Is income from your rental properties active or passive? What is the best way to report your income and expenses for rentals? How long do you have before having to pay taxes on the sale of your property rental? Toby Mathis and Jeff Webb of Anderson Advisors answer your tax questions about income from rental properties. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- Is retirement income considered passive or active income? If it is a passive income, then can passive real estate depreciation be used against retirement income? Retirement income is not passive, active, earned, or portfolio income. It’s ordinary income. Retirement income is not going to offset your passive losses, but it can cause social security to become taxable.
- I’ve been told that filing Schedule E for rental properties, which I’ve been doing for the past several years, is not a good way to report your income and expenses for rentals. I want to file 1065, but I don’t have a partner and don’t intend to get one. I don’t think Form 1120 or 1120S is a good way to file either. What do you recommend for next year? Stay away from corporations because of liability and other issues with appreciated property. If you take an appreciated asset out of a corporation, it’s a taxable event.
- I closed on a co-owned rental property in April 2021. I did not have an LLC with my co-owner, and we are still in the process of forming an LLC to protect the asset. Can we still take all the real estate deductions on our 2021 tax return, absent having an LLC in place last year? You don’t have to necessarily have a partnership agreement to form a partnership. Whether you had an LLC or not, you have effectively created a partnership, unless you’ve done this as tenants-in-common.
- I just sold my condo that I owned for three years. One year I lived in it and two years I rented it out. How long do I have before I have to pay taxes on my sale? Technically, your taxes are due as they’re accrued. You might have some quarterly taxes on it and your actual tax bill is going to be April 15 of the following year. If you sell it in 2022, you have to pay the tax on April 15, 2023.
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Full Episode Transcript:
Toby: All right, welcome to Tax Tuesday. If you are expecting to hear about taxes, you’re in the right place. If you’re expecting to hear about car repairs, I think you’re on the wrong spot. It’s Tax Tuesday. I’m Toby Mathis.
Jeff: And I’m Jeff Webb.
Toby: It’s bringing tax knowledge to the masses. We’ve been doing this for a lot of years. Let’s explain the rules since like Bryan, the guy on CNN who says he wouldn’t go to a party if there were no rules. We’re going to have rules so that Bryan will show up at our party.
Ask live. See if anybody catches that one. If anybody has been paying attention, this guy Elon Musk bought Twitter. I just find that fascinating. All right, so you can ask live questions via chat. You can ask live questions via the Q&A. If you have specific questions to your situation, ask via the question and answer. If you just like to harass me or harass Jeff, go into chat. All right, so we got to dive in because I tend to go over and Jeff’s really good about not going over. I bet you guys were on time.
Jeff: I think we were. I think we got done a few minutes early.
Toby: Who did you have?
Jeff: Eliot. Eliot was rocking it.
Toby: Eliot, you’re on. I didn’t see you. I got to check that out. Eliot is good. He’s concise to the point. All right, it’s supposed to be fast, fun, and educational. We want to give back and help educate, feel free. It’s free for all.
Speaking of Eliot, Eliot is answering questions in the Q&A along with Troy. I don’t think we have anybody else. We have Patty and Ander answering questions, but from an accounting standpoint, I think we have Troy and Eliot. It’s just been crazy.
Somebody said I was in Anacortes over the weekend for the Tulip Festival in Skagit Valley. It’s beautiful this time of year. You should check that out guys. If you’ve never been in Skagit Valley, when all tulips are gone, it is beautiful, just acres and acres and acres of tulips. So yeah, it is beautiful. Anacortes is very pretty. My mom lives near downtown and the rockfish grill she likes to go to a bar. She says it’s a girl but I think my mom’s probably drinking the beers again which she’s entitled to do. I think that’s not necessarily a bad thing at times.
All right, let’s go over all the questions that we have. “Is retirement income considered passive or active income? If it is a passive income, then can passive real estate depreciation be used against retirement income?” That one is a little bit wonky, but I’m trying to read it, please let me know. Maybe I read it wrong. We’ll answer that question.
“My S-Corp, which was established over 30 years ago, owes me over a million dollars accumulated for several year’s of losses. Last year, we sold two properties owned by the business and we still had to pay gains on the properties. Why is this? Why can’t the profits be paid out to me tax free based on the loans I’ve made to the company?” Good question. These are really good questions, by the way for them for a couple of reasons but you guys don’t even realize it’s a good one.
“I have been told that filing Schedule E for rental properties, which I’ve been doing for the past several years, is not a good way to report your income and expenses from rentals. I want to file Form 1065 but I don’t have a partner and don’t intend to get one. I think form 1120 and 1120-S is not a good way to file either. What do you recommend for next year?” We’ll go over that; we’ll explain it to you.
“I closed on a co-owned rental property in April 2021. I did not have an LLC with my co-owner and we are still in the process of forming an LLC to protect the asset. Can we still take all the real estate deductions on our 2021 tax return? Absent having an LLC in place last year?”
Jeff: Good question.
Toby: Good question. Very good. “Can you defer the depreciation recapture along with the capital gain by doing a 1031 ex, which just stands for exchange. How does cost segregation play into the calculation?” That’s a good one, too.
We have good questions today. We get about 400 questions and they answer a ton of them. Then they grab ones, they say this would be good for live, and they dump them on me. Then I’m like oh, let me grab 10. I’m probably the laziest person at picking questions because I’m like oh, here’s 10, and then usually I throw an extra couple in there because I can’t help say that’s a good question. But then we’re here until midnight, so I grabbed 10 today, these are good ones. Then Jeff always says did you even read them?
