Welcome to another episode of Tax Tuesday, where tax experts Toby Mathis, Esq., and returning guest Jeff Webb, CPA, CFO of Anderson Business Advisors share their expert advice on writing off business expenses, end-of-the-year options for saving on tax deductions, inquiries about organizational vs. startup expenses, and how to borrow from your life insurance policy to invest in real estate. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- All my LLCs are disregarded…. I’m in the process of setting up…What are some of the write-offs for 2023? – You normally can’t write off until the business has begun operating, but the cost of setting up, you can grab that, but you have to have income to benefit from those write offs.
- Can I 1031 a long-term rental single-family residential.. into short-term AirBnB rental.. Then do a cost seg? – Yes, but there’s a timing issue…the long-term rental cannot extend into the next/same year.
- How do I write off biz expenses before the bix makes money? – There are ‘organizational’ and ‘startup’ expenses that you can write off, of $5K each….but it also ‘depends’
- If we are flipping a home within 6 months, can we write off depreciation, closing costs etc.? – The home is considered ‘inventory’..if you bought it with intent to sell, no matter how long you own it, it is ‘dealer property’
- My husband owns and operates an electrical business… if a client doesn’t pay, is it considered a loss? Is it tax deductible? – You don’t recognize income until it is paid to you. You can only write off expenses.
- Please discuss pros and cons of borrowing from my life insurance to purchase real estate? Is any of the interest tax deductible? – The interest on the property is deductible. Different policies have different ways of accounting for the loan. I don’t see a lot of ‘cons’.
- How do I offset passive losses other than increasing rents and paying off debt?.. What can I do before the end of the year so I can use this year’s taxes? At this time of year, there’s very little you can do, you only get the portion from now until the end of the year.
- I am a licensed contractor working part-time as a salaried employee… am I a real estate professional for tax purposes? – Yes… if you’re the owner, and you have 750+ hours working in the real estate business… more than 50% of your time.
- Can I create a 401k for my real estate biz? Will this affect my employer’s 401k- Yes, but you can only contribute the total amount allowed by the individual by the IRS. You have to have an ‘active’ business, not passive income.
- Is there an age limit for hiring our kids? We have 6 and 13-year-olds. – Yes, but you have to have them working on actual tasks to be paid. Sweeping, modeling, acting, etc. What is the market value of those tasks? Labor laws don’t apply – you can put YOUR OWN kids to work, and pay them, at any age.
Resources:
Tax and Asset Protection Events
Full Episode Transcript:
Toby: Welcome to Tax Tuesday. Hopefully you’re popping in there. I don’t know if I can see whether people are flowing in or not. Zoom is being zoomy today. If you’re looking for Tax Tuesday, you’re in the right spot. We’re trying to bring tax knowledge to the masses. My name is Toby Mathis.
Jeff: And I’m Jeff Webb. Sorry, I was distracted by the thing crawling across the screen.
Toby: What’s crawling over there? Is something crawling? We’re not the best at computers here, so Jeff’s trying to show me a thing or two, and Zoom likes to just put things up there. Anyway, let’s dive in. You’re here for taxes, not for lessons on Zoom etiquette. All right, let’s talk about this real quick.
If you have questions today, put it in the Q&A. Questions today, put it in the Q&A. That actually rhymes. We have Dutch, Eliot, Jared, Tricia, Amanda, Patty, Matt. We have a bunch of tax attorneys and accountants on who will answer your questions for you. If you have any year end stuff, if you just have, boy, this is bugging me, I just wanted to know the answer, throw it in there in the Q and A.
If you start asking questions like, hey, my 1040 is this, that, and the other, blah-blah-blah, strategy, this, that, and the other, we’re probably going to ask you to become a platinum client or to become a tax client.
You could email in general questions to taxtuesday@andersonadvisors.com. We grab 10–15 of those every event. We go through, we read them, answer them, and then answer all your questions.
If you have comments, feel free to put them in chat. In fact, one of the favorite things we like to do here is say, what city and state are you sitting in? Don’t say intoxicated in Seattle. What city and state you are in? Put it into chat so we know where everybody’s sitting. It’s always fun to see.
There’s Claremont, Florida, Kansas City, Kansas, Odessa, Florida, Osteen, Florida, Fort Collins, Colorado, soaking in Seattle, Springfield, Eastern, PA. Now they’re flying by […]. Hyattsville, Houston, Wisconsin, California, Massachusetts. What Cheer, Iowa. I didn’t know there was a What Cheer. Oh, my gosh, now it’s doing weird things up on top.
New Jersey, Pompano Beach, Florida, I bet you it’s nice. Tulsa, Oklahoma. Maple Lake, Minnesota. I have not seen a Hawaii. Anybody out there in Hawaii? Salt Lake City, Utah. Usually we have all time zones covered.
There’s Wichita, South Florida. I’m not seeing any Hawaii. I’m feeling bad now. There are more Colorado, Vancouver, Washington. Hey, Joe. NorCal, Northern California, two of them from there. Again, I didn’t see any Hawaii. White Plains. I’m sad here. There’s Mark Perry. All right, so now we have Hawaii in the house.
All right, Seal Beach, California as well, and Bellevue, Washington. If you want to be a tax client, please let me know what will be the cost. Hey, Raj, nice. There are some more Hawaii. I always know that we got them on both coasts, so we have to check that out.
Anyway, this is supposed to be fast, fun, and educational. We try to get done in an hour, but Jeff is very, very talkative. Talkative Jeff. All right. Speaking of talkative, let’s go through the questions that we are going to answer. We’re not going to answer them yet, but we’re going to read them out so you get to see what are the questions. Hopefully one is ringing true with you and you go like, ah, gosh, I really want to hear the answer to that. So you stick around.
“All of my LLCs are disregarded right now. I’m in the process of setting up one LLC to be taxed as an S-corp or C-corp as management for all my LLCs. What are some of the write-offs by 12/31/23 as a corporation?” We’ll go over that. Jeff will probably have something to say. You’ve been a CPA for 30–40 years?
Jeff: Thirty years.
Toby: Thirty years? I’m just estimating high. You got somebody gave you a little, what is that called?
Jeff: Yeah.
Toby: Somebody gave you a reaction, whatever that’s called. Confetti? Is that confetti?
Jeff: A party…
Toby: It’s a party thing. Give Jeff a thumbs up if you think that 30 years is good to be a CPA. I don’t know how he’s done it. There we go, you get some thumbs up. They’re all down here, though. We have three screens, and it picks ones to do it. I don’t see any crying emojis, so apparently they think that’s good.
All right. “Can I 1031 a long-term rental, single family residential depreciating over 27½ years into a short-term Airbnb, and then perform cost segregation analysis on the new property?” He picked a good topic.
“How does this impact depreciation recapture and depreciation schedules going forward moving from straight line into accelerated. The goal here is to apply paper losses against W-2 income.” Good questions again.
“How do I write off business startup expenses before the business actually starts making any money? LLC cost, education cost, travel expenses for business education, business essentials, phone, office, et cetera.” Good questions thus far. Elliot always picks these. He’s one of our tax attorneys. He’s probably on. Yeah, I see Eliot’s name. We always rate whether he gave us good questions or not. How are you thinking thus far?
Jeff: So far so good, but I know he’s got some that I have to keep answering no on. But go ahead and give him a little love.
Toby: Eliot, that’s good. All right, “If we are flipping a home within a six-month period, can we do accelerated depreciation on top of the fixing costs, real estate commissions, closing costs, et cetera?” Dealer status question.
“My husband owns and operates an electrical business. When he finishes his job, he provides a statement due upon receipt. If a client does not pay, is it considered a loss and is it tax deductible?” Good question. I get that one a lot, actually.
