It’s the middle of a sweltering summer and the July 15 deadline to pay your income taxes is fast approaching. Don’t worry because Toby Mathis and Jeff Webb of Anderson Advisors offer a bevy of knowledge to avoid getting burned. Do you have a tax question? Submit it to taxtuesday@andersonadvisors.
- What is the most tax-efficient way for 401(k) to Roth 401(k) conversion? Entire amount does not need to be converted in one year, or you’ll take a major tax hit
- How do I start a real estate business with income from our current businesses? Is this possible? Yes, pull money out of businesses to establish new real estate entity
- How do I elect trader status? State that you are a trader or select mark-to-market election method of accounting for securities traders
- How can I identify tax breaks at certain income levels? If your income is below the $100,000 threshold, use standard deduction, IRAs, and more to not pay any or much tax
- What is the easiest or best accounting software to keep up with your business expense and get the best tax reductions? Most prevalent software used for accounting and bookkeeping services is QuickBooks
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Full Episode Transcript:
Toby: Hey, guys. You’re listening to Tax Tuesday. This is Toby Mathis.... Read Full Transcript
Jeff: And Jeff Webb.
Toby: And welcome. Happy Tax Tuesday.
Jeff: Thank you. Happy, happy, happy.
Toby: Happy, happy. I couldn’t have said it better myself. This is tax season. This is what’s weird. We’re in the middle of summer. It’s like six hundred degrees outside here in Vegas but it’s a dry heat. All it does is cook you.
Jeff: You don’t even know you’re roasting.
Toby: Yeah. Your fire is a dry heat. It’s still painful. We’re in the middle of summer. We have a tax deadline next week. It’s evil. It just feels really messed up.
All right. Let’s jump in. We got a whole bunch of stuff to go over. It’s going to be fun. Unlike other Tax Tuesdays, this one’s going to be a bevy of knowledge. If you’re here, we’re going to have a good one today.
Be sure to follow us on social media. The place that I really advise you to go is YouTube just because we put up a lot of content. The other thing to make sure that you know are all the fun rules we have here. We have two accountants on, two CPAs, a bookkeeper, and two other folks, Patty and Susie, that will help point you in the right direction. If you have lots of questions, we have professionals on right now. I don’t know any place where you can do this. Especially, not on the low, low cost of free.
If you have any questions that pop up, by all means, go into the question and answer field. Yes, we actually answer them. When you’re corresponding with us, sometimes we’ll have a conversation with you. You’ll be writing and we’ll be talking but we’ll have some conversation or ask for some clarification.
Also, that little Tax Tuesday, this guy right here, you can see it right there, you can send in emails and ask us questions that way too. That’s where we pick our opening questions every time.
Our opening cut question today, “What is the most tax-efficient way for a 401(k) to Roth 401(k) conversion?”
“How do I start a real estate business with income from our current business? Is this possible?”
“How do I elect Trader status?”
“If you are an active investor investing for passive income, is FICA taxes ever required to be paid on income?”
“How can I identify tax breaks at certain income levels?”
“I 1031 exchange a rental house from California to Nevada quadplex. How can I get an LLC protection without any 1031 tax consequences?” That’s a good question.
“What is the easiest or best accounting software to keep up with your business expense in order to get the best tax reductions?”
Then, these are some deep ones here. “My mom and her siblings quitclaimed my grandfather’s house for me. Once I get a loan, I will pay them out of the proceeds tax-free at a price that was agreed upon. Being that, technically, I didn’t buy it from them with a purchase and sale agreement, how would depreciation work on this house?” I will answer that. Some of these have a bunch of nuance issues that are going to be fun to go over. I just grabbed these at random to give me a big old spreadsheet with hundreds of questions. I grabbed ones that looked like they’re not six pages long even though these ones look long. You can see this with the stuff we’ve got.
“I understand that the CARES Act allows me to borrow up to $100,000 or 100% of my vested interest in my 401(k) account through 180 days from the CARES Act enactment date of March 27, 2020, that I won’t owe any penalties or interest if I pay back the loan within five years. Also, the loan repayment period can be longer than five years if the funds are used to buy a home that is used as my primary residence. Is this information correct?”
“Is it possible to borrow more than $100,000 from an IRA by combining it with the $50,000 401(k) maximum loan limit that existed prior to the CARES Act (i.e. take out two loans, one of $100,000 and another of $50,000)?” I’ll answer that.
“I have a limited partnership. My corporation is 1%. The partners have different shares. They all want to do a 1031 exchange into their own purchase. Is this allowed?” Interesting question.
“I am a new home builder with 15 homes built a year. Do I expense home by home after it’s sold or can I do fiscal year expense and income accounting altogether?” Good question. We’ll go over that.
“I need to make a real estate business in California. I formed a Wyoming LLC. Do I need to file another California LLC or is it okay to register the Wyoming LLC in California? What’s the difference?” We’re going to go through all of those.
First off, we have a little giveaway. We have come up. I believe it’s in a week-and-a-half. Here we go, July 18th. This date, we have another Infinity Investing coming up. I have some really cool people coming on, including Hans Johnson, Erin Adams, Eric Dodds, and myself, for this one which is going to be fun. If you guys have never heard of Hans, he’s a really good speaker. He’ll be a lot of fun.
That you can register for. It’s absolutely free. I’ll give myself some white ink at aba.link/iiw. Patty can probably send you out a link as well. It’s going to be a lot of fun. It’s free. It’s a full day and we go over Infinity Investing strategies which if you really want to know what it means, Jeff, how long have you been a CPA?
Jeff: Going on 30 years.
Toby: Thirty years. I’ve been doing this for 27 years. We see a lot of tax returns. We notice who makes money and who doesn’t. You know who usually doesn’t make money? It’s the ones that are telling you to do exactly what they’re doing. They’re doing something crazy and you see patterns. You see who consistently makes money and who doesn’t consistently make money. What we do is we figure that one out.
We just teach what helps people make money. It’s a lot of fun. This is always good. That is absolutely free. Invite your friends if you want. It’s a live stream. Again, every one of them is a little different because the world’s always changing plus I have some really cool people. Again, if you haven’t heard Hans, Erin, and Eric, they’re a lot of fun.
Anyway, let’s go to some Q&A that’s already come in. You guys are fast to the punch. I know that there’s been a whole bunch of people that are already asking questions.
“I have several rentals, no registered entity, and claim the loss on 2019 taxes. Can I apply for an EIDL loan?” Brandon, the answer is yes. The Economic Injury Disaster Loan. Pretend the typical disaster that triggers this type of loan with the Small Business Administration. This is a loan directly from the Small Business Administration.
It’s usually like a hurricane or a flood or a tornado. It just hit something and it just really messes up your business. You’re getting a loan to basically cover you for the period of time that you’re going to be unable to operate or down. Usually, they’re based off of your expenses from the previous year. They give you about a half of it. It’s a 30 year loan. It’s at 3.75%. They’re non-personal guaranteed. I don’t know if it’s non recourse against you, but they have a collateral requirement for over $25,000.
What they did under the CARERS Act is they give an emergency grant that is free money based on how many employees you have. They basically treat you as having one employee that’s just you, so they’ll give you $1000, and then, they’ll give you a loan. The loans right now are capping out at $150,000.
You would take yourself and we would try to apply for you under an EIDL. You would be looking at your lost rents and we’d be looking at that. The answer’s yes, we’d be able to apply for it. We would treat them all as one big activity.
It looks like priority got to one of the tax implications of investing in real estate to a self-directed IRA. I’m still going over it a little bit. Let’s see if there are a few. These guys are so nice to have on here, Jeff. We’re panicking at this point that we’ve got 20 questions in the hopper.
Jeff: And we just introduced ourselves.
Toby: Yeah. They’re just going to knock them out. The idea of investing in real estate and an IRA is fantastic, the thing you have to be aware of is that if you have any debt in that IRA, you have Unrelated Debt-Financed Income issues. It means that if you make $10,000, it was a property that was $100,000 and you have a $50,000 loan on it, that means half of that income is now attributable to the debt. You pay tax on that.
After your expenses and things like that, you get to pick that off. You get half the depreciation. In other words, basically find out whatever that net is. You’re going to have to recognize half of it as income. It’s not true of a 401(k). There’s a pretty big difference there. The good part about having anything inside of an IRA or a 401(k) is that you’re deferring the tax on anything and the income in there. With real estate, we can usually frontload a lot of our deductions into those first couple of years. You lose the incentive to do that but it’s still not a horrible thing.
Again, if I have to choose either I leverage myself like crazy or I have $200,000 sitting in a retirement account and I buy two rentals, I’d buy the two rentals instead of trying to lever myself like crazy as an individual. That’s just me.
Anyway, somebody says, “Of that loan that we just discussed, the Economic Injury Disaster Loan, is that forgivable?” No. The EIDL is not. The PPP is. The emergency advanced on the EIDL, you do not have to repay that. It’s free money and it’s limited to $1000 per employee. The lowest amount they’ll give you is $1000. The most they’ll give you is $10,000. If you do have a PPP loan, whatever they give you on the emergency advance is taken off of your forgiveness under the PPP. That’s how those two interact. But you can have both.
