Today’s Tax Tuesday episode answers several listener questions on S-Corps vs. LLCs. Eliot Thomas hosts with special guest Jeff Webb, CFO of Anderson Business Advisors. Online we have some of the staff from Anderson – Dana, Dutch, Ian, Piao, and Troy here answering live chat questions.
In this episode, you’ll hear our advice on several scenarios regarding potentially switching from an LLC to an S-Corp and the likely tax benefits, along with several questions about purchasing property for your children to live in while they are attending school or just getting on their feet. Submit your tax question to taxtuesday@andersonadvisors.
- “I have an LLC now for a small business, and I’m wondering what the benefits are of switching to an S-Corp and what the tax deduction benefits might be?”— If it’s an LLC, it’s got liability protection. If it’s not making a lot of money, (under $50K) – probably don’t go the S-Corp route.
- “Can cost segregation depreciation be done on a property purchased one or two years earlier? If so, is it state-specific? Would it be a great option if that was a possibility with REP status?” You can go back in time and do the cost segregation. Let’s say you bought the property in 2020. It’s now 2022. You could do cost segregation. That depreciation from the cost segregation would appear on your 2022 return. If you do not have REP status or can’t get REP status, normally cost segregation is not a great idea.
- “Is there a way to convert from a 401(k) to an IUL (Indexed Universal Life) or Roth without having to pay the high tax burden, or at least minimize the tax hit?” The problem is you are going to get a tax hit if you take 401(k) money and put it in an IUL. Anything you take out the 401(k), money’s going to be taxed at ordinary rates. And if you’re not 59½, you could be hit with a 10% penalty on top of it.
- “I’m a member of WREIN. I purchased a house and a condo in the past few months that two of my children currently live in. There is a mortgage and my soon-to-be daughter-in-law is on that with me. I pay the mortgage on the living costs, including tuition. Should I claim this home as a rental?” You can’t just write a check or gift it and say, now I’m going to have them pay me rent back. The IRS has seen through that. That’s a gift. It doesn’t sound like they’re paying anything so I see no rental here.
- “My son is 26 and in his second year of post-secondary education. The condo doesn’t have a mortgage. I purchased it with funds from a private money lender in April that I have paid off with a HELOC from my primary residence. What would be the most advantageous way for me to claim this home, rent, and the best strategy? We’ve created a problem with our second home because we now have more than two private residences. Once again, I would probably deduct the HELOC as investment interest. Whichever one has the higher mortgage should be your second home. The next one would just be investment interest on an investment you own (the condo). And again, you can deduct the taxes on as many properties as you own. But again, you still have that $10,000 cap for state and local taxes.
- “Due to having two W-2s, I cannot qualify for real estate professional status nor can my partner. What is the best solution to minimize the tax bill coming at the end of the year? By the way, with both W-2s, I will be moving to a higher tax bracket that neither W-2 knows about. I will owe more taxes than they take out at the end of the year, unless I find some way to get my passive losses from depreciation available to lower my W-2 bill.” If you make $50,000 in each job, you’re going to have a whole lot more taxes and probably going to be under-withheld because it’s based on $50,000 on each job. REP status doesn’t work. You could do a short-term rental. Be sure to adjust your W4s for two jobs/withholding.
- “I just moved to Arkansas and sold and purchased properties here in Arkansas through a 1031. How do we get taxed on the remaining amount that was not used as a 1031 replacement property? I reserved some of the money from the sale as I don’t know what my tax bracket here is for taxation, and how much. I would be paying income tax. Can you give me an answer using the percentage of the sale?” Every dollar that you held back from the 1031 exchange is going to be taxed. And the first tax is going to be depreciation recapture, at a max of 25%. And the rest is capital gain at around 15%.
- “I’m interested in using an accountable plan. Can you differentiate between a home office deduction,” which is on Schedule A, I believe, “and requires an exclusive home office use, versus the administrative home office which appears not to need the exclusive use?” ‘Unreimbursed employee expenses’ was eliminated at the end of 2017, so that doesn’t work anymore. Your only choice (especially in an S-Corporation) is a reimbursement.
- “I’m not qualified as a REP (real estate professional) but with passive losses. Is there any way I can reduce my income with these losses and what can I do before this year is completed?” The only thing you can do with passive losses is offset them with a passive income, which effectively means you’re not using your passive losses to reduce your income. Short-term rentals are not rental activity.
- “We have mainly W-2 income and also some investment properties passive. Our W-2 is too high to get tax deductions from its loss besides doing a short-term rental Airbnb. What are other ways we can deduct our W-2 income tax?” Max out those retirement contributions. Oil and gas is another still popular investment. There you have to have a working interest—that’s very important—but it is a write-off that’s substantially all of your investment for the most part.
- “We are about to apply for a HELOC. We do not own our home yet. My husband is the only moneymaker right now. We want to buy my daughter a mobile home. It’s approximately $47,000. Our credit score is over 800.” I don’t think this is a business, and I think wrapping an LLC around this property is a bad idea. But the daughter would have to be paying market rent. You would have to run it as a real business.
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Full Episode Transcript:
Eliot: Hello everybody. My name is Eliot Thomas. This is our tax Tuesday for today. I’m sitting in for my boss, Toby Mathis, and I’m joined today by our CFO back from vacation, Jeff Webb.... Read Full Transcript
Jeff: Glad to be here.
Eliot: Yup. Glad to have him back. Just before we get started, of course, this is where we answer your questions, bringing that tax knowledge to the masses.
