How to Sell Rental Property as a 1031 Exchange

Jeff: And Jeff Webb.

Toby: You’re watching Tax Tuesday where we’re bringing tax knowledge to the masses which is a noble endeavor. We’ll see what we can do.

Let’s jump right into the rules because I pontificate too much and take up too much time. We want to be done in an hour.

Jeff: I will never accuse you of that.

Toby: We will give you a big dose within an hour. All right. You could ask questions live. We have a bunch of folks on. We got Christos out there, Ian, Piao, Eliot, Dana—gosh, we have a lot of people on—and Trisha, subbing in for Troy.

You have a whole bunch of tax folks out there to answer your questions. You can put them in the question and answer. It says Q&A. If you have and you’re willing to, just respond normally. You just go right into chat and respond that way.

You guys can say hi and let us know that you’re out there. Just go into chat and let us know you are rolling around. Tell us where you’re at in the country, too. That’s always fun. See where everybody is. Not really?

There are a few people. Hilo, Oklahoma, Houston, San Jose, Orlando, Vegas, Fort Myers, Redwood City, Denver, California, La Quinta, Boston, PA, SoCal, Austin, Denver, California, Corona, New York, Austin again, Tennessee, Ann Arbor, San Antonio, Riverside, Jacksonville, China. Where in China, Steve?

Morgan Hill, Dallas Fort Worth, Charlotte, Detroit, St. Louis, Missouri, Hartford, Connecticut, Delaware, somebody’s phone number, Portland, Baltimore, Louisiana, Guangzhou. I probably just butchered that, Guangzhou.

Somebody said, “Big looking for a tax strategy.” Hey Rick, if you could put that into the Q&A, our guys will answer it. If it’s in the chat, they’re not going to be able to see it. New Jersey, Atlanta, Georgia.

Somebody’s asking about Alpine 1031 Exchange. Of course, yeah. If you’re buying properties with Alpine, those are buy and holds, and absolutely, unless you’re doing the occasional flip they will do. But for the most part, they’re buy and hold folks. They would qualify.

If you have questions during the period that we’re not meeting—we meet every two weeks—you can certainly ask questions via taxtuesday@andersonadvisors.com. We’ll get back to you and give you a response. If you need something that’s very specific to you and more importantly when it starts carrying some liability for us, then you need to be a Platinum Client or become a Tax Client, which our folks can talk to you about. It’s actually really inexpensive to be Platinum, $35 a month. Tax Client just means you’re signing up, but there’s a small retainer and then you could ask all the questions you want.

This is fast, fun, and educational. We want to give back and help educate, but if you have general questions, just ask them. We’re always going to answer it. There’s no cost.

Jeff: Every Friday, between 4:00 PM and 5:00 PM, Eliot and I also answer questions in Tax Office Hours, so feel free.

Toby: Every Friday, between 4:00 PM and 5:00 PM, Pacific Standard Time?

Jeff: Pacific Standard Time.

Toby: You guys do that at the end of the week? Do you have any brain power left or you just sit there drinking beers?

Jeff: Sometimes, I’m sure they wonder.

Toby: No, these guys are great. If you’re a client, then on Friday, you come in especially if you’re a Tax Client and you’re trying to get a quick answer.

Somebody says, “Please cover depreciation on rental property.” Really? We just explained that depreciation is just a deduction. It’s based on the useful life of the property. There are tons of different ways you could calculate it depending on how many days you’re renting it, whether it’s personal use, whether it’s something you reside in, vacation property, short-term rentals, with substantial services, and non-substantial services. If I spent going off on depreciation, I need to know specifics. Otherwise, we’d be teaching a class which we do every month.

There you go. That’s where you want to go. Or go on to our YouTube. I do a ton. If I know what type of things you’re talking about, a depreciation is just a deduction. But there are a million ways to nuance us to those rules. Whether it’s 5-year, 7-year, 15-year, 27 ½-year, or 39-year, whether it is subject 168, 179—all these fun things—whether you’re cost-saving, the methodology that you’re using for your accounting. All of that comes into play. You’ll all know a little bit more.

All right, opening questions. We have a ton of them, so I’m just going to go over them quickly and then we will answer them.

“Can I offer my condo as a rent-to-own rental for six months and sell it as a 1031 exchange?”

“I own real estate, a business, and have W-2 income. I was told that I can’t take all deductions allowed because I’m in the process of acquiring more real estate and won’t be able to qualify for financing. Is this true?” We’ll answer that.

“Should I invest in LP multifamily syndications with the same LLC as I have active personal rentals?” We’ll talk about that.

“I have been told that as a land wholesaler, I would not be considered a dealer by the IRS like it would be if I wholesale houses. I make no improvements, I do not subdivide, I don’t move any dirt, no utilities, no roads, and added nothing, but the IRS still considers me a dealer if I simply wholesale.” We’ve had similar questions in that vein a little bit, so I have a feeling that there’s somebody out there teaching some funky stuff, but we’ll answer that.

“I am a co-founder of a startup C-corp. Can I establish a self-directed Roth IRA and put my company share in it?” We’ll put the rules out for that.

“How do I handle a family rental for income and expenses that was just inherited? The property name will be in my parents’ family trust with part income distributed to the children as their share of the property. The parents will be claiming all expenses and sharing the income to the children. Do the parents deduct the income given to the children as part of their expenses?” We will answer that. These are long.

“I bought a property in Texas in my name and am now putting it into an LLC. The LLC will be put inside a Wyoming LLC. I still have mortgages on the above property and keep making my payments. Do banks still use my above mortgage liability to calculate my debt-to-income ratio?” We’ll talk about that. Good, long questions.

“When I file my personal taxes, can I still write off my taxes on my property held under my Wyoming LLC?” We’ll answer that one.

“My husband and I divorced in 2009 for asset protection reasons,”—interesting—”but have lived together this whole time in the same home. I purchased a home in Florida in January 2019 that we moved into and is our primary residence. If we get remarried before we sell, can we use the joint exclusion of $500,000?”

“What is the approximate price point that the S-corporation should be moved to a C-corp?” Interesting question there.

“Regarding the Tax Reform Act of 1986,”—just a few years ago—”if I make under $100,000, I could write off up to $25,000 of real estate losses provided I have active participation. If I make over $150,000, I cannot write any losses off unless I’m a real estate professional with material participation. Can I write off the real estate losses against my other income?”

