Welcome to Episode 197 of the Tax Tuesday show. Host Eliot Thomas, Esq., and Kurt Bergfjord, CPA help answer your questions. We send a big thank you to all our people online answering your questions today.
Today Kurt and Eliot answer listener questions on tax liens and wholesaling. They discuss the complexities of property tax implications, the benefits of a C-Corp for property flipping, and the tax implications of inheritance. The episode also answers inquiries about home office expenses, the intricacies of short-term rentals in real estate, and running an active business in a retirement account.
If you have a tax-related question for us, submit it to taxtuesday@andersonadvisors.
- “Are there any tax implications for wholesaling and tax liens?” – Yes, tax liens can lead to property auctions, affecting real estate investment strategies.
- “When I pass on and leave property to my children, are there estate taxes?” – right now estate exemption for a couple is 25 Million dollars. Better to let them inherit than to gift it to them…
- “I own properties in two states… any restrictions on travel deductions?” – The IRS would say as long as your trip is more than 50% business days, your travel is 100% deductible.
- “We have 8 properties to sell, no longer want to be landlords…but we want cash flow” – Calculate the capital gains…pay or defer, use a 721 exchange to turn rentals into units in an investment trust, which provides more stable cash flow and hands off investments.
- “What is the right way to deduct my personal residency expenses, such as mortgage interest, mortgage insurance, real estate taxes, homeowners insurance, depreciation, so on and so forth? How do I do that? Through an accountable plan as an employee of my corporation, or do I do that tax time on my personal return?” – An accountable plan requires a separate dedicated office space/room in your home…
- “I own a single member disregarded LLC, which in turn owns a rental property. The rental property provides me with tax Tax deduction, mainly because of depreciation. If I were to take the property out of the LLC as an owner-drawer distribution, would I be liable for any capital gains tax or depreciation recapture?” – In this circumstance, if you’re just pulling it out of an LLC that you own, that is disregarding to you, is not really considered a sale for the IRS purposes.
- “When you pay your kids, may that payment come from your personal bank account?” – Generally, it’s advisable to pay from a business account for clarity and separation.
- “If I use a Sidra self-directed IRA to purchase short-term rental property, does that qualify for me as a real estate professional?” If I use the Sidra self-directed IRA funds plus a mortgage to buy a rental property, once the mortgage is paid off, is the whole property considered property of the IRA?” – No, activities in a retirement account don’t qualify towards real estate professional status. If the IRA funded the purchase, the property belongs to the IRA.
- “What are the requirements to have a second home be considered a short-term rental? Will I be able to expense furnishing costs and other expenses? Also, how does cost segregation work in this situation? – If you’re going to be using any property for more than 14 days or 10 percent of the fair market rental days out there one you have to allocate the expenses associated with the property between personal time and business time.
- “I formed my two LLCs last year but haven’t funded them or used them in any way. I missed the tax return filing deadline this spring. Now what? File the returns and beg forgiveness to not have to pay late fees, close the business down, start over? So I got some LLCs set up not telling you anything about those LLCs, kurt, but I will tell you that I didn’t file the returns. What am I going to do?” – How are these LLCs taxed? Knowing that answer will be the first step in determining what you need to do with your LLCs.
Full Episode Transcript:
Eliot: Good afternoon, everybody. Welcome to Tax Tuesday. My name is Eliot Thomas. I’m Manager of the Tax Advisors here at Anderson filling in for Mr. Toby Mathis, who is away right now. I’m joined by our CPA extraordinaire, Kurt Bergfjord. Say hello, Kurt.... Read Full Transcript
Kurt: Hey, everybody. How’s it going today?
Eliot: We’re excited to bring you as we call it, bringing the tax knowledge to the masses. This is our free program to all the clients here who want to come in. You can submit your questions throughout the week. We’ll give you some information on how to do so. We pick them. These are your questions. We’re trying to help you out with some of them here, free of charge like I said.
This is our 198th episode here on July 18th, 2023. We’re getting really close to that 200 mark. Hopefully we’ll have Toby back for that. Maybe you have some special questions or something. Who knows what we’ll be doing?
Anyway, some rules we have here. First of all, you can ask your questions to the Q&A section. We have the chat section and Q&A. Please, if you have questions related to some of the tax topics, please put them through the Q&A, question and answer.
We have quite a staff in the background helping out. We got Dana handling our YouTube. We got Dutch, one of our CPAs and tax prep. We got Trisha here with some bookkeeping. We have a whole team back there.
Please be patient because we get a lot of questions during this, typically anywhere from 100-200. They’re back there feverishly trying to answer as many of your questions as we can, but please do so again through the Q&A section. The chat section is more just for really anything else. Toby always likes to ask, if you just want to put where you’re all from in the tax section.
As far as the detailed responses, the type of responses that we get through this, you may need something more in the way of a tax consultation or tax planning session. We’re just given general answers here. They’re not meant to be full-rounded or in-depth by any means, but just trying to assist and give a little bit of guidance or something on a particular tax topic. You may need to have a tax package, tax consultation, tax planning, or something of that nature. Hopefully we’ll be able to answer what we can for you here today.
It’s just an idea to have some fun, fast education on tax. We try to bring that every two weeks to you. I’m just going to go through the questions here real quick. Before we get there, a reminder to go to Toby’s YouTube channel. He’s got a lot of videos. It’s well over 500 now and a lot of different topics. Kurt, I think, just cut a video the other day, did you not, Kurt?
