It’s Tax Tuesday again, and Toby Mathis, Esq., hosts, with special guest Eliot Thomas from Anderson Advisors, and they are here to help answer your questions.
On today’s episode, Eliot and Toby answer listener questions including what can be written off as far as expenses for the preparation costs of setting up an LLC, several questions (as usual) around short- and long-term rentals, real estate investments, passive vs. active income connected to your properties, and quite a bit of information about cost segregation – who to work with, what you can deduct, the timelines, etc.
If you have a tax-related question for us, submit it to taxtuesday@andersonadvisors.
- “If I put a short-term rental in operation in October or November, does the bonus depreciation get prorated accordingly?” We’re looking at whether or not we prorate from October November for the rest of the year, or how do we handle that? – It doesn’t matter whether you bought it in January or December, you put it into service before the end of the year, not prorated.
- “Useful strategies for pulling money out of a small business tax-free, not being double taxed?” – The only time you ever worry about a double tax is when you have a C-corp because they’re taxed at the corporate level.
- “Mileage deduction in a partnership, does this go on a Schedule C?” – No, it doesn’t.
- Number four, “Is the expense related to the preparation of your LLC tax deductible such as travel costs to go see a property, et cetera?” – The expense relating to the preparation of your LLC is absolutely deductible. It’s going to be an organization expense up to $5000 for the year, and that includes the state fees, the registered agent fees, accounting fees, attorney’s fees.
- “Please talk about the $25,000 deduction for real estate investing. Where does it apply and where doesn’t it? I have only one rental single-family home at this time.” – When you have passive losses, normally, they only offset passive income. One of the exceptions is this $25,000 active participation.
- “How should I set up my taxes on my properties?” – We’re looking at an LLC (Limited Liability Company), probably one that’s what we call disregarded. Disregarded means it just doesn’t file a tax return.
- “I have two rental properties in California I’ve been managing full time since 2021. I have been working more than 700 hours per year. Do I qualify for real estate professional status? If so, what is the process at the time of filing the 2022 taxes?” – It’s 26 USC 469(c)(7). You can go straight to it. You need to aggregate those two properties as one activity. Otherwise, you have to meet that test for each property.
- “What is cost segregation?” – Cost segregation is a fancy way of saying you’re breaking a piece of property that’s real estate into its pieces, as opposed to just treating it as one uniform structure. (Picket fence, sidewalk, driveway pavers, new carpet, new appliances, etc.)…you need to do what’s called a cost segregation test or report, which is what cost segregation refers to, which means having an accountant pop out to the house, and break these down into their pieces.
- “Is it more beneficial as an LLC owner to pay myself as a W-2 or 1099 employee?” – There’s no such thing as a 1099 employee, The correct term is a W-2 employee or a 1099 independent contractor. I would say it depends on how that LLC is taxed. If you are an LLC that’s disregarded and your sole proprietorship, you cannot pay yourself a salary.
- “What are some creative ways to save money on the gains from real estate investing?” – Here are some cool ones – (1) The low-lying fruit, 1031 Exchange and you defer the gain. (2) You can also still do this thing called a qualified opportunity zone.
- Lastly, “Hi. How are crypto gains taxed? When? At the time of selling the crypto to convert back to cash? I have been doing short-term trading with my own account. Please advise the best strategies to minimize taxes. My hubby is W-2 and I’m a real estate professional with three rentals. Thank you.” – Once you own the crypto, it’s when you sell it or when you convert it, or trade it for something else of value. Protect it with a partnership LLC, or put it in a Roth, or deferred retirement account.
- Rapid-fire chat questions answered at the end of the show
Full Episode Transcript:
Toby: All right, guys. Welcome to Tax Tuesday. This is a special Valentine’s edition. Okay, Eliot. How are you doing there, brother?... Read Full Transcript
Eliot: I’m doing very well. Happy Valentine’s Day to everybody out there.
Toby: For Valentine’s Day here in Vegas, we had snow, which is weird.
Eliot: Yeah, a little bit of flurries.
Toby: Every now and again, it does that in Vegas. It drops 20 degrees and decides to do that. My name is Toby Mathis, and Eliot’s going to be from the control room running everything today, so I’m going to hand off to Eliot. Before I do, how many of you guys this is your first Tax Tuesday? How many of you all have never been on a Tax Tuesday before? Just put it in chat whether this is your first one.
Eliot: Both hands raised.
Toby: We got some hands raised. Look at that. All right. Eliot, you get to go over the rules.
Eliot: All right. First of all, a little bit about what we do here. The whole idea is to help educate clients. As Toby calls it, bringing the tax knowledge to the masses. That’s our responsibility here. You send in questions and we’ll see where to send the questions in here in a little bit on one of our slides. We pick from a vast grouping of questions that you send in and then we’ll ask a few of them. We try to get to all the questions that we can.
We also have staff on site right now answering the Q&A section. If you have questions, please feel free to open up the Q&A, submit your questions there, and then one of my colleagues will pick it up. We have several CPAs, EAs, and all kinds of people there to help answer the questions.
Like I said, we try to get through all the questions that we can. We do have a, not a hard cut-off in an hour, but it’s about an hour-long program. If we can’t get to all the questions, we’ll try and throw it through the platinum portal to help you there as well and get you answered. Anything else you want to add there, Toby?
Toby: Yeah, advance the slide. It has all the rules on the next.
Eliot: That’s a good idea. There you go, okay.
Toby: All right.
Eliot: There we go, then push it.
Toby: There we go. For the newbies, you could ask detailed questions, not too specific to your situation. But if you’re seeking clarity on an issue, go right into the Q&A. That’s where you put it. Somebody says, “I was told by my CPA I can no longer take the home office deductions as an S-corp.” They’re already starting to do that.
We have a bunch of folks—Jared, Amanda, Dana, Dutch, Sergey, and Tanya—all sitting by answering questions all day. A bunch of accountants and attorneys, believe it or not, are sitting here and they’ll answer your question. If you have any questions that you’re burning or you want clarity on an issue, we’re going to go over a bunch of questions. Eliot’s going to read through them all here in a second, but then you can absolutely go in and ask your specific question. Write it in there.
If it’s too detailed and you’re like, hey, I filed my return last year, I did XYZ, and I want to amend it and do this, what should I do? What are my steps? We’re probably going to say, hey, you got to become a client because now we’re giving you advice. But if you’re just asking like, hey, how do I write off the vehicle, how do I do reimbursement, and things like that, throw it into the Q&A.
Eliot: We’ll go through all the questions first and then we’ll come back and start answering.
The first question, “If I put a short term rental in operation in October or November, does the bonus depreciation get prorated accordingly?” We’re looking at whether or not we prorate from October November for the rest of the year, or how do we handle that? We’ll look into that question.
“Useful strategies for pulling money out of a small business tax-free, not being double taxed?”
“Mileage deduction in a partnership, does this go on a Schedule C?”
Number four, “Is the expense related to the preparation of your LLC tax deductible such as travel costs to go see a property, et cetera?”
“Can I give my son a 1099 from my Wyoming holding company to get a tax deduction?”
“Please talk about the $25,000 deduction for real estate investing.” I think we’re talking about passive losses there. “Where does it apply and where doesn’t it? I have only one rental single family home at this time.”