“I am turning 70 and have a traditional IRA account which has lost money. At some point, it was worth $90,000 and now it’s worth around $30,000. Now that I have to start withdrawing, am I going to pay taxes given the fact that I lost money?” Getting good questions. We’ll get to them.

Let’s jump on the first one. Jeffery?

Jeff: Yes, sir?

Toby: “Can I offer my condo as a rent-to-own rental for six months and sell it as a 1031 exchange?”

Jeff: Here’s the problem I see with the way this is worded. If you’re offering your condo as a rent-to-own, you’re contemplating the sale of that property. I think that in itself, from what I’ve seen—we’ve had to look this up before—it becomes a sale of property. It doesn’t become a rental property.

Toby: What Jeff is saying—if you don’t mind me writing it down—is that we have different types of income. When I am doing certain activities, it is taxed one way. For example, if I’m running a minimart, I buy Cheerios, and put them on the shelf, that is taxed differently than if I buy a bunch of equipment that I’m going to leave there for a long period of time.

One of those is inventory and the other one is a fixed asset that’s going to be either attached to the building or is in there, whatever. There are different rules when we’re talking about real estate. If I’m buying property to sell it, it’s treated like the Cheerios. It’s just inventory. If it’s just inventory, then it’s not eligible for a 1031 exchange because 1031 exchanges, you can only use those on real estate investments. An investment is when you buy it for a long-term hold and rent.

When you buy a condo and when you say my condo, it really depends. Is this your personal residence? “Could I do that?” Yeah, maybe, because you bought it for the long-term. Now, I just have to convert it into an investment property potentially.

Or, is this something you bought recently and you’re going to do a rent-to-own thinking that hey, I want to do a rent-to-own, sell it, and I want to just buy something new?

The answer to you—assuming that you just bought this—is no. It will not be eligible for a 1031 exchange. It will be considered dealer property. The problem with dealer property is if you carry that note, you are not eligible for installment sales, you’re not eligible for that 1031 exchange, and you’re subject to not just ordinary income—your normal tax bracket—but you’re subject to self-employment taxes as well, which are social security taxes, old-age, disability, survivors, and health insurance, whatever you want to call it. It’s that extra 15.3%. Nasty situation, so make sure that you’re talking to an accountant.

I’ll ask you this, Jeff. “If I buy a property, I tend to sell it, and I own it for three years, can I take advantage of long-term capital gains? Dealer property?”

Jeff: No.

Toby: It doesn’t matter how long you held it for either. Its inventory. It’s like going into the grocery store and finding something that’s been sitting on their shelf for two or three years. It doesn’t matter. Inventory is deducted against the sale price. That’s it.

Jeff: I’m assuming that this was either a primary residence or a second home.

Toby: Let’s say it’s a primary residence.

Jeff: If he wants to 1031 this, I think he could possibly do it if he removes the whole rent-to-own scenario.

Toby: You just need to rent it. You could have an option. The rent-to-own really just means a lease with an option to buy it at some point.

Somebody says, “It’s a primary residence.”

Jeff: What the IRS has typically done on these rent-to-own deals is they consider the whole thing a sale. They do not consider it a rental property.

Toby: Jeniffer, how long have you held this property if you’re out there? Because what we care about is whether there’s another route for you. If I have 30 years, then you have a 121 exclusion. Has it gone up more than 250,000 or 500,000 if you’re married? “Yes.”

What you do, Jennifer, is you’re in a classic situation. The IRS explains this actually. By the way, I’m looking at the chat. Apparently, the person who emailed this in, Jennifer, is corresponding with me so I can see her answers.

If this is 30 years, you have a whole bunch of gain that you’re worried about. We know that we have a 121 exclusion which is I’ve owned it and lived in it as my primary residence two of the last five years. If I’m single, I get a $250,000 exclusion. If I’m married, I get a $500,000 exclusion of capital gains. You can do that.

Here are the big issues that are outside of that. If you had a home office, we have depreciation recapture. Anything above that, we have capital gains on, so we could use the 121 exclusion.

Let’s say we bought it for $200,000 and now it’s worth $1 million. So $700,000 would be safe—$200,000 I bought it for plus any increases. If you did add a pool or whatever—in a condo, you probably didn’t do any of that—let’s say it’s $500,000, you have $700,000 now that is tax-free and wouldn’t have $300,000 that is subject to long-term capital gains which is going to be about 23.8% plus your state tax.

If you want to avoid that, you turn the property into an investment property by renting it. Would you say that a year is the safest?

Jeff: I would. You don’t want to have the initial rental and the sale on it in the same tax year for sure.

Toby: Yeah. Jennifer, what I would say is rent it out for a year just to be safe. This is a lot of money. I’m talking about $80,000 maybe, something like that. I don’t know your numbers. I’m just making up numbers. In my little made-up numbers, it’s a lot of money, but you probably are going to want to lease that out.

“No need to inform tenants of my intent to sell?” If you’re going to sell it, you could always sell it and offer it to the tenants. You probably want to let them know.

If you have somebody come in there, it doesn’t really matter because you’re going to sell it subject to the lease. If you have a provision that says if I sell it, it cancels the lease or maybe there’s not going to be renewal, you may want to let somebody know or say, hey, I’ll offer it to you when I sell it.

You don’t have to give them an option. You say, hey, I’m going to list it probably in a year if you want to buy it.

But you want to make sure it’s an investment property because then you can 1031 exchange it. When we 1031 exchange, it doesn’t mean that you’re out of luck of being able to live in the exchanged property. In fact, the Code anticipates this by putting an exclusion for using the 121 exclusion for five years after 1031 exchange. They know some people are going to exchange properties and then go live in it.

But when you buy it, it needs to be an investment property. The same scenario, I rent it for a year and I then do the 1031 exchange.

I use an example of $1 million. I put $1 million into other real estate. Let’s say I put it all into my dream home for $1 million. I would just need to make sure that I’m leasing that out when I close on the 1031 exchange.

There’s no real hard-and-fast rule on it, but you do it and then voila. After you’ve rented it, now, you can convert it back to a personal residence, you can move back into it, and then you don’t have to worry. There’s a $1 million sale price, but your basis is now $700,000 in my example. You get to add your 121 exclusion to the basis. Anyway, it could be fun.

