, Yorktown, Vancouver, Washington, Chicago, Montana, The Triangle, and North Carolina (I got properties there). Orlando, Tucson, New Jersey, Colorado Springs, Portland, Oregon, California, Sta Rosa. We got a lot of folks from all over the place. Monterey Peninsula, beautiful.

Today, we’re only 100 degrees in Las Vegas. It was down from 118 yesterday. We went out of the oven and we’re in the warmer. I’m sure they’ll crank it back up. Jeff and I are withered husks of human beings. We’ve been copiously watering ourselves. You have a bunch of accountants on. We have Ian, Eliot. We have a whole bunch of folks on. Who else is out there? Troy, Eliot—I know earlier I said Troy is out there. Christos is out there. Dana is rolling around out there. We also got Matthew, Patty, and Jen Guanlao. We have Massachussettes. We got a few stragglers.

Welcome, we’re going to jump in. Let’s go over the rules because Jeff and I love rules. First off, ask questions. We do answer questions live, but if you want to make sure that you get it answered, put it on the question and answer feature, which means go on in and you’ll see that there’s a chat feature and there’s a question and answer feature.

The question and answer, we will make sure that we’ll get to you. We have a whole staff there to answer. Whenever we start recording, my little mouse disappears and I can never find it ever again. It just disappears. Maybe it’s over here.

Jeff: It’s like where’s Waldo.

Toby: I put a nice big box that says I’m being recorded right over our screen so we can’t read anything. And then you can’t see them out. This is great. I’m just going to shoot this at some point. You can ask your questions live. Go out here to chat sometimes. It won’t show up. It’s like it’s mean. It likes to do that. You could also ask questions during the week or anytime during the two weeks in between these sessions at TaxTuesday@AndersonAdvisors.com.

By all means, take advantage of the fact that you have CPAs, accountants, attorneys answering your questions right now, not just Jeff and I. Jeff is a CPA, I’m a tax attorney, but we’re here to answer your questions but you can get a written answer. It’s supposed to be fun. We do answer quickly. We do answer, which is unlike a lot of accountants because it depends. We’ll give you an answer and if we say, hey, there’s some hedging in it like there’s something we don’t know. I’ll just say, hey, send us a question during the week.

Let’s go over the questions now that I can read them because otherwise, I’ll just be guessing. What do we got today? “An SMLLC,” which stands for single-member LLC, “that earned $20,000 in stocks, does it have to pay self-employment tax?” We’ll get into that, but the SMLLC, you’ll see that vernacular used. All it means is that it’s an LLC that’s going to be ignored for tax purposes so we don’t really care who owns it.

“How do I borrow against a stock versus selling the stock outright?”

“To my knowledge, can I use a short-term rental up to 14 days or 10% of the total rented out days. I’m a REP (real estate professional). Can I take all the bonus depreciation in year 1 or must it be prorated based on my personal vs. business use?” Good question, sounds complicated, easy to break down.

“I bought a stock (USO) in 2020 and received a K-1,” woo-hoo, that’s always fun. “The stock price has more than doubled,” good, “but I never sold any shares. Why do I have to pay tax for the gain which I never received? What happens when I sell that stock?” We’ll go over that.

“Can we defer capital gains tax or spread across multiple years?” We’ll certainly answer that one.

“Can I 1031 exchange from a single house rental into a percentage group rental? We’ll have to dig into what that means, “Or to a partial interest in multiple rentals?” These are all good ones. These are going to be fun to dig into.

“If I have a home in an LLC and have a property manager on the property, can I rent out the home to myself but have my employer pay my rent through the property management team?” This is weird. It’s like I live in the house but I have a property manager living there. Whatever floats your boat.

“My accountant informed me that if I make over $150,000 annually, I would not be able to claim any deductions from short-term rentals. Can you explain this? Also, if I don’t provide “substantial services” for Airbnb, do I still need an LLC/C-Corp for management to decrease my taxes? I would like to report the income on Schedule E while writing off active short-term rental income from 100 material participation hours.” A lot going on on that one. We’ll dig onto that one, that’ll be fun.

“How does an LLC that is disregarded entity different from a living trust in terms of estate planning? What if you have both? How do I use both in estate planning?” Great question. This will be a fun one. I like those ones.

“Are the gains in a traditional SDIRA,” just remove the SD, it stands for self-directed IRA, “taxed the same as the rest of the money in the self-directed IRA when doing a conversion to a Roth self-directed IRA?” When you remove the SD out of there, just say, hey, is an IRA with capital gains taxed the same?” We’ll dive into that. It will be fun.

“If I buy a new house through a 1031 exchange, and I make it my personal residence after one year of renting it out, how long do I need to occupy it to qualify for the full Section 121 capital gains exclusion when I sell it?” Good question.

“Can the 1244 rule be applied to an LLC that has not filed income taxes in over 10 years?” We’ll get into what the 1244 rule is and we’ll encourage you to pay your taxes right now just in case there’s any IRS out there. We will not be giving out your identity.

“A single-member LLC that earned $20,000 in stocks, does it have to pay self-employment tax?”

Jeff: Most likely not. The income is most likely coming from capital gains, interest, dividends—none of that is subject to self-employment. The only time it could see it is if you’re a trader.

Toby: I don’t think you’d ever have a self-employment tax on capital gains.

Jeff: I think that’s recorded in Schedule C.

Toby: Only the expense.

Jeff: Oh, the 4797. You’re correct.

Toby: On the income, it’s still on Schedule D. It would still be portfolio income. I can’t think of an instance when it would be unless you have a limited partnership that you’re invested in.

Jeff: Even then you wouldn’t be.

Toby: You wouldn’t have self-employment tax ever because you’d be a passive partner no matter what. It would be on Schedule E under those circumstances.

Jeff: I’m going to change my answer to highly unlikely whether you have self-employment tax.

Toby: I don’t think you have to worry about it. That’s one of the most beautiful parts of portfolio income. In the hierarchy of all taxes, number one is the income that you make by sweating, working your butt off, getting up and doing the job. You get hit with not only income taxes, but you get hit with self-employment tax, Social Security tax, FICA, old age, disabilities, survivors, hospital insurance—all that good stuff. They crush you with it.

