Are there any strategies to mitigate capital gain tax on the sale of a vacation home? Can you reduce those taxes from your vacation home? Toby Mathis and Michael Bowman of Anderson Advisors answer your questions about how to mitigate capital gains taxes. Submit your tax question to taxtuesday@andersonadvisors.
- For a partnership LLC, can capital gains (such as stock sale) from brokerage account owned by the business be combined/offset with real estate losses *such as depreciation) in the LLC? It depends on the type of real estate. If it’s rental real estate, no, unless you’re a real estate professional or active participant in real estate, and you make less than $150,000.
- When I sell a property for 1031 exchange, can I sell 100% ownership of the owning LLC instead of the actual real estate to avoid the transfer taxes, title fees – assuming the LLC is single owner and only owns the subject property, nothing else? You can’t do a 1031 exchange of an entity to try to avoid the transfer taxes and title fees, nor should you. Technically, the change of ownership of an entity, even 50%, is a deemed sale of the underlying asset.
- If I buy an existing home inside an opportunity zone will I be able to save tax on the capital gain, if I keep the property for 10 years? You can buy a piece of property, but you have to double its depreciable basis. If you do that and hold it for at least 10 years, you could step up the basis on any given year to its fair market value and avoid tax on the growth of that asset. Yet, you have to recognize the deferred gain in the 2027 period.
- Our vacation home is in another state and it’s solely for personal use and never rented. We’ve owned it for 10 years. Are there strategies to mitigate capital gains tax on the sale of a vacation home? Do we have to make it our primary residence for two years before we can sell it and get the capital gains exemption? You have to live in your vacation home as your primary residence for two years prior to selling it. Or, make it into an investment property and do a 1031 exchange.
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Full Episode Transcript:
Toby: Hey, guys. This is Toby Mathis. Welcome to Tax Tuesday. I’m joined today by…... Read Full Transcript
Michael: Michael Bowman. Great to be here.
Toby: Welcome. We’re off-location. We’re sitting on an island called Maui. We’re in beautiful Hawaii, on the island of Maui. It’s beautiful. We’re really lucky and we wanted to do a Tax Tuesday.
Anyway, it’s the middle of tax season. Our tax department is busy, busy, busy, but we still had a few folks. Who do we have on? I see Dana. Piao is probably on. Eliot’s probably on. We have a bunch of folks helping you out.
Michael: Great support. Excellent, high-end individuals.
Toby: Yeah. They’ll make sure that they get your questions answered. I can’t see the chat this time. It’s just the nature of the beast. Look at that. I won’t be able to see that. You’ll have to be in charge of chat today.
Michael: We got someone from San Diego, which is summer and a nice place. That’s great.
Toby: Where are you guys at? We could just say that. Hey, where are you guys at? Let us know where you’re at. We can compare.
Michael: I always love to figure out where people are from, either I’ve lived there or there are some nuances to the law that we can discuss, too.
Toby: Read some out.
Michael: All right, we got Rockport, Texas. We got Houston, Denver, Ann Arbor, Fort Collins, Carmel. Beautiful place, Carmel, California. A couple of people from Tampa. Tyler, Texas. You and I went out there and shot guns out in the middle of…
Toby: Loosened stuff up in Tyler, Texas.
Michael: Yeah, that was fun. Great clients out there. Charlotte, Boston, San Antonio, Rosamond, California. Hey, Sherry Roddy. Hey, how are you doing, Sherry? Good to hear from you.
Toby: Sherry and Don.
Michael: This is like a family reunion. I’m recognizing a lot of clients out there. Clients have been with us for, I like to say sometimes years, but it’s actually been decades now. Is that cool?
Toby: That is cool. You could say hi to them. It’s been probably a year since you came on.
Michael: About a year. Actually, the last time we were in Maui, you and I did Tax Tuesday.
Toby: Was that the last time you did Tax Tuesday?
Michael: No, I think I posted more about myself or maybe Jeff in between. I always love coming out here.
Toby: We’ll just kick Jeff off.
Michael: No, that’s all right.
Toby: We’ll just bring Michael on. I’m just kidding.
Michael: I can join you two, but I think Jeff, what a wiz in tax. The guy is amazing, the way he understands the tax code, and also being able to regurgitate it, and teach people how to actually use it appropriately.
Toby: Jeff is fantastic. All right, let’s dive in. We got a lot to cover in a short period of time. We don’t want to keep guys here all day. Tax Tuesday rules, real simple. You can ask questions via the live Q&A. There’s a Q&A feature in Zoom. All you got to do is use that to ask longer questions.
If you have comments to what we’re going over, and every now and again, I’ll have a conversation with one of you and Michael will have a conversation with somebody, where we’re asking specific questions back to you, use chat for that. But if you have a question, we have a team right now that can answer your questions for you via the Q&A. Don’t use chat for that.
If we ask a poll question, then we’d ask that you use chat. Otherwise, if you have a serious question that pertains to your situation, it’ll fly by us if you use chat, so use the Q&A. If you have questions during the two weeks in between each session, you could ask questions via firstname.lastname@example.org. That’s where we pick the questions that we use for every Tax Tuesday.
Usually, there are 10 to 15 questions that we grab, not in any particular order either. I just go in there and see what has been flagged by something that would be appropriate for the larger group. Usually, it’s a generic question. It’s not identifiable information, where we can grab it and teach a lesson out of it. We just grab those and go through them.
Michael: They’re also really relevant to what’s going on today and tax talk on tax rumors out there. I’ve noticed that with people.
Toby: Yeah, you’re seeing a lot of activity right now, by the way. It’s usually political. It doesn’t matter which team is in power at that particular time, whether you’re team Democrat or team Republican, or any other team for that matter.
There’s always something they’re trying to do with the tax code, unfortunately, because it makes it very, very complicated. There’s over 20,000 pages of code, over a million pages of interpretation, and nobody really knows the code. Let’s make it more complex. That seems to be smart.
Michael: William just said, “Hey, are you guys live from Maui, actually, live, live?” And he says he doesn’t care if it’s pre-recorded, just don’t play him. Anyway, yup. William, we are live from Maui.
Toby: Hi, William. Where’s William from?
Michael: I don’t know where he’s from.
Toby: William, where are you from so we can make fun of you? No, he’s probably over here.
Michael: He just said this is a pre-recorded promotion. We’re not playing you, William.
Toby: Hey, if you need something very, very specific to you and you need advice that’s beyond just generic counsel, you need to be a platinum member. It’s really inexpensive. It’s $35 a month. There, we give written answers to tax questions. You’ll realize that we don’t like doing just having a meeting on tax.
Tax is very specific. Usually, you’re attaching a code section or a forum to something. I like it to be in writing just so there’s no misunderstanding and also because people have the same question year after year. You’ll find that in the platinum portal. Every year, you go back and say, what did they say last year? And take a look at it.
For example, everything from quarterly taxes to when are your taxes due. When are taxes due, all that stuff comes up. Hint, your tax return is actually due on October 15th because you get an automatic extension, but your taxes are due on April 15th. Technically, you’re supposed to pay taxes all years ago, which is the quarterly system. There’s all little nuances on each one.
Michael: I can’t remember if the price is right in the Plinko game, where the ball comes here. One little variable shoves it over here or it can go over here depending on the bounce. It bounces around down and finally get the answer using the tax code and the summation of everything.
Toby: Nobody really knows. Speaking of nobody really knows, we have a bunch of questions to go through. Let’s see if we can figure out the answers.
“For partnership LLC, can capital gains, e.g. stock sale from a brokerage account owned by the business be combined to offset real estate losses and depreciation in the LLC?” Good question, we’ll answer that.
“When I sell a property for a 1031 exchange, can I sell 100% ownership of the owning LLC instead of the actual real estate to avoid the transfer taxes, title fees, et cetera? Assume the LLC is single owner, LLC only owns the subject property, nothing else.”
“If I invest in a working interest in oil well and I take 100% deduction on my investment in the year I invest, does that amount reduce my AGI on my tax return for the year or is the deduction and investments subtracted after AGI is calculated?” Good questions. That’s a little technical, but it’s interesting.
“If I buy an existing home inside an opportunity zone, will I be able to save tax on the capital gain if keeping the property for 10 years?” Really good questions.
Michael: Yeah, and somewhat technical, too. Again, we’re going to be playing this Plinko game if this then that.
