How can reinvesting help you avoid capital gains taxes? Jeff Webb and Eliot Thomas of Anderson Advisors answer that question and others about capital gains. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- Is it true that creating a revocable living trust will raise my capital gains taxes if I sell my primary residence vs. if I transfer the house into my name, I must live in it for two to five years to qualify for lower capital gains taxes? If you take advantage of Section 121, you have to live in it for two to five years, no matter what. Putting it under the revocable living trust or in your own name can be done.
- I have sold a real estate transaction in 2022. Can I avoid capital gains taxes if I purchase another real estate transaction in 2022? It depends. If you have already sold it and received the proceeds from the sale, Section 1031 (like-kind exchange) is no longer available or possible.
- I am a retired person, wanting to give a sum of money to my son. How can I advise him regarding deferring taxes on that inheritance money? You don’t have to tell your son anything because he’s not the one who has to pay taxes on it. The recipient doesn’t have to pay tax. It’s the grantor, donor, and gift-giver that may have to pay taxes on it.
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Full Episode Transcript:
Jeff: Hi, I’m Jeff Webb. I am the Vice-President of Professional Services here at Anderson Advisors. With me today is Eliot Thomas, the Tax Advisor Manager. He’s in charge of all your tax advisors at Anderson. Toby Mathis is unable to be with us today so we’re going to try to pull through without him. We’re going to go ahead and do the Toby check. So if you want to tell us where you are, so we make sure everybody can hear us. That would be great.
Eliot: We got San Jose, San Diego, Idaho, San Francisco Bay Area, Michigan, Dallas—go Cowboys.
Jeff: You’re not going to be able to keep up […].
Eliot: Miami, Dallas again. Sacramento. Now here they come. San Jose too, Missouri. Very nice.
Jeff: As you all know, we get everybody from everywhere.
Eliot: Just few of our rules for those of you who are new to us. This is ask live via question and answer feature in the Zoom. If you have any questions, please don’t put them into the chat. Please put them into the question and answer section. We have a whole staff there. I apologize I don’t remember everybody on it, but we do have a team there of our CPAs, EAs, just about everybody back there answering your questions. They’ll try and get them through there.
So again, put them on the chat section. I’ve seen the question and answer section so they can get to them. We’ll get through all the questions that we can. We do get a lot of questions during this one hour or so, then the chat would just be for other questions. We may not be able to get through all those because we have our list that we have already picked out that we have to get through as well.
Jeff: You could also use chat if you just want to be rude to Eliot, that’s fine.
Eliot: Yup. Any other questions that we don’t get to, feel free to email it into taxtuesday@andersonadvisors.com. If you need a detailed response, you can become a platinum member where you can submit these questions online. If you already are a platinum member, then you know you can do so.
Then lastly, we just try and get through these few questions and have an educational section while we’re explaining the answers. Just to give you guys an idea of just more than what the simple yes-no answer is, we try and go a little bit more in depth, maybe come up with some scenarios of where we would do something this way or that way. Kind of just playing off your questions that we’ve already selected.
Jeff: We have Piao, Troy, and Dana.
Eliot: I’m sure Dutch is in there. I know.
Jeff: We are less than a week out from our big April 18 deadline, so we may be a little short on people today to answer the questions.
Eliot: Ian and Christos as well. Outstanding. Nice heavy hitters. Everyone.
Jeff: There’s Ian and Christos, my two senior tax managers. They carry a lot of my load in the tax department, so I’m glad to have them on.
Eliot: Absolutely. Let’s see what we got here. We just read through the questions here. We’re going to go through all the questions that we will be reviewing, then we’ll come back and start answering them.
First question, “I am thinking about investing in a Bitcoin mining fund. We will take 90% depreciation in the first year. Can I use that loss to offset against my gains over the next few years of the fund, passive loss for passive gain?”
Number two, “Our business generates substantial income in 2022 in a single-member LLC. Can I create a new LLC and elect S-Corp status in 2022, and move income from the single-member LLC—the older one—into the newly created S-Corporation, and be taxed as an escort for 2022?”
Third question, “Is it true that creating a revocable living trust will raise my capital gains taxes if I sell my property primary residence home, versus if I transferred the house into my name, I must live in it for 2–5 years to qualify for lower capital gains taxes?”
Number four, “I have sold a real estate transaction in 2022. Can I avoid capital gains taxes if I purchase another real estate transaction in 2022?”
Number five, “If I am a retired person wanting to give a sum of money to my son, how can I advise him regarding deferring taxes on that inheritance money?”
Number six, a long one here, “I’m on Social Security and still an entrepreneur but currently have no significant income over the outside of Social Security. I’m looking to buy a duplex with my business partner’s mother, whose sole source of income is also Social Security and we would each reside separately in the two units.” On each half, I guess.
“I understand that as co-borrower, we would be fully responsible for the payment of the property if the other one dies, and the other person is fairly concerned about her liabilities if something happened to me. The question, is a living trust a possible vehicle to address her concerns either by guaranteeing the payment account, or by paying off some of the selling of the property or some other means such as a life insurance policy tied to the property?
Also, in the case of the need for either of us to get medical care or care facilities of some nature that will look at the assets, is there a way by means using the living trust or some other financial vehicle that can be used to protect assets for the other party?”
Jeff: Long question.
Eliot: Yeah. I think we’re at number seven here. “I have a $14,000 tax liability for 2021. I need to open a SEP or SIMPLE IRA to reduce that 2021 tax liability. What else can I do for 2021 to lower the taxes?”
Number eight, “My LLC bought a fixer-upper in 2021, and sent the 1099 to the contractor who did the repairs. Property is now rented. Does my LLC have to include that 1099 for repairs in my 2021 taxes or do we have to wait until the property is sold? If I rent a property, is it better to declare it as personal income or should I better register an LLC or S-Corporation? Thanks.”