“Please discuss the pros and cons of borrowing from my life insurance policy to purchase real estate. Is any part of the interest I would pay on this loan tax deductible?” Good question. I have a feeling Jeff will answer that because he loves that type of question.
“How do I offset passive losses other than increasing rents and paying off debt? Do I partner with someone who is generating a lot of passive income, buy a property that has generated a lot of income for the year? What can I do before the end of the year so I can use it for this year’s taxes?” Good question again.
“I’m a licensed contractor working full-time in my 100% owned construction company. I am a salaried employee, so I do not have a punch card to track my work hours. Am I a real estate professional for tax purposes?” We’ll dive into that one too.
“Can I create a 401(k) for my real estate investment business? Does it cause problems if my salary job provides me with a 401(k)?”
“Is there an age limit for hiring our kids to work on our family business? We have a six-year-old and a 13-year-old.” I love that question. Somebody is thinking way ahead. Do that for a few years, your kids are going to be millionaires if you do it right. We’ll show you that way.
All right, already a ton of questions already going into the Q&A. You guys are already making our folks work. Thanks again to Dutch, Eliot, Jared, Tricia, Amanda, Patty. Probably I’m missing somebody, but there are a bunch of folks. Matthew, he’s on there too.
Hey, if you like questions and answers, and you just want to learn more about real estate tax, asset protection, even investing, and if you want to learn about welding, I had Tyler Sasse on. We were talking about how much you make as a welder. It’s pretty cool. He’s one of our clients. He’s a really great guy.
Some of you guys know who Tyler is. He’s a rock star. He did a really good job. Go to my YouTube channel, subscribe, like all the stuff, or just go watch videos for that matter. If you’re on YouTube watching this right now, make sure, see, Tyler’s that guy over there in the corner. Why you should learn to weld. I just decided that everybody should learn to weld. Those guys do really, really well, and we need people in the trades.
Jeff: Absolutely.
Toby: Somebody says, I love to weld. If you like welding, put it into the chat. I like welding, and other people should learn to weld too. Even if it’s not your career, it still sounds like fun. I know it’s hard work, but you get paid a lot. These guys are making about $100,000 a year.
He has a school. They’ll even cover the cost of doing the school. They have ways to do that, where you work it off later. It’s actually really cool. Let’s say, I want to list to all these people. Go to my YouTube channel. That’s my shameless pitch.
If you want to learn how to save your money, if you want to learn how to protect your money, keep it away from the lawyers, snoops, and Uncle Sam, then by all means, come to our free real estate tax and asset protection workshop. The virtual workshops are 100% free. They’re one days. Looks like we have some coming up on the 16th, the 21st, and the 27th.
We have a four-day event coming up this week, actually in a couple of days here in Vegas, where we’re going to have hundreds of people here in Vegas. We’re going to be hanging out going over an Infinity day on investing and then three days on tax and asset protection. If you really like this, it’s fun.
Somebody says, I taught welding in 1969 in Cleveland, Ohio. You’ll like Tyler. He’s a really cool dude. He dropped out of high school at 16. I’m learning all this stuff while I’m interviewing him, but he ended up building a very successful school. He has done really well financially for himself. But what’s more important is he’s making America a better country, he’s teaching people how to be good workers, and he’s teaching them a skill that nobody can take away from.
All right, there’s the YouTube stuff. If you want to come to YouTube, Clint has a great channel as well. My partner, Clint. Clint and Michael are my partners, but Clint has a really good asset protection YouTube. Michael, we were just trying to get him. I’d keep trying to push him like, Michael, have a YouTube channel. He’s good enough to let Clint and I do it. We’re weird, we love it.
All right. Let’s do the first question, Jeff. “All of my LLCs are disregarded right now. I’m in the process of setting up one LLC to be taxed as an S-corp or a C-corp as management for all my other LLCs. What are some of the write-offs that I get before 12/31/23?”
Jeff: One thing we need to put out there is you normally can’t start writing off stuff that happened before you had your entity. There is the exception for certain startup expenses. You don’t have as many to choose from in an S-corp as you would a C-corp, and there are organizational expenses. The cost of setting up the S-corporation is an organizational expense. You’ll be able to write that off.
Toby: Let’s hit some basic real quick.
Jeff: Okay.
Toby: When you see LLC and you hear disregarded, and you see LLC taxed as an S-corp or a C-corp, I just want to make it clear, the IRS doesn’t know what an LLC is. They go like this. I don’t know what you got, tell me what you got, tell me what you got, and then you say, oh, it’s just me, that’s disregarded. Or oh, it’s a partnership, or oh, it’s an S-corp, or oh, it’s a C-corp. You do this on an SS4. If you do an S-corp, it’s a 2553, but you’re just letting the IRS know what it is because they don’t recognize an LLC.
When I see disregarded LLCs, that tells me somebody is probably doing real estate, and they probably want to have it one LLC that is taxed as an S-corp or a C-corp to collect rents and to gather expenses. That’s what it’s telling me when I see this. You agree?
Jeff: Yup.
Toby: All right. Now we have these LLCs that are doing real estate. You get deductions on your ordinary and necessary business expenses on those. It’s not like you lost out, but now we set up an S-corp or a C-corp before the end of the year. Does it trigger anything special that I get to write off? The answer is probably not. There’s $5000 for startup expenses, $5000 for organizational expenses that you can grab. Lickety split and reimburse yourself and write off, but it has to have income to really get a benefit out of that.
Jeff: I’m not sure if you agree with this, but I’m not crazy about having an S-corp as a management company, especially if it’s managing real estate, because then any management fees just create passive losses, most likely, and ordinary income at the same time, which both end up back on your 1040 with an S-corporation. That’s why I prefer the C-corporation. Like I said earlier, there are actually more deductible items.
Toby: What about double taxation? My accountant has a heart attack and immediately starts saying, oh, my gosh, you’re so dumb, you set up a C-corp, it’s double tax. What do you say to those people?
Jeff: There are so many things you can do. There are times where dividends are applicable. You can pay a salary out of that C-corporation so you don’t get hit with double taxation.
Toby: Let’s be real, 80% of C-corp is zero out at least.
Jeff: Thank you. That was the other thing I was going to say. You can make your management fees really close to whatever it is you’re reimbursing, and the C-corp never makes hardly any money.
Toby: What Jeff said about C-corps get more deductions. C-corps, assuming you don’t have another company that’s a C-corp with a bunch of employees, we have discrimination rules. Assuming that this is just you and it’s, hey, this is my family and I have a W-2 job or something, I can write off 100% of my medical, dental, vision expenses for myself, my family, anybody who’s a dependent of me, including my parents if they’re dependents. I can write off all of their medical.
We’ve seen $25,000–$30,000 medical expenses reimbursed out of a C-corp, 100% deductible to the C-corp. You don’t have to report it as an individual. It’s under an accountable plan. Plus you can do administrative offices and get another $5000–$6000 a year tax-free, plus you can do 280-A, which is this Augusta rule. If you’ve never heard of it, stick around. We go over this in a lot of our courses.
There are a whole bunch of different deductions that are sneaky deductions, that are available to corporations, that are not available to you and me. It’s because when you have an S-corp or a C-corp from a tax perspective—it could be an LLC taxed as an S-corp, LLC taxed as a C-corp—you can be an employee, which means you can have an accountable plan.
If that sounds like Greek to you, it just means your company can treat you just like if you were working for Boeing or something else. They can reimburse all these expenses and cover these things for you. The company gets to write it off. You don’t have to report it as income.
Jeff: If you have an S-corporation as a management company, I would say it’s highly likely that you’re going to have more personal income than if you had a C-corp managing your company, your entities.