I just want to thank the staff who’s helping out here behind the scenes. We have Matthew, Patricia, and Ander. As far as answering questions we have Dana, Dutch, Ian, Piao, and Troy right now in the background. There’ll be answering your questions that come through over into the Q&A section. We’re going to go through 10 questions here. We’ll show them here at the beginning, real quick.
First of all, here are our rules. We do answer live Q&A. That again is the group that will be answering the back in the Zoom. You can email your questions to email@example.com. That’s where I actually drew these questions that we have today from. We do answer them, we do select from them, and try to get to as many as we can.
If you need a detailed response, you will be needed to become a platinum client or a tax client, and we can have those questions answered on the platinum portal. We try to make this fast, fun, and educational. We want to give back to help educate our clients and those who aren’t clients just to help learn a bit more about tax.
Jeff: Patti just added to the chat to make sure. If you’re asking a tax question that you need answers to, ask it in the Q&A section, not the chat section. The chat section is for making general comments and so forth, making fun of Toby or stuff like that.
Eliot: Or the battle between Clint and Toby, we can do it there. I apologize for that. I’m used to the Zoom meetings where we have the chat, but here it’s a Q&A section where we ask the questions, so sorry for that confusion.
I’m going to go through all the questions first that we’ll be answering today. First one, “I have an LLC now for a small business, and I’m wondering what the benefits are of switching to an S-Corp and what the tax deduction benefits might be?”
Number two, “Hello. Can cost segregation depreciation be done on a property purchased one or two years earlier? This was a common. I happen to notice it in one of the blogs. If so, is it state-specific? Would it be a great option if that was a possibility with REP status?” That’s real estate professional status. We’ll look into that one.
Number three, “Is there a way to convert from a 401(k) to an IUL (Indexed Universal Life) or Roth without having to pay the high tax burden, or at least minimize the tax hit?” Excellent question there.
More questions here. “I’m a member of WREIN. I purchased a house and a condo in the past few months that two of my children currently live in. Both are in Pennsylvania where I live. The house is occupied by my son and his fiancee as they both attend college nearby.
There is a mortgage and my soon-to-be daughter-in-law is on that with me. I pay the mortgage on the living costs, including tuition. Should I claim this home as a rental?” Then I think we’re talking about the next thing, the condo here.
“My son is 26 and in his second year of post-secondary education. The condo doesn’t have a mortgage. I purchased it with funds from a private money lender in April that I have paid off with a HELOC from my primary residence.
I just finished rehab and she moved in last month. I’m the only one on the deed. I believe she’ll only live there for a year or two maybe. She’s a recent college grad and currently a teacher. What would be the most advantageous way for me to claim this home, rent, and the birth strategy? I’m planning to purchase another home as soon as I find a good one, also in Pennsylvania.”
Next, “During the pandemic, I resorted to working two W-2 jobs, both full-time, and took their share of taxes away before I saw it in my bank. Due to having two W-2s, I cannot qualify for real estate professional status nor can my partner. What is the best solution to minimize the tax bill coming at the end of the year?
By the way, with both W-2s, I will be moving to a higher tax bracket that neither W-2 knows about. I will owe more taxes than they take out at the end of the year, unless I find some way to get my passive losses from depreciation available to lower my W-2 bill.” So we’ll examine that.
“I just moved to Arkansas and sold and purchased properties here in Arkansas through a 1031. How do we get tax on the remaining amount that was not used as a 1031 replacement property? I reserved some of the money from the sale as I don’t know what my tax bracket here is for taxation, and how much. I would be paying income tax. Can you give me an answer using the percentage of the sale?”
We’ll do what we can to help you with that one. We might need more detail to really narrow that one down. But we’ll be able to walk that through, I think.
Next, “I’m interested in using an accountable plan. Can you differentiate between a home office deduction,” which is on Schedule A, I believe, “and requires an exclusive home office use, versus the administrative home office which appears not to need the exclusive use?” We’ll definitely tear that apart there and look into it.
Next, “I’m not qualified as a REP (real estate professional) but with passive losses. Is there any way I can reduce my income with these losses and what can I do before this year is completed?” Now, I picked that one because it goes very well with the very next one.
“We have mainly W-2 income and also some investment properties passive. Our W-2 is too high to get tax deductions from its loss besides doing a short-term rental Airbnb. What are other ways we can deduct our W-2 income tax?” Those two go together and we’ll look at that whole issue in a mass spectrum there.
Last question here. “We are about to apply for a HELOC. We do not own our home yet. My husband is the only moneymaker right now. We want to buy my daughter a mobile home that happens to be in a town in Indiana but not Alpine property. It’s approximately $47,000. Our credit score is over eight.
What will be our tax obligations and what to prepare for, and should we make it an LLC? Maybe you have a link from a tutorial you can direct me to as well. She and her husband will be making the loan payments until they can qualify to buy it in about three years.”
We’ll get to those questions here in just a second. Just a reminder, that you can join us on YouTube. Subscribe on YouTube for the latest updates. We have a lot of videos. The partners are always putting out videos as well as fellow staff, and colleagues here at Anderson. You can listen to podcasts at andersonadvisors.com/podcast and watch the replays in your platinum portal.
Jeff: That’s why I’m sitting here quietly. Can’t make mistakes if you don’t say anything.
Eliot: Okay, first question. “I have an LLC for now with a small business, and I’m wondering what the benefits are of switching to an S-Corp and what are the tax deduction benefits.” Jefferson?