“Can you explain what cost segregation is and how you apply it when you buy a rental? What can be used in cost segregation? Also, if you depreciate a rental property for 5 out of the 27.5 years, and then sell, how does the recapture work? How do you calculate it?”
Jeff: Yeah, that’s all the things where we have a lot of our content. We are on YouTube right now. I believe you can ask a question through YouTube and they will be relayed. You can watch replays. I think some of them are on YouTube, but you can always get them. If you’re a platinum member, they will be available on your platinum portal.
Eliot: Let’s get started then. First question, “I am thinking about investing in a Bitcoin mining fund where we will take 90% depreciation the first year. Can I use that loss to offset my gains over the next few years of the funds? Passive loss for passive gain.”
Jeff: If you’re investing in a Bitcoin fund, it’s probably going to be passive to you. Bitcoin mining means you don’t own the equipment, and you’re not actually doing any of the mining yourself. You’re going to get 90% depreciation on all that equipment they purchase, probably thousands and thousands of dollars.
But if it’s all passive, you’re not going to be able to recognize it unless you have other passive income. Since this is business income, we talk about the active real estate rule, where you can deduct up to $25,000 if you’re in a certain income bracket. There’s nothing like that for business passive losses.
Eliot: That’s right, just for real estate. For those of you who have heard a lot of our questions about bitcoin taxation, things of that nature, the fact that this is a mining operation, typically you hear that mining is an ordinary activity, probably not what we have going on here, because as Jeff pointed out, this isn’t a fund. So probably it’s set up so that the investor has maybe a limited partner or something like that, too, where it’s going to be all passive to them.
Just keep in mind, though, for those of you out there who are mining Bitcoin, that that is typically an active business and ordinary income. We would set that up in a separate C-Corp or something like that typically for you.
Jeff: Investing in a fund is quite a bit different than doing the business yourself. You actually probably have a staff of people in this fund that’s actually doing all that investing.
Eliot: For all those real estate clients out there where we talked about the material participation for real estate professional status, same thing in a business. If they’re not materially participating in the operation of that money fund and it’s just passive to them typically, which is I suspect what we have going on here.
All right, that’s number one. Number two, “Our business generates substantial income in 2022 in a single-member LLC. Can I create a new LLC and elect S-Corp status in 2022, and move income from the single-member LLC into the newly created S-Corp and be taxed as an S-Corp for 2022?”
Jeff: You and I talked about that this morning. Sometimes we talk about these questions. You and I were both in agreement that this is taking the long way around.
Eliot: If you have an LLC already as a single-member, and I’m assuming that while single-member you mean disregarded—maybe we shouldn’t make that assumption but we’re going to go ahead—you can go ahead and do an S election for 2022. You don’t have to move it anywhere. You can do what’s called a late election. We do it quite often.
There’s a checklist of things you have to do mainly having the right language at the top of your return and things like that. You could go ahead and get this in an S-Corporation for 2022 and not bother with a new entity. I can understand maybe there are reasons you might want a new entity later on. Well, at the end of the year, you can set up the new LLC and then merge that business underneath it, or start all over and the new one for next year, if you wanted to.
Jeff: While we’re past the deadline for creating an S-Corp for the whole year. Like you said, we have that late election terminology that will let us do it anyway. I very seldom see them turn that down.
Eliot: I’ve never seen it myself. They have the right, though, but they are usually quite generous with granting that.
Jeff: We can make your existing LLC and S-Corporation for the entire 2022. If you created another LLC, it would only begin at the earliest sometime in April.
Eliot: At the date, wherever you started going forward. You’d still have that tag at the beginning of the year where you were an S-Corp. You’d be talking Schedule C there, which we frown upon; high audit risks, traditionally. So really, your option here would turn that LLC into an S-Corporation, get through it. If you’re not really happy with it, maybe you wanted it in a different state or different operating […] or something like that. We can always set up the new one beginning of next year and actually put that business started under the new one or look at different options.
Jeff: Before you go to LegalZoom to create your new S-Corporation, talk to a business advisor here and they’ll give you some good advice.
Eliot: All right. Number three, “Is it true that creating a revocable living trust will raise my capital gains taxes if I sell my primary residence home, versus if I transfer to my name, I must live in it for two of the five years to qualify for the lower capital gains tax? I’m talking about this one as well.
First of all, I’m going to jump back to the the last part of the question here first. I think the client is asking, well, if I do it in my own name, I have to do it the old fashioned way. I have to live there in two of the last five years. You’re going to have to do that no matter what if you want to take advantage of 121. That’s an exclusion, so we’re not getting around that.
It’s just a matter of distinguishing whether or not it’s put under the revocable living trust or basically in your own name. That can be done but you got to be careful because in the wrong kind of trust with the wrong kind of language, it could fall it up. But putting it in a revocable living trust itself, typically, that’s a grantor trust. It can be taken back out and that usually doesn’t impact it negatively.
Jeff: Now, what section 121 says it doesn’t change your capital gains rate. It just says this amount, either $250,000 or $500,000—depending on if you’re married or not—is excluded from gain recognition. As you said, you had to live there in two of the last five years before you sold the property.
Putting it in a revocable trust, a living trust is usually not a problem. The one caveat I will say is if you are married and you both are co-owners, you may want to talk to somebody first. The reason is because should you pass away before your spouse does, that trust becomes an irrevocable trust. At that point, it could cause issues with the two to five years, even though your spouse is going to get a step up and basis. It’s a good question to ask what happens if I die before my spouse or my spouse dies before me? Does it foul up the things in the exclusion?
Eliot: There are definitely situations out there where people have different trust that develops once one’s passed, that could maybe take away the ownership of that property from the other spouse. They just have what’s called life estate and you may not be entitled to it then, so there are some issues there.
Certainly, that’s a great question. Glad you asked. We want to sit down and it can be structured in a way that would be all right. But you want to sit down and make sure it’s structured that way.