Kurt: Yeah, indeed. It should be coming out pretty soon, hopefully.
Eliot: Do you remember what the topics were by chance?
Kurt: Short term rentals.
Eliot: There you go.
Kurt: Great benefits with those short term rentals, so watch out. Keep an eye out for that YouTube channel. Hopefully you’ll see that video coming out real soon.
Eliot: I don’t think we have a thing on here, but we do have a Vegas event coming up live at Tax and Asset Protection. It’s approximately the 14th of September here in Vegas. You might be there too. Is that right, Kurt?
Kurt: Yup, indeed.
Eliot: Maybe you can sign some autographs and 1040s for the people?
Kurt: Yeah, exactly.
Eliot: There you go. All right, carrying on. Again, Anderson, YouTube. You can subscribe on YouTube at the aba.link/youtube. You can get some replays of all those episodes. Again, this is number 198, so we got quite a few in there.
We’ll kick it off right away with a question. Kurt, our first question of the day, “Are there any tax implications for wholesaling and tax liens?” Any thoughts on that?
Kurt: Yeah. This is a really good question. Not everyone is involved in either wholesaling or tax liens. Let’s just talk about what those items actually are.
What is a tax lien? A lot of people might not be aware, but what essentially happens with a tax lien is a property owner, maybe a homeowner, hasn’t been able to pay their property taxes, actually falls behind those property taxes. The local government, all local governments need money to keep all the vital services going. They need that cash to operate the county, the city, whatever it happens to be.
A tax lien will arise, the government will actually put a lien on that person’s property, and then go out and sell that to outside investors. If you’re into real estate investing, this might be another avenue for you to get more into. Usually, it’s an auction process or a bidding process. Usually, you can go down to your local property assessor and figure out where these auctions will take place, things along those lines.
You can actually bid on something like a tax lien, which essentially is like a debt instrument on the unpaid property taxes of that. Let’s say the property owner has a property they owe $10,000, for example. You can invest that, pay then undue property taxes or overdue property taxes, and then you own what’s called a tax lien certificate. Essentially, you have more or less a lien on that property. Until that is paid off, the property owner might not be able to sell or negotiate that property to some other party in a sale.
How does this play when it comes to investing? Typically, there could be a couple of scenarios where this happens. One scenario might be, they actually end up paying the taxes back. Usually, each certificate will come with a stated interest rate.
Various states have different rules on this, maximum interest rates, minimum interest rates, things along those lines. But you will be entitled to receive your amount of investment back and also a stated amount of interest. That is usually one scenario. That interest is usually going to be taxable to you if the property owner decides to pay for that.
Another type of scenario is when you actually make an investment in a tax lien, and the property owner becomes further delinquent. You go into foreclosure. You actually get access to the home. What are you going to do with that home? If they’re delinquent, they don’t pay that.
Essentially, you’ve got this home you might have owned now. What you want to be aware of in that scenario is, what are you actually going to do with the property? Looking at the property, it looks like a good area. Maybe you make a great rental, that’s one thing. Maybe you might just be looking to flip that.
When you’re investing either wholesaling or tax lien investing, you want to be aware of, ahead of time, maybe what your ultimate intent with the property is and what you’re going to do with it. We might structure based on your intent of what you’re going to do with those a little differently.
Sometimes if you’re planning on flipping, often wholesaling is a flipping activity, we might buy those tax liens or do that wholesale investing through a corporation because it is an ordinary income to you. If you just did it in your own name, you might generate self-employment tax, which might not be the best. Maybe we do that instead in a corporation.
In another situation, say you are investing in tax liens, and you might hold the property out for rental instead of just flipping it. In that case, maybe just wrapping that tax lien certificate investment in an LLC disregarded to you, instead of maybe your corporation that you use for the rest of your flips or wholesaling with that possibility that you might end up actually holding it out as a rental.
Again, something you probably hear a lot of is we almost never want to put appreciable rental properties directly into corporations. We’re going to flip or do something, where we’re going to have it for a little bit of a period of time and then turn it over, sell it.
Any kind of flipping, wholesaling, that’s your intent going in. Maybe hold it in the corp directly. But if you’re on the fence, you might rent it, you might eventually flip it. You don’t really know, though. Maybe you just end up buying in your own name or an LLC that’s disregarded to you.
Eliot: All right, excellent. To just recap and help me out here, Kurt, if we do these things, wholesaling, tax liens, we very well might be going on active income where we probably, as you’re just noting, want to do that under a C-corp type arrangement.
Often we have LLCs disregarded as C-corp, but Kurt and I know that’s all going to go on that same corporate return. We like to use our active income vehicle, the C-corp, for that. Possibly an S-corp, but it usually is a c-corp. We have a lot of benefits with that C-corp to work with. Is that correct?
Kurt: Yeah. Right off the top, especially if you’re a high income earner, the C-corp doing these flipping, wholesaling, active, tax lien investing activities, again, they’re most likely going to be an active business. If you do that out of the C-corp, you might benefit from the low corporate tax rate, which is only 21%. Maybe a high W-2, you’re already in the 37% tax bracket. You also don’t want to add self-employment taxes if you were to do that in your own personal name.
When you do it with a corp instead, you might get some of those additional benefits like having the accountable plan for all your business expenses, have all that stuff reimbursed, health reimbursement all out of pocket, medical, dental, vision, all those things with a C-corp for you, your spouse, and your family. It can be reimbursed to the corporation or from the corporation to you. It would become a deduction for the corporation.