Somebody says, “How would the market be in a year?” That’s your waiting test. You could pay all the tax now. You could also sell it and do an installment sale since it’s your personal residence. You could just sell it, carry back the financing, and take the tax hit over a number of years depending on your tax situation. It could be 0%, 15%, or 20%.

Jennifer, see? There are options. You may want to have somebody to take a look at some of your options. It’s never a hard-and-fast rule. Usually, there are shades of gray in all this as to what you want to do.

“How long would you need to lease it before you move back into it?” Probably about six months. Some people are going to say a year, but what I would say is find somebody that you know and say, hey, do you want to lease it and live in it gently? Lease it?

All the IRS is looking at and saying is when you close—and this is what anybody that’s doing 1031 exchanges would say—was it an investment property? Yeah. Good, that’s all we care about because there are lots of people that will convert it into something else.

Somebody says, “It just solved my future problem.” It’s what we’re here for.

Anything else you want to throw on that one?

Jeff: No.

Toby: That was a good question. I always like good questions like that. Thank you, Jennifer, for sharing that with us. Now, you know that it’s real. Some people are always like, you’re recording these and you’re not answering them live. We take things as they fly at us.

“I own real estate, a business, and have a W-2. I was told that I can’t take all the deductions allowed because I’m in the process of acquiring more real estate and won’t be able to qualify for financing. Is this true?”

Jeff: This one kind of makes me crazy. Not because this person’s asking it, but I’ve heard this before. A lot of times, what people are wanting to do is get their income levels up higher in their rental properties so they can get more financing.

While you’re doing that, you’re also kissing deductions goodbye. I think there are better ways to do this. One that we’ve talked about frequently is putting these rental properties in an entity. Get them out of your personal name.

Toby: I’ll give you guys a little trick. Anything that’s underwritten or that’s purchased by Freddie and Fannie—so it’s not underwritten, but they’re going to buy the mortgage. They will use 75% of anything that’s on page one of your schedule E which is where real estate goes if it’s in your name. They will use 100% of page two of Schedule E which is where it becomes via K-1, via partnership.

Number one, you want to make sure that your real estate is probably going on to page two of your schedule E and your business more than likely is either a C-corp or an S-corp. You don’t want to have a schedule C. It’s going to cause you issues in your financing.

Your W-2 is pretty straightforward. The big question is do I want to take all the deductions I’m entitled to for real estate? You don’t have to take depreciation. You must recapture depreciation. You’re going to pay tax on it whether you take it or not.

But let’s say somebody has purchased real estate and Jeff, hypothetically speaking, they choose not to take the depreciation in that year so their income is higher. Could they do that?

Jeff: They could.

Toby: Could I take that depreciation in the following year if I choose to catch up?

Jeff: No actually. You can’t. You either have to amend your returns or file a change of accounting method.

Toby: What if I haven’t depreciated a property for 10 years, could I catch it up?

Jeff: You could catch it up all in one year, but again, you’d have to file that change of accounting method which is onerous.

Toby: Could we do that though? Couldn’t we just wait and say, hey, you know what? I’m in my building phase. I need to show the highest income. I’m okay paying the tax on it now, but I would like to recapture that depreciation at some point in the future.

Jeff: One thing that concerns me is I’ve seen people not take deductions, usually not depreciation, but other items. The problem I see with that is you’re not reporting all your deductions and you’re giving those income statements to the bank.

Toby: The bank’s not stupid. If they have an underwriter that knows real estate, they’re already looking at your depreciation because some people accelerate their depreciation and they know to add the depreciation back in.

Jeff: That was my thought, too. You’re usually adding depreciation back anyway.

Toby: Yeah. They’re going to add it back in. The only thing that you could do is what if I choose not to take deductions? What should I do? Usually, you’re going to go back and amend if you didn’t take the deduction and you’re just trying to jam up your income, or you’re going to forego it because you’re not required to deduct things.

Jeff: We usually will not prepare an amended return for a return that has gone to the bank.

Toby: You’re going to have something where the accountant’s involved like us. We’ve dealt with this before and you’re like, I don’t want to know about it. You’re going to play a little bit of a game here. You’re going to say, oh, here are some expenses called sandbagging. I’m not going to calculate. I’m not going to check them.

Then, you’re going to come out a year later to your accountant and say, hey, I forgot to do these and I need to amend. Your accountant is going to charge you, look at you grumpily, and say, why didn’t you tell me about this? You’re going to say such is life.

Jeff: I forgot.

Toby: The fact that you were told not to take the deductions because of your process, it’s not true that you can’t take them. What they’re saying is they want to make sure that you qualify for your mortgage.

What I would be doing is not listening to somebody giving you crappy advice. I would talk to your mortgage broker, the mortgage company, and the underwriter and say, what’s the number you need to see so you don’t go do things that hurt you because somebody is telling you, hey, here’s what you do?

Jeff: Something else I’ve seen with this is people trying to up their income to get those mortgages when they’re chasing really expensive and really overvalued properties.

Toby: Don’t do that either. You got to qualify for the stuff you’re buying, so don’t do a 2008 and overbuy your house.

I’m going back to this one just for a second because somebody says, “Show me your calculation.”

Let’s say that the basis of your house is $200,000 and your sale price is $1 million, so you’re looking at $800,000 (in theory) of capital gain. You have an exclusion for $500,000—I’m assuming this is married filing jointly—and you made this into an investment property, so you’re going to 1031 the additional $300,000.

You’re going to 1031 which means your new basis is equal to $500,000+. I’m just going to do this $200,000 as your basis plus the exclusion. Your new basis in the new property under 1031 exchange is $700,000.

Hey, we always like talking about books. We like talking about Infinity Investing. We like talking about money and making money. We’ve been really good at helping people make money for the last few years.

Somebody said, “Can you rent the condo to yourself?” No, you cannot rent it to yourself—it would be neat—nor to a family member, nor to somebody who’s under your control.

All right. Infinity Investing, a book we published in April, hit number 1, has over 100 ratings now, a bunch of certified ratings, and is still getting 5 stars. We’re very proud of it, but we’re even more proud of some of the comments, some of the people that have truly changed their lives.

Even more so, we’re proud of the fact that we offer our Infinity Investing Workshop for free. We’re coming up on Saturday. We’re doing another one.

If you want to register and you want to learn how to make long-term, infinite cash flow machines—we’re trying to not do quick hits, we are long-term thinkers. That’s why it’s called Infinity. We want things that pay revenue forever for an infinite period of time. Go to aba.link/iiw if you know young people, especially college kids who are thinking about getting into debt, doing what Jeff just was talking about, really reaching for homes that are buying a liability with a liability, and is extremely dangerous.