“Is lending considered active income versus rents or passive income? How do I count for any income I get on lending on real estate deals and how is it run through my LLC account?” Interesting question. We will answer it.
“I borrowed $100,000 to purchase a property. I got a good deal on the property since I paid $100,000 for a property valued at $150,000. Is there a taxable basis of $50,000 in the year of the purchase? Or is the $50,000 capital gains only taxable upon the sale of that property if I sell it for $150,000?” Interesting way to phrase this. We’ll definitely go over that and answer it. We have a few more.
“I am a limited liability partner in an apartment complex LLP (Limited Liability Partnership). It is registered as an LLP in Delaware, but the apartments are in Alaska. This will be the first year of the partnership, how do you recommend preparing for next year’s tax liability? It’s my understanding that I’ll pay tax on my share of the K-1 income regardless of the amount paid out to investors during the year. How does this affect state taxes also?” Good questions, right?
“I just sold my condo that I owned for three years. One year I lived in it and for two years I rented it. How long do I have before I have to pay taxes on my sale?” Good question. Interesting.
“How do you establish the cost basis of Passive Real Estate Investments upon the owner’s death?’ Now that we are done with death, we’ve saved the best for last. All right, that’s all the questions today. We’ll go through them all. After five minutes, we didn’t answer a thing.
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If you would like to attend, Patty will share a link in chat and you guys can absolutely register. There is no cost and don’t worry we’re not hitting you over the head with anything. The whole idea is to help people make money. That’s what our Infinity side does. They’re doing a very good job. There’s been a lot of success there. When the stock market’s doing things like it did today, you’ll be glad you’re an infinity.
Let’s dive in. “Is retirement income considered passive or active income? If it’s passive income, then can passive real estate depreciation be used against retirement income?” Please let me know, Jeff, what do you say?
Jeff: Retirement income is in one of those weird categories. It’s not passive income. It’s not active or earned income. It’s not portfolio income, it’s ordinary income.
Toby: It’s ordinary income. We just had this discussion not that long ago, did we?
Jeff: Retirement income is one of those things that have, especially at the state level, really special considerations. A lot of states won’t tax retirement income, especially if it’s from the government or from military service. Kentucky I know doesn’t tax retirement income at all but what you brought up earlier was while it’s not going to offset your passive losses, the other side is it can cause social security to become taxable.
Toby: The easiest way to look at it is that people like to talk about active income and passive income. Active income is the sweat on your brow where you’re going to be materially participating in an activity that creates a Social Security tax on it. When you have retirement income, it’s not subject to Social Security, but it can make whatever income you have or whatever social security benefits you’re receiving if you’re retired taxable, and that’s kind of mean. It’s not considered passive or active. It’s just ordinary income.
The other two types of income are portfolio and passive. You have active portfolio income and passive. In passive, there are only two types, businesses in which you do not materially participate and rental real estate. It’s not one of those, you’re not engaged in a business. It’s just rental income so it’s just ordinary income. It’s not a portfolio income, it’s not capital gains, it’s not dividends. It is just literally ordinary income.
There’s really not a thing called retirement income, there’s no designation, it’s just income. The only question is are you materially participating to generate it? If the answer is no, you don’t pay Social Security on it, so you just pay regular taxes on it. But if it’s not passive, you can’t use your real estate depreciation against it. Although there are two ways to make real estate depreciation that creates a loss. There are two ways to make it to where you could use it against that income, which would be to be a real estate professional, or to be an active participant in real estate.
If you’re retired, there’s a good chance you’d qualify for the active participation for sure, which is if you’re making less than $150,000 a year, you’ll be able to write-off up to $25,000 of your real estate losses if you are managing the manager. Active participation is really minimal. You’re doing something with your properties. Very exciting, I know.
Some of you guys are like, get me something with some caffeine and I have a Coke Zero. This is a good question. “My S-Corp, which was established over 30 years ago, owes me a boatload of money. It owes me $1 million. I had been beating this thing with money. Last year, we sold two properties owned by the business and we still have to pay tax taxes on the gains. Why is this? They were losing money year after year and you’re dumping it in. Why can’t profits be paid out to be tax-free based on the loans I made to the company?”
Jeff: Here’s how S-Corps works, cut me off if I get carried away. You’ve had an S-Corp for 30 years, and let’s say you’ve taken a loss every single year. You’ve also been recognizing that loss on your personal return. If I lose $10,000 this year, I’m going to have a $10,000 loss on my 1040. Now, you’ve also been financing those losses by putting money into your S-Corporation. What that does is you’re eventually going to use up your basis, that originally money that you put into your S-Corporation. You’re using those shareholder loans to the S-Corporation to be able to take those losses over the past 30 years.
Toby: It’s kind of weird. Your company making a loss or a gain doesn’t matter about you putting money into the company.
Jeff: Correct.
Toby: Let’s just say that I put $10,000 in and the company uses that $10,000 to buy $100,000 of equipment or $200,000 of equipment. They put $10,000 down on something that becomes a deduction. It would create a paper loss in that scenario, if it’s the equipment, of $200,000 and then the only question is do I have an adequate basis to be able to take that loss against my other income? Yes or no, but whatever the case, that loss flows out and now we’re back to zero again the next year.
It didn’t matter how I did two years ago. What matters is how I did this year. All the million dollars that it owes you still owe you but it has nothing to do with whether it makes money or not. If it makes money, it could pay you back. But if it makes money, it’s paying tax on that income, regardless.
