In this episode of Tax Tuesday, Toby Mathis and Jeff Webb of Anderson Advisors provide answers to your tax questions. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- I bought a property in Georgia in 2021, doing renovations and repairs, planning to rent it out in March 2022. I didn’t collect rents in 2021, so, I can’t claim this property on my 2021 tax return, correct? Can I deduct the expenses ahead for renovations in 2021 in my next year’s tax return, 2022? Correct, you cannot claim those deductions in 2021. They don’t disappear, but what happens is the majority of those renovation and repair expenses go into the basis of your property. You will get to depreciate them if you do cost segregation.
- Is YouTube income considered passive or active? It depends on whether you’re passively or actively participating. What matters is a test for material participation.
- I manage properties for a relative as an employee of a C-Corp. During a banking transaction, I personally received the rents through Zelle in 2021, the start of 2022. Those rents were then redeposited into the property owner’s personal bank account. Will I have a problem with my 2021 tax return? Do I need to issue a 1099 to the property owner for 2022? Never accept payments in your personal name that belonged to somebody else. You’re not going to have a problem, but if you did receive a 1099 for this money, then issue a 1099 back to whoever the money was paid to.
- Can you elaborate on revocable versus irrevocable trust from a tax standpoint? A revocable trust is almost like a disregarded entity. It’s good for protecting assets—your estate and so forth—from probate, but you can change it every day if you want. The revocable trust is taxed as though it doesn’t exist.
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Full Episode Transcript:
Toby: All right, guys. You are listening to Tax Tuesdays where we bring tax knowledge to the masses. My name is Toby Mathis.
... Read Full TranscriptJeff: And I’m Jeff Webb.
Toby: We’re going to have fun today going over a bunch of questions. I was just looking through them if you cannot tell if you are not on the title screen when you come in. I like to do things like that. Let’s go over rules because we’ve got a lot of stuff to get over. We’ve got State of the Union tonight. This is going to be exciting. I probably shouldn’t bring out any politics at all because the chat will explode.
Let me know where you’re from right now as you come in here. Just tell me the city and state if you’re willing to. Jeff and I like to see where everybody’s coming from. Let me see how many people are on.
Look at that, Vegas—right at my backyard. Coeur d’Alene, Anchorage, Austin, Minnesota, California, Red Wood. They’re just flying through. Chicago, Miami—I love Miami—Irvine, Sandy, Utah, San Jose, Boise—for real life, military, Boise for life. Grambling—fantastic. Augusta—home of the 288 deductions. White Plains, New York, Pembroke Pines, Florida, Oregon, Atlanta. Bordentown, New Jersey, Carson, California, South Lake Tahoe. Joan Schaumburg—what’s up Joan? I haven’t seen you forever. That would be Doug’s wife.
Jeff: Oh, okay.
Toby: Dougie Doug. We have about 400 people here, 450 of us, but Doug has been with us practically since day one, 1999.
All right. Minneapolis, Minnesota—the land of ten thousand swamps. Don’t candy-coat it, Greg, tell us how you feel. Chico, Saratoga Springs. We got people from all over the country.
“Toby, looks like I will be in Vegas in October. You better be in town.” I’ll be in town for October, I’m sure. The last time you were here, Sherry, I think we went to Battista’s Hole in the Wall. Have you ever been to Battista’s?
Jeff: I have not been to Battista’s.
Toby: It’s a lot of pasta and a lot of lines.
Jeff: Is Sherry nicer to you in person?
Toby: Sherry is always nice to me. She has asked us the […]. They’re good people. We rode motorcycles all over town. We went out to Valley of Fire on the bikes, Red Rock, tried not to get hit by things. Vegas is like you’re taking your life in your own hands when you get your motorcycle out here.
Anyway, they were much better than me. I was driving a 2008 Street Bob and they go cruising on the freeway. I feel like I’m going under every semi because I don’t have a fairing or anything to block it. They’re just zipping through and I’m like […]. I feel like I’m going to end up being somebody’s bump in their thread. All right. Salt Lake City, we got a whole bunch of people from everywhere.
This is going to be fun today. We’re going to go over a whole bunch of questions. Feel free to put stuff in chat. More importantly, if you have questions on your specific situation, I have Dana, Troy, Eliot, Dutch, Ian, Piao. I can’t believe we have this many people around. We’re two weeks away from a major deadline. Christos, Matthew, Ander, and Patty.
Is that 10 people? We’ve got 10 people to answer questions. Not all of them are accountants. We got some tax attorneys and a bunch of accountants in there. Got the head of our bookkeeping department. If you have questions, today’s the day to ask them. If you have some stuff out there that’s a burning question, get in there. I see Ian typing right now, Christos, they’re already pumping through questions.
We’re not going to send you an invoice. Everybody says why do you do this? Because we’re weird. If you have other questions during the week just send it in via taxtuesday@andersonadvisors.com.
Here’s what we do. If you ask a general question, we’ll answer. If you ask very specific questions, then we’ll just make sure of your client first. It could just be as simple as being a platinum client, $35 a month, and our guys will get back to you and answer. We are that free with our stuff. We figure it’s hard enough, a lot of people play hide the ball, and that’s frankly how accountants and attorneys have made their living over the years, but we don’t do that. It’s not as much fun.
All right. Let’s go over the questions. Opening questions. “I bought a property in Georgia in 2021, doing renovations and repairs, planning to rent it out in March 2022. Because I didn’t collect rents in 2021, I can’t claim this property on my 2021 tax return, correct? Can I deduct the expenses ahead for renovations in 2021 in my next year’s tax return, 2022?” We’ll answer that.
“Is YouTube Income considered passive or active?” Great question. A lot of people are making money on YouTube. I’m going to pimp my YouTube channel. I’m going to give you a link at some point and say please subscribe because I’m behind Clint, and he’s got way more than I do.
“I manage properties for a relative as an employee of a C-Corp. During a banking transaction, I personally received the rents through Zelle in 2021, the start of 2022. Those rents were then redeposited into the property owner’s personal bank account. Will I have a problem with my 2021 tax return? Do I need to issue a 1099 to the property owner for 2022?” We’ll go over that. 1099 are always funky. I don’t think he said he got a 1099. We’ll go over that one here in a little bit.
“I’ve been filing my taxes on Schedule C and all my business income is loan interest from private lending.” Schedule C is a sole proprietorship. “My first year 2020 was a net loss. This year 2021 and hopefully all future years I’ll have a significant profit. If I continue to report the interest income as gross receipts or other income on Schedule C, am I assuming I have to pay C taxes on the profit? I’m thinking maybe I should report the interest on my Schedule B and my expenses on Schedule C. What are your thoughts? Should I be paying a C tax on interest income?”
“Can you elaborate on revocable versus irrevocable trust from a tax standpoint?”
“How can I actively participate in my short-term rental while maintaining a W-2 job?” Great questions. Great questions so far.