We do the calculations and we show them how to think properly about it. Sometimes, they won’t listen to parents or grandparents, but we will help you.

Somebody says, “I had the whole family join.” Absolutely. Don’t listen to Jeff. Buy the most expensive ones. How much can you afford? How much plasma do you have?

Go to aba.link/iiw, by all means. It’s free. It’s this Saturday. It’s always cool. I’m going to have Pia on. I’m going to have Nicole on. I’m going to have Aaron on and Jeff is not invited. You might like it.

Jeff: I probably would.

Toby: You should come on sometime.

“Should I invest into LP multifamily syndications with the same LLC as I have active personal rentals?”

Jeff: I’m going to give my short answer to this and see what you say. I don’t see an issue with this. The LP’s protecting you with the syndication to own it in the same LLC is as other active rentals.

Toby: Here’s the LP. Let’s say there’s a property in the LP. Your interest in the LP is held inside an LLC that also has properties in it. If something happens inside the LP, it doesn’t hurt you. You’re out here. You’re like, hey, look at me. I don’t get hurt. It doesn’t come get me. That’s called inside liability.

The problem that I have is outside liability. If something happens here in this one and it blows up, they take the LP. I don’t want them to take my LP. I don’t want them to be able to do that, so I would not put it in the LLC with anything.

Jeff: That’s why we talk about (ideally) everything in its own LLC and how much are you willing to risk?

Toby: Yeah. Let’s say that now we just look at the LP, it’s worth X number of dollars, and somebody sues you. Angry person sues you and they want your LP. It’s still a limited partnership interest and you’re not in control of it.

Depending on the state, they could potentially take it from you and then stand in your shoes. It’s like taking somebody’s Microsoft stock or whatnot. It really depends on what state that LP is in.

If it’s in Nevada, Wyoming, or Delaware, chances are I’m not too worried about it. If it’s someplace else, then I may have a place where I put all my securities and my cash, usually a Wyoming LLC that just holds the securities and the cash to protect the interest in the LP from you.

Kid gets into a car accident and they sue you. Do you want them to take your business interest? I like to keep it outside of my state, so some judge there can’t give my stuff away, force it to be liquidated, and sold to pay a creditor. I’d rather do it in a state where you can’t do that.

There’s a few. Again, we like Wyoming because it’s cheap and because the statute is explicit. They can get a lien against your entity. That’s it. They can’t sell the entity. They can’t force you to distribute anything. It really locks it down.

If you want to learn more about that stuff, come to our Tax and Asset Protection Classes. We teach one a month at least. That’s actually free as well.

Jeff: That’s a good point because we often talk about protecting yourself from your assets and investments, but sometimes, it’s about protecting your investments from you.

Toby: Absolutely. I think it’s almost more to protect the investment because do you want to be dealing with somebody who’s divorced, with their debt, who got into a big, old dispute with an ex partner, or their neighbor’s suing them because they painted their fence pink and they’re fighting with each other? Do you want to be dealing with that nonsense? I don’t. Generally speaking, most syndicators don’t. They’re like, this is you. That’s it. I don’t want to deal with it.

But here they come. Somebody comes along, tries to take that interest, and they get to. I’d much rather be isolated to where we can cut that and nip it in the bud.

Somebody says, “What’s the difference between Nevada and Wyoming?” They have the exact same statute, except Wyoming does not list the names. Nevada lists names, but it could be a nominee.

In Nevada, it’s about $400 a year and in Wyoming, it is $100. It’s cheap. I’m maybe off $50 on those. But Nevada has a business license that’s $200 a year plus their filing fee’s at least $100 something. Then, Wyoming is really cheap.

Somebody says, “Is the workshop on Saturday in recordings? I would love to attend, but I’m a single mom of toddlers. I’m a complete REI newbie and don’t know what I’m doing. I would love to learn as much as I can.” Of course. Register for it, Lizzie, and absolutely, we will make sure that we get to the recordings.

If you go into the free area of Infinity Investing, just so you know, we have three trading rooms every week absolutely free for the basic area where Pia, our team, Jason, and everybody will teach you how to invest even if it’s $10. We’ll show you how to invest in the market for the long haul instead of doing this craziness that’s going to give you ulcers.

Jeff: They’re not going to get you in trouble. You’ll have to do that on your own.

Toby: Yeah. But Lizzie, if you do this with your kids, if you have toddlers, you’d be shocked at what the numbers look like if you get some money put aside for them, where they’re going to be in 30 years. Anybody can do it. Absolutely, 100%. We’d love to help you.

“I have been told that as a land wholesaler, I would not be considered a dealer by the IRS like I would be if I wholesale houses. I make no improvements. I do not subdivide. I do not move any dirt. I don’t have utilities. I don’t add roads, nothing. Will the IRS still consider me a dealer if I simply wholesale?”

Jeff: I think the answer to this is it’s going to depend on the quantity.

Toby: There’s a statute on it. In the statute, there are seven tests you have to pass to not be considered a dealer if you’re subdividing land.

Number one is it has to be less than five or they start taxing you on the sixth. But more importantly, you can’t be in the business of buying property to sell it. You can’t do any dealer properties whatsoever or you fail the test. If you’re buying this to sell it, you’re a dealer. There is no exclusion. There is no safety.

If you’ve held the property—let’s say you’re not a dealer. You’re not doing anything else that would make you a dealer. I’m not buying anything to sell it. I’m all about the long-term. Then, there’s an exclusion if you’ve held it for, I want to say, five years as the minimum.

If you’ve held it for five years, it was a single parcel, and it’s five or below in any given year—actually, I think it’s just the tract. If you do five or more subdividing, you’re going to be taxed no matter what, five or less.

Then, if you didn’t add substantial improvements which is what you’re saying, then you could not be considered ordinary income and you’ll be taxed as long-term capital gains.

But there are seven tests underneath this, so we have to apply the seven tests to see whether you’re an exclusion. I got to tell you, based off of what you’re saying, if I simply wholesale it, and I’m buying it to sell it, you’re a dealer. It’s not horrible.

If I’m a dealer, that means I have ordinary income that is subject to self-employment tax, which means I can fund retirement plans. I could defer the entire amount potentially. I could stick it all on a retirement plan. I can’t do that with rental income or capital gains.