Other things like 280A meetings for the corporation, you’re really whittling down the profit for tax purposes that you’d see with these active businesses, wholesaling, flipping, tax lien investing, and things along those lines. The C-corp can be a tremendously beneficial vehicle to minimize your taxes in those circumstances.
Eliot: If we had some extra cash, you could even pay yourself a wage, maybe set up a solo 401(k). Now we’re talking retirement plans as well on top of everything Kurt was just talking about. There are a lot of opportunities there. But again, we’re talking about active income there with the wholesaling certainly in the tax lien, just depending on how you want to use that house, should you end up with it.
Kurt, if we’re not so certain, this tax lien vehicle might turn into us holding on to the house. If we’re not really sure that we know that we want to do it with a flip, or that maybe we’re probably better leaving it outside of the C-corp until we know exactly because we were just talking about trying to get that appreciable property out of a corporation and create some problems, does it not?
Kurt: Yeah. The example I like to use with properties and corporations is, imagine a seashell, you can go into a seashell very easily, it’s not so easy to come back out. Same thing with corporations. Properties can easily be contributed into corporations, no tax consequence almost always. Go very easily in.
The problem is when it’s time to take them back out, that can cause additional tax complications. That’s why if you don’t really know what you’re going to do with the property ahead of time, oftentimes it would just be good to set up an LLC that’s not really connected to your corporation, it’s just a disregarded LLC to you personally.
With a disregarded LLC, you can pretty much do whatever you want with it. Bring it out, put it back in, and things along those lines without worrying about an income tax consideration, not so much with a corp. If you’re on the fence, maybe it’s going to be a flip, maybe it’s going to be a rental, it’s probably better to keep that in just a disregarded LLC.
Eliot: Very good. All right, thank you. All right, moving on to question number two. All right, “When I pass on and leave some assets to my children, will my children be subject to income tax for the year in which they receive the assets from me, even though the assets don’t reach the then taxable inheritance threshold?”
Kurt, we pass away, we’re leaving some assets to our children. Are they going to have to pay some income tax if we don’t meet that threshold that we’re given for the gift tax and inheritance tax?
Kurt: Yeah. Right now, the estate exemption for a married couple is about $25 million. If your total taxable estate is less than that, most likely there will be no inheritance or estate taxes associated with those assets that you do pass on to your heirs. That’s great news for a large amount of investors who have estates smaller than that.
However, when you do pass your properties, say you have some assets or some properties that you’re going to leave to your children, usually when you pass them via inheritance as opposed to a gift during your lifetime, when you pass them via inheritance, they will benefit from what is called a stepped up in tax basis. When you and your spouse finally pass away, say you have a rental property that was purchased 10 years, 15 years ago for $100,000, usually the tax basis would be $100,000 minus any depreciation you’ve taken on that rental property.
Let’s say the fair market value at the time of your passing was $300,000 or $400,000. If you give this property to them as an inheritance and pass it to them when you pass, the tax basis will actually step up to the fair market value on the date of your passing. If they sell those properties without further appreciation in the year that they inherit those, there should be very little gain or capital gain associated with that time, because say the fair market value in the year of passing is $400,000, and they’ve received a stepped up in basis to $400,000, there should be almost zero capital gain on those assets. Pretty much all assets that I’m aware of, whether it’s real estate, stocks, bonds, similar items like that, will receive a step up on the basis of their inheritance.
Maybe some of you have considered giving stocks, bonds, rental properties to your children before you pass, that’s a little bit of a different circumstance because when you give it to your children during their lifetime, they will actually inherit your tax basis, which could be substantially lower. You might be in a situation where if they were to sell those, once you get those properties during your lifetime, you might have unintended consequences. If your plan is ultimately to always give your assets to your children, oftentimes it’s better to wait and let them inherit those properties when you pass as opposed to gifting those properties during your lifetime.
Eliot: Excellent. All right. Real distinction there is between receiving a gift while we’re alive, giving a gift and receiving at that lower basis versus inheriting, where you get that stepped up basis. Big difference from a tax perspective.
One thing I just wanted to point out on this question, now we’re going to get real technical on the words here. With income tax, usually we think of income tax coming from a business or something like that. Generally, […] of that until the children receive the asset. If it starts making money at that point, once they have ownership, if you have any actual productive income coming from that point forward, they might have a little bit of tax, but your gift tax, your inheritance tax as what Kurt’s referring to and those things, are the taxes you really have to worry about, not so much an income tax necessarily.
A different type of tax, and that does have that exclusion of almost $25 million approximately, give or take. That can certainly write off a lot of potential tax loss right there with that exclusion. All right, thank you so much.
Getting on to question number three. “I own investments/rental properties in two states. What travel deductions are permissible when traveling between properties to work such as air, meals, rental cars, et cetera? Are there any limitations or restrictions? We got some travel going on, Kurt. We got some properties that are outside of our locale where we live. What can I deduct?
Kurt: You’re out traveling for work. Maybe you have a trip planned somewhere for business. Definitely, you’re going to incur some costs for travel, lodging, meals, things along those lines. We want to figure out what exactly we can deduct and what we can’t deduct. The IRS would say, as long as your trip overall is predominantly for business, meaning over 50% for business, all the travel costs associated with it would be 100% deductible.