Just the same way that if you’re paying off a mortgage, you could say hey, I have to pay this mortgage. Why do I have to pay tax on my income? I’m just paying off my mortgage? Because they’re two very different things. One is a liability that’s owed. Your company has a liability to you of $1 million. You’re saying hey, pay me that back. Then that company sells a bunch of assets at a gain. The fact that it’s using it to pay you back means nothing. It can write off the interest, but that’s about it.
Jeff: Here’s where it gets really wonky. If I’ve used this million dollars to support losses, as soon as my S-Corporation pays me that money back, it triggers a capital gain because you have no basis in that loan. You’ve already used it up for this past year’s losses. This often surprises people.
Toby: That means you’ve been taking a loss all this time.
Jeff: Yes.
Toby: You’re not paying tax on other income. Hey, I have a loss coming through my S-Corp of $10,000. It means I didn’t pay tax on $10,000 that I received from my employer or someplace else. Again, it’s two different things. Whenever you’re dealing with an S-Corp or a partnership, you’re looking at did it make money? It’s passing down to me. My interaction with that company is as far as how much money I put in or take out is completely different.
I can give you 20 examples. An S-Corp could make a million dollars but not pay it to you. You still pay tax on the million dollars. It flows down to you and you’re saying, hey, it never paid me the money. It doesn’t matter. The money going between you and it does not matter. What matters is did it make money in that 12-month period? That’s it.
I’m sorry that you’re getting that and it’s a mind twist. You’re like hey, it owes me all this money, can I just make money and not pay tax on it when it pays me back? No, because it’s not an expense nor do you recognize it necessarily as income. If I’ve been traditionally loaning it to the company, and it pays me back and I have a shareholder loan, loan from a shareholder, the company can pay me back. If I didn’t use it to take losses, there are no tax ramifications.
Jeff: What we like to do, because of the whole capital gain issue, is instead of doing shareholder loans on that S-Corporation, we contribute it. You can always pull that money back out as a distribution.
Toby: Contribution just means that your basis is shared. You don’t take a deduction for it, but when you do that, that increases your basis so you’re able to take more losses, but then it’s not a loan. It contributes to shareholder basis and your shares. If it pays you back, if you take a loss, and then it pays you money someday and it pays that again, that’s capital gain because you already got your money back.
That’s why I found this one pretty interesting because you’re looking at it going this is where it’s a brain twister because you’re like hey, it owes me the money, but that doesn’t mean it’s deductible. Let’s go.
“I’ve been told that filing Schedule E for rental properties, which I’ve been doing for the past several years, is not a good way to report your income and expenses from rentals. I want to file a Form 1065 which is a partnership tax form, but I don’t have a partner and don’t intend to get one.” Now they’re thinking corporations, maybe. What do you recommend? What do you think?
Jeff: I would stay away from corporations. There are just other issues with them in having an appreciated property. I think there are some liability issues that go along with that.
Toby: If I take an appreciated asset out of a corp, it’s going to be a taxable event. If you ever have real estate and you have to refi it, it’s going to be a big tax hit for you to pull it out, do the refi, and put it back in.
Jeff: That’s going to be for an S-Corp or a C-Corporation.
Toby: Always a taxable event, so you don’t want to do that. I’ll ask you a question. I do a partnership return. Where does that K-1 end up anyway?
Jeff: It ends up back on my 1040.
Toby: What schedule?
Jeff: Schedule E but page 2.
Toby: The reason that you hear Schedule E isn’t good is it’s not that it’s not good. All of your real estate, if it’s coming through a partnership or you own it individually, is going on your Schedule E. It’s whether it’s page one or page two and the lenders treat them differently. Page one, they use 75% of the income. Page two, 100%.
Jeff: Let’s go to that question about it’s not good on page one of Schedule E. If I’m not planning on buying any more properties or refinance or anything, does it really matter?
Toby: If I’m buying for cash, it doesn’t matter at all. The only reason you wanted it on page two is for lenders and the simplicity of your return. Let’s say I had 20 properties, and I have it on page one of my Schedule E. I think it’s three properties per page so you’re going to have seven pages plus an additional seven pages for the supporting document. You’re talking about 15 pages of properties, at least.
Whereas if I do it on a 1065, I’m going to have the same thing on it on my partnership return, but it’s going to give me a K-1 and I’m only going to have one line item, which is going to be my K-1 line item on page two.
It doesn’t really matter unless you are financing and you’re doing traditional financing. It only matters if you need that income, if you’re having difficulty qualifying for loans. If it’s just you and you don’t have a partner, you’d have to create a partner, which means you’d have either a trust, or a corporation, or another partnership that would have to be the other partner. If you’re married, it could be a spouse. Even if you’re in a community property state, you could still elect and treat it like a partnership. I get what you’re saying. Simplicity is sometimes a little easier.
Jeff: I would even consider having a partner that’s a family member. Give them a half a percent or whatever, enough that you can create that partnership.
Toby: If you really want it. I don’t think it’s that big of a deal. I see it as a big deal when you’re growing your real estate and you’re using traditional loans. It’s not a big deal at all when you’re going for portfolio loans. You get over 10 properties, you’re out of this anyway. I guess what I would say is this is really only something if you’re getting Freddie and Fannie loans and you’re less than 10 properties.