Toby: “How will electing real estate professional status impact my rentals when I will sell them? Will they be considered as capital gains or will I be taxed as ordinary since I have elected to be a real estate professional? When I QDC (quitclaim deed) a property from my personal name to an LLC which is solely owned by my wife, when I was told there is a possibility I would lose the title insurance, is there a workaround to retain the title insurance?”
Michael: It’s very interesting and more of a practical level dealing with title companies and what they’re going to do. Great questions.
Toby: And there are issues that you have to be aware of. We’ll get into that.
“Gifting versus business pay. We have a rental property not much to manage. The rental check goes in, the mortgage payment goes up. What would be a fair amount to pay our child so she can pay for college out of a paycheck from the rental account? Or should we just gift her up to $30,000 for mom and dad each year?” Good question.
Michael: It’s going to be, are we doing parental advice and guiding with parents or tax advice room played probably into a little bit of both?
Toby: We get that all the time. We’re trying to make their kids get an education.
“How can I reduce my taxes if I have an Airbnb, but I do not own it? I leased my Airbnb from another owner and I realized that I can’t take any of their normal depreciation since I don’t own it.” Good questions.
“I’ve been filing my taxes on Schedule C (sole proprietor), and all my business income as loan interest from private lending. My first year (2020) was a net loss. This year (2021) and hopefully all future years will have significant profit.
If I continue to report the interest income as gross receipts or other income on Schedule C, I’m assuming I’ll have to pay self-employment taxes on the profit. I’m thinking maybe I should report the interest income on Schedule B and my expenses on Schedule C. What are your thoughts? Should I be paying SC tax on interest income? I sincerely appreciate your advice and help. Thank you.” It’s always nice when somebody actually says thank you. By the way, we get a lot of questions.
“If clients did large conversions of traditional IRA to a Roth IRA in their 60s leading up to their retirement, will that affect their health, their Medicare premiums? Is it considered to be part of their pre-retirement income level?” All these little nuances.
Michael: Very much so.
Toby: “Are there any strategies to mitigate capital gains tax on the sale of a vacation home? Our vacation home is in another state. It’s solely for personal use and never rented out. We’ve owned it for 10 years. Do we have to make it our primary residence for two years before we can sell it and get the capital gains exemption?”
Michael: Great question and a lot of nuances in there, too.
Toby: “I am planning to do a cost segregation study. If I do some cosmetic light remodeling before cost seg, will it generate a bigger benefit or it doesn’t matter? Please advise.” Lots of good questions today.
Michael: A lot of good variables and things that we’ll be talking about and expanding out.
Toby: Yeah. Here’s a little fun one. If, during the week, you want to get good answers to questions, we have about (at this point) 1200 different videos on different topics on our YouTube channel. I invite you to go to our YouTube channel. Plus, there are recordings of Tax Tuesdays and we usually put which questions we’re answering there.
By all means, feel free to go to aba.link. You can go to YouTube and subscribe and click the bell. There’s a little bell up there. What that’ll do is whenever we put something up, you’ll be able to go get it.
I find it interesting. Sometimes I don’t go over all the different videos that are up there right now. We had a really good one on using private money to add capital assets. The reason this is really important is because selling an asset usually creates a taxable gain, as opposed to borrowing against an asset. You get to keep the asset and you don’t actually have the capital gain.
We’re going to see a lot of that with this appreciation that’s gone on and especially with inflation. People are making that mistake, where if they need capital, they’re selling things. You don’t have to do it. Jill did a really great job. You know Jill and Dave in Honolulu.
Michael: The other thing is with these videos, I just had a client comment that they felt like they opened Pandora’s box. Once they saw one video, they saw the next one lined up, and then said, oh, I want to know about this too. I think this individual said they were up till about 11:30 PM going through all the videos and information. That’s great. Love that, as a firm, we put out education. I always say an educated client’s a better client.
Toby: Yeah. There is a lot of fun stuff in there, so feel free to subscribe.
Michael: And stuff they’re not going to find anywhere else, too.
Toby: You could try. You got to read all the journals.
All right, let’s have a fun one. “For partnership LLC, can capital gains, e.g. stock sale from a brokerage account owned by the business be combined to offset real estate losses and depreciation in the LLC?”
Michael: We want to first look at this. I kind of look at it in the rules that are surrounding all types of incomes and how to write things off, passive gain, passive loss, active active, long-term versus short-term. In the long-term, you got to take against long-term.
What happens if you have leftover losses? You can’t use them in that current year because there’s some rule. You carry them forward. Are there any strategies there? I think that, first of all, we have to look in. Also, what is your tax situation like? When is it good for tax harvesting?
Toby: Let’s break this down. I have a partnership LLC and it’s trading. Trading can fall in different categories, by the way. You could have capital gains. If you have capital losses, is there any way to use those against real estate and rental real estate, which again, it depends on the type of real estate you’re doing. If it’s rental, then that’s passive. Can capital gains offset passive income or vice versa? Can passive losses offset capital gains?
Michael: Then look at the rules. Later on, you’re going to be looking at active participants and professionals.
Toby: You don’t have to get that far. Capital gains are offset by capital losses or by ordinary losses. If it’s rental losses, then we can’t use it. If there’s capital gains on the real estate, then capital gains can be offset by capital losses.
Again, we get into this weird little dichotomy where when somebody says, can capital gains from the stock sale be offset by real estate losses? The answer is, generally speaking, if it’s rental real estate, the answer’s no, unless you’re a real estate professional or you’re an active participant in real estate and you make less than $150,000. It must be real. There’s a phase out between $100,000 and $150,000.
If you have real estate losses from that type of real estate activity, from rental real estate activity, then there’s an opportunity to use the losses. Here’s the reality of it. Most real estate investors who are generating big losses are going to have more income. You’re either going to be a real estate professional or you’re not doing rental real estate activities, which means you’re doing construction, you’re doing rehabs, you’re doing property management. You’re doing something else that’s not rental real estate, at which time, now you’re not passive activity anymore.
For example, seven days or less. I’m doing Airbnb. It’s not rental income. That’s considered ordinary income, ordinary loss. Then the only question is, like Michael said, he actually right spot on, is it, am I materially participating? Is it a passive loss or is it a non-passive loss that I can use against my other income?
Here’s another fun one. Do I want to use real estate losses against capital gains? If that’s long-term capital gains, it might be taxed at zero or 15%. Why the heck would I even do it?
Michael: Yeah. See all the little balls you jog around and then you shake them around, you get the end result? What’s included inside of active participation? Are you making decisions regarding the rentals? That can include managing contractors, approving bids, and things like that.
Toby: Anything that you are managing on your properties. This is where it gets kind of fun. Are you an active participant and could just be hiring a manager? In which case, then you could take the loss up to $25,000 and use it against other types of income, ordinary or capital gain.
Generally speaking, if you’re going to have a real estate loss, if you’re going to mess around and create some sort of loss, you’re going to want it to offset ordinary income. You’re not going to want it to be against capital plans.
Michael: Or just use it as a limitation too of $25,000, right?
Toby: If you have $25,000 of active participation. Otherwise, if you’re a real estate professional, unlimited.
Michael: Remove that cap?
Toby: Yeah, but I wouldn’t use it against capital gains. The answer to this question, if it’s not convoluted enough…
Michael: Did we just get off on some rabbit trails there?
Toby: Yeah. The type of income that’s coming down, they can be offset, but there are rules regarding losses. Can the capital gains from a brokerage account be offset by real estate losses? The answer is yes, potentially, depending on the type of the real estate activity if it’s ordinary non-passive or whether it’s passive. If it’s passive, no.
The other fun one is when you have capital gains and a stocks account, hopefully it’s gain, but are we a trader? Are we making a mark-to-market election? Are we changing the nature of the loss on it? This one’s on gain, so I’m not going to go down that rabbit hole. As much as I love rabbit holes, I don’t want to go down that one.
Michael: Also things for everyone to be aware of too. Just don’t take this one answer that fits into a particular set of circumstances. You have to actually put your circumstances to be able to get to the end result of the answer on that.
Toby: Yeah, so it kind of depends. Really good question, by the way. I’ll just go back to that for two seconds. Really good question, but I hope that illustrates a good point too, which is real estate activities, when you isolate them, they could fall into any one of different categories. Is it a rental? If it’s a rental, then it’s presumed to be passive. You cannot use passive losses against any other type of income other than passive income, so it can’t offset capital gains.