It’s actually 33% of the total taxes collected in this country are employment taxes. It’s not a small amount. Compare that to all corporate taxes together, it’s 7.8% of all taxes. You’re collecting a lot more in this tax that nobody ever talks about.

You have your sweating my brow income that you get crushed on, and then you have everything else. Everything else is just pretty much you’ll never have to pay self-employment tax or Social Security on. That’s your portfolio income, which is royalties, dividends, interest, capital gains. Then you have your passive income, which is rents or income from businesses in which you do not materially participate. Did I miss any?

Jeff: No.

Toby: Accountants, when they look at stuff, it sounds all complicated, and you realize there’s only one type of income that gets crushed with that self-employment tax, then we just say, can’t see that now with stocks, not unless you’re running the company.

“How do I borrow against a stock versus selling the stock outright?”

Jeff: If we’re talking about borrowing against a stock to invest in other stocks, that’s usually through a margin account through wherever your stocks are at your brokerage account. But I think they’re talking about stock loans.

Toby: Yeah, security-backed line of credit. Go to your brokerage house and say, hey, I got all this stock. Elon Musk does this. This is part of the big thing they wrote about in ProPublica where they were saying, look at these billionaires, they don’t pay any taxes and they make all this money. He hasn’t made any money yet, he hasn’t sold his Tesla stocks. It’s just sitting there.

They’ll loan you based on its value. They usually loan 50% of the value and they’re securing the underlying shares with that loan. It’s borrowed money, not taxable. How do you do it? Security-backed line of credit. If you have crypto, you go to Unchained, DeFi, or one of these others. They’ll loan you money on your crypto too, and that way you’re not selling it because if I sell it, now I have a taxable event. If I don’t want the taxable event, borrow against it. Sorry, I […] that one.

Jeff: No. Not at all.

Toby: Speaking of […], Infinity Investing. I didn’t realize it was the number one best seller in financial engineering. I don’t even know what that is, but it sounds really cool. It has engineering in it so it must be good.

Hey, guys, if you feel like it, I would recommend that you do it because it took a long time to write and it’s actually good. You could actually get Infinity Investing and we break down how to build a good passive income machine.

Somebody says, “Great book, read it twice.” We like that. There’s a whole bunch of reviews that are getting up there. It’s only been out for a month or so and it’s still picking up. We did get picked up, if you guys know how Amazon works, we got the vine and we have some reviewers that are hitting it. It’s nice that they don’t say, man, that sucked. By all means, feel free to grab it. It’s an easy read. It’s just a lot of stories and then it’s step-by-step how to build it.

You can go to infinityinvesting.com and you can get a free membership and immediately implement everything that’s in the book. If you want to buy a bunch of real estate, you’ll have to pay that to increase it. For the most part, anybody that’s getting started, you don’t have to come out of pocket. If you have to come out of pocket—Kindle today, it must be on special, 99¢. The book itself is $27. You can go and grab it. By all means, go in there and do it, and if you do, please give an honest review because it helps other people decide whether it’s right for them.

Let’s jump in. “To my knowledge, can I use a short-term rental up to 14 days or 10% of the total rented out days. I’m a real estate professional.” We’re going to break this down, guys, don’t worry. “Can I take all the bonus depreciation in year 1 or must it be prorated based on my personal vs. business use?” Jeff?

Jeff: There are special roles that once you personally succeed that 14 days or 10%, then your expenses are lent to your income, a really bad thing.

Toby: Basically, if I’m not using a property much personally, it’s going to be an investment property and I can write the whole thing off. But if I use it more than 14 days or 10% of the total rented out days, so if I only rent it for 10 days and I’m in it for 10 days, I’m more than 10%, I have to prorate.

Jeff: You can take the bonus depreciation, but you’re still going to have to do some allocations between the personal use and the business use. It’s going to be pretty unsubstantial. If you use it for 14 out of 300 days or 5% of your total expenses, that doesn’t prevent you from taking bonus depreciation.

Toby: You just get a piece of it, so you’re going to get 95%.

Jeff: Yes, you’re still going to get the majority of it. Being a real estate professional, it’s going to allow you to deduct that with no limitations. Also, going back to the first question, if average rentals are less than eight days, then you may have that deduction anyway, real estate professional or not.

Toby: If you’re a real estate professional, that just means we’re in that passive rental category, but you don’t have to treat it as passive for loss purposes. It’s an ordinary loss.

If I have a whole bunch of bonus depreciation and I have a huge chunk of loss that’s passive loss on a typical rental, now I can take it and offset my W-2 income. In English, if I end up with $10,000 paper loss because of my bonus depreciation, I took a house that would normally be depreciated over 27 ½ years, I broke it to its components, and I accelerated the depreciation on about a third of the house, it’s about what it comes down to. A third of the improvement is personal property and I write it all off in one year. I can do that. It’s called cost segregation and I elect to bonus it.

I could use that money to offset all of my other incomes. If it’s me and I’m working as an attorney, I’m making W-2 income, I’m getting wages, then I have this big loss from this property that I have, then I can use it against my W-2 and lower my total tax just with paper. I think that’s what they’re looking at. They’re saying, hey, I like to use the property too. Let’s use a scenario. Let’s say it’s rented for 200 days and I used it for 40 days, what proportionally would I use?

Jeff: You use 20%.

Toby: Twenty percent would be personal. I would calculate it as though it was 100% rental property and I would only get to use 80% of that because I used 20% of the time personally. It makes sense that I wouldn’t get to treat it as a rental property for that portion that I used.

“Must it be prorated?” Yes, you have to prorate it.

All right, question and answer. “I bought a book on Kindle, 99¢ is a great deal.” I guess it is 99¢. It must be because they’re doing Prime Days. Is it still Prime Days?

Jeff: I think it’s getting close to the end.

Toby: It must be on sale. Yes, 99¢ was a great deal because it’s normally not. “Today is the last day for Prime Days.” There you go. Better tell somebody if they want it for 99¢, go get it.

“Real estate professionals shouldn’t matter with short-term rentals. Those are separate buckets, right? Unless you have a short-term rental not longer than seven days average” Not really. Do you want to explain? There are three buckets for Airbnb.

Jeff: You mean starting Airbnb with substantial services?

Toby: Yeah.