“If I use a property management company for short-term rentals,” short-term rentals is just Airbnb guys, “somewhat practical due to distance from the property, does this automatically exclude me from demonstrating material participation? Or are there other test activities that could demonstrate material participation beyond a property management company assisting?” Good question.
“My husband receives guaranteed payment shown on a K-1 as a limited domestic partner of an LLC. He is taxed as a sole proprietor. To lower taxes, can he create an S-Corp for his guaranteed payments and still be a limited domestic partner of that LLC?” Again, really good questions. We’re getting hammered now with questions. We’re probably getting 500 a week, but we’re seeing the types of questions you guys are asking versus years ago when we started this, a few years, five, six, seven, whatever the years ago it was we started doing Tax Tuesdays, it’s pretty amazing.
“We hear residential homes exception is $250,000 for singles. If I buy three houses this year, I will stay in the first house for two years, stay in the second house for two years, and live in the third house for two years. In the fifth year after buying the first house, sell it, and use the $250,000 exemption. In the fifth year after buying a second house, sell the second house and take $250,000. In the fifth year after the third house, take $250,000. Residential home exemption assuming profit of $250,000 for each house on sale. Would this work?” Really good question. We got the map of that one out. Might have to write it out.
“My company is based in the US. We have a customer from Thailand. My supplier is from Honduras. I have an American account. I would like to know how to pay my supplier. Do I withhold taxes? They are not residents or citizens of the USA.” Really good question and not asked enough to those of you guys out there.
Last question, it sits on its own. “I am looking to learn about the small landlord exemption which allows small landlords to deduct real estate losses from their W-2 income. I’m trying to figure out if I qualify for that.” We will make sure that you understand the rules.
All right, so we are going to get started. Before we do that, by all means, jump on and subscribe to YouTube. If you like Tax Tuesdays, I’ll probably put out 2–3 videos a week now on my YouTube channel. A lot of it, you could actually see some of this stuff here depending on the topic. Obviously, some people like it, some don’t. There are a lot of them that are really easy questions that you can just go Google in there and find out whether somebody asked it before and we answer it. Then you can always put in things that you want us to do videos on. We love doing it.
I like doing it and I’m trying to build up the YouTube thing. I don’t know why. Clint was way ahead of me on that one. I used to have a channel. It was another company, we merged it into his, and then he kind of was doing his own thing. I said we’ll make a second one not realizing how far ahead he was and then he likes to remind me. He’s like hey, I have like twice as many people as you.
Jeff: I have a good sense of why you’re producing more videos.
Toby: Hey, we’ve been partners for a long time. We’re slightly competitive, but he does a great job on YouTube. I said hey, I’ll come join you so you guys got to help me, please.
“I bought a property in Georgia in 2021, doing renovations and repairs, planning to rent it out on March 22. Because I didn’t collect rents in 2021, I can’t claim this property on my 2021 tax return, correct? Can I deduct expenses ahead for renovations in 2021 in my next year’s tax return, which would be in 2022?”Good question. Jeff, what do you think?
Jeff: You’re correct that you cannot claim those deductions in 2021.
Toby: Do they just disappear?
Jeff: No, they don’t disappear. Actually what happens is the majority of those renovation and repair expenses are going to go into the basis of your property. You will get to depreciate them if you do cost segregation. I’m sure this will come up again. You’ll be able to possibly carve out some of these deductions.
Toby: Is that called placed in service? Is that what they refer to?
Jeff: Yes, placed in service means it’s available for rent.
Toby: It will be placed in service in March of 2022. Everything they’ve spent up to that point is just going to land in 2022?
Jeff: Yeah, there’s a possibility that there are some true repairs in there and you’ll be able to write those off in 2022.
Toby: How about 2021?
Jeff: 2021, no.
Toby: What about property taxes?
Jeff: No, you basically can’t write off anything,
Toby: It’s just considered personal property? I think they would get the taxes, insurance, things like that.
Jeff; They could technically write off the taxes on their Schedule A, which is probably not going to do many.
Toby: Okay, so that’s considered personal because it’s not invested yet. It’s basically personal property. Otherwise, you lump it all into 2022?
Jeff: Yes. The whole thing is not considered a rental property because it’s not available to rent.
Toby: If they had purchased it in 2021—this is a planning tip—and they had just rented it out a few times, what if they just made it a short-term rental?
Jeff: They could have done that. We’ve had clients do that where they start off as a short-term rental and then convert it to long-term.
Toby: They put it into service, make sure it’s an investment property, then fix it up and put it back in a rental property. Can I depreciate? Are we going back to day one?
Jeff: As soon you’re […] the rent short-term, yeah.
Toby: It makes sense, guys. When you’re buying properties that you’re going to do a rehab on, you might want to buy properties that are already rented that are getting close to the expiration of their lease, or put it into a rental pool for a period of time to make sure it’s in service.
Even if it’s just, hey, I’m just going to put it out there for a year and I know I’m going to have to fix it up, because you get such a better deduction. That’s only if you have a tax appetite. If you don’t have any passive income and you’re not a real estate professional, you don’t qualify as an active participant, then it’s no harm, no foul.
Jeff: We’ve had this come up that as we said, we started out we weren’t short. Short-term rentals are Airbnb and such. I go ahead and cost segregation while it is a short-term rental.
Toby: First off, I love that. What Jeff is saying is, let’s say you bought it in 2021 towards the end of the year. You rent it for average use of seven days or less. That’s considered an ordinary loss. If you are the one handling the rentals—I say rentals, the Airbnb, the short-term rental—and you’re materially participating, those losses actually become active or non-passive and offset all your other income. It can offset your W-2 because it’s not a rental. Just to be clear, seven days or less is not rental activity. You’re basically a hotel, it’s a business.
You could do a cost seg which is breaking down that property. It’s a much smaller basis. Then when you improve it the following year, you can do the exact same thing with that because you’re going to have the invoices. It’s really easy to say hey, this is all stuff that we added in. You can tell which property is which.
Jeff: Especially when you’re considering something like a kitchen or bathroom tear-out. A lot of it you’re going to be able to deduct as bonus depreciation.
Toby: You could get a nice, big, fat loss if you do that if you keep it as a long-term rental. Again, if you create a loss, it may not be used by you. You may have passive loss, which cannot be used against anything other than passive income. Unless I have a whole bunch of other rents, I’m just going to have a loss that I’m carrying forward so it doesn’t really do me any good. Or maybe I’m on a lower income and I don’t really want the loss. I’m looking at it going, I’m making $75,000 a year, do I really want a $30,000 loss? Maybe not. I’m in a low-enough tax bracket, which does not hurt me, and I plan on making more so I might save it.
Those are your choices. That’s the whole thing with tax planning. As you’re making which way should I go, it’s going with your eyes open. The calling of this question is really what can I do? I don’t get to claim the property. Technically, you can claim some things on your personal return, but probably the better route is just to add everything to basis and do it in 2022.
Wow, this is the shortest question I think I’ve ever pulled out of there. “Is YouTube Income considered passive or active?”