Capital gains are referred to as portfolio income and you can’t do it, unless you fall into one of the two exceptions. The two exceptions are real estate professional or active participation in real estate. If it’s not rental activities from real estate, you’re a dealer or you are doing Airbnb, then it’s ordinary.
The question, is it passive because you’re not materially participating or is it non-passive? In which case, if it’s non-passive, I can use that against any type of income. The big question is, should I ever use it against capital gains because capital gains are actually preferred treatment, especially long term capital gains? In which case, I would say, you might want to keep that one in your back pocket.
Michael: When you’re working with a lot of clients and then also listening to other practitioners, it’s important to note that there’s an active participant test. That’s something and then the real estate professional test. I see that people, they always talk about them together and confuse people. It’s very important to understand because there are different qualifications on it, absolutely. It gets fun, but I see that people take the active participation test.
Toby: They’re asking good questions there. I wish I could actually see those. When they’re asking the questions, I love reading the chat. I’m a chat addict. I’m just going to have withdrawals all day.
“When I sell a property for a 1031 exchange, can I sell 100% ownership of the owning LLC instead of the actual real estate to avoid the transfer tax, title fees, et cetera? Assume the LLC as a single owner. LLC only owns the subject property, nothing else.”
Michael: Whenever I hear 1031 Qualified Intermediary, that’s something that I recommend highly. I think that it’s overlooked. I think people have to take money on. I’ve seen and heard too many horror stories about people missing deadlines and quashing the entire thing.
Toby: Yeah, but you can’t 1031 exchange the interest event. I’ll just make it simple. You have to sell the real estate and it has to be named. If it’s an LLC selling the real estate, then it has to buy in the name of that LLC. You can’t take it in a different name. Can you drop it into a different name later? Potentially.
There’s a starker exchange, which is actually a case. But there are cases where individuals would close. I would go, Toby Mathis, buy something else, and then drop it into an LLC. The question was, how long do you have to hold it? The IRS has taken a position that’s pretty logical, which is if the beneficial ownership didn’t change, then we don’t care.
I don’t believe you’d ever be able to do a 1031 exchange of an entity to try to avoid the transfer taxes and title fees, nor should you because technically, the change of ownership of an entity, even 50% is a deemed sale of the underlying asset.
Michael: Be careful with drops and swaps. […].
Toby: You can do a drop.
Michael: You can, but I’d be very careful on it.
Toby: You tell them what you’re referring to when you talk about a drop and swap.
Michael: Basically, before you’re actually doing the 1031 and you’re in a partnership, and let’s say that one partner has a desire just to go and get the funds, they’re going to pay the tax. The other partner wants to 1031 their interests, move it over attendance in common, and then the partners can separate it out. There are still some little nuances there. The IRS, for some reason, I guess they give us enough rope to hang ourselves with at times or they give us enough stuff to actually play the game and benefit from it.
Toby: Yeah, so the big question there is, again, we’ll go back to that beneficial ownership. If you have an entity that has a certain number of owners in it, and they’re selling a property, and they’re selling it in the name of the LLC and going to another property, the question is, all partners would have to go along for that ride.
Most people are going to say you do the swap, do the 1031 exchange, and then you drop the owner. But you could have an existing agreement to buy out that partner and you do it after the 1031 exchange. The problem is, you never want to do this in a bubble. You want to do this with the guidance of a Qualified Intermediary to make sure that you can at least point at somebody else. If it’s undone, you can try to get out of penalties.
Michael: And there’s something about experience. They do this all the time. They understand it. They’re going to run right through it if you have a qualified one. With changing ownership or resultant ownerships, that’s something we have to be careful of, even with state taxes, county taxes, and things like that. The more congruence of ownership I think is something that I’ve had a lot of questions over my career on.
Toby: All right, I think we have an easy answer on that. Don’t sell the entity. You can’t do that. You’re going to have to sell the property.
“If I invest in a working interest in oil well,” that’s a specific phrase. If you guys have never invested in oil and gas, you can create ordinary loss when you do so. It’s called a working interest in oil wells. “They took 100% deduction,” which is just an ordinary loss. It’s no different than if you were in a sole proprietorship. “Does the amount reduce my AGI on my tax return for the year or is the deduction for the investment subtracted after AGI is calculated?”
Michael: I am not an oil and gas expert. I looked into the work and I know a lot of people look to it to save on taxes. But again, we get into a few of the nuances here, and how much you’re at risk, and how much you’re putting in. Tell me a different one to you. I like oil and gas and I think it’s a good one.
Toby: You can like it. It went down to zero during the pandemic and now it’s over $100.
Michael: I find it very interesting to watch, that’s for sure.
Toby: I’ll do this. I’ll give credit to the oil and gas people and to the crypto people because you are able to, for whatever reason, went down 30% last week. Somehow you guys can do that. Me, I’d be rolling around and having trouble sleeping.
Michael: Some of them really, it’s like a game almost. High risk tolerance, I guess these individuals.
Toby: They like the feast and famine. This is why people invest in oil. You can take a massive first year deduction. I’ve run into this with clients that have deferred revenue or deferred income, so they leave a large corporate employer and they have big payouts for three or four years.
We’ll use the working interest to lower their tax hit, so that we’re not having to go the real estate professional route. But they’re trying to lower their income and then spread it out over a period of time. What you’re really doing is you’re taking a big deduction for digging oil and then you’re going to have revenue coming in over a period of years as the oil well depletes and as it produces income.
Michael: Where the worker enters, that’s what they’re taking the risk on, right?
Michael: There might be demolition.
Toby: Yeah, you’re digging a hole. You’re drilling.
Michael: I guess the IRS is maybe giving you a little reward for taking that risk.
Toby: Absolutely, as long as you’re at risk and you just said a magic word. If you’re not at risk, then you lose. Even if you toss this into an LLC, you got to be really careful that you’re drafting around the loss of risk because you can’t take the loss if you avoid the risk. You have to have the personal risk on it.
Michael: There is risk. Underperforming, that’s one of them. Commodity price fluctuations, things like that.
Toby: It’s more than that. You have to actually be personally responsible. You have to be in a general partnership. Otherwise, you lose the ability to take that loss as ordinary loss, which is what we want. We want ordinary, active, non-passive loss, which is what this is.
The question here, though, is does it come before your adjustment? Because the old adage was first adjust, then deduct. What they’re talking about is an adjustment is things like student interest, contributing to an IRA, things like that. A deduction is standard deduction or Schedule A. Is it my mortgage, health coverage, or health deductions?
I used to have miscellaneous itemized deductions and those went away in 2017. We have our real estate taxes, things like that, that you’re looking at your schedule, too, your charitable deductions. You’re looking at those and you’re taking those after you do your AGI. This would be done before your AGI is calculated.
To answer your question, whoever asked this, is in the calculation of your AGI, your AGI is all sources of income and losses. If you’re a sole proprietor, if you’re a member of a general partnership and you have loss, if you have K-1s, if you have wages, if you have any income, that’s part of your gross income. Then you have an adjustment, which is the things like the student interest, IRAs, HSA, and all that stuff, and then you get to your standard deduction.
The answer to your question is, it’s before the AGI. Does it reduce your AGI? Yes, it reduces your AGI. Some of you guys are probably going, there’s a reason that that’s a big deal because things like charitable donations are based on a percentage of your adjusted gross income. If I lower my adjusted gross income, I’m lowering my ability to take certain charitable donations and things like that. They all work together.
I love that nuance in that little bit of complexity, but you’re always saying gross income, then you adjust, then you deduct. But to get to your gross income is losses, wages, and all the positive net income, then you get to do your adjustments, then you get to take your deductions. Clear as mud?
Michael: Clear as mud. Again, the nuances always bounce it up your tax advisor.
Toby: That’s what we like. All right, let’s play another one. “If I buy an existing home inside of an opportunity zone, will I be able to save tax on the capital gain keeping the property for 10 years?”
Michael: The funny thing about this, first, look at the issue spot in there. The first thing that got me, if I buy an existing home in an opportunity zone, will I qualify for an opportunity fund? You need investment money.
Toby: Yeah, there you go.
Michael. Again, we got to be careful in how we’re talking.
Toby: What’s an opportunity zone?
Michael: I was going to say the Vegas joke. I love opportunity zones. I think that the premise behind them was that we live in different big cities. You were in downtown Seattle. You were in SoDo or?