How do we determine if a trip is predominantly for business or not? We’re looking at the number of business days compared to the number of non business days. Usually, travel days will be considered business days, days that you’re with clients, meeting with clients, looking over investments, doing similar business activities. Those are going to be considered business days.
The golden rule is, any business any day that you spend over four hours and one minute in that period of time on business is going to be considered a business day. Not a tremendously high threshold. You can do some business in one city for most of the day, have the rest of the day to relax, recoup, and that’s still going to count as a business day.
When we look at your lodging or your travel expenses, say you flew by air, if your entire trip, when you do the calculation on how many business versus personal days, if it’s over 50%, then you’re looking at transportation, any airfare, rental, train, whatever it might be, is going to be 100% deductible.
When it comes to things like meals and lodging, similar rules apply, except that for lodging, you would be able to deduct the days that you actually were doing business, the same thing with meals. If you’re doing meals and lodging on any particular day you’re doing business, usually it’s going to be deductible. On those personal days that maybe you’re just taking a break or taking a couple of days at the end of the week to not conduct business, generally those would not be deductible. That’s generally how the rules work in those circumstances.
Eliot: Any thoughts on what happens if we bring a spouse along, bring the kids, or things like that? How’s that? Can that play into it, or is it just a no go?
Kurt: Yeah. Oftentimes, a lot of clients employ their spouses in their businesses, and employ their kids in their businesses. If there’s a business reason or business justification, meaning you need the employees there for help conducting the business meetings or the business purpose behind the trip, that should be no problem. You can deduct the cost of their travel, their lodging, and their meals just like you would yourself.
Eliot: All right, going to Disneyland. All right. A little bit different, though, if we’re going international. If you go international, they step up the game here, the IRS does. There we’re typically looking at over 75% of the days have to be business days. As Kurt was pointing out here in the US, it’s over 50%, 4 hours in a minute, that makes the business day.
We went over 50% of our days here in the US. But if we’re going overseas, we’re going to go to Europe, which is really hot right now from what I hear. You’re looking at 75% of your days have to be business, so it’s a little bit higher standard there, I think we can understand why the IRS is a little more skeptical.
There is a special rule. If you can really prove it’s seven days or less that the majority of it, which may be your four days in a week that was business, then you typically can get the deduction. There was a big case, where a guy used a trip to Ireland, used all the bars to meet with business people, and was able to survive an audit on it. A little bit of a different thing overseas if you’re less than a week, but usually 75% of the days have to be business. Back in the US, over 50%.
All right, excellent. Next question. “We have real estate properties that we want to start unloading. We’re getting to the point where we do not want to be landlords anymore.” I can’t imagine why. “When we do that, we want to invest the proceeds in another investment that we can get cash flow to sustain our living, but most likely not being landlords again.” They don’t want to have all that control there, all the responsibility, but they still want to have some flow of income.
“What options do we have? Tax wise, is it better to sell and pay taxes on the capital gain in one lump sum, or are there other routes we can take? If we were to sell one property per year, it would take us eight years.” We’re looking at a lot of problems. We got eight properties. We’re trying to slowly get out here, maybe quickly. What did you get first, Kurt? Any ideas?
Kurt: Yeah. Obviously, you always want to calculate, make sure you know potentially what the capital gains would be in any circumstance so you have an idea. Do you want to pay the capital gains? Do you want to defer the capital gains? Do you want to eventually not pay taxes at all?
There might be a couple different strategies depending on your circumstance. There’s a couple of things that we were talking about, situations, what’s called an UPREIT. It’s like a 1031, but it would actually involve you using a 721 exchange, which you can turn your rental properties in a relatively complicated transaction into units of a real estate investment trust.
What this is going to do is it’s going to diversify your investments. It’s going to prevent you from being the landlord anymore because these are usually, you’re transforming your real estate investments into other real estate investments that are managed by professional managers.
Another benefit is more stable cash flow, you’re not going to be involved day to day. It can be a great way to systematically diversify out of your current real estate holdings into more stable hands-off investments that will provide you cash flow for years to come.
Eliot: Very good option there. The UPREIT, some of the benefits there as Kurt was pointing out, is you just basically take your property, get an exchange of ownership in a partnership, and that’s what the UP part stands for in UPREIT, umbrella partnership, real estate investment trust. A little bit more liquid too than some other options that might be out there because you can typically sell those units. Usually, there’s an open exchange form, or the overall general partner of that UPREIT happens to be usually a C-corp with publicly traded common stock.
Even if it’s not commonly traded publicly, it’s traded stock, it’s still usually a pretty good open market for it. The point being, you can exchange your units for that stock, which would be a taxable event at that point. But if you needed cash, you can get the cash at that moment, or you could sell your units. Or if they happen to sell the property in the UPREIT, then you would be responsible for taxes at that time. They generally don’t do that.
Another great point that Kurt brought out is the diversification. A lot of people have invested in this, a lot of different types of real estate. Maybe you had single family rentals while someone else brought commercial real estate into it. You’ve got a vast inventory of different types of real estate investment, a little more security in that unit.
You’re not just in one sector or something like that, or indeed, in just one geographical area. A lot of upsides to the UPREIT, no pun intended. It might be a good option for you. There might be some other options. Any thoughts about maybe doing an installment sale or anything like that to try and curb some of the tax here on this, Kurt?
