On today’s Tax Tuesday, tax experts Toby Mathis, Esq., and returning guest Jeff Webb, CPA, CFO of Anderson Business Advisors, share their expert advice on tax strategies associated with setting up a home office, the potential consequences of being classified as a real estate dealer instead of investor, and how the IRS can view real estate flips as inventory and treat you as a dealer, leading to self-employment tax and other repercussions. Listeners are also guided through minimizing stock gains as a day trader and understanding rental property ownership. Submit your tax question to taxtuesday@andersonadvisors.
- What are the requirements for bonus depreciation? – Bonus depreciation applies to tangible personal property with a depreciation life of 20 years or less.
- Can I 1031 exchange the entire proceed from the sale of a property with two structures, one rented and one as a main house? – Yes, you can 1031 exchange the rental portion, and possibly the entire property if it is converted into a rental before sale.
- Can I still invest in the 2022 tax year such as starting a solo 401K if I extended my tax return filing to October 2023? – Yes, you can make retirement contributions for 2022 up until your tax return deadline, including extensions.
- What are the benefits of an S corporation status for a small business owner versus sole proprietorship or LLC? – S-Corp can provide tax savings through reduced self-employment taxes, and may have lower audit rates than sole proprietorships.
- Can first-year business expenses be carried forward to the following year if there is no income in the setup year? – Yes, you can carry forward business losses to offset future income.
- Can I have a home office deduction if I rent the property? – Yes, renters can take a home office deduction if they meet certain requirements.
- How can I minimize day trading stock taxes? – Strategies include careful risk management, using tax-advantaged accounts, and offsetting gains with losses.
- Can I deduct expenses from my LLC registered as a partnership for fix and flip houses? – Yes, expenses related to the business operation can generally be deducted, though there may be limitations.
- Are all expenses related to the purchase and rehab of a rental property included in the basis for depreciation? – Yes, purchase price and most rehab expenses are included in the depreciable basis of a rental property.
- What’s the best way to minimize the loss of passive losses on rental activities due to the AGI phase-out? – Carry forward passive losses until passive income is earned, become a real estate professional, or dispose of the activity.
Full Episode Transcript:
Toby: All right. Welcome, guys, to another Tax Tuesday. My name is Toby Mathis.... Read Full Transcript
Jeff: I’m Jeff Webb.
Toby: Yeah, it is Jeff Webb. Welcome back again, my friend. I think I missed last week, so I had to make up for all the shenanigans. Did you guys have a good week a couple of weeks ago?
Jeff: That went well. Eliot’s easy to work with.
Toby: Eliot’s easier. It goes smooth.
Jeff: I didn’t say easier.
Toby: I get it. You didn’t have to. It goes without saying because he was like, hey, Toby, press this when you say your name. It’s Toby Mathis. Just not very nice. All right, Tax Tuesday rules. Let’s talk about some rules.
First off, if you have questions that are specific to you, put them in the Q&A. If you have comments as we are speaking right now in the chat, you could say, hey, I am sitting in which city or state you could just put in there right now, then we can see it. I love getting the comments. If you could, just put in there where you are literally sitting right now, what city and state you’re in. Put that into chat.
Let’s see. Eatonville, Washington, home of Brandon Jumper. He was a great running back back in the day. I think he played for WSU. Gainesville, Florida, Washington, Mooresville, North Miami, Phoenix, Oregon, Minnesota, Ormond Beach. I’m in Half Moon Bay, beautiful. San Luis Obispo, Lahaina. Hey, David, nice to have you with us. Hope things are going alright over there.
Goose Bay, that’s in Canada, and then Bellingham, Washington, near my mom, she’s in Anacortes. Maine, Texas, Santa Clara, Boston, California, confused in Oklahoma. Or is that the name of the state? What kind of state are you in right now? All right, Massachusetts.
All right, somebody says, it says disabled. Hopefully, they undisabled it, because people are using it now. All right, use chat if you have comments. Is there a reason we can’t see chats? Yes, it’s because people solicit on free events when we don’t require you to be a client, and they come in here and they ask you to buy insurance and all sorts of stuff, maybe some Tupperware. There’s usually a prince or two from some other country that needs a little bit of money to get whatever they need to get. So we disabled the chat.
But you can still ask questions. We have a whole staff here to answer your chats. We have a bunch of accountants. Troy, Tanya, Ross, Jared, Amanda, an attorney. There’s Patty, Matthew, and me. I guess I count as something, but you got a bunch of folks there, even during tax season, here to help you.
Somebody says, can we get a recording? The beautiful part about this is we record these and put them on our YouTube channel. I will show you what that channel is in a little bit. You could always go in there and watch all of the wonderful Tax Tuesdays that we’ve done. We’ve done over 200 of these. If you’re bored for about two or three weeks, you could just watch them all.
All right, lots of fun stuff. Taxes. You’re going to sit there and say, I was going to watch The Last of Us. But no, I don’t want to watch a zombie apocalypse, I want to learn about taxes. Okay, I’ll probably do the zombie, but I don’t know.
Jeff: We’ve got three weeks to the last deadline?
Toby: It looks like The Last of Us in our tax department right now, because they’re just working their tails off to finish. No, they don’t look like that. They look more like they need to see us do it. Everybody is working their tails off. This is our tax season right now, October 15th. If you didn’t know, with your extension, this is the hard deadline of getting your tax return filed.
All right, let’s talk about the questions. We answer a whole bunch of questions. I will read them before we go through them individually, and then you can always ask your own questions in the Q&A feature. Q&A is where you put in your personal question. Chat is where you make comments.
If I say something like, hey, if you’re the person who wrote this question, could you elaborate on that, do it in chat. We have a whole team there to answer your questions. No, it doesn’t cost you a nickel. You don’t get an invoice, I always call it the love letters from lawyers and accountants. You don’t get that here, because we are just here to answer your questions and hopefully make sure that we’re bringing a little more tax knowledge into the world so it’s easier, because our tax system is funky.
They do things like, hey, you owe some taxes. And you say, okay, how about this? They don’t really say yes or no. It’s like, you figure it out, you tell us what you owe. It’s a confusing system. There are lots of different rules that can benefit you and a lot of different rules that will hurt you. The trick is figuring out the best scenario for you that you’re comfortable with and that comports with the law.
All right. “What are the requirements for bonus depreciation? What assets qualify?” It’s the first question, and we’ll answer that.
“My property has two structures, a main house and a large guest house. I rent out the guest house. When I sell the entire property, can I 1031 exchange the entire proceeds from the sale?” Great question. I love that question. It’s my first time seeing this, except right beforehand, I looked at a couple of them with Jeff. I actually really liked that. Eliot, you get a star on that one. He knows. I’m watching the questions that he draws.
All right, “Extended tax return filing to October 2023 for the 2022 tax year. Am I still able to invest now for the 2022 tax year, such as starting a solo 401(k)?” Really good question. And the answer is going to surprise you.
All right, “What are the benefits of an S-corp status for small business owner versus sole proprietorship or LLC?” Spoiler alert, there’s no such thing as an LLC for tax purposes, but we will answer that too.
“Can first year business expenses for setting up a business be carried forward to the following year if there is no income in the setup year?” We’re talking about carry forwards here, we’ll answer that.
“I’ve been watching the videos of home office deductions from having an accountable plan. Does the residence have to be your own to be able to do the home office deduction? Or if you rent the property, can you also have the deduction?”
Really good questions today. Here, hold on real quick. We have to give Eliot some props. I don’t even think he’s on. But if he was on, I would say, Eliot, you get a star, because sometimes he picks some questions that are questionable.