Toby: I was in Georgetown.
Michael: Georgetown, but it was not south of the dome, I think it is.
Toby: There were no lawyers. There was me and the ex-[…] Howard Rosellini. He was in a dry ice plant, literally. He had the Cadillac, said the guy that he was a little bit connected. It wasn’t much down there.
Michael: That was really exciting because you take these areas that maybe are depressed. Revitalization, rejuvenation, I think that the theory behind it have been fantastic. They really gave us an incentive to be able to invest in it or getting some of the capital gains rolling investments over there.
Toby: You’re telling me the zone now, like it’s basic. It’s just a place that we want people to invest in. It’s an economically disadvantaged area that we need to spur investment. You’re giving somebody something.
Michael: I thought you were using them or their turn to describe those areas. I know we’re a little more relaxed here on Tax Tuesday.
Toby: They’re not bad. They’re actually really good opportunity zones. For example, you could unintentionally go into an opportunity zone. It’s a list of zip codes where we want to spur economic activity, we want to spur investment. What they’re giving somebody is the ability to defer your capital gains.
The first thing you have to have is capital gains and then they’ll let you defer it until 2027. They’ll even allow you to step up the basis a little bit and avoid tax on a portion of it. When you go into an opportunity zone, what they’re really saying is, hey, we won’t make you pay tax on your capital gains right now. You will pay tax on it, but you only pay tax on 90% of it if you wait five years.
Michael: Five years, then 7 years, and then was it 10 years?
Toby: Seven years is an impossibility now because we are in 2022, yeah. Originally, you actually had the chance to get 10% step up in year five, another 5% in year seven, but we can’t hold seven years anymore because you have to recognize it at the end of 2026. Actually, can we even get five years? I think we can get five years now.
Michael: Years go by so fast now. It’s 2022.
Toby: You’re going to just defer your capital gains, then the asset itself. Let’s say that I buy a business in an opportunity zone or I buy a piece of property. As long as they meet certain requirements and improve that, which this is the problem with the real estate, I buy a home, not a personal home. You can buy a piece of property, but you’re going to have to double its depreciable basis, which means the improvement on the property is going to need to be doubled.
If you do that and you hold it for at least 10 years, you could step up the basis on any given year to its fair market value and avoid tax on the growth of that asset. But you have to recognize the deferred gain in the 2027 period, as though you sold it on December 31st of 2026.
Michael: Think about it, it’s a win-win. There’s a lot of investors who went ahead, got into there, and then look at the appreciation we’ve had too. I know this is one of those cool things that came about for everybody.
Toby: Here’s the stinky part. Why would you sell? You have to wait 10 years.
Michael: Correct on that. One of the investment strategies I use is I look at areas that are up and coming and they’re changing over or that were depressed. With the growth of the area now, that’s where you want to live. That’s where people want to live. It’s a good investment strategy.
Toby: You said something in the beginning. I don’t want to let go of the qualified opportunity zone fund. You deferred gain into an opportunity zone fund, which then invests in the opportunity zone property. It’s not something you get to do. In order to be a fund, it has to be a partnership or a corporation. This is not appropriate if it’s your personal residence or if you’re doing it as a house.
Michael: The red flag […].
Toby: Yeah, if you’re out there. Are you seeing any of the chats? I see the chats and I just want to read the chat. But it’s so far away, I can’t read it. I’m sad.
Michael: Some of them aren’t directly on here on the points of the actual topic.
Toby: I want to read all the chats. All right, let’s dive into this. There’s Clint. This is the Tax and Asset Protection workshop. You guys should register and come watch Clint speak. He talks in the morning and I talk in the afternoon. He does a great job, though.
If you want to learn about LLCs, land trusts, corporations, S-corps, retirement plans, how to protect your house, how to protect your real estate, how to protect your assets, he does a great job. Then in the afternoon, we go over tax planning specifically for real estate. We go over everything from your dealers to your real estate agents, to people that are buying rentals, to Airbnb, all the different types of real estate, and then we finish off with some legacy planning. It’s absolutely free. The next one is on April 9th of 2022. It starts in 10 days and 22 hours.
Michael: What’s consistent in that is the comments we get of how much information we can actually pack into that. Supplemental information, we cover in the structural mentation workshop, too.
Toby: And it’s free. You got to devote a weekend and we don’t give you a recording of it. We do them live and we reward the people that are there. We give a ridiculous offer. Every time we do it, we change it up and give you guys something that makes it a big all thank you for being there.
Michael: We made a foundation for everyone. Everybody who’s interested in business or investing, whether it’s stocks or real estate, you got to understand those principles or at least be exposed to them.
Toby: Here’s the truth. People like to try to take things away from people that have stuff. It goes back to when you’re a little kid, and somebody who’s got a toy, and somebody wants to walk up and take away the toy. It’s because you have the toy. I want the toy because you have the toy. If you have the fund, somebody is going to try to take it from you.
All right, “How will electing real estate professional status impact my rentals when I sell them? Will they still be considered as capital gains or will it be taxed as ordinary since I have elected to be a real estate professional?” Good question. What say you, Michael?
Michael: Again, I think we have to go back to how we get there. Why are you doing real estate professional? Is it current or is it for the future sale? On the sale of property, there’s very few downsides to a real estate professional when you’re working on properties.
Toby: The sale remains capital gains.
Michael: It’s congruent.
Toby: Yeah, it does not change it to ordinary. The only issue where you have ordinary income when you are a real estate professional is when you do a cost segregation. When you change the property from 1250 to 1245, which is a fancy way of saying structural property versus personal property, if there’s value in the personal property, there might be some ordinary recapture because it’s taxed as ordinary income when you have recapture a personal property, as opposed to depreciation which would be taxed as recapture at 0%–25%.
If you didn’t follow that, don’t worry, because most accountants don’t know all those rules either. I’ll just say that the people that do real estate and if you do real estate enough, you’re going to realize that when you sell a property, and you depreciate it, there’s always something to be paid unless you 1031 exchange or unless you hold it until you die and it steps up in basis. Or what I tell people that invest—and I wrote a book called Infinity Investing—that infinity part is the part you focus on, don’t sell your stuff. If you want money and you have a bunch of real estate, just borrow against it.
Michael: I’ve got a good question out of the chat. “If I have not used my LLC or C-corp for real estate business, can I use it for a different business as a 1099 employee?” I guess this would be in parenthesis as a contract employee.
The way we draft our operating agreements or by-laws, you can do a lot of different activities. One of the things I would say is, though, make sure that one of those activities isn’t bringing more risks than you would want against another activity. I would never put a high risk activity with a low risk activity. But you can go ahead and change the direction of a corporation. This isn’t really tax wise.
Toby: It depends on the documents that you have.
Michael: The documents, I want it.
Toby: If it’s us, we generally draft things that are for any lawful business purposes, but there are attorneys and law firms that draft things specifically and they will mail you in. If they put it in their articles that you have a restriction or if you put in your by-laws, if you have partners, you got to read what you actually say.
Michael: I was speaking with an attorney just actually last year. They were saying, well, it’s not specific enough. I said, okay, our clients are fluid, entrepreneurial in nature. You want to go ahead. If a client changes direction of their business and adds another avenue of business, what do you do for them? I’d redraft their operating […] by-laws, you amend them, or what have you. I said, what you’re doing there is another billable opportunity, because I asked them if they did it for free.
Toby: If you had investors, I could get it. Hey, I’m going to raise money to do self storage.
Michael: But raising money on third-party is a real problem.
Toby: That’s a different animal. Then, okay, keep it narrow because the investors, if they’re putting money in for the self storage, they don’t want to go out and find out that you built an airline out of it. But if it’s you and it’s somebody, I want my clients to have versatility. You should be able to do whatever you want with the dang thing.
Michael: I think it’s also the type of people you and I are, we want to be able to be nimble and seize opportunities quickly. I don’t like to be pigeonholed into something. We look at our estate plans. We plan for the what ifs with our estate plans. We want to make sure that as life evolves, we don’t continually have to change them. We already have provisions in there that take care of the what ifs in life because life can change quite a bit.
Toby: All right, back to our friends, the real estate professional status and how it will impact your capital gains. One of the things that you do want to know is that there’s a weird nuanced benefit, perhaps, of being a real estate professional.