Let’s jump into the questions just because I know what I’ll do. I’ll be answering the questions that people are asking online and I’ll forget that we have questions written down.
“What is the most tax-efficient way (basically) to convert a 401(k) to a Roth 401(k)?”
Jeff: As far as tax-efficient, you don’t have to convert the entire amount in one year. I’ve seen people do that. I’ve seen people convert $1 million in one year and take a huge tax hit because of that. Whereas if they’ve taken smaller chunks, they could have kept their taxes much lower in those years.
The problem with converting a 401(k) to a Roth 401(k) is you’re either going to have to work with your plan administrator to do that, or if it’s a self-directed 401(k), you’re going to have to work with the custodian to get that Roth 401(k) account set up and established.
Toby: Here’s the thing. From a tax standpoint, the difference between these two is I get a tax deduction for putting money on a 401(k) and I pay tax when it comes out. On a Roth, I don’t get a tax deduction for putting it in. I don’t pay tax when it comes out. Whether it’s a Roth 401(k) or a Roth IRA, the biggest difference is Roth IRA’s based on income and Roth 401(k)s don’t. I don’t think you have a conversion. You can always convert something.
Jeff: Oh, yeah.
Toby: Here’s the thing. It almost never makes mathematical sense to convert at a higher tax bracket. In other words, if I convert and I pay tax now, let’s say I’m in the 37% tax bracket, it’s next to impossible for me to make up that big tax loss, that 37% loss of every dollar by the time I retire to make the math work out, so I’m better off.
I actually have a calculator that I use to see whether or not it’s better to do an IRA or a 401(k) versus a Roth or even do an IUL, a nonqualified plan. If you are in a higher tax bracket, take the deduction always. Chances are you’re going to be a lower tax bracket when you retire. If that’s you, a traditional IRA or 401(k) is better.
When a Roth is better is when you’re younger and you have more time to let it cook, simmer, and grow. You’re in a lower tax bracket and you’re either going to be in the same or greater tax bracket when you retire. If that’s you, then you do the Roth. If you’re young, lower tax bracket, put it into a Roth 401(k). Put it into a Roth IRA.
If you’re in a higher tax bracket, do not convert. I see people do this all the time when they’re in their 50s. You realize that you’re never going to make that tax hit. It literally takes 25–30 years to absorb that tax hit. This is not going to happen.
Jeff: One other time that it makes sense to do the conversion, I’ve had a crappy year. My business has done terrible. I’ve got that big net operating loss, not a capital loss, but a net operating loss.
Toby: Right, but you’re not in a high tax bracket.
Jeff: At that point, go ahead and do that conversion.
Toby: Absolutely, I agree. All right. Here’s the rule.
Jeff: But it still goes along with what you’re saying. Don’t do it when you’re in a high tax bracket.
Toby: I’ll give you guys a bright line rule. If you’re at 22% or higher, probably don’t do it. If you’re 22% or lower, probably do it. It’s worth getting a pencil out and doing the math to see. If you have a great, huge, opportunity that’s once in a lifetime that you think is just going to explode, you are sure it’s going up, you’re going to invest, and you could invest with retirement money, maybe you convert because you’re going to make so much money in Roth. I’ve seen that. The PayPal guy did that. Millions and millions of dollars in his Roth.
Jef: Say, you’re a senator and you’ve got inside information on this […].
Toby: You’re not allowed to […] docket anymore. They were actually able to do that for years. That only stopped 10 years ago. Ridiculous.
All right. Q&A. We’ve got lots of questions. You guys are typing a lot today. “Can negative depreciation from a business offset W-2 income?” Leo, you wouldn’t call it negative depreciation. What you would call it is depreciation that creates a loss or depreciation when you have a loss.
Can it offset W-2 income? It depends. It depends whether it’s an active trader business or whether you’re passive. If you are passive, no. Which means, I don’t materially participate in the business or it’s real estate. There are some exceptions—real estate professional status, active participants in real estate. In a typical business, then, yeah. Usually, it’s going to offset your other income.
You have some rules. If it’s an S Corp, your loss is limited to your basis, whatever you’re putting it in there. If it’s a C Corp, you can’t take it unless you dissolve the C Corp, which in this case, you can write-off up to $50,000. $100,000 if it’s a married couple.
Partnership flows right on through. Sole proprietorship flows right on through. Sole proprietors have their own issues. But generally, yes. Within that, if it creates a net operating loss, Jeff’s just going to tell you how far can you carry that back.
Jeff: Not at all. I’m sorry. You can’t carry back five years.
Toby: Yeah. We just changed that.
Jeff: I know […] 2018, 2019, 2020, you can carry back in five years. Then, in 2021, I believe it goes back to the old rules. It no longer carries it back.
Toby: All right. “I made $100,000 trading options at an LLC so far for 2020. Is it possible to be taxed as a corporation?” Brian, you’re not going to want to be taxed as a corporation if you made option money. Option money is considered capital gains. If it’s realized option money, it’ll probably be short-term if you made it this year, and it’s not subject to self-employment tax. That said, you still want to have a corporation in the mix. Usually, it’s going to be a partner. In a partnership, the LLC is taxed as a partnership.
We have to look at that LLC and see how it was taxed and do we have a corporation to help split income as the management entity. That’s a nice chunk of change, but you’re going to find that the hard news is it can be an ordinary income, more likely, unless you can find some expenses.
Now, there are ways to shave that down. The big ones, this actually goes to another question someone has asked which is about deductions at certain levels. When I have people that are in the million dollars and above, my go-tos are I’m looking for a spouse to qualify as a real estate professional or them to qualify as a real estate professional, and look at buying more real estate.
I’m looking at conservation easements, legitimate conservation easements that are not listed transactions, which means none of this craziness out there. You’re looking for 4–5 times, 5 times being the maximum, 250% deductibility.
I look at public charities that you may set up and operate beyond the boards where we make some deductions that way. I’ll look at income splitting with corporations. I’ll look at defined benefit plans like a little bit more amped up retirement plan, not just a 401(k). We do both at the same time. I don’t do defined benefit plans but if you use it, you’re almost doing it in conjunction with 401(k).
Those are the big ones. Any of that I’m missing? Kids? Maybe paying your kids.
Jeff: Not that you’re telling them to have more kids.
Toby: Yeah. Have a lot of kids to get that. No, no. Pay other taxpayers that are doing things for your business to the extent that you’re able to. Then, during the year, you want to incur expenses that you’d be incurring later on. You want to make sure, if you’re going to incur them next year anyway, you may want to incur them before the end of the year. Just giving you a whole bunch of bevy of options.
Next question. “How do I start a real estate business with income from our current businesses? Is this possible?”
Jeff: Typically, you’re going to have to pull money out of those businesses and establish a new entity for real estate. I’m assuming these are trades or businesses where they’re actually doing some type of trade. I don’t know that I want to put real estate in that mix.
Toby: You always have this weird thing where people are, I want to start a real estate business. Do I blend it with my current business? Is there a way to do it? The answer’s going to be a big, fat ‘it depends.’ The reason it depends is how was your business taxed? What does your business do? And is there a way to treat it as one activity from a tax standpoint while separating out the liability of the two?
Let’s say that, in my case, I’m doing tax work. We have a firm and we decided to buy a building. We could still buy that building, same owners as the firm. We can rent it to the firm and the IRS let us treat that as one activity. That’s one of the few cases where you can take real estate losses and offset the income from your active business.
I have a feeling what these guys are asking is how do I get money out of my business so I can start a real estate business? The issue there (again) is what type of business is it? Is it an S or C Corp? Partnership or sole proprietorship?
If it’s an S Corp partnership or sole proprietor, you just take the money out. They’ll tax you no matter what. C Corp, you may want to make it your lender. You might want to set up a separate business just doing the real estate. Buying passive real estate is the best in my opinion.
It’s absolutely possible to do it. It’s possible to do it. In some cases, you can get huge tax benefits. In other cases, you’re just saying, I want to keep it separate from me. You could actually do it.
Somebody said, “From my previous question, for stock option trading, which tax status is better? C Corp or S Corp? What’s the rationale for that?” For stocks and options trading, Adam, you’re looking at capital gains.
Actually, I have a question here. Actually, it’s the next question. It’s the trade status, one that’s going to pop up here. What I usually do is I look and I say first, do no harm. I want my capital gains to flow on my return if I want them to. You’re either going to have capital gains that are short-term or long-term, and they’ll be taxed at either your ordinary rate or at long-term capital gains rate, depending on how long you held the securities and how long you held the option.
Jeff: And while capital losses for the individual are limited to $3000 a year, for a corporation, they’re limited to $0. You actually have to have other capital gains to offset them.
Toby: Yup. Which means, Adam, we want your stock account. Generally speaking, it’s going to be a limited partnership or an LLC taxed as a partnership. A partner in that is going to be a corporation. We’re going to give it guaranteed payments to operate and run that LLC because you’ll get to write anything off against it. You don’t even get miscellaneous itemized deductions anymore. They completely mix those under the Tax Cuts and Jobs Act.