All right. “How to minimize day trading stocks?” Should we tell Eliot that he did a great job? He brings up a question. That’s not really a question, but we will answer whatever that is.
Jeff: The best we can.
Toby: How to minimize day trading stocks? I guess that would make it a question.
All right, “My LLC is technically registered as a partnership, because it is just my husband and I as a member managed LLC. We would like to fix and flip houses, and we have invested about $15,000 in learning so far and want to be able to take the deduction as pass-through expense for a personal income. Will we run into any issues with that?” We will definitely go over that. There’s a case right on point for almost that exact scenario. Actually, Woody case, Woody the commissioner, right?
“I purchased a rental property this year. Are all expenses related to the purchase and rehab to be included in the basis for depreciation or can any be expensed this year? Expenses include purchase price, rehab, which was paint, remodel, change locks, utilities, out of state travel expenses.” There’s a bunch of stuff here, so we’ll unpack that and go through it.
“If you have amassed a large amount of passive losses on your rental activities that you cannot use due to the AGI phase out,” You must be an active participant. You must be talking about the the $100,000-$150,000 phase out, but immaterial. “What would be the best way to try to minimize the loss of the losses, no pun intended, before trying to reach REP status, which is real estate professional status, or can you offset them once you do get rep status?”
Those last two, I think we’re going to be tired today. Speaking of tired today, go to my YouTube channel. There’s a lot of good stuff on my YouTube channel. There’s also Clint Coons’ channel. I don’t see it as a slide.
If you feel like it, and you want to stay plugged in to the different content that we create, especially me, it’s absolutely free. There are 647 videos, most of them with Jeff. Okay, only a few of them with Jeff. But if Jeff wanted to do videos, I’m always available. There’s a lot of Tax Tuesdays in there. So yes, a lot are with Jeff’s smiling face.
We do a lot of things on asset protection, investing, and tax. It’s absolutely free. You can just go to aba.link/youtube. I think Patty just put it into the chat. If you want to register for Clint’s channel, he’s been my partner for the better part of 25 years, and he’s excellent on the real estate asset protection. If that is your interest, by all means, go there, subscribe. We don’t spam you or anything. It just lets you know when new videos come up.
We put up about two or three a week, so it’s not like it’s once in a while. We’re not one of those groups. We just constantly put out content based off of the questions we are getting asked. Speaking of questions we are being asked, Jeff, “What are the requirements for bonus depreciation? What assets qualify?”
Jeff: Real simply, it has to be personal property.
Toby: Tangible Property, right?
Jeff: Personal, tangible property, correct, with a depreciation life of 20 years or less. Eliot and I were just talking about, we don’t know when we’ve last seen a 20-year life, so 15 years or less.
Toby: It’s 15-year, 7-year, or 5-year. Those are the years. Is there anything else there?
Jeff: There’s a three year asset, but that’s mostly for farmers and stuff like that.
Toby: What does this means, by the way? Bonus means I can write the whole thing off or a significant portion of it in the year of acquisition, regardless of how long I’ve owned it. I could buy a cell phone, five-year property. I bought it December 31st. Can I bonus it?
Toby: And what amount is bonus this year?
Jeff: Eighty percent for 2023.
Toby: Eighty percent. If I can’t write it off as bonus depreciation, maybe I’ll write it off as…
Jeff: You could take it as section 179.
Toby: Up to $2 million?
Jeff: Yup. One place you can’t take section 179 is on rental properties.
Toby: You can’t do 179 on rental properties. Also, what if you create a loss? Can you create a loss with 179?
Jeff: No, and you can’t have a business loss and take 179. Bonus has always been much easier that’s why we didn’t talk about 179. We didn’t really need 179.
Toby: Until this year. For 2022, we never talked about it because you’d always bonus it, because you can create a loss with it. In 179, you’re limited. You can’t have losses. But if you’re making money, it doesn’t matter. You can use 179 and write the whole thing off in the year that you buy it. If you’d rather write it off over five years, you can. You can opt out of bonus depreciation. You have to opt out, otherwise you’re going to take it.
Toby: Then you’ve got to treat all asset classes of a certain year the same. All your five-year property, if you want to bonus it, you’re going to have to take 80% of all of the five-year property, not onesie-twosies.
Jeff: That might make sense sometimes. If you got a bunch of 15-year property, you definitely want to bonus that. Not bonus the five-year or maybe even the seven-year property, but that’s when you say calculate, calculate, calculate.
Toby: Three rules, calculate, calculate, calculate. Sometimes it is better. Why would I be writing things off at the 12% bracket when I could wait until next year, and it’s going to offset the 24% or whatever it is? Maybe I’m better off not taking a deduction this year when I’m thinking about it critically. I say, hey, this is really worth quite a bit more to me.
If I don’t bonus it, that happens a lot of times–80% bonus depreciation max is for short term or long term or both? There is no short term or long term. It is tangible personal property, and it’s anything that would be 5 years, 7 years, or 15 years.
If you’re doing bonus depreciation on a home, you’re doing a cost seg first, breaking it into its components. If you have a rental property, you’re allowed to do this, and then you’re riding off the 80% of the 5-year, 7-year, and 15-year property. Somebody says, what about a car?
Jeff: Five-year property and gets bonus. Let me pull back on it. We talked a lot about 280A, but there’s another section 280, 280F that limits luxury vehicles, which up until a couple years ago was $10,000. It limits how much depreciation?
Toby: Is it $18,000 this year?
Jeff: It’s $18,000, I believe.
Toby: The first year, the max you could write off on your bonus and regular depreciation is $18,000 for a car, a luxury car. For equipment like a suburban, a big truck, or a Tesla X, something that’s over 6000-pound gross vehicle weight, you can write off 80% of that in year one, which is why people do that. I always look at it and go, stop it, you’re not using it 100% for business.
Most people are using it less than 50% in which case you don’t want to touch this stuff. Stick to writing off mileage, because if you fall below 50%, you have recapture issues that nobody ever talks about. It’s crazy.
Somebody asked a question in chat. I’m sorry, you guys can’t see this. “How does a 3115 change an accounting work for the rental that I didn’t take bonus depreciation for in 2019?” In order to take bonus depreciation, you have to do the cost seg. If you bought a property in 2019, you could still make a 3115 Election even for last year, for 2022, and take all the bonus this year.
Since you bought it in 2019, it’s 100%. You could literally write off all of your 5-year, 7-year, and 15-year property that’s part of your real estate for 2022. Or you wait and you say, I do it right now, but I’m going to apply it to 2023.
Jeff: I think what they’re talking about here is they didn’t take any depreciation in the past, which establishes your accounting procedure. They just want to do a 3115.
Toby: To change it to do a cost seg?
Jeff: No, just to be able to take that depreciation for all those past years. I agree with you, though, that you might as well do a cost seg on top of it.
Toby: Yup. Javier, I assume this is pre recording and that the chat Q&A are live. No, this is live. Second home on rental. I don’t know…
Jeff: Yeah, if we screw up.
Toby: Yeah, sometimes we do. It’s live. Sometimes we don’t agree, and then you have to go back and figure it out. All right, “My property has two structures, a main house and a large guest house. I rent out the guest house. When I sell the entire property, can I 1031 exchange the entire proceeds from the sale?” What say you, Jeff?
Jeff: When you do this, when you sell this property, this parcel, you actually have two sales built into one. You have the sale of your personal residence, and then you’d have the sale of the auxiliary building. Part of what you need to do when you do this is you need to get very good appraisals. You need to be able to get very good numbers for your primary residence and for that auxiliary, so you can divide that sale into two and say, this is what I’ve got for the private residence, and this is what I got that I want to 1031 exchange.