Michael, you and I have talked about it before. It’s the net investment income tax that gets assessed on individuals that are over $200,000 if they’re single or $250,000, just this 3.8% on investment income. Capital gains generally qualify for that. There’s a nuance that if you’re a real estate professional and you sell, you may be able to avoid it.
Here’s the one thing. Real estate professional status is not something you do every year. Real estate professional status is something you qualify for every year. The more you do it, the easier it is to qualify, but you could be just a regular Joe Schmo investor.
If you’re going to sell a property and it’s going to have a pretty big impact, you may want to consider if I’m selling it in a particular year. If I qualify as a real estate professional, I may avoid an additional 3.8% imposition of tax. If I’m selling a multimillion dollar property, it’s something to consider.
Michael: Look at your other activity you’re doing too. Maybe it can change things around and to maximize that.
Toby: Fun one.
Michael: This one is a good one.
Toby: All right, “When I QDC,” which just means quitclaim deed, “transfer a property from my personal name to an LLC, which is solely owned by my wife,” assuming it’s husband and wife, you’re transferring your property into an LLC held by your spouse, “then I was told there’s a possibility I would lose title insurance. Is there a workaround to retain the title insurance?”
Michael: Fifteen, 16 years ago, you would have heard nonstop just quitclaiming into the LLC, quitclaiming over here, and quitclaiming over there. That was really, with investors, prominent information from many advisors, attorneys, and tax people, without really understanding what is the difference between a quitclaim deed and a warranty deed. Really quickly, if I quitclaim my property to you in a quitclaim deed, I’m saying, hey, Toby, any rights I have on this, you can have it.
What does that really do? I think it’s important that when you look at this, what does that really mean? If I don’t have the bundle of rights that we associate with property law, then all I’m giving you is this pen. I might not even have full claim to that pen. Tom or Eliot might have some rights in there. It might be a clouded title.
What did I just do? I just gave you whatever rights I have, which might not have been very many, as opposed to a warranty deed, which I’m actually warranting to you and their 60s in the title, but warranting you that, hey, I own this property full and I get full—
Toby: What does that have to do with title insurance, though?
Michael: That’s what the title insurance is doing. When I got these rights, they’re ensuring that I do have these rights. If later on, a cloud is on the title, you get that with it and there’s no real recourse.
Toby: Could I affect my title insurance by quit claiming it?
Toby: Technically, you could void out your title insurance because title insurance will cover you. It can cover the title, so long as there’s an insurable interest in it. If I transfer away without having any warranty on that title, then my policy just lapsed. I no longer have a valid policy, which is, I think, what they’re talking about here.
If I quitclaim, depending on the type of title insurance I have and whether it’s talking about the interest I have to ensure, if I do have language in that policy that says that the policy remains in effect, so long that the interest is insurable, then by transferring it even to a spouse, even into an LLC via a quitclaim deed, I could just have canceled my title insurance. Here’s the easy answer. Talk to your title company. And if in doubt, you always do a warranty deed.
Michael: I love that we’re exposing this to people. Again, I’ve heard practitioners even recently. They just quitclaim.
Toby: There’s a nuance and not every title policy would get voided. Not everybody would stick to that. But if you did end up with a clouded title, and you’re thinking that you have title insurance to cover you, and they find a way out of covering you, that’s going to suck.
Michael: Even when you go for financing and things like that, it’s just a sloppy way to look at it.
Toby: Just ask the title or just do a warranty deed. Easier to do the warranty deed.
Michael: And nicer and cleaner.
Toby: Do the warranty deed and make it simple. Don’t do a limited warranty. You want to make sure that you don’t unintentionally undo that title insurance.
Michael: Or even when you go to sell the property too, I think you’re going to have some nuances too. Some investors are like, I don’t know, I mean, here’s inside the chain of title, here’s where either quitclaim deed and destroys those kinds of warranties.
Toby: What did you quitclaim over? We don’t even know.
Michael: We don’t know.
Toby: Yeah, because we don’t know if anybody else is out there and maybe sitting there on title.
Michael: Depending on the value of the property or the cost of the property, I might be okay with it or I might not be okay with it.
Toby: All right, let’s talk about gifting versus business pay. “We have a rental property, not much to manage. The rental check goes in, the mortgage payment goes out. What would be a fair amount to pay our child so she can pay for college out of a paycheck from the rental account? Or should we just give her up to $30,000 for mom and dad each year?”
Michael: I thought this was really interesting. Again, I think it is parenting too. What do you want to do? What are your overall goals with your estate plan that might be very viable?
One of the things that when reading it, immediately, one of my head being that I have, again, a 5-year-old and a 19-month-old, I have no idea what direction. If they’re going to have financial stewardship, I’m getting them into Infinity Investing. They’re going to understand those principles. They’re going to have financial stewardship, but something that came out is the words, not much to manage. Immediately, there’s a discrepancy between $30,000 and, what’s the value of not much to manage?
Toby: I’m just putting a little thing here, spend. If I’m going to spend $30,000, here’s the problem with us parents that have kids that go to college. When you are dealing with the tax world, you have this little guy here before you get to spend it. You earn X and you’re taxed at a certain percentage in order to spend $30,000.
Let’s pretend that you’re paying 30%, which is the average United States payment. It’s actually 29.9% that people pay, which means you have employment taxes, you have income taxes. But we would have to make, under this theory, $45,000 in order to have $30,000 to spend. I’m allowed to gift my child up to a certain annual exclusion and I think it’s around $15,000. Mom and dad could each do $15,000 to their child and they don’t have to pay tax on the gift.
It’s kind of weird, but they tax gifts in this country. You’re either going to use your annual exclusion or you’re going to use your lifetime exclusion, which is sitting at almost $12 million each right now. You have this huge exclusion. Giving money away is never really an issue, but you have to pay, in this case, it’s $15,000 a year in tax that you’re paying on that. And we don’t want you to pay that.
Let’s say that a child earned $30,000 and their tax bracket isn’t going to be $30,000 because they have a standard deduction of $12,000 in some odd change. It’s almost $13,000 and then they’re going to be at 10% and 12%.
Total tax bracket, let’s just say they’re at 10%. It’s going to be less than that. That means that they could make, let’s just say, $33,000 to spend $30,000. They can make a lot less than you and pay a lot less in tax, but you have to justify it. It has to be reasonable.
Michael: Again, not much activity. Is there anything else that they can actually do to maybe bump that up, too?
Toby: We have one piece of property, but it tells me you probably aren’t going to get there. It’s going to be really tough, unless there is some significant activity. If that’s an Airbnb, you might be able to get there.
Michael: In most cases, compensation must be reasonable.
Toby: Yeah. It just depends on what they’re doing for the money and what you are doing. My experience is that you got to have a management company and you got to be doing other activities. Anything you guys can do to make money, even if it’s a side gig or something, if that daughter is able to do something that is a high-value activity.
For example, anything that’s in internet marketing right now, if you’re paying a ton for people. It’s hundreds of thousands of dollars a year for somebody who’s qualified that’s a really good expert in marketing that does this stuff, they’re making good, good money. You’re not going to be sweating $30,000 if they’re able to do things. Anything with social media, $30,000, you’re not sweating it at all.
Michael: Especially, the kids know more about that than us.
Toby: But for one rental property, it’s not going to be sufficient. You might be able to get some.
Michael: It has to be reasonable. It’s a good guiding light for almost anything when you’re dealing with tech.
Toby: What I would be doing with this is I’d say, either I’m going to go buy a bunch more properties or I’m going to start to up my game, in which case, then my daughter, even if the activity isn’t super profitable, there’s an opportunity to transfer money from me to her that’s deductible to me and is taxable to her at a much lower rate than what I’m paying for school.
Michael: Yeah, maybe I want to document the duties and obligations.
Toby: In this particular example, it saves me about $13,000 a year.
Michael: Questions that are run on point. “What if I don’t have kids, can I gift to my niece and nephew?
Toby: The same situation. I can gift, but I’d be so much better giving them a job instead and having them work.
Michael: Yeah, you can always gift to anybody.
Toby: Because I want to be able to deduct it.
Michael: Correct, tax-wise.
Toby: Yeah. By the way, if it’s a family member, a parent, or somebody that’s an adult, there are ways to transfer money from your business to them, tax-free, without creating a paper trail either. It’s not just about paying somebody.