Jeff: There’s an Airbnb with substantial services, and that’s actually 30 days or less.

Toby: What kind of substantial services, cleaning?

Jeff: We’re talking about things that you do while the place is occupied, not between occupancy. It’s got to be services for your clients that are staying there. Cutting the grass or doing the linens after they leave, none of that is going to count. Taking the garbage out. It’s got to have to be something like what a hotel will do or a resort.

Toby: I will write this down while you’re doing this because I can just tell people are going to lose their minds. Less than 30 days?

Jeff: Yes.

Toby: With substantial, where does that end up in a tax return?

Jeff: That actually ends up on Schedule C.

Toby: Schedule C, self-employment tax. That’s kind of nasty. We don’t necessarily like that. What’s the next one?

Jeff: The next one is less than seven days without substantial services.

Toby: Where does that one end up?

Jeff: That ends up on Schedule E much like a rental, but it’s not considered a passive activity. It’s a nonpassive activity.

Toby: It’s not passive.

Jeff: It means there are no limitations on your losses.

Toby: Which is why I think Susan was saying, hey, would it really matter because in both of those cases, you’re going to have a nonpassive loss, so you’re not going to have to worry about real estate professional status.

Jeff: The third bucket is if you have an Airbnb where the average rental days is greater than eight with no substantial services.

Toby: Greater than eight days.

Jeff: Your signs are backward.

Toby: I thought it was the other way. So this is less than?

Jeff: That’s less than.

Toby: Somebody corrected me last time. I don’t think anybody really knows. Greater than eight days, no substantial services equals rental, passive, and then Schedule E, right?

Jeff: Correct. It’s subject to the passive limitations we talked about.

Toby: Why is all this stuff important? Because substantial services are what kicks you in the teeth. Somebody says, “You’re using the greater than symbol instead of the less than symbol.” Somebody else is picking on me. You guys are smart. You guys actually know this. The alligator points to the left. I don’t know this. Somebody probably told me the alligator thing 20 times and I just think immediately of alligators eating something.

Jeff: I think what you’re doing is the alligator is eating the number so it’s getting less and less.

Toby: When I think of an alligator pointing to the left, I’m thinking of its mouth open going to the left. I’m just making excuses at this point. That’s enough of that, let’s jump in. Less than so it looks like an L. These guys, the L shape for less. Now I got it. Matthew got me. Thank you, sir.

“I bought a stock (USO) in 2020 and received a K-1. The stock price has more than doubled but I never sold any shares. Why do I have to pay tax for the gain which I never received? What happens when I sell the stock?” Jeff?

Jeff: You’re not paying tax on the gain, that will come when you sell it. What’s really going on here, USO is the United States Oil Fund. It is a limited partnership, a publicly traded partnership. As a limited partner, you get a K-1.

Toby: Is it a stock?

Jeff: It’s a publicly-traded partnership. It’s kind of a stock and kind of isn’t.

Toby: It’s like a partnership interest.

Jeff: You’re buying a partnership interest and you get a K-1 for your share, income, and losses. To make matters worse, this is an oil fund, so all those numbers on the front of your K-1 probably don’t mean anything. You have to go into the detail of all those pages behind it, and that’s where you’re going to find the real nitty-gritty.

Let’s assume you understand what everything means on those K-1 pages. Honestly, if you have a substantial investment in this stock in this USO, I’d probably go see a CPA.

Toby: I was just thinking, somebody else who gave me the L too. You guys wrote it right next to each other. Matthew and fixated on the alligator at this point. You would also add whatever you would receive to the basis, right?

Jeff: Right.

Toby: Because I may not receive any money. They’re going to allocate me revenue out of a partnership that flows through to me no matter what and increases my capital account, which is my basis. When I do sell, yes you’re being allocated. Let’s say it doubled in price, but what we care about is how much did you get allocated of the total amount? How much did you personally receive, $20? Great. Then you take your basis, add the $20 to it, and then calculate your gain.

Yeah, it’s a little nasty surprise and there’s a lot of publicly traded partnerships floating out around there.

Jeff: That’s a really good point that any income you’re recognizing now and being taxed on is going to increase your basis. So when you do sell the stock, it’s not going to be the same amount that you paid for it.

Toby: “Can we defer capital gains tax or spread it across multiple years?”

Jeff: I’m going to give you two methods I’m aware of and then I’ll let you […] the rest. The first is the 1031 exchange that we’ve talked about. If it’s real estate and you want to defer the capital gains on that, you can basically trade your property for another property through the old qualified intermediary.

Toby: Real estate only though.

Jeff: Real estate only. We do have another question about this later on that we’ll talk more about the 1031. The other way is through the Qualified Opportunity Fund where it can be any kind of capital gain. If you invest in the Qualified Opportunity Fund, Qualified Opportunity Zone, and there are several other qualifiers.

Toby: You’re going to pay tax on that deferral though in what, five years?

Jeff: Five years, 2026.

Toby: Let’s just do this one. Your capital gains, what really matters is when the sale is and when you receive the funds. If I am selling any long term asset on an installment sale, meaning between more than one tax year, I sell something and it’s payable over six months. Some of it is going to be in 2021 and some of it is going to be in 2022. Then I would recognize part of it in 2021, the part that I received, if I elect to treat it as an installment. I have to make an election.

I could also opt-out. For example, if you sold your house, you may say, I have a capital gains exclusion under 121. I’m not going to pay any tax, so I’m going to go ahead and opt-out of the installment sale even though I’m carrying the note on it. If I’m carrying paper on it, some of you guys have heard that term. It’s just a fancy way of saying I’m going to get paid overtime so I didn’t get paid yet. You could spread it across multiple years that way. Really create […].

If you have a large capital asset, they’ll say, hey, let’s do a deferred sales trust where they will put it into an LLC and they’ll sell it to an irrevocable trust. They’ll let it step up its basis, and then in a year or two, you don’t want to do it really close together because the IRS could collapse and say, hey, the only reason you did this was taxes. Probably the only reason you’re doing it is because you’re passing it into heirs and things like that. You want to get the best dollars for your sale, and if you don’t have to worry about the tax that changes things.