Toby: It doesn’t matter if there are two structures. Somebody says, ADUs are big thing in California. Yup. But if this was one structured, you had part of the house used for rental, and part of the house was used as your primary residence, you get the capital gain exclusion under 121, which says that you must live in it as your primary residence two of the last five years.
If you do that, if you’re single, you avoid tax on $250,000 with a capital gain. If you’re married, it’s $500,000. But you can still 1031 exchange that portion of the house that wasn’t your primary residence, because it was used for investment purposes.
Just to twist your brains a little bit further, you could make the whole thing into a 1031 exchange and still get the 121 exclusion, so long as you change the whole house into a rental and you sell it within three years. You have to have lived in it two of the last five years as your primary residence to use the 121 exclusion, not the last two years. You have three years that it can be treated as an investment property, and you still get the capital gain exclusion, and you can actually 1031 exchange the entire home.
Jeff: I usually say, if you’re going to do that, you don’t want to convert it to a rental and then sell it in the same calendar year. What are your thoughts on that?
Toby: There’s no rule on it.
Jeff: There is no rule on it.
Toby: The IRS is going to say, is it actually an investment property? Technically, there’s a case where they never even made it. They never even rented it out. They made it available for rent. In good faith, they tried to rent it. I think it was in 2008, it was in that range. They tried to rent it out, they could not find a tenant, and then they sold the property after trying in good faith to rent it out. It would have been a house they lived in, and it converted the property into an investment property, even without the rental.
Don’t try that at home. There’s a reason that it’s a case. It went to tax court, which means it went through an audit, they lost, they went to an appellate, and a decision didn’t appease either side so they went to tax court. It was a case of first impression. The court said, here’s what we look at. There’s not a hard and fast rule. There isn’t like, hey, you have to do it for a year, hey, you have to do it for two months.
My general rule is rent at arm’s length to somebody else for at least six months, and you should be good. But chances are, you’re not going to get audited, because the audit rate is less than 1% anyway. There’s not a lot of agents, even though they’re hiring agents. They’re hiring over the next 10 years. We’re losing more agents than they’re hiring still, in my opinion. I don’t think they’re making it up.
This isn’t something that we’re really going to sit here and fight about. You don’t get to write it off that way, and you’re excluded from being taxed in the game this way.
My short term rental is in in-law suite within my residence onto a portion of my home mortgage, insurance, property taxes deductible in my LLC. Yeah, Jimmy, part of your home is actually a trade or business in that particular case.
If it’s short term rental, it’s actually depending on whether you’re doing all the work and what type of services you’re providing, that could be actually considered active income subject to self-employment tax. Or it could just be an active ordinary loss which is non passive, which could offset even your W-2 income. But yes, you get to depreciate a portion of the home, and you get to write off a portion of the expenses. Yeah, it rocks. Yay. What a great question.
Again, Eliot did a great job picking that one out. It just opened up a whole bunch of issues that we could sit here and talk about all day, but we’re not. Jeff. Extended tax return filing to October 2023 for the 2022 tax year. An enlightened taxpayer knows that taxes are due in April, but your tax return is not due until October. “Am I able to still invest now for the 2022 tax year such as starting a solo 401(k)?”
Jeff: Here’s the good news. Two years ago, they changed the rules and said, hey, you can start a 401(k) or retirement plan up until the due date of your extended return. Yes, you could do that. I’m not sure where you’re putting it, is it sole proprietor?
Toby: They didn’t say who’s the sponsor of the solo 401(k). Here’s the issue. You can set up a 401(k) for your business up until that business files its tax return or is required to file its tax return. You have to look at the type of business. If this is a partnership, or it is an S corp, that tax return was due back in March with a six-month extension to September 15th, which means too late to set up the solo.
If this business is a sole proprietor, then you’re in luck. You’re paying more in self-employment tax, but the employer can make a contribution to the 401(k), you cannot. You as an employee must defer your income into the 401(k) during the tax year. You would have had to have made your employee deferral into a 401(k) in 2022 proper or soon thereafter.
Technically, you could do it in January for payroll that was run for December of 2022, but not getting too technical. Here, “Am I able to still invest now for 2022?” You could do a solo 401(k) and make an employer contribution. You could do a SEP IRA and still make a contribution. Are there any others that I’m missing?
Jeff: That’s all I can think of, because most of the other ones are going to have deadlines before 15th.
Toby: Do you still have KIO or anything like that?
Jeff: I don’t know about the KIO.
Toby: We know for sure that you have SEPs and 401(k)s that you could still do. Again, depending on the type of business that’s making the contribution and depending on whether you filed a return for it. The other stuff you do for 2022 is you could still do cost segregations and bonus depreciation on real estate that you own in your name that flows onto your personal tax return not through a partnership, though.
There’s a few of you out there that may still have some flexibility. We just did a DB plan. I think it was last week or whatever it was. Was it last week? Yeah, just a little over a week ago. That’s $75,000 contribution for 2022, because the client still had that ability. This law changed.
Jeff: And you just mentioned another plan that you can do up until the deadline.
Toby: The defined benefit?
Jeff: Yup. It might be a little hard to get accomplished at this point.
Toby: Yeah, I think that most people are going to say there’s no way to run the numbers in time.
Jeff: About the employer contribution, there’s a couple of stipulations there. If the sponsor is an S-corp or C-corp, you have to have the W-2 for 2022 to make that employer contribution. If you’re a partnership or sole proprietorship, that doesn’t necessarily follow. Your earnings are what the partnership or Schedule C have earned.
Toby: Underlying and putting explanation points over what you said, you got to have earned income to make a contribution. This isn’t for your rental income this isn’t for interest income, this isn’t for capital gains. This would be if you have active income from a business. Jeff’s pizza shop, he’s a sole proprietor, he made $100,000. He would be able to put, in theory, up to 25%, $25,000 plus makeup, so an extra $75,000. For the employer side, you can contribute up to $32,500 into a 401(k) up until October 15th.
Jeff: I’ll tell you what, even if you’re not going to benefit 2022 for this, I would probably still do it for 2023.
Toby: Get it in there now. The thing is that the longer that money is in there, it’s like baking a cake, the longer it bakes. If you’re going to do tax deferral, even if it’s for the same year, I could put money into a plan on January 1st or December 31st. The money that goes in on January 1st has all that year baking of making that interest tax deferred. I end up doing better.
From a tax standpoint, it won’t make any difference for the deduction, but you get to avoid. In theory, if I didn’t make the contribution that’s sitting in my account, and I make income over the year, make a bunch of capital gains, or whatever, now I’m going to have a tax.
Somebody says, “I emailed two questions a few minutes ago prior to the webinar. Will they be answered during the webinar?” Go over to the Q&A and put those questions in there. Nobody’s going to be able to get to those questions. We get hundreds from the email, so yeah, they wouldn’t be. But if you go into the Q&A, then they’ll get to you.
They’ve already answered almost a hundred questions. They’re churning them out. We have a whole team. Matthew, Patty, Amanda, Dutch, there is Eliot. Eliot, you rock star. Jared, Ross, Tanya, Troy, all these guys. Somebody says, doesn’t a cake a little dry after baking for 12 months? John?
Let’s go to the next one. “What are the benefits of an S-corp status for a small business owner versus sole proprietorship or LLC?”
Jeff: The number one benefit is if you’re making money, you don’t pay self-employment taxes on an S-corp. There are some other benefits. I prefer an S-corp for the 401(k)s or retirement plans. You can do an accountable plan with your S-corporation that you can’t with a sole proprietorship.
Toby: Extra tax savings, because you’re an employee and you’re not a sole proprietor.
Jeff: Correct. You’re talking about your phone earlier.