Let’s say that I used your home. I could use Michael’s house and let’s say I had a business. I can say, hey, Michael, let me use your home to have a corporate meeting. And we will watch Tax Tuesday, and we will discuss, and I want you to be part of a conversation with my board. I could pay you a reasonable amount. Let’s say it’s $1000.
I could pay Michael that money. He doesn’t report it, I have a deduction, voila, I’m a big winner. Michael is a big winner. I’m saving some money on my taxes. Michael is getting some tax-free revenue and he’s maybe being exposed to some things that he otherwise wouldn’t be exposed to.
Michael: And there’s a whole kit inside platinum, too, for those who are interested in that strategy.
Toby: Yeah, that 280A?
Michael: 280A kit.
Toby: It’s in the tax toolbox. All right.
Michael: Another one. I really like this because, again, reasonable. “How old can a child be for this scenario?”
Toby: There are cases with the IRS with children as low as nine years of age that we’re getting Screen Actors Guild traits for their use of their imaging on marketing. But I know some accountants that have gotten younger don’t do that stuff.
Michael: Pigs get fat, hogs get slaughtered.
Toby: It’s reasonable. If they’re able to use a broom, they’re able to clean up their 10, 11, 12, yes, but it still has to be a reasonable amount. You can’t pay them $50 an hour. You might be able to pay them $10, $11, $12 an hour. Nowadays, they’re hiring at In-N-Out Burger with $20 an hour.
We were going through there. One of our accountants was taking a picture of the sign. It’s crazy what’s going on in some of these areas. But a reasonable amount, what you could pay a third-party to do something equivalent.
Michael: I would pay if you file a document, document, document.
Toby: Yeah. You don’t have to worry about the 16 years. If it’s your kids, related parties, you’re okay. You don’t have to worry about child labor.
Michael: I’ve got a 19-month-old. What can we get her to do?
Toby: Take some pictures. Get her images out there.
Michael: Marketing, right? It’s just been a lot of creative. It’s really fun. Over the decades, I’ve seen how our clients have taken principles and actually implemented them. Some of them just bring tears to my eyes. I’m proud of our clients for taking this to the next step.
Toby: I’m thinking about the horrible things you could do. All right, “How can I reduce my taxes if I have an Airbnb but do not own it? I leased my Airbnb from another owner and realized that I can’t take any of the normal depreciation since I don’t own it.”
Michael: You can run it like a business, I guess, and try to get as many business deductions as possible. Again, when I read this, the I, I, I, I, I. Are we doing it as an individual? Are we doing it as a business? Are we using a C-corporation or do we have exponentially more deductions? One thing I always like to do whenever I teach anything, customer, ordinary, reasonable, and necessary deductions.
Toby: I would break this down a little bit differently because I would say Airbnb activity if they are a host. They’re renting it and they’re basically a host. It’s seven days or less, then it’s not a rental activity. You’re just a typical business.
What would I do to lower my expenses? I would make sure that I have an administrative office in my home. I’d be using an S-corp more than likely as the host. I don’t think I’d be doing this in my individual name under any circumstance. Or I might be a C-corp, where I can reimburse 100% of my medical, dental, vision expenses, things like that.
I’d be adding those things up seeing how much money I can get out tax-free. Then the remaining portion of the money, I might have to take a salary. But again, I could do a 401(k).
Michael: I was going to say, you take your salary, everyone says, oh, my gosh, taking a salary, you’re exposed to the additional 15.3% plus whatever. But then you made contributions over to the retirement plan, which there are tax savings there, but they’re also after your retirement. You’re able to contribute it over later.
Toby: And you have to. Social Security for a bunch of people bash on it, if you don’t pay into it, you don’t get any benefit from it. If you pay into it, you’re going to get a benefit anyway. The company’s paying half, you’re paying half, the half that the company is paying us deductible. You’re half, you’re getting back at some point, at least a portion of it. You’ll probably be taxed on that portion.
Michael: I just like that sometimes we can do things that maybe seem on the front. They may be a detriment, but when you start boiling it down, again, looking from a tax employee standpoint, like QRP, qualified retirement plan, but also you’re saving for retirement. If you get the QRP right, you’re also able to control those funds. You can roll them over from past employers.
Toby: The depreciation is simply a deduction. Just because I don’t have that one particular deduction, it doesn’t mean that I’m off and I can’t get other types of deductions. It’s just one of many. We’re talking about everything from a cell phone to your computer. All of those things are deductions.
If you really want to lower your expenses, you start buying things like Michael’s computer here, an Apple. Those things are expensive. You could buy it on credit and write it all off, boom, I just lowered my income. Could I do that as an Airbnb host? Absolutely.
Could I also do, hey, I need to be able to be on call? If you’re doing as an S-corp, or a C-corp, or an LLC taxed as an S-corp, or an LLC taxed as a C-corp, again, you have the ability to write off full on a lot of things, everything from my data to my cell phone, to all those things.
Michael: But it’s necessary. You have to have these tools.
Toby: All right, “I’ve been filing my taxes on Schedule C,” that’s a sole proprietorship, by the way, “and all my business income is loan interest from private lending. My first year (2020) was a net loss, which is good that it’s on Schedule C.” Now we’re going, yay, I can write it off. “This year (2021) and hopefully all future years will have a significant profit.
If I continue to report the interest income as gross receipts or other income on Schedule C, I’m assuming I’ll have to pay self-employment tax on the profit. I’m thinking maybe I should report the interest income on Schedule B and my expenses on Schedule C.” I’m going to give you the stink eye again. This is how trader status came about. “What are your thoughts? Should I be paying self-employment tax and interest income? I sincerely appreciate your advice and help. Thank you.”
Michael: At first glance, you would say that the interest would go on Schedule B. If you didn’t know that that was their trade or business on being a private lender, but when combined with the private lending that that’s your business, then that would go on Schedule C. But if you just quickly glanced at the tax code, you would think it went on Schedule B.
Toby: If I earn interest in a savings account, it’s going to go on my schedule B. If I earn interest as a trader business…
Michael: Trade or business. That’s what they said, I’m doing private lending.
Toby: I’m sure they took an ordinary non-passive loss. Technically, interest income is portfolio income. The way to change it into active ordinary income is to be a material participant and run it as a trade or business.
Once you go down that path, just to answer this question and keep it really simple, you’re a trader business. You don’t have interest income anymore, you have income. I don’t care whether you’re selling services or interest. You are in the business of loaning money. You are a bank, essentially.
Now it’s active. You’re materially participating, it’s ordinary income. I wouldn’t be doing this on a Schedule C. What I’d be doing is saying, the business that’s going to be dealing with third-parties, I would want to make sure that’s an S-corp or a C-corp to isolate the liability and to allow me to take some of that income that would now I’m subject to that self-employment tax.
This guy right here, it’s not a small tax. That’s 15.3%. You know that the largest revenue source for our government is the collection of old age, disability, survivors insurance, and Medicare, Social Security taxes? It’s more than income taxes. That is a huge tax. If you use S-corp, you can minimize it.
What I would be doing in this situation is I would put my cash in a bucket like in an LLC and I would loan on a long-term, not as a trader business, to a corp. That could be an LLC taxed as a corp and then that’s the guy going out there to third-parties.
Michael: When I hear private lending, this is exactly the structure that I’m going to recommend. In most cases, you always have a little asterisks here. But in most cases, it accomplishes many of these.
Toby: This guy then goes on to your Schedule B because it’s not a business. This guy right here, if it’s an S-corp, that’s the easiest route around. Hopefully, without being too convoluted, you have a reasonable solution to what you could do to minimize your tax and not get destroyed.
Michael: If this is you, please contact your office and get an appointment with one of the advisors.
Toby: We could save you some tax.
Michael: And protect you.
Toby: If I’m doing everything to third-parties out here, my loan lending in my entire business becomes a trade or business. I’m materially participating, which means either I’m doing all the activity, or I’m spending more than 100 hours in more than anybody else, or over 500 hours, it doesn’t matter. If I’m doing everything, I am now on Schedule C. Everything’s going on Schedule C. If you want to break that, you need to break your business into two pieces.
You’re still going to have the trader business section, but I’m going to put the money down here. I’m going to loan that percentage rate to, more than likely, it’s going to be a C-corp or S-corp. And that’s for tax purposes.