“How should I set up my taxes on my properties?”
“I have two rental properties in California I’ve been managing full time since 2021. I have been working more than 700 hours per year. Do I qualify for real estate professional status? If so, what is the process at the time of filing the 2022 taxes?”
“What is cost segregation?” A simplistic question, but an important one because we’ll talk a lot about that.
“Is it more beneficial as an LLC owner to pay myself as a W-2 or 1099 employee?”
“What are some creative ways to save money on the gains from real estate investing?”
Lastly, “Hi. How are crypto gains taxed? When? At the time of selling the crypto to convert back to cash? I have been doing short-term trading with my own account. Please advise the best strategies to minimize taxes. My hubby is W-2 and I’m a real estate professional with three rentals. Thank you.”
Those are the questions we’re going to hit. Before that, Toby has a little advertising here for his YouTube channel.
Toby: Hey, yeah. First off, we put our recordings of the Tax Tuesdays right on in there. But if you have any tax questions, asset protection questions, or you want to go there and fill your brain a little, I don’t even know how many videos we have up there. I think it’s about 400 videos. Since 2014, we’ve been running that channel. Feel free to hop in, subscribe, put the little notification on.
About three times a week, we put up new videos. You go in there and fill your brain with a bunch of tax knowledge. But if you like what you’re hearing today and you’re saying, geez, they’ve been doing this for years and years and years, and I want to go check out what other questions people are asking, by all means, they’re up there on the YouTube channel. We put them up after every event.
Eliot: To get there, you can subscribe to our YouTube channel at aba.link/youtube for the replays and all Anderson-type material we have up there.
Toby: My partner, Clint, also has a channel that goes over specifically more of the asset protection stuff. By all means, go Google Clint Coons if you want. We’re all over the Internet. It’s hard to miss us, or Patty just shared the link right there. You can pop on in there.
Again, if you like, looking, going out, and trying to find new ideas, it’s one of those endeavors for us that we see pays off in spades for people. If they go out there and they try to get a little bit of tax knowledge, it’s usually a worthwhile endeavor. You never know when you’re going to run across somebody that could benefit from that knowledge by saying, hey, I heard this, you might want to go check it out. You might be able to help somebody out.
Eliot: All right, first question. “If I put a short term rental into operation in October or November, does the bonus depreciation get prorated accordingly?”
Toby: Good question. Let me jump in. Normally, I get to read them and make you answer. This is way more fun. This is the really cool part about bonus depreciation. Typically, when you have an asset that’s being depreciated over a long term like 27½ years, 39 years, you’re going to have this half yearly convention of when you put it into service, in other words, you are prorating over the year.
But when you have personal property, especially into the bonus depreciation that you’re accelerating the depreciation, it could be in service for one month. It doesn’t matter, one month or the full year. It doesn’t matter whether you bought it in January or December, you put it into service before the end of the year, not prorated. That bonus depreciation has taken a push right now. You don’t have to just spread it out. It ends up being a huge boon depending on your scenario.
Eliot: Very much so. As far as the scenario, it’s going to depend on whether or not those losses can be taken if you’re a real estate professional. But you have a short-term rental, so I guess it would be material participation. If you’re the one managing it less than seven days average and things like that, then more than likely, you’re going to be what we call a Schedule C. It’s going to be an active business. Yes, it’s going to work to your favor given those losses that will set off against any other income you have on your return.
Toby: I know that there are questions in here that are going to go into cost segregation. Some people might be saying, what is bonus depreciation? Anything that’s 20 years or less, in 2022, you could accelerate that depreciation. When I say 20 years or less, like this phone here. The IRS says this will last five years. Or if I went out and looked at my deck, that’s a 15-year property. It’s land improvement. It’s spread out over that many years.
Under 168(k), we could accelerate that and write it all off in one year. Again, I’ll use my cell phone as an example. I could write it all off right now. That’s the big benefit. When you’re dealing with rental properties, you do something called a cost segregation to break the property into its 5-year, 7-year, 15-year property, then you can accelerate that 5-year, 7-year, 15-year property and write it all off in year one.
For 2022, it’s 100%, which means if a 30-year property is comprised of this stuff like the carpet, cabinets, appliances, the driveway that you put in, the fence that you put up, the new backyard that you put in, window coverings—you guys know what you do—the new linoleum, putting a new paint job on, all that stuff. If it’s comprised of those items, you could write that all off. The question is, what’s the benefit to you?
If you’re just a real estate investor and you have passive losses—you’re familiar with that term—you know that passive losses only offset passive income with a couple of exceptions. One of the exceptions is this thing called active participant in real estate. The other one is something called a real estate professional. The active participation phases out when you hit $150,000 of adjusted gross income. It’s gone.
Mostly, we’re talking about real estate professionals. Otherwise, you’re just taking a loss and carrying it forward. You don’t lose it. Eliot, let’s use an example like a $500,000 property. Let’s say the land is worth $100,000. You have $400,000 of improvement there. Let’s say we could write off 30% of it, so 30% of $400,000 is $120,000. That is a 5-year, 7-year, 15-year property.
That’s about right, by the way, guys. That’s pretty close to being spot on. I bonus that depreciation. I now have this big loss. Let’s say I had a positive rental income of $10,000 a year. You’re not going to be paying any income tax on any of that, it’s going to wipe out that rental income probably for the next 10 years. That’s why people use it.
If you’re a real estate professional, not only do you wipe out your rental income for the year, but then you could take—let’s say it’s a $100,000 loss in excess of all your other rental income—you’re going to use that against your W-2. It’s just really hard. I know there’s a question here about real estate professionals, so we’ll hit on it, but that’s what it really boils down to.
We always call it, is the juice worth the squeeze? Is it worth doing the cost seg? Is it worth doing the bonus? What’s the net benefit to my pocket? They’re not free. When you do a cost seg study, does it cost $3000 to save $4000? Probably not going to do it. If it costs $3000 to save $30,000, I’m probably going to do it. You’re always doing that balancing test.
Eliot: Absolutely. Again, that’s the big difference doing the bonus depreciation. In October or November, you do get to take-it-all, as Toby said, immediately in that year, as opposed to if we didn’t do a cost seg, then you’re looking at a straight line, 39 years or 27½ years in the case of a single family residence or something like that. We’re just not going to get nearly as much depreciation from it.
Toby: All right, let me just put a quick caveat here. I already see that people are jamming the Q&A. We’ve got Amanda, Jared, Dana, Dutch, Sergei, Tanya, Ander. Patty. Everybody’s answering questions the best they can. A couple of people are like, hey, I’ve submitted a question. We are getting through them. We’re probably about 10-15 minutes behind those questions.
They’re going to get answered today because we don’t leave until we answer them all. There are about 45 that are in queue, and they’ve already answered about that same amount. Just be patient. If you put something in Q&A, they’re getting through them. Remember. they’re not charging anything for it, so be patient. There are a couple of guys in the chat saying, hey, where’s my answer? We’ll get through it.
Eliot: It is Valentine’s Day. Time for a little bit of patience and love.