This isn’t necessarily a bad thing. A really good structure is to have an S-corp with a 401(k). If you’re flipping a few properties here and there, this may be a really good thing.

There are people in our clientele who are trying to take that type of income and turn it into ordinary income so they can contribute more to retirement plans because they know they pay no tax as opposed to capital gains or anything else. They don’t want the tax. They want to push the money into a vehicle that they can continue to invest in, not pay tax on, and only have to pay tax when they take it out. The only way you do that is with active income. It can be great.

Look at that. I’m trying to see if there’s anything else. Nancy Reagan, “Just say no to being a dealer.” That’s not right. We love Nancy.

All right, any other things? Let’s see.

You’re a dealer if you wholesale houses. It’s ordinary income subject to self-employment tax. If you are a wholesaler, you are in business for years. It’s no different than a real estate agent.

If you’re a construction person, developer, if it’s Jeff preparing tax returns in his business, it’s just sweat off your brow. You’re wholesaling. You’re doing all the work. The property is not doing anything.

You got to make sure. There are lots of good things that go along with that type of income. We just want to minimize it.

When you look at the people making over $1 million, the average is between 4% and 37% that’s coming from active income sources. The minority of their income are dealers, wages, and 1099 income from their services. The majority are rents, royalties, interest, dividend, and capital gains.

We do close to 10,000 tax returns a year now. When we look at the wealthiest clients, it’s not all W-2. More likely than not, we’re going to see a mix where they have multiple streams of income.

“Can I do a wholesale inside of a self-directed IRA with lots?” Potentially, the problem with it is whether or not you’re going to do UBIT.

Eliot’s answering that right now.

When you’re wholesaling, there’s no rule on it, so we always say it’s the number. Where are you comfortable? If they’re going to wholesale lots inside of an IRA, what would you say?

Jeff: I feel like even if they’re doing five, they’ve established themselves as to when to trade or business inside that IRA.

Toby: You got to be careful. I would say five is about my number. They’re going to look at all the other activities you’re doing, so you better be doing something else. If you’re wholesaling and that’s all you’re doing, please do it inside of a corp.

Jeff: I think part of it is going to go back to what percentage of your revenue is coming from that activity.

Toby: Yeah. “Does the cost of the property matter?” Not really. I don’t think it matters. Do you think it matters?

Jeff: I don’t think it matters.

Toby: Yeah. They’re looking at the nature of the income. If I make $10 or $100,000 from active activity, they’re just saying, hey, it’s not qualified. They’ll tax you. It’s called unrelated business income tax. It’s not like the IRA will implode. You’ll just pay tax as you go along.

Somebody says, “So if I put improvements on the lot, would that make it active?” Chances are it’s going to be dealer activity. If you buy it to sell it, it’s just inventory. But I would talk to somebody to have to take a look at your actual situation because it’s not quite that easy.

If you put in roads, sewer, and electricity, I don’t think those things automatically qualify as substantial improvement so I think you could still do it. But if you go beyond that, that’s where you look at the issue.

Do you remember off the top of your head?

Jeff: No, I don’t. We usually look at it case by case and say, yeah, you didn’t really do much here.

Toby: This is gray, so we just want to do all the indicia to show that and protect you.

“I am a co-founder of a startup,”—congratulations—”can I establish a self-directed IRA and put my company shares into it?

Jeff: The easy answer is yes, you can. The more difficult answer is how you go about that.

Toby: I already founded a company. Can I put my shares of the company that I’m working with and I am a co-founder in? Do you think I can put that into a Roth IRA?

Jeff: I know it allows in kind transfers, but I don’t know if it allows in kind—meaning something other than cash—contributions.

Toby: You can do in kind contributions for sure.

Jeff: But you’d have to have an appraisal of the business to find the value.

Toby: But you’re also working for the business, so you’re a disqualified party. We’d have to know, is it being covered by the contribution limits?

Jeff: Yeah. You’re looking at $6000, $7000 max.

Toby: Yeah. I’m looking at this in two different ways.

“Hadn’t Peter Thiel did it?” Peter opened up a company. The way that I’m going to explain this is called a rollover as a business startup.

Jeff: I was going to suggest that.

Toby: You do a ROBS. The reason being is because here’s the startup. The stuff prior is not disqualified. The stuff after, you are now disqualified which means you can no longer have transactions between the retirement plan and the business.

If we set up a business, the C-corp’s the proper route to do it. You can’t do it as an S. We use our money that’s in our retirement plan. We can do that as a ROBS.

But then that’s the last you’re investing in it. You could work for the business. You could take a salary. You could do everything else which is what they’re talking about with PayPal. They made millions of dollars inside of his Roth IRA because he used the Roth IRA at the very beginning.

Once you set up that business, your startup, and you go forward, you’re disqualified which means you cannot contribute it to your Roth IRA or anything else. No transactions.

Jeff: Did Thiel do a Roth IRA or a Roth 401(k)?

Toby: I can’t remember if it was a Roth IRA. I’m trying to remember. I think that was before they even had Roth 401(k). Perhaps. Who knows?

You could do it with either. It’s a ROBS—rollover of the business startup. The IRS does, but I’ll tell you that they’re highly scrutinized too because usually, it’s a franchise you’re setting up.

Pretend this is a startup. Let’s just say that you have a McDonald’s franchise, you need $500,000, $1 million, or something, you’re sitting on a 401(k) with a couple million dollars, and you say I want to partner with it. You could have your IRA or 401(k) contribute money.

I don’t know if you have to put in the same amount of money. I can’t remember off the top of my head, but it could have its contribution, you have your ownership that’s individual, and you’re okay. That’s not a disqualified transaction. You just purchased the stock on pennies on the dollar.

“What does ROBS stand for?” Rollover as a business startup. Rollover of the funds in a business startup. It has to be a brand-new business.

“How do I handle a family rental for income and expenses that was just inherited? The property name will be in the parents’ family trust with part income distributed to the children as their share of the property. The parents will be claiming all expenses and sharing the income with the children. Do the parents deduct the income given to the children as part of their expenses?”

Jeff: We got inherited property that is in (sounds like) an irrevocable trust.

Toby: Sounds like it’s an irrevocable trust.

Jeff: That means the beneficiaries of the trust are the people named by the trust which I’m assuming are the parents. I don’t really see a way of passing that income onto the children—actually passing the income on, not just giving them money—other than to pull that property out of the trust, maybe form a partnership, and make them partners in the partnership.