Toby: This actually came up during our live event here in Vegas. There was a guy going through an audit as a sole proprietor, and they disallowed his entire phone expense, because he couldn’t itemize each call as to whether it was personal or business.
Jeff: What if you’re an S-corporation?
Toby: As an S-corp, the employer can reimburse you 100% of anything you have out of pocket. You get to write it off, and you don’t have to recognize it as income. If he had been an S-corp, he could have written off the whole thing, not just the business portion, the whole flipping thing. It was bad, so he lost it.
Jeff: And we see that for phones and for internet. Now there are certain expenses that if the employer requires you to have it…
Toby: There’s a question here I saw earlier about administrative office. You can only have an administrative office if you are an employee of an organization. You are not an employee of an organization if that organization is a sole proprietorship or a partnership. You can’t be. You’re a partner or you’re the sole proprietor, but you cannot be an employee. It has to be a separately taxed entity like an S-corp or C-corp, a nonprofit, an LLC taxed as an S-corp, or an LLC taxed as a C-corp. LLCs don’t exist for tax purposes.
Jeff: One thing you and I have talked about in the past is if you’re a sole proprietor, and your profit is $5000-$10,000 a year, it probably doesn’t make sense to become an S-corporation.
Toby: I would say that the line where it makes economic sense to go from a sole proprietorship, and by the way, it’s a sole proprietor or LLC, an LLC could be a sole proprietorship, or it could be an S-corp. We ignore the LLC, it doesn’t exist for tax purposes. We’re really only comparing, do I put this on my Schedule C of my 1040, which is what you would do if you’re a sole proprietor, or do I put it on 1120-S, which is the tax return for an S-corp?
I just have to compare those two things. If you decide, hey, you know what, I’m much better off from a tax standpoint of being an S-corp, usually, you’re right around $30,000 or above. What it does is it saves you about $1500 a year. The way the math works is, I only have to pay self-employment tax on about 1/3 of the income I make as an S-corp. Technically, you’re supposed to take a reasonable salary. The courts have come back and repeatedly said it’s about a third.
Let’s just say it’s $30,000 of net income, and I take a $10,000 salary, I dump it onto a 401(k), and I have $20,000 that hits me. That $20,000 would not be subject to the self-employment tax, which would ordinarily be 12.4% and 2.9%, which would be 15.3%. I would save myself, what’s 20 times 15%, somewhere around $3000. I’d probably saved myself enough money to justify the hassle of setting up an S-corp and running payroll. That’s what it is, and that’s how you should be doing the math.
If you’re making $100,000, it’s a no brainer. You’re going to save yourself close to $10,000 a year being an S-corp, because you can avoid the payment of the employment taxes on about 2/3 of that money. Let’s just make it even more fun because I’m a data geek. Your audit rate is over 800% higher.
Just set up a scenario. If you’re making $100,000, it actually was 2.4% for sole proprietors, last year, they tracked it. This year, we are below a fraction of a quarter of a percent for an S-corp. It’s not even close. But even in that year where they gave us the data, the S-corps were at 0.2%. It is quite literally 800% more chance of getting audited if you’re a sole proprietor, but that’s not the end of it.
The sole proprietors lose their audits about 94%-95% of the time according to the IRS data. It’s publication 55. I think it’s table 17A if you want to just go for kicks and look at it. You could see the audit rates, and you could see the change rates. They actually do it reverse. They say the number of returns with no changes was 5% and 6% respectively, depending on whether it was a field audit or a correspondence audit.
You get audited a lot more as a sole proprietor, and you lose those audits over 90% of the time. It’s not true of the sole proprietors that are making very little income. That’s not elevated. It’s a little bit, but not enough to make you go crazy to do it.
The IRS believes that sole proprietors are more likely to overstate expenses and understate income than any other entity. That’s why they pick on them, because those are the people that are walking around writing off everything. Hey, I wrote off my whole phone, I wrote off my whole car. Hahaha, suckers. You guys pay tax on this stuff, look at me, and the IRS comes in and says, let me see your records.
What was the business use of your phone? What do you mean? I use it all for business. Denied. How about the car? Where’s your mileage log? What mileage log? Denied. You lose those deductions, and they always do. They usually mix all their stuff up anyway, so don’t be a sole proprietor.
Let’s keep going. “Can first year business expenses for setting up a business be carried forward to the following year if there’s no income in the setup here?”
Jeff: It just becomes another deduction that gets carried forward with all your other expenses. There are two kinds of expensive, startup expenses, which we talked about a lot, and organizational expenses. You get up to $5000 each of those in the first year. But anything beyond that, and this usually happens more of a startup expenses, gets amortized over the next 15 years. On top of your loss in that first year being carried forward, you’re going to have more startup expenses each year that are being amortized.
Toby: It’s over 15 years. It’s onto long stretch. But if you have ordinary, they’re called 162 expenses, customary, ordinary, reasonable, and necessary. We just call them reasonable and necessary, or just ordinary expenses. If you have those that you’re incurring as you’re open, even if you’re not making any money, but you’re trying, you have a store, Jeff has his pizza shop, he’s selling some pizzas, but he’s losing money every month, you don’t lose that, you just carry it forward. It will offset other income, though.
If you are a sole proprietor, a partnership, or an S-corp, and those losses flow onto your return, then you could write them off against other W-2 income. Let’s say you have a spouse who’s making good money, and you’re starting up the family business, and you’re going to go through a couple years of pain, it might help you out as a family. It might lower the tax rate you have for that year, but you would use the loss. Otherwise, you just carry it forward.
Jeff: And they made a really important change with TCJ in 2018.
Toby: The Tax Cut and Jobs Act. I’m just saying, they don’t know this one.
Jeff: With a big tax law change. Net operating losses used to expire, and they don’t anymore. They go into infinity.
Toby: Weren’t they like 20 years?
Jeff: Yeah, I think some of them or even shorten that for different types of entities, but mostly 20 years.
Toby: Never underestimate Congress’s ability to make things that were simple, more complicated. They’re really good at it. Annoying? Yes. Good at it being annoying? Yes.
This is fun stuff. Actually, somebody has asked a question. “If you incur recorded expense while on a nonprofit board but are not reimbursed, can you write it off?” No, we did away with miscellaneous itemized deductions, so you eat it. I’m sorry, Joyce. I’m spreading joy to Joyce. I’m sorry, Joyce, but no, you can’t write that off. And it stinks.
The only exceptions are for teachers. I think they can write off $300 of unreimbursed expenses. You should give me a smiley face. I’m so sorry, Joyce. I was giving bad news. You’re supposed to be an angry taxperson. But thank you for sitting on a nonprofit board and then say, hey, I can’t write this off. Could you please reimburse me now, because you’re making my life worse? If they reimburse you anytime, next year even, you should be okay.
Let’s see. “I’ve been watching the videos of home office deductions from having an accountable plan.” I don’t care which channel. Hopefully, you’re getting the benefit out of it. “Does the residence have to be your own to be able to do the home office deduction? Or if you rent the property, can you also have the deduction?” The question is, do you have to own the property personally in order to do the home office deduction or administrative home office?
Jeff: I want to start off with making an important distinction. Sole proprietors have home offices. Everybody else has administrative offices for which they’re reimbursed for their expenses.
Toby: Remember the accountable plan we are talking about that S-corp, S-corp, LLC taxed an S-corp, LLC taxed as a C-corp or a nonprofit? If you’re an employee, you get to reimburse the employee. The employer reimburses the employee, me, for the use of their home.
Jeff: I want to make a distinction here. I understand your question when you say, does the home have to be yours mean ownership? The expenses for the home have to be yours, and you have to be living there. To your point, you’re asking about, can it be a rental property? Yes, absolutely.