Toby: We will make sure. Hey, Mike, go ahead and put your question to the Q&A. We will get through to you guys no matter what. We don’t leave. Somebody says, “Prayers for Jeff.” If you guys know, normally, I have Jeff Webb in here. He’s got some stuff he’s going through, so we’re going to give him our prayers today.
He’s actually hopefully doing just fine. Everybody has health issues once in a while. We just pray for them when they do, and they come back. I have no doubt that Jeff’s going to kick you out of that seat, Eliot.
Eliot: I’m up for it. I would love it.
Toby: Maybe he’ll kick me out of mine. Keep going, buddy.
Eliot: All right. Next question. “Useful strategies for pulling money out of a small business tax-free, not being double taxed?”
Toby: I want to respond to something real quick. There are always different ways to get money out of a business depending on the type of business it is. If you have a small business, it’s a sole proprietor, very different from if you have a small business that’s an S-corp or a C-corp.
The only time you ever worry about a double tax is when you have a C-corp because they’re taxed at the corporate level. If you have profits and you leave it in the corporation, they’re taxed at 21% flat, no matter how much it is. It can be $10 million, it’s 21%. Then if it pays that out to you in the form of a dividend, then you might pay tax on it. It depends on your tax situation.
If you are in the bottom couple of tax brackets, it’s zero. If you’re in the middle brackets all the way up to the top, you’re at 15%. Then if you’re a rich guy making lots and lots of money, you’re probably at 20%. The point is that it’s only for C-corps where you ever have to worry about that double tax. What we’ve found is that there’s really no difference.
If I make a million dollars as an individual versus I make $500,000 as an individual, $500,000 as a C-corp, and then I pay the entire amount that I made in the C-corp back out to myself, it’s all about the same amount of tax. It’s not markedly different. I think it calculates right just under 37% which is the top bracket.
I’ve never found it to be something that dissuaded me, but what it does give you is C-corps have very specific benefits. (1) It’s a flat tax. (2) C-corps can reimburse 100% of your medical, dental, and vision expenses, including those of your dependents. You don’t have to report it and it’s deductible to the corporation. Depending on your scenario, that could be really, really enticing. Depending on your tax bracket, it can be really enticing to have that 21%.
Let’s say you’re in a household and you have two really high income–earning spouses, it might be wise if you have the control of one of the businesses to make it into a C-corp so that you could pay 16% less on the federal side alone. You can cut your tax bill almost in half by doing that. It ends up being a little bit of math strategy that you’re looking at, but it can be a huge benefit.
Now, talking about getting money out of the business. Otherwise, I’ll say this. Using retirement plans, you could defer a substantial amount of your income. For a guy like myself, it’s up to $30,000 a year immediately that I could defer right into a 401(k), and then I could put an additional, I think it’s up to $73,000 for somebody who’s over 50.
For other people, I think it’s $22,500 that you can immediately defer, and then the company can contribute on your behalf, 25%. If you’re a sole proprietor, you could be messing around with a set plan, with a smaller amount, but you could still defer it right there. If you’re a small business, you probably want to marry that to a retirement plan. Then of course, it’s writing everything off under the sun.
I’m not a big fan of sole proprietorships because their audit rate is about 800%–1000% higher on a typical business making $100,000 a year. It’s not even close. When they do get audited, which is a lot more than their counterparts, the S-corp or the C-corps, they lose. They lose over 94% of the time.
I’m not really interested in doing that. One of the reasons why is because something like this cell phone, I want to pay for out of my business. If I’m a sole proprietor, I have to figure out what portion of this cell phone is being used for business and what portion is being used personally, which is I don’t know how you do that in this day and age. You’re going to have to track it. If you don’t track it right, then they’re going to disallow the deduction.
Versus if I’m an S-corp, a C-Corp, an LLC taxed as an S-corp, or an LLC taxed as a C-corp, I can reimburse 100% of that expense under an accountable plan, and I don’t have to report it as the taxpayer.
It makes my return so much more simple, but those are the types of things. It’s things like an administrative office for your home, making sure that you’re reimbursing for the actual cost of a home office. I’m using a home office here and the company can reimburse me for a substantial portion of my house.
In my case, it’s close to 20%, which includes my property taxes, my mortgage—I don’t have a mortgage, but if I did—some of my mortgage interest. If you have a cleaner, then part of that, my utility bill, my electric, all that stuff, my water bill, you add everything up and you say, what percentage of that house is being used for the benefit of the business, then that business can reimburse you. It’s not reported anywhere.
It’s not like when you’re a sole proprietor and you have to do that crazy home office deduction, where you actually have to do a special form. Then the other benefit of running a business as a corporate entity, versus just as a sole proprietor is you get to avoid a lot of the self-employment tax.
One of the sad parts of being a sole proprietor is that it doesn’t matter whether you take the money out of the business or not, 100% of the net profit is taxed under old age, disability and survivors, and Medicare. One hundred percent. That’s not a small amount that adds up to being about 15.3% in addition to your federal income taxes, which is in addition to your state income taxes.
When I start seeing questions like this, useful strategies for pulling money out, it’s: (1) expense everything that’s business-related out of the business, (2) make sure that you’re the right type of business and reimburse yourself anything under the sun that you are using personally for the benefit of the business. I don’t care whether it’s your computer, whether you’re getting your kids involved and maybe they’re getting some pay, maybe they have a small business on the side that you’re paying, maybe you’re covering for their equipment, their computers, their cell phones, their data. All that fun stuff becomes a deduction if they’re actually working for the business.
Here’s the rub. I can be doing this for people, even if they’re not taking a salary. This is always a bone of contention with a lot of accountants. They’re like, oh, you got to take a salary to get fringe benefits, and there’s no such requirement. In fact, technically, there’s not even a requirement if you’re profitable in an S-corp that you take a salary. That’s going to make some heads explode.
I know there are some CPAs out there. The actual rule is, if you take distributions out of an S-corp, you need to take a reasonable salary. But if you’re just running an S-corp and you’re just leaving the money in there, it’s slowing down and being taxed to you, technically, you don’t even have to take a salary unless you take the money out. There are all these little things out there that are beneficial with the business, that makes you go one direction or another.
I’ll just say this before I hand it off to you, Eliot, and get your comment. You really want to be sitting down with somebody and asking somebody who knows, because I can look at a business, I know Eliot can do the same thing. You start seeing, hey, you’re making $25,000 last year, you’re probably okay being the sole proprietor, we’re willing to take the risk, we’re not in the danger zone yet. You get over that $25,000, $30,000, $40,000. You should be an S-corp or a C-corp.
They say, but my accountant told me about an LLC. It’s like, okay, an LLC does not exist to the IRS. We’re going to tell the IRS how we want it to be treated. You could still have an LLC that’s treated as an S-corp or a C-corp, but you’re probably going to want to be a corporate entity. There’s no such thing as an accountable plan if you are a sole proprietor or a partner in a partnership. You’re almost always going to want to have some corporate entity floating around there if you’re really looking at the benefits of a small business.
Eliot: The only thing I can really add to that just as far as retirement plans, and you could do this with other businesses, but you could have a defined benefit plan. I don’t know if you touched on that. That’s just a lot more that one could put away just more tax savings.