Jeff: It depends on whether you’re passively or actively participating. What we’re talking about is material participation. I’ll give you the easy test, there’s actually test two with substantially all the activities performed by me.
Toby: My YouTube channel, for example, that’s going to be active forever because I’m producing it all on video. We have a whole bunch of other people there so it’s not just me, but I’m involved. I’m materially participating.
How could I not participate? Maybe if I’m a silent owner in a business and that income comes in and flows through to me. Maybe you’re in a partnership or an S-Corp and you’re not materially participating. You’re just for the money person and you have a YouTube channel for your business and incomes flowing through. That would be passive because you’re not a material participant.
Jeff: I guess you could be the pretty face and somebody else is actually doing all the research and the work and they’re just handing you what to read on the screen.
Toby: I always look at this, because this is one of those weird areas where I tend to look at royalty income as portfolio income, and you’re looking at it saying it’s not. It’s never subject to self-employment tax, just the royalty unless I’m the creator. Sometimes I don’t put that caveat on there unless I’m the one who’s doing something. If I write a book and I’m getting a royalty stream, that’s going to be active income.
If I create some code or something, and somebody uses it down the road, they have to pay me a royalty for it, in that case it is probably passive. If somebody is using my patents or something, then imagine I’m going to get something different. If I buy an asset that has royalties like I buy a music library, wouldn’t that be passive? Not passive, but a portfolio.
Jeff: One of the things you need to consider, and this kind of goes back to the other question about do I want my income to be active or passive? If I have rental properties showing losses, then I want some passive income.
Toby: Yup, but this isn’t passive as a portfolio wouldn’t be passive.
Jeff: I’m referring back to YouTube.
Toby: Even if I buy a music catalog and it’s producing portfolio income, that’s interest income. That’s not technically passive. If I am an investor in a business with you as a partner, but I don’t do anything, and it’s kicking my income or losses, that would be passive.
It’s kind of weird. The waters always get a little bit muddy. That’s why you want someone that’s kind of navigating and sometimes it’s facts and circumstances you’re looking at. What did you do? What was your involvement in this thing?
Jeff: That is actually the last test on the material participation test—facts and circumstances.
Toby: Jeff likes to be a CPA and he likes it. It is the material participation, facts and circumstances. That’s number seven, right? There are seven different things. I never get past the first three. Then there’s a whole bunch of crazy ones, but facts and circumstances is the last one for material participation.
The other thing you could do, and you’re going to see this pop-up and a lot of things, is it’s not so much is it passive or active. It’s whether it’s going to be subject to self-employment tax. Active involvement, material participation is going to subject you to tax under old-age, disability, survivors, and Medicare, which is going to hit you at about 15.3%. It phases out at $147,000. I think it’s 47-ish this year, a portion of it is. You get hit with this extra tax, which is not insubstantial, it’s a pretty big hit.
The way to avoid it if you’re doing YouTube or anything where you have income that is borderline, is it active? Is it just regular? Ordinary? Put it through an S-Corp. Make sure that you have an LLC taxed as an S-Corp or just an S Crop. Then if you’re making that money, you can take a small salary for whatever it is you’re doing because you might say hey, I barely did anything. I did a couple of YouTube videos, it took me all of 10 minutes, and I got this great response. I have this big following and I’m making good money, monetizing it, just letting YouTube run ads on it. Why do I have to pay this extra tax?
This is the easy way you say hey, you worked three hours, I’ll pay you $200 an hour so pay $600 bucks. The rest of it, there’s no self-employment tax, no FICA, no Social Security, whatever you want to call it.
Jeff: We’re seeing gamers making millions of dollars just sitting there playing their games, but bringing money in from advertising from their followers. You don’t want to pay more tax on that than you have to.
Toby: We have folks that make $3 million a year plus doing marketing, advertising, doing clicks, they create funnels, and they really don’t do anything. It’s not even their product. They’re getting paid for having built the funnels and they’re always like that, but I don’t do anything. I’m like I know you don’t do anything except you’re smart and you’ve figured out how to build these funnels. Now you’re sitting back, let the money come in. That’s another way you can turn that into something that’s not subject to self-employment tax.
Usually in that case, if you have millions, we’re dealing with different types of vehicles—you’re going to be using a C-Corp or foundation, more likely—probably defined benefit plan, probably a 401(k), you’re using other tools that are in the toolbox, maybe a conservation easement, depending on what type of activity you’re in.
You might even be doing captive insurance. You’re going to be doing some other things. It always comes back to the ground to this thing of like hey, do I want to get hit over the head with an extra tax on that first chunk of money I’m making? No. Let’s see if we can avoid it. An S-Corp will usually save you somewhere in the $10,000 a year range if you’re making $100,000 net. It’s a pretty potent tool if you know how to use it right.
“I manage properties for a relative as an employee of a C-Corp,” Cool, you guys are doing it right. “During a baking transition, I personally received the rents through Zelle in 2021, the start of 2022,” Somebody paid you instead of the C-Corp. “Those rents were then redeposited in the property owner’s personal bank account. Will I have a problem with my 2021 tax return? Do I need to issue a 1099 to the property owner for 2022?” Jeff?
Jeff: Let me get on my accountant soapbox. First off, never accept payments in your personal name that belonged to somebody else. Never ever. I completely trust you did the right thing where they’re supposed to be. It’s the whole perception.
Toby: They Zelled you, they threw it right in your account. What are you supposed to do?
Jeff: Give them the correct information after the first time they do that?
Toby: Yeah. Okay, so they did it once?
Jeff: No, they did it for 2021 and 2022.
Toby: I personally received the rents. Oh, so maybe they did it more than once. I thought it was once.
Jeff: Anyway, will this cause a problem with your tax returns? Something you said when you were first reading the questions was did you receive a 1099 from Zelle?
Toby: That’s what I was looking at because Zelle’s now reporting. PayPal and all the platforms are now issuing 1099s.
Jeff: You’re not going to have a problem, but if you did receive a 1099 for this money, I would issue a 1099 back to whoever the money was paid to.
Toby: Two ways to do it. Venmo, yes, somebody is asking about Venmo. Zelle, Venmo, GoFundMe, if you received money everybody thinks it’s charitable. Yay. No, it’s not a charity. GoFundMe is not a charity. You’re going to get hit.
I have a problem with my 2021. It depends on whether you got the 1099. If you did not get a 1099, no issue. You just say, hey, as long as the employer or your C-Corp is collecting the information and reporting it, they are required to report it whether they get a 1099 or not.
If you did get a 1099, then you have two choices. You call up Zelle and say, hey, you need to switch the information on the 1099. If they won’t do it, chances are you’re doing a Schedule C, showing the income with a corresponding deduction for the exact same amount. You’re zeroing out a Schedule C and paying it over to the owner.
Jeff: A little note on these Zelle, PayPal, Venmo, and all of these. It’s only supposed to be for business transactions. What you’re primarily looking at is whether or not you have a business account. If it’s money you just transfer back and forth, like I had doing transfers with my sister, then they’re not going to 1099 for that kind of thing based on what type of account I have.