Toby: Fair enough. What Jeff said about the C-corps is if they do show profit, they’re taxed at 21%. If they pay that profit out to you, you pay long-term capital gains rates on it. It’s called a qualified dividend, so it could be at zero anyway. Everybody always says, oh, double tax. Realistically, it’s not so bad a thing anymore since the Tax Cut and Jobs Act came out.
It used to be really bad when dividends were ordinary income, and the corporate rate could be as high as 39%. You’re getting nuked at that point, and that’s where most accountants got trained. It was like, oh, they’re bad. They didn’t actually do the math. When you do the math, it’s not that bad anymore.
Jeff also said something really smart, which is you can just pay yourself a salary. Worst case scenario, you’re sitting there on the C-corp and you’re running, you don’t have to work for free. You can pay yourself a salary and get it out, so you’re no worse off.
If you’re making ordinary income and you’d have paid tax at ordinary income rates here, we can still get it back out to you. Or if you’re really scared of that C-corp, do an S-corp, quit worrying about it. Don’t stress yourself out. Let yourself sleep at night, right?
Jeff: Right.
Toby: Whatever works for you, but it’s got to be your decision. You shouldn’t just default to your accountant’s decision. Anything else on that, sir?
Jeff: No. Like you said, a lot of the old CPAs that are stuck on C-corps are bad, especially the smaller ones.
Toby: C-corp’s bad, because they don’t want to learn how to use them. No offense. There are probably some CPAs out there that I just pissed off. I’m sorry. We learned certain things. Even in lawyering, you learn certain things like, hey, in order to be a C-corp, you have to meet all these different tests, and then they check the box regs and makes it a moot point. We all learned. under one system, and then the Congress changed it. I still think that.
Somebody says, what any point does an S-corp make more sense than a C-corp? Absolutely. When you need to live off the money and you’re going to be taking it out anyway, then we can avoid employment taxes on about two thirds of that money or if we’re taking it out.
There are lots of reasons why you might do an S-corp versus a C-corp, and sometimes you do both. There’s nothing that says, I can’t have family management company over here, consulting, dental practice, medical, whatever the other business is, construction company, electrical contractor, whatever as an S, real estate, maybe I’m a realtor, maybe I just have a management company that I’m doing certain activities, and I have a C-corp that’s managing stock accounts or something else. I could actually have both.
Yes, you can have the best of both worlds, and you can have your cake and eat it too. I’m thinking about cake. Cake. Wait, darn it. Sometimes I’m not quick on the draw there.
All right, next question. “Can I 1031 a long-term rental, single family residential depreciation over 27½ years into a short-term Airbnb, and then perform cost segregation analysis on the new property? How does this impact depreciation recapture and depreciation schedules going forward moving from straight line to accelerated? The goal here is to apply paper losses against W-2 income?” Jethro.
Jeff: A couple of things here. Yes, you can do this. There’s a timing issue here that this long-term rental really can’t extend into the next year, because then you taint your whole short-term rental.
Toby: Good point. A short-term rental, seven days or less. You take the total number of people that you rented to. What do you call it, hosted or rented to? It’s still a short-term rental. All of our guests, and you take the number of days. It was actually rented, divide the number of people into that, and that will give you your average days per unique rental.
If it’s seven days or less, it is not passive rental activity. It is a trade or business. You’re an electrician, you’re a pizza shop, you are fill-in-the-blank, you’re an active business. What Jeff just said is, hey, if I’m a long-term rental, and in the middle of the year I go into an Airbnb, I have to look at the whole year for both those properties. Correct?
Jeff: Yup. If you’re still long-term through January, is it still possible? Yes, but it makes it all that much more difficult to get that seven-day average. Now, depreciation recapture, the nice thing about 1031 is depreciation recapture is also deferred along with all the other gains.
Toby: What they’re talking about is when they do cost segregation ordinarily on a property, a long-term rental is 27½ years. Airbnb, technically, is 39 years. That’s called straight line. Hey, I’m just divvying it up over that period of time.
When I go in and cost seg a property, I’m walking in there going, hey, that carpeting is five-year property. Hey, those cabinets are five-year property. The appliances might be five years. That deck outside is 15-year property. Those shrubs and those flowers we planted, that’s 15-year. Hey, that new driveway, that’s 15-year property. And then I can accelerate that.
This year in 2023, you can accelerate 80% of whatever that dollar amount is. I can write off right now, the year that I decide to do the cost segregation. Here’s the weird thing. Because you had a long-term rental and you 1031, we have to go back to the year that, I believe, that that one is put into service to determine what’s the amount that we would get it for our accelerated depreciation, because that property would be put into service at some point. I believe that’s correct, but verify.
It’s going to be whatever year that property was put in service. I don’t think we can sneak around that fact, but it might be 100%. I’ve had this property since 2018, and I 1031 it into a new Airbnb, which is a great idea, by the way. You always want the best use of your dollars, and I don’t want to incur a tax.
Your basis is the amount of the first property. When you’re doing your cost seg, it’s still based off of these numbers over here, my depreciable basis minus land. You look at just the improvement, the box that you put on that property plus any improvements.
Jeff: Another issue with this is let’s say I originally purchased this property for $200,000 and I’ve had it for a while. The basis is now about $100,000. It doesn’t matter if I sold the property for $500,000. The basis in my replacement property is still $100,000.
Toby: Yup. It’s whatever that was minus the depreciation.
Jeff: Correct.
Toby: You may be better off. Sometimes when you do these numbers, it sounds weird. But if you’re going to do accelerated depreciation, you may want to consider just selling it. We’d have to look and see. You might have a passive losses that are from other properties or better yet, you might have lost carry forward that you didn’t realize get released when you sell.
You may not have a big tax hit anyway. But depending on the value of this property, you may be surprised that it’s actually called a lazy man’s 1031. You might be better off selling it and not 1031 it. You may be better off saying, hey, you know what? I want the higher basis, and I want to accelerate depreciation.
By the way, we can get those numbers for you before you sell. You could decide, do I want to do a 1031? You could always pull out of the 1031. Even after you sell, you still have these requirements. You could just say, nix it. Give me the money, boom, everything’s taxable now.
Jeff: Because I might be perfectly okay with paying the capital gains on the sale. By putting that half a million towards a new property, I have a lot more depreciation to work with.
Toby: The last line here, the goal is to apply paper losses against W-2, you’re getting a tax benefit if you’re doing Airbnb and you materially participate. Material participation, seven tests. Really only three that we pay attention to, which is either you’re doing all the activity, hey, I self manage it, or I have other people working on it that do substantial activities, but I do 100 hours between myself and my spouse. You add both times and nobody spent more time. No other individual spent more time.
The last one is 500 hours between you and a spouse. On this one, because it’s Airbnb, it would be only on your Airbnb property. If you’re doing, hey, I want to be a real estate pro, we would actually structure this slightly differently. You’d probably sell the long-term rental. We’d want to lease that new purchase to an S-corp, a C-corp, or an LLC taxed as an S-corp or a C-corp. That will be the host so that we can keep it long if we’re going to aggregate it with our other rental properties.
If you just want to do the Airbnb, you’re going to self-manage this, you just want to do it for one year or two years, and you’re just trying to unlock the tax benefit, then we wouldn’t do that. Again, there’s a little bit of convolution here, but people that know this stuff, they’ll be able to figure it out lickety split. If you looked at us, it would take us five minutes to figure out which is the better way.
Jeff: Another thing, Toby, it reminded me of is if that long-term rental has suspended passive losses under it, I’m probably more likely to sell it, because the one at 1031 does not release those passive losses.
Toby: And now you’re stuck carrying them forward.
Jeff: Right. I have to keep carrying them forward. But if I sell the property, I can release them, which will go against that W-2 income.