Jeff: Here’s my thing with the small business. It’s in an LLC, so it’s got liability protection. If it’s not making a lot of money, I probably don’t go the S-Corp route. And by a lot of money, I’d say under $50,000. What’s your feeling on that?
Eliot: If we go back and forth behind the scenes talking about this and I’d say we’re $40,000–$50,000, you might change my mind if you really know what you’re doing with operating your business. By that, I might accept a little bit lower.
We’d like to see a client have a fair amount of income before you make that S election because it is going to add a new tax return to you and bring a little bit more complication into your world. We want to see you get those tax benefits. To be sure, there are tax benefits and we will definitely go over those.
Being an LLC, I was assuming when I first saw that you’re talking about a sole proprietorship, but that doesn’t necessarily need to be. It could be a partnership, it could be a C-Corp, in which case there are different issues if you went to an S. I probably wouldn’t recommend it necessarily from a C to an S perhaps.
Jeff: So assuming that it is a sole proprietorship. Another, we just talked about if you’re not making a lot of money. But if you have (say) a high W-2 over $150,000–$160,000, you’re already maxing out the social security part of that.
The reason we bring that up is because you’re not paying the social security part on the self-employment on the sole proprietorship. That gives you even a little more leeway or let’s say less of a reason to go to an S-Corporation.
Eliot: There are three things, three prongs we typically look at for an S-Corporation of really nice tax benefits leading into that part of it. One of them is savings on self-employment tax.
But as Jeff points out, if you’re already making a lot of other income on your return that’s covering your bill (so to speak) for the initial part of that 15.3% which is about $150,000, there’s not a whole lot of savings to be had from self-employment savings in an S-Corporation.
If you’re under that, well then that’s a different story. If you had no other income, and it’s just your sole proprietorship, then maybe we will have possibly some significant self-employment savings, plus other tax benefits, which again, we’ll get into. I think that’s what Jeff’s referring to. It does matter on the amount of income we have coming in.
But once we’re there, if we did decide to do an S, two of the things that we typically talk about is the accountable plan, which just means that’s fancy for IRS reimbursement, and that’s usually where you have your administrative office which we’re going to talk more about later on one of these questions, but that’s reimbursement for that. Cell phone, internet, mileage, they’re all reimbursements you can do through that and you can do your corporate meetings through ADA, and those will be your tax benefits.
Jeff: I’m not sure how much of a benefit this is. You can do a 401(k) plan through the S-Corporation, but you can do a SEP contribution through sole proprietorship. The big difference I see there is that a retirement plan contribution through a sole proprietorship is not deductible from the Schedule C income whereas a contribution to your retirement and the S-Corporation does reduce that income.
Eliot: Yeah. We see that reduction from the overall corporation, the income that would otherwise be taxable through the flow through onto your return. There are benefits like that, too.
Unfortunately, what this boils down to is that it would really need a consult to really look at the numbers to see if this was beneficial to you or not. But just to give you an idea, if we’re looking at around $50,000 of income coming in, then I think we would typically go stronger towards maybe an S-Corporation and might be in your best interest with these reimbursements and corporate meetings and things like that, and possible savings on self-employment tax.
Also, something I guess we didn’t bring up here yet that Toby really hits on is that Schedule C traditionally has been a lightning rod for audit risks. If you have nothing to hide, you shouldn’t worry about an audit, but they do get audited a lot. That’s one thing that Toby often will tell us, hey, maybe we won’t get into an S-Corp because they have statistically much less chance of getting audited.
Eliot: All right, number two. “Hello. Can cost segregation depreciation be done on a property purchase a couple of years prior? This was common I happen to notice on one of the blogs. If so, is it state-specific? It would be a great option if it was a possibility with REP status.”
Jeff: Let’s talk about the first part of the question. You can go back in time and do the cost segregation. Let’s say you bought the property in 2020. It’s now 2022. You could do cost segregation. That depreciation from the cost segregation would appear on your 2022 return. You don’t go back and amend prior year returns. You do what’s called a change of accounting method. What that allows you to do is catch that depreciation up and collect all of that from the cost segregation.
Now, I liked that he pointed out the state-by-state issue. It’s not a state-by-state issue because it’s one or two years old. It’s a state-by-state issue because some states—I’m going to use our friend, California—don’t allow bonus depreciation. I do a cost segregation and I end up with $100,000 of bonus depreciation, and I got this huge deduction on my federal return. Then I look at my California or whatever state that maybe return…
Eliot: And I still owe.
Jeff: And I still owe, exactly.
Eliot: That’s the big thing. The issue of state-specific is always there when you’re dealing with California. This is one of those times where you have to know the state you’re in, and whether or not they allow that bonus appreciation. California is not alone in this. There are other states that don’t recognize that as well. I think they’re in the minority, but they are out there.
If you did have the REP status, though, and this was on long-term rentals that you’d aggregated or this was a property that you materially participated in and made you 750 hours, et cetera, all those tests, then yeah, this would be a great play for writing off against ordinary income on your return. That’s correct.
Jeff: I’m sure this is coming up later, but if you do not have REP status or can’t get REP status, normally cost segregation is not a great idea.
Eliot: The only time that it would be beneficial is if you had an abundance of positive passive income, and you still are trying to write off against it. That’d be about the only time I would still recommend REP.
Jeff: Like maybe they’ve invested in Toby’s pizza shop that’s just making them money.
Eliot: Exactly. Every time we talked to Toby, that thing is doing great.