Toby: Correct. I wouldn’t be betting against them doing weird stuff. At the end of the day, you have choices and how you want to deal with it.
Jeff: Don’t sweat it.
Toby: Somebody says, “Zelle isn’t doing the 1099 thing, FYI, since direct transfer from the bank. Venmo and PayPal, yes though.” You guys are getting me. Zelle apparently is not the subject. I thought Zelle was.
Jeff: I had heard that they were not going to do that, which kind of surprises me.
Toby: Maybe they do, maybe they don’t. They said it’s a direct transfer from a bank.
Jeff: The banks run Zelle.
Toby: Yeah, but it’s still me paying something to somebody. We’ll see. I have a feeling that they’ll end up reporting someday. Maybe they will.
“No 1099? Easy. Get 1099? Might have issues. If you do get a 1099 ever mistakenly or you’re supposed to get paid $10,000 and they put $100,000 on the 1099 do not just say they screwed this up, I’m going to report the $10,000. You call them up and you say you need to reissue the 1099.
If they won’t reissue the 1099, then what I would do is whatever you received goes on your return. If it’s $100,000, you never received it. You put $100,000 with a $90,000 deduction next to it with an explanation. I never received $100,000. I actually received $10,000, this was to make the numbers right.”
Jeff: That’s a great point, don’t ignore those 1099s because you will get a notice.
Toby: It’s the easiest thing. Right now, they’re just going to pop it out. Hey, I got a 1099 that Jeff has on his return that he never reported. It’s really easy for them to say oh, this doesn’t match. We’ll just add it to your return and send you a bill. They’ll say hey, they have the right to do your return for you. You forgot this, Jeff. Here, let me send you a bill with some interest and some penalties.
“I’ve been filing my taxes on Schedule C,” it just means a sole proprietor on your 1040, “and all my business income is loan interest from private lending.” They’re hard money lenders, which used to be like this crazy thing. I always thought hard money lenders were like sitting in the back of a bar, breaking your kneecap if you didn’t pay it back, but now it’s more common.
“My first year 2020 was a net loss,” so they lost some money. “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 have to pay taxes on the profit. I’m thinking maybe I should report the interest income on Schedule B and then my expenses on Schedule C. What are your thoughts? Should I be paying C tax and interest income?”
Jeff: You’re reporting correctly. I’m assuming that also you’re doing this money lending, so they’re holding this LLC out to be a money lender.
Toby: You’re a trader at that point.
Jeff: Yeah, you don’t want to put it on Schedule B because if you do that, you can’t put your expenses on Schedule C. It’s now investment expenses and most of them won’t be deductible.
The other problem with that is if I’m reporting an interest on Schedule B, I’m saying it’s an investment. If somebody burns me on the loan, I have limitations on how much I can deduct.
Toby: If you’re a business, you get a whole bunch of other deductions. If all you’re worried about is the S/C tax, there’s the easy fix. S-Corp. Make it the S-Corp, pay yourself a small salary. If you’re going to pay yourself a small salary and it’s your business, and this is your income, put a 401(k) on it, defer a big chunk of it. You can defer $19,500 if you’re under 50. Is it 50 or over or over 50?
Jeff: Somewhere around there.
Toby: I always forget. I think it’s when you’re 50 or over, then you could put another $6500. You could put $26,000 of your pay directly in there, then the business can also contribute an additional 25% up to, I think, it’s $61,000 this year.
You could put a lot of money aside if you want to in a retirement plan. But the point is that that’s the only money that you’d have to pay the self-employment tax on, which would now be employment taxes because it’s an S-Corp and you’re an employee, as opposed to a Schedule C where you’re the business. You’re not an employee of your own partnership or your own sole proprietorship.
Jeff: S-Corp was the first thing I thought of when I read this question.
Toby: I kind of looked at it, too. Here’s the thing. People get confused in this and accountants get confused on this. You have portfolio income, you have passive income, and then you have active ordinary income. You can turn any of those into active ordinary income if you make it into a trader business.
Real estate is the prime example. Everybody’s like, oh, no, it’s capital gains or it’s passive and it’s like, no, if you’re flipping a property, everything you do is active ordinary income. Oh, it’s rental, it’s Airbnb. No, if you’re doing Airbnb in seven days or less, it’s not rental income, it’s active ordinary if you’re materially participating. So there are all these things.You can make interest income, royalty income, capital gains. You can make all of that into ordinary income if you’re not careful.
Other than stock trading, that’s the only one where they didn’t really codify it. You act as a trader that for whatever reason, if you qualify as a trader, they don’t make you pay self-employment tax. But then again, almost nobody qualifies as a trader. It’s fun to watch and try, though.
Jeff: What’s crazy about trading is not doing it individually. But if you’re investing like a private equity fund or something like that that does trading, that’s considered trader business income, usually.
Toby: Yup, but when you do it for your own account and you’re making the mark-to-market election, you’re doing all this craziness which we don’t subscribe to here, then you put your expenses on Schedule C with no income, and your income on Schedule D, and you’re like, yes, I just avoided self-employment tax.
What you just did is said to the IRS, please audit the crap out of me. It’s like you couldn’t wave a bigger red flag. You always see those people just get torched. Famous last words, but I was a trader. No. IRS always seems to find a way around it. Even when they make you a trader, then they find that you didn’t do the mark-to-market, so they’re like […].
Jeff: The thing I see what the trader status mark-to-market is they find a number of different ways to attack you.
Toby: And then they just have to win on one. They might have 10 arrows they could shoot at you, and you’re like, but I managed to avoid nine of them. You got a big arrow stuck in your head. This is fun. I have a bunch of red dots. It looks like I have prepubescent slides here.
Learn the Infinity Investing steps to build long-term wealth. We have the Infinity Investing workshop coming up on Saturday. It is a lot of fun. If you guys want to learn how to make money, basically we just sit here and we look over returns of individuals that make money. We’ve been doing this for 20-something years. You’ve been doing this for how long?
Jeff: Thirty something.
Toby: Thirty something. Forty?
Jeff: No.
Toby: Getting close. The fact that you even used that, that was like the 80s, so I guess you could. Anyway, come to the Infinity Investing Workshop. We work with great real estate investors.
By the way, I never tell you guys who’s going to be there, but the speakers that I’m always there and then Nicole DiBraccio. She was season six of the apprentice, she got to the final, and she got fired. She was the last one fired by the Donald on season six. Wonderful, wonderful.
She and her husband are down in Winston-Salem right now working with us. We have several hundred properties down there, just doing a great job, and she always comes in and goes over real estate. And then PO Washington who’s in our offices here. She oversees basically all of our investment folks.
She’s in charge of all the education that goes on that side and does a great job of teaching the basics of the, she calls it the BRRRR Method for trading. I still use stock market landlord. I like to make money in multiple ways in a portfolio. It’s never been more important if you don’t like to watch the 700 point declines, or 800, or 600, depending on what the day is, and then the market is going this way and that way.