Toby: A hundred percent. You’re writing off what you spend. Let’s say that it’s a three-bedroom, two-bath. You got a big area for the kitchen, a big area for a living room. I would call that a five bedroom. One of those bedrooms is being used as your home office. It’s 20% of your out-of-pocket expenses associated with that home including your rents, including your utilities, including your electric bill, your water. If you have a cleaner come over and clean things up once a month, all of that goes into the kitty, and you write off 20% of it. The company reimburses you 20%. The same way.
We had somebody asking about it. Joyce was trying to get reimbursed from a nonprofit. This is no different from whether it’s something you control or a separate. They either reimburse you and say, here, Jeff, thank you for allowing us to use your home. We didn’t have to rent a space for you. I’m going to reimburse you the out-of-pocket expense that you incurred. Jeff doesn’t have to report it anywhere.
As the employer, I still get to write it off, and sometimes you’re wearing both hats. Sometimes you have your own S-corp, and it’s weirding you out. You’re like, wait a second, I’m on both sides of this transaction. My accountant said, they usually come up and say, I don’t feel comfortable with that, whatever, something silly. It’s like, no, you’re wearing two hats. The IRS expects you to do this.
When are you wearing your personal hat? When are you wearing your employee hat? When are you wearing your business hat? And they want you to track it so that they can tell, oh, here’s all these business expenses on this S-corp return individually. Oh, there’s not much going on here, there’s some W-2. That’s it.
Even though the corporation had reimbursed you $5000 that year for a bunch of stuff, they see the expense on the S-corp return, it flows onto your return. They don’t want to see anything on your return for that. It works out great. Isn’t that fun?
Tanya just jumped in and says, it may be possible for you to include these in out-of-pocket expenses on your charitable donation. You would need to get a donor letter from the nonprofit, though. That’s really smart, Tanya. I didn’t think about that. Tanya is one of our accountants. She’s out there kicking butt in the nonprofit world.
Jeff: That’s why we keep her around.
Toby: She’s very smart. Here’s the thing. What she just hit on is, hey, if a nonprofit owes you money, and you don’t get reimbursed, you can’t write it off. But if you are itemizing, keep in mind, this is only if you’re above the standard deduction, you might say, don’t worry about it, I’m just going to contribute that to you. In exchange, in order to make it a valid donation, I need a letter from you saying that I didn’t get anything in return.
Hey, Joyce, we owe you $100. And Joyce says, don’t worry about it, but give me a letter saying that I’m contributing $100 to you. They give you a donor letter, you write it off as a $100 donation.
Jeff: The one exception to that is charitable mileage, it goes directly on your Schedule A. You don’t have to get a letter or anything for it. It’s just mileage.
Toby: It’s still itemized though, right?
Jeff: It’s still itemized. Correct.
Toby: When we say itemized, it just means as an individual, you have $13,850 of standard deduction as an individual, as a married couple, you’re over $27,000. If you don’t have the combination, mortgage interest, state and local taxes, medical expenses, mortgage interest, those things, the combination of those that don’t exceed that amount, then it doesn’t matter anyway. I’m not writing it off.
Jeff: And as many of you are finding it out, it gets harder and harder to beat that standard deduction.
Toby: They raised it up in 2017 and 85% of the people use the standard, which is good.
Toby: It makes it easier. “If we hit the limit, can we donate forward?” I’m not sure what that means.
Jeff: There is a limit of 60% of AGI that you carry forward for five years. If you make $100,000, and you give $70,000 to a charity, good for you to start with. But that extra $10,000, because you’re limited to $60,000 in that case, that extra $10,000 gets carried forward until you can use it up.
Toby: Yup. “Nonprofit deduction or donation, how much can you deduct?” Up to 60% of your AGI if it is cash, 30% if it’s appreciated assets, 20% if it’s a private foundation. It’s just itemized, so it didn’t go away.
Somebody says, “I’m interested in sole proprietorship. What if you’re self-employed or a consultant?” We just went over that, Liliana, with the S-corp. Almost always, it’s going to be an S-corp if you’re making over net $25,000-$30,000 a year. Almost always.
“How to minimize day trading stock gains?” Which we never get to see because most day traders lose money, but that’s a topic of a different day.
Jeff: It’s really hard to beat the computers. Anyway, first off, if you’ve got losses to harvest, especially short term losses, dump them puppies. You can buy them back in 30 days if you’re really in love with those losses, but that will help offset your gains. Our buddy Eliot brought up, and we were talking about this, another good way, a strategy we have is trading partnership. You partner with your corporation.
Toby: You put it in an LLC, usually in Wyoming, you tax it as a partnership, and the partner is…
Jeff: Your corporation, and they are the general partner.
Toby: There’s a reason we’re doing this because in 2017, they did away with miscellaneous itemized deductions, which is where the management fees used to go. You can’t write it off individually if you’re paying a manager. You want the manager to get paid regardless. You want to make sure that it’s getting paid out of the profit. The profit never hits you and then you pay it, it’s just getting the profit.
If you’re a day trader, and you’re doing a good job and you have expenses, like you want to be able to write off your phone, your computer, your data feeds, go into classes and things, you can’t write that off as an investor. Normally, you’d have to qualify as a trader in securities, which is this huge thing that they love to audit and find 10 ways why you don’t qualify, even if–this is an actual court case–you spend $15 million a year trading.
There are people with thousands of trades, and they find all sorts of reasons to deny them. But if you don’t want to deal with all that, you set up a trading partnership owned, usually 20%-25% by the corporation, the money goes to the corporation and uses it to pay the expenses. If it’s not enough and you have lots of expenses, then you do a guaranteed payment to partner maybe $1000 or $2000 a month that you’re kicking that partner, and then it comes off the top. It lowers the profit that flows onto your return.
Again, your return looks really, really simple. It just has capital gain. If you’re a trader, short term capital gains showing up on your return, the net of all those expenses and the amounts that you paid to the corp.
Jeff: And we justify. I know some people may question that monthly payment or annual payment, whatever. But we’re actually just financed by saying the corporation is actually managing the trading, the LLC itself, and so forth. Like Toby said, a lot of our expenses are running through the corporation, not the partnerships.
Toby: Somebody says, why would someone want to minimize their gains, I would want to maximize my gains but minimize my taxes. What they’re trying to do is taxable gains. The easiest way to look at this is I know what they’re saying. How to minimize day trading, or day trading taxable stock gains.
They know they’re not trying to make less money. They’re like, darn it, this day trading is so easy. How do I make less money? God, I’m too good at this. No, they’re not saying that. What they’re saying is I’m making money, how do I pay less tax on it? We get it.
You don’t want to be a day trader for tax purposes. You don’t want to be a trader in security, because the IRS loves to audit the heck out of you. What you do want to do is be the partnership with the corporation holding a portion of it so that you can write off your expenses. Nobody should ever give me things like this ever again.
Jeff: I hear some people saying, why need to be a trader in security? It’s because I keep losing money.
Toby: They want to write off the losses, ordinary loss.
Jeff: Here’s the solution to that, quit trading.
Toby: Yeah. You’re just horrible. You’re horrible, but stop trading. I can’t read this. I’m not allowed to have toys. Forget it.
Hey, if you guys like tax and asset protection and you’re like, gosh, this is fascinating, I want to hear more about LLCs, corporations, and things like that. That looks like Clint. Join us, we’re doing a one day virtual event on September 28th, again on October 7th, and the 12th. We just can’t do these enough. This is so much fun. At least Joanne likes me. She says, I like your humor. That’s one of three people.