Where do you go with this?

Toby: I look at it and I think it’s an irrevocable trust with beneficiaries more than likely the parents and the parents want to share the income with the kids. They can gift it, but the income’s all going on the parent’s return.

I don’t know a way around that unless the children are permissible beneficiaries, in which case, the children would be taxed on their distributions and it makes it easy. It always comes down to who’s the beneficiary, who gets that K-1 from the irrevocable trust which is going to file. It’s 1041. It’s going to give K-1s out to the beneficiaries.

Usually, it depends on the type of income. You could retain it technically inside the trust depending on the type of income. It might be capital gains. I think you could elect to treat that as nontaxable if it stays inside there and added back in the basis.

Jeff: Yeah. Any capital gains will be taxed to the trust instead of the beneficiaries.

Toby: There are some ways to avoid that if they’re reinvesting it, but if it’s being given out, it’s going to be taxed to the recipient 99% of the time.

I’m looking at it and it’s saying the parents will be claiming the expenses. It’s not the parents. It’s actually the trust. The parents are just being forced to recognize the income.

If the money was distributed to the parents and they’re not taking the distribution out, then it would still all be going to the parents. The parents, if they give it to kids, would just be giving gifts to the children.

There’s another work around where if you have a business, have the business pay the kids, let the kids pay the taxes at their tax bracket, and use the trust money as the contribution. Let it generate income and then the income gets paid out to the kids.

Jeff: Have them do the maintenance and things like that around the property.

Toby: Yeah. A lot of folks don’t realize that if you have kids going to college, you’re paying for school, or whatnot, you don’t have to deduct the school. You just have to make sure that the dollars being used to pay the school are tax-free.

Sometimes, it’s as simple as paying your kids $10,000 a year to do things that they actually do. Have them do the things, whether it be sweeping, working on tech, doing research for your business, or whatever it is. Just make sure that they’re doing something. If you pay them, $10,000 is below the standard deduction. They’re going to pay zero tax on it.

Somebody says, “Is trading non-fiat crypto taxable?” I know you get taxed on capital gains when converting crypto to fiat. If you have crypto, it’s considered a capital asset.

Sorry, I’m just reading this off of the chat. If you buy something with crypto or if you change crypto for crypto, it is taxable as capital gain when you do it. It’s fun.

Somebody said, “Roth IRA. It was a $2000 contribution. He probably just bought pennies on the dollar.” I have to look and see.

You can’t do it as a disqualified party, but I imagine it wasn’t disqualified if he bought the PayPal interest and it was public. He’s going to be small enough to where he’s not going to be disqualified, but if you have control of a business, it could be a problem.

The IRS audited Peter on that, by the way, and lost. They didn’t like it, but there was no rule against it, so he made all this money. Then, we all looked at it and said, boy, I wish we could do that. It’s quite lightning hitting.

“I bought a property in Texas in my name. I’m now putting it in an LLC. The LLC, we put inside of a Wyoming LLC.” That’s pretty smart. “I still have mortgages on the above property and keep making my payments. Do banks still use my mortgage liability to calculate my debt-to-income ratio?”

Jeff: I think the banks are going to ignore everything in the first two sentences. They’re going to look at what’s actually going on, that you own this property and it’s got a mortgage on it. That’s going to be their debt-to-income ratio.

Toby: Yeah. They’re going to still look at your Schedule E and U and they’re going to say, what debt are you on? If it was a Wyoming LLC owning an LLC and it was a non-recourse debt, in other words, you had property that was a portfolio loan and you’re not on the hook for it, then they wouldn’t.

But if you’re on the hook for it, if you’re a personal guarantor, they’re going to use it. They’re also going to use a calculation of this guy which is why it’s really important to remember if you can get it on page two because that makes a big difference. Also, they’re going to be adding back in the depreciation in most cases.

Somebody says, “Thanks. Been on Tax Tuesday for over a year. I’m taking many of the free courses and now I want to get started the right way.” We always like to see that. We like it when people stick around. Give us a year. We’ll put some money in your pocket.

“When I file my personal taxes, can I still write off my taxes on my properties held under my Wyoming LLC?”

Jeff: Yes. The matter is going to be where you put it out. We’ve had people who just own a plot they get property taxes on or a second home.

You can own 10 properties that are owned by you personally as a resident of. They all go on Schedule A. The problem with that is Schedule A taxes are limited to $10,000. That includes your state and local taxes, income tax, and so forth. If these are rental properties, where you want to deduct that is against the rental income.

Toby: Which is?

Jeff: Schedule E.

Toby: This is where we get to make fun of people. LLCs are not a tax status. When you see a Wyoming LLC, it doesn’t mean anything for tax purposes. We really need to know how it’s taxed. I guess that goes for the previous question too.

I’m assuming that you own this LLC either outright or with a spouse, in which case, it’s flowing onto your 1040 and going onto your Schedule E.

“When I file my personal taxes, can I still write off my taxes on my properties?” Absolutely. You’re going to get to write that off whether it be individually on your Schedule E or the business if it’s a separate business like a  corporation.

I would never own real estate instead of a corporation, but if you’re crazy and you did, then they can use it. I’m assuming because it says personal taxes.

“Can I write off the property taxes?” Yeah.

What if you created a loss with the property taxes, then what do you do?

Jeff: On the Schedule E? Hopefully, you can deduct that loss that you created with those taxes.

Toby: Yeah. Because you have a loss, we have to worry about passive loss rules. You can’t use your passive losses against your ordinary income except in two cases. Two cases are?

Jeff: Act of participation.

Toby: Or a real estate professional. That’s what it comes down to. If we have to look into this, generally speaking, yes. We could write it off. Worst case scenario, you have losses, you carry them forward, and when you sell, you get to write it off.

Jeff: Yeah. You don’t lose those. The only place you lose some is you have Schedule A and you go to that $10,000 limit.

Toby: Schedule A for you personal, man, they’d beat us up on it.

Jeff: If you live in California or New York, I am so sorry.

Toby: Follow us on social media, Facebook, YouTube, LinkedIn, Instagram, and Twitter. YouTube is the best place. You guys ask some really good questions. Chances are we’ve done a video on it because I have Carl, Michael, Jeff, Eliot, and I doing them. You have Clint always on there.