Kurt: Yeah, certainly. If you’re talking about over eight years figuring out what the game would be before you go into a transaction, but using an installment sale to potentially—say you have $100,000 gain that you’re sitting on on one of your properties. If you sell it on an installment basis, have a contract with the seller to receive payments over a period of time, say 10 years, that capital gain can be spread out over a period of years say 10 years, and you’ll just record or have capital gain income over a period of years as you receive payments.
Usually, if you can keep your capital gains smaller in any given year, you might be able to spread out the effects of that capital gain so you don’t get ramped up into higher tax brackets in any given year. You can manage or massage your tax bracket in those years that you receive payment and ultimately smooth your tax liability. Installment sales are also a very great alternative to just straight selling.
Eliot: It just is always the truth. As we hear from Toby and as Kurt pointed out, you got to calculate, calculate, calculate. You may fall into a situation because if we’re talking capital gains, and you had nothing else going on that 1040 of yours, you might be looking at a 0% tax bracket for capital gains if you’re under certain thresholds. A lot of opportunities, so hopefully that will help our client out here on some options.
All right, moving on to the next question. “I need to implement an accountable plan for my S-corp. My question is, what is the right way to deduct my personal residency expenses such as mortgage interest, mortgage insurance, real estate taxes, homeowners insurance, depreciation, so on and so forth? How do I do that through an accountable plan as an employee of my corporation? Do I do that tax time on my personal return? What’s the best route to go?”
I’m trying to get that accountable plan. Kurt, you’re talking about it all the time. Can you explain to them? How do they use the accountable plan for that administrative office?
Kurt: The accountable plan is usually set up with the corporation. The corporation makes a declaration to have an accountable plan for all its employees. One of the big things with the accountable plan is what’s called an administrative use of home. Essentially, the corporation is relying on you as the employee to have a place in your home that you can conduct corporate business out of, and it’s for the benefit of the corporation.
Maybe you have a spot in your home pretty much used for the business of the corporation, exclusive use, continuous regular exclusive use. It’s not necessarily your living room or something, it’s a separate dedicated space in your home that you exclusively use for the business related to the corporation.
In that circumstance, we’re looking to, hey, what are my total expenses with the home? I have mortgage interest, I have mortgage insurance, real estate taxes, homeowners insurance, depreciation, and all those types of things. With the regular home, how much of that is applicable to this home office? Then we’re looking to take a proration, some kind of allocation. Usually, they’re based on square footage of the heart of the home office compared to the entire home, or based on that room compared to the number of rooms.
There’s a couple ways to calculate it. You can actually use the one that’s more advantageous for you, either the square footage method or the number of rooms method, and go through there. And all those expenses, the mortgage interest, the insurance, real estate taxes, even depreciation. You’ll get some kind of calculation for that.
I believe we have a great template here that will actually help you walk through that. Go line by line item, help you calculate it all out. At that point, you’ll know the actual reimbursable cost for the administrative use of the home that you’re entitled to. What’s important is that we’re submitting that to the corporation regularly.
I often tell people, if you can do it once a month, get in the process of submitting those reimbursements to the corporation, document those expenses that you’re paying out of pocket personally as an employee of the corporation, and submit those to the corporation for reimbursement. What’s important to note is, while you can submit those for reimbursement, we shouldn’t be submitting those pretty timely during the year. This is not necessarily something that’s done.
When you do that corporate tax return, you’re going to be submitting the reimbursements throughout the year to the corporation, and then the corporation has time to decide when they want to actually pay that reimbursement back to you. What’s a common thing and a common question we get is, if the corporation doesn’t pay that deduction by the end of the corporation’s tax year, will the corporation actually be able to deduct it?
The answer in that circumstance is actually no. If it pays it after year end, meaning it reimburses you for all those expenses after year end, it will fall on the next year’s corporate tax return. We want to make sure that those reimbursements are paid before the end of the corporate year.
You might wonder, hey, well, maybe this year, my corporation hasn’t actually made a lot of money, there’s not a lot of cash in the corporation to pay those expenses, that is understandable. But the thing is, a lot of these expenses are dependent on the corporation actually paying it as a cash basis taxpayer. The corporation only gets a deduction when it actually pays those reimbursements back to you.
You might be in a situation where either you make a loan to the corporation, or you actually contribute cash to the corporation so that the corporation can take that cash and actually pay you the reimbursement back and actually get the deduction.
Eliot: Very good. All right. Just to recap on that, you can start out by taking the square footage of the office, usually divided by the square footage of the house. You might be able to improve on that. You get a percentage there. We can improve on that percentage by maybe excluding square footage for areas that are what we call uninhabitable or unusable, such as restrooms, hallways, and stairs. We can add that.
Let’s say we have a 1000 square foot home. We take the square footage of restrooms, hallways, and stairs. Let’s say that’s 100 square feet, subtract that out, that would leave us with 900. If our office was 90 square feet, then 90 divided by 900, that’d be 10% of the area.
You get a little bit higher percentage use there so you can improve on that. And then take it, times all these expenses that our question are asked here with the mortgage interest, insurance, real estate taxes, such and such, homeowners association fees, anything having to do with the running of that house, pretty much utility, so on so forth, and that depreciation component, all to their benefit.
Just get that reimbursement. As Kurt has pointed out, it’s so critical that you actually have a cash transaction, which means do it at the end of the month, fill out your form. We got Toby’s cheat sheet calculator. It’s the spreadsheet that Kurt was referring to. We have that all over the place. Just ask and we can get you a copy of it.