Here’s a good one. Let me see if I can remember this, because there were three engineers, they get in the car, and the car won’t start. The electrical engineer says, obviously, there’s something wrong with the electrical system, like starters shut. What’s another type of engineer?
Toby: The mechanical engineer says, it’s obviously something with the engine. It shuts. The IT engineer says, let’s get out of the car, get back in, and try it again. Come on, somebody like that. Engineers are all like, I got an engineer joke. Yeah, there’s something else. IT guys says to roll down the window, roll it back up, and try it again. See, I like that too.
“My LLC is technically registered as a partnership, because it is just my husband and I as a member managed LLC. We would like to fix and flip houses and have invested about $15,000 in learning so far, and we want to be able to take that deduction as passed through expense for a personal income. Will we run into any issues with that?” What do you think, Jeff?
Jeff: First off, I don’t like flipping in a partnership. Any dealer status from flipping is going to pass straight through to you.
Toby: When you say dealer status, what are you talking about?
Jeff: I’m talking about the IRS deems that you are a dealer in real estate and not a not an investor in real estate.
Toby: And the consequence is?
Jeff: Let’s say I sold three flips, but I also sold some rental properties. They’re going to consider them all flips, all ordinary income.
Toby: You’re a trader business. You lose 1031 exchanges, you can’t do installment sales under 453. There’s a bunch of bad, bad consequences that you have including self-employment tax, because they treat you as a dealer.
Just think of a car dealership. You’re holding your houses as inventory, not as a long term hold for cashflow. If they decide that’s you, then all of that income is ordinary active income. It’s very, very bad for people that are buying houses, fixing them up, and selling them to people on an installment sale. It means you pay tax on the entire sale, even if you haven’t gotten the money yet. I’ve seen it really destroys people. I’ve seen folks negatively impacted. There was one guy, it was $700,000 plus penalties and interest.
Jeff: I’ve seen a bunch of people walk into these. I’ve done flipping, I did an installment sale before they even realize the consequences of having done that.
Toby: Yup. It looks good until your accountant gets a hold of you and then says, oh, look, you made $200,000, great. You owe $65,000 in tax on that. You’re like, but I did a $25,000 down payment, I’m carrying it, and they’re not really paying. I’m chasing them, and I might have to foreclose. There’s a real life situation. And all of a sudden, you’re way underwater.
The IRS is very, very sympathetic to that. Not, right? They don’t care two poops about it. They just come after you, and that’s what they did. In 2008, there was a big land deal. Somebody sold on an installment sale, and they didn’t realize it was all taxable to them. The IRS chased them for several years, ruined their lives, made them really suffer, and they had to go through a foreclosure to finally get the property back and lost the property as a result to the IRS. It’s just a bad, bad situation because they didn’t understand how flips work.
If you want to flip homes, our recommendation is always going to be to do them through an entity like an S-corp or an LLC taxed as an S-corp. As for the $15,000 and learning expense, when can you write that off?
Jeff: If you’re already in the business of flipping, you’re doing this, and you’re learning additional stuff, you can write that off in the S-corporation. You can always write it off in the C-corporation, usually as startup expenses. Say this is something new to you. If you’ve never flipped before, and you’re learning how to do it, you probably want to go with a C-corp if you want to write that expense off.
Toby: Yeah. It depends on your scenario. I need to say it that it depends. But the question is, are you a trader business, or are you getting into a trader business? If you’ve already have a flip, and you go to courses, and you learned to flip better, the IRS says, that’s an ordinary necessary business expense, you get to write that off now.
If you do not have a flip, and you go to a course to learn how to flip, the IRS says, you are not in a trade or business, that is a startup expense, that needs to be amortized over the next 15 years. There’s a big difference. If you set up a corporation, a little bit of a different animal now, because we can reimburse ourselves for having paid for the fix or flip. The corporation, when it makes money, can reimburse you, and then it writes it off as an expense for the reimbursement to an employee later, so you need that accountable plan showing up again.
There’s a few different scenarios. Unfortunately, sometimes taxes get complicated depending on your situation. Can you write it off as a deduction? Yes, if you’re in that business.
If you’re an S-corp, a partnership, or a sole proprietor, and you lose money in that first year, yes, you could write that off with the S-corp if you contributed, at least. If you have basis of at least $15,000, you can write the 15,000. Obviously, you’ll have the $15,000, because otherwise you wouldn’t have been able to buy it. It ends up helping you.
Somebody says, what qualifies you as a dealer in California? There’s no set number, it’s your intent when you buy a property. There’s no set holding period, by the way, Mario. When you flip, there’s a case on point. I’m trying to think of the name of it. But it was a guy. He held a property for 10 years. He bought it, and he intended to sell it, but the economy shifted. Every year, he would get it appraised. He’d look to sell it, and time wouldn’t be right.
Eventually, 10 years go by, and he sells the property. Is that dealer property or investor property? Let me see if you guys are listening out there in chat. Based off of that scenario, somebody bought a property, held it for 10 years, and sold it. But when they bought it, they intended to sell it right away but they couldn’t because the economy shifted, and they sold it 10 years later. Is that dealer property or investor property?
They’re all over the place, dealer, investor, dealer, investor, dealer, investor, dealer investor. It is a dealer property. That is a court case from the Internal Revenue Service or from tax court, and they held your intent. When you bought it is what controls.
Technically, I could buy an investment property, sell it a month later, and it’s still an investment property. It doesn’t make me a dealer. When you bought it and you intended to sell it, it doesn’t matter how long you held it. You can’t hold it for a year, then sell it, and say, there, I’m an investor. I have seen that.
Somebody says, dealer if not rented. It was rented that whole 10 years. It does not matter. What matters is your intent when you bought it. If you bought it with the intent to hold it as inventory to sell it, even if it’s for a week or 10 years, you are a dealer. “Are you telling your intent to the IRS?” Now you’re getting smart. You have to be able to prove it.
These folks, you can look at the course of dealing. You could look at what you were doing. You could look at advertising, trying to sell it every year, communications with your accountant, and all that stuff. How did the IRS know: They didn’t, but they went in there and said, hey, we want proof and they looked at the guy.
I think it was somebody who flipped land quite often. They were just looking saying, there’s no way this guy was holding on to this property intentionally. He’s in the business of selling things and the economy has shifted. How do you identify intent? What we do for dealer properties is we put them in one entity, or taxed at one entity.
You might have an S-corp that holds four or five LLCs that offer flipping properties. You space them out for asset protection wise, but it goes on to one tax return. Clearly, if you’re putting those all in one, and it’s a trade or business, great. Those are dealer properties.
On the same token, you have all your investment properties in another set, where you have a holding entity like a Wyoming holding entity, and you have different states where you have LLCs. That’s pretty clear that I have all my long term holds over here. Then if I sell one, the IRS isn’t worried. Oh, are you a dealer? They see your dealer properties here, and you’re making quite a delineation. And it’s up to you to track it.
Sometimes you don’t know. I’ve been there. In Vegas during 2008, 2009, 2010, 2011, 2012, we were buying, selling, and doing all sorts of crazy stuff. You’d buy one. Am I going to sell it? No, I think I’m going to keep it. We kept a bunch of properties.
What we would do is we’d buy them in land trust, and then we’d really declare our intent the first year that we’re putting it on a return, and it was that same scenario. We had our holds over here, and we had our flips over here. We’d report the flips on the flips and the holds on the holds.
It gave us a little bit of time to kind of figure it out, because sometimes you’re just not quite sure. If you’re in there and you’re like, oh, gosh, I don’t know yet, okay, use the land trust to buy. And then we can assign the beneficial interest once you figure it out. But whatever the end of the tax year is, you got to make sure.
Jeff: Mixing types of properties, flips and investment properties in the same entity, does that really muddy things?