If you want to quit thinking about it, just rent it out, and rent it once in a while, and then just forget about it. I would say one of the best ways to make money in the market is to open up an account, fill it with good companies that you really like, like, I’m drinking a Starbucks, I’ve been drinking this since 7:30. I’m getting closer. I know it’s kind of gross. I just sip.
Good companies. You fill it full of good companies and then you lose your password for about 10–20 years. Then when you come back and you finally remember, hey, I opened up this account and I filled it with some really good companies, you’ll be surprised at how much it’s grown. That’s what I’ll say, at least.
Just know, it’s Saturday, March 5th. By all means, come. It’s absolutely free. We go from 9:00–4:00. You’re going to learn stock market landlord and the real estate side. Especially in real estate, we’re laser focused on mobile, manufactured shared housing this year. We’re underbuilt by about 3½ million units for low- to moderate-income housing. So if you’re under $75,000, you’re being really hit hard by the increase in real estate expenses, especially folks that are renting.
There are some really unique approaches that are good for guys like us to implement people like us. Really hard to do for the big institutions because they always have to be so cognizant on getting that little bit of return out to their investors, so there is so much stuff.
Anyway, I think it’s going to be pretty amazing what we’re going to see over the next two or three years. Everybody’s saying, hey, when does the bubble burst? I’m like, I can’t see it.
We’re underbuilt. We haven’t been keeping up with the population growth. We’ve been focusing really high on the higher-end stuff. We’ve seen just this radical growth in the cost of real estate inflation. Maybe if they raise interest rates, but it’s not going to be anytime soon, and they get it up there in that 3% range, which I think would take three years, at their current pace it’s never going to happen.
I just don’t see it. There’s too low of inventory, too much need, and we just really have a serious issue for lack of housing for a lot of our population here. My personal view is that you’re going to see these areas continue to be really, really huge. I also think the shared housing. I really think the shared housing is going to be something to watch, especially in the denser areas.
But anyway, we love real estate. I’m a real estate investor for years and years, several hundred properties. Me and Clint love to buy things. We’re not really good at selling them, but we do like to accumulate. It’s great to have that passive income because long-term rental income is passive.
“Can you elaborate on revocable versus irrevocable trust from a tax standpoint?”
Jeff: A revocable trust is something that’s almost like a disregarded entity. It’s good for protecting assets—your estate and so forth—from probate, but you can change it every day if you want it. What’s in, what’s out. The revocable trust is taxed as though it doesn’t exist. If I set up a revocable trust, say, a living trust and put all my assets in there, all the income that it’s being generated through there is still going to be taxed to me personally.
Toby: It’s a grantor trust and they just ignore it. If you’re a living trust, they always say, what kind of return do I file? You don’t, as long as the grantor is alive. Grantor passes away, it becomes an irrevocable trust, and then technically, you have a trust return requirement unless you distribute all the assets. Even if I distribute all the assets, I’m probably just showing a zero return at 1041?
Jeff: Yup.
Toby: In some cases, you don’t have to file one at all.
Jeff: When we talk about the irrevocable trust, you have actually given your property away. My mother had this with the farm and I had a hard time explaining to her that you don’t own the farm anymore. It’s not your property anymore. It belongs to the trust, then after that, the beneficiaries of that trust.
Toby: And just to make your head spin a little bit, an irrevocable trust generally has a tax return, unless you make it effective for tax purposes. It’s called an IDGT. If an accountant goes, inapt, adapt, and IDGT, they use something that just sounds kind of funky, what they may be saying is, I drafted it for other purposes than taxes and I made it ignored for tax purposes. It’s a grantor trust for tax purposes.
Wyoming statutory trust, Nevada asset protection trusts, Delaware asset protection trust, a lot of these are set up as IDGTs, where they’re not for taxes.
If you’re setting it up to get something out of your estate, like you’re doing an irrevocable life insurance trust, you’re doing a charitable remainder trust, you’re doing an asset protection trust that’s a true spendthrift so it’s non-self-settled, you have somebody else managing the asset, you have no claim to those monies, then it could be doing its own tax return.
At that point, you have two choices. If you have capital gains, you can apply it back to principle. Quite often, you don’t have to pay tax on it. It’s actually quite kind of wild. Or I distribute it out to the beneficiaries, in which case, I get to deduct that, so I may not have any taxes.
I don’t want to get too deep into it because they’ll make you guys’ heads spin. All trust, you got to look at the actual terms of that agreement and what it’s set up to do. A land trust is just a grantor trust that is set up to hold title to a piece of property. That’s all it is. It doesn’t file a tax return, nothing. A living trust is just a grantor trust set up to cover me while I’m alive and then spring into becoming irrevocable when I die.
Jeff: I want to point out one important difference between revocable trust and irrevocable trust. If I have a property that I paid $100,000 for, it’s now worth $500,000, if I put it in the irrevocable trust, it is a gift to that trust, and that trust takes it on at my basis, which is $100,000. If I put it in my revocable trust and then die, you get a step up to the $500,000.
Toby: That’s a big one. From a tax standpoint, when it transfers in. I could still do an irrevocable. Not to contradict you, but we could goof around and we can make it irrevocable, but we could still make it effective for tax purposes if we don’t care. That’s where attorneys get annoying because we can make these things, like you hear these SLATs, GRATs, DINGs, which is, there’s domestic income non-grantor trusts.
You just have an irrevocable non-grantor trust goofy stuff out there. We always name them. What is the 1041 tax return? It’s a return for a trust. It’s a trust tax return. Is that complex trust when it’s doing its own taxes?
Jeff: No. Simple trust as when it’s required to distribute all the income to the beneficiaries complexes. It just means discretionary.
Toby: It means that the trustee gets to decide whether you get anything. Mostly, when you’re setting up an irrevocable trust that is not effective for tax purposes, it’s going to be a complex trust. That’s what the people that are playing the tax evasion game sometimes set up and they go, complex trust, you don’t pay tax on it. Yeah, you still do, but they get to make that argument.
Usually, when they make that argument, they’re like this, but it’s not taxable. All right. We can’t make fun of those folks. We had one in Vegas. They were paying everybody in gold coins because it was a currency. It’s like, the creative will give them that.
“How can I actively participate in my short-term rental while maintaining a W-2 job of that or an LLC of that, or LLC of that LLC?” I don’t know what that last part was, but I just grabbed their questions.
Jeff: This is actually pretty simple. It is a business, so you don’t have to worry about all the long-term rules. If you do at least a hundred hours of activity in the rental and nobody is putting in more hours in you, then you’re materially participating.
Toby: It’s actively participating here, though.
Jeff: Actively participating really doesn’t have any meaning in this. It’s a long-term rental.
Toby: If the short-term rental is seven days or less, then you have two choices, you’re material or you’re not. That’s probably what they meant. Active actually has another meaning for rental. It’s one of the two exceptions to the passive activity loss rules, but you can do both.
I interrupted you when you’re going through the material participation. What are the big ones that you…?