By the way, if you like obscure information, by all means, go to our YouTube channel. I have a ton of different videos. You can go in there and you’ll see I put up a few examples. There’s a whole bunch. Everything from protecting your assets to lowering your taxes. There we go. Business credit, protection from creditors, avoiding capital gains, how to avoid the wash sale—which is pretty ingenious if I might say so myself—avoiding penalties, and legally lowering your taxes are just a few that have come out in the last few days. You’ll see that there are top videos and uploads.
If you feel like it, join, and if you join, turn on that little ring bell or whatever it is where it gives you notifications because whenever we’re putting out new information, especially on new laws that pop out, it will just let you know there’s a new video. It doesn’t bug you, it doesn’t spam you or anything like that so don’t worry, it’s just YouTube.
All right, “I closed on a co-owned rental property in April of 2021. I did not have an LLC with my co-owner and we are still in the process of forming an LLC to protect the asset. Can we still take all the real estate deductions on our 2021 tax return absent having an LLC in place for the last year?”
Jeff: Before there were LLCs there were these things called partnerships and you didn’t have to necessarily have a partnership agreement to form a partnership. Still don’t. Whether you have an LLC or not, you have effectively created a partnership unless you’ve done this as tenants in common, which I think has to be declared that way when you purchase.
Toby: I think it’s going to depend on how you guys took the title. If it’s tenants in common, then you don’t have to do anything. You just take your portion, they’re taking their portion, whoever you bought it with. It depends on how many co-owners there are.
Jeff: Depending on what state you’re in, you may have to file registering the state.
Toby: They’re doing an LLC.
Jeff: Yeah, they’re doing an LLC, but what about before doing the LLC?
Toby: Chances are I’m just treating it as a partnership. I may have to file a partnership return. If you’re tenants in common, you don’t have to. But if you guys bought it as joint tenants, now we have an issue. If you’re married, maybe not as big of an issue.
The answer is you can still take the deductions. It doesn’t matter whether you own it at an LLC or not. You get the real estate deductions if it was investment real estate or rental property, assuming it’s not an Airbnb or VRBO, you’d still get all your deductions, your real estate taxes, and your interest. It’s not a primary residence since it says rental. You still got all the deductions and you get to depreciate it. It just gets a little funky.
Jeff: From a practical point of view, we know the LLC is going to need an EIN. Would you use that EIN for the original partnership?
Toby: No, I don’t think you could.
Jeff: I don’t think you could either.
Toby: Chances are what they did is they are tenants in common, if they’re unrelated individuals, in which case, you would just cut it down the middle and you wouldn’t have to do a partnership. You just say I own a 50% interest in this real estate and this is my portion. When you put it in the LLC, then it goes to a partnership return and it’s going to give you 2K-1 and you quit doing that. That’s the easiest route. That’s just me. What do you say?
Jeff: I like that idea. It’s a lot less complicated than filling a partnership return then filing an LLC as a partnership, because what you end up doing is you start off the first year with your tick interest, and it’s a common interest. Then the second year, you contribute those interest to that LLC.
Toby: Hey, by the way, I have a partner, Clint, who also has a really great YouTube channel. Apparently, he’s trolling me right now because he’s mad. Patty, you should shout out his YouTube channel as well, because if you guys like asset protection, he focuses really well on asset protection and he explains it. He’s been doing it 20-something years. He’s really good at it so you can check out Clint’s YouTube channel as well. Don’t want him to be a hater. He’s supposed to be nice. He’s supposed to be nice to his partners.
Anyway, Clint and I have been partners for 20 years but we do like to make fun of each other sometimes. Somebody says, “I already subscribed to both,” so you have good taste, Francis.
All right, somebody asked a good question and I know that it’s over on the other side but, “If I’m forming a partnership, can one of my LLCs be the partner and I’m the other partner?” Technically, yeah, anybody could be another partner.
Jeff: Even if it’s disregarded to them?
Toby: I would say even if it’s disregarded to them as long as another EIN. It’s going to end up on your return, you’re going to be reporting it on both sides. You might want to use a corporation depending on what type of expenses you have. I don’t think I’d ever do that. I’d always been looking for a spouse. If you don’t have a spouse, then I’d be just keeping it as disregarded.
Jeff: So you’re looking for a spouse because you need one to be a partner?
Toby: I need a partner. I need a partner in real estate, will you marry me? There are worse. You’ll probably do better percentage-wise if you did it that way.
All right. “Can you defer the depreciation recapture along with the capital gain by doing a 1031 Exchange? How does cost segregation play into the calculation?”
Jeff: I’ll answer the first question. Yes, that’s the beauty of the 1031 Exchange, is that you get to defer all gains including that depreciation recapture. Eventually, it’s going to catch up to you when you sell that final property and don’t replace it.
Toby: It gets a little weird when you get the cost segregation. Here’s the only rule you have to know. If you guys don’t know what cost segregation is, it’s actually the way you’re supposed to be depreciating your real estate. Here’s just the rabbit hole just for a second. Depreciation recapture, when you depreciate real estate, which is the structure of the real estate, has a useful life according to the IRS.
Most accountants use it for single-family residences, duplexes, things that somebody who’s living in, apartment complexes, 27 ½ years. The land, you don’t depreciate because the land doesn’t lose any value, but the building’s going to fall over and 27 ½ years is the way to look at it. You’re going to have to replace that every 27 ½ years.
If you take that deduction and you write it off when you sell it, you have something called unrecaptured depreciation which sounds weird, but it just means I have to pay tax on my write-off.