Toby: Yes if you’re mixing them, because you want the IRS to know what you are. I used to use an image. I had a buddy, and we had to pick two pictures. Picture one was a plantain, picture two was a banana, and I’d show a gorilla. We’d say, the gorilla wants to eat the banana. He’d say, great. I want to be the plantain. I’d say, the gorilla doesn’t know that’s a plantain.
There’s only one way it’s going to find out that that’s not a banana, and it’s going to be because the gorilla takes it, shoves it in his mouth, and chews it up. Do you want to get chewed up, or do you want to clearly show that you are not a banana or plantain, you want to be a cheeseburger, because the gorilla doesn’t want to eat the cheeseburger? Make sure you look like a cheeseburger if you don’t want the gorilla to pick you up and eat you like a banana.
Make sure that it’s not technical. You’re like, hey, will the IRS really know? I’m definitely a plantain. Yeah, but you look like a banana. The only way they’re going to know is if they pick you up and chew on you. We don’t want the IRS to pick you up and chew on you, unless you’re into that. I like pain. I can’t wait to get audited, said no one ever.
Jeff: I’ll show them.
Toby: Yeah. They’ve never dealt with anybody like me. All right stop it. All right, “I purchased a rental property this year. Are all the expenses related to the purchase and rehab to be included in the basis for depreciation, or can it be expensed this year? Expenses include purchase price, rehab, flooring, paint, bath remodel, change locks, et cetera, utilities, out of state travel expenses.” Jeff, what do you think?
Jeff: All right, let’s compare answers here. I’m under the impression that if you just bought the property and have not placed it in service, all these expenses are going to go to basis.
Toby: If you have not put it into service, you’re not going to get an argument from me. Everything before you put it into service, which means make it available for someone to rent. It doesn’t have to be rented, available to be rented. You make it available, they’re added to basis. But if it’s already in service, what do you do?
Jeff: If it’s already in service, some of these items are going to be deductible, your flooring, your paint, certain things that are true repairs, not the remodel or probably the bathrooms or kitchens. But some of these expenses are going to be repairs, and you’re going to be able to expense this during that service year.
Toby: You have a de minimis safe harbor which is $2500, unless you have an accountant preparing your financials for non tax reasons like for a loan or something. You go up to $5000. That’s per item.
If I’m looking at fixing things, flooring, I might say yes. There’s also the I’m going to replace it two times the next 10-year test. If I’m going to rent this thing out, and I know that I’m going to be replacing the flooring every few years, then I could write it off for sure.
Purchase price is always going to be included in basis., but rehabs or things like that might be deductible right away. Or you could cost seg it, and then use bonus on anything that’s 5-year, 7-year, or 15-year property, which could be any land improvements, fences, decks, putting in shrubs, trees, things like that, appliances, painting, putting in window treatments, all that stuff, carpet. All that is 5-year, 7-year, or 15-year property, you can write off 80% right now.
Utilities are always going to be an expense assuming that the property is already in service. I think you’re always going to write off utilities. That would never be added into basis, and then out of state travel expenses if you check in on the property. You generally can write those off, but the question is if you’re creating a loss out of it, I think, is the only issue. But again, if it’s in service, generally speaking, you’re writing those things off.
Jeff: You mentioned the de minimis, and I’ve had plenty of clients do this. They’re putting in a new bedroom. They’re going to tear out, and they ask the contractor to give them all these invoices under $2500. I’ve gotten 20 invoices under $2500.
Toby: This is Paul’s question. Everything was done before the property is put into service, so all of your expenses. With utilities, I always think of it as an expense, period. It would not be added to basis.
Jeff: I’m not sure about that. I think utilities and taxes, you have an opportunity to decide which way you’re going to go.
Toby: Paul, you would add everything, the purchase price, the rehab, everything else. But here’s the beautiful thing, Paul. We can still do a cost seg on it and write off all the 5-year, 7-year, and 15-year property 80% of it right now. You add it to basis, but then we’re going to write it off anyway. I hope you follow that.
Jeff: Like I said, no, you can’t write off the remodel. That’s not necessarily true, because if you’re going to be remodeling your kitchen, there’s a lot of 7-year property in that kitchen.
Toby: Absolutely. If it’s 5-year, 7-year, or 15-year, we’re talking about $168,000 bonus depreciation running off 80% of that in the first year. Boom, we get to do it. I guess we’re a little bit late.
Jeff: A little bit late, but I’m having fun.
Toby: Somebody asked about typical supplies. You can put that in the Q&A, and we’ll make sure somebody gets the answer. They have answered, by the way, 253 questions in the question and answer. Troy, Tanya Ross, Jared, Eliot, Patty. Who else? Dutch. Dutch is always there kicking butt. Matthew, Amanda. You guys rock today, 254 questions now.
All right, “If you have amassed a large amount of passive losses on your rental activities that you cannot use due to the AGI phase out, what would be the best way to minimize the loss of the losses before trying to reach rep status, which is real estate professional status? Or can you offset them once you do get rep status?” Jeff.
Jeff: Okay, I’m going to answer the last question first. Once you take that rep status, and you aggregate your properties, that loss is locked in until you get rid of virtually all of them.
Toby: If you have a bunch of carry forward losses, it’s probably not a good idea to aggregate your rental activities as one activity.
Jeff: What you may want to do, and you may not like this answer, is sell one or two of the properties if you got a bunch of properties, and they’re losing money anyway.
Toby: You don’t lose. If you have the passive loss, you don’t lose it when you have an AGI phase out. What he’s talking about is, when you have passive losses, they only offset passive income. There are two types of passive income, rental activities and businesses that you do not materially participate in.
If Jeff and I have a pizza shop, and Jeff works in the pizza shop but I don’t, I’m passive, he’s active. My income from the passive pizza shop can be offset with any losses from my rental activity. Let’s forget about that.
We have passive losses only offset passive gains or passive income with two exceptions. Exception one, active participation in real estate. You get to write off up to $25,000, but it phases out between $100,000 and $150,000. In this case, he says there’s an AGI phase out. It tells me, he makes over $150,000.
Option two, real estate professional status, which is 469(c)(7) of the Internal Revenue Code. It says, one spouse on a joint return has to be a real estate professional. Step number one, 750 hours in more than 50% of their professional time. They do that, we can look at step number two. One spouse has to meet all their real estate activities, which is construction, development, management, self-managing your own properties, being a broker, being a real estate agent.
If you are an active participant, materially participate in those businesses, and you have to own more than 5% of the business, you get to add that time up. If it’s more than 750 hours, more than half of that spouse’s time, so one spouse qualifies, then you go to step two. Step two is you materially participate in all of your rental activities. You tend to aggregate them all together, but it could be per property. It’s really bad.
There are seven tests for material participation. The easiest one is I do everything myself, the hardest one is 500 hours, but we’re not even worried about that. Rep status is one year at a time. If I qualify for those two things, it’s no longer passive loss. It’s ordinary non-passive loss, and will offset my other income, including my W-2. That’s why they’re asked.
Why do we care? I have passive loss. I don’t lose it. I carry forward, it gets released, and I can write off against all my income if I do what?
Jeff: I’m not sure because once you aggregate, that aggregation election stays forever.
Toby: Not aggregation. I have passive losses, I never aggregate. He has passive losses from rental activities. In order to release that passive loss, how could I do it?
Jeff: Stop being a rep.
Toby: You’re not a rep, you’re a passive loss. You might not be following, so I’ll answer.
Jeff: Answer for me.