In which case, you can step up the basis and sell it, not have any capital gains recognition, but you would be paying it on an installment sale over the rest of your life, for example. The kids could be the beneficiary of that trust. You could be getting a note based on the fair market value that you sold it for and then it turns around and sells it, even if it’s close to the same amount, you’ll have this big pile of cash in there that is in essence just there. It’s buying you back out. Usually you put a kicker in there that if you pass away, in the interim, the note’s forgiven. We won’t get into all of that.

The last one that I would hit on is don’t sell it because if I have capital gains, depending on what I need the money for, it might be wise to borrow against it—especially nowadays with the interest rate so low—and let it step up in basis when I pass.

That’s a weird concept to think about, but if you’re 80, 90 years old, then I would say it’s something that you should absolutely consider because you can avoid the tax entirely. If you have to pay a little interest to avoid a big tax hit, especially if you’re in California, do it. That tax could be 30%. That’s something you do. That’s when you sit down with a guy like Jeff or a guy like me.

The last one is if you’re doing real estate, you may want to look at cost segregation because capital gains are reduced by the amount of recapture. Some recapture is not taxable. For example, if I have broken down personal property in five years and it’s beyond its five years, there’s not going to be any recapture in that.

I guess it would push it all to capital gains, but you definitely want to have somebody take a look. If you have a sizable amount, what would you say? Like $500,000 or something like that, maybe have somebody eyeball it first to see if there’s a better way to sell it.

Jeff: One more idea I’ll throw out, it’s not really deferring capital gains, but it’s avoiding capital gains. If you have appreciated property, especially stocks, you may want to contribute them to charity directly.

Toby: Great one. Why would you do that?

Jeff: You get a pretty substantial deduction for the fair market value of a stock, not what you paid for. If I bought a Tesla at $150 and sold it for $200. I contributed it to go under.

Toby: Think of this, what did you pay for Tesla?

Jeff: $150.

Toby: And what is it worth?

Jeff: $200 now.

Toby: You have $50 of gain. If I sold that, I’d have $50 again that I need to pay tax on. If I donated my Tesla stock to charity, assuming I held it for over a year, I would get a $200 deduction plus the charity—if they sold that anytime in the future—has zero tax. The only time you would have tax in that scenario is if you paid yourself for running the charity.

A lot of you guys, I know my clients, you guys are charitably inclined. You guys give more money away than just about any group I’ve ever seen. You do the tax returns, you’d say at least about 10% probably closer to 15%?

Jeff: Yeah.

Toby: Our people are givers. I put our clients up against anybody because they really do. We have a lot of folks that are just voracious givers.

Speaking of givers, here’s a freebie. Tax & Asset Protection Workshop Live. The next one is coming up on July 17th. There’s a link, they are free. This is probably Clint and I. I have no idea where I’ll be. I’ll be traveling around. We did a really cool one this weekend. It was on clients Frank and Sherry. They do the recovery residences and the NAR Certifications, so did one on NAR Certification.

If you guys are into shared housing and some unique ways of really doing some neat stuff that changes society, I’d welcome you to watch the replay at least, it’s pretty interesting. They do a lot up in Washington State with the King County Jail System.

We don’t need a bunch of jail cells for a lot of these folks. A lot of them, there’s just a lot of drug issues, there are abuse issues. You don’t need to put them in jail. You can put a bracelet on them and put it in a residence. It’s probably better off. It’s a lot cheaper. There’s a lot going on in that realm. Then there’s the clean and sober living and things like that, keep them away.

All right, more. “Can a 1031 exchange from a single house rental into a percentage group rental? Or to a partial interest in multiple rentals?”

Jeff: Why’d you look at me?

Toby: I’m looking at you, Jeff. I know this one because I dealt with a couple of it.

Jeff: A 1031 exchange has to be real estate, we talked about that, and it has to be for an undivided interest. However, there’s another way around that, it’s called tenancy in common. You can buy for your kick in for which you can buy a portion of a skyscraper, office building, houses, whatever. I think it gets a little more complicated if you’re buying into multiple rentals. I think in that case it will probably have to be through a partnership.

Toby: You can still do it as long as you’re a tenant in common, what you can’t be is a partner. Even with the tenant in common, what’s really important is they don’t call it a tenant in common and treat it like a partnership. You need to have an undivided interest, a small percentage in that property.

Jeff: That’s a really good point. When you’re a tenant in common, you report it on your tax return because only individuals can be tenants in common. You report your share on your tax return. You may get reports from the people handling—the property managers and things like that.

Toby: It’s got to be named a name. It’s one of the things. You don’t have to be an individual. You could be a disregarded LLC or something along those lines, but you’re going to have to go name the names.

If I have a single family rental and it’s in an LLC, that LLC needs to be the tick, the tenant in common in the other properties, but it has to be of greater value. You can’t have […] or you can’t have a bunch of debt relief. Yes, you could do a partial interest in multiple rentals. But I will say this, use a very good 1031 exchange facilitator because this is not your […] what they’re used to dealing with in a 1031 exchange.

Jeff: You want to interview your qualified intermediary. If it’s something other than just I want to trade this house for that house.

Toby: How about, have you ever done this before? Have you ever done this? No, but I read about it once. That’s a great feeling. Have you done this? No, have you? That makes two of us. But don’t worry, I’ll represent you in the audit.

Let’s see, “They announced at the event that you receive a replay.” Usually we have a replay. It always depends on the group. There’s probably some floating around out there, you should see if you want to look at some of the previous. I’ll just answer this and we’ll go to some of the questions. Looks like they’re just pumping through them.

Jeff: Good job guys.

Toby: The group that does the Tax Tuesdays, I don’t think you realize it, it’s usually a lot of professional time going into these. We answer tons and tons of questions during the week, nobody is getting paid for it. I guess you get paid in different ways. You reap what you sow. We like to answer questions, but it’s always interesting when you get the people that are, can you do this, do this, and this. We’re answering a lot of questions then they get a little pushy. You’re like, you’re not a client. Be nice.

“If I have a home in an LLC and have a property manager on the property, can I rent out the home to myself but have my employer pay the rent through the property manager team?”

Jeff: I thought this was really interesting. I had to work through this.

Toby: This is a second home. This is a different home. This is not my home. I was trying to think of this and the first time I read it, I was like, my house. If I put my house in an LLC and hire a property manager, why would I do that?