Let’s say I bought a piece of property for $1.5 million. The land was $500,000 and a million was the building, and I sell it after depreciating the entire building, and I sell it for $2 million. I have some gain, all of it’s going to be depreciation recapture. I’m going to have to recognize that, and it’s going to be taxed at my ordinary rate maxed out at 25%. That’s number one, we have to pay tax on recapture before we pay long-term capital gains. You pay to recapture first.
When you seg a property, you’re looking at the property and you’re doing it the way you’re supposed to, which is that the property isn’t just structure. There’s stuff in that property, there’s stuff outside the property. The stuff outside the property might be you have a walkway, you have a fence, you have a driveway, you have some trees that you planted. If you’re like me, I think I planted 40 trees at one of our buildings, that’s a 15-year property. You can write that off under the rules as they are right now. It’s called 168(k). I could write that off in one year.
You go inside the building and you look at the cabinets, you look at the carpeting, you look at anything that’s removable, and that’s going to be a five or seven-year property and you could write it off in one year. When we do these tests, it’s called cost segregation. That means usually you get about 30% of the improvement value.
Back to my example, I bought it for $1.5, half a million dollars is the land which means there’s a million-dollar improvement. In year one, I could get around a $300,000 deduction by doing cost segregation. If you want to learn more about that, by all means, jump back onto the YouTube channels. Both Client and I go over that ad nauseam in there. That’s a cost set.
If I choose to do the cost segregation, the only difference between a traditional 1031 Exchange where you just have regular recapture and capital gains that I’m kicking down the road is I have to keep that same methodology when I buy a replacement property. I need to cost seg the replacement property, but I don’t have any recapture at that point. It just moves forward.
I bought the property for $1.5 million, half a million of land and a million dollars of improvement. I took a $300,000 deduction, I waited two years, I sell it and buy a $3 million property. As long as I use the same methodology and break out the components of that building, my basis isn’t going to be $3 million, it’s going to be the original basis of those properties, the $1.5 million, and my depreciation would just continue forward. Assuming that I sell my business for $3 million and buy a $3 million replacement property. That’s how it works.
Not to get too crazy, but it doesn’t matter. You’re going to get to 1031 Exchange. You’re going to get to do a real real estate replacement, whether it’s 10 properties or one property, you get to do a 1031 Exchange, and no, you will not have to pay any sort of recapture when you do that so long as you acquire under the rules, replacement property of equal or greater value. Cool?
Jeff: Cool.
Toby: Sometimes I like to go down the rabbit hole on that, but I think it’s worth it. Some of you guys know what cost segregation is. Some of you guys, it’s probably the first time you’re hearing that. I think there are two types of accountants in the world. Those that understand real estate tax, and those who don’t.
Those who understand real estate tax understand cost segregation because it’s a huge tool in our toolbox and you want to work with accountants that actually know what they’re talking about when it comes to real estate. That doesn’t have to be us by the way. Any good real estate accountant will be able to help you with that.
We have a great group that we work with that does cost segs and it’s really simple to us. Is the juice worth the squeeze? If I look and see how much a cost seg is going to cost and break down, if it’s going to give me $7 for every dollar I spend, I’m probably doing it. If it’s giving me $2 for every $1 I spend, probably not. It’s not going to be worth my time, but you get to decide that.
Jeff: This is one of those areas you often hear us talking about. To do cost seg, you may want to be a real estate professional but that’s not every single time. There are situations where cost segregation still works out. I think this is one of those areas where it always pays to ask ahead of time.
Toby: You know what’s weird? You could actually do a cost seg on a property that you already sold and see if it lowers your taxes. How about that? Because when you start treating the personal property inside it differently, the tangible property, the 7-, the 5-, the 15-year property, even if we just make that election, you don’t have recapture on that property if it doesn’t have any value.
Again, the example I will use, buy a building at $1.5 million. Let’s say there’s $100,000 worth of carpeting, linoleum, and tile. I sell that building, it’s all destroyed. Somebody’s just going to tear it out because I’ve had the building for 10 years. I have to pay 25% on that.
Whatever I wrote off, I have to pay 25% if I use regular depreciation. If I cost segged it, I would have to pay zero recapture on it because it has no value. That’s the difference between those. We see significant savings when somebody goes to sell a building.
I think the last one I saw was a building that was purchased at $2.5 million. They sold it at $3.3 million and the tax savings after the sale were $78,000 in that client’s pocket. We liked that.
All right. Let’s see. Somebody asked about NARR. That would be Frank and Sherry Candelario. He’s looking for the NARR folks. That’s the National Association of Recovery Residences. It’s actually a really interesting way to get involved in real estate.
All right, “Is lending considered active income versus rents or passive income? How do I account for any income I get on lending on real estate deals? How does it run through my LLC account?” What do you say?
Jeff: This is how I look at it. If I’m running the lending through an entity, I’m looking at, is this their primary purpose in life with that entity? If it is, then I’m treating it as an act of ordinary income. I’m getting interest back on those loans. I’m treating that as ordinary income.
If it’s not or if I’m just doing the lending in my own name, that interest is going to be considered portfolio income. It’s going to go on your tax return as interest.
Toby: Which is just ordinary income.
Jeff: Yeah.
Toby: It’s not passive. It’s not active. It’s just ordinary income.
Jeff: The only way I could see making the income passive is what we’ve talked about in the past. You’re just sponsoring the entity. Somebody else is managing it and I’m not doing anything.