Jeff: There’s another kind of trust, called the QPRT. Not the old video game. The qualified principal residence trust, I believe it is. That also kind of serves the same purpose. I don’t know that we…
Eliot: We haven’t done a lot with those that I’ve seen.
Jeff: But they are out there and that’s something else you could look into, to kind of retain the 121.
Eliot: All right. Next question. “I have sold a real estate transaction in 2022. Can I avoid capital gains taxes if I purchase another real estate transaction in 2022?” This is a popular question. I hear this all the time. So Jeff, I sell something. I got capital gains in this year, I take it automatically, go and invest in something else, and not have to pay for capital gains on it.
Jeff: It depends. If you have already sold it and you’ve gotten the proceeds from the sale, section 1031 is off the table, the like-kind exchange. That’s pretty much what you’re talking about. I want to sell my property and replace it with another property. Well, when you do that, you have to use what’s called a qualified intermediary and you can never touch the money.
Eliot: It has to be done within that tight timeframe, 45 days on listing to new properties, replacement properties they’re called, a total of 180 from sell to original. You can’t just pick out and start a 1031 right after the process. It’s really too late. As Jeff points out, you want to work with a qualified intermediary. I think you’re required to now, I believe after the 18th, I don’t think you have a choice.
Jeff: Because if you get a hold of the cash in any form, you’re done.
Eliot: We’re not going to avoid capital gains tax in that manner by reinvesting perhaps like that. There are still the opportunity zones where you could put capital gains in there and defer for just a little bit. I don’t think that’s the best choice because it is just a temporary deferral for a very short period of time.
Jeff: And the 10% step up’s gone.
Eliot: Yes, there’s no step up. All the real juicy parts of the opportunities are gone for the most part, so that might not be an option. Still, really thinking outside the box for this particular tax question, there could be other things that you’re doing.
If you invested in the right kind of real estate—short-term—and you materially participate, or you or your spouse have long-term rentals, you might be able to do some cost segregation and bonus depreciation, which we’re going to get into one of the later questions. But those might be other methods to attack your return somewhere else, lowering the effective tax rates all over the return. Maybe impact on your capital gains, maybe not, but at least it’ll go through your ordinary income first, which is always best.
Jeff: And depending on how much gain you have—what’s the number that Toby usually quotes—if you’re married and making $85,000 or less, you’re not going to pay any capital gains tax. I think the next bracket comes in. You don’t hit 20% until like $400,00 or $500,000.
Eliot: Almost $500,000 now. It’s zero up to approximately $85,000, married filing joint. But remember, that’s collective income. People get understandably confused on this. That’s all the income, including the sale that you just had, so if you had $40,000 W-2 income, $35,000 of capital gains, the capital gains would be zero. But if that total goes over $85,000 then you start paying capital gains.
All right. “I’m a retired person who wants to give a sum of money to my son. How can I advise him regarding deferring taxes on that inheritance money?” The first thing is you don’t need to tell him anything, because he’s not the one who has to pay taxes on it. I can give all kinds of money to Jeff, he doesn’t have to pay tax. The recipient doesn’t have to pay tax. It’s the grantor that may have to, or the donor, the person gifting, if it goes over a certain amount.
It’s $16,000 a year right now I can give without having to report anything. It doesn’t impact me at all. But if I go over the lifetime exclusion, which is just short, maybe around $12 million.
Jeff: $12,060,000.
Eliot: There we go, we broke to $12 million. That’s a lot you can give away in your whole lifetime. So I give Jeff a million today. Now I do have to fill out a form if I went over that $16,000. I think it’s a 709, I always mix it up. The 706 and 709 are very similar to me. But anyway, it’s 709. We file that form. It just tells the government doesn’t create any tax burden, just says, hey I gifted to Jeff a million dollars. I want that taken away from my lifetime exclusion. I don’t have to pay any tax.
Certainly Jeff as recipient doesn’t have to pay any tax. What I would tell your son here isn’t what he needs to do about deferring taxes unless it’s over $12 million, but maybe about how to invest it so that he can have great tax returns. He can get into real estate or something like that, or proper structuring, with trading and Bitcoin, and things like that.
Jeff: What that gift tax return does is that you gave me a million dollars and you filed it. You’re saying I gave away a million dollars, and it’s going to lower that $12,060,000 limit down to $11,060,000. It comes off your estate. When you die, they’re going to look at how much—I believe it’s called credit—is left for your lifetime estate. No, that’s the wrong word. But for your estate.
Eliot: I’m a bit short on that right now, like I always do.
Jeff: I want to talk about, you mentioned the $16,000 gift, the annual exclusion where you don’t have to report anything. Well, let’s look at the math and the multipliers in there. I can give my son $16,000. But I’m married, so my wife can also give my son $16,000. My son is married, so we can each give her $16,000. We can effectively—by different individuals giving to different people—give $64,000 couple to couple.
Eliot: It’s a really great deal and none of it has to be reported.
Jeff: Something we never talked about is also the 529 deduction. You can donate up to five years worth of gifts. So that’d be $80,000. You could contribute $80,000 to a child, or grandchild, 529 plan in year one. You can’t give any more over the next four years. But it’s a way to front load your 529 plans also.
Eliot: And all that will just grow.
Jeff: It’s a way to get more money in there quicker so you can take advantage of that timeline.
Eliot: It’s kind of a nifty little deal for college and things like that. It doesn’t even have to be college anymore. It can be for other…
Jeff: K-to-12 for private school.
Eliot: So a lot of benefits there.
Jeff: One last thing. If you receive gifts from foreign individuals. If those gifts are more than $100,000, there is a form to fill out. I want to say it’s a 3520 but I’m not sure.
Eliot: That one I’m not going to remember.
Jeff: But yes, that is the only other exception where if you receive a gift, if it’s from a foreign individual or a foreign trust, you may have to fill out a form. Still no taxes to pay.