Jeff: Here’s how I worked it out in my head how this could work, so feel free to shoot it up. Your employer is not you. The employer is a third party that has reason to pay you for your use of the home.

Toby: Other than a parsonage allowance under a nonprofit, I’m not aware of any way you can get a house without having to pay taxes.

Jeff: If it was work-related? Say you had a home in another state.

Toby: If I was working remotely and I came for a temporary housing situation, I believe it’s a number of days. I forgot the number. If I go to someplace for a set period of time, I still have my own house, and they let me use it, that’s one thing. It doesn’t have anything to do with the property manager. It doesn’t have anything to do with that.

Jeff: If we cut a lot of these out, first off, you can’t rent to yourself.

Toby: It’s one pocket into the other.

Jeff: IRS says, no, just plain no. You can’t rent a house to yourself or to your business. Do you see any way of making this work?

Toby: I can’t. I look at these things and I’m always trying to figure out what they’re trying to get at. I have a rental house, put it in an LLC, the property manager is a red herring to me because it doesn’t matter whether there’s a property manager. It matters as to where that property ends up on a tax return. Can I rent it to myself? It’s income to myself with no expense if it’s my personal property. It’s income to myself and an expense if I’m renting it to somebody else, which is like subletting it.

Can my employer pay my rent? It depends on what benefit I’m getting because I know it will be taxable to me. Again, depending on what they’re doing. There’s no tax reason you would do this.

Jeff: The employer that does this would actually have to be able to justify on their books on why they did it.

Toby: Question and answer. There’s a really good one up here. “Are you familiar with the difference between personal goodwill versus business goodwill?”

Jeff: Goodwill is generated by that person working in that business.

Toby: Maybe Dana, you’re answering this one. Maybe you know this off the top of your head. Personal goodwill is ordinary income to the individual, whereas business goodwill is a capital gain, I believe.

Jeff: Yes, you are absolutely right.

Toby: If it’s the business goodwill and the business did something from a tax standpoint, if you are selling it, it makes a huge difference. If you’re buying it, I would imagine that if I’m buying it, goodwill is generally a 15-year property. Would personal goodwill still be depreciable over 15 years?

Jeff: Yeah, it would still be over 15 years. It makes more of a difference on the seller’s side.

Toby: The seller is getting it. Does anybody else know that one because I’m pretty sure that I’m right, but I’m wavering right now?

Jeff: I know you’re right about the personal ordinary income.

Toby: The question, like you said, is the business getting that money because of Jeff, which what they would equate it to is really a non-compete to you, you sticking around the business. We can’t say, oh, it’s all goodwill so that they could write it off without an adverse consequence to you.

Jeff: How have you seen that divided, usually? Is it what the company is worth with me and without me?

Toby: Basically, you actually have to have an appraiser come out. John is the seller. I would want more business goodwill because it’s capital gains treatment to you versus ordinary income treatment to you. I cannot think of a single situation where the capital gains would be more.

Somebody says I’m correct. Eliot, you’re a good man. Hey, Eliot, what’s the big definition of personal goodwill? I’m going to ask questions while we’re sitting here.

Jeff: We can’t sit here quietly?

Toby: No.

Jeff: I like allocating more income to things like client lists. Things that I can treat as capital gains rather than non-competes are going to be ordinary income. This personal goodwill is going to be ordinary income.

Toby: That non-compete is going to be ordinary income to you, and it will be deductible to the buyer as an ordinary necessary business expense. Personal goodwill is an asset that is owned by the individual, not to the business itself. It’s generated from personal expertise or business relationships of an individual employee or shareholder.

Jeff: He says it so much better than I did.

Toby: Troy actually did that.

Jeff: Good job, Troy.

Toby: Eliot, you got scooped by Troy.

Jeff: Sometimes it’s all about knowing where to find the answer and not exactly knowing the answer.

Toby: Let’s keep going on. You could always follow Anderson on social media: Facebook, YouTube, LinkedIn, Instagram, and Twitter. You can always go to aba.link/ and then your favorite social media because you may as well plugin. The YouTube stuff is actually really good. Patty is setting it all up.

YouTube for sure. Twitter, I know we’re always posting tax stuff on. LinkedIn, good. Instagram, good. Facebook, probably more. But I like the YouTube stuff personally because I like the videos and I teach them. But you really can’t go wrong.

This is a big one, look at this thing. We’re going to have to get our shovel up on this one and really dig into this. “My accountant informed me that if I make over $150,000 a year, I would not be able to claim any deductions from short-term rentals.” First off, that has nothing to do with short-term rentals. The $150,000 sounds like active participant real estate, but we’ll get into that.

“Can you explain this? Also, if you don’t provide substantial service for Airbnb, do I still need an LLC/C-Corp for management to decrease my taxes? I would like to report the income on Schedule E while writing off active short-term rental income from 100 material participation hours.” Do you want to try wack this thing into pieces?

Jeff: Let’s start at the top with a short-term rental. We want to assume that it means under eight days, but maybe they don’t.

Toby: Without substantial services.

Jeff: Without substantial services. If it’s seven days or less average stay, I disagree with your accountant. You would be able to deduct the loss.

Toby: Schedule E nonpassive loss.

Jeff: I think we’re a little confused here. He says, “I would not be able to claim any deductions from STRs.”

Toby: I think he means loss.

Jeff: I think he means losses, too.

Toby: But they talked about material participation. What they’re saying is it’s Schedule E, it’s nonpassive, and you’re materially participating in the business. What happens is you’re not in the business of renting anymore when you’re doing Airbnb, when you’re doing short-term. You are in a trader business. As a result, those losses would be ordinary loss, nonpassive loss because you’re actually in a business.

Jeff: Jumping down to the portion about do I still need an LLC/C-Corp for management to decrease my taxes, I like the idea especially if you have several properties that you’re doing this with, of having that C-Corp because C-Corp can deduct things that you cannot deduct. We like running some income through the C Corporation and then you can do your medical expenses there. Your corporation could have corporate meetings, things of that nature.

Toby: You can actually lease to the corporation and separate off some of the liability both as the host. There’s been claims made, everything from discrimination to wrongful conduct by the host. It separates it from real estate and there are also real estate claims.