Jeff: The big one is, is it the 750 hours or is it the 500?
Toby: Not as real estate professionals. It’s 500 hours if you and your spouse together manage your properties. If you’re involved in the day-to-day operations, then you can even add in your investment activities with those properties and with your grouping of all your properties. You go to a guy like Jeff and say, make sure I group all my properties together. That’s another way that it can’t screw this up. But if I manage it myself, even if I have a W-2 job, I am automatically a material participant.
Jeff: You don’t even have to meet the hundred hours. If you’re doing all the work yourself, you’re materially participating.
Toby: If you’re not doing all the work yourself, you have to hit a hundred hours as long as nobody else is hitting a hundred hours. It’s the individual, not the organization. If you have a property manager, you actually have to say to him, can you guys track your time on my properties? I need to know who’s doing what and how much time.
They come up and maybe they have 20 hours here, 20 hours there. You hit a hundred hours between you and your spouse, you’re materially participating. Even if you have the property outside of your geographic area, it is possible to be a material participant. It’s just, you better make sure you have good records.
Jeff: One of the tests—this one’s always made me a little crazy—is I’ve materially participated in 5 of the last 10 years.
Toby: Those are the ones that I try not to pay any attention to.
Jeff: I was a partner in a firm for the last five years. I retired and I’m still drawing money from them. I’m still actively participating, even though I haven’t shown up at that office.
Toby: You are a material participant. Anyway, “How can I actually participate in a short-term rental while maintaining?” Yes, you can do that. You don’t have to have an LLC or anything. It’s just your activities and it’s you and your spouse.
Again, this is not the same thing as real estate professionals. This is just, am I a material participant on my short-term rentals?
By the way, I’m going back to that. If you do this, and you also have other properties that are long-term, and you’re trying to make real estate professional status, you can’t use the time that you’re using on your short-term with the long-term. The way that you could is if we did throw a corporation in the mix, do the short-term rental, and we rented the property to the corporation on an annual basis, then we could. But otherwise, no.
Again, not for shameless plugs, but this is why you talk to an accountant like Jeff, or somebody on our staff to see what those rules are, or if you have a good investor. The only thing I say about accountants is make sure they’re doing what you’re doing. If you’re going to work with people, make sure it’s a friend that does real estate investing. Don’t be the one off or don’t make mistakes. There are too many nuances here.
“If I use a property management company for short term rentals, somewhat practical due to distance from the property, does this automatically exclude me from demonstrating material participation? Or are there other test activities that could demonstrate material participation beyond a property management company assisting?”
Jeff: That’s what we were just talking about. If you’re a distance away from your rentals and you have a property manager, I think it becomes harder and harder to meet those tests.
Toby: You still have the same tests, the three that we focus on. You manage all your properties and nobody else does. I think the term is substantial service. Here, if you have another property manager, you throw that one out. I do 100 hours and nobody does more time.
There’s actually a court case, where an individual and his spouse owned property in another state. They would drive to the short-term rentals, and they would say they’re working on this, that, or the other. The court did not believe the numbers they were throwing out there. They said there was no record-keeping by the manager of their time, and therefore, we don’t believe you. We don’t have any data from the property manager, so voila, you don’t need the material participation because we didn’t find you credible, because they were doing stupid stuff.
You could still do it, but you have to ask your property manager to please track their time. Whoever’s working on the property, please track your time. If it ends up being five hours a month or whatnot, as long as you hit a hundred hours, you’re okay.
How do you hit a hundred hours? It has to be in the active management of those companies, unless you’re involved in the day-to-day operation of that thing, which you’d have to be working hand in hand with that property manager on those numbers. Otherwise, it’s only when you’re actively managing. Really tough to do.
Last way is the 500 hours, in which case, if you’re doing 500 hours and you have other short-term rentals, again, your short-term rentals are not your other rentals. Short-term is just your hotel. Your hotel hours would have to equal 500 hours. You have to have a bunch of other properties that are short-term and you’d have to be treating them all short-term. You cannot do this and add that in with your other real estate.
If you don’t think you’re going to make it, then what you do is, again, you set up a corp—S-Corp, C-Corp, LLC taxed as an S-Corp or C-Corp—and you rent the property to them and let them be the host that then employs the manager. Now we’ve made it passive again and you could wrap it all up with your other properties to meet material participation. You’re probably, at that point, going for a real estate professional. One of the spouses qualifies under the first prong of 469(c)(7), which is 750 hours more than 50%.
Jeff: My personal feelings with I’m qualifying as a real estate professional for my long-term properties, I’m not doing any short-term rental on my name.
Toby: I don’t want to do short-term rental on my name. I’ve seen too many bad problems. You’ve had deaths, you’ve had people fall off the things, you’ve had parties. A lot of people here in Vegas, for example, these houses were party houses. I don’t even know how many issues there were, but there were shootings and all sorts of stuff in California. You have all sorts of liabilities that come along with short-term rentals.
For the most part, they’re pretty benign. You’re up in the wine country, you don’t really care. Everybody’s pretty mellow. But every now and then, you have somebody that does something dumb. You don’t want to have that come into your personal realm.
From a tax standpoint, you just want to realize that there’s a big difference between 7 days or less and everything else, 30 days or less if you’re doing way more for those people. Still, you can be an average tenant, like an average guest stays for three weeks. If you’re driving them around and doing tours or anything else, there’s a good chance that you’re no longer a rental that’s actually active.
Jeff: What do they call it, extraordinary services?
Toby: Substantial services.
Jeff: Okay.
Toby: You’re right. Extraordinary is over 30 hours and then the other one is, gosh, I forget the term. It might be substantial services, I always forget.
Jeff: If you’re running a drug rehab for celebrities…
Toby: Drug rehab for celebrities is never going to be a rental. Platforms, never going to be rentals. All these, where you go out into the wilderness, and stuff, and you’re out on somebody’s property, and you’re learning to overcome your fears, no. Outward bound and stuff like that, those are not going to be rentals. That is just incidental to the other […]. You get your cabin because incidental to something else.
All right, let’s keep going. Lots of ways to get more information on these and other topics. Go to our YouTube channel again. We also put our podcast. We bring a lot of our stuff. A lot of the content that Anderson does, we put into a podcast format, including tax Tuesdays. We break them into bite-sized pieces. I think right now we’re just doing two pieces.
We used to do these for an hour and a half and two hours every time. You guys go to the podcast and it’s absolutely, absolutely free. If you’re a platinum member, you can always go back and look at it.
“My husband receives guaranteed payment shown on a K-1 as a limited domestic partner of an LLC. He is taxed as a sole proprietor. To lower taxes, can he create an S-Corp for his guaranteed payments and still be a limited domestic partner?”
Jeff: A short answer is no, he can’t do that. The guaranteed payments to the limited partners are usually paid when they’re doing work and it’s their share revenue or something like that. Like I went out and sold something for my company.