Toby: I see Dina put in there in the chat, and I saw Patty’s responding. You would want to talk to a tax person. I know there are 1031s that we already know what that rule is. We would just look and say, hey, based on your tax return, what’s your loss carry forward? We’ll see if they’re associated with that property. We look at the depreciation schedule, and then we look at the target property and see what we could unlock there with the cost seg.
We work with Cost Seg Authority. Erik Oliver over there is absolutely aces. We would run through the analysis to see how much we could unlock, and then we could tell you, here’s your gain that you would have if you don’t 1031. Here’s it is if you 1031. Which one’s better for you? They’ll be looking at your total circumstance. One of our accountants could do that. I would say, I want to talk to a tax advisor. Is it tax analyst or tax advisor?
Jeff: Tax advisor.
Toby: Tax advisor. You say, I want to talk to a tax person. You’re the CPA. Jeff’s the CPA. I’m just a tax attorney. Frankly, some days that’s even questionable.
All right. “How do I write off business startup expenses before the business actually starts making any money? LLC costs, education costs, travel expenses for business education, business essentials like phone, office, et cetera.” What say you, Jethro?
Jeff: Those expenses are tallied up. There are actually two categories. There are organization expenses for setting up the entity, and there are startup expenses. They both have a $5000 automatic expense line.
Toby: Yes, and you have education that would lop into that. Let’s go through these. LLC cost, is that startup or organization?
Jeff: Organization.
Toby: Education cost. Is that startup or organization?
Jeff: That is a startup.
Toby: Travel expense for the business education.
Jeff: Startup.
Toby: Business essentials like phone, office, et cetera.
Jeff: Startup.
Toby: There you go. You can write off startup expenses of up to $5000 of organizational expenses. Boom, immediately. If you go above that, you get to amortize them. Over 15 years, you get to write them off. It’s a slow, painful process, but eventually you’ll write them off.
Jeff: If you have substantial education expenses, you’re probably going to want a C-corp. That’s the only place we can deduct those.
Toby: Yes, we want to see what you’re doing. We will make sure that we are treating it the best we can. Where can we find a list of write-offs in their category? You talk to Jeff.
I think we have a bunch of different types of expenses, but it depends. It depends on what you’re doing. It’s just one of those weird things. I wish that there was a simple answer, there’s not. It’s section 162 of the Internal Revenue Code. It’s reasonable and necessary for the type of business you’re in. Reasonable, customary, and necessary.
Jeff: I guess we could pull Amazon’s chart of accounts.
Toby: Custom, ordinary, reasonable, and necessary.
Jeff: Yes.
Toby: Yes. You’re just trying to write things off. You grab a chart of accounts of a big company and look at what they’re using. They all use different charts of accounts, by the way.
Jeff: Look at it this way. The definition you gave is, is this really a business expense? Am I spending money for the business, or did I just feel like I needed a new lawnmower?
Toby: Yeah, and get this. If you have one of these things, a cell phone, and I want to write it off, and I am a sole proprietor, I’m in a partnership, I can only write off the business expense with this. Who the heck tracks their phone? Here’s my business phone. Maybe you get a different phone for your business. It’s just annoying.
If I am an employee of an organization, so I have an S-corp or a C corp and I work for it, my employer can reimburse me 100% of this. If I work for Jeff CPA firm and I’m like, hey, I use this phone to benefit as part of my duties, Jeff could reimburse me 100% of not just the data and the cell, also the phone itself, 100%. The trick question is, where do I report it? I don’t.
It’s no different than if your employer said, hey, on the way in the office, pick up some pizzas and I’ll reimburse you. The employer is going to write off the pizza. When they write you a check or hand you cash to reimburse you, you don’t have to put it anywhere. There’s no line item on your 1040 that says reimbursed expenses. It doesn’t exist. You’re good.
Somebody says, you can look at forms on the Internet. Yeah, the forms are found on the website. We have some of those where we have a whole list of different things. All you have to ask yourself is, is this the type of expense that would benefit? There are all sorts of things. Meals, hey, I’m meeting with a prospect, I’m traveling for my business. Hey, I’m going to an event for realtors, I’m a realtor, and I’m trying to continue education or whatnot. Yeah, that’s deductible.
Hey, I’m driving around, how about the mileage? See if I can write that off. Hey, I spend money on paper, a printer, some computers, and I have to get some subscriptions. Yeah, all that’s reasonable, ordinary, and necessary. Somebody says, the Anderson event, yes, 100% deductible. How about if I go to a golf course? The IRS is going to say, probably not because that’s not where business really takes place, even though it’s where business actually takes place.
Jeff: And they’re going to classify it. It used to be you could write off entertainment. No more.
Toby: Yeah, they did away with that. Guess who did away with that before everybody? Tax Cut and Jobs Act, that was the Trump administration. He got rid of the dang golfing and entertainment, except…
Jeff: And he owns golf courses.
Toby: Yes. Come on, self-inflicted wound. All right, let’s move on.
“If we are flipping a home within a six month period, can we do accelerated depreciation on top of fixing costs, real estate commissions, closing costs, et cetera?” Can you give them what flipping is?
Jeff: Flipping is when I purchase a property with the intent of fixing it up and selling it to somebody else, which makes it inventory. It’s just like if I bought some apples to sell in my fruit store.
Toby: That is 100% correct, which means think about your fruit store. Do you depreciate the apples in your fruit store? No, they’re cost of goods sold. When you buy a house and you’re going to sell it, I bought it with the intent to sell it no matter how long I own it—I was just talking with a former IRS trial attorney on this one, and we were just sitting here chatting. He’s like, nope, 10 years.
If the IRS sees that when you bought it, you were intending to sell it, but the market turned or whatever, and you end up making it into your rental for 10 years, that is dealer property. You can’t depreciate it, you can’t do installment sales, you can’t do 1031s. Even if you held it more than a year, it does not matter. You are a car dealership with a car in the lot, but that car is a house. When you buy a house with the intent to sell it, you don’t depreciate it.
Jeff: But I’ve held this house for 10 years. What if I’m winging it out on that, even though I intentionally intended to flip it? No.
Toby: It doesn’t matter. It’s still inventory. There are a number of cases on it. Don’t worry, it’s out there. It’s not what people expect, and then there’s so much bunk information on the Internet about it. They’re always like, yeah, hold it for a year and a day, and you’re an investor. No, it’s the facts and circumstances surrounding the purchase. If you bought it with the intent to sell it, you’re a dealer, even if you hold it for 20 years.
If you bought it with the intent to hold it, it’s still investment property even if you hold it for two months, because somebody comes in and offers you an outrageous price, which we’ve seen. If this is you and you’re flipping, we’re not doing accelerated depreciation. Besides, you would just recapture at ordinary rate anyway as soon as you sold it.
What it is is all those expenses get added into your basis. If I bought a house for $100,000, and let’s say I sell it for $200,000, and I put $30,000 into it, I add up all my expenses, I have a $100,000 basis, I put $30,000 of improvements, that would give me $70,000 of ordinary income treatment.
I would not do that in your individual name. I do that through an S-corp or a C-corp because it would be subject to self employment tax. When I say S-corp or C-corp, it could be an LLC taxed as an S-corp or LLC taxed as a C-corp. Do not do these in your name because what it does is it causes confusion.
If I am the IRS, I need to know what Jeff is doing. If I see Jeff flipping properties or he’s a developer and he develops property, and then he has a property that he holds for 20 years, even if it was clear that that was an investment property on the IRS, what do I think Jeff is?
Jeff: A dealer.