Toby: I didn’t. What is a defined benefit plan? What is this weird thing in which you’re discussing?
Eliot: What Toby was talking about earlier, the other retirement plans are defined contribution, where we define how much the contribution is. Defined benefit goes the opposite way and says, well, we’re going to define how much the benefit is at retirement. Generally speaking, it’s going to allow you to put away a lot more.
Let’s say you could do $60,000–$70,000 in a solo 401(k). Defined benefit, many times, we’ve had clients in excess of—correct me if I’m wrong, Toby—maybe over $200,000.
Toby: We had a client put in over $700,000 in one year. It’s a defined benefit plan. It’s all a question of how old you are and how long you have to make up the nut that has to be in there to kick off the income. A DB plan, the easiest way to think about it is we can either define what we’re putting in it, hey, you can put $6500 a year into an IRA. That’s called defining the contribution, or you can say we’re going to define what comes out of it.
Eliot’s used to making X number of dollars a year, when he retires, in order to get that same amount of money out of retirement plan, we get to reverse engineer. We use an IRS actuary and they calculate. You need to have $2.6 million into your plan in order to kick that income out, Eliot, and you have 10 years to do it. You can do simple math and realize that’s about $260,000 a year. That’s about right.
It’s not quite that simple, but that’s what it really boils down to. You can go in reverse. If you like this topic, then I’d suggest you go into the YouTube channel. There’s something called the $100,000 a year retirement plan. It’s sitting in there because I actually brought an actuary who broke it down and got into the weeds with it.
Spot on, Eliot, is that once you have a small business, you have access to things others don’t because as an individual, I can’t do a DB plan. I have to be associated with the business.
Eliot: Just one last comment on when I’m talking to clients about this and my other teammates, it’s really, do you want your tax money to go to the government or would you rather have a go to your retirement plan? That usually makes it quite simple in their decision making, and that’s what we’re looking at.
Toby: The last little thing on this one is make sure there are travel expenses, there’s food. 2022 meals were 100% deductible if they’re at a restaurant or from a restaurant. Your travel, make sure that you’re reimbursing your mileage that you’re doing for your business. Get it out of that business. You’re supposed to do it by the end of the year. But obviously, as you’re going on, keep doing it. I think right now, the mileage reimbursement rate is 65½ cents. There are these low-lying fruits that sometimes we forget about. Make sure that you’re getting them.
Eliot: Very good. “Mileage deduction in a partnership, does this go on a Schedule C?” What think you, Toby?
Toby: No, it doesn’t. Next question. It’s this funky thing, I believe, where you have the unreimbursed deduction that’s sitting on the partnership that reduces the amount of income that flows down to the partners. That’s how they take it. Technically, you’re not an employee, so it shouldn’t really be reimbursing you the expense, although I’m sure that there are a number of people that do. But technically, I don’t think you’re supposed to do that.
I think it’s just an unreimbursed expense. It’s going to end up in your pocket anyway as the partner, and that’s how you’re getting your mileage back. Did I do that right?
Eliot: No, you’re pretty much on that. I’ll just say that the Schedule C, for those who get confused, that’s the sole proprietorship that Toby was talking about in the last question, which we really are not a fan of higher chance of audit, more chance of them finding something on audit, doesn’t allow you reimbursements, although a partnership doesn’t as well. But in partnership, at least we’re keeping you off as sole proprietorship. Toby, do you remember from your research what audit rates are like for a partnership?
Toby: Yeah, they were 0.01%. It was a fraction of a percent. They actually had an asterisk on it last year. It’s really, really, really low. What it does is they end up looking at the individual return. If you guys haven’t gotten to a Tax and AP event, I’d encourage you to go to one. I break down the stats, it’s about five-to-one audits of poor people versus everybody else.
This is going to sound horrible on Valentine’s Day. I’m probably going to get cursed for saying this, but if you don’t want to get audited, don’t be poor. It’s a sad truth because they don’t fight, they don’t have accountants, and it’s horrible. The highest audit rates, period, are folks that are taking that earned income tax credit and that are in the lower brackets. It’s just not fair, but it is about five-to-one.
For partnerships, S-corps, and small corporations, small C-corps, the audit rates are virtually non-existent. We can tell you exactly why you’re going to get audited. It’s not rocket science. If you’re a sole proprietor, the reason you get audited is because you took a distribution and you never paid yourself a salary. Nine times out of 10, that’s what’s going to trigger. They just know how to look for it.
For partnerships, it’s doing bizarre things in the partnership. It’s trying to write things off and taking salaries out of partnerships that gets you audited. You can’t do it. You’re a partner, it’s guaranteed payment to the partner, so it doesn’t quite work that way. Definitely, there’s the error that people would have to trigger on those. But the actual partnership returns, they’re just rarely, rarely audited.
Eliot: All right. We’d still be off in a partnership, better off than we would a Scheduled C. We pointed out this would not go to a Schedule C to begin with, so 1065.
Next, “Is the expense related to preparation of your LLC tax deductible such as travel cost to see the property, et cetera?
Toby: Good question. What you’re really asking is there are two categories. There are startup expenses and there are organization expenses. In both of them, you have up to $5000 in your first year. The expense relating to the preparation of your LLC is absolutely deductible. It’s going to be an organization expense up to $5000 for the year, and that includes the state fees, the registered agent fees, accounting fees, attorney’s fees, my favorite, any of those that you could lump in there. Then your travel costs going into a property would be a startup expense, unless you already own the property before you set up the LLC, in which case, it’d be a current expense.
It always comes down to, is the business operating? Is it already making income? In real estate, it’s when did you get the investment property? When did you buy it? Now we can start writing things off, versus is it pre, is it before? In which case, then, is it a startup expense? There is a little bit of a nuance between an LLC that’s a partnership, for example, versus if you set up a corporation. In any event, you’re going to get to write things off.
Eliot: Sometimes some preparers also take a little bit of a different approach. If you have some of these travel costs to look at a particular property, they may just add that to the basis of the property. Sometimes some repairs will do that because there is some guidance that way in the publication. But other times, as a preparer, I know I’ve done it, they’ll put it in the startup cost that Toby’s talking about, so don’t be surprised if it goes to your basis as well.
All right, next. We got some of the Tax and Asset Protection workshop. I don’t know when’s the next one. February 25th, coming up here.
Toby: Come on in if you want to learn about land trust, LLCs, corporations, taxes. We even do legacy planning. I tend to go over because of that. February 25th, it’s a Saturday. Take the time off and come hang out with us.
Clint does a really good job of breaking down the different types of entities, everything from Wyoming statutory trusts to land trusts, to LLCs, to using when to use Wyoming when not to, when to use your home state, how to structure your real estate. He does a really good job on that and then I come in and do tax and legacy planning. It’s absolutely free. I think it’s worth your time.
One of those things is what we call security through obscurity. It’s not being liable on a lawsuit that gets you. Every now and again, you have somebody that gets taken out with a lawsuit that gets crushed. They go to trial and they get a runaway jury. Ninety-nine percent of them don’t get there. It’s the death by a thousand paper cuts that gets it. It’s the time, the anguish, the four years of suffering, and having to pay lawyers or be around lawyers and stuff.