Eliot: That’s the key. Typically you never tax the recipient. It’s the one giving the gift if anybody’s going to get taxed. As we’ve said, there are a lot of ways to get around that where you don’t even have to be taxed on that. So great question. I think hopefully that will give you some options of what you can do for your son there.
Jeff: IRS just wants to make sure you’re not laundering money for the cartel or something.
Eliot: Exactly. All right. Let’s see here. “I’m on Social Security, still an entrepreneur, but currently no significant income over Social Security. I’m looking to buy a duplex with my business partner’s mother, whose sole source of income is Social Security, where we would each reside in one half of the duplex.
I understand that as co-borrowers we will each be fully responsible for the payment on the property if the other person passes. The other person is fairly concerned about our liabilities if something were to happen to me.
My question, is a living trust a possible vehicle to address your concern either by guaranteeing the payment amount, or by paying off and selling some property? Some other means such as a life insurance policy tied to the property. Also in the case of the need for either of us to need medical care or facilities that would look at your assets. Is there some means by which the living trust or some other financial vehicle may be used to protect the assets for the other party?”
That’s a lot. This is one that definitely Jeff and I kind of looked at beforehand. First of all, we don’t like the idea of being co-borrowers there. You really want to have it separated if at all possible because that really kind of creates a fly in the ointment on things.
Certainly, life insurance policies can be set up to where something’s paid off. That’s not unusual. But the living trust around these are different documents for two different people. They really want to be intertwined too much. This is really an elderly law specialty type thing. Also, we talked about the five years for the irrevocable trusts.
Jeff: Let’s break this down. Two different, unrelated people owning one property. It’s not a rental property. It’s both a primary residence. First off, I think if you were purchasing, it sounds like it’s one property, correct?
Eliot: Yup, duplex.
Jeff: I would probably be more comfortable if you were buying your half and she was buying her own half. There are still things you can do so that whoever survives can end up with it, the whole thing, whether it’s through a will or through a living trust. I think you may have issues with both of you owning half of it and only living in half.
Eliot: We weren’t sure they could even title out as individuals for each separate half if there is the same loan covering that.
Jeff: Let’s look at a couple of different things. Tenants in common, does that work here? I don’t know that does because if you’re tenants in common, you still own a fraction of the whole thing.
Eliot: That’s right. I think when we’re trying to keep as co-borrowers, co-owners, in a sense, but yeah, called separate parts, it would just be a lot easier if you could each independently own your own half.
Jeff: What about joint tenancy with the right of survivorship?
Eliot: That might be a possibility. Basically, you’ll just be giving it all over to the other person if one passes. It might be but I just don’t know that you’re going to have to make sure everyone’s will is saying that. The living trusts are properly assigning that out for each.
That takes some trust. Jeff would never know what I’m writing in my living trust. Nothing to say that would stand as an agreement, so I get back to why we don’t want to dodge around this question. If at all possible, we could keep the separate owners. I think that’s just going to make your life a lot easier.
Jeff: Let’s talk about a couple of things like mortgage interest and taxes. Taxes really isn’t a problem because if you pay taxes, you get to deduct them up to that $10,000 limit.
Eliot: Correct.
Jeff: Interest, on the other hand, you have to own the property. It has to be titled to you. The property has to secure the loan. I feel like there will be a conflict there. Unless you’re both on title, and then the title gets very confusing for me.
Eliot: Real estate attorneys who deal with this might be able to have some solutions to that. Like some of our staff, our platinum attorneys might be able to look at a little bit more from a tax aspect, though. It creates some problems we may not want to have to address.
Jeff: Let’s talk about, she mentioned life insurance. You and I buy a condo together or duplex together. I die. We’ve set it up so you’re going to inherit my half. But what about the mortgage? Well, I have life insurance that will pay off that mortgage.
Eliot: Yeah, that idea I like. Plans can be worked with, like insurance plans to use those funds. But again, we need to make sure it’s earmarked towards that. I never trust the other person if it’s not family or something like that.
Jeff: So you get my share of the property with a step up in basis and my death pays off any loan. I want to have my death investigated because you seem to come out really well ahead.
My problem with the insurance in this case is you both mentioned you’re on social security. So we know you’re at least 62. The problem with life insurance is it gets really expensive as we get older, even during life.
Eliot: Great point.
Jeff: So yeah, it’s still a good idea, but is it going to be plausible to do that?
Eliot: Jeff brings up an excellent point. Those rates are much higher as we get older, so that could be a put down. I kind of liked that idea a little bit. Life insurance plans are used often to pay off debt in a business or something of that nature. There might be a play there, but those rates are probably going to be pretty high.
Jeff: One thing you want to do at a minimum is talk to somebody who does estate planning. PS Group does.
Eliot: An excellent source.
Jeff: Yeah, and John Anderson, who does estate planning. Talk to them about what you want to accomplish. You want to go in together and buy this duplex. Have you both own it, but should one of you pass suddenly, you want the other one to get it as mortgage free as possible. I strongly suggest you talk to somebody right about that to make sure that you’re addressing your concerns and they can help you out with that.
Eliot: Absolutely. Great question, though.
All right. “I have a $14,000 tax liability for 2021. I need to open a SEP or SIMPLE IRA to reduce that 21 tax liability. What else can I do for 2021?”
Jeff: Let’s talk about the SEP or SIMPLE. You need some kind of retirement account. Traditional IRA and Roth IRA, you have until April 18th to fund that. As far as the SIMPLE, or the SEP, or even a 401(k), or any kind of qualified retirement plan, it’s going to depend on where your income is coming from.
If it’s coming from an S-Corp or C-Corp, like you’re drawing a salary, you could set up a 401(k) plan for that that’s coming from a partnership or from self-employment. You could go the SEP route. It’s probably a better way to go. I don’t know about SIMPLE IRA.
Eliot: SIMPLE just has a very low amount that you can contribute to it. The bonus of that, though, is that your SEP is going to be based on up to 25%, depending if it’s an employee or 20% if you’re self-employed, of your overall earned income. The SIMPLE doesn’t have that limit.