One of the most famous ones was the rope swing in Texas. There was an Airbnb with this big old rope swing out in the yard, somebody got in the rope swing, and the branch cracked, fell right on him, and killed them. Stuff like that still happens. You isolate that liability through the use of the entity and insurance. Just know that Airbnb, by the way, all short-term rentals, that’s a different type of insurance than your typical landlord insurance. All of those things, yes, you still isolate it. Yes, you can still do it.

Having a C-Corp, for example, in the mix will definitely lower your taxes because you’ll get income taken off of your return. You’ll still have that loss on your individual return, but you’ll also have the means to generate more tax re-income for yourself.

Jeff: What if we restructure this a little bit differently? I assume right now that this person is renting through his own individual account. What if we pull that Airbnb out of his account and have the C-Corp rented out or even an S Corporation.

Toby: Generally, what I would do, the structure would look like this. Let’s say I put my piece of real estate into an LLC and I lease it to my corporation that’s going to be my host. My host is going out with all the third parties and it’s keeping my real estate away. My real estate will always be passive because I’m going to rent it out on a monthly basis to my corporation. That way I get a really good benefit. I can pay a management fee if I need to to the corporation as well. Generally speaking, it’s enough to work the rent.

It’s like a lot of folks do. They’ll rent properties and make them into Airbnbs too. I think it was Trump’s kids that did it. They rented one for $10,000 a month and they were going and breaking it off and making $30,000 a month on it. The landlord was all mad saying, you violated your lease. Show me where it says that. No subletting. I’m just letting people use it. There is all sorts of fun stuff we’ve learned about Airbnbs in the last five years.

That was a bizarre one. Sometimes you get these long ones and I’m like eh, do we really want to bring that in? Yeah, there’s a lot of pieces that we can break.

Jeff: We just sometimes have to line out certain parts of it to get to the meat of it.

Toby: “How does an LLC that’s disregarded entity differ from a living trust in terms of estate planning? What if you have both? How do I use both in estate planning?”

Jeff: The LLC is for liability protection. I don’t consider it an estate planning tool. It can be if you have a family LLC or a family flip where you’re gifting interest to children or so forth. I would actually do what it suggests in the second question is have both. I would have the LLC owned by the living trust. What say you?

Toby: Yeah, that’s how generally you’re going to do it. The easiest way to think of a living trust is you’re carrying on baggage for you. You have a little roller that you’re carrying around during your lifetime and there are two ways the living trust really comes in and helps you.

Number one is if you can’t carry your roller anymore, so you have somebody designated to help you with it. If you’re disabled, somebody’s there already in your document. Everything is already in the trust.

One of those items that’s in the trust might be an LLC and it goes like this. Let’s say that I have toothpaste. Let’s say it’s my wife and she has a beautiful dress. The last thing I’m going to do is stick toothpaste right next to her dress because the toothpaste, say we get into a plane and it explodes, it’s going to get all over her dress.

We’re going to put that toothpaste in a container, I used to use a ziplock. The ziplock is an LLC. Usually, when you have the LLC, it’s holding something that could get all over your other stuff like real estate. It might be holding some cash to make sure the cash is protected in case it gets wet, but that’s going into the suitcase. You still need the suitcase.

From a legal standpoint, the reason a living trust works is because it’s a contract. That contract does not need a judge’s involvement when one of the parties dies to that contract. If I have a contract with myself that says, hey, during my lifetime, I am the guarantor of this document, I’m the trustee, and I’m the beneficiary. Basically, I just say, but if I can’t act as the trustee because I am incapacitated, Jeff steps in as the trustee. That’s all it says. If I’m incapacitated, Jeff automatically pops in.

Now, I die so I can no longer be the beneficiary anymore. We are now left with the trustee, Jeff, and the beneficiary which could be my written instructions. It could be Jeff for all that matters. Jeff does not need to go ask a judge, hey, could you please order this removed? He’s already there. He’s in control of it.

When we own things individually, we can’t do that because once I’m dead, now the court’s going, we need to do a court order as to who has control of that. That’s why you end up probating wherever you own something that’s in your name.

Let’s say you had property in four different states and you had it all in LLCs, at least you avoid probating in each of those four states because you don’t own anything. The only thing you own is the membership interest in that LLC. If I take those membership interests in those LLCs and I put them in my suitcase, my living trust, now I don’t need a judge anymore. Voila, you avoided the whole probate mess. That’s all it is.

If I have something in my name and it’s with a third party, they’re not going to change it unless I get a court order. If it’s not in my name and if it’s Toby Mathis’ trustee of the Mathis family trust, then they’re going to say, actually the Mathis family trust owns it who’s authorized on behalf of it. I don’t need a court anymore. It says right here that Jeff is the successor trustee, great, here you go, and they’re off the hook.

What if there wasn’t a trustee? Then they would say, who are the beneficiaries? Can you guys elect one? Let’s say there are no beneficiaries, no nobody, then they might just give it to the court saying, hey, we don’t know what to do with this. The attorney general at that point would contact the parties.

I hope I understand that there. Let’s see. “How is a holding LLC able to file as a partnership if it’s a single member, s a living trust of a married couple whose name is on the […]?” This is what’s funny. You have a choice when you’re in a community property state, generally speaking, a husband and wife are considered one person.

If you are in a separate property state, they’re considered a partnership. Even if you’re in a community property state, you can still choose to treat it because the IRS says, hey, you can use the state. They don’t care. You want to be a partnership? It’s two people. You can do so.

If it’s one person listed as the trustee, now you can’t. You’d have to be both listed as trustees of your living trust. If it’s a married couple, hopefully you are, otherwise, you’re going to have marital issues.

If you want to avoid having to file a tax return on your community property state, that’s how you do it. You have one spouse who still owes a duty to the other. You could do that and you can actually too. You could have it be a community property. You can have it be one person owns it for purposes of the LLC, but then convert it to community property again inside the trust. It’s kind of fun, it makes your head spin.

Let’s go on. “Are the gains in a traditional self-directed IRA,” you’re directing an IRA. It’s not in a brokerage house, it’s probably with a custodian. “Are the gains taxed like the rest of the money when you’re doing a conversion?” Basically, are the capital gains inside of that? Let’s say you bought Jeff’s Tesla and it ran up and you have a bunch of capital gains, are they taxed just as ordinary income when you convert that to a Roth?