Here you are working […]. Let’s say that you’re working real hard, you’re running a great structure, and you’re profiting, somebody said, you made $100,000. That is almost like a hobby. It’s not quite as bad. In fact, it’s worse because you can’t write anything off. They’re going to treat you worse than a hobby. You don’t get to write not enough. You might get an investment interest expense.
Jeff: What makes a corporation important is the fear of having substantial fees or expenses from your investing. I know some of the brokerage firms. If they’re managing your account, charge a substantial fee for that. You cannot write that off on your 1040. How will a corporation can since you’re managing your investments and your limited partnership? We found that this is the best way to work if you want to invest in an entity. You can do some of that income over to the corporation where you’re going to have additional expenses anyway.
Toby: I’m probably using a C Corp in those circumstances because I want to be able to split some income. In case I have a little extra money that I’m paying over there, keep it out of my tax bracket knowing that if I want to get that money out of the corp, all I have to do is wait enough time, incur enough expenses that is reimbursing me.
I like to have a family business. I don’t know about you guys but I’m never going to set up a corporation and say this is all it’s doing. No, it’s going to do lots of fun stuff. It’s going to manage my accounts. It’s going to look for investment opportunities. It’s going to make sure that we are educated on all the new strategies. Everything from real estate to stocks, to small business, to management, to legacy planning. You name it. Anything that will help you as a family and your business grow, you run it through there. If your kids need better equipment to help that business, they’re working for that business. You don’t have to pay them a salary. Although it makes sense (quite often) to pay kids a salary because you pay them $10,000 a year, it’s tax free. It’s going to be pretty money to them. Anyway, long answer.
“Can a REIT be formed from an IRA based on real estate?” Technically, no. A REIT is Real Estate Investment Trust and it’s set up to own real estate. It’s subject to specific rules. You may be thinking, can I just own a real estate entity like an LLC inside of an IRA? The answer’s yes. If you’re doing a traditional, publicly-traded REIT that has profit requirements, you wouldn’t use an IRA. An IRA can own a piece of a REIT, but the IRA wouldn’t be the actual entity.
I like REITs. Personally, I wouldn’t form one. Somebody’s asked me how I would form it. I would talk to a good securities lawyer if that’s the route you’re going, but it’s going to be very, very, expensive. We’re talking probably close to seven figures to get one off the ground. That’s just my best guess. They’re very expensive and you have to distribute (I think) 90% of the profits every year anyway. For me, I’m not probably going to do it.
But I don’t mind buying them, the really good ones. Federal Realty Trust has been paying out increasing dividends on an annual basis for more than 50 years. It’s taken a little bit of a bloody nose with the real estate fears. It’s a dividend king and I like it, FRT. I think it’s around $88 or something like that right now.
Jeff: It kind of tells you how complicated REITs are in that their 1099s don’t have to be issued until May 15th.
Toby: No. They’re dumpster fire from an accounting standpoint.
Jeff: Which is why you often see corrected 1099s from your broker.
Toby: Somebody says, “Thoughts on going the Roth 401(k) route as insurance against future higher rates?” Everybody’s been saying that for decades. The government’s going to raise rates. Who they raise rates on?
Jeff: The wealthy?
Toby: The wealthy. They’re going to hit the wealthy, eventually. That Roth 401(k) depends on what your tax bracket is now. The Roth is going to be $0. I get it. It’s a great hedge but if you’re in a high tax bracket, I’m not willing to bet that my tax bracket is going to be higher than what I am in the prime of my earning. It’s not going to happen.
Almost everybody’s income goes down in retirement. The average tax bracket—I looked this up about two months ago—in some states it was single digit. Average. Then, you look at the median and it’s probably closer around 15% which means the 50% percentile. If you’re average, chances are you’re going to be in a much lower tax bracket than you are right now.
Let me jump into this next one because I know you’ve been salivating to talk about trader status. You can go out for this one. “How do I elect trader status?”
Jeff: You elect trader status simply by saying you’re a trader. However, there is a second election that’s far more important.
Toby: Wait, you could just say I’m a trader?
Jeff: Now, you can say I’m a trader.
Toby: I know. Isn’t that crazy?
Jeff: It really doesn’t change anything.
Toby: Someone just wrote it in their return saying, hey, I’m a trader.
Jeff: What most people are actually talking about is the mark to market election which allows you to recognize capital losses as ordinary losses with no limitation. However, there is a bevy of cases throwing trader status out.
Jeff: Tons and tons, and it is so easy to screw this up.
Toby: Yeah. Trader, frequent, continuous. If you have a W-2 job, chances are you’re not going to qualify. They’re saying you’re safe for about a thousand trades right now. Some people say 700 trades a year. You have to be really active. You better make sure they’re short term. If they sniff appreciation or a long-term play, you’re not a trader.
Jeff: By long-term, we don’t mean a year. We mean days, weeks.
Toby: Yeah. They actually say daily swings. Technically, what they do is they look and they say, what’s the average holding period? Or they’ll divide them up, saying you held these ones for this long and you held these ones. If you go over 30 days…
Jeff: We have one case where they threw […]. They weren’t traders because their average holding period was around 30 days.
Toby: […] 32 days, and they said nope. The case is like a minefield out there of why you’re not a trader which should just tell you, I don’t really want to do it because I don’t have to go and explain it to a judge.
Number two, when you make that mark to market election. I’m prejudiced, so I’ll get out of this one because in 1999, the market was going crazy, then it just turned and face planted in 2000. That was the tech bubble bursting. The way that mark to market election works is they treat your account as being liquidated on December 31st. If you have positions, it’s just like you sold them all.
We have Qualcomm. I still remember this like yesterday. It was hundreds of dollars in those last couple of months. It skyrocketed and then it face-planted in three months in 2000. People couldn’t sell it and pay their tax bill. I said why would you do that to yourself? You’re creating fake rules and you’re just punishing yourself. I don’t think I’d ever do that. I don’t like people filing for traders status. I don’t like mark to market elections.
Jeff: I don’t either.
Toby: The reason people do mark to market election is so that the loss goes on to Form 4797. It becomes an ordinary loss as opposed to capital loss, meaning, if I lost my […] gambling in the stock market, then I can write it off. I likened it to say I’m a professional gambler. Be prepared to be scrutinized and you better show that’s how you make your living.
I would hope that this is not you. Most people don’t make money consistently as traders. Most people I see, about 80% lose money doing active trading, when they’re trying to play the daily swings in the market.
Jeff: Yeah. You’re really betting against the computers. Some people do well but most do not. Let’s say that you do the mark to market election. That election has to be made by the original due date of your tax return, meaning it’s due in eight days.
Toby: You have to make that election without extension. The due date for the extension for that year. Not from last year, for this year. This is the weirdest rule. They use last year’s tax return as the due date for an election that would be this year.
I don’t even want to tell people this because I don’t want them to do it. The only people who do mark to market elections are the ones that lose money.
Jeff: And worst, we have clients who’ve taken advantage of those capital losses, then had a really good year, and it hurt them badly. They had to pay ordinary rate tax rates on it, not the capital gains rate.
Toby: Yup. The easier route is just structured as a partnership LLC or an LP with a corporation as the manager, as the guaranteed payment to the partner, the person that the company gets paid no matter what. That gives you a lot of opportunities to get some deductions. That’s the reason people make the trader status election anyway. They do it because they say, I’m a business, even though the IRS doesn’t let you write-off expenses unless you really have to be in this stuff to get a write-off.
A few questions, you guys have a lot of them. I know that Elliot, Kyle, and Javier are kicking around and zipping through this, but this would be fun.
“My wife and I are S Corp with another partner. Can we open and fund a solo 401(k) for my wife before July 15th?” Not for 2019. The rule changes this year so that you would be able to do this next year under that scenario. You can actually start your 401(k)s later.
If you’re partners in an S Corp, you guys can do a solo 401(k) with the partner. I think you can have up to three, potentially, if you’re all partners. I think a husband and wife and a partner would work. If you couldn’t, you would just open up a traditional 401(k), but the solos are a little bit easier to operate. As long as you don’t have employees. If you have employees, as long as they’re under 30 hours a week, I think you can put a three-year vesting on it or something like that.
Would you be able to do it and contribute for 2019? No. Would you be able to do it for 2020? Yes. You can go all the way up to the end of the year in an active 401(k). The big benefit to a 401(k) is you can defer income into it. The employer can make a contribution up to 25% of that income.
Jeff: One of the keys to the 401(k) is you have to have salaries. You have to have compensation as defined by your plan. It’s usually a salary or some kind of wages.
Toby: What does it say, “Does the IRS allow one time non-taxable gift to a spouse?” Yeah. You actually have the gift exclusion per spouse, right?
Jeff: Yeah. It’s not a one-time exclusion.
Toby: Yeah. This is a one time non-taxable gift to a spouse. You have an unlimited spousal exclusion. Your one-time gifts and things like that, individuals other than your spouse and it’s $15,000 a year. I think your lifetime limitation is the same as the Federal or is it $5 million?
Jeff: No. The lifetime limit is the same as Federal, $11-whatever it is.