This could be an LLC. The reason I’m doing that is because this loan interest, as it earns money, the money is flowing in interest this way, cashola. I’ve loaned the money up here, so I’m putting it on the street. This is now going to go through and it’s going to remain portfolio interest income, which is not subject to self-employment tax.
This guy up here is a trader business and I don’t want the Schedule C. The reason I don’t want Schedule C is because it’s about 800% more likely to get audited. When you’re a sole proprietor, you lose your audits more than 90% of the time. It was 94%–95% of the time.
Michael: The sole proprietors get audited much more than C-corps.
Toby: They do.
Michael: I have my own theory. If you take the extra steps to formalize your business, then you’re more adept to actually keep better records than if you’re a sole proprietorship, you’re kind of […].
Toby: I think the IRS knows that sole proprietors don’t keep records.
Michael: That’s my opinion. I don’t have any stats behind it, but I think that the people who actually take the next step to formalize their business into a corporation or what have you.
Toby: It’s much more difficult.
Michael: But you’re also looking at keeping receipts. You’re more, I guess, formal. That’s my own opinion on that. You seem congruent in that?
Toby: Yes, but I just look at the stats. The IRS publishes their data, but you know who gets audited the most in this country? Syracuse University just came out with a study.
Michael: Are they going to say Syracuse University?
Toby: They don’t, but you know who gets audited the most?
Michael: I’m guessing, who?
Toby: People that make less than $25,000 a year are audited five times more than anybody else.
Michael: Because they’re the ones that are trying to maybe spend more and take more advantage of things.
Toby: I think the IRS—
Michael: They don’t have attorneys?
Toby: They don’t have attorneys or representation when they pay things.
Michael: That’s disgusting.
Toby: They roll over quickly. You know who doesn’t get audited? Everybody else.
Michael: Usually, nowadays, with the lack of staff that the IRS has, it’s—
Toby: Forget the number. I think it was 11,000 audits the last time I checked of people making more than a million dollars a year. There were over 170,000 returns and it was just a small percentage, but it was such a small number. You want to get audited? Don’t make money.
Michael: You don’t make money, you won’t get sued either, probably.
Toby: There was a Table 17b of the Publication 55. If anybody wants from home, you can Google this stuff. It’s the IRS Data Book. That form would break down depending on the type of schedules that were filed on a return. You can see it.
The last year where they did it was 2019. 2019 was the last year they had that form 17b. Sole proprietors were audited more than 2%, 2.4% of the time, and then it dropped down too. If you’re making decent money, $100,000 or so, that’s like 1.6%. But the S-corp’s 0.1, 0.2, fraction.
Partnerships were so small, it was 0.00-something, where they had to put the little asterisk. That’s really low. Anyway, if you like this type of information, by all means, I’m going to say go to our website. Go to our YouTube. When I say our YouTube, I’m being completely selfish here. It says my name on it, so they think I’m there.
Michael: You are Mr. Taxwise.
Toby: Please go there and click that little bell because there’s so much information that we’re putting out. I’m trying to do videos three or four times a week. Get it out to you guys. Right now, it’s really important because there’s lots of stuff that are on the table for the tax.
Michael: I like action-adventure movies and stuff like that. Do you read the tax code as an action-adventure movie?
Toby: No. Not at all.
Michael: Sometimes, I wonder, Toby, you’ve got an innate ability with the tax code.
Toby: The tax code, nobody understands.
Michael: I know about the tool. You know the tool that you’re able to use, you have a passion for this tool.
Toby: No, it’s just there’s a little golden nuggets in it. You have to figure out what the nuggets are. Every time they take something away, they have to give something back. Once you know that, then you start looking for what they gave.
Michael: I got a great chat here. “You guys are awesome. I’m learning so much. I feel much more confident about my ideas after listening to you.” Thank you, Julie. That’s great to hear. We love what we do if you can’t tell. We love the company. We have some awesome employees, by the way.
Toby: Here’s a good one. “If clients did a large conversion of a traditional IRA to a Roth IRA in their 60s,” so it’s taxable event moving it over to their Roth. “will that affect their Medicare premiums? Is it considered to be their pre-retirement income level?”
Michael: The first thing is, let’s look at tax planning. When do you want to do this? Do you want to do it all at once? Do you want to break it over the years?
Toby: I almost never want to do it because the numbers are really simple. If your income tax bracket is going to go up when you retire, do a Roth. If it’s going to go down, do a traditional.
Michael: And also calculations on Part B, too.
Toby: Yeah. The answer to this is yes, it will affect your Medicare premiums absolutely for at least two years. Then you have the five-year look back on Medicaid, too. You’re going to have all sorts of fun stuff that get triggered, but for this realistically, it’s just the income thing. But I don’t know why somebody would do that.
Let’s just say that your tax rate was 20%. Now you’re going to have 80% of the asset to generate income, you’re going to have a 20% makeup, and you’re thinking that my taxes are going to be so bad. I’m taking 4% out over my life. It’s probably going to be about 4% a year that I’m going to have to recognize this income.
The average tax rate drops when people get over 65, significantly. I’m always shocked that people are doing these conversions. In their 60s, they’re probably making good money, unless you have a really compelling reason, like I have a private investment that’s just going to go bonkers, and I think I’m going to be the PayPal guy, and I’m going to make millions of dollars.
Michael: Investors are a little bit of a different breed outside of the normal people, too. That’s tax planning and looking at the big picture.
Toby: Yeah. All right, here’s a good one. “Are there any strategies to mitigate capital gain tax on the sale of vacation homes? Our vacation home is in another state and it’s solely for personal use and never rented out. We’ve owned it for 10 years. Do we have to make it our primary residence for two years before we can sell it and get the capital gain exemption?”
Michael: I’m glad they haven’t rented it out if you’re looking at this now. If you’re going to move back in and all of a sudden you rent it out, now you got the fractional ownership and fraction of tax. That’s my point.
Toby: What would you do? What would you tell this person?
Michael: I’m at a loss here. I think we look at it tax wise or we can look at it from a practical aspect. What do they want to do in their life? Do they want to live there? Do they not want to live there?
I’ve had clients do things from a tax motivation standpoint, that personally, they got into it and then before they actually were able to realize any tax savings, they decided, it wasn’t for us. Sometimes I look at things not only from a tax wise standpoint or a legal standpoint, but from a practical standpoint.
Toby: I’d look at it and say, are you worried that you’re going to sell it and you’re not going to have a capital gain exclusion? If you’re worried, you have personal property, which you’re going to pay capital gains on. There’s no exclusion on it, unless you live in it as your primary residence two of the last five years. What are you going to have to do on a vacation home is you’re going to have to live in that as your primary residence for two years prior to selling.
Michael: If you want to. I mean, it’s a vacation home.
Toby: That’s query number one. Query number two is you make it into an investment property and you 1031 exchange it into something else. Same situation. If you’re going to sell it and you don’t want to pay tax on the gain, assume that it’s gone up in value, we should figure out what that number is and then say, is it so bad that I don’t want to pay the tax on it when I sell it?
The last thing I would look at and say, why are you thinking of selling it? It’s your vacation home for 10 years, you just don’t want it anymore? You maybe want to get a different vacation? Make it into an investment property and borrow against it. Take that cash and go buy something else.
Michael: Actually, I already like that solution right there.
Toby: Yeah, and then you can depreciate it at least. When you die, it steps up, so your kids won’t pay any tax on it if you sell it.
Michael: Great point.
Toby: I always say that whenever I look at capital assets, the best thing to do is just not sell it and borrow against it. That’s number one. If you’re going to sell it, let’s find an exclusion. The best exclusion for personal property, the only exclusion is if it’s your primary residence, you got to live in it two of the last five years.
Yes, you can have multiple properties and qualify multiple properties as primary residence. It’s not in the same year, but in different years. You might say, hey, I don’t want to pay tax. I have a $500,000 exemption if I’m married, $250,000 exemption if I’m single, and I really want that exemption. Okay, make it your primary residence for two years and sell it.
Michael: And make sure you’re going to be there for two years. Your life will allow you to be there.
Toby: Yeah, don’t sell it. Borrow against it. Buy something that you want. Or if you said, hey, but this is a really crappy property, or I would never be able to rent it, great. Rent it for six months and then 1031 it into something that is a good rental if you don’t want to pay the tax.
That’s just me. It always depends. Is the juice worth the squeeze? How much tax are we talking about? $10,000 here? Eat it.