We turn that in every month. S-corporation writes you a check for it. That’s a cash transaction, that’s your money tax free, and now we can put down their turn, but we don’t want to wait till next year’s tax time. It’s too late. We got December 31st year end, so we gotta get it all in before then so that we can get it on the return for that particular year.
If you don’t have the money, you can put it in as a shareholder and put cash in there because you’re going to get right back with the reimbursement. A lot of opportunities on this one. Thank you, Kurt. Good job.
All right, next. “I own a single member disregarded LLC, which in turn owns a rental property. The rental property provides me with tax deduction mainly because of depreciation. If I were to take the property out of the LLC as an owner draw or distribution, would I be liable for any capital gains tax or depreciation recapture?” I got my rental property and an Anderson disregarded LLC that’s disregarded to me. Kurt, I want to take it out. Am I going to suffer any consequences tax wise for that?
Kurt: Yeah. In that circumstance, you want to look at, did actually a taxable sale or taxable transaction occur? In this circumstance, you’re just pulling it out of an LLC that you own, that is disregarded to you. It’s not really considered a sale for the IRS purposes. You’re just essentially taking the distribution out.
You’re pulling the asset out. It shouldn’t produce any capital gain or any income tax effects, at least for federal and state income tax purposes. However, what you want to be careful of sometimes is certain types of other state and local taxes that you might get hit with, transfer taxes, different kinds of state and local taxes, that would be applicable to moving a property out of an LLC.
One particular example that I can think of is Pennsylvania. Transferring a property out of an LLC is going to get hit by a transfer tax. You have to make sure where the property is, what kind of LLC it is, what state you’re actually dealing with, and just watch for that. But really, for income tax purposes, you can take it out, you can put it back in. No tax consequences on that.
Eliot: Excellent. If you ever have any questions, clients, about how to actually do that, what needs to be done, we have our whole attorney staff. Kurt is amongst all of our attorneys. The majority of them are at our Utah office, so I’m sure he could direct you to one or two, I would think.
Eliot: Every time I talk to Kurt, I can hear an attorney coming in asking him questions because he’s got all the tax knowledge there. We definitely want to help out our attorneys with the tax issues, so Kurt’s a good sport to handle that.
When we have a disregard LLC, there isn’t any income tax consequence certainly at the federal level and typically not at the state, other than those property transfer taxes or something like that that Kurt was pointing out. That is the one, sometimes, that sneaks by. We don’t expect to hear about the transfer tax because we’re so concerned with the other taxes, but we want to look out for that one to be sure.
Next, “When you pay your kids,” Under the strategies that we often talk about here. “May that payment come from your personal bank account.? I’m trying to pay the children Kurt, get them some money shifted over there. Can I do it from my personal account? I’m thinking there’s probably an it-depends coming up here.
Kurt: Yeah, I think that’s a very good depends. In very limited circumstances, say you had a business, but you weren’t using an LLC, a corporation, an LLC taxed as a corporation, or an LLC taxed as a partnership, you were just simply in business in your own name as a sole proprietor, you really don’t have a separate bank account for business, you could, in theory, pay your kids out of your personal account.
Would we ever really recommend this kind of strategy? Most likely not. You’re muddying personal expenses, personal incomes with business incomes, business deductions, all out of your personal bank account. I think it’s just not going to end up in the best situation.
Usually any kind of business that we’re going to have operating, any operating business that you have, you’re going to be wanting to operate out of some type of entity, whether it’s an LLC, corporation, partnership, whatever. All those entities should have their own bank accounts. In most circumstances, it’s never advisable to pay your kids business expenses out of your personal account. Always use the business bank account.
Eliot: Very good points. We want to really separate our personal world from our business world. We’re undoing that if we’re paying any expense for that matter out of our personal bank account. It just makes good business sense asset protection wise. I know we’re here for taxes. But if you’re paying for your personal expenses out of a business, it could erode your asset protection. A lot of reasons not to do it, not too many good reasons, if any at all, to do it through your personal bank account.
It does depend on how your business is taxed, what kind of LLC, how it’s taxed, what you’re going to do there, how you’re going to go about it. We could spend the rest of the better part of a day talking about the different types of tax structures, entities, and how we would do something like this. Generally speaking, stay away from that personal bank account. Keep it separate from your business when you’re paying your kids. Great question.
Just a reminder, here it is, Tax and Asset Protection Workshop. We got some virtual events coming up here, July 20th, 2023. That’ll be coming up here this weekend and July 29th, 2023, both of those one day free events. Come on in, online only, and then we have the four-day live ticket event coming up in Las Vegas. I guess my date’s cut off here, but I want to say it’s September 14th to the 17th approximately live here in Vegas.
You’re going to see a lot of Anderson people there. A lot of clients, a lot of networking going on. They’re fantastic events. Kurt and I had the pleasure of doing the Last Vegas event together. We got swamped, I think that’s fair to say. Yeah, Kurt?
Eliot: We had a good time. It was a lot of fun. Anyway, if you can, get into town for that and you’ll never regret it. It’s a great event, they do a wonderful job.
All right, continuing on with our questions. “If I use a SDIRA, self-directed IRA, to purchase short term rental property, does that qualify for me as a real estate professional?” We hear that term a lot. “For all my real estate investing activities. If I use the SDIRA, self-directed IRA, funds plus a mortgage to buy a rental property, once the mortgage is paid off, is the whole property considered property of the IRA, the Individual Retirement Account arrangement property?” Kurt, what do we got going on here? A lot of different things here.