Toby: It was $11.4 million in 2019, so 2020, it’s going to go up. Probably closer to $11.5 million. You can give me $11.5 million and you don’t have to pay any tax on it. Be sure to remember that on Christmas, Jeff.
Jeff: All my kids are getting millions.
Toby: All right. “If you are an active investor, investing for passive income (rental income), is FICA taxes ever required to be paid on income?”
Jeff: Rental income is almost never subject to it. It’ll be self-employment tax which is the self-employed version of the FICA and Medicare.
Toby: And it’s not. The only way you’re ever going to get hit in real estate was FICA which in real estate, what Jeff said was true. It’s actually old age, death, survivors, benefits, and Medicare. The only way you’re going to get hit with that is if you’re a dealer, you’re flipping properties. You’re a developer, you’re developing properties. You’re a builder, you’re building properties. In which case, your income is active income.
If you’re passive, even if you’re an active investor, you’re still passive. It’s not subject to self-employment tax. Rents, royalties, dividends, interests, and capital gains are never subject to self-employment tax. You have to make it into ordinary income by doing something. The way you do something in real estate is you become a dealer. You buy things to sell them.
If you’re buying things for appreciation and cash flow, you’re fine.
Jeff: Just being a real estate professional doesn’t change that either. That is not the same as being a dealer of real estate.
Toby: That is true. Somebody says, “How do I become a real estate professional?” A real estate professional is a tax status. Really, all it is is a section of the Internal Revenue Code 469(c)(7) where it just says, here’s an exception to real estate being treated as passive—the losses. If you have passive losses, you can’t subtract them against active income except in very few circumstances.
One of those is active participation in real estate where you make less than $100,000 a year. It phases out between $100,000–$150,000 but you can write-off up to $25,000. If you’re a taxpayer and you’re making less than $100,000, you hire your manager for your properties, then you’re not going to have to pay over the year and get to write-off the loss against your active income. If you lose $10,000 and you make W-2 income of $100,000, you would reduce your taxable income now down to $90,000.
Real estate professional, this makes that unlimited. Now, it doesn’t matter how much I make. If you want to pay $0 taxes, we have doctors that do this, the spouse will qualify for the surgeon. They’ll be able to go out and buy big chunks of real estate, lever it on up, take a big write-off, and save themselves hundreds of thousands of dollars in taxes. It makes real estate that much cheaper.
“If you currently have $0 income and take your retirement, does it make sense to convert to a traditional IRA to Roth IRA? If you have $0 income, why aren’t you in a lower tax bracket?” You’re actually in the same tax bracket. So, $0 versus $0. If you’re in a $0 bracket, does it make sense to convert it?
Jeff: No. It’s going to push into a higher bracket.
Toby: It’s better to just keep taking the money out unless you have a big windfall coming up.
Somebody said about trades. “Do you need to be trading for 4–6 hours a day?” Oh, traders status. I see what you’re doing, Sherry. The cases don’t require it. There are people that actually got a trader status where the number of trades becomes the most critical thing where they nail you is when they showed that you have a full-time job and that you couldn’t be trading. They like to say this is your full-time occupation. They average you out over the year.
Jeff: Yeah. I’ve seen it where they did substantial, regular, and frequent for a period of time but not for the whole year and they got busted for it.
Toby: Yup. Somebody said, “Will my question be answered?” Yeah, they’re getting to you. Do not worry. We’re answering all the questions that pop up. I’m grabbing a bunch of them and I’m reading them out when I see a gap. I’ll look back at yours.
Here’s the one that was written in. “How can I identify tax breaks at certain income levels?” That’s one of those open-ended questions we all love. Here’s a general thumbnail sketch, this is what I use unless you want to throw in. Everybody’s a little different, but if you are, generally speaking, below the $100,000 threshold, you’re able to do IRAs, you’re able to do HSAs, you have various types of tax credits that you’re not phased out on. You have the standard deduction which is going to be $24,000 this year. It’s a big standard deduction. You’re not going to pay much in tax anyway.
Where I look at people and I get annoyed is when you have somebody making $40,000 a year and they have capital gains at the end of the year, they don’t sell it because they’re afraid of the tax hit on it. Then, you explain to them, there is no tax hit on it. It’s $0 if you got it over a year and long-term capital gains. If you’re married and filed jointly, you’re less than $80,000 is $0. Sell it and buy it right back. You never have to pay tax. You just reset your basis.
You look at those things under $100,000. We’re looking at those things. You’re able to do standard retirement plans. You’re using your 401(k)s. I personally think it makes sense to start looking at things like your Roths underneath that amount. It makes sense to look at the Index Universal Life underneath those amounts as far as supplementing your retirement plan. Those types of things.
When you get over that level, now we’re looking at other types of retirement plans. That’s when I switched from IRA and 401(k) to just 401(k)s. When I hit around $200,000, I’m looking at defined benefit plans. If you’ve been there for a while, a defined benefit plan is a retirement plan on steroids. We have people putting hundreds and thousands of dollars a year in those taxes deferred just like your IRA except 1k is literally $600,000 a year, a little over.
When you get over the million dollar mark, now we’re using everything in our toolbox from oil and gas to conservation easements, to defined benefit plans plus 401(k), plus splitting income with the corporation, plus splitting income with kids or other adult relatives that work with you. We just have to justify it. We’re trying to get that money from hitting you because you’re losing half of it for every dollar that hits you. That’s when we’re really looking at real estate saying is there any way we can get somebody to qualify as a real estate professional?
Then, the end all, be all is if you’re going to be making that type of money, you really do need to have some sort of charity attached to your plan. In our world, it’s a charity that we organize and that we run. That allows us the ability to—with the stroke of a pen—reduce our tax bracket at the end of the year easily, consistensitently. Before you think charity is just giving your money away, you can operate a charity in housing. […] qualifies as all sorts of things that we have people do. Sometimes you see them on this show because we’re pushing them.
If you want to see some of the really cool charities that we work with that are being created from our clients, just go on to our podcast. Invariably, I’m probably putting one in a month, but you can see some really cool stuff that they do.
Let’s see what else we got. Did you have anything you wanted to throw on there?
Jeff: Sometimes, these tax breaks are going to be circumstantial based on what business you’re in. My brother has a produce business and it’s a time job grade equipment to take tax breaks for that. You’re going to see a number of things that are circumstantial depending on your circumstances. I guess it would make them circumstantial.
Toby: What you’re saying is actually true. Sometimes, you’re looking at purchasing something and you’re front loaning the purchase. A really good example is us. Probably, 10 years ago, we purchased copy machines in one of the buildings. I think we purchased five or six of them. The book value on those was over $1,000,000. We leased them. We had that dollar lease. I forgot the term for it now. I used to know it and it’s at the tip of my tongue. When you have a paid on expiration of 10% or less, you can capitalize that. All that meant is you can write it off in the year that you acquire it even though you didn’t put the money down.
The dangest thing was at the end of the year, they gave us a $56,000 check to pay off our other machines. They took the machines out. We’re storing them until the end of that lease term. We took our machines and we’re able to capitalize them, and we’re able to take a deduction for the value of those machines. We took about a $1.4 million deduction. We didn’t actually come out of pocket. A penny was actually $56,000 and was put back in our pocket.
That’s what you end up doing. Higher income goes, you’re starting to look at things like that where you’re able to get some tax relief. Then, you also start to switch your income type to things where there’s a maximum. For example, long-term capital gains have a maximum of 20%. I’m probably going to start looking at dividends and long-term capital gains a lot more closely because I don’t have to worry about the dreaded 37% tax bracket, what used to be the 39.6% (depending on who gets elected). Expect that to go back. Expect the state taxes to come back. Expect the whole bunch of stuff to come back. Really, regardless because we just lever the heck out of ourselves with all these wonderful programs that we enacted to bail everybody out.
“I had started an LLC last year with the intention of getting started with my real estate business. However, there were some changes in my main job that kept me from proceeding. Am I correct to presume that I still need to follow the tax return even though I have no deductions?” Jeff, ìf you have no activity, you’ll just file a no activity. If you have expenses which you definitely do if you set up an LLC, you have this organizational expenses, startup expenses, the filing fees, and everything else, you’ll need to file that in the first year.
Jeff: Now, we’ve had some people opt not to file that return but that was knowing that they were going to lose those expenses.
Toby: Yeah. Why would they do that?
Jeff: They would rather not file that initial return because there’s only $1000 or so.
Toby: I have deductions and they say it’s not worth it.
Jeff: It’s not worth it.
Toby: Yeah. Then they would capitalize that, right?
Jeff: No. What the code says about partnerships in general is if you have any income or expenses, you’re supposed to file a return.
Toby: You’re supposed to file a return. If you have any expenses, file a return. Make it easy, unless there’s a compelling reason to not have any expenses, attribute them to another entity.
Jeff: IRS is not going to make you report expenses.
Toby: Yeah. They’re just going to say, hey rather than file a return.
“Is it still possible to elect S status for 2019?” Yes. You do a late election. You end up writing across the top of the return.
Toby: Jeff would know this way better than I. Is it on the 1120-S?
Jeff: No. You actually have to put it on 2553. You’ll include the 2553 with your return and you still send them into entity processing.