Toby: I sell it, I dispose of the activity. If I have passive loss, so I have a rental activity, I don’t lose that loss. It carries forward until I have passive income to offset. Let’s say this year, I have $10,000 of passive loss. Next year, I make $20,000 of passive income. My $10,000 that I didn’t get to use, carries forward and wipes out $10,000 of that $20,000, so now I only have $10,000.
Jeff: This is really important, especially when you’re talking total losses exceeding six figures. You don’t want to go into that rep status with large passive losses just sitting there.
Toby: I always look at these, and I see they’re trying to reach rep status. Don’t try to reach rep status. You either are or you’re not. If you meet 750 hours, and the IRS determines that you did 750 hours solely to get rep status, that’s a reason to deny rep status.
Jeff: Do you ever see clients or people, individuals that fall in love with properties they own, even though they’re losing money hand over fist in them and won’t sell them for that reason?
Toby: They’re only 10 years away from making all that backup. We say, you’re 10 years away from usually getting out of those situations. At least I tell myself that, because I get a crappy property. I’m like, just wait 10 years, it’s going to be worth a lot. And then I’ll look back and go, hey. Remember when I thought about selling this? This is the best thing ever. You don’t lose it, that’s the whole thing.
Let’s say that you are in a syndication. This is where it gets really interesting. A lot of you guys are doing syndications out there. When they sell, there’s capital gain. If you are a passive participant in that syndication, hear me clearly, you have passive capital gains that will be offset by your other passive losses.
This trips people up because you’ve always been told, you can only offset capital gain with capital loss. You can only use capital losses against capital gains. There are passive capital gains. If it’s passive, you can use passive losses against it. If you have a bunch of passive losses on your rental activity, you exit a syndication, and it gives you a nice two times return or something, and you’re feeling pretty good, you can offset it with those passive losses and eliminate a bunch of that.
Jeff: I never hear anybody talking about those passive capital gains ever.
Toby: I say, it’s 99% of the accounts have no idea.
Jeff: Yeah. Like Toby says, you’ve got a passive capital gain. That not only frees up any losses probably in that syndication.
Toby: It gets released when you sell too.
Jeff: But that gain gets applied against other passive losses.
Toby: Yup. You don’t lose your passive losses, you just carry them forward. I know rep status is like this panacea of all that ails us. Somebody says, oh, I want to do that, I have $600,000 of losses. That $600,000 of losses, you just keep carrying forward. Now you have a strong passive income appetite.
This is where if somebody comes up and says, so you want to be involved in my business, you could be this, that, or the other, and you say, maybe, I wanted to kick out a bunch of income, because I get $600,000 of free income as long as it’s passive. I will not work in your business, but I’ll bank roll it. I might help you, but I will not work actively in that business.
Jeff: I agree strongly with what they say. I would rather not be the REP, the real estate professional so I can recognize my losses. I would rather make other income to offset my losses.
Toby: A hundred percent, and sometimes that’s the way to look. That’s how rich people look. I can tell you because I deal with it all the time. They’re always saying, hey, this is my scenario, and I have a bunch of carry forward loss. Or hey, this year, I do this, Hey, maybe we should cost seg one of our apartment buildings. Great. If I have a bunch of passive income, I could do that. I can decide to do that after. W
e did this recently. We had a bunch of passive income this year. Clint and I are always being knuckleheads. What are we going to do this year? These two properties, we just grabbed two of our apartment buildings. Let’s cost seg those, great. There comes the loss. It wipes out all the income. No, we don’t have tax on it.
Jeff: I know what you’re talking about, because I saw the financials on that. This is a perfect example that what these guys preach is what they’re actually doing. As I picked that up and looked at it as, oh, look at this loss, they did cost seg.
Toby: Yup, it works. We’ve been doing that for years. Every now and again, we’re right. We’re broken watches twice a day.
All right. If you guys liked this type of stuff, and you want to watch the old Tax Tuesdays, I don’t see any on the top videos that are Tax Tuesdays, because again, usually a few hundred people come in and watch them after the fact. But if you look at the little thumbnails on YouTube, you’ll see that some say Tax Tuesday in the bottom right corner, the quadrant there. You’ll see it say Tax Tuesday, then you know that it was a Tax Tuesday, and it’s in this format.
You can fast forward. You could say, done listening to Toby. I only want to pause it or stop when I see Jeff’s lips moving. If you want to just hear Jeff, then you could just fast forward through me or you just do that little 10-second forward. I do that sometimes. Or you put it on time and a half because you say, I’m okay listening to him for a little while. I do it. Somebody says, looking good, Jeff, stay strong.
Jeff: I like hitting the pause button when Toby is going […].
Toby: Yeah. Clint used to take those screenshots and send them to everybody. Look how dumb Toby looks. You don’t think you’re all over the internet too, my friend? If you guys have never seen Clint as the tiger king picture…
Toby: Yes, and it looks just like it. I may have had that one done.
Jeff: We should put the bloopers on sometime.
Toby: No, we shouldn’t. We should never put bloopers on. Speaking of bloopers, you might see one. We have one coming up September 28th. When is that? Is that this weekend? We got one coming up on the 28th, another one coming up on their 7th, and then the 12th. If you want to learn about LLCs, corporations, living trust, land trust, how all these things go together, come join us.
Jeff: Yeah, you guys talk about so much on the asset protection side and how the tax side works with us. If you have never been to one of these, you’ve got to go.
Toby: Jeff is very kind. When is it, Patty? Is it Thursday? It’s two days, so Thursday. All right. Now get my head straight. Yay, we’re doing one on Thursday. Yes.
I don’t know. I just show up when they tell me to go to things. They say, look at that camera and talk, and I do it. All right, questions. If you guys have questions in the meantime, because we do these every two weeks, and you say, you know what, I was really thinking about what Jeff said, and I have a question, send it to firstname.lastname@example.org. If you’re just asking general tax questions, we do not charge for that, but we also grab your questions and put them into the presentations.
We get hundreds of them. We usually grab about 10-15 and go over them and use them for Tax Tuesday. The rest of them, we try to answer the best we can. If you need specific advice about your situation, and you’re asking for tax prep or advisory services, we may ask you to become a platinum client for $75 a month. You could ask all the legal and tax questions you want.
We’re going to have some cool stuff that we’re launching here in the very near future as well. It’s going to give you even more access to our team of attorneys and accountants. We want to make sure that we are giving you as much helpful information as humanly possible without charging a fee. That is our giving back, and we work really hard to make sure that we are doing our best to give back to people.
I remember what it was like when I got started. It cost me $300 to meet with an accountant who made me feel like an idiot. I still remember those $300. I saved up to meet with this guy. I was couch diving looking for anything I could so I can meet with an accountant, because Jerry, my mentor said, it’s really important to meet with the accountant. And that accountant made me feel like I was about two inches tall.
Why don’t we do this? Because we want to make sure that you never have that experience and that you realize that taxes aren’t something to be feared. It’s just one of those skill set areas that’s a little bit more funky. You almost have to drink before you read the tax code. But you want to make sure that you’re looking at it from a thing of like, hey, there are incentives and there are disincentives. I just want to know what they are.
The tax code’s this huge behemoth, there’s lots of complexity, but it is your decision. You get to choose what you do with that complexity. A lot of people choose to use it to their advantage. Those are the ones that tend to be very successful, so we’re just trying to make it accessible to you. If nothing else, you’ll learn a little bit of something and maybe have a little bit of fun. Anything else?
Jeff: Nothing else from me.
Toby: Good luck, guys. They answered 314 questions today, plus all the questions that we did in chat. Guys, go out and do a bunch of good stuff. Have some fun, and don’t be afraid of your taxes. Have some fun, and hope you guys have a lot of success. We will see you back here in two weeks, and it’ll be fun. See you guys in two weeks.