Toby: How do you think you can get interest? If I gave money to a bank, and I’m just a silent owner in a bank, and I’m getting the profit out, that’s going to be passive income to me if I’m a silent partner. If I’m loaning money in, it’s going to be portfolio income back to me when it gives me interest.
It’s going to be an active income if it rises to the level of a trade or business. It rises to the level of trade or business when it’s regular, continuous, and substantial. Jeff is right. It just means this is what I do. The courts are kind of all over the place, but there are some temporary regulations out there on material participation.
If you want to be a trade or business in lending, I would say you’re probably spending over 500 hours a year on it. If you’re just occasionally lending portfolio income, it’s not passive. It’s just treated as ordinary income. It is not subject to self-employment tax, but you can’t use passive losses to offset it since obviously, it’s already a gain. You’re making money.
“How do I account for income I get on lending on real estate deals and how to run through my LLC account?” Here’s the one thing I would say. This is going to sound kind of weird. If I am loaning money to Jeff, I have exposure to Jeff going after me for Dodd-Frank or some some state law, usury, am I doing predatory lending? Am I violating? It was Jeff to buy a house and I didn’t use a qualified mortgage. What are they called? I’m not an appraiser, but basically a mortgage. I forget the actual.
Jeff: The underwriter.
Toby: Basically underwriting, but they have a term of art for it. I forget what it is. If I don’t have somebody who’s qualifying you, then I could have exposure underneath that statute. I don’t necessarily want my pot of cash to be exposed to Jeff.
What I would end up doing is having an LLC that does nothing other than hold cash, my investments. If I’m going to lend it, I’m going to lend it at an interest rate to an entity that I’m using to lend to third parties. I’d use a corporation, typically. That way, there’s nothing in the corporation for them to get.
If Jeff gets mad at me and I did something wrong, they can’t get into my pot of cash. The most they’re going to get is that corporation. My worst case scenario is I did a bad thing and I lost my loan money. I’m not exposing myself to have massive loss of all my value in my account. That’s the only thing I would say.
If you’re just doing a once in a while loan to somebody on real estate and you’re not doing a ton, maybe one or two a year, I’m okay out of your main account. Otherwise, you should strongly consider putting an intermediary entity in between you, the pot of cash, and whoever it is that could come after you for any of your activity as a lender.
Jeff: Looking at your corp example, you lend to me, then the only asset in that corp is my loan.
Toby: Correct.
Jeff: And maybe some cash but…
Toby: Not much. Let’s say that I loaned it to my corp at 5% and loans it to you for 7%, the corp’s is only making that little 2% spread. The rest of it is going back to the actual lender, so there’s not much to buy.
Jeff: Because I have to repay that.
Toby: You got it. If you guys like that type of activity, here’s my partner’s face. There’s Mr. Coons. We are teaching another tax and asset protection workshop live on May 7th. Again, absolutely free. If you want to learn about asset protection, we do a tax planning and legacy planning session in the afternoon.
It’s a day well spent there from 9:00 till 4:00 Pacific Standard Time. You can learn about LLCs, land trust, living trust, corporations, S and C. It’s actually pretty entertaining. Clint does a fantastic job in the morning. It’s 9:00 AM Pacific Standard Time to 4:00 PM.
Jeff: This is not a paid promotion. What I do like about this is you can go to an asset protection seminar and they’re going to teach all about liability and whatever. You can go to a tax seminar and they’re going to teach you that side of it, but I think this kind of brings the balance to it. They have to work together.
Toby: They got to go together. It’s even more than that. Clint calls it the four-legged stool. The asset protection has to go well with the tax planning. It has to go well with the business planning. It has to go well with the legacy planning. There’s a lot of truth to that. You want to make sure that you don’t have one leg that’s longer than the other or that a leg is missing. Otherwise, your stool could fall over.
All right, “I borrow $100,000 to purchase a property. I get a good deal on the property since I paid $100,000 for a property valued at $150,000.” Let me just stop you right here. If you bought this and it was an arm’s length transaction, you did not buy a $150,000 property, you bought a $100,000 property. That’s the fair market value since you paid the fair market value.
If we start saying I underpaid and I paid below market for something, you could get hit with a taxable event. If Jeff sold me a sweetheart deal and he marked the property way under, like it was $150,000 all day long, and he could sell that for $150,000, and he comes to me and he says, hahaha, I’m going through a nasty situation. Somebody’s coming after me, I’ll sell it to you for $100,000, I have to pay tax on the amount that’s under.
Usually, it’s related parties where they get into trouble. But if you bought this arm’s length from somebody else, forget about what it’s worth. It’s what you paid. “Is there a taxable basis of $50,000 the year of the purchase?” Jeff?
Jeff: No. Your basis is what you paid for, including your loan money. If you’ve turned around and sold it the next year for $150,000, at that point, you’d have a capital gain of $50,000. I was going to mention about buying something at a discount, especially from related parties, family and all. That ends up triggering a gift aspect of the sale.
Toby: And probably just could be taxable too.
Jeff: I’m usually seeing it as, I sell you the property for $100,000 that’s actually appraised at $150,000. I gave you a $50,000 gift.
Toby: What you don’t want to say is, it’s $100,000. Because if the IRS sees that it’s appraised at $150,000 and you sold it for something below that, that would be a taxable event to you. In theory, you just transferred value. It wouldn’t be a gift because you were buying it. You pretended like there was no value, but I don’t think we want to worry about that.
Jeff: No.