Toby: The answer is yes, we can still treat it for last year. That’s going to trip some of you guys out. There’s a revenue procedure that allows us to do it. What’s the success rate on that?
Jeff: Pretty high. More often than not, there’s something wrong with the form as a reason for rejecting it.
Toby: Somebody tried to do the 2553, it was rejected.
Jeff: Yeah. They did a 2553, maybe it was missing a signature or the effective date was incorrect.
Toby: When you do the rev proc, is it almost automatic?
Jeff: It’s almost automatic. You do have to give a reason as to why you’re filling late, but it’s…
Toby: Blame it on the accountant.
Jeff: Blame it on the accountant.
Toby: We’re good at being blamed. Somebody says something about their 121 exclusion. You have to live in it two of the last five years as your primary residence. You don’t have to pay tax on the portion of the capital gains on somebody’s house if you lived in it. If you moved out three years ago, would you even get a partial? You wouldn’t get anything, would you?
Jeff: If you moved out three years ago?
Toby: Yeah. I didn’t live in it two of the last five years. I lived in it one of the last five years […] I’ve rented it for four years now. I wouldn’t get any—
Jeff: There’s a partial exclusion if it was job-related or some other circumstances that are extreme.
Toby: That’s if you’re forced to sell and you didn’t meet the two of the […]. But here, we […] our two but then we waited too long.
Jeff: I’ll go back and amend it, the return. I would definitely go back and amend.
Toby: Here’s the thing. It’s not bad to have investment properties, guys. You can 1031 exchange. What I would do is if you have it as a rental, you can actually do a 1031 exchange and a 121 at the same property. It twists people’s heads because you lived in it for two years as your primary residence, you rented it for two years. It is now a rental property that you lived in two of the last five years. You can 1031 exchange it into another investment property but you can actually take the exclusion which is $250,000 for single people or $500,000 for married and filing jointly to take that exclusion.
Jeff: So, in this particular case that you’re talking about, they lived in it for at least two years but they held it more than three years before they sold?
Jeff: Yeah, there’s nothing you can do there.
Toby: Yeah, I think you’re toast, but you can still 1031 exchange.
Somebody says, “What if I sell a rental property that I’ve been holding through 20 years that is debt free? My annual income in 2019 was $32,000 filed jointly. Did I hear you say I would not have to pay capital gains?” Capital gains still gets added into your tax bracket for determining where you land on the capital gains schedule. You would get $50,000 of that if you sold it for $3 million. We’ve got to figure out your basis and your capital […].
Jeff: Your basis is going to be very low.
Toby: Yeah. You would get $50,000 of it tax free. Maybe you want to sell a small interest. I can see this being something where they sell it to maybe a family member or something and start piecing it off. No. When you have that type of deal, if I’m selling that, I’m 1031 exchanging it into something else.
What usually happens, Julia, is somebody will be at the $32,000 level. They’ll have a bunch of stock that’s gone up. The accountant will say if you sell it, you’re going to have to pay tax on it. I’m looking at him going, wait a second. If you don’t have any real income, like in your situation, you can literally sell and generate, what would that be? $48,000 and not have any capital gains at all? It’s capital gains but it said $0 until you hit the $80,000 mark. It’s huge.
Let’s see. “I 1031 exchange a rental house from California to a Nevada quadplex. How can I get LLC protection without any 1031 exchange tax consequences?” The way that 1031 exchange rules work is you have to go name the name. If I own a piece of property in my name, I can sell it and I can buy any real estate of equal or greater value. That just rolls my basis in the property I sold into the new property or properties.
For example, I could sell this rental house. I could’ve bought a quadplex or I could’ve bought a mobile home park. I could’ve bought a storage unit. I could’ve bought six condos. I could’ve bought three other rental houses. I could’ve bought one rental house. I could’ve bought one condo. You’ll still fill in the blanks as long as it’s equal or greater value. It just gets my new basis. Now, I’m sitting out there just naked.
If I put it in an LLC, I will be fine. It does not destroy your 1031 exchange. The issue that you see sometimes is people will want to put in an LLC with other owners and then they’ll play that game. You have to be careful because you have to own that with the intent of holding it as an investment property. If you play around with that and you do it quickly, the IRS may investigate.
But for the most part, if you sell a property, buy another property, there’s something called a swap and drop, there’s a drop and swap, and then there’s buy and transfer into another property. There’s buy and transfer into an LLC, but as long as you are the beneficiary of that LLC, it’s your LLC, you are still the same beneficial owner, nobody cares.
They’ve already tried that. Accountants used to say it’s six months, but all the facilitators that I’m talking to do them after because nobody really cares now. It used to be they thought it was a disguised sale. I’m going to 1031 exchange and then I’m selling it out on installment sale to Jeff over here. I’m transferring to the LLC and Jeff bought that membership interest. Now, I just disguise the sale which doesn’t even have much of an effect.
Jeff: A little caveat since you 1031 a California property, California doesn’t like when you 1031 outside of their state. What they’ve been doing for the fast few years is there’s a new form—I can’t recall the form number—you have to continuously file with California until you get rid of the replacement property.
Toby: They want to know what their portion of income is because they’re going to say that you have income, that you’re in California, and you didn’t pay tax on.
Jeff: And if you exchange the Nevada property into another property, you still have to file the California form.
Toby: Yeah. California just wants to get paid at some point.
Jeff: That’s all it is.
Toby: Yeah. That’s a wonderful state with great beaches.
Jeff: I didn’t say anything.
Toby: Yeah. We have the same thought. Nobody here likes the Board of Equalization (their tax authority)—a bunch of empires—and California is really hard on these people. They have a great case. The Hatt v. Commissioner case where the agents followed the California resident into Nevada, broke into his house, dumpster diving into them, trying to nail that guy to the wall. They violated his civil rights. The guy sued, he won, and he went to the Supreme Court because California was saying that it was immunity, not sovereign immunity, but they we’re trying to declare immunity and they ended up losing in the Supreme Court.
They put it back down and they said there’s a cap of $50,000 on a case against us, they went back to the supreme court, and they upheld it. This poor guy had about 10 years of his life just turned on its ear. They followed him around and at the end of the day, they had to pay, but it wasn’t just nearly as much. It was supposed to be millions of dollars for violating his civil rights, but that’s California for you. The best thing to do there is just don’t lock horns with them. I’m not going to tell you not to 1031 exchange, but it better be worth it. Let’s just put it that way.
Somebody is saying, “Hey, why don’t you answer my questions.” There are hundreds of questions popping in and we will get into them. I have five people actually going through the questions, so we’ll get through them.
“What do you do with income monthly interest if you do a seller carryback note?” Let’s say I sell Jeff my property and I got paid 100% or whatever I sell that property for. I’m going to pay capital gains on whatever amount exceeds my basis minus the depreciation recapture. I have a certain amount of gain. Let’s say I brought it for $100,000, sold it for $200,000, and I depreciated it $20,000.
I sell it to Jeff, there are some expenses that I’d be able to write-off in the sales transaction. Let’s just say I made $100,000 capital gains, $20,000 of that is depreciation recapture. I would pay long-term capital gains assuming I had it for over a year on $80,000, I’d have $20,000 that’s assessed to me as depreciation recapture (assuming I depreciated it for $20,000) and it would be taxed at my ordinary bracket with a maximum of 25%.
My basis is I’d get it back, so whatever I invest in that property, I get that back. Ordinarily, that would be the case. Let’s say I’m in the 20% long-term capital gains bracket. I would pay long-term capital gains of $16,000 thereabout on that. If I was in the highest bracket, I would also pay that Net Investment Income Tax, which by the way, if the Affordable Care Act goes away, everybody who paid that should be […]
Jeff: You think so?
Toby: I think that’s going to make a mess.
Jeff: I find that hard to believe that would be overturned. I mean, that part of it.
Toby: But that was part of the Affordable Care Act. They throw out anything unconstitutionally, but it paid a Net Investment Income Tax.
Jeff: Yeah because the whole goal of that Net Investment Income Tax was—
Toby: They’re saying they’ll file a protective claim and stuff, but I think it’s going to be really interesting. Anyway, that’s on the side. There’s $16,000 of tax. Now, let’s say that I sell that same house to Jeff and instead of him giving me all the money, I agree to carry back a note. Let’s say he gives me a portion of it down and he’s going to pay me an income stream for the next 30 years.
A portion of the money that I received would go to basis. A portion of it would be considered capital gains. A portion of it would be considered depreciation recapture and a portion of it would be considered interest. I would elect to do the installment sale on that. It’s actually a form you file and I don’t have to pay tax until I actually receive the money. Then, it’s a formula and I can’t allocate most of it to basis. I have to spread it out all over that.
Jeff: Right. Within your first year of sale, you’re going to calculate what your profit percentage is and each payment—after you take the interest portion out—will be multiplied by that profit percentage.
Toby: It gets funky.
Jeff: You’ll have an amortization schedule just like you would get from your bank when you get a loan.