Toby: This is what’s weird. It says an LLC, and then it says he’s a limited domestic partner, and he’s getting a guaranteed payment. I would say first off that he’s not a limited partner because he’s materially participating, he’s getting guaranteed payments. Unless he’s not doing anything for the guaranteed payments, in which case, I’d say they’re misclassifying it. It’s actually a preferred return.
Let’s assume that they’re doing it right. They’re paying him for stuff he’s doing. You could actually make that into an S-Corp, his interest and avoid the self-employment tax on it because a guaranteed payment is generally active ordinary income.
Jeff: They would have to contribute his entire interest in the LLC to the S-Corporation.
Toby: Correct.
Jeff: And the LLC would have to be okay with that.
Toby: It says, can you create an S-Corp for his guaranteed payments and still be a limited domestic partner? The answer that Jeff said is correct, which is no, but what you can do is put your entire interest into the S-Corp. The S-Corp is now just getting paid as a guaranteed payment to a partner. The S-Corp has to be a partner in this, and they have to agree to it under almost all operating agreements.
You can’t just willy-nilly transfer. You’d go to them and say, hey, wait a second, you’re killing me with this guaranteed payment, I’m getting hammered with self-employment tax, can we put it and change our interest over to an S-Corp?
Before you say, oh, my gosh, but then I lose out on capital gains and all this other fun stuff, S-Corp doesn’t change any of the nature of the income. It just says if I have an active income and I take distributions, I have to take a reasonable salary. Only that little reasonable salary is subject to self-employment taxes.
Jeff: One of the things I thought about was, if these guaranteed payments are for services performed or sales commission, whatever, could he have the S-Corporation 1099 for that and still be a partner?
Toby: If it’s a guaranteed payment that’s lowering the profitability, I believe he’d have to own it.
Jeff: That’s what I’m saying that we’re no longer calling a guaranteed payment. We’re calling it a payment for the services.
Toby: If it was payment for services, then I think you could say, hey, pay whatever. Let’s say that I was a plumber and I had my S-Corp. I came in and I said, it’s Toby’s plumbing, they could pay me for my plumbing. What they can’t do is, say, guaranteed payment to a partner and I’m going to pay it to your plumbing business when it’s not a partner.
Jeff: Correct, 100%.
Toby: All right. I know we’re getting a little late. We’re getting close to that 4:00 time. “We hear residential homes’ exception is $250,000 for singles. If I buy three houses this year…” Boy, this is going to be fun. I’m just going to map this out because I know it’s going to get crazy. Year one, you buy three properties. Stay in the first house for two years, so I’ll go one, two, three, do it this way, and this one is two years. We’re now at year three. One, two, so this is two. Make sure I’m doing this right.
Jeff: We buy at the beginning of year one.
Toby: We buy three houses at the beginning of year one, we live in one for two years, and then we live in the third house for two years, so now we’re at four years, and then we live in the third house for two years. So then we have four and then we do two years down here. Technically, we’d be at year six.
Jeff: Yup.
Toby: Okay, on year five, after buying the second house, sell second house and take the exception. When did they get the first house? On the fifth year, after buying the first house, sell it. Okay, so we’re here and we sell it on year five. We sell house number one. Let’s just address that one, first off. You lived in it two of the last five years. Two of the last five years, you get a homestead exclusion of $250,000. You would get that $250,000 deduction if you sold it by the end of that fifth year.
Jeff: Here’s my question. Do I need to wait until that fifth year?
Toby: No, you could sell it at any time.
Jeff: Once I’ve done my two years, I can sell that property, right?
Toby: Yup. I’m making this a big mess. I should do this differently. Let’s just do house one. Two years, sold year five equals $250,000 exemption. All right, second house. Let’s see, after buying on the fifth year, fifth year. On the fifth year, after buying a second house, sell the second house.
This is house number two, you lived in it in year three through four. You lived in it two years, sold year five, equals no. Why do I say no? Because you can only use your exemption every two years. It doesn’t matter about the properties. It manages how often you can take it.
If I had lived in property one for two years and sold it, I could have had the $250,000 than I lived in property two for year three and four, and then I sold it, I would get the $250,000 on both. The same thing with the third property. I lived in it just year five, and sold, equals no because I didn’t meet the two out of three years test.
Jeff: What I was getting at is that don’t wait until year five. As soon as you’re done living and you met the two years, sell it, and then the clock starts running for the next house.
Toby: Yup. The trick is live in a house for two years, sell it, and buy another. Or let’s say that I bought three houses but I staggered them a year. It’s much easier that way than the first house. I lived in two years, I could sell it, take my exemption, or I could wait three years and take it whenever I sell it.
The second house, let’s say I bought it in year two and lived in it for the first year. The question is, what do I do with it? Did I leave it as a secondary residence or did I rent it? Because if I rented it, I’m going to have a period of disqualified use on that growth, which gets confusing.
I don’t want to warp your mind. But let’s just assume you bought it, you just kept it as a second place, you’re fixing it up. Once it was all good and hunky dory, then I moved in and I lived in that for two years. I could sell that within three years after that point and I would be entitled to the exclusion, but I can only take the exclusion every two years.
I’d have to look and say, did I take the exclusion at any time prior to that period of time that would throw off my two years? If I did, I wouldn’t be entitled to it. So I’d be like, oh, nuts. I would be better off selling that one right away and hanging on to moving back into property one, or keeping property one, or better yet, just having sold property one after the second year. Then in the third year, we’re really in a no-win situation under these circumstances. There’s just no way to make it work because it’s every two years.
I bought three properties, the most I’d be able to do in a five year stretch is two of them every two years, every two years. Otherwise, let’s say we bought property three in year two or three, we could hold on to it potentially for five years. We could make it work if we sold property one, after two years, property two, after two years, then we could sell property three, six years from the first date of property one, but it would be five years from the first date that we bought property three. If you follow that, you get a star.
Jeff: You’d have to sell a property after year two, after year four, and after year six to make this work.
Toby: And then you have a period of time to do it. I don’t want to say, hey, don’t consider this type of thing. Most of the time, what you’re really doing is you’re saying, oh, shoot, I’m going to lose my $250,000 exemption. If you want to keep the house and still get your $250,000 exemption, sell it to a closely held S-Corp on an installment sale, opt out of the installment sale, take the full $250,000 exemption, do it on an installment sale, put it into a rental. Now you’re not forced to sell it to any third parties, you could just keep the property at that point, and then you 1031 it if you’re ever going to do that.
Jeff: You brought up a really good point. One of the things I’ve thought about is that I buy three houses today. What am I doing with the other two?
Toby: If I’m renting them out and I lived in them first, no issue. If I rent them out and then move into it, issue, because you have a disqualified use. The IRS has little jabs for you. If you’re 1030-ing a property and if you do the combo, I had a residential property that I lived in, but it had so much gain that I want to protect that gain, and I’m going to reinvest it into another property, and then I decided to move into that property, the property I move into, chances are, there’s going to be a period of disqualified use because of an investment property.