Next, number three. “Is there a way to convert from a 401(k) into an IUL (Indexed Universal Life Plan) or Roth without having to pay the high tax burden or at least minimize the tax hit?”
Jeff: I’ve seen the strategy out there converting from a 401(k) to an IUL. Each has its own advantages. The problem is you are going to get a tax hit if you take 401(k) money and put it in an IUL. Anything you take out the 401(k), money’s going to be taxed at ordinary rates. And if you’re not 59½, you could be hit with a 10% penalty on top of it.
Now, there’s a way to get out of the 10% penalty. I’m not sure how well it works. There’s an exception to the 10% penalty if you have substantially equal payments being paid to you. First, you’d have to roll over your 401(k) into an IRA, and then start taking those substantial payments.
The problem I have with that is if you’re willing to put it in an IUL, you’re not going to be receiving large amounts of funds that you can contribute to that IUL which is what you typically want to do.
Eliot: I’m not a big fan of what I’ve read out there about trying to do this. Instead of doing a convert, you could maybe take a loan. Pay that into the IUL for the premiums or whatever, but you’d have to still have to pay back for the loan. That’s not a perfect solution, either, but I think you’re going to get hit with the taxes.
Jeff: The IUL has downside protection, whereas with the 401(k) you could lose a lot of money if you invest wrong. There are advantages to this and disadvantages to that. Maybe you think we’re going to be going into a bear market for the next 20 years and IUL would obviously make more money, but is it going to make enough to offset that tax burden?
Eliot: Yeah, that liability you’re going to get hit with. I think 72(t) was the removal you’re talking about to try and get money out of the 401(k). There’s rule 72(t) they call it if you take equal payments but you’re paying tax. You just don’t get it. You don’t have the penalty on them. So there’s (I guess) that half-plus if you will.
Other than that, I always bring up this. You bring up that last sentence or at least minimize the tax hit. If you are doing the right type of investments, we can always look for other things on your return. It’s just not going to come from this set of facts with a 401(k) going into IUL.
If you invest in other things that give you a write-off, maybe oil and gas or something like that, or a short-term rental that you are materially operating or something of that nature, we could look for other things on the return to help offset this tax hit. But from this specific scenario, moving 401(k) to an IUL, I don’t see a lot of options.
Jeff: This is one of those strategies that could possibly work, depending. If I’m a high W-2 earner, it’s going to trash me. If I’m taking a year off from work or just retired, my income is low this year, and I’m married and as you said, get some other good write-offs, maybe you’re in the 12% bracket, maybe you’re in the 0% bracket, and can make this work for you. I’m much more willing to do this in a 12% bracket than I am in a 34% or a 37% bracket.
Eliot: Again, not wanting to speak for Toby, but I’ve heard him often say that in these situations, it’s tough to make that money back up if you had to pay out that tax bill if you’re in a higher bracket. So he often questions the wisdom of moving into a Roth later on from a plan like this.
I know we’re all worried about taxes going up but you got to remember that loss that you’re taking of investment power by paying it into the US government. That’s something to take into account as well.
Jeff: But you know? That’s a good point. You mentioned Roth. I would think a lot of the same rule of thumbs of converting to a Roth applies to converting to an IUL.
Eliot: Because we’re still having that tax hit.
Eliot: All right. Hopefully, that helped.
“I’m a member of WREIN. I purchased a house and a condo in the past few months that two of my children currently live in. Both are in Pennsylvania where I live. The house is occupied by my son and his fiancee as they both attend college nearby. There is a mortgage and my soon-to-be daughter-in-law is on that with me. I pay the mortgage and all the costs of living, including tuition. Should I claim this home as a rental?”
I’m going to stop right there and break these up. The next part is the son in secondary education might be part of the same scenario. It doesn’t really matter one way or another. But let’s separate the house from the condo and just deal with the house going on here.
Jeff: And if you’re wondering what WREIN is, that’s a Women’s Real Estate Investors Network.
Eliot: Yes. It’s a group that we’ve had a lot of fun working with lately and good success and hopefully been very helpful to them.
So we got the house. I think the key here is do we want to maybe turn it into a rental? Well, that begs the question. I don’t know. Are they paying rent? It sounds like you are providing all this stuff to them. You can’t just write a check or gift it and say, now I’m going to have them pay me rent back.
The IRS has seen through that. We’ve seen the cases. They’re not going to accept that. That’s a gift. We don’t have a rental situation here. They would need to have earned income and be paying you not just rent, mind you, but market rate rent before we would have a rental situation. Right now, what you have is a second house, and you have a family living there.
Jeff: Basically what Eliot said, this is not a rental property at all. The mortgage interest you’re paying, you could deduct that on Schedule A. Likewise, any taxes that you’re paying on the real estate up to the $10,000 cap. There is that. But otherwise, just because the potential daughter-in-law is on the mortgage really carries no weight at all.
Eliot: It doesn’t really change the fact pattern too much because they’re not paying anything right now on this as it is right here.
Jeff: And with you paying tuition, I’m sure they’re not paying rent.
Eliot: And all the costs of living including tuition, so it doesn’t sound like they’re paying anything so I see no rental here.
Now moving on to the next one, the condo. “It doesn’t have a mortgage. I purchased it with PML (private money lending) in April, and I’ve paid that off with a HELOC for my primary residence. I just finished the rehab, she moved in last month, I’m the only one on the deed.
I believe she’ll be there for a year or two. She is a recent college grad and is currently a teacher. What would be the most advantageous way for me to claim this home rental birth strategy? I’m planning to purchase another home as soon as I find a good one, also in Pennsylvania.”