Toby: Just do it on a spreadsheet, guys. It’s actually easy. You do it once, you just extend it out. You do the formula once and then now you know of every dollar received. Then every year, you’re probably running that because somebody may miss a payment or pay an extra portion ahead of time, but always remember there are four categories. There’s basis, there’s long-term capital gains, there’s the depreciation recapture, and there’s that interest. One of it’s zero tax. One of it’s 0%, 15%, or 20%. One of them is a maximum of 25% and the other one is your ordinary bracket. Installment sales are cool but what a pain.
Somebody else had some cool questions. “What is the definition of real estate professional?” We answered that probably once every few episodes. It’s 469(c)(7) and all that is one spouse. Let’s say you’re married. One spouse has a real estate job where they spend 750 hours or more per year that’s in construction, development, sales, reconstruction, redevelopment. Basically, you work in real estate.
Jeff: But not financing.
Toby: Not financing, right. Brokers have tried but unless you’re in the actual acquisition, no. That’s number one and it has to be your number one use of your professional time. If you’re doing a job or you’re spending 800 hours, you wouldn’t be able to qualify. You, personally as the one that hit that 750 hours. One spouse test to qualify. Usually, what you see is spouse one is a full-time job. Spouse two is part-time at max and also a real estate professional. Sometimes, they’re in the real estate industry. You don’t have to be licensed or anything like that. That’s step number one is that 750 hours.
Number two is both spouses marturely participate. Technically, it’s on each piece of real estate you own, but you can group them as one, what do you call it, when you grab all the rental?
Toby: Yes, you just group in the activity. You make a grouping election, you’re going to grab all your rental properties, and treat them all as one activity. There are nine ways to qualify for material participation, but the easiest is 500 hours between you and your spouse. Both of you added up together. Test number one is one spouse. Test number two is both spouses and you just add all of that fun stuff up.
Jeff: For the one spouse test, it has to be more than half of her time spent on all activities, and has to be in the real estate activities.
Toby: That’s why I said if they’re doing something else and they spend 800 hours, then you wouldn’t be able to if you spent 750 hours in real estate, if they spent 800 hours as a part-time teacher. I’ll give you guys a real scenario. Wife’s a surgeon, the husband is working as a teacher. Husband spends 1000 a year as a teacher, husband now needs to spend 1001 hours on real estate to meet test hurdle number one. Hurdle number two, you’re probably going to be okay.
Jeff: You probably already met test number two by meeting test—
Toby: Yeah, you probably did. If you own a business and if you’re worried, what if I have a business and I have partners?” If you’re greater than 5% shareholder of the business that’s doing those activities, you count it towards you. Let’s say that you’re in a construction company and you’re 25% owner, your time in that business counts towards your 750 hours. Your material participation is always on your properties, so that’s whatever you’re doing.
“What is the easiest or best accounting software to keep up with your business expense in order to get the best tax deductions?” Jeff?
Jeff: I’m not saying it’s either the easiest or the best, but by far the most prevalent is QuickBooks. You’re more likely to find accountants to know how to use it than if you’re using Peachtree, J.D. Edwards, Zapper, or any of these others. All of the software are going to accomplish pretty much the same thing. QuickBooks has a lot of good qualities about it. Now, the crux is do you want to be spending your time doing your own bookkeeping? And are you actually good at doing your bookkeeping?
It’s true what they’re saying, garbage in, garbage out, so you really need to know what you’re doing. Just knowing how to use a software doesn’t necessarily make you a bookkeeper or an accountant. You really need to have at least basic accounting to do this.
Toby: When I first started, I sucked at book statements. I cannot imagine somebody learning QuickBooks, starting up a business, and running it. What I would do is hire somebody who knows QuickBooks and then I would use spreadsheets. I would just give them summaries or I would just give them my bank statements and then I would meet with them and say, what do you need to know? Usually, with a basic chart of accounts I give you this looking at a profit and loss, you talk about 20 different categories maybe.
Jeff: For profit, for expenses.
Toby: Yeah. It’s not a huge amount and you would just track those. You would go through your bank statements. The bookkeeper usually just has to learn how you spend money and what it is on. You make it easy for them if you have a business account and you have a business credit card. Whenever you do something personally, you make sure you note it in case you use that credit card and you say, I just had a personal expense. Or let’s say that you did a business expense and you need to be reimbursed. You just tell them. You just put a little expense report, it’s the easiest thing to do.
Put it in spreadsheets and say here’s the expenses that I incurred. Keep a track of the receipt. It could be on your phone. It could be a picture. It could be something that you type in there and say I got the receipts in my box somewhere. As long as you have some backup somewhere, the accountant is going to be fine with you, and then let them do the QuickBooks. It’s not worth it for you to be paying for QuickBooks—it’s not cheap—and to try to learn how to use it. It’s not just a good use of people’s time. So that’s me.
Somebody says, “Is there any reason you folks don’t have an automated […] or just fill it in to make sure you have a spreadsheet?” Yeah, we do that. That’s actually what I would suggest most people do. We have a virtual bookkeeping service and that’s exactly what it is. You just send it in. We put it in a Google Sheet and you fill it in. If you have a question, you just question. Ask my accountant, you just put it in there so we can go back and make sure it’s done. It’s a little bit easier. It saves you a lot of time. I know […]. I think that we learned […] from some of you guys that we don’t want everybody to happen to do QuickBooks. It’s such a pain. They keep making it so easy to use.
Somebody is asking, “Can you 1031 exchange a residence?” Yeah, the same property. You can actually 1031 and 121 the same piece of property. You just have to make sure that for the 121 exclusion is your capital gains only. Capital gains exclusion, it’s not for depreciation recapture, but it’s for personal property that you use as a primary residence.
The 1031 exchange is for investment property. So, if I want the capital gain exclusion, I just have to live in it for two of the last five years as my personal residence, primary residence. It does not mean I lived in it the last two years. It’s two of the last five. Technically, let’s say I had this happen in San Francisco. Somebody bought a house for $500,000. It was worth $2 million and they ‘re going to sell it. They we’re looking at the tax bill as being over $300,000 and something They said is there anything I can do about it? I said, yeah. Move out of it. Rent it to a friend or something for six months, and then 1031 exchange it. You’ll be able to avoid the tax in the entirety and roll that into other properties.
You can actually move back into that property. Don’t do it for six months. Give yourself a period of time, but would you do that for $300,000? Yeah, I can probably for $300,000. I’ll live in a different property for a while. Maybe I’ll rent a house and just make sure that I’m crossing my Ts and dotting my I’s.
There is no technical requirement that you rent your house, you just try to rent your house in a fair market, but I would say put a renter in there. There’s no time frame, but I would say six months so you never have issues. Then, just make sure that you rent a property for a few months and just look at it as an extended vacation for $300,000. I’ll take that action. You’ll make up thousands of dollars a day in tax savings. I think I would do it.
If somebody walked up to you and said Jeff, I’ll pay you $1000 a day to rent a house, would you go do it?
Jeff: I’d say, see you.
Toby: Yeah. “My mom and her siblings quitclaimed my grandfather’s house to me. Once I get a loan, I will pay them out of the proceeds. Being that technically I didn’t buy it from them with a purchase sales agreement, how would the depreciation work?” I see what’s going on.
Jeff: I’m not sure that I agree with the whole tax-free situation because in my view, they are technically buying them.
Toby: This is a purchase without a sale agreement and they agreed to a price.
Jeff: That’s a sale.
Toby: That’s a sale. Now, it’s supposed to be writing, but you have something here that we agreed upon a price and now you’re paying them on it. If you didn’t agree on a price and now you’re just gifting them money, they gifted you a house. you get their basis, you would depreciate your basis, their basis on the gift.
Jeff: At the very best, this would be two gifts. A gift from the siblings to you which they need to follow a gift tax return on.
Toby: “My mom and her siblings quitclaimed my grandfather’s house,” that sounds like grandfather’s house went to mom and her siblings.
Jeff: I’m guessing she had an interest in it, too.
Toby: It’s my mom and her siblings, so that would be grandfather’s kids.
Jeff: Oh, got you.
Toby: Grandfather’s kids got it. Their basis would be the value of the home on grandfather’s passing. That’s their basis. That’s where they would depreciate this. They give it to you with the understanding that you’re going to pay them back. That’s a purchase. Your basis for depreciation is whatever that purchase and sale agreement is. Then, you get a loan and you pay them back. The thing is, the gain would be determined by their sale to you. I’m hoping this is fair market value. Hopefully, it’s pretty close to one when your grandfather passed, the house hasn’t moved much.
Jeff: I was going to say that. There might not be much gain at all if the grandfather recently passed because your mother and her siblings’ basis is going to be fair market value at the time of death.
Toby: Yeah, it’s going to be really high, so this is great. This could be good for you. Somebody is asking funny questions. “Can I 1031 exchange on a property that was rented five years ago and is now my primary residence?” The answer is no, unless you make it into an investment property. If it’s personal property, you can’t 1031 exchange. I think it’s the same thing where you have to get out of it.
Jeff: It currently has to be an investment property to do the 1031. It doesn’t matter what it was years ago.