If you’re looking at lower amounts and what the max, maybe the SIMPLE. I think it’s about $14,000 as I recall, approximately give or take. Whereas the SEP has a higher limit, almost equivalent to the Solo 401(k), $58,000 in 2021 plus $65,000 for the catch up. Higher amounts you can put into the SEP, but if you don’t have a lot of income because you’re hampered by that 20% earned income from your self-employed business, potentially.
That would certainly be one. You already know in your question that that is something that you’re already looking at, so you might want to calculate there, as Toby says. You’ll calculate, calculate, calculate, and see which one gives you the best of the two that you can put the most in there. There are other other options outside of what you address here.
The next one that’s popular is an HSA, but you’re going to have to have a high deductible plan, which is approximately $1400 deductible for a single and $2800 I think for married filing jointly in 2021. You may not want to change your plan that you already have, so that comes with baggage as well. It’s not a perfect idea. But if you could make that work, if it does fit into your scenario, it’s a great deduction.
Jeff: Once the year has ended, it makes it really difficult to find deductions.
Eliot: I think that’s the key point.
Jeff: We could talk about if you own a real estate, can you do cost segregation? You could do that. But then again, we’d have to look at, are you a real estate professional? Are you going to actually be able to use the deduction? Once the year closes, it gets really hard.
Eliot: The options kind of get limited. But employment plans as you address here, HSAs, those are the things that we are allowed to do after the books have closed for 1231.
Jeff: Time is also running out for HSA.
Eliot: Yeah. We want to get on that if it’s at all feasible.
All right. “My LLC bought a fixer upper in 21 and sent a 1099 to the contractor who did the repairs. My property is now rented. Does my LLC have to include this 1099 for repairs in 2021 taxes or do we have to wait until the property is sold?”
A couple of things here, a fixer upper and we’re talking about renting. This really turns on, what was the original intent when you got the building? What was it you were trying to do? And not that that intent can’t change over an investment time, but we really need to know that because you’re talking about fixing up, and then selling right away, and there were some rentals in there. It doesn’t seem like we really know what it was. Was it a flip or was it a long-term investment? That’s going to change our answer a little bit.
Jeff: Again, it depends. This is a case where you really want to be careful about how you segregate your expenses. If this is a flip, it doesn’t matter. It’s all going to go into the basis and then that’s going to be a case of where you’re going to be included in your cost when you sell the property.
Eliot: Yeah, not until.
Jeff: If it’s a rental property—I bought a $50,000 property that was really beat up and I put a lot of work into it to make it livable—a lot of that’s probably going to go into the basis of the property also.
Here’s what typically happens. If I can have two properties that are identical or should be. One is selling for $100,000 and one is selling for $50,000. Why is the one selling for $50,000? Because it’s the $100,000 model that just had the tarnation beat out of it.
I no longer have to put money into it to get it back up to that standard. The IRS doesn’t want to let you write that off as repairs because they know that you are bringing it back up to standards. That house probably should be worth $100,000, so they’re identical. A lot of times, we’re going to capitalize those costs.
Eliot: Which means depreciate, typically.
Jeff: Again, we talked about cost segregation. If you’re a real estate professional or if your income is not all that high to start with, we’ll say below $150,000, then you might want to do a cost segregation, where you can actually pick out what pieces of those repairs, and the actual cost of the house that you pay for are not really the building but are parts of the house—furniture, fixtures, things of that nature.
Eliot: Exactly. First, again, the key, is it a flip? Or is it a long-term hold or rental? You note going into rental, so I’m going to say that. You’re going down the path of being a rental. Any repairs up right before it was available for service, available to be rented, will go to basis to be depreciated. Any repairs after that or any work done after that will either be a repair or will be an improvement, which will be added to basis repair deducted immediately in the current year. Improvement added to basis.
But as Jeff points out, you can do things like cost segregation, perhaps. Break that depreciation up, speed it up, and then if you hook it with bonus depreciation, you’re getting a massive deduction potentially right away the first year.
How’s that affect our return? All depends on whether or not it’s going to be a passive investment, or is it active? Unfortunately, your questions got a lot of deep crevices that go into it, but that’s what’s kind of neat about it. It shows that there’s a lot of flexibility here, but we need to know what is happening on your return. Are you a real estate professional? Is it a short-term rental that you’re materially participating in or not and those type of things? Or are we looking at the true passive activities land?
If you have $100,000 AGI as Jeff mentioned earlier, you can deduct up to $25,000 of passive losses in real estate that’s unique to real estate, not in the Bitcoin example, as Jeff pointed out. That slowly phases out as your AGI gets to $150,000, so you may lose that too.
If you have a high AGI—$150,000-plus—you may get stuck in passive losses, which isn’t the end of the world. You may have a plan for that, but just be aware of it. I’d hate to see a situation, put this money in there, fix it up, and you’re able to release that expense to help you out immediately.
Jeff: One thing I don’t like to see on Schedule E, which is where you report rental property, is this big giant number under repairs. Because if I’m an IRS agent, I’m going to go look at it and say, I wonder if these really were repairs and if they can prove them. I don’t like giant numbers, unless my income is also giant. If I’m bringing in $100,000 of rent in here, I don’t mind some of those larger numbers on the expense side.
Eliot: You have to reflect what else is going on on the return and be in line with what we would expect what’s reasonable.
Jeff: You often hear people say red flag, red flag. There’s really no such thing as a red flag. The IRS does have its programs that are looking for certain things. When I worked there, they didn’t tell the people who work there what those programs we’re looking for.
Eliot: Won’t let that information out.
Jeff: However, Schedule C is even worse. If I’m seeing numbers that just don’t make sense, I have $8000 in revenue but I have $50,000 of travel, don’t give them stuff to question.