We’ve taken a proactive approach to realizing that if people can’t see what you have, they tend not to sue you. That’s a big part of what we teach. Here’s how you can isolate liability, but here’s the most important thing. Here’s how you can keep from getting messed up because, hey, your taxes are probably great. It doesn’t mean you want to go through an audit. Hey, your asset protection is great. It doesn’t mean you want to go through a lawsuit.
Let’s avoid those things by being really smart and realizing they tend not to sue really poor people. They tend not to audit people within a certain category types of businesses. Let’s be those. It doesn’t mean you want to get hit, it doesn’t mean I’m telling you to go be homeless. I’m just saying that on paper, from an attorney’s perspective, make sure you don’t look like an attractive target. We do that and we want to make sure that you don’t put a big old bullseye on your back.
Eliot: Absolutely. All right, “Please talk about the $25,000 deduction for real estate investing. Where does it apply and where doesn’t it? I only have one rental single family home at this time.”
Toby: This is just the active participation we were talking about a little bit earlier. When you have passive losses, normally, they only offset passive income. One of the exceptions is this $25,000 active participation. Active doesn’t mean that you’re a real estate professional. This just means that you are in charge. You hire the property manager. You hire whoever it is that’s working on the property. You ultimately are the one that’s the decision maker.
Everybody here, if you’re a real estate investor, chances are, you’re an active participant. The only question is, do you qualify for that extra up to $25,000 a year of passive loss that becomes ordinary loss on your return? There’s an income phase out. The first $100,000, you worry nothing about. Then for every $2 over $100,000, you lose $1 of the deduction. If you get up to $150,000 of adjusted gross income, you’ve lost your deduction entirely.
For every $2, you lose $1. For every dollar over $100,000, you go up to $150,000, that’s $25,000 that you lose. But if you’re in the middle level and you have a $10,000 loss, let’s say you make $125,000 a year and you have a $10,000 passive loss, and you’re an active participant on your real estate, you get to take that. If you’re making 125,000, now you’re making 115,000. It ends up working just great.
Eliot: Also, again, outside of those numbers, there are things that sometimes we’ll advise clients. Maybe make a contribution to an IRA or something like that to lower their income so they can get more in there if they’re above $25,000 losses. Possibly working with a tax professional might get to where you can take more of that $25,000.
Toby: This is before you take your standard deduction, too. This is going to whittle away at your income tax. There was one thing. Somebody was sitting here in the chat, and I think they probably kicked him off into the Q&A.
They were paying their kids by their corporation. One of the spouses set up a sole proprietor, an LLC taxed as a sole proprietorship or just a sole proprietorship, and they paid all the money to their children under 18. You can absolutely do that, by the way. The kids, if you did that and they made less than… this year’s $13,825. I can’t remember what it was last year. Remember the standard deduction for single last year?
Eliot: I believe it’s $12,950.
Toby: Yeah, you’re right. For some reason, I kept saying, that seems like too big of a leap. It jumped up almost $1000. They don’t even have to file a tax return. If they’re under 18, not only do they not have any taxes, they don’t have any employment taxes, but they also don’t have a requirement to pay a tax or to file a tax return.
Out of your corporation or whatever your business was, you paid your kids, let’s say you had two kids and you paid them each $10,000, you just got $20,000 tax-free that was deductible.
Somebody else asked about passive losses and what they are. Really simple, there are only two types of income that are passive, rents and then businesses in which you do not materially participate, so profits from businesses. If you’re in partnership or an S-corp and you don’t do anything in the business, then chances are, it’s passive.
Eliot: Very good. “How should I set my taxes for my properties?”
Toby: I have no idea what that means. I’m going to punt this one to you, Eliot.
Eliot: All right. As Toby was saying earlier, really, we want to look at the entity first. If it’s going to be a rental property, maybe long- or short-term rental, we’re going to want to put that some asset protection.
We’re looking at an LLC (Limited Liability Company), probably one that’s what we call disregarded. Disregarded means it just doesn’t file a tax return. That might be owned by a Wyoming holding. That would be our classic structure for these types of rentals, properties, if that’s what you’re referring to.
That way right there just on that structure, all that income is just going to flow through to your 1040, unless that Wyoming holding is a partnership, in which case you would go a partnership return, but it still comes right back to your 1040 or what we call a K-1.
Then as far as looking for tax bonuses or what have you, many times our clients might set up a management C-corporation. Any work that you’re doing on behalf of your rentals, you can now do as an employee of that C-corporation. The C-corporation is going to earn a fee from your rentals for providing those services, and we call it a management fee. You’d have an actual contract between your C-corporation and this LLC that holds your rental. It might pay 10% of gross rents or something like that that shifts income into your C-corp. That’s going to give you tax savings potentially on your 1040.
Then in the C-corp, once it’s up there, we talk about the reimbursements that Toby was mentioning earlier through the C-corp, the medical reimbursement, administrative office through your accountable plan, cell phone, internet, and things like that, as well as the 280A corporate meetings. It helps you get that money on the corporation back to you tax-free, and at the same time, it’s a deduction to your C-corp.
Typically speaking, when we talk about properties, I’m thinking rental properties more than likely here and how we would set up for your taxes. It’s going to involve structures with these LLCs and maybe a management corporation to get, normally, would be our best result.
Toby: Sounds good. I didn’t know what the question was.
Eliot: I’m reading into it a little bit, but I had a feeling that’s where we probably were driving at. Also though, you’re more in depth on this because you can really go a lot of ways with this.
Also, we talked about earlier is if they are rentals, if you are a real estate professional or materially participating in your short-term rental, you can hit into those cost segregations, which we’re going to talk about here in a little bit, and bonus depreciation, things that might give you a little bit more loss and give you a little bit more tax benefit as well.
“I have two rental properties in California I have been managing full-time since 2021. I’ve been working more than 700 hours per year. Do I qualify as a real estate professional? If so, what’s the process at the time of filing my 2022 taxes?”
Toby: All right, you just hit on something really important. First off, let me give you the site for this. It’s 26 USC 469(c)(7). You can go straight to it. It’s 469(c)(7). What it is is when you have passive losses, if you don’t want them to be passive, there are two exceptions. We already mentioned one of them, the active participant. The second one is, I am a real estate professional. That’s what he’s or she’s asking about.
This is what it boils down to. There are two parts. First part of a test, I’ll call it a prong one. It’s a two-part prong, and then there’s prong two. Prong one is do you spend 750 hours a year on a real estate trade or business? The second part of prong one is, is it more than 50% of your time that you spend at work? Your personal services. And one spouse has to meet this.
He says, “I have two rental properties in California,” so it sounds like we’re in passive activity, “I’ve been managing full-time since 2021.” I’m going to assume these are long-term rentals and that they qualify as rental activity. If it’s Airbnb, a little bit different, it’s even easier. But let’s just assume that these are month-to-month rentals. Maybe they’re duplexes, fourplexes, whatever they are. And they’ve been working more than 700 hours a year. I’m going to assume that they mean on those properties.
It’s not, hey, I spend more than 700 hours a year working and I also manage my properties. It sounds like this is what they’re doing for their living or this is what they’re doing with their personal services. Under the first prong, 750 hours more than 50%, we have to know how many hours you actually spent. It says more than 700 hours. If it’s 740, you don’t qualify. If it’s 790, you do. If it’s 751, you do. You would qualify under prong one.