Kurt: Yeah. When we look at properties that are owned by any type of retirement account, whether it’s a 401(k), an IRA, we want to put a very clear and distinct wall between anything that might qualify for real estate professionals, which would be under your regular LLCs.
Any non retirement assets, and put a big wall and then anything with retirement assets on the other side. Because if you’re doing anything with retirement, that is generally not associated with anything to do with real estate professionals. You can’t use deductions from your rental property held by your self-directed IRA towards your real estate professional on your personal return or anything like that.
It’s very important to put a big wall right between anything retirement asset related and anything non retirement asset related. That’s where this kind of question comes up. Self-directed short term rental sounds good, but that isn’t going to help you at all with your real estate professional hours. You’re not going to be able to write off the losses from that short term rental that’s held by the IRA against your ordinary income. It’s just very good to keep those ideas very separate.
Another thing to mention here, the short term rental held in an IRA, that might qualify as an active business. You might have UBIT concerns, unrelated business income tax concerns by running an active business in your retirement account. Oftentimes, that isn’t the best idea to have active businesses in your retirement accounts, your IRAs, your solo 401(k)s because of those additional heavy taxes.
UBIT, unrelated business income tax, is usually a pretty heavy tax that can be levied. Oftentimes, people think of retirement accounts that say tax deferred. But if you’re running active businesses out of using assets that are owned by your retirement account, that can trigger taxes like unrelated business income tax if you’re generating business income in conjunction with taking on debt.
Other examples or other issues like unrelated debt income tax financing might arise. It’s often best to keep those very separate and distinct. Minimize the active businesses that you’re conducting in your retirement accounts.
Eliot: Very good. Sometimes, also if you get into debt on a property, you might have an unrelated debt financed income portion of income being earned in a retirement account based on debt, might incur that extra tax. It’s a subset of UBIT, the unrelated business income tax that Kurt was talking about.
To give you guys just a picture of what that looks like, that heavy tax, think of your regular tax bracket, the upper level 37%, approximately, is just that for an individual taxpayer, it takes maybe $300,000-$400,000 of income to reach that level. When we’re talking about UBIT, it takes all about $15,000 to get into the 37%. It’s a steep rise right away, so you want to watch out for that. We like to avoid that.
That active business short term rental as Kurt was pointing out, that’s a very good indicator that you’re going to run into UBIT. You might have some debt problems, and real estate professional status wouldn’t have anything to do with what’s going on in your retirement accounts.
Real estate professional staff, you’re going to have to be self-managing. You really are responsible for overseeing your properties, or at least some of them. That’s one thing you cannot do on a rental that’s in your retirement plan.
You can’t manage that at all. Otherwise, you could destroy your whole plan that’s considered a prohibited transaction. A lot of little warning flags on this question, that’s one reason we picked it to try and set some items straight here in our minds how we look at this. Excellent question.
All right, moving on to our next one. “What are the requirements to have a second home be considered a short term rental? Will I be able to expense furnishing costs and other expenses? Also, how does cost segregation work in this situation?” It looks like we’re looking at short term rental. It may be a second home. There might be some issues there, Kurt. Any thoughts on how these expenses would work in that scenario?
Kurt: A lot of times, when we talk about short term rentals, the big thing is, oh, I’m running an active business. Hey, if I’m materially participating, maybe I can take a healthy loss against my other income, maybe my W-2, maybe a high W-2, I create a big loss on my short term rental, I can offset my W-2 with this big loss from a short term rental. Sounds great.
However, in a situation where it’s a mixed use property, meaning that it’s a vacation home, use it for part of the year. The other part of the year, you’re renting it out on a short term basis, you have to be very careful with mixed use property because it’s not necessarily the same as if you just had a short term rental that you never used at all during the year.
If you’re going to be using any property for more than 14 days or 10% of the fair market rental days out there, you have to allocate the expenses associated with the property between personal time and business time. Also in that circumstance, while you can take certain deductions like expenses for some allocation of the furnishing costs, other maintenance costs, things along those lines, you’ll be able to offset the short term rental income down to a point, but you actually won’t be able to create a loss on a short term rental that could carry over to your personal tax return.
Your expenses in any given year with mixed use property will be limited to the income associated with that investment property. That applies to long term rentals, as well as short term rentals.
When we talk about an idea of, hey, could you do a cost segregation study and front load a bunch of the depreciation on this short term rental, the answer is, well, yes, you could to an extent, but how much would it actually benefit you is hard to say. You can certainly zero out the rental income.
Let’s say you made $10,000 of rental income in a second home renting up for a short term basis. But if you already have expenses of $9500, for example, and you want to do a cost segregation study, and front load a bunch of depreciation, you can only come down to zero. You can actually create a loss in any year that you use that property for over 14 days.
While you can do a cost segregation study, and you certainly can expense all the furnishings and other types of capital expenditures, to what benefit you will actually get is a little harder to say. Just be mindful that anytime you have mixed use property, these are the little traps that you should be aware of.
Eliot: Very good points. That’s exactly right. We want to be really careful of that personal use. The greater of 14 days or 10% of the days, that’s the number of days that it’s rented at fair market rate, that means it’s rented to unrelated parties. There’s a calculation. If you use it more than that for personal use, as Kurt points out, you’re going to be limited in your expenses that you can take in that year to the given rental income of that year.