Eliot: You’re throwing a snowball to hit on the park there. The 1099 is going to be going with the year that it was associated in 2021. Certainly, it’s going to be attached to that. It depends what we’re doing with this property. Did we put it in the service or not or was it a flip?
Like Jeff said earlier, if it was a flip, well, then it’ll just go with whatever year you sell it, 2021, 2022, whenever. The rental, though, we have to look at. Was it before it was placed in service?
Jeff: Good job on giving them a 1099.
Eliot: Absolutely. Make sure you’re doing that. Never ever work with a contractor. Don’t engage them until they fill out a W-9, so that you know how to tax them. Make them fill that out every year. I have not had a year yet where I don’t get asked about that. Well, I didn’t do it.
Jeff: I’ll take a step further. You said don’t work with them, which I agree with. Don’t pay them a dime until you have that W-9 in your hand.
Eliot: Absolutely. All right, great question.
“If I rent a property, is it better to declare it as personal income or should I better register it in an LLC or an S-Corp? Thanks.”
Jeff: What do you think, Eliot?
Eliot: Certainly, I like the idea of using an LLC not having it in my personal name for asset protection purposes. If Jeff has his rental property and he makes that cardinal sin of having Eliot as a tenant, I’ll sue him. And if I know it’s in his name, I’ll end up taking the whole house from him.
Putting it in an LLC, absolutely. Now, it doesn’t necessarily have to have been bought in the name of the LLC, but you do want to get it transferred in there and signed over. You got our Anderson staff that does that all day long. We put it into these things for asset protection. The one thing we know about LLC and a lot of our clients should, that doesn’t tell us anything about how it’s taxed.
Jeff: Correct. You mentioned an S-Corporation. I don’t particularly care for assets that can appreciate to be put in an S-Corp or C-Corp. The reason is that they’re difficult to get out without triggering tax. I’ll give you an example of when you might have to pull a piece of property out.
I have an S-Corp. I want to refinance it. It’s in an S-Corp PAC or LLC taxed as an S-Corp and you hear from the bank, well, we don’t like that, we want to refinance in your name. And then you can put it back. Technically, that triggers a taxable gain if the property has appreciated in value. There are other issues.
If it was a partnership instead of an S-Corp, I can put it in, I can take it out. I can put it back and I can take it out all day long. Please don’t do that. It makes some of my people crazy. But those transactions don’t trigger taxes.
Corporation is even worse than the C-Corporation. Definitely, you can have multiple properties in an LLC. One thing Toby says when asked, how many properties can I have in the same LLC, is what is your risk tolerance? How much can you afford to lose?
Eliot: It’s kind of like, how many properties are there? How many angels on the top of a pin or whatever it is? You can put an unlimited amount in there. But again, if you have Eliot in one of those and I sue, I can see which LLC owns all the others. You just let the ultimate Trojan horse in there. That’s just bad asset protection.
Get it in there and not just have it in the LLC, but you’ll want to have it owned by an entity that’s going to give you further asset protection. All of our clients know we love to work with the Wyoming holding because it has that charging order protection.
We certainly want to get into that kind of setup at the very least. How’s that LLC taxed not as a corporation, not as an S or a C. Keep it disregarded up to that Wyoming holding and either have that Wyoming holding disregarded to you or in a partnership, one of those.
Jeff: A little bit about asset protection. I know we like to trust people, but you can’t. When it comes to your finances, you can’t. I have known people who have been injured, possibly not even on the property, but have done stuff like pulled up carpet and things of that nature so they can sue their landlord. So make sure you’re adequately insured. Make sure your liability is protected through an LLC or something. Bad things can happen. What you want to do is mitigate the possible negative results.
Eliot: I think Clint has some of the best stories about that with some of his family renting out some buildings, where they had just bad tenants doing bad things, drugs and whatnot. If you ever see him in the Tax and Asset Protection class, he goes into that quite a bit talking about that.
It’s just something that you can be responsible for. If someone just turned off your smoke detector, it’s your tenant. You didn’t have anything to do with it. There are lots of little things like that.
I remember back in the days if we go back, people talk about a possible bubble and all that. I don’t know if that’s happening or not. But I remember back in the old one, I’d hear constantly from clients and people like that, people would throw cement down into the pipes and you just purposely wreck the house.
You want to have LLCs and of course insurance as well. You just never know what kind of damage is going to come and what kind of lawsuit, so protect yourselves. Great questions.
Next one, “Can you explain what cost segregation is and how you apply it? When you buy a rental property, what can be best used in cost segregation? Also, if you depreciate a rental property for 5 out of the 27.5 years and then sell it, how does the depreciation recapture work? How would you calculate it?”
Fantastic question. It gets back to the core of a lot of questions we had today. An example I give everybody and those who’ve heard and talked to me or whatever before—it’s the same one—normally, we straight line depreciate a single family residence over 27.5 years. That’s where our clients are getting that number, 27.5. You take the cost of the house plus any improvements, less any depreciation. That’s your adjusted. Before getting the cost of the house plus improvements divided by 27.5 years, that’s your same depreciation each year, straight line depreciation.
Now, cost segregation steps in and it’s a different form of depreciation. It says, well, now hold on Eliot, that house has all these different parts—carpet, lights, doors, foundation—and all those independently have their own tax life, 5-year, 10, 15, 20, and summer, 27.5.
Cost seg breaks those pieces apart. When you’ve done that, now your carpet is taxed at five years. Instead of depreciating over 27.5 years, you’ve sped it up to 5 years. You’re going to get a bigger loss, a bigger deduction, which can be good if done right on your tax return. You got all these 5-year categories and 10 and such, and they’re speeding up that depreciation.
Right now, this year of 2022, you can cut one to that bonus depreciation, which says a 5, 10, 15, anything under 20 years can be deducted immediately at 100%. So you get this massive depreciation. That’s the key. That’s why you always hear us talking about it over and over and over.