It says, “Clint or Michael.” Yes, they still do them, Sherry. They’re good. We’re going to make fun of them.

We’re constantly putting out content, guys. If you have a question, chances are we’ve answered it.

“Do you guys do tax returns for passive investors with bunches of K-1? If you guys do, give me some info.” Yeah, absolutely.

Jeff: Those are actually fairly easy returns to prepare. You just take them from over here and put them here.

Toby: All right. “My husband and I divorced in 2009 for asset protection reasons but have lived together the whole time in the same homes.” Ouch, that just sucks. Somebody got sued or somebody had some issues.

Jeff: There’s a story there.

Toby: And I’m curious, but we won’t ask that. “I purchased a home in Florida in 2019.” They both lived in it as their primary residence. “If we get remarried before we sell, can we use the joint exclusion of $500,000?”

Jeff: Section 121 has three rules that you have to meet. The first one is that at least one of the spouses owns the property. I think that’s true here. One of you obviously owns the property.

The second rule is that both spouses use the property. There’s no timeframe for that other than one of them has to meet the two out of five years, I believe.

The third test is did anybody use the Section 121 exclusion in the past two years?

Toby: Ownership and use.

Jeff: And didn’t use the exclusion in the past two years.

Toby: You have a washing statute that says, hey, you can only use this two of the last five years even if you weren’t married.

I don’t feel like you have to get remarried to do this, but you have to have ownership and use. If you own half the property, “I purchased a home in Florida and we moved into it.” It sounds like it’s in one person’s name.

Jeff: That’s what I thought.

Toby: You both resided in it. If a married couple sells, as long as one person owns it—somebody says, “I owned.” It sounds like we got you. I’m not going to ask you all the question as to why you’d do that, but you own it and you both use it, you quality. Two out of five years.

Jeff: Do you have to be married one day? You have to be married the day you sell that property.

Toby: From an ownership standpoint, but the use—

Jeff: You should have to have two years of use. They’ve been there since January of 2019 I believe.

Toby: There you go. You’re going to be good, Barbara. You’re going to get the $500,000 exclusion. Hopefully, that takes care of all your capital gains if you have any depreciation recapture.

Yes, two years. See? You guys are good. Yahoo! There we go. We had two good bits of news. We’ve had yahoos today. It makes me feel good.

“Regarding the Tax Reform Act of 1986, if I make under $100,000, I can write off up to $25,000 of real estate losses.” Actually, it’s rental losses, but real estate because it could be capital. Not to mince words, but technically, it’s passive losses. “Provided I have active participation.” Yes. “If I make over $150,000, I cannot write any losses off unless I’m a real estate professional with material participation.” For that year. “Can I write off the real estate against my other income if I had become a real estate professional?” Yes.

Anything you want to throw on there?

Jeff: Yeah. The one exception to that is you could possibly write off losses if you have passive income from somewhere else.

Toby: Yeah. That’s a really good point. The Code provision is IRC 469. They’re looking at passive income sources.

If you have passive losses, let’s say I invest in Jeff’s Pizza Shop but I don’t materially participate in it. I am just a silent partner and it kicks me down $50,000, but then I have real estate losses from my rental. It makes money, but I depreciate it. I accelerate some of that depreciation, so I make a paper loss of $50,000. Can I use the $50,000 of real estate loss from that rental, my passive activities, against my pizza business income?

Jeff: Yes, you can.

Toby: What if it was you? Again, we were 50-50 in the pizza but you materially participate. Could you use your half? Le’s say that it’s $50,000 each loss. Can I do that?

Jeff: I’m running the place. I can’t use my $50,000 of income because it’s not passive.

Toby: So not fair. The people in 1986, we should go back and smack them. They were trying to stop people from writing everything off, but what did they do? They made some unequitable results because I’m not doing a deadly squat and I can write off. It’s better for me not to do anything. Kind of weird.

If I have passive income from any source, I can write it off against any passive losses.

Here’s a fun one just to totally mess with your brain. Capital losses can be used against capital income, you could take $3000 a year, and you use that against your ordinary income, but did you know that you could sell your crypto when it goes down, harvest those capital losses, and then use it to offset any of your capital gains when the market’s going up? Not in crypto, but in SMP.

I have all these people that are doing great in the market this year because the SMP has been going nuts and crypto lost half its value. Sell the crypto, harvest that lost, buy it back.

There’s no wash sale rule for crypto. You have this big loss and then at the end of the year, sell a bunch of your stock to use up that loss—you have zero tax on it—you buy it right back, and you adjust your basis up.

If that doesn’t make sense, what you’re really doing is you didn’t actually really have a loss because you still have your crypto against a gain, and all you’re doing is you’re setting your basis up higher. If you sell that stock in the future, you probably won’t have any tax. That’s a lot of fun. I just like doing stuff like that.

“I’m turning 70″—congratulations—”and have a traditional IRA account which lost money. At some point, it was worth $90,000 and now it’s worth $30,000.” That really sucks. Market’s been doing great so you’re doing something, probably trading options, day trading. Stop that. I’m giving it a stink eye.

“Now, I have to start withdrawing. Am I going to pay taxes given the fact that I lost money?” It’s a traditional IRA.

Jeff: Let me give you the good news first. You don’t have to start withdrawing yet. They changed that a year or two years ago.

Toby: Now, it’s 72.

Jeff: It’s 72 now. You don’t have to start taking those.

Toby: It was about 1 ½ years ago now. That’s the SECURE Act at the end of 2019.

Jeff: It used to be when you turn 70 ½. That was the dumbest rule in the world.

Toby: This is still pretty stupid. They’re talking about making it 74.

You don’t have to start taking it out, but you have to take it out because you wrote off whatever you put in there. Just because it lost money, they’re going to say, hey, it doesn’t matter because you can’t use it. You’re just going to pay tax only on what you take out.

If I put in and I wrote off, let’s say that I was making contributions every year and I contributed $200,000 but I only would have to take out $50,000 because I managed to lose $150,000. I only pay tax on the $50,000.

You got the loss already because remember, you wrote off $200,000 putting it in there. You don’t have to worry about the loss because you already took the deduction.

Assuming that you put in some contribution that was $90,000 or below. You wrote that off when you put it in the IRA. You’ve got a deduction for it. Now, it’s worth $30,000. You’re only going to pay tax on the $30,000. No, you don’t get to write off twice. You don’t get to double dip. You get your deduction and then you don’t have to pay tax.