Prong two is, did you materially participate in your rental properties? I would say absolutely because there are seven different tests. One of them is 500 hours that you spent on your properties. You spent 700 hours. You met that test. What I’m going to say is this is really important and listen to me clearly. You need to aggregate those two properties as one activity. Otherwise, you have to meet that test for each property, so you’d have to separate out like silly, but I’ve seen it done.
The courts actually screwed this up and applied the 750 hours to each property at one point. Hopefully they won’t do that, but you could be involved in any real estate trade or business, management counts. To the extent that your hours are management activities, you’re going to be fine as wine, but I would end up more than likely aggregating those two activities together so that you’re not trying to do it for each property. Then on your taxes, on your Schedule E, you’re just selecting that you’re a real estate professional. It’s actually a one little checkbox.
What it does is it makes your passive losses into ordinary losses. Magic. We call them non-passive loss. It’s a non-passive loss that goes and you can use it against all your other income. That’s it. It’s not any more difficult than that. You just have to make sure that you know what the test is and meet it.
Eliot: There it is. Pretty much.
Toby: I know it’s exciting stuff. It was like, okay, that was awesome. See what time it is.
Eliot: We get asked a lot about it understandably so, I guess, by a lot of real estate clients out there.
“What is cost segregation?”
Toby: Cost segregation is a fancy way of saying you’re breaking a piece of property that’s real estate into its pieces, as opposed to just treating it as one uniform structure. The best example I can give you is I want you guys just to visualize this for a second. Think of the cutest little house you’ve ever seen—white picket fence, great backyard—and we’re going to walk through it.
Let’s walk up to the white picket fence. We open up the white picket fence. We start walking up this cute little sidewalk. Take a look over on your right or your left, whichever side you have the driveway. They poured some new concrete or maybe they put in some pavers in the driveway. You walk up to that front door, it’s freshly painted, and you open it up.
This is a great little rental house. You smell new carpet, you see all the cabinets are gleaming, all the appliances are brand new, and it’s freshly painted. There’s new tile in the kitchen, there’s a new deck out back. You walk out back and you see they put in new flower beds, and a new pitch was put down. They planted a bunch of fruit trees, and there’s a brand new fence surrounding it. It’s just a great little rental property.
Your accountant would probably look at that and say that’s 27½-year property. In other words, whatever is not land, they’re going to write off over 27½ years. Let’s just think about that. Wait a second, the deck’s not going to make it that long, the carpet’s not going to make it that long, those appliances aren’t going to make it. Why are you treating it all as 27½-year property, when clearly some of this property’s not going to make it? This is where cost segregation comes in.
The IRS will certainly allow you. It’s called an impermissible tax treatment. It’ll allow you to write off that building over 27½ years, single family residence, it’s residential property. They’ll straight line deduction over 27½ years. That’s what 99% of the accountants do. But you have the choice to opt out of that.
You could either do it in year one and do it the right way, which is technically the permissible method, which is to break it into its pieces and say I’m going to write off the carpeting over five years, the appliances and the cabinets over five and seven. I’m going to write off the deck and back over 15-years, and the trees over 15 years. The fences, it’s a 15-year property land improvement. That driveway is a land improvement. I’m going to write that over 15 years.
In order to get there, you need to do what’s called a cost segregation test or report, which is what cost segregation refers to, which means having an accountant pop out to the house, and break these down into their pieces. What it usually does is it gives you about 30%–40%. In some cases, in manufactured housing, it’s up to 80% of the value of the improvement in year one. It allows you to make huge deductions or at least take 30%–40% of it and write it off over 5-, 7-, and 15-year property.
You could choose whether you bonus and accelerate that even further. But at a minimum, it means I’m writing things off over a faster period of time. Why would you do that? If you have other income to offset, if you’re a real estate professional and you don’t want to pay taxes on your W-2 income, if you have a lot of other real estate activities and you have income coming in off them, and you don’t want to pay tax on that income, then you could cost seg properties and accelerate the loss so that it wipes that out. That’s when you’re using a cost seg.
Eliot: Very good. “Is it more beneficial as an LLC owner to pay myself as a W-2 or a 1099 employee?”
Toby: There’s no such thing as a 1099 employee, so I would say it depends on how that LLC is taxed. If you are an LLC that’s disregarded and your sole proprietorship, you cannot pay yourself a salary. It’s just going to flow down on your Schedule C as income. It’s going to be 100% attributed income for Social Security.
They call it the self-employment tax. You file an actual Form SE on your return and you pay, but it’s essentially 15.3%. Half of it is tax-deductible. The math I think is 14.1%. That’s the actual tax bite.
If you are an LLC taxed as an S-corp or a C-corp, it’s an LLC taxed as an S-corp or an LLC taxed as a C-corp, you can pay yourself W-2, and it really depends. Everybody’s situation is a little bit different.
If you are making, let’s say, $100,000 a year net and you need that money to live off, and let’s say that I have the choice between an LLC that’s disregarded as a sole proprietorship versus an LLC taxed as an S-corp, that’s probably the category I’d put you in, it’s going to save you about $7000 or $8000 a year to be that S-corp because you could pay yourself a salary out of the S-corp, and the profits then flow down. They are not subject to self employment taxes.
Versus if I am a sole proprietor, $100,000, I don’t get to take a W-2, I don’t get to take a wage, 100% of the profit is subject to the Social Security taxes. It ends up making a pretty big difference to you if you are an LLC to be an S-corp if it’s an active business versus your friend, the sole proprietorship. Or if you’re an LLC with others, better than a partnership is probably going to be that S-corp.
It begs the question, which one’s better? I would say it’s almost always better to have yourself in the position as an employee because you qualify for an accountable plan. You can reimburse so much stuff and get other tax benefits, versus just being a flat out 1099. The correct term is a W-2 employee or a 1099 independent contractor.
Eliot: Very good. Anytime you’re getting a 1099, if you were getting it from another party, I know you mentioned your own business, but take that 1099, throw it into an S-corporation like Toby was talking about, have the S-corporation be the recipient of it, or maybe a C-corp depending on your situation, and you’ll be able to take advantage of all those things Toby was talking about, the reimbursements, retirement plan, so on and so forth. Just a much, much better situation either way.
Toby: Eliot, can we go back to the previous question real quick? Somebody asked a good question, the cost segregation. Somebody was asking, “Does time acquiring a new property count towards,” technically it was the 700 hours. It was a question even previous to this one, but I don’t remember which. Yeah, this one.
I want to hit on this real quick because the IRS says a trade or business is construction, development, management. It’s not investing. For the 750 hours versus the 50% of your time, looking around for new properties would not count towards the 700 hours.
If you are in a property flipping business and it was part of the trade or business as a whole like that was just a big part, or you’re a wholesaler, they might allow you to count that. But for 90% of you all out there that are investors, you have to break this down into, when am I involved in management and active business versus when am I an investor?