Next year, it’s still really a great deal. It goes down to 80% bonus appreciation. Not 100% anymore, but still a really great deal. I personally think that’s one of the reasons no one ever talks about why people keep investing in houses right now, even though the prices are going up. They’re usually investors. That’s just it because they know about depreciation.
Jeff: Let’s say I have a $250,000 property, $50,000 of it is allocated to land and the rest is the building. I go and do the cost segregation and they say, all these cabinets are seven-year property, your appliances are five-year property. Oh, you have a swimming pool, that’s $50,000, 15-year property.
By the time they get finished pulling us out, I have a house that’s now worth, as a base, $100,000. I pulled another $100,000 out and all these other assets, this cost segregation.
Eliot: Huge deduction.
Jeff: I’m a real estate professional. I’ve taken that depreciation the year that we did the cost segregation. But a couple of years down the road, I sell the property. I only have a basis left of $100,000. I’m not going to worry about the depreciation and all that. Plus $50,000 of land, so my cost in that sale is going to be much lower than it was originally because I’ve already taken that deduction for the shorter life assets.
Eliot: We’re looking at more capital gain, potentially, because you have that lower adjusted basis. Our client here on this question very astutely asked, what about the depreciation recapture if you just said you had it, let’s say, five years? If you made it up to the five-year point, then all that five-year property, you can basically write off. Yes?
Jeff: Yeah, the bonus depreciation for some reason is not subject to recapture. You’re not recapturing all this depreciation there. Instead, you’re paying capital gains on the house itself, which you really want to do because you don’t want to pay what’s called Section 1245, recapture, at your ordinary rates. You want to pay long-term capital gains at those lower rates.
Eliot: Yeah, a big point there is that this property is no longer what we call real property. All those 5, 10, 15, we turned it into what’s called 1245 or basically a tangible property. Different depreciation rules there.
You’re going to get taxed at ordinary rates. But if it’s at five years in a five-year property, you can go ahead and just write that off, typically. You don’t have to worry about that 15, 10-year property. You’re going to have some capital gains that you got to pay tax on, but not the five-year in this case.
Jeff: Let’s go back for a second back to the 1245 property, the anything under 20-year lives. Here’s why the depreciation recapture doesn’t happen on that. When I go to sell my property, I am allocating all the sales price to the land and the building. I am not allocating any money to my carpet, or my garage door, or this or that because I’m figuring those are probably pretty much worthless. They’ve already been fully depreciated and so forth.
The thing with depreciation recapture is depreciation recapture is limited to the gain on sale. If I’m not getting any gain on those assets, the short life assets, then I don’t have any recapture on those assets.
Eliot: Exactly. That works out really well at that point. But you’re still going to get it because as Jeff points out, you did lower your adjusted basis. You’re going to have more capital gains. But also, I’d say, let’s not be afraid of capital gains.
That’s a far better deal than 37% if you’re in a high tax bracket. It’s always going to be lower, I think I can’t think of an instance where capital gains would be at the same level as your ordinary capital tax bracket, so it works out really well.
Jeff: Let’s talk about I’m not a real estate professional. Cost segregation always works if you’re a real estate professional, or what’s the other one?
Eliot: Materially participating short-term?
Jeff: Yeah, short-term rentals, which aren’t really rentals, but we’re not going there today. Let’s say I’m not a real estate professional and I’m holding these long-term properties. Why would I do a cost segregation? I’m not going to be able to take the loss, but that loss doesn’t go away. It sits there until you get rid of the property or you have other passive income.
I hold it for five years, I got this $100,000 of depreciation expense that I’ve never been able to take the loss. When I go to sell the property, it releases all of that loss.
Eliot: Lets the PALs out.
Jeff: It lets the PALs out. Who’s your pal? It’s a good opportunity to take it at that point. We do have a few clients that have a lot of losses from cost segregations just sitting there with a full realization that they weren’t going to be able to recognize them at that time.
Eliot: When they sell it, those things just come out. You’re not a real estate professional, so you didn’t aggregate or anything like that. You sell one property, all your PALs get released to help defeat the capital gains on that property. Not just the capital gains associated with that property, but all of your PALs get released for that to wipe it out.
It can’t be used to go higher on other things on your income. But if that one property had more PALs than what the gain was on it, then those extra PALs have been released and that will go against other income on your return for that one property. Some neat things can happen with it. Even if doing the cost seg, there are just a lot of benefits to it.
We have the specialist that we work with, a cost seg authority, Erik Oliver. He speaks with Toby a lot. I think he was at one of the recent events. I can’t remember which one it was, but a fantastic guy, a fantastic team. They’ll tell you about just the benefits of selling. Even when you think about selling it, maybe it’s a good play and they’ll explain all the different rules and scenarios around it.
Jeff: Here’s another strategy you can use that kind of goes along with what you were just saying. I have a rental property. I actually have two rental properties, the one that has $100,000 cost segregation, but I’m planning on selling property one. I know I’m going to have a $200,000 gain on it.
When I sell that rental property that has not had a cost segregation on it, that capital gain is passive. What does that mean? I got a $200,000 passive capital gain and I got $100,000 passive loss over here. I can offset those two.
Eliot: Exactly.
Jeff: Anytime you’re looking to buy or sell, I think that’s a really good time to just explore it. You mentioned Erik Oliver. I know he does some quick analysis just to give you an idea of how it would work out for you, free of charge.
Eliot: Yeah, they’ll take your data and give you a rough idea what a cost seg would be. Of course, they’ll tell you a rough estimate of what their fees would be if they conduct it. A great group. The whole team there is great. We always talk about Erik here because we’re familiar with him, but just a great group all around there. You will not be disappointed.
All right. I’m not sure, but that might be it. Yeah, that is it.
Jeff: Questions. Hey, before we go on, see if we got anything up there.
Eliot: Yup. I see here, “I like what you’re speaking, Eliot.” I’m looking for some questions here. “Is the cost of cost segregation deductible as well? If so, is it taken in the year it was paid?”