Any additional expenses that you couldn’t deduct, they just carry forward next year, but that’s not going to help you out probably next year either. Probably be in the same boat if you use it a lot.
Personally, I’m not a fan of ever mixing the personal world with our business world. If you got a property, make a business, keep it business, don’t use it personally. Obviously, some people who got the rental in an exotic location or something like that, want to use it a little bit.
Just be very careful knowing the 14 days or 10% of the fair market rental days of that rule because I’ve seen it sting a lot of people who came to us onboarded as clients, and we’re looking at prior years, where they’re trying to get the return done. And they realize they can’t deduct a whole lot. We’ve seen that more than once. Very good points, Kurt. Thank you.
I think we are down to maybe the last question here. All right. “I formed my two LLCs last year, but haven’t funded them or used them in any way. I missed the tax return filing deadline this spring. Now what? File the returns and beg forgiveness to not have to pay late fees? Close the business down, start over?”
I got some LLC set up. I’m not telling you anything about those LLCs Kurt, but I will tell you that I didn’t file the returns. What am I going to do?
Kurt: This is a question that we’ve seen before or we seem to get a lot, actually. The very first thing that I’m always going to ask in this circumstance is, hey, I have these two LLCs, LLCs can be taxed in a variety of ways, how are those LLCs taxed?
It will really depend on the answer to your question here. Will you have late fees? Do you have to file returns? What do you need to do to get back into compliance? How those LLCs are taxed knowing that answer will be the first step in determining what you got and what you need to do.
With an LLC, there’s a couple ways that it can be taxed. Usually, the most basic way that an LLC can be taxed is if it can be merely disregarded to you, simply a disregarded entity. In that circumstance, no activity, really didn’t do anything with it, you really probably don’t even have to do anything.
You never did anything with the LLC, you didn’t generate income, you didn’t have losses or deductions from that. You probably don’t even have to do anything. If you did, usually it would just go on your personal tax return. If there’s no activity, it’s probably fine. You don’t have to do anything.
For partnerships, say an LLC was taxed as a partnership, we’d look, hey, did you have any activity at all? Any minor expenses, any income? If you had income, expenses, or any activity, really, we’re looking to file a partnership tax return for that LLC.
There are penalties associated with the partnership tax filing. We’ve had pretty good success with getting those abated. You asked for first time forgiveness. There’s a variety of ways to get that first time forgiveness for a partnership. As long as it’s not a recurring item where you just neglected to file the tax returns year over year, we have a pretty good system of getting those penalties abated, getting the returns filed, and moving forward.
A couple other ways an LLC can be taxed, sometimes an LLC can be actually taxed as a C-corp. In that circumstance, hey, we didn’t really use a C-corp, don’t have any income, don’t really have any expenses. With a C-corp, when it comes to not filing your taxes, if you don’t actually have taxable income for the C-corp, often there’s really no penalty associated with failing to file those returns on time because the penalty to file a C-corp return is actually dependent on the profits of the C-corp.
If you don’t have profits, then you can’t really calculate a penalty. All you really have to do is get those returns filed preferably as soon as possible to keep things in good order and just move forward. You don’t really have to worry about abating penalties or anything like that. It can be pretty streamlined, cleaned up relatively simply.
An LLC taxed as an S-corp is probably the final way that we’ve seen these things done. Any activity at all really for that, you really do want to be filing tax returns. Abating the penalties on the S-corp becomes a little bit more challenging.
We’re still going to recommend getting it cleaned up, getting it filed, getting all that stuff done as soon as possible. Seeing if we can abate penalties, but oftentimes it’s a little bit harder to abate penalties on an S-corp. Those are pretty much the options you have in front of you.
Eliot: There we go. Just remember, I can’t really improve on what Kurt said there. He just nailed it. Again, a reminder, get your extensions out. This is one of the reasons we always recommend doing so.
All kinds of things have happened. I’ve seen the IRS website go down. I’ve seen our own tax preparation software have problems the day of a tax deadline, so do those extensions. Whether you intend to use it or not, that could help us here, perhaps giving us some leeway. We wouldn’t be talking about penalties. But certainly, a lot of them can be abated, just check with your tax preparer.
That’s it for our questions right now. Just a real quick to the rest of our team out there. They’ve done well over 115 questions. I know there’s some left in there trying to answer those. We thank our staff for helping that. Please be patient with them.
We got Dana, Dutch, Sergei is in there, Tanya, Trisha, everyone trying to answer your questions as best as they can, as fast as they can. Just please give them a little chance. If we can’t get to it, feel free to submit it through the online platinum portal.
Another reminder to hit Toby’s YouTube channel. Lots of videos. I think Kurt probably has a new video he just cut. Toby will probably be in there sometime soon. I know I’ll be doing one sometime soon with him. I actually filmed the same day just about as Kurt did his, but I flubbed up so we have to recut. We’ll be doing that here in a couple of weeks.
Well over 500 videos. Check out Clint’s as well, his YouTube site. Again, a reminder for the Tax and Asset Protection workshop. We got two virtual dates back to back. I don’t think it’s back to back weekends, but on July 20th and July 29th. Then the big four-day event live here in Las Vegas, where it’s going to be toasty, about 116-120 degrees when you come, but it’s all indoor. It’s got the AC blowing, so no problem there.
I hope to see you there as quickly as possible. Any questions feel free to email us at firstname.lastname@example.org, or visit us at andersonadvisors.com. Get those questions in, and we’ll have them here maybe in two weeks again. Thank you.