Jeff: Now we’ve created a problem with our second home because we now have more than two private residences. Once again, I would probably deduct the HELOC as investment interest.
Eliot: I think that’s where you’d want to go because we can’t probably get on Schedule A with the two house limits.
Jeff: Whichever one has the higher mortgage to be your second home. The next one would just be investment interest on an investment you own (the condo). But again, if she is not paying fair rental market rate, arm’s length transaction, and so on and so forth, it’s not a rental property and it makes the argument even harder that she’s a relative.
Eliot: I have seen cases where they look into that. Some of them I’ve seen were more geared towards where you have a family member renting a house that you picked up as a replacement in 1031. The same applies that even if it wasn’t part of 1031, the IRS wants to see that they’re paying market rate.
In one particular case I read, the taxpayer documented that the market rate would say $1500–$1700 in that neighborhood a month. But the IRS found someone paying $1800 and they said that that’s the market rate, even though that wasn’t the outreach. The IRS can play hardball on this one, so I’d be careful with that.
Jeff: We had one where the parents were renting to the daughter. The rent was $35,000 a year. It’s an expensive place in LA. But when you looked at the daughter’s W-2s and her income, her income was less than half of that, so that’s almost an automatic fail to that test.
Eliot: Makes you wonder. That’s the kind of thing the IRS is going to see right through. We would hope they’d see that. Anyway, the most advantageous way probably the best you can get off here is maybe interest investments. Is that our interest expense?
Jeff: And again, you can deduct the taxes on as many properties as you own. But again, you still have that $10,000 cap for state and local taxes.
Eliot: Yup. All right.
Jeff: Hang on. She asked about combining the PRR which is fine, but if we’re talking about the condo, you want to make that a true rental property first. I even see that as being a problem when going to the lender to do the refinance and they’re not really seeing a cash flow coming in.
Eliot: I see it as a potential problem for a lender. You want to show some profitability, maybe absent the depreciation expense.
Jeff: And once I get to three true rental properties, I’m probably considering putting them in definitely an LLC partnership.
Eliot: Better lending terms typically with a partnership. Hopefully, that will give you some path going forward on that. Great questions.
“During the pandemic, I resorted to working two W-2 jobs, both full-time jobs, both take their share taxes away. Due to having two W-2s, I cannot qualify for real estate professional status, nor can my partner. What is the best solution to minimize the tax bill coming up at the end of the year?
By the way, with both W-2s, I’ll be moving into a higher tax bracket that neither knows about, so I will owe more taxes than they take at the end of the year unless I find some way to get my passive loss from depreciation available to lower my W-2 bill.”
Jeff: When you fill out a W-4, if you fill it out correctly (and hardly anybody does), there is a place to calculate income from two W-2s for this very reason. I mean, you’re exactly right.
If I make $50,000 in a job, I’m not going to have a whole lot of taxes. If I make $50,000 in two jobs, I’m going to have a whole lot more taxes and I’m probably going to be under-withheld because it’s based on $50,000 on each job. The first thing you might want to do is adjust your W-4s.
Eliot: You can now request more to be taken out.
Jeff: You can request it from both. We don’t know how much we’re talking about in this situation. REP status doesn’t work. You could do short-term rental. I don’t know. What else do you have?
Eliot: Little things that we look at maybe contributing to a retirement plan, HSA. I don’t mean to say that those are small ideas, but they typically wouldn’t have that big bang like a short-term rental. HSA, retirement plans, things of that nature, anything to lower your overall tax burden while getting some benefit. Even though you lose the cash, it goes into an investment, but you’re getting the tax benefit at the same time.
I would recommend probably adjusting those W-4s like Jeff’s saying to have a little bit more taken out. That way, you don’t have to worry about cutting a check at the end of the year. You got that burden taken care of and now you can just focus on investments such as what we were just talking about that can help your taxes.
Jeff: I’m going to approach this from a different angle. This is me. I’m working two full-time jobs, and getting two W-2s. Do I want to take a massive amount of money and put it into an investment to save myself some taxes? I’m thinking about working 80 hours a week and I suppose there was a reason for it. Maybe it’s to make the extra money. Maybe it’s to just get by to fulfill my needs. But when it comes to dumping into an investment, I think I’m very careful about what I’m investing in.
Eliot: Yeah. Why are we doing this extra work and putting ourselves through this? One investment that might work, we get into Toby’s pizza shop that we always talk about.
If you do have a passive loss from depreciation which you’re noting here, what if you found another passive investment like a pizza shop that you don’t have anything to do with, you’re just a limited partner that is generating income? That passive income would be offset by depreciation. Now, that is not going to change anything on your return as is, but it’s going to help you use that depreciation loss instead of just building up on your return.
That might be something to look at because as Jeff pointed out, there’s a reason you’re doing twoW-2 jobs. If it is to try and make an investment, you could carefully architect it in a manner that’s getting written off by what we call a PIG—a passive income generator. Hopefully, that helps you out.
“I just moved to AR—Arkansas—and sold and purchased properties here in Arkansas through a 1031 exchange. How do we get tax on the remaining amount that was not used as a 1031 replacement property? I reserved some of the money from the sale as I don’t know what my bracket year is for taxation. How much are we paying come tax time? Can you give an answer using the percentage of the sale?”
Eliot: But we can help you here.
Jeff: We can give you an answer. Every dollar that you held back from the 1031 exchange is going to be taxed. And the first tax is going to be depreciation recapture, which is at what percent? Twenty-five?