Michael: I love that you’re pointing that out. Again, sometimes people will get caught up in all these tax savings, tax mobilization. Is it really that bad? I mean, you made a profit.
Toby: It depends on how bad it is.
Michael: It depends on how bad it is.
Toby: I’ve learned my lesson. You look at it and if somebody was like, I’m going to sell my house, and it was a California client, they had a million and a half gain. You’re thinking, oh, it’s only long-term capital gains. At that time, it was 11%–12% on the state side, plus the net investment income tax, plus the capital gains. They were 30% something, like a lot. It was 34%.
I was looking at it going, that’s about a half a million dollars in tax, more than that. All we had to do is a tiny little bit of planning and convert it over. Then we could do 121, the capital gain exclusion, and a 1031.
Just that little bit. Giving the client. Hey, for $500,000, would you do this? And they were like, yes. Okay, then here’s what you do step-by-step. But if it was $5000, would you do this? The answer is hell no. I’ll just pay for it. It’s always trying to figure out whether it’s worth it.
Toby: All right, “I’m planning to do a cost segregation study. If I do some cosmetic light remodeling before cost seg, will it generate a bigger benefit or it doesn’t matter? Please advice.”
Michael: Looking at this, in a platinum area, there is a company that we’ve had great success with. I’ve seen a lot of people lower their tax woes and a lot of great things coming out of it.
For those of you who don’t know what a cost seg is, there’s a ton of videos on our site that will go into detail. Basically, it’s breaking out the property, as opposed to the 27 ½ year breaking it out into looking at the different types of property inside the property. There are a lot of great companies that do it. One of them is listed inside of our planning resource.
Toby: Yeah. Cost seg study in English, for someone that’s never heard of it before, when you buy a piece of property, you can’t depreciate land. Land is not going to go down in value. When you buy a property, you can’t take a deduction. Deduction lowers your tax. You can’t take a deduction for land. The IRS allows you to do something really dumb, which is to treat your structure as though it’s 27 ½ years if it’s residential or 39 years if it’s non-residential.
The reason I say it’s dumb is because you have things like carpeting that aren’t going to last 27 ½ years. You have fixtures, you have cabinets, and you have all this stuff. There’s no way it’s going to last 27 ½ years or 39 years, but the IRS says you can use an impermissible method and write it off over a longer period of time.
Michael: Many people don’t know about this, by the way, and it seizes real estate investors too. Shocking.
Toby: What a cost seg is, it’s saying, hey, that carpet is going to last five years, you can write it off over five years. That’s all you’re doing. Hey, that cabinet over there is seven years. Hey, these light fixtures might be seven years. Hey, the driveway is going to last 15 years.
The fence you put in is 15 years old. You put in a bunch of trees, they’re going to last 15 years and you’re writing it off over a short period of time, which means you’re going to have more deductions. Yes. You could do it in year one. You don’t have to do anything special, you just do a cost seg study.
What they’re saying is, hey, I’m going to do some light remodeling. This is the big word, this light remodeling tells me they may get the deduction anyway. What I mean by that is when you better a property, if I fix a roof versus replaced the roof, if I replace a roof on a property, that’s called betterment and it’s going to be 27 ½ years, unless I do a cost seg, in which case, it’d still be 27 ½ years or 39 years because it’s part of the structure.
If I have a hole in it and I fix that roof, I can deduct that repair. There’s a safe harbor at $2500. If you’re doing light cosmetic work, that tells me you’re probably going to get to write it off anyway, but it really doesn’t matter. The cost seg, even if you did it now and then you did the light cosmetic work, you’d have invoices. You’d be able to say, oh, this was for this type of work, I would just stick it in the 7-, the 5-, or the 15-year category.
If you did it before and you did the light cosmetic work, you’re just going to be allocating. The reason this is important, guys, this is the part that people don’t get. If you have property that is 20 years or less, under the Tax Cut and Jobs Act, you can write off 100% of that in year one or whatever year you decide to make the election to cost seg.
You could have a massive deduction. It’s usually 20%–30% of the value of the structure that you can write off in one year. Whether that’s worth it for you depends on your circumstances, but for real estate investors, it’s a very large deduction if you know what you’re doing. Cost segs are worth their weight in gold if you do them right.
All right. I think we’re at the end. We went a little over, about 30 minutes.
Michael: We get two attorneys together and it’s not shocking. This has been awesome. The questions are well-presented. I love getting outside the box. I love what you’re talking about. Yeah, the tax code, but the practical side and how to mend them together.
Our clients are pretty fantastic. We appreciate everybody on here. If you’re not a client, become one. We appreciate you guys and wish you guys the best of success.
Toby: Yeah. I will say this, that if you have questions, by all means, email them into email@example.com. We don’t charge to answer the questions, guys. We’re just going to give you a response. Unless it’s very specific to you and technical, in which case, we may invite you to join platinum. But in any case, we’re not going to do the switcheroo on you and charge an hourly rate on this stuff.
We like getting the questions because that’s where we grab for the events. That’s where we grab the questions when we do the Tax Tuesdays. All of those that were emailed in today came in in the last couple of weeks. We just grab them, throw them up there, and answer them.
At this point, it’s about 400-500 a week that come in and we just answer them. It’s just something we decided to do years ago. People always say, why do you do that? Why don’t you just charge? I said, because we get rewarded for it. The universe is a strange place.
Michael: We got a directive here for Mark. He says, “Have a great time in Hawaii.” I can guarantee we will, but the cool thing is we’re out here with Infinity Investing. The way we structure it, it’s a business trip.
The way I describe it is from about 8:00 or 9:00 until about 1:00 or 2:00 depending on how long the presenters go on Thursday. What do we do? We learn and then after that, we’re free to go about them.
Toby: I just say we goof off.
Michael. I like that one. Friday, when we do it? 9:00 AM till about 1:00-2:00 PM. Then what do we do?
Toby: Goof off.
Michael: Saturday and Sunday, we do not have an event. What we do is excursions. Monday and Tuesday, 8:00 or 9:00 AM till about 1:00 or 2:00 and then we…
Toby: Goof off.
Michael: And then Tuesday.
Toby: It’s a business day. It’s four hours, one minute, and that’s all you got to have.
Michael: One of the cool things is that we’re here with other like-minded people, people that just aren’t in the normal world. We’re the ones that are expanding on making betterment of working hard, investing, and building our businesses. If you haven’t found out about it, learn about it, and join us next year.
Toby: Come do Infinity Investing. It’s free, by the way. We do workshops a couple times a month. The basic membership is absolutely free, too.
Michael: It’s a club of like-minded people. Patty, if you want to go ahead and post a link in there, that’d be great.
Toby: Last thing is thank you to Piao, to Dana, to Matthew, to Kenny, to Eliot, to Michael for joining in, and coming in here, and having to do it with me. I don’t know if there’s anybody else on. I’m sure Patty and Lisa are rolling around out there too. To anybody that helps do these and answers the questions, thank you.
Michael: Troy Butler. Troy’s at bookkeeping.
Toby: Is Troy there?
Michael: Yeah, Troy is out here. Troy, you’re awesome.
Toby: Okay. We have guys that come out.
Michael: Christos, Dutch, Ian. We got the power hitters on here.
Toby: There is a whole crew of CPAs and bookkeepers that come on and answer questions. This is tax season, so these guys are going nuts 24/7. I come in on Saturdays all the time to teach events and I’m shocked at how many people are there. They really do work their katushes off to help our clients and help you guys out. I really appreciate that. We don’t say it enough, but thanks, guys.
Michael: It’s who they are. Just awesome people. Now you can tell it right as I saw the list coming in here. It brought a smile to my face. I appreciate all you guys and everything you guys do for us and our clients.
Toby: Yeah, they’re good. In time you guys have questions, just reach out. We’ll try to make sure we get back to you as quickly as possible and give you some right direction. At the end of the day, all we care about is that as a group, we do very, very well. We’re really, really lucky.
We’d like to share that and get you guys pointed in the right direction because there’s so much bad information out there. We’d like to spread out some tax wisdom to the masses to help make sure that you guys don’t get spun around or have any more anxiety than you need to have on taxes. That is it. Let’s go get out on the beach, Mike.
Michael: Let’s do it. Yeah. Anyway, hey, appreciate everyone out there. Thanks a lot for joining us and we’ll see you next time.
As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, a great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets. One of my favorites as well is our Infinity Investing Workshop.
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