Jeff: Yes. Here’s how this is going to kind of work out. You can still get cost segregation for 2021 up until the due date of your return with extensions if you have an extension. The cost segregation itself, that extra depreciation would be 2021. The expense of the cost segregation would go in 2022, cash basis.
Eliot: There we go. “Can you touch at all on nonprofits? Taxes for nonprofits?” Basically, as long as it’s doing its mission, if you will, typically if it’s anything income-related that’s not taxable, it is possible.
That’s a great question. I’m sorry, I didn’t catch your name. Is it Latina? You could have a nonprofit and get into some business that isn’t really on its path of societal benefit that could cause it to pay taxes. We call that UBIT (unrelated business income tax), and it’s taxed really high. We want to really avoid that like the plague if we can.
Jeff: I’ll say this about nonprofits. I’m all for people starting a nonprofit. You have to decide what your mission is before you start, before you create that entity. It’s typically going to be a true corporation. You’ll set up, you create, you’ll donate to it. You could donate cash. Appreciated property is always a good one.
We’ve had people donate appreciated cryptocurrency. If you donate appreciated property, you typically have to get that appraised even for cryptocurrency. The one thing that it’s not the mission of your nonprofit is to benefit you. I think there may be some benefits to you. You get to write off that contribution, especially that appreciated property contribution and so forth.
What we really want people to keep in mind is this is you doing something for the community because you’ve done well in life and you want a pay back. We’ve talked about affordable housing, shared housing, and various other things. We have people […] benefit.
Eliot: One of our clients set up a whole thing for autistic adult children houses, especially when it’s time for them to live in and things. I just need ideas out there. I’m sorry, Lanisha, for butchering your name there, but it is a great question. But back to it, you’re specifically asking about taxes and nonprofits. Usually not an issue as long as you’re doing your mission.
But to just point, you want to have that mission kind of clear when you start. You want to have something that you’re passionate about and you love. Don’t just do it for a tax deduction, because ultimately, I don’t think you’re going to be happy with it. Have something you care about and make sure you’re doing it for the nonprofit purpose. Usually, that will help avoid any UBIT or something like that.
We have all the staff here. We have an incredible staff that Karim has set up. He’s head of our nonprofit department. He used to work for the IRS as well, probably the same building as this guy. Who knows? That team will be able to walk you through anything you need to know about the nonprofit. I highly recommend going to their classes.
Jeff: Talking about what you can invest in your nonprofit—securities, properties. You can’t do flipping. You can’t do anything that would be considered a trade or business. My usual example is St. Elizabeth Hospital is a nonprofit. They don’t pay tax.
Eliot: They’re doing that bingo.
Jeff: They have a gift shop in the lobby, so you can buy stuff for your loved ones that are in the hospital. That gift shop is owned by the hospital, but that is UBIT because it is unrelated to their business purpose. It’s a side business in the IRS.
Eliot: Very good example. It’s something you want to watch out for, that UBIT is nasty. Why? Because it has the same tax brackets, but they rise really quickly. It takes very little income to be at the top bracket paying 37% or more. So you just want to watch out for that.
Lanisha again, “I have a nonprofit that will buy a home for the aging, foster youth, and I’m looking to get properties to allow them to help rehab and live in for 12–24 months at no cost to the fosters.” That might be an issue because you’re doing that rehab thing. Rehab is fine, fixing it up perhaps, but not selling, not flipping. We want to watch out for that.
Again, Karim and staff, we have that nonprofit event. I don’t know what the next date is, but we have that on our website under events. Karim is just excellent.
Jeff: I’m kind of on the fence about that. One in particular about, if you’re buying properties at lowest discount or cheap, fixing them up and then selling them. You really need to have somebody to look at that model. That may actually be okay, but…
Eliot: I want to be very careful with that one, though.
Jeff: Yeah.
Eliot: That can get you into trouble. One example with the UBIT is, Karim is still amazed that they could, in egregious situations, take away your nonprofit status. So we want to watch out for that.
Jeff: The other term you want to be aware of is private inurement. It means you can’t profit from your nonprofit. You can certainly take a reasonable salary for what you’re doing, reimburse expenses to you for things that you provide for the nonprofit. But over and over again, you’re going to hear the term reasonable.
Eliot: The idea there is you donate $100,000, don’t give yourself a $50,000 paycheck. That’s just not reasonable. No business would be able to run on that. Why should a nonprofit be able to?
Jeff: We love the nonprofits and we love the people with good motivations for doing it.
Eliot: Yeah. I talked to a lot of clients who do this and they do that thing that they’re passionate about. Years down the road, they always say the same thing. The deductions are nice. It truly is that they feel like they’ve done so much more in life than any deduction. It’s just doing whatever that societal benefit is, that means something to them. And that’s incredible.
We’ve got clients doing all kinds of things. I know one client who helps out with acting for minorities, I believe it is. You got, of course, all the housing. There’s just everything. Dogs for the veterans, that was the most astonishing thing.
One of our clients does these dogs for post traumatic and something like 100% just incredible success rates with those little dogs. They’re not little German Shepherds, but just amazing things our clients are doing with those. A lot of great stories. Very inspiring.
Jeff: Yeah, these nonprofits work best where it’s your passion. Questions, you can email us at taxtuesdays@andersonadvisors.com and please visit us andersonadvisors.com. We got a lot of good material out there. Look for the video page. Look for it on YouTube and I think it’s the next slide.
Eliot: We’re always adding more.
Jeff: We appreciate you stopping by, and listening to me and Eliot chat, try to answer your questions. Toby, hopefully, will be back in two weeks.
Eliot: I’ll be in the back answering questions.
Jeff: We’ll chain Eliot back up to his desk. I appreciate you filling in for him today.
Eliot: Happy to do so.
Jeff: Everybody, have a good week and we will see you next time.
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