Eliot: A maximum of 25%.
Jeff: You’re going to get taxed on the depreciation recapture first, and then the rest will be capital gain. Let’s say you have a $75,000 capital gain total of $10,000 recapture and you held back $30,000. Did that make it too complicated?
Eliot: No, I got it. $75,000, $10,000, $30,000.
Jeff: So you first got to recapture that $10,000 at 25% a year. The next $20,000 is going to be taxed at whatever capital gain rate you are—0%, 15%, or 20%.
Two points here. Depreciation recapture is never going to go above your capital gain. If you had kept $200,000 of cash, you wouldn’t be taxed on all that. Just the amount that is capital gain. In this case, I think I said $75,000. I would pretty much count on every dollar being taxed somewhere between 15% and 25%.
Eliot: There is a huge bracket for your capital gains at 15%. I did bring the little cheat sheet here, but it takes me time to find it here.
Jeff: Is it around $500,000?
Eliot: It’s $83,000 up to $517,000. That’s your 15% capital gains rate. That’s a big chunk. A lot of territory in there so you can almost bet your bottom dollar against in this case that it’s going to be 15%. Unless you’re over half a million, and then it will go up to 20%, just the amount that’s above $517,000 mind you.
That will give you a rough ballpark of what you’re looking at. But back to your original part of the question, “Hey, I withheld some of the money from the sale,” that will be taxed. We know it’s going to be depreciation recapture first at a max of 25% and then the rest of cap gains is probably a lot of it at 15%. It just depends on the dollar amounts we’re talking about here.
Jeff: There’s nothing wrong with holding money back. Sometimes you may need a new car or house repairs or any number of things, whatever you want to do with the cash. It’s fine as long as you keep in mind that 15%, 20% (maybe) is going to go to the government.
Eliot: And 3.8% net investment income tax.
Jeff: Once you get over $250,000.
Eliot: We can’t give you the exact percentages, but hopefully that helps narrow it down for you.
Jeff: And the depreciation recapture is going to be at your ordinary rate.
Eliot: Yup. All right. “I’m interested in using an accountable plan. Can you differentiate between a home office deduction,” which is on Schedule A, I believe, “and requires an exclusive use of the home office versus the administrative home office which appears not to need an exclusive use?”
Jeff: You are correct about Schedule A if this was still 2017. That was considered unreimbursed employee expenses. That was eliminated at the end of 2017, so that doesn’t work anymore. Your only choice especially in an S-Corporation is a reimbursement. While you don’t get to deduct it on your return, in a way you still do because it’s being deducted on your S-Corp return and it’s going to lower that S-Corp income that’s flowing back to you.
Eliot: And if we’re in an S-Corp situation, we’re using the accountable plan which means that this (as you point out) administrative office is a reimbursement, so you’re going to get cash back in your pocket.
If you had $1500 worth of expenses for this office, the S-Corp will cut you a check for $1500. You put that in your pocket tax-free, and then the S-Corp takes the deduction. You’re saving on your tax return via the S-Corp as well as getting your money back.
It’s a no-brainer to use the administrative office if we can if we are in a corporation for that. We can’t do that unless we are an employee. We cannot be an employee of our sole proprietorship or our partnership, so we must be an S-Corp or a C-Corporation.
Another aim here, though, you get into this exclusive use. You still have to use this for the exclusive use of the business. Even if it’s an area where you have your dining table where you would have formal events and you’ve turned that into your office.
You take everything away for one day for Thanksgiving to have everybody in there, you’ve lost the ability—at least in the tax code’s eyes—to use it as a deduction because it has to be used exclusively for the business, on both of them. Exclusive and on a regular basis use. Alright, so hopefully that helps you out there.
“I’m not qualified as a real estate professional, but I have some passive losses. Is there any way to reduce my income with these losses and what can I do before this year is completed?”
Now this question ties in very much with the next question. That’s why I brought both of these in together so we’ll try and look at this whole as an issue. We already started answering this in one of the earlier questions. Jeff, what do you think?
Jeff: No. And you brought this up earlier, the only thing you can do with passive losses is offset them with a passive income, which effectively means you’re not using your passive losses to reduce your income.
Eliot: You found some other investment, creating more income, but instead of paying tax on it, it’s going to be written off by your passive losses. That’s one thing you can do. Again, we’re not lowering taxes. We’re taking advantage of the fact that we have passive losses we haven’t been able to use.
But then there is Airbnb, the short-term rental. If we truly qualify for what’s in the tax code a short-term rental, which is not the same definition as a general public out there, and we are the one operating it, we’re getting services done, and it’s less than seven days average day, you can do some great things with depreciation to write off against any income on returns. That’s always a first. That’s probably our first go-to or having the passive income generator business or something like that.
Again, we have the HSA. Maybe you can contribute to retirement plans, things of that nature, oil and gas investments if you have a working interest. Those are all things that would still help us write off income here.
Jeff: I don’t think we can say this often enough that when we talk about Airbnb, short-term rentals and all, it can’t be combined with your other long-term passive investments. They’re not the same thing.
Eliot: Your long-term rentals which are giving you the REP status or not giving you REP status, that is a rental activity. In the tax code, unfortunately, it’s very confusing, but a short-term rental is not a rental activity. Short-term rental is not a rental activity. Only the US government can come up with this, okay?