Toby: Yeah, and that’s what they do. The only way they know is they come in and do facts and circumstances, which means discovery, which means digging into all your documents, which means asking you uncomfortable questions and digging in to see whether they can reclassify that puppy and disallow all the depreciation you took.
I had a client that bought a property for $4 million and sold it for $7 million under installment note. The entire $3 million of gain was due year one. The party that they sold it to, this was in 2007, ended up defaulting immediately thereafter.
The IRS didn’t care. They’re like, I want my $700,000 of tax. I want that money, I want interest, and I want penalties. They went after him. At the end of the day, it was a loss for him. He ended up with the property back, but that took two years.
The IRS says, hey, you got to show you’re actually trying to recover. You have to show that it’s bad debt before you can write it off. All those things. They make you jump through some hoops. It was two and three-year stretch. I think it was over three tax years.
They just got bapped, and they never even got paid on that sale. They had a massive tax hit. They ended up with some loss. Thank God, we were able to carry it back at that time. If it’s probably now, I don’t think we can carry it back.
Jeff: No, there’s no NOL carry back.
Toby: Yeah, at that time we could carry it back, but it just stinks. By the way, I can see the chat. I’m always scanning for ones that are relevant to a question that we’re asking. They said, “Hey, I have losses from a flip. I recently sold a home and took a huge loss, about $20,000 I have to take into account, rehab, holding costs, realtor commission. How can we solve the loss in our taxes?”
Here’s the beautiful part. It’s trade or business. It’s no different than if you ran a pizza shop at a loss. Or I was running a CPA firm at a loss. It’s ordinary loss if you materially participated. If you were the one doing the flip, you could write it off against your W-2 income, Sonny. You don’t have to worry about it being a capital loss, that’s restricted.
Jeff: In regards to some of these other expenses he mentions the real estate taxes, commissions, closing costs, those also are not deductible as you would think they would be.
Toby: They’re added to basis.
Jeff: They’re added to basis of both front and back end closing costs. You will get to recognize them when you actually sell your flip.
Toby: But some people, I know you’re sitting there going, I’m cash poor. The IRS is asking for money. Why is this? It’s because you’ve been spending it on things that may not be readily deductible right now. It might be something that’s going to be in the future you may not have to pay tax when you sell it and things like that. It’s something about Supreme Court and tax laws, I don’t know.
All right, let’s keep going. “My husband owns and operates an electrical business. When he finishes his job, he provides a statement due upon receipt.” It’s an invoice. Please pay me.
Jeff: I was really trying hard not to say that.
Toby: It’s an invoice, come on. “If a client does not pay, is it considered a loss and is it tax deductible?” Jethro.
Jeff: No, you’re on the cash basis, most likely. Even if you’re on the accrual basis, it might be a loss, but let’s just think of cash basis. You don’t recognize any income until you’re actually paid that income. I’ve had people who rent out their cabins through churches and all for things, and they want to write off the loss of income from those. It’s like, no, you can write off your normal expenses, all the expenses he put into that job, he can write off, but you can’t write off a loss for money you never got to start with.
Toby: Jeff just hit it on the head. As a cash basis taxpayer, you recognize income when you receive it. You don’t get a loss unless it’s actually something that costs you. There has to be a deduction. Not paying just means I don’t recognize the income. So I’m at zero.
If it cost me money to do the job, if it’s electrical business, and it costs your husband gas to get over there, some employees to work on things, the materials, hey, I did some wiring, I had some caps, and I had this, that, and the other, maybe I have $300 of cost, and maybe it was a $1000 invoice, you would get the $300. Your expenses, you could use those as losses and write it off against your other income, but I never received $1000. Just because they didn’t pay me, it doesn’t mean I get a tax deduction. I just don’t have to recognize it as income.
Jeff: We hear that pretty often that people want to write off their lost time for working on stuff they were never paid for. The IRS is going to tell you that’s not a thing.
Toby: It’s tough.
Jeff: Yeah.
Toby: We get that all the time, and people do this again. Like, hey, I donated my time to a charity. Do I get to write it off? No, you can write off your expenses. I think it’s 14¢ a mile or something like that. They have reduced the miles. But if you did postage or something—hey, I took a whole bunch of envelopes to mail out for my church, and I spent $30 on postage—you can write off the postage. But I can’t write off the time that I spent on it because you never got paid for it. If you got paid for it, then you don’t have losses, obviously.
I hope that helps. I know it sucks. That’s why it really hurts when people don’t pay their invoices. If you’re an accrual-based taxpayer, this could be a slightly different story. You would have the income accrued when he sends the invoice, but then they didn’t pay it. So you’d have to write it off as an uncollectible invoice and you write it off. You’re still at zero. You’re not worse off, better off, you’re still at zero.
Jeff: That’s exactly right.
Toby: It’s like a broken clock.
Jeff: You’re right, twice a day.
Toby: Twice a day, that’s about it. Depends on the clock too. All right. We got another one, because we love answering questions here. By the way, really good questions. I’m going to just say, where’s Eliot? Eliot, good job today. We really like your questions. All right, so Eliot, you can do it again. Nobody wants to pick the questions. There are 400 questions you guys send in every two weeks.
Jeff: And he’s been really good about not giving us this question.
Toby: There was a time when we would have two-page questions. We had to have a chat, no two-page questions. I had to talk to myself. I was probably the worst offender. I’d be like, wow, this is a really good one. It’s six pages.
All right. “Please discuss the pros and cons of borrowing from my life insurance policy to purchase real estate. Is any part of the interest I would pay on this loan tax deductible?” Jeff.
Jeff: I’m going to give you the second part. The interest is certainly deductible on the property you’re purchasing. It might be much if it’s an insurance loan.
Toby: But here’s the thing. What are the pros? I have access to a policy. Usually it’s whole life, indexed universal life, or variable universal life. Different policies have different ways of treating the loan. Some call it a wash.
Hey, you don’t make money on the money that’s in the account, but you don’t pay interest either. It’s a zero. You’re like, okay, no harm, no foul. I’m just not making money on it, but I’m not paying interest. They’d still probably assess you an interest so you could write that off, but then there’s income of that same amount in the policy, which puts you at a zero, but you’d still get a deduction.
Some of them, it’s hey, this is the rate that we’re going to use. It might be something like, I know LIBORs not around anymore, but it might be a LIBOR plus, Prime plus 1%, or whatever it is. Or it’s, here’s a baseline that we use, some calculations that they use for the interest rate. Maybe you’re paying 5% interest. You could be making 20% on the money in that policy, unless it’s whole life. Did they say?
Jeff: They did not say.
Toby: They didn’t say. Let’s say it’s whole life, you’re probably making 6% or 7%. Maybe they’ll charge you 5% percent of the policy. You’re still making money, and you’re getting to write that off. This is really important.
If I do a HELOC, if I borrow against my insurance, if I borrow from a related entity, that money, the interest that I’m paying is investment interest expense. It’s going on my Schedule E, and it is going to be deductible against my rental income. I’m still going to be writing it off. It’s absolutely 100 percent deductible to you. I don’t see a lot of cons on borrowing from my life insurance policy.
Jeff: I have one thing. It’s not really a con, but it’s what I’ve seen as a common misconception. By default, all my HELOC, my bank loan or something is going to generate income to me. If I default on my life insurance loan…
Toby: It’s already secured, and it’s not secured by the real estate. There’s the thing. I borrow against my life insurance. It’s not secured with the investment property, but it’s secured by my life. All I got to do is die someday. Hopefully, I can do that part like, oh, I couldn’t do anything right, the only thing I could do right was die and pay off my policy. That’s great.
The death benefit is going to pay that back, and it’s not taxable. It’s actually really a good thing to borrow against. Again, I don’t care whether it’s a HELOC, I’m going to write off the investment expense on my Schedule E, even though you might be thinking, hey, no, I have to write off my mortgage interest on my Schedule A.