For the first prong, it has to be, I’m in business, I’m in a trade or business. I could be doing construction for third-parties. It doesn’t have to be on my buildings. I can be a real estate agent helping other people buy properties, but that time does not include my investor looking around for property activity. I just wanted to answer that one live since I thought, Paul, it was a good question, and I saw that in the Q&A.
Eliot: I will just add that Toby talked earlier about this as under Section 469(c)(7). Actually, if you continue just a little bit farther south, the (c)(7)(C), that’s where the code actually lists out the 11 real estate trades or businesses that Toby is talking about so you can see a whole list of what qualifies for real estate trade or business. A lot of information in that one little particular section of that tax code.
I’d seen earlier there, John had asked in the webinar chat about if one has to get all seven of the material participation tests. No, you just have to meet one. It makes it a lot easier.
Toby: Here’s another one. Somebody says, “What are the steps for a W-2 wage earner with rental property that I managed to get to be a real estate professional?” It’s 750 hours, and it has to be more than 50% of your personal service time. If you’re a W-2 employee, chances are, you’re never going to qualify because you’re going to spend more time on your W-2, unless you’re working part time, in which case then I would track your time.
People have tried it in tax court and they get blown out because the courts just won’t believe that somebody has got a full time job, that they’re spending more time on their real estate than their full time job. They just don’t believe it. But I have seen people on a good note.
He also said, “I only have a couple of properties where I have one property.” There is a case where somebody qualified his real estate professional on one property. They’re managing it themselves, and that’s all they did. When you’re a W-2 employee, for somebody else, it makes it really, really, really tough.
Eliot: And then the YouTube site here?
Toby: Yup, go on in there. Some people are asking where the recording for this event will be? It’ll be right on my YouTube channel. Click on subscribe and the notification. It doesn’t mean they send you anything other than they’ll let you know when the videos are uploaded.
When something comes out, it lets you know, that’s it. It isn’t spammy or anything like that. But if you subscribe and turn on notifications, then when a new video pops up, it’ll say, hey, Toby put a new video out. You go check it out, read the title, and see if you like it.
Eliot: For those of you who are platinum clients out there with so many questions, you’ll notice that we’ve started adding at the end of our answers, links to (say) our structure and implementation series. That’s a really important part of what we do here at the education branch, learning about how to make sure you’re compliant with your different entities and things like that. They go through really the A-Z of all of it. You’ll start seeing that. We highly recommend joining in.
We also have some information about links for the funding community. That’s something that you’re going to get on your platinum. The answer is just a little bit of additional information, free, thanks to you if you’re a platinum client, so check that out, too.
Toby: Somebody asked. Mark. He said, “How do I search for a cost segregation company in Texas?” You can go look around or you can just use one of our referrals. We use the Cost Seg Authority. They have engineers all over the country. We’ve used them successfully over many years, doing hundreds of cost segs, and it’s free.
If you want to have them do an analysis on your property, they can tell you whether they can do it. Patty is sharing the link. Patty, you can share it out. She just sent it to one person, but I would share it with everybody. If you come through Anderson, they’ll do your cost seg analysis for free. You look at it and see if it’s worth the squeeze.
Somebody says, “Cost Seg Authority doesn’t want to work with you once you sell the home, no access to sell a home.” They need access to it to do the cost seg. If you don’t have access to it, it’s a little tough to do a report. Yes, you can do cost segs for 2022 all the way up until you file your tax return or until the business files its tax return.
This is where it really gets cool. If I sold a property last year and it benefits me, I just have to have access to it. If you need me to break through anybody or to smack around and make sure that they give you enough time, reach out to me or reach out to Patty. We’ll make sure it happens because those guys have been great, Cost Seg Authority. Erik Oliver has just been a cracker jack.
If you ever have any issues with those guys or whatsoever, reach out to us. I’m sure that they don’t want anybody up there upset. They want to give you a fair shake. But if they do need access to that, they do need access to the home.
Eliot: All right, “What are some of the creative ways to save money on the gains from real estate investing?”
Toby: If you have other losses or other capital losses, here’s some cool ones here. I’ll throw some funky ones out there. (1) The low lying fruit, 1031 Exchange. Hey, I’m going to keep buying more real estate. I sold real estate, I have big gains, and I want to buy more real estate through a 1031 Exchange and you defer the gain. (2) You can still do this thing called a qualified opportunity zone. If you want to defer some of the gain into an opportunity zone, although you would still have gained recognition in 2026 on whatever it is you sold this year, so you’re only going to get a few years, but you can do that.
What’s even more fun is if you have losses like capital losses from other things like crypto or your stocks down, I would harvest those capital losses on those to offset your gain from your real estate investing. If you have capital gain, hey, I made $200,000, I sold a property, and you had a bunch of bitcoin, sell it and buy it right back. Sell it, harvest your loss, use that loss against real estate gain, and you can buy it right back. Before you guys say wash sale loss rule, no, it doesn’t apply to crypto.
It does apply to stocks, but there’s a way around it. What you do is when you sell, then you buy it in the money call to cover that position. That’s the same as you buying it back and attaches to that in the money call, then buy back the shares, and then sell that in the money call, which won’t move that much. The loss is attributed to that and then you get your capital loss, voila. It’s magic, but there’s always a tax way to work around these things. The wash sale loss rule, use an option after you sell to cover that position for the wash sale, and then buy it back.
Somebody says, “Where can I find a cost seg in Seattle?” It’s still Cost Seg Authority, I’d still just use those guys. They have engineers in all states. I’ve yet to find a place where they didn’t do it.
What else is there out there that you think of to offset the gains? I guess the one I would say, Eliot, because I just asked you a question and I’m going to interrupt you, is if you’re selling your house and you have a lot of gain, you can do a 121 exclusion, $250,000 if you’re single, up to $500,000 capital gain exclusion, and couple it up with a 1031 exchange. A lot of people don’t realize that you can do both on the same property.
If you’re in a state that, hey, I’m in Austin and I bought a house for $500,000 10 years ago, and now it’s worth $3 million and I’m selling it, but then I’m going to get killed in gain, turn it into a rental for six months before you sell it. Then you get your $500,000 exclusion, you can 1031 it, and go find another property.
Make sure that when you buy that property, it’s a rental property. Maybe rent it for six months to a year, then you can actually move back into that property, too. If it saves you $400,000–$500,000, it’s probably worth it.
Eliot: Absolutely. We don’t talk much about it, but there’s also the opportunity zones. We’re not big fans. I know I’m not. A lot of the benefits of that have long expired, but that does allow you to take capital gains and put them into another investment in a specialized LLC for that, a partnership, sometimes at a corporation. There are a lot of other contingencies to that, so you might want to sit down and talk to somebody about what else you have to do for that type of investment.
If they aren’t real estate investing talking about rentals—short-term rentals, long-term rentals and things of that nature—you could look towards what we talked earlier about the cost segregations on your other properties.
Maybe you have real estate professional status or something of that nature. These would be things that would wipe out against your ordinary income first and then come down and hit your capital gains, which would be in your best benefit and typically how that works.
Just about anything on your return that we can do to save, even putting into an HSA, could overall impact what’s going on with your gains from real estate, not just the capital gains.