It is like a hotel when we talk about short-term rental. Here in Vegas, we have a lot of hotels. They’re not renting to people. The average day is less than seven days of providing some services. You look like a hotel. That’s what you want to do for a short-term rental because if you’re the one managing that, putting more time in than everybody else, it’s less than seven days.
Now, you’re no longer in your REP status. It’s not a rental. You could do depreciation cost segs and things like that, and get some heavy write-offs that are ordinary losses that would go against your W-2 income.
Jeff: Here’s the thing with short-term rentals. I probably should have brought this up before. Clock’s ticking. Please don’t go out and buy something on Christmas eve and try to say it’s a short-term rental. It’s probably going to fail. That’s probably a little harsh. It’s going to be a challenge.
Eliot: I think it’s true. It’s going to fail. But yes, that is harsh. It’s going to be a challenge.
Jeff: If you’re talking short-term rentals, you want to go out and buy a property and Airbnb it, buy the property now. Find and buy the property now. I know mortgage rates are high. I think they’ve actually dropped back down a little bit. Buy the property now. Get a couple of guests to stay in your Airbnb for less than seven days. Don’t screw it up with somebody staying there for like three weeks.
Eliot: Don’t have a big family or someone related.
Jeff: Very important. We’ve had that. If I buy an Airbnb on December 15 and I have my brother-in-law stay there, no.
Eliot: Have someone that’s not related. I don’t care if it’s your best friend or something like that. That’s probably okay but just don’t make it family.
Jeff: We’re talking about cost segregation. Don’t worry about the cost segregation right now. Get that established as a short-term rental by having renters in it and a property that you own. You have until the due date of your return, including extensions, to get that cost segregation done. On the other hand, please do not do the cost segregation in October of next year. Please get it done early.
Eliot: While we’re not in a mad rush to get it done, we also don’t want to delay too much into next year to get it done, either. Those are things that you might be able to do here if you don’t have that REP status going on which leads us to our next question, almost similar.
“We have mainly W-2 income. We also have some passive investment properties. Our W-2 is too high to get deductions from its losses. We’re probably not going to be able to do Airbnb, Eliot. Are there other ways that we can deduct our W-2 income?”
Yeah. If our income is too high, we probably won’t get to be put into an IRA for deduction, but we might have some other retirement plan like a solo 401(k), maybe even a defined benefit plan if we’re lucky at work or something like that, things that might assist us that way.
Jeff: Max out those retirement contributions.
Eliot: Absolutely. Oil and gas is another still popular investment. There you have to have a working interest—that’s very important—but it is a write-off that’s substantially all of your investment for the most part. Things along those lines.
Jeff: I would say some of the syndications. But if they’re real estate syndications, you’re probably going to be limited on taking losses. Even other syndications that may have losses that aren’t real estate are still going to have passive limitations.
I always like retirement. If we’re not taking advantage of retirement contributions when we’re able to, it’s almost like leaving money on the table.
Eliot: It really is. We talk a lot about Airbnb, obviously. But remember that concept of Airbnb is like you’re a motel. That holds true to any other business. If this is a time in our situation here for these taxpayers asking this question, maybe they had thought about a side gig and have something that might have an extensive outlay of cash for some asset that’s depreciable. Well, you could still do 100% depreciation on that, too, more than likely.
One of our colleagues used to have a dog-washing van or something like that. If you want a side gig you wanted to get into and you bought that van, you could probably take a heavy write-off for that right away this year. It’s all business that will have its loss. And if you materially participate in that business, it’s going to have the same effect as having an Airbnb.
We just always talk about Airbnb because that’s real estate, but any business you go into where you’re buying a heavy asset that’s going to give you bonus depreciation and cause that loss in the first year will have the same effect.
Jeff: One thing we don’t really talk about often enough is businesses, especially in pass-through entities that are profitable and we get the year-end. And one of our biggest tax planning tools is to go out and buy something.
Your catering service, have you replaced your refrigeration units lately or things of that nature? It’s an immediate write-off against the income that prevents that income from landing back on your 1040.
Eliot: Absolutely. Bonus depreciation. It was our friend at 100% until the end of this year. It doesn’t leave us totally next year. It goes down to 80% though.
Jeff: The bonus drops to 80%. The good news is for retirement plans, contribution rates are increasing dramatically. I believe 10%–15%, so we shall be able to put more into our 401(k) and IRAs.
Eliot: Perfect. All right. And I think this is our last one. “My question is we’re about ready to apply for a HELOC. We do not own our own home yet and my husband is the only moneymaker right now.” Now we’re assuming that while you may not own it, you are paying on it because that’s why you can do the HELOC.
“We want to buy my daughter a mobile home. It happens to be in Bluffton, Indiana but not an Alpine property approximately $47,000. Our credit score is over 800. What can you tell me about our tax obligations and what to prepare for, and should we make an LLC? Maybe you have a link to some of your tutorials or something that can direct me. She and her husband will be making the loan payments until they can qualify to buy it in about three years.”
Assuming that we have a HELOC we can get. Remember, that’s our primary residency. When you take that and you go out and you buy an investment property, there may be a hesitation to be able to deduct that interest because that HELOC wasn’t used on the house, that it’s backed by your primary residence. You wouldn’t take those funds somewhere else. But it wasn’t an investment, so you could maybe argue as an investment and interest deduction there, perhaps. I don’t know what your thoughts are.
Jeff: I agree with that, but what are your thoughts on using an LLC?