That’s only your personal mortgage. It’s on your personal residence that was used for acquisition indebtedness when you bought it or fixed it up. Here you’re taking money, you’re securing it with your home, and you’re investing in something else. I can write that interest off as investment expense.
People don’t always realize that, and they leave some money on the table. We want to make sure you do not leave that money on the table because it’s kaching kaching, kaching. We want to make sure there’s money.
Jeff: Something Eliot and I were talking about on this very subject is, you take a line of equity on your home to buy another property. The interest you pay on that doesn’t go on your Schedule A, it goes on that property.
Toby: It goes on your Schedule E for that property, which is money in your pocket. I don’t know why more people don’t do that.
You can do it against the security back line of credit. You can have a stock account. You’d go there. I always say don’t go over 50%, but they’ll loan you for 70%–80% on some of these up to 90%, depending on what it is. And it’s at a lower rate than you would get if you went to a real estate lender. It’s like, why aren’t you taking the money that is available to you right here?
Or you could borrow against your 401(k), or go find a friend’s IRA where they’re self-directed. Let them stake it and pay interest. At the end of the day, it’s not the source that matters, it’s what it’s used for. If you’re using it for rental real estate, you’re going to be using it as a deduction regardless. Very exciting. Anything else on that one?
Jeff: Nope.
Toby: All right, let’s get this one. As soon as I see passive losses, I’m like, all right, somebody knows what they’re talking about. “How do I offset passive losses other than increasing rents and paying off debt? Do I partner with someone who’s generating a lot of passive income or buy a property that has generated a ton of income for the year? What can I do before the end of the year so I can use this year’s taxes?”
Jeff: Going to that very last question, it’s the key. At this time in the year, there is very little you can do. If I go in and buy into Toby’s partnership who has a ton of passive income, I only get that portion from now until the end of the year, not what he’s earned previously.
Toby: Right. You’re looking around for passive income from your other sources. If I have passive losses, and I’m like, shoot, yeah, increase your rents to market rents if you’re doing under market. Yes, go find businesses that create passive income that you can offset.
I always use the pizza shop, Toby’s pizza shop. Jeff has passive losses, and he needs some passive income. He could partner as a silent partner who does not materially participate in my pizza shop. When I pay him, let’s say we make $100,000 a year, we split it 50/50, he gets $50,000, he may not be paying any tax on that because he has passive losses from his rental properties. Me, I’m working in the pizza shop. I’m going to have active ordinary income, so it sucks. I don’t get to do the same thing.
There are two types of passive income and passive losses. There are two types of income sources. There are businesses in which you do not materially participate and rents. Rental income, and not just any rental income, long-term rental income, which is more than seven days.
Jeff: There is one other thing you can do before the end of the year, and that is sell one of your businesses or properties that has all this passive loss.
Toby: He has passive losses, so he’d have to sell it with passive gain.
Jeff: Yes. The passive losses would be freed up upon…
Toby: If he has passive losses on a property and you said, geez, we’re not getting to use it, you could sell that property. It would release that passive loss to be used against that property’s gain, and then carry it over and use it on another.
Jeff: Correct. Going back to what you were just saying, if he has a gain on that property, that’s also passive. He can apply that against any other passive losses.
Toby: Sometimes we’re playing a game. We’re looking at things and say, which one has loss? Which has the gain? Is there a tax reason to do something? Maybe. But then here’s the last thing I’ll say on this. If you have excess passive losses, they don’t go away. You don’t lose them.
Jeff: No.
Toby: It’s not like you’re on a timeline like, oh, shoot, I need to get some passive income or I lose it. You just carry it forward into the future years. We’ll still use it.
If you like this stuff, guys, I know I already mentioned this, but we got a four-day live event here. We’re going to do another one. I think it’s in March. I think we’re looking in Texas to do a live four-day event, four days of having to hang out with lawyers, investors, real estate investors, stock market people. A four-day event here in Vegas starting on Thursday, Friday, Saturday, Sunday.
I’m speaking on Thursday, probably on Saturday, probably on Sunday. It’ll be a lot of fun. Who else are going? Hey, guys, give me a thumbs up if you’re going to this event. Some of you guys might be. There we go. We got some people in the chat, but give me a thumbs up. There are a few folks. Two thumbs. There we go, there’s some more. All right, there are a few more. All right, a bunch of you guys are coming.
Come hang out with us in Vegas. Actually, there’s a whole bunch. There we go. Hang out with us next year, but we also have the free one-day events. I just had Brent Nagy, who’s a really cool client for a long time. He’s a real estate investor. He did Clint’s portion last Thursday.
He did a very good job. He’s a pilot and a very successful real estate investor. He really wanted to talk on this because he said it had such a big impact on his business. He says, I’d like to teach it. We’re like, okay, come on out, hang out with us.
Jeff: It is a lot of fun and you’ll learn a lot of important stuff.
Toby: Yeah, you’ll learn about land trust, LLCs, corporations, Wyoming statutory trust, living trust, personal residence trust, all the different types of tax treatments, S-corp versus sole proprietor, depreciation, accelerated depreciation, cost segregation. We’re hitting a lot of different topics, and then we go into legacy planning.
What is a living trust? How is it used? What are your options? Three options that you have. Four different ways that you can distribute an estate. There are a lot of stuff that we go over in that one day. It’s pretty action packed. Sometimes it goes slightly over, but for the most part, it’s a 9–4 type of endeavor. Take a day, learn a lot of good stuff.
All right. “I am a licensed contractor working full-time in my 100% owned construction company. I am a salaried employee, so I do not have a punch card to track my worked hours. Am I a real estate professional for tax purposes?”
Jeff: I’m assuming that’s a C-corp or S-corporation. Since you’re 100% owner, this does not make you a real estate professional, but it goes towards what we call the first test of being a real estate professional. Meaning you had 750 or more hours in a real estate business.
Toby: It’s 469 of the code, and it’s where they did the passive losses. This is actually 1986. They were sick of tax shelters. They basically said, we’re going to create this new category called passive income. Passive losses, paper losses, can only be used against passive income unless you’re a real estate professional, unless you’re an active participant in real estate making under $100,000 and then it’s $25,000.
They carved off some exceptions. The reason they did the exception is because the year following this new law, construction owners said, this is not fair. Developers said, this is not fair. We need those losses because we get treated like crap, because we have inventory instead of depreciable assets.
When we are buying our houses, we need losses to not be passive. We need them to be ordinary losses that I can use to offset the income in my business, because I’m treated so unfairly under the tax code. And they won. They actually said, yes. They changed the law to basically create those exceptions, the real estate professionals and the active participant.
Active participant is the easiest one to qualify for, but it phases out between $100,000 and $150,000. If you’re somebody who makes less than $150,000, there’s a good chance you don’t have to be a real estate professional to write off a bunch of your losses. You could be writing off up to $25,000 in a year just for hiring your own manager. That’s what it is. Are you ultimately in control of that property? You’re an active participant.
Real estate professional, there are two big tests. Jeff just said prong one, prong two. Prong one is I work in the realm of real estate trades or businesses. I spend 750 hours a year at least in those businesses, and it’s more than 50% of my personal service time. If it’s a joint, married filing joint, so it’s a joint taxpayer, one spouse has to qualify.
Here, we have a licensed contractor. They own their own business. The threshold is you have to own at least 5% of that business for the time to count. Under this one, if he’s working full-time, he just has to have some reasonable tracking.
It might say, I worked full-time, this is my only business. The IRS would probably buy that if they could see. Keep some calendar like, hey, I work 40 hours a week. You don’t have to have a punch clock, but you have to have something that shows this is what I was doing.