Toby: For this guy or this gal, whatever it is, it’s a purchase basis. You have a basis of $100,000. You only have to worry about that increase if you sell the property for $150,000. If it’s a rental property, you’re going to be using the $100,000 for depreciation. You probably are going to have some long term capital gains if you hold it over a year or you’re going to have short term capital gains if you sell it in less than a year.
If it’s your home, hopefully, you’re getting the 121 exclusion, which is the $250,000 or $500,000 capital gain exclusion when you sell your principal residence. What is the capital gains amount? Let’s say that I bought a property for $100,000 and I sell it for $150,000. The capital gains under that scenario would be $50,000. It would either be short-term or long-term, depending on how long I held it.
The only other nuance here is if I bought it to sell it. If I bought a property for $100,000 knowing that I was getting a good deal, and I was immediately going to turn around and sell it, they could turn you into a dealer, in which case, it’s still taxed as ordinary income. You’re going to hear that term over and over again. It’s short term capital gains, which is taxed as ordinary income. But I am a dealer and I find materially participating, then I’d be assessed Social Security taxes on that as well. That’s the problem with buying properties to sell them.
Somebody says, “Why is there a difference between $250,000 and $500,000 on their 121 exclusion?” It’s because an individual gets $250,000. If you’re married filing jointly, you get $500,000.
Jeff: And if you’re a widow or widower within two years of your spouse’s death, you can qualify for half a million dollars.
Toby: Yeah, 121 is actually fairly simple. You lived in it two of the last five years as your primary residence. It doesn’t have to be your only residence, you could have two residents and still qualify under a four-year stretch, but you have to have lived in it for two years and your name has to be on title.
If you’re married, they consider both spouses on title. If you get a divorce, they can consider as long as it’s sold within a certain period of time, both spouses on title. If you’re a widower, the same situation. It needs both spouses on title for a certain period of time, but you get the $250,000 versus $500,000. Then if you don’t make it for two years out of five years, there’s a reason for it—death, divorce, changing your job—you could get a partial exclusion too.
I taught whole classes on 121. In fact, you had to sit through one. We did a continuing education for accountants and it was a joy. An hour of nothing but 121 exclusion nuance. All right. That’s good for that. Let’s go into this one.
This is Jeff’s favorite because it’s a limited liability partnership. Whenever he sees LLPs, he immediately comes into my office and goes, hey, there’s an LLP.
All right, “I am a limited liability partner in an apartment complex, LLP. It’s registered as an LLP in Delaware, but the apartments are in Alaska. It’s an entity holding a bunch of apartments in a different state. This will be the first year of the partnership. How do you recommend estimating and preparing for next year’s tax liability? It is my understanding that I’ll pay tax on my share of the K-1 income, regardless of the amount paid out to investors during the year. How does this affect state taxes also?” This reminds me of the question earlier on.
Jeff: You should see how excited I get when I see a triple LLP.
Toby: He gets excited. Jeff never smiled. He comes in and he goes, did you see the one in Alaska? That’s true.
Jeff: Yes, you’re exactly right. What is reported on that K-1 that you will report as income or loss on your 1040 is going to be your portion of the partnership’s income. It doesn’t matter what they pay out to you.
A lot of these sounds like a syndication. A lot of them have different payment plans that they’re going to pay you out so much. I’ve seen them where I’m showing a loss on my K-1, but I got $100,000 back of return on capital. One has nothing to do with the other.
Toby: Yeah. You have two things going on. It was like the S-Corporation. We have the income that’s going on inside the apartments. I’ll just tell you, my experience with syndications is the first year, you’re going to have a loss. It’s not because you lost money, it’s because they’re depreciating the hell out of the apartment building.
Jeff: It’s a tax loss.
Toby: It’s a paper tax loss. Remember that cost segregation? If I buy a $5 million apartment building, there’s a good chance I’m going to have a $1–$1.2 million deduction in year one. It’s going to kick through a loss. But since you’re a limited partner, you’re not going to get to use all that loss. You’re going to carry it forward.
It’s going to be a big loss. It’s going to prevent you from having any income from the partnership. Then if it gives you cash, if it’s returning your investment, there’s not a tax liability. If it goes above your investment, now we have a long-term capital gain treatment on that because that’s returned in excess of bases, like you were just talking about. That’s it.
What are we going to look at for your next year’s tax liability? We want to get the projections from the syndicator. What do you expect in year one and two? There’s probably a 99% chance you’re not going to have any income.
Jeff: If the syndication is really good at all, they’re going to have those projections already established of how much they expect to make this year, the next year, the next year, and what your share of that’s going to be. I would depend on those. If they’re projecting, you’re going to have $100,000 of profit a year. I’d probably tuck away maybe a third of that for tax purposes.
Toby: Here’s something else. Somebody’s asking, “What can I use the loss against something else?” You can use passive losses against passive income. If I am a silent partner in a business, like Jeff’s pizza shop and I don’t do anything, I don’t materially participate, I don’t have substantial activity in it, I’m not regularly and continuously participating, and I’m just a passive owner, I could actually use whatever I’m making off the pizza shop. I can use my real estate loss on because this would be considered passive real estate loss.
If I have other income from other rental activities, if I have a bunch of other properties and I’m making money and it’s positive, let’s say I make $20,000 of income from my other activities, I could use the losses from this LLP to offset that, which is why real estate investors continued to accumulate more real estate even when they don’t need more real estate because quite often they’re doing it just for the tax write-offs so that they don’t get killed in taxes on the income.