Eliot: If we’re going to get an LLC, we probably are talking business. That means it would be a rental. It doesn’t look like if the daughter is going in there is going to pay rent. And again, we have to make this a business. It has to be arm’s length rent, fair market rent rate. Then yes, put it in LLC. Get it protected, I would say.
Jeff: I would love to sell you an LLC just because I can. But in good conscience, I don’t think this is a business, and I think wrapping an LLC around this property is a bad idea.
Eliot: As it is right now, she’s not paying fair market rent. It’s not a business, no LLC.
Jeff: That goes back to that earlier question. I think you already addressed the HELOC. I’m not really sure what kind of taxes mobile homes pay. Usually, you’re running the pad wherever it’s parked.
Eliot: Maybe some personal tangible property taxes perhaps?
Jeff: What else can you do with a mobile home once they start renting it out?
Eliot: Once they start renting, then you can run it as a business if they are paying rent on it, and then they decide to buy in three years. You could make that play and then put it in an LLC. But they got to be paying market rent. You have to run it as a real business.
I realize it’s family. That’s why we say don’t get in business with family because it’s got to be a real business. We can’t be cutting corners on it and sliding off on the rent a little bit on them. Other than that, I think that’s about all we could do.
Jeff: If you’re talking about her buying it in three years, I don’t think I want to treat it as a rental. But one thing. If this is not an anchored mobile home—if you’re curious as to what that means, you can look it up—if it’s not anchored to the ground, it’s a five-year property.
Eliot: There you go.
Jeff: And I don’t want to depreciate that mobile home. Because if I do, I’m going to have a huge capital gain when I sell it to my daughter.
Eliot: Have no basis left or very little after three years and depreciation recapture.
Eliot: You got to make the decision. Is this going to be a rental or not, or are we just going to eat the cost right now, maybe be able to deduct some of the state and local taxes on property taxes or something like that? Other than that, it’s either you’re going to turn it into a real rental business or not. If it is a real rental business, put it in LLC. If not, I wouldn’t spend the extra money on it.
Jeff: A couple of these questions. I’ve noticed people buying properties for their children, especially when they’re in school or trying to get on their feet and all. That’s great. I am all for that. You just have to keep in mind that it’s probably not going to have a tax benefit, at least currently.
Eliot: It might have an investment positive effect, and then goes up in value but right now you’re not going to get that tax write-off typically. That was a real theme on some of the questions, and that’s why I picked them because we are hearing a lot of those come through the platinum portal, et cetera, and wanted to address some of them here.
All right. I think that was our last one. As a reminder, if you have questions, please send them to firstname.lastname@example.org, or go on to our website, andersonadvisors.com.
As a reminder, I believe we do have this coming Saturday, the Tax and Asset Protection workshop, so please feel free to be a part of that. I think it starts at 9:00 Pacific, as I recall. That’s right, Patti. Maybe you can send that through the chat.
Jeff: If you’ve been to that in the past, maybe you went a couple of years ago. I know I first went five years ago. It changes with the law. Not only tax law but legal law. Always go in and get that refresher every so often.
Eliot: You’ll never walk away not learning something new. I always sit there and listen to it even if I’m at the office here working. I’m not even part of the thing. I’ll sometimes try and get in there and listen, and I’m always learning more.
Clint always got something new. It’s the world of tax. There’s always something new there. I would highly recommend it. Get a refresher. If you’re not familiar with it, please join.
I think Patti put the link up there, but definitely on our website. We can get in there at andersonadvisors.com and look at events. Again, that’s this Saturday.
Jeff: No, we’re not promoting Ms.Patti, but I believe we also have a Tax Wise coming up on November 17th?
Eliot: Eighteenth, I thought? It’s a Friday.
Jeff: Which Toby always goes through a number of…
Eliot: Oh heavens. Yes. That’s his big thing. That’ll be coming up and a lot of good ideas, tax advice on that. As he says, he’s going to overload you. You want to walk away with three or four good ideas. Two or three actually, I think is what he says, and always something new there as well to learn.
Jeff: There are several. The Tax Wise is always excellent. If you have not been to Tax and Asset Protection, please do that. Or if you haven’t been in a while.
Eliot: Yup. A lot of good stuff coming up here.
Jeff: Structure Implementation workshop. I know we do that every so often.
Eliot: That is probably I think the most critical. Once you’re in the door, that is the most critical of all the things that we have. Now we call it the Structural Implementation Series. It’s SIS now. Nonetheless, same thing, the same great content. That’s where you learn okay, now I got all these tools. How do I use them? How do they all work together?
Jeff: It answers that one really common question we get. Why do I have this structure?
Eliot: Exactly. If you’ve ever asked yourself why Anderson gave me this, you need to go to that event. That is just huge. They do a fantastic job. Michael Bowman’s on it (one of our partners) and I know that Carl has been on there. He’s on a lot of them. I don’t know if he’s on everyone, but they have set the tone for that program, and there are a lot of great resources and great people that can help you out with that.
Jeff: Toby, Clint, and Michael like educating the clients.
Eliot: That’s the biggest deal. It’s not just talk. Believe me, we hear it behind the scenes. Educate, educate, educate, and that’s how we all learn. Huge on that. We want you to be a part of it. Get that learning in and you’ll be all the better for it.
Well, that’s all we have. Thank you so much for joining today. I think I will be actually back next Tuesday as well or the next one but then Toby’s after that. Yes?
Jeff: Yes. If you enjoyed Eliot and I, we’ll be back in two weeks.
Eliot: Otherwise, if not, there’ll be someone else here. All right. Thank you so much and have a great afternoon.