You could be looking at all the jobs, you could be looking at the income. The best thing to do is to put it in a calendar so that you don’t even have that issue. But if you hit the 750 hours, and it’s more than 50%, so long as in this construction company you’re working full-time, you don’t have another job, you’re going to be more than 50%.
Then we go to test number two. Test number two is, did I materially participate on my rental properties? In that case, what do we usually do? We aggregate them?
Jeff: We aggregate them. If you have more than one property, you really need to aggregate them.
Toby: Which means we treat them as one activity. The material participation test, again, there are seven of them. See if I can actually do seven. You’re going to have to qualify under one of those. The three that, again, we pay attention to is you’re the only one doing the work, substantially doing all the activities, which is possible to do if you have a property manager.
Prong number two is you and a spouse do over a hundred hours together, and nobody else spends more than 100 hours in your properties. Prong number three, and you just have to meet one of them, is 500 hours or more. You could qualify together. If you’re a real estate contractor, and you’re working on your properties, you would actually track that time.
I understand you’re not doing a punch card, but you’d want to track that time, because if the IRS comes in, they’re going to want to know, all right, did you meet the material participation test? You could use the time that you work on your properties towards that test. Otherwise, we’re really looking at you and your spouse. What did you actually do on your rental properties?
Jeff: Payroll records might suffice, but I would want to have that number hours worked in there, even if it says 40 hours every week.
Toby: We just don’t see a lot of challenges on this because they know the accountants. I should say, we don’t see it probably because all of our returns are professional taxpayer–prepared. Have you ever seen one? This last year, did you see any?
Jeff: I didn’t see any. No.
Toby: We do over 10,000 returns a year and we didn’t see it. They’re not really looking at the real estate professionals if there is an accountant, because the accountant is the one who’s certifying, signing it, and all that good stuff. They’re deferring.
What they’re really going to do is look at the person who’s probably taken a big old loss. They know that person has W-2 income. It looks like they have another job. There’s no way they’re spending more than 50% of their time on real estate trades or businesses, they’re just writing it off. It’s 20 something years we’ve been doing this, Jeff, for about 50. Just kidding.
Jeff: One of the difficulties I’ve seen is two unrelated non-married people will be in a partnership, and they both want to be real estate professionals. We have to explain to them, well, you both have to meet the 500-hour requirement so you both be real estate professionals, which becomes a little more difficult.
Toby: Remember, prong one, active businesses, development, redevelopment, construction, real estate agent, and all this stuff. It doesn’t have to be anything to do with your properties. You have to be in the real estate trade or business, 750 hours, more than 50% of your time. It doesn’t have to be the same.
This person could be doing a construction company, be a real estate agent, and be a developer. They spend 300 hours on each and you add them up, it’s 900 hours. Great, you qualify, but then you have to materially participate on your rental properties. It’s per property, unless you decide to treat them as one activity called aggregation. You have to aggregate your properties.
The court cases that I’ve seen that are against taxpayers, almost always because somebody didn’t aggregate. The tax judge has to follow the law. They’re looking at it and it’s going, it’s per property. You chose not to aggregate. Then they yell at their accountant. The accountant had no idea that was even an issue. It’s not their fault. Let’s just be real. The number of accountants that do real estate returns is very, very low.
All right, next question. “Can I create a 401(k) for my real estate investment business? Does it cause a problem if my salary job provides me with a 401(k)?”
Jeff: Not at all. You can certainly start a 401(k) in your business. The amount you personally can contribute is still limited to what it was for your 401(k) with your employer. If you do $10,000 here…
Toby: The employee deferral portion.
Jeff: The employee deferral. You can’t do $10,000 in your business and $30,000 in the other business.
Toby: What that is is the employer can contribute up to 25% of your salary. They can always do that. You can have 10 401(k)s with different employers, but they’re limited on what they can contribute up to 25%, and then each plan has a limit of $66,000. If you’re over 50, then there’s a makeup. I think it’s 7500. The employee can contribute up to $23,500 or whatever it is in the particular year. Is it $22,500?
Jeff: I know the total is $30,000 for catch up.
Toby: Yeah, I think it’s $22,500, but you can contribute that. The employee can put that into their employee side. That is not per plan, that is for the employee. If I put $20,000 in this employer’s plan and then I put $20,000 in over here, I’ve over contributed. I can only put in up to $22,500 plus any other amounts. But the employers can contribute to each plan up to the $66,000.
Jeff: What plan A is the employer contributes has nothing to do with what plan B is.
Toby: Yeah, but then I want to touch on one other thing. It says 401(k) for my real estate investment business. Depending on what type of business you have, in order to contribute to a 401(k), you have to have active business. It can’t be passive. If you have rents, and you make $10,000 a year in rents, you can’t contribute that into a 401(k). That’s passive income. It needs to be ordinary income, active ordinary income.
There is a way to turn that in. You need a management corporation. That’s why you use an S-corp, a C-corp, or LLC taxed as an S-corp or a C-corp, manage your properties, and then you could put that money into the 401(k). Just remember, those 401(k)s are deductible for federal income taxes and state income taxes, but not for employment taxes. No matter what, you’re going to be paying old age, disability, survivors, and Medicare.
Jeff: Actually there is time. If you have an active trade or business that has substantial cash, you could put and should pay yourself a substantial salary now. You have until sometime in 2024 to set up your 401(k) and make that employer contribution.
Toby: Yeah. The employer contribution, I think it was the Tax Cut and Jobs Act or the Secure Act that gave us the…
Jeff: It’s the Secure Act.
Toby: They basically said, hey, the employer can set it up and contribute all the way up until they file their tax return plus extensions. If you work for an S-corp, for example, it could be next September 15th, and they could make the contribution of 25% of your salary in there. Yeah, the employer could still do that.
You could still do a defined benefit plan if you want to really ramp it up. I’ve had clients this last year that were putting in $70,000–$80,000 towards the filing deadline because they wanted to lower their tax bill for the previous year. Yes, you could do those things. There are all sorts of little tricks to those.
To answer this question, can I create a 401(k) for my real estate business, yes. Even if you can’t contribute to it, you could roll over your IRAs and do other things. But if you want to contribute to it, you need to have active ordinary income. It does not cause a problem with your salary job with the exclusion of you have one amount that you can max, that you could hit for the year as an employee, putting portions into your employee contribution plans. You just can’t exceed that.
Jeff could go up to $30,000, I go up to $30,000. You’re under 50, you’re up to $22,500 I think is what it is. You look at whatever the year is, use that number.
Jeff: How do you know I could go up to $30,000?
Toby: Because you’re old. All right. I think it’s the last one. Here’s the last question. “Is there an age limit for hiring our kids to work in our family business? We have a 6-year-old and a 13-year-old.” Oh, my god, 6-year-old kids working? What is this, a work camp? Yeah, anyway. Can we do that?
Jeff: No, I wouldn’t hire the 13-year-old. That’s when they start getting a little mouthy. Yes, you can absolutely do that. However, you have to have tasks assigned to them that they’re doing. You have to be paying them for something. You can’t just say, oh, yeah, my six-year-old is on my payroll, even though he’s been in school the whole time and sweeping the floor. We talk about modeling for the cute little one.
Toby: There’s a court case with the IRS, where it was a nine-year-old. The question was, what’s a reasonable amount that they could be compensated in? In that case of the Screen Actors Guild, it was modeling and being an actor for marketing. It’s not like they look at it and say, oh, you’re a six-year-old, you can’t get paid. What they always say is, what’s the task you’re doing, and what is the marketplace for it?