It doesn’t mean you’re toast, it just means you’re going to lose a portion of the $250,000. Let’s say there’s one year of non-qualified use and you had it for five years, 20% is non-qualified, which means you’d lose 20% of the exemption, so it’d be a $200,000 exemption in your case. If the property made $100,000, you’d still avoid 100% of the capital gains, but it’s limited to that portion.
Jeff: The other place we see being a problem is if you’re depreciating that property. When you recapture that depreciation upon sale, that $250,000 doesn’t offset that.
Toby: That’s a really good point. The exemption that Jeff is talking about is capital gains. It’s not recapture. If you had a property that you’re using, that you rented for a period of time, you just have to be careful. Even if you have a huge exemption, hey, I only made $100,000 and I have a $200,000 exemption in the case I was just giving you, there’s still recapture. That would be 0%–25%.
Talk to an accountant. See? It complicated, but it’s not rocket science. It’s just mapping things out with a pencil. I used to have a joke. The only three things you have to know in accounting are calculate, calculate, calculate. Just get your pencil out.
“My company is based in the US. We have a customer from Thailand. My suppliers are from Honduras. I have an American account. I would like to know how to pay my supplier. Do I withhold taxes? These are not residents or citizens of the United States.”
Jeff: I am not an international expert, but I’m pretty sure that for the sale of goods from a foreign country, there is no withholding
Toby: You’re absolutely 100% correct. When US residents, let’s say that they’re going to give money to an individual or an organization, because the way that the US works is an individual could be a corp or a foreign partnership and they make money. They want to make sure they get paid their tax. They do it on FDAP?
Jeff: Yeah.
Toby: Do you remember what all that is? Fixed or determinable.
Jeff: Fixed , Determinable, Annual, or Periodical.
Toby: FDAP, which just means that if I am paying consistently to somebody who’s out of the country, I got to make sure I’m doing withholding. Depending on whether there’s a treaty, some treaties make it zero. Otherwise, it’s 30%. You’ve had to deal with this. If you’ve ever sold or bought a property from somebody who was foreign.
If you remember, when you went to your closing, they had to sign something saying that they were either exempt, or they would talk about having to do the withholding, and then they would file their taxes, they would either give it as a credit towards their taxes, or they would get it back. But it’s services that are performed to the United States is number one. It’s always derived from the United States.
In your case, your supplier from Honduras, I don’t think it would be considered derived from the United States because they’re sending stuff in from Honduras. If you were paying them and they were doing something in United States, you’re paying the Honduras company and they were doing work for you in the United States on your factory, that would be different. Then it would be derived from United States and you’d have the withholding, but I think you’re 100% correct.
Jeff: There are two terms you got to know. One is the FDAP and the other one is ECI, Effectively Connected Income, which you were just talking about.
Toby: Effectively connected means you’re going to also get a little bit lower rate, right?
Jeff: Yes.
Toby: That’s like if you’re doing real estate and you’re a foreigner, and you’re doing real estate in the United States, and you have a partnership or whatever, you’re doing things consistently in the US, you have effectively connected, then I think you could avoid a huge withholding or at least it gets lowered. I always forget that one. We deal with it with rentals that are held by folks that are outside of the United States.
“I’m looking to learn about the small landlord exemption, which allows small landlords to deduct real estate losses from their W-2 income. I’m trying to figure out if I qualify for that.”
Jeff: I’ve heard people used this term before. It’s not an actual term. It is called the active participation test, which means if you make less than $150,000 Modified AGI, I believe, then you may be able to take some part of your real estate losses.
Toby: The easiest way to think about this is if you have passive losses, you can’t use them against anything other than passive income. A passive loss is really easy to generate in real estate because you can depreciate the real estate. Maybe I do a cost seg on a property and create the $200,000 loss. It doesn’t mean I lost $200,000. It means, hey, I got rents. But I get to write off a big chunk of whatever I purchased or maybe I financed it and I can create this big loss.
Ordinarily, I can’t use that. Let’s say it’s a $200,000 loss. I can’t use it against my other income, only against passive, but there are two exceptions. The two exceptions, Jeff just named one, active. Active participation is for folks that are making $100,000 or less. It phases out between $100,000 and $150,000. I think it’s $1 for every $2 over. So it’s gone at $150,000, but it’s $25,000.
Let’s say that I buy real estate, and I have a loss of $10,000, and I make $100,000. I could use that $10,000 loss against my $100,000 if I manage the manager. That’s all it is. Active participation in real estate just means, hey, you’re ultimately the decision maker. You don’t have to spend hours or anything.
As long as I hired the manager and I get to control him, that’s it. I’m an active participant. But if I make over $150,000 of Adjusted Gross Income, it’s gone. Then I only have the other choice, which is real estate professional. You’ll see, in our offices, we’re always talking about real estate professional because that’s the big one. You could be making $1 million a year and I could offset 100% of it if I’m a real estate professional or somebody qualifies and I buy enough real estate.
Accountants that do real estate, we always joke. If you don’t want to pay taxes, buy more real estate. Get more actively involved. If you’re paying taxes you don’t want to, buy more real estate, get more involved. We can eliminate it all. That’s how our former President Trump wrote off $90 million and carried it back.
He got beat up in the press for it and I’m like, hey, you didn’t write the code that said you could carry back, why are you mad at him. It’s like all these guys. They’re always like, write these incentives and then you can’t be mad at somebody who takes advantage of it. It’s there for a reason, which is to grow our economy and continue to incentivize people to put their monies into these big projects.
This is one for the little guys and that’s how you qualify. If you need more clarity on that or you want to see whether it applies to your specific situation, by all means, shoot an email and we’ll make sure we get it.
Somebody says, “Even if that $100,000 AGI is partially from RMDs?” There’s no exclusion.
Jeff: No.
Toby: It will offset ordinary income. What it does is it makes the loss non-passive, and you can use it against any income.
If you have questions, taxtuesday@andersonadvisors.com. Visit us at andersonadvisors.com. I got to say that our team here, let’s see, I’m looking at 178 questions answered. Dana, Christos, Dutch, Ian, Piao. I think they just don’t want to work. Eliot.
Jeff: They’re tired on tax returns.
Toby: They’re tired. This is their break. Literally, they’re probably eating cookies and say, this is so nice. I get to answer questions instead of looking at bar graphs. Piao, Ian, Dutch, Eliot, Dana, Christos. Troy was on earlier. Matthew, Ander and Patty we’re knocking it out of the park. Again, nobody’s billing you for this. Just make sure you reach out and say thanks if somebody’s answering a bunch of questions. They work their katushes off.
They’re not required to do this. They do it. People will just say, hey, we want to jump on and answer questions. These guys are awesome. One of the ways that we learn too is, Jeff and I, we’re always looking at these things, trying to figure out the right answers, and like, oh, my goodness. It’s a good teaching experience for us too, so it’s great.
I appreciate you guys coming on. We will see you again in two weeks. If you have questions, by all means, taxtuesday@andersonadvisors.com. If nothing else, we will see you in two weeks.