Somebody says, “Should my husband roll his 401k IRA into a Roth even if he’s in his late 60s?” What do you say?

Jeff: I’m not a big fan of that. I’m in my 60s.

Toby: You’re in your 60s? You look great.

Jeff: It’s the beer. I feel like the Roth is the younger persons’ game. They’re the ones that are going to be benefited. They’re usually in lower tax brackets.

Toby: It takes too long to make up for the loss. The rule is if you’re in a higher tax bracket now than you will be when you retire, use a traditional because the deduction is worth more. If you’re going to be in a higher tax bracket when you retire than you are right now, do the Roth because you’re paying less and you’re going to get all that taxable out. You don’t want to pay tax in the future when the higher tax bracket is there.

Jeff: Here’s how I view it. If I do a big conversion—you can say $100,000—that’s going to be a lump sum of income that I got to pay taxes on.

Toby: Unless you have a loss or unless you have some weird situation. Maybe I’m accelerating depreciation and I’m going to get a big fat loss this year. I don’t want to have a big fat loss this year because I don’t want to have a loss. I could roll over whatever that is and say, hey, I can roll over up to a certain dollar amount at X percent, then I might do that.

Jeff: It makes really good sense if you can keep that load to start with, but you have to work out the figures. Do I believe the market’s going to increase enough to make up for what the taxes I paid early?

Toby: It’s really hard. If your taxes go down when you retire, use traditional. You don’t want to do the conversion. If your taxes are going to go up when you retire, do the conversion.

There you got YouTube sitting there, staring you in the face. We always like to point out that (again) we record a lot of these things.

Also, by all means, please join us at the Infinity Investing Workshop this weekend. It’s myself, Nicole, and Pia. We’re going to have a special guest, Aaron Adams, popping in in the afternoon. It’ll be fun.

Somebody says, “Oh, you said you could take the crypto loss or the real estate depreciation gets to roll over to the Roth.” That’s smart. You could, potentially. The crypto loss is going to be capital.

The real estate depreciation will be passive, so we have to look. We always have to make sure. If we can create a loss, you’re a real estate professional, or something like that, absolutely. We can use it.

Anyway, come join us at the Infinity Investing Workshop. It’s always fun. It’s always relevant. It’s always different. I like to look at current data.

We’re going to go over a lot of real estate data because there’s a lot of fear mongering out there. Two biggest things that could hurt you in the market, fear and greed.

Buffett said this, “When others are fearful, be greedy. When others are greedy, be fearful.”

Facts will set you free. If you look at the data, you’ll feel a lot better about taking away some of the edge so you don’t do anything crazy.

Come in and listen to the Tax Tuesdays on the podcast plus our other content. We have a lot of podcasts that we record. A lot of them are going to be the Tax Tuesdays that we break down. You can always listen to some of the old ones where Jeff talks more than me. I doubt that has ever happened.

Jeff: Ever since we started videoing.

Toby: Jeff used to be the chatty Cathy.

Anyway, replays are in your Platinum portal. If you’re a Platinum, you can have all of them in there.

Let’s see. “If your IRA grows $2 million–$3 million over 30 years. Isn’t there a risk that your tax bracket will be higher when you take out that 4% required minimum distribution?” Yeah. But you didn’t pay any tax all during that time and you took a deduction in the very beginning.

“In the same token, isn’t there a risk that I’m going to have no taxes or it’s going to be really low when I retire?”

I can look at this statistically, Walter. During your major earning years, your chances of reducing your tax bracket is really high. It’s close to 100% when you retire because the average tax bracket when we retire is in the teens. When you’re making money, it’s about 29%. It’s higher.

Statistically speaking, you should always do a traditional if you are in your main earning years, but what you want to do is, for kids especially, get them into Roth early on when their taxes are closer to 0%, 10%, et cetera because statistically speaking, their taxes will be higher than 0% when they retire. That’s how you do it.

If you have 30 years too, I’m more apt to go the Roth route. If I have five years to invest, I’m going to save my money. I’m not going to pay the tax now. I’m not going to give the tax money that I could be spreading off until I’m 100. I’m just not going to do it.

Jeff: Just think. If you’re pulling 4% out of a $2 million IRA, that’s what, $80,000?

Toby: Yeah. Your capital gain is $0 under $80,000 if you’re married which means your dividends are taxed.

We won’t get into all of it, but when we actually do calculations, it’s usually telling us a different story.

Jeff: If you win the lottery, you can pay a lot of taxes.

Toby: If you have questions, by all means, email them. If we didn’t answer your question today, I think there are 148 questions that our team has answered thus far.

Jeff: That’s amazing.

Toby: I always look at that and say that’s 148 hours of revenue that we just lost. Then, we cry and that’s why we drink a lot of whiskey after.

No, I’m just kidding. We answer, but if you have a question that didn’t get answered, taxtuesday@andersonadvisors.com or just come on and visit us by all means.

We try to do this to make sure we’re not playing hide the ball, that we give you good responses, and give you something to think about because quite often, there are calculations that are necessary and you don’t realize that there are ways to avoid the tax right now.

Maybe it’s the situation where you want to make sure that you’re still qualifying for financing. We can show you the things that you could do that are not going to hurt that.

“The whiskey is tax deductible.” If you go to a restaurant, meals are 100% deductible. If you go there, you’re safe as long as you’re eating in a restaurant. Can’t help it.

Jeff: Food seems to deactivate the COVID.

Toby: The COVID does not respond well if you have a pizza in front of you. It’s better than a mask.

Jeff: We make jokes, but we know it’s serious.

Toby: This kills that, right here. I’m just kidding. Our leaders are doing what everybody else is doing. They’re human. Sometimes, we pretend that there’s something greater than human but they’re not. We’re all just doing the best we can, so just try to be good to each other.

“Try Old Grand Dad 114.” There we go. See? You guys are good. I actually have a Pappy Van Winkle sitting in my office that I’ve had for Clint. He has not gotten it yet.

Jeff: The girlfriend asked, what will you be doing if you go back to Kentucky? I said, we’re going to do the Bourbon Trail.

Toby: That’s right. You’re a Kentucky boy. Jeff knows more about whiskey than most people. You like the good stuff.

All right, guys. Until next time. We’ll see you in about two weeks.

As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, another great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets. One of my favorites as well is our Infinity Investing Workshop.

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