Before you say, well, the Department of Labor is going to come crack down on me, no, the labor laws is 14 and 16 years, plus states have different ones, but that’s not the case when it’s your child. If it’s the parent-owned business, then you can put these kids to work early. If they’re under 18, you don’t have to withhold employee taxes.
If this is a sole proprietorship disregarded LLC, if this is a real estate business partnership, and you are paying them, then you do not have to do old age, disability, survivors, and Medicare. And it gets better if you pay them less than whatever the standard deduction is. This year it’s $13,850. They pay zero tax. They don’t have to file a tax return. They can put a good chunk of that.
I forget what the limit is this year in IRAs. It’s $6500, I think. I can put that amount of money into a Roth IRA. I never paid tax on it, and I’ll never pay tax again on its growth or any of the income that comes out of that. You could set your kids up. Just think about the six-year-old.
Let’s say they were able to do $5000 worth of work. That’s $5000 that goes into a Roth IRA. I don’t even know how many times that would compound before they hit retirement age, but they’re going to be very well-off if you put that just in SPY or some index fund. For the 13-year-old, the same thing. They have so long. Just think about it. They retire at 70, so you have 57 years of compounding before they even touch the money.
Jeff: $1 billion.
Toby: Somebody says, “I own a construction company. My son is 11 and flies the company drone to get updated aerial photos every week of the projects. How much can I pay him?” I’d call up a professional drone company, usually photographers. They do the drones and figure out how much they would charge.
Jeff: I’d call Delta and see how much they’re paying their pilots.
Toby: No. That’s horrible, Jeff. No. Don’t listen to Jeff. What you do is you go and you find, hey, what is the cost of getting something comparable? If your kids are over 18, or if it’s parents or siblings that you want to put to work, if you’re covering their expense, you don’t get any deduction.
If I can move that money to their tax bracket, quite often I’m saving some substantial amount of money, you just have employment taxes, but it counts towards their quarters. It’s where they get actually benefit. They may be getting that back at some point, assuming that there’s still social security when they retire.
Jeff: What you’re talking about with the drone is perfect for a situation like this.
Toby: Isn’t that fun? Again, I always just think of the parents that are working their butts off. Here’s a 6- and a 13-year-old, I’m saving up for college and all this stuff, or whatever it is. Trade school, go to Tyler Sasse and go to welding school. That’s on my YouTube channel, I’ll show you that in a second.
Let’s just say that you’re saving up and you’re like, hey, I’m really worried about these guys, I want to make sure that they are set. Instead of you paying for something, if Jeff pays for it, it comes out of his bracket. If he’s paying $10,000 for a kid to go to school, it’s probably cost again closer to $15,000 after employment taxes and his tax bracket to make the $10,000.
Again, we earn money, we pay tax, we spend what’s left. If we can get it to a kid whose tax is zero, you make $10,000, you spend $10,000, you’re great. Even better yet is, hey, I’m okay to take a little bit of a tax hit on my money, I want that deduction, though, and I’m going to put it aside for their well-being.
Think about this. Let’s say that you’re putting it aside because you want them to go to college, or because you want to get them into real estate investing. You want them to have a nice amount that’s sitting there. You do this over the years. You make (let’s say) $5000 a year, and you do this for the six-year-old. They’re making $5000 a year, and they’re doing that for 12 years, you got $60,000 sitting in there plus all the compounding, so maybe it’s $100,000 because that’s over a long period of time.
If they need to get the $60,000 back out, it’s tax-free. They can always take the amount that you put in, and they can take it out and use it if they need to. You can’t loan it out in an IRA, but you certainly can take it out.
If there’s an emergency, or if they’re going to go to school or whatnot, the amount that it’s grown stays in there, just leave it. But the amount that they put in, they can take that back out and then let the rest of it ride. There’s so much more flexibility here than those 529 plans and all that other stuff there.
Jeff: I was going to say something about that. Before I wouldn’t have said this, but now, if you put in $6500 into that Roth IRA, you still got $6500 left. I would be tossing that into the 529 plan because now those 529 plans can be converted later into Roth IRAs.
Toby: Yeah, you could do it.
Jeff: You still have that tax-free gain. For these guys, I would definitely be putting that into a Roth.
Toby: That’s what I would be doing. Yes, you can hire your 6- and 13-year-old. The answer to this question is, is there an age limit? No. If it’s under 18, there are no employment taxes. Over 18, there are employment taxes, but you still can pay something to anybody who’s working.
By the way, you could do this with a non-profit, too. I push people towards these things quite often because I like it as a family legacy. You got something that you’re doing that you really care about. Maybe it’s affordable housing, veterans housing, recovery housing, women housing, this, that, just fill in the blank. Even section eight housing qualifies as non-profit. It’s out of your state. Nobody can take it from you.
If you get sued by a ton of people, they still can’t take it, but it doesn’t get probated. If something happens to you, your kids work for it. They don’t take that money and buy a Ferrari. They actually have to work and they make a nice salary, but they’re working on something that you created. It’s a nice legacy tool. I just like those.
If you like this type of information—I’m going to throw this back out at you—boom, there’s the YouTube channel. I mentioned Tyler Sasse. If you guys weren’t on in the very beginning. Let’s talk about Tyler because he’s really cool. He has a welding school. He came on, we did a nice interview.
Go check it out because if you know anybody who’s thinking about going to college and paying $200,000 for basket weaving 101, this might be a better thing for them. There are all sorts of tools where it’s not even going to come out of their pocket. There are other groups that takes about six months to get their certification.
Right now, we need lots. I think it was 15,000–20,000 shy. It’s a huge amount of people that were short in the trades. They’re making good money, and he’s a good dude. Again, if we all know somebody that might be better off going in and doing some welding rather than jumping and do the basket weaving thing, or just maybe they just don’t know what they’re going to do.
If you like tax strategies, different types of ways to make money, by all means, jump in there. It’s absolutely free. Subscribe, like and all that stuff. Good stuff. I think there are over 700 videos sitting in my YouTube channel. A lot of them are questions and answers from these types of Tax Tuesdays.
I already mentioned this a million times. I’ll just say it one last time. Join us for a tax and AP event. They’re free one-day events. The ones that you actually pay for, our live events, they’re four days. They’re less than a thousand dollars, and I think substantially less. We’re always doing different types of deals, so be on the lookout for those.
You can come in and learn how to make money on day one, learn how to keep it on day two, three, four. It’s really, really fun because you’re around a bunch of investors, and you get to hang out with us, Jeff and me, maybe me. Are you going to come to one?
Jeff: I hadn’t planned on it, but I may have to stop down there.
Toby: He’ll be sleeping in now. No. If you have questions in the meantime, because we do these every other week, email taxtuesday@andersonadvisors.com. We answer your questions. We also pull the questions that we use during these events out of that. If anything else, just go check out Anderson Advisors. We put these on, because we’re trying to get anything, but because we think it’s really important to educate people on taxes because there’s a lot of bad information, and there are a lot of bad folks out there.
You don’t have to pay tax. All right, let’s not get everybody in trouble. There’s a legal way to do things right. You’re probably seeing that there are a lot of loopholes, whatever you want to call them. There are laws written to incentivize certain behavior, and there are incentives given to people like people that make dividends, people that do real estate, and there are lots of different ways to get great results out of your tax planning if you spend a little bit of time learning about them.
That’s what we do. We’re just like, hey, can we teach this? Will people listen? If they will, we’ll keep teaching it. We have hundreds of people that come on every other Tuesday, plus thousands of people that watch the videos. We have tens of thousands at this point that are grabbing this information. I just don’t feel like we have to charge for it. I think it’s a great thing if people are just getting smarter. That’s it. Jethro, anything?
Jeff: No. You got it covered.
Toby: All right. Guys, we’ll see you in two weeks.