Toby: It doesn’t matter. The only thing that we have to be careful of, Jennifer, is if the original property, this property was a 1031 exchange. I think you’re okay because you had at least five years. If you make a 1031 exchange property your personal residence, you can’t 121 for five years. If you do what I just mentioned, you rent your property out, your personal house out to make it into an investment property and 1031 exchange it, your basis steps up (by the way) of that 121 amount. You get a higher basis. When you do sell it (if you ever do), it’s great. But you just can’t do a 121 exclusion on it for five years, not that you’d want to but that’s the only downside. I hope I made somewhat sense. I’m thinking it clearly but it’s probably coming out as gobbledygook.
“I understand that the CARES Act allows me to borrow up to $100,000 or 100% of my vested interest in my 401(k) account, through 180 days from the Act. Then, I wouldn’t owe any penalties or interest if I pay back the loan within five years. Also, the loan repayment period can be longer than five years if the funds are used to buy a home that is used as my permanent residence. Is that information correct?” What say you, Jeff?
Jeff: Let’s break this up a little bit. You’re correct if you take a loan out and pay it back within five years from your 401(k). You’re not going to pay any penalty. Same with distributions, you’re not going to pay a penalty at this time. Interest you will pay, but that will be interest you’re paying back to your 401(k) plan that actually goes into your account.
Toby: You don’t have to worry about penalties, but you will have interest and it’s going to be about 4% that you’re paying back to yourself.
Toby: Under this portion of the CARES Act, but they might be thinking of this as the 10% penalty of an early withdrawal which they can get up to $100,000 for three years. That one really is no tax, no interest if paid back within three years. That’s an early withdrawal that you pay back and they treat it as a rollover, but they’re two different things.
There’s this, which you can take $100,000 out and then there’s this, the loan, borrowing loan. Also, $100,000 and this one actually is six years. You have a year where you don’t have to pay anything back and then you have five years to pay it back.
If it’s a primary residence, it’s the dangest thing. They don’t have a term. It’s up to your administrator. We say 15 years so you can pay it back over 15 years, but it’s still limited to that $100,000.
Jeff: But I don’t think they’re going to let you take $100,000 out if you’re using it to buy a home.
Toby: On the loan, you can use it for any purpose. On this, the early withdrawal, it has to be COVID-related. So, you or somebody you know has drastically been affected by COVID, you do a statement.
Jeff: Even though you don’t pay anything in that first year, I will let you know that interest is still accruing on that loan.
Jeff: There’s a part two.
Toby: A part two is that? This?
Jeff: No, there’s another part. The next question.
Toby: You want to go to another question?
Toby: Okay. We’re just going to shoot on over to this one. “Is it possible to borrow more than $100,000 from an IRA by combining it with the $100,000 401(k) loan limit that existed prior to the CARES Act?” These are two unrelated. I don’t know how they got close to each other but sometimes they do. First off, can I just say this?
Jeff: Will you say what I’m going to say? You are.
Toby: No loans from IRAs.
Jeff: So, you can’t borrow from your IRA. You can’t use it as collateral or security.
Toby: But you can take out $100,000 early withdrawal under the CARES Act with no 10% penalty and no tax if repaid three years.
Jeff: The $100,000 limitation that the loans, that is for all loans for qualified retirement plans. Let’s say you took out $50,000 last year in a loan, you’re only going to be able to take out an additional $50,000.
Toby: And it’s up to your administrator. They don’t have to move it to the $100,000. The maximum amount is $100,000 under the CARES Act, but it’s up to your administrators as to whether they move it. But this early withdrawal, you can take an early withdrawal for $100,000. This needs to be paid back—this is the way I read it and I might be wrong—by December 31st of 2022, and then you pay zero interest or tax. You just pay it back and it’s treated as a trustee-to-trustee transfer. Then, you can take another $100,000 out if you want to. This is a loan and it’s paid back over six years when you defer five years pay. You can actually get $200,000.
I’m just going to jump into this last one. I don’t know if this is the last because Jeff has gone over. “I have a limited partnership. My C corporation is 1%, the partners have different shares. They all want us to do 1031 exchange into their own purchases. Is this allowed?” The answer is really no. What you’d have to do is you go limited partnership to limited partnership. It has to say name to name. Then, what you do is you would dissolve it after that and you would issue out the individual properties. You basically liquidate it, issue out individual properties into the individuals. I believe you can do that.
Jeff: To spitball in here. Could they distribute the property beforehand to the partners as tenants in common? Assuming they are all individuals.
Toby: That’s called a drop and swap and you could potentially do that, but it will have to be done in advance of the exchange. They all want to do a 1031 exchange.
Jeff: But they want to purchase their own property.
Toby: They’re already sold, so assuming that it’s sold or imminent, then we have a little bit of an issue.
“What happens to the EIDL loan if the owner of the business passes away?” They’re not on the hook. That loan will actually be securitized by the assets of the business. That’s all they’d get.
Somebody says, “The EIDL loan is not recourse to you and it’s secured by the business asset so the business will be responsible.” If you die, it wouldn’t mean anything to it. You’re not even a guarantor.
Somebody says, “Can I take an early withdrawal from my 401(k) for the CARES Act, even though I’m retired as an early withdrawal or would it be taxed? I’m 59 years old.” You could borrow money and it would not be taxable at all or if you’ve been affected by COVID, you can take up to $100,000 out and pay it back over the next three years. I hope that makes sense.
“If I start using my business office for W-2 work, do I lose the home office deduction?” The answer is…
Toby: For a sole proprietor, right?
Jeff: Well you said for a W-2 business, so I’m assuming he’s an employee.
Toby: If you’re an employee for your W-2 work, then I think you can actually have two work places. What you won’t be able to do is get reimbursed by one employer and use it for your own C Corp. But I believe if you did it as an administrative office, you’d be okay. If it’s a sole proprietorship, then it has to be exclusively used for that one business.
Jeff: Yeah. Your employer could reimburse you to work at home and it will be tax free to you, but the old home office deduction for employee expenses is gone.
Toby: I guess there are two ways to look at this. The traditional home office is a separate tax form that you file and put with a Schedule C. Your employer, if it starts reimbursing you or if you tell anybody that you’re using it for that, it might not pass the exclusivity test and you might have an issue. If this is a reimbursement where you have an administrative office in the home, you can have multiple administrative offices in the home, but you can’t get reimbursed for the same space twice. You have to say this half is this, and this half is this.
Somebody asked a good question. I’m just going to repeat it to you guys. “For those owners who have not yet filed income taxes for 2019,” this is really important. Your taxes are due on July 15. Your tax return isn’t due until October 15th if you file for an extension. I’m telling everybody because we don’t know what they’re going to come out with in this next tax act in this bill.
Jeff: They could do another extension which I will not be happy about, but they can do it.
Toby: They can do an extension, but better yet, I’m waiting for them to give you some relief off the taxes you paid in 2019. I still think the easiest way to give people money is to give them back some of what they just paid because we know what it was. We know how much it was and if you didn’t pay it, then just keep it.
I don’t know why the government didn’t do that, We’re paying out stimulus checks to by definition, 85% of the people don’t need it and they’re giving it to a bunch of dead people and they are giving it out to people who don’t even live here. They are a bunch of idiots. I don’t know why they did that. Just give it back to the people that paid it. They bolstered up if people are really affected, but the unemployment all they did was they made a mess.
“If you haven’t filed your taxes for 2019 and this far has only estimated gross revenue, is there any concern whether the gross revenue stated on the EIDL […] will be cross referenced and they’d be substantially different?” No. When you’re submitting that application, it’s the day on when you’re testifying as to how much you incurred. It used to not be uncommon for somebody to come back and get more money, depending on how badly they were affected, and now it’s pretty brutal because we’re still working through April. Literally, we’re getting to the end of April. April was the cutoff, so we’re still working on those.
We’re applying for new ones. Maybe somebody on my staff could tell me that we’ve actually obtained for people that filed in and actually received their money. Not just the approval, not just filling out the paperwork, but having actually got funded from the second tranche because that didn’t open up until about two weeks ago. Anyway, I wouldn’t be worried about it.
Let’s go to this next one. I know there are lots of questions out there. Our guys are going at it. “I am a new home builder with 15 homes built a year. Do I expense home by home after it’s sold or can I do fiscal year expense and income accounting together?” Do you want to hit this or would you like I?
Jeff: Home builders have some special rules. They can usually use the cash method. The prefered method is the completed-contract method where you’re not deducting expenses or recognizing income on a home that you built until it’s 95% complete and the customer started using it.
Toby: If that wasn’t a corporation, wouldn’t you just treat that like inventory?
Jeff: Yeah, a work in progress. Same thing.
Toby: It’s not that you don’t have to do a tax. You’re paying the tax. I think what they’re asking is, can I just do it all together?
Jeff: There was a case back in 2017, I can’t recall. Shea Homes, where they argued that they were building the development that had streets, a lot of common area, structures and all, and their argument was the home has been sold but the common areas aren’t filled out so we haven’t hit the 95%. They actually succeeded in winning the entire development until the entire development was 95% complete. They didn’t have to recognize anything.