Jeff: The answer is simply there is no such thing as capital gains in IRAs.

Toby: They don’t pay tax, they’re exempt.

Jeff: What they are actually taxing you on is distribution amounts from the IRA. When you do a conversion from an IRA to a Roth, they’re considering all of that money distributed that you convert, which becomes your basis in the Roth IRA.

Toby: Because you wrote off whatever you put in there.

Jeff: Yes. If I contribute $6000 from the IRA, if I contribute that this year and it goes up, and I pull $10,000 out because it went up to $10,000. The IRS Section 401(a) says that’s all ordinary income.

Toby: It’s taxable too that’s why you’re going, hmm, I thought it always made sense to do that IRA thing.

Jeff: Another thing I want to point out is I see a lot of people do Roth conversions where they take everything in their IRAs and throw it all into Roth. You don’t have to do it all in that year.

Toby: Here’s the rule, your taxes are going to go up and it’s going to be a little while, by all means, go ahead and convert. If your taxes are going to be down when you retire, don’t. The average tax rate goes down when you retire. I see all these conversions and I’m always like, conventional wisdom would be don’t convert.

You should get the deduction that’s worth more to you at your highest tax rate. I’ll see people in really high tax brackets think they’re going to make all this money in their Roth so they convert and just get killed in taxes, and it almost never materializes. I’ve seen it a few times, but it’s rare.

I’m like, your averages are not with you. Again, if your taxes are going to go up, the Roth is better. If your taxes are going to go down, the traditional is better. I see people in the height of their careers, they’re making a lot of money, and they’re doing conversions. I’m just looking at them going, it’s going to take a long time to make up that tax hit, man.

Jeff: I’m going to talk about the other side of the coin. If you’re having a crappy year, let’s say you did some big cost segregation. You got all these losses you’re taking.

Toby: Now convert because your taxes are going to be higher when you retire.

Jeff: Yeah.

Toby: Your taxes are going to be higher when you retire, now it’s a great time to convert. If your taxes are going to go down when you retire, don’t. It’s simple. If you can create losses, then you’re going to be in a really low tax bracket. It’s hard to beat 0%, 12%, or even 20%. Good one.

“If I buy a new house through a 1031 exchange, and I make it my personal residence after one year of renting it out, how long do I need to occupy it to qualify for the full Section 121 capital gains exclusion when I sell it?”

Jeff: I like this question. We’re assuming that you’re exchanging an investment property for 1031, but you buy a new property, and you do need to rent it out for at least a year, 12 months, 365 days. Don’t shorten it.

Toby: Technically you don’t have to.

Jeff: Technically you don’t have to, but it seems like most of the cases are going to.

Toby: We like appearances though. It needs to be an investment property.

Jeff: You need to live in it for five years or you need to own it for five years after that 1031 exchange.

Toby: Before you can even qualify for a 121. 121 has an absolute exclusion which is $250,000 or $500,000 for using a property as your primary residence for two of the last five years prior to selling. I’m going to throw a curveball at you here in a second, but you cannot use 121 for five years after a 1031 exchange.

If you sell a house in a 1031, buy a house in a 1031, and then move into it, you have to wait five years from the day of the sale before you’re even eligible to do the 121. Even when you do, this is the part you just have to get the pencil out. You’re going to have a period of nonconforming use.

What that means is whenever you have a rental property, let’s say you have a rental property for 30 years, and then you moved in it for the last two, you don’t get the 121 exclusion for the full amount. You’re going to get proportionate because you have 30 years of a nonconforming use out of 32.

You’re going to get a very small percentage of that exclusion. You’re still going to get it, the way that they do it is, it’s not the inclusion that they use that percentage of, it’s the gain. They say, here’s the amount of the gain that’s being attributed to the period of time that you reside in it.

If you’re going to do that, just know that there might be a portion that you don’t get to use. There might be a portion, and you have to live in it for five years. Realistically, you’re going to get 80% plus of the gain that will be eligible for the 121 exclusion.

If you did the 1031 exchange in the first place, what do you think you’re going to do five years from now? You’re probably going to convert it back to a rental, 1031 it again, and do the same thing again. If money is big enough, you just keep doing that. Then you die and you step up the basis.

Jeff: Where was your curveball?

Toby: That was it, the nonconforming use.

Jeff: Another thing you can do is—

Toby: It’s kind of a slow curve.

Jeff: Change up. Let’s say we’re talking about this house you’re selling is your personal residence.

Toby: You cannot 1031 it.

Jeff: You have to convert it to a rental for a year.

Toby: But that’s not nonconforming use because it’s between the period of time when it was a personal residence and the sale.

Jeff: You can do that 1031 exchange, rent out the new home for a year, and then move into that home.

Toby: Correct. That’s what we teach.

Jeff: I’ve heard that.

Toby: I’ve seen it once, that’s the funny thing. When we teach, we have these people with $2 million of gain and they’re like, I don’t get to use any of it. This is what you do, and then you never hear from them again. I assume they go and they take it, but I want to see it. I want the letters saying, hey, thank you for saving me half a million dollars on a free show.

Jeff: One thing I would caution you when doing this is you don’t want to tell people during this exchange that you’re planning on using your new house for your residence. The IRS catches a smell of that and they’re going to blow it.

Toby: They’re always going to look over the substance over form so they’re going to say your form was correct, but the substance was trying to defeat a tax. You’re still allowed to do tax planning, tax avoidance, no problem. Don’t invite it because they don’t like stuff like that.

They had an opinion today, I don’t know if you saw it. They denied a Christian 501(c)(3). They denied it as exempt status because they believe that Christians are more affiliated with Republicans. You see the IRS do stuff. It’s patently wrong.

Jeff: I thought you had this happen about 10 years ago.

Toby: That was […], and yeah they target […]

Jeff: Yeah, out of Cincinnati.

Toby: You’re going to see it again. You’re seeing it again happen today, but they said that Christian organizations are associated with Republicans, and therefore they’re going to deny the exemption because of political activity even though there’s no political activity.