Toby: The other fun one is just don’t sell the real estate, borrow against it, and use those proceeds. The easiest way to never pay capital gains is don’t sell the property, just keep buying more. They always say, but I need to sell it and blah-blah-blah. Sometimes it’s better just to borrow against it. See if you can’t find a lender that allows you to pull money out of one property and accumulate more. It saves you the tax, the transaction costs, and all that.
If you’re just dead set on selling something, 1031 Exchange is the way to go. If you can’t 1031 Exchange, then you’re probably looking at opportunity zones or harvesting losses to offset.
Eliot: Our last question, “Hi. How are crypto gains taxed? When? At the time of selling the crypto to get it back to cash? I have been doing short-term trading with my own account. Please advise the best strategies to minimize taxes. Hubby is W-2 and I’m a real estate professional with three rentals. Thank you.”
Toby: This is fun. We’re talking about portfolio income. I don’t see mining going on here, which is always the sticky wicket of it. People get all sorts of crazy about mining. It’s taxable when you mine.
Once you own the crypto, it’s when you sell it or when you convert it. When I say sell, when you buy something with crypto, the IRS treats it as though you sold the crypto, turned it into US dollars, and then used the US dollars to buy something, so it’s a taxable transaction.
How is crypto gains taxed? Just like any other capital gains. You hold it for more than a year, short-term, hold it for longer than a year, it’s long-term, so 365 days–plus.
Is it taxable at the time of selling crypto to convert it back to cash? Yes. Or when you trade it for something else of value. If I bought a car with my crypto, they treat it as though I sold it, turned it into US dollars, and then bought it. “I have been doing short-term trading with my own account.” Chances are, you have short-term capital gains.
“Please advise on the best strategies to minimize taxes.” Realistically, it’s going to be the same thing as with any other trading. You’re probably going to want to have an LLC around it, probably a partnership LLC. You’re going to have a corporation own a piece of that partnership LLC so we can push money up to cover expenses and to give us a safety valve on some of the income. But if you can get it into a Roth IRA or a Roth 401(k), you’re golden. If you can get it into a deferred retirement account, you’re golden. Sometimes that’s what you want to do.
“Hubby is W-2 and I’m a real estate professional with three rentals.” That means that if you really want to lower your taxes on crypto and you’re making money, then you probably want to buy more real estate and use the paper losses from accelerated depreciation. I would be doing a cost seg, I’d be using bonus depreciation, and I’d be trying to wipe out my other income as a real estate professional.
Eliot: I would just add that sometimes when we have clients who have a lot of the cryptos and stocks that they’re trading, then we do have a special structure for that, where we have a partnership. You put the trading account into that partnership and then you could basically partner yourself with it with a C-corporation. That’s going to allow you to shift some income off of your return into the C-corporation because it can earn not a management fee, but it’s going to be called a guaranteed payment that puts income into the C-corporation that would have otherwise hit your personal return. Now we have all those reimbursements we’ve been talking about all hour, or medical reimbursement, accountable plan reimbursement for maybe a home office or cell phone, and then also corporate meetings. It’s just another way to push the tax savings a little bit higher for you.
Toby: Yup. There are a couple questions in here that I want to go to, unless you have anything else on that one.
Somebody says, “So cost seg can write off capital gains tax, too?” Cost seg creates the lifetime of those items. If you couple that with a bonus depreciation, you can create a loss. Unlike some things like a 179 can’t create a loss, a 168(k), which is the bonus depreciation can, and then it keeps its nature. If I’m accelerating my depreciation on real estate, it means I’m going to have passive losses. I can use those against passive income.
“Capital gains is considered a portfolio.” It’s not, unless there’s a really twisted way capital gains could technically be passive. If it’s through a passive activity like a syndication, then technically, you could actually have passive capital gains and you can offset it with cost seg, but I want to break your brain today.
What you’re looking at is, when can I release that cost seg the type of loss and make it into non passive loss, then I could use it against capital gain. Most people use it against their ordinary income because ordinary income is usually a lot higher, but you could absolutely do it.
Somebody says, “If I put the short term rental and operation, does the bonus depreciation get prorated accordingly?” No. The bonus depreciation gets used as long as it’s put in service for a day. During the year, you get to write it off. All right, go back to the very last slide, Eliot, since you’re in charge of the slides.
This is our invitation to you to write in your questions at firstname.lastname@example.org. Eliot’s been picking the questions lately. Send in your questions so he can grab a handful. He usually grabs a dozen or so and throws them up here, but we get hundreds of questions over the weeks that we will answer.
We still have a lot of open questions that we’re going to answer. When we end today (which we’re going to do), I might go bust through some of these questions to help our folks. We have Tanya, Sergey, Dana, Dutch, Amanda, Jared. Everybody’s answering questions right now, they’re trying to pump through them. We might go through some of these.
Eliot: We’re just short of 200 questions already answered, so they’ve been doing work.
Toby: Yup. They’ve answered almost 200 questions, but we’re going to keep going. Here’s what we do. “Regarding crypto, is it considered a sell if you’re exchanging one crypto for another?” Yes. Make it really simple for you guys. If it’s crypto to dollars, crypto to crypto, there’s no such thing as a 1031 crypto exchange. It’s just like trading, any capital asset for another asset.
Somebody says, “When you’re filing taxes, do you file on behalf of an entity or do you file your own name? It depends on the type of business it is. If you’re a sole proprietor, it’s going on Schedule C under your own personal return. If it’s a partnership—S-corp or C-corp—you’re filing a separate return and then it flows onto your personal taxes. It always depends on how that’s treated.
Guys, if any of this confuses you and you get questions that you’re like, hey, I’m a newbie, I’m just getting started out, check out the YouTube channel. Go in there and spend some time listening to some of the questions. Go to the Tax and AP event. Reach out to us. We’ll sit down and go over some things with you, too.
Somebody says, “Can I take bonus depreciation on a regular rental? I put in service September of 2022, not short-term?” Yes, you can bonus depreciate any personal property so long it was put in service, at least a day during the year. When you’re doing a cost seg, you’re breaking your property into its structure, the 27½-year property versus the other personal property, which is your 5-year, 7-year, and 15-year property. Do you see any that you want to answer, Eliot?
Eliot: Under the Q&As, Dana had submitted one probably on behalf of a client maybe from the YouTube channel. “Can you share how the QSPS (Qualified Small Business Stock) works for state taxes in states where there’s no exemption? You’re going to have to pay taxes, there’s no exemption.
“Does the taxpayer use PALs to offset the state tax?” No, those are passive losses, it’s not going to connect there. You would have to look for more, either federal deductions that are going to lower your overall taxes that would hit your state. It’s very unusual to find some that’d be very state-specific for deductions. I can’t even think of anything off the top of my head that would be state and not federal.
Toby: All right. Let’s do this, Eliot. I’m going to bust through more answers here so we can get through these because there are a lot of questions. What we’re going to do is end the event as far as the live portion, and we’re just going to go through and make sure that we’re answering questions for the people that are in there.
Eliot: I’m going to get down to my office and jump in.
Toby: All right. Guys, until next Tax Tuesday, we will see you. If you have a question, do not leave the event because in order to answer your question that’s in the Q&A, we need you to be on. Hang tight. We’re going to bust through these and make sure that we’re getting them to you as quickly as possible.