Toby: For these guys, assuming that they’re not developers, they’re putting out in the streets what they would say is I recognize on an annual basis only the homes I’ve sold and I’m not doing it everytime I sell a home. I’m doing it on an annual period based on the homes I sold during that 12 months.
Jeff: Correct. You would recognize income on any homes that are considered complete each year. Completing a contract only works for long-term contracts of at least 12 months from start to finish. If you have shorter contracts, you’re going in and renovating kitchens, bathrooms, stuff like that, that’s going to be a much shorter period and those income expenses are recognized as they come up.
Toby: Somebody says, “For amounts $25,000 plus, what if the business has none of the assets stated on the loan agreements?” Again, this is for the EIDL loan and I believe what they’re saying is I get a $100,000 EIDL loan and I go meet my marker in year two. What’s SBA going to do? I’ve negotiated a few of these during the 2008 fiasco. I actually did a very large one, about a $4 million issue with the widow of somebody who passed. I’ll just tell you, the SBA was easy-peasy to deal with.
What ends up happening is they look at what are the assets there. In this particular case, they even had a personal guarantee that they let her out of and she had other assets. We just made another compelling argument that we needed their assistance to allow her to unwind herself out of a very large restaurant here. Let’s say $100,000, it’s the company loans […]. It’s supposed to be being used to help it recover from this nasty period. It’s just giving you a long-term to pay it back. The SBA knows a lot of these are going to default and that’s why it’s not a regular bank that’s giving it to you. Regular banks don’t do disaster loans.
Jeff: Let’s say that I’ve gotten an EIDL loan, but I don’t have any entities, no LLCs. I just have rental properties in my Schedule C. Is there any recourse there?
Toby: They’d be able to go after the assets.
Jeff: But they still would only be able to go after assets, not even personal assets?
Toby: That’s an interesting one since typically on EIDL, it’s going after a business and the business equipment. Here, I’m not seeing them do a deed of trust. It’s all UCCs, so it’s all the equipment. They’ll just look at the business. They can go get your computers and things like that. That’s about it.
What do we have next? I think this is the last one. You guys are lucky. we’re only 45 minutes over this time. “I need to make a real estate business in California. I formed a Wyoming LLC, do I need to file another California LLC or is it okay to register Wyoming LLC in California? What is the difference?”
First thing, LLCs are creatures of state law. You can form them anywhere. When they’re doing business in a state, that’s like you’re moving into a state. The LLC is moving there saying, hey, California. I’m going to be here for a while, in which case you registered.
Whatever it does in California, it applies California laws, so if you do something with the California citizen or anything like that, they’re going to apply all the California law. On the internal workings of the LLC, you go to the home state Wyoming. This could become pretty critical, depending on what type of business you’re doing.
If you’re doing a real estate business, Wyoming has a lot of protection. It has a lot of protection from creditors. It protects the business from you so if you do something individually, and you may live someplace else, depending on where you live—it could be Wyoming, California, heck it could be Texas—and they get a judgement against you, they have to go to Wyoming to try to take that away. Wyoming is 10 times better than California from that standpoint.
I like Wyoming. There is privacy there. In California, you would lose some of that privacy. What you can do is either register the LLC directly into California or if you’re a privacy buff, you set up a California LLC and make it member managed with the member being Wyoming. If you know how that works, your name is not going to be part of it. It ends up working really, really well.
there are a couple of questions that are popping around out there. Somebody says, “I’m a physician with W-2. My wife is a real estate professional status. Can we deduct cost segregation depreciation from our cash flow and rentals from my W-2, given that it’s passive income?” The answer is yes. As long as your wife qualifies as a real estate professional, it’s an exclusion to the passive income test. It’s 26 USC, 469(c)(7) that allows you to do that, and this is very common.
If you don’t know what cost segregation is, it’s a fancy way of saying breaking out the components of a property to allow you to rapidly depreciate them. In our purposes, we can write them off in one year so it gives you about 30% deduction of the value of the improvement real estate. So if you buy a house for $1 million and $200,000 is land and $800,000 is the improvement, you’d get about $240,000 deduction in year one. About typical; it would offset your W-2.
“Can I open a Wyoming holding without having other ties in the state and if I live in one state and have property and taxes?” Yes. That’s why we use them. The only tie you will have is you as an individual owner and it’s a lot of fun.
Those are good questions. There are a bunch of questions. “Hey, did EIDL reopen?” Yes, it did reopen for all businesses about two weeks ago. It might be a week-and-a-half ago. It might have been last week. The weeks are blending. Somebody knows better than me. Maybe Patty or somebody knows. Somebody can answer it. We’ll make sure.
You can go to our podcast if you like this stuff. We actually take the Tax Tuesdays, we break them down. Somebody just asked about the affiliations. The business tie is you use an office suite in Wyoming so you can actually have it there. They always call it a principal place of business. It has to be more than an empty office, but it’s just called a nexus.
We have a little service that meets on an annual basis that we just aggregate amongst all the clients and ends up being a pretty low cost alternative to actually getting an office suite. It’s hundreds of dollars on an annual basis, not thousands or anything like that.
Anderson Advisors podcast, go in there. We actually put these Tax Tuesdays. I hope you’re realizing that Tax Tuesdays is about stuff that’s going on with other people. Sometimes, you get your stuff answered, but half of the half is listening to everybody else’s scenarios and answering them. I do grab and pull stuff out when I’m answering questions. You could always ask your questions by the way. Here, I’ll just put a bunch of our podcasts and go in there, Google Play. I’m going to give you guys where you could ask questions.
You can always ask questions on email@example.com. You can send them in. If I don’t get to your question here, we actually pull those ones out and answer them, too. Somebody says, “You do consultations?” Absolutely. It’s part of our Platinum service, but if you reach out to Patty or send it in, we can have somebody to take a look at some of your returns and give you an idea of what’s being done right or wrong.
If you have a good accountant, by the way, we’re never going to break you free of them. We’re going to say go and hug that person. Maybe buy them some roses. It’s hard to find good accountants.
Somebody asks, “I rent out a home for 20 years then move into it. How long do I have to live in it to qualify for the full 250 Section 121 capital gains exclusions?” There are two sides to that. The answer is two years, you get a partial after any period of time if you’re forced to leave, but it’s going to be based on the fair market value when you move into it.
It’s not like I’ve had this house for 20 years and it’s gone up in value, now I move into it I’m going to get this huge chunk of capital gain exclusion. It’s only on the capital gains from the time that I move into it to the time that I sell it if you’re living in it as your primary place of living. Realistically, I would 1031 exchange that puppy unless you really want to keep that property.
Anyway, here’s some more funstuff. Let’s give you guys one last giveaway and […] about this tax software. You guys go back and listen. He wants me to repeat it. We actually went on for a while on that one. Do the livestream with us with the Infinity Investing on Saturday, July 18th. I love having lots of people on. Again, I’m going to have this one […] Adams, Eric Dodds, Hans Johnson coming on. If you don’t know Hans, he’s really cool. I’ve never had him on one of these. It’s going to be fun.
Go to this link, it is free. It is one-day live streaming. If you want to learn how to invest like people that make money consistently invest and you don’t like rollercoasters, this is where you want to be. We just flat out figure out how to make money. It’s called getting rich slowly, but mathematically it’s almost certainty. That’s one of the few ways to do it. I’ll show you guys how we cashflow things. I’m a cashflow freak. I have over 200 properties of my own, I shouldn’t say just my own. Clint and I own a lot of them, some of my own, but we have everything from warehouses to office buildings, to a lot of single families, and all that fun.
Come on in and join us Saturday, July 18th. By all means, if you know young people, before they do bad things to themselves and incur lots of debts, send them there. I will make sure that they never do it. They’ll be able to pull a pencil out and actually do some calculations on their own. They will surprise you. They’ll get very well-acquainted with the real estate and the stock market from a cash flow perspective.
This is not trading and flipping houses. This is all about cash flow so a little different, but it’s mathematical formulas and how to calculate it. It’s profit and loss. It’s a balance sheet for individuals. It’s being able to tell the different types of entities or asset types. We focus really on rent royalties, dividends, and in our case, short term capital gains as infinity income sources. Please join us for that. It’s free.
I’ll go back to that little website again some of you guys have probably been on. It’s so much fun. Last but not least, please join us on social media and continue to fill your brain. Ask us lots of questions. This is good for us, good for you, good for everybody so we like doing them. Jeff has been doing this for 30 years plus and I’m catching up.
Jeff: I hope you don’t catch up.
Toby: I hope I don’t either. I hope you always stay ahead of me. But every single time we do this, you should see us scratching our heads something and be like, what is that? Trust me, this helps us stay on our toes. Thanks to Susan, Patty, Elliot, Piao, […] for answering questions. I’m sure that you guys will have more follow-up from them.
We will make sure that we’re trying to demystify that tax world. We almost finished on time, give or take an hour. Anyway, thanks, guys. Watch the recording and share it with your friends. Keep growing this community and it’s a lot of fun. Until next time, this is Toby.
Jeff: And Jeff.
Toby: And we’ll see you at the next Tax Tuesday in two weeks.
As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, another great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets. One of my favorites as well is our Infinity Investing Workshop.