They’re absolutely dead wrong. This is why you don’t invite issues with the IRS because they’re wrong a lot. When we call them, how often are they wrong? I think they did a study on it, 70% of the time they’ve given out erroneous advice. You’re not even allowed to say, well, they screwed it up and I relied on them. You’re not allowed to rely on them. They can be wrong all the time without consequence.

Jeff: If I call you up, you’re an IRS agent, and you give me advice, that advice is worthless.

Toby: Zero. The only time we ask them a question is because we’re gauging their temperature. Then they’ll write stuff and they’ll have a Treasury ruling like they did over the ridiculous stuff with the PPP loans where finally Congress acted. Usually, you don’t get the benefit of Congress acting. We’ll just say we don’t agree with you and we’ll file a form on our return that says we’re taking a contrary opinion because you guys don’t know what you’re doing. They like that.

Jeff: You can rely on the private letter rulings, but they’re really expensive.

Toby: Most IRS folks are great, I had an IRS agent say, oh it’s a tax avoidance scheme to use a pension plan. The accountant didn’t know what to do. It was in North Dakota. The accountant was like, I guess we shouldn’t have done it. It was a 401(k). It was back when it was profit sharing […] purchase plans, but it’s like, you’re just wrong. That’s just stupid. IRS agents sometimes have a blind spot or they just get a little willy-nilly. Sometimes they’re just not nice folks, and they may just be having a bad time. Maybe they got booted out of the house or had a car accident.

Jeff: That’s certainly the case now.

Toby: Or they just don’t know any better and they think they’re right, nobody pushed back on them. I don’t want to beat up. They’re mostly really cool. We don’t get to deal with them very often. How many audits did we have last year? Probably thousands and thousands of returns.

Jeff: Yeah, we had about 6500 returns and maybe a handful of audits.

Toby: Less than 10?

Jeff: Oh, yeah absolutely. I think we’re seeing a little bit of an uptick of it still.

Toby: You get letters, somebody forgets to put a K-1. You get that type of thing. Audits are rare, guys.

Jeff: Again, going back to what brought this one up is appearance. Don’t throw yourself out in front of a bus. There’s no need for it.

Toby: Don’t poke yourself in the eye. What we used to say, I worked in criminal court for a judge I was clerking there and he said, Toby, nobody is in jail for talking too little.

“Is there a way to live in a property purchased through a 1031?” Absolutely. Once you’re through the first year, then you can go ahead, move into it. That’s not even a hard and fast rule. We just say for the sake of appearances, at least six months, better off a year. Just to show that you intend to buy it as an investment property.

Last one, “Can the 1244 rule be applied to an LLC that has not filed income taxes in over 10 years?”

Jeff: You know when I read this question, I thought this was actually a tough question and then I realized I was missing the point.

Toby: First off, LLCs don’t pay taxes. You have to say how it’s going to be taxed. That LLC can be taxed as a disregarded entity, it could be taxed as an S-Corp, it could be taxed as a C-Corp.

Jeff: Let’s assume it’s an LLC that is taxed as a C-Corp.

Toby: All right. It’s an LLC being taxed as a C-Corp then you have to look at 1244, which says you can take up to $100,000 of loss from a C-Corp, the shareholder can.

Jeff: From the loss on their stock.

Toby: Yeah, it’s the stock loss rule. The easy question is do LLCs have stock? And they do not.

Jeff: I know.

Toby: That’s the only difference between an LLC taxed as a corp and just a traditional corp.

Jeff: Let’s say I have $100,000 worth of loss in my LLC taxed as a corp.

Toby: Then I’ll take a capital loss, which means I would be able to use it against my ordinary income of $3000 a year, or I can offset my other capital gains. Otherwise, if it was a regular C-Corp, then you get an ordinary loss.

Jeff: Supposing this was an Inc. instead of an LLC and they haven’t filed their income tax returns in over 10 years, I don’t know this and I doubt if I can find anything.

Toby: How would you know if they had a loss?

Jeff: I was going to say I think the IRS would question whether or not…

Toby: You couldn’t. I’ll make it easy because you couldn’t have a loss. Where would your loss be? They have no idea. In order to write off your loss, you actually have to file the return showing you have the loss.

Jeff: There’s a gross revenue rule that you have to prove where your gross revenues are coming from and frankly, you haven’t proven anything by not filing returns.

Toby: Not filing a return, by the way, is a gross misdemeanor. It could be a felony if you did two years in a row. File your tax returns even though it’s rare that people get called out on it. If they wanted to mess with you, that’s what they would pick on. They’re going to say, oh, technically, here we have 10 felonies so let’s get some money out of you.

Jeff: If you’re taxed as a C-Corp or an S-Corp, you are required to file a return every year that it’s in existence.

Toby: Yup. All right, guys. We went a little bit longer, but not horribly.

Jeff: No.

Toby: I thought it was actually 4:00 PM. YouTube, by all means, go in there and subscribe. We love our people that are on YouTube. We reach out, we give a lot of information. Go to our podcast if you like listening to Tax Tuesdays. If you like these, we record them, we break them into pieces and you can always go in there and listen to some old episodes. They’re fun. If you like replays, you can go in and listen to the Platinum Portal and you’re always in there.

Somebody says, “The presentation was powerful. Thank you so much for your presentation. God bless.” We like that, God bless you too. It’s a lot of fun. We always have a good time.

If you have questions, by all means, email them in. We get hundreds so we pick usually on Mondays and usually, they’re waiting for me to grab. I just grab a bunch and throw them on there. I don’t necessarily edit them, but I like to look, so it’s kind of cool.

Jeff: There’s no grammar spelling in this one that I saw.

Toby: I actually ran it through because I’m so annoyed. There were a couple of ands and ans, but the really major stuff, I was like, okay I’m not just going to leave that. But I try not to change the context because I don’t know if I’m screwing it up or changing the meaning. Usually I read it three or four times. Some of you guys write kind of funky, to be real. We’re all that quick email stuff.

TaxTuesday@andersonadvisors.com, visit us on the internet. Just say AndersonAdvisors. Guess we’ll see you back here in two weeks. In the meantime, go out and think of some questions, throw them at us. Jeff likes the really hard questions. I like the easy ones so just put ‘for Toby’ if it’s going to be easy. When it’s going to be annoyingly hard, just say, Jeff, this is what I really want you to answer. All right guys, we’ll see you next time.

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