There’s a tax appetite there that is, in essence, subsidizing their purchases. If somebody walked up to you and said, you buy this, you’re going to save $50,000 this year on taxes, now you’re looking at that going, well, I get a rebate of $50,000 if I buy into this deal. Yeah, it makes it very attractive. Whereas, if you didn’t have a tax appetite, you would just be going on the deal itself. But when you get into where you have lots of different types of income coming in, it is part of the calculation.
Jeff: In regards to the state issue, the LLP is registered in Delaware and they will file an LLP return with Delaware. It’s more or less like a $300 fee with information.
Toby: In order to operate an apartment building in Alaska, that entity is either registered in Alaska or they have a sub-entity sitting in Alaska. If it makes money in Alaska, you’re paying Alaska tax on it.
The syndication could choose to do a composite return. They could pay the state taxes or they could just pass it to you on your K-1 and say you pay the state taxes. It depends on your syndicator. What do you think?
Jeff: I’ve seen an optional to do. I kind of liked the composite returns, especially if I have a whole bunch of them, so I don’t have to deal with all these state returns. The tax is paid, they’ve paid it for me. In this case, Alaska is one of those states that doesn’t have an individual income tax.
Toby: Yay, so we don’t have to worry about it.
Jeff: You’re going to have to report it on your federal, but you’re not going to have to pay either Delaware or Alaska.
Toby: Yeah. If you’re in a state that has a state tax, then it becomes critical here. It’s a non-issue, so you don’t have to worry.
Jeff: If you don’t live in Alaska and you live in a state that has tax, let’s say you live in California, you’re going to have to report this income on your personal return to California.
Toby: If you live in a state that has income taxes, they’re going to use this to assess more income tax. No offset on this one.
All right, “I just sold my condo that I owned for three years.” This just made me think of Fight Club. Do you remember his condo? “I just sold my condo that I owned for three years. One year I lived and two years I rented it.” One year I lived, I think they lived in and two years, they rented it out. “How long do I have before I have to pay taxes on my sale?”
Technically, your taxes are due as they’re accrued. You might have some quarterly taxes on it. Your actual tax bill is going to be the April 15th of the year following your…
Jeff: If you sold it in 2022, you’re going to have to pay tax on April 15th, 2023.
Toby: Yeah, but if you don’t want to pay tax on it, it depends on how much you made. Whether you have capital gains, you can’t go back and do a 1031 exchange. The only thing you really can do is if I have capital gains, you’re looking for capital losses. You can always pick up some things you have that are losers you could dump. Or you look at a qualified opportunity zone if you want to defer it. And you could defer it out until 2026.
There are some ways around even if you’ve sold it. Technically, because if it’s a condo, if it was sold last year in 2021, you’d have until just the end of June to set up a qualified opportunity zone fund if you wanted to go that route. So, you’re on a clock. Otherwise, it would be next year.
Let’s see, “How do you establish the cost basis of passive real estate investments upon an owner’s death?” Jeff.
Jeff: I’m going to say it was a little different. You really don’t. When a person dies and you inherit their assets, they’re new assets to you at the current fair market value. Going back to this, how do you establish that? If it’s real estate, I’m getting appraisals on everything I inherited. It’s going to cost a little money, but I really want to do that to establish my cost.
Toby: 100% correct. There is a way to do it. You could do it on the date of passing or you could do it six months later. That’s only under one circumstance when it goes up in value or down in value. I can’t remember which one.
Jeff: I want to say if it goes down in value, but yes, there’s only one circumstance that you can do the six months alternative valuation.
Toby: Right. Basically, if somebody passes away and they have an asset, the basis of that asset steps up to the fair market value on the date of passing. If it’s real estate, you can start re-depreciating it at that new high basis. This is why it’s really important.
The old adage is, if you want the best tax strategy, you buy, borrow, and die. That’s technically the best tax strategy that exists out there. You buy assets, they go up in value, you borrow against them, you don’t pay tax when you borrow against them, and then you pass away. When you pass away, the basis steps up.
Your heirs get it. They could sell it and not pay any tax. Or let’s say that you’ve been writing off a bunch of houses and that continues to grow, you 1031 exchange them. Now you have $5 million of real estate and you pass away, they now have $5 million of real estate at $5 million a basis. They do the exact same thing. They just let it continue to grow. You trade it for more real estate. If they need cash, they borrow against that and continue to allow the asset to do its little expansion thing.
Jeff: I want to distinguish one thing, the difference between a gift and an inheritance. If I have a rental property that I bought for $100,000, it’s now worth $300,000, and I gift that to my children, they step into my shoes. Their cost basis is $100,000 plus whatever depreciation has been taken.
Toby: Hint, parents. Don’t give your kids stuff right before you die. You’re like, oh, I’m going to transfer to you and I’m going to transfer to you. From a tax standpoint, that’s a horrible idea if it’s an appreciated asset. If it’s sentimental stuff, go for it. But if it’s something that I have a $100,000 basis and it’s worth a million, please don’t do that because you just created a huge tax liability if they dump it, because they’re gonna get your basis.
I’ve lived that. I’ve watched many, many clients come here going, what did my accountant do? And you’re like, well, they were worried about the estate tax going down, so maybe we had one where they gave away a building. The extra liability was over a million dollars.
The accountant is obviously in a corner at that point. They’re not too responsive. You’re like, why did they do it? Because they were worried about a huge estate tax. But what they just did is gave you a huge capital gain issue when the assets were disposed of and you missed out on all that step up and basis.
They did that with a building that was about a 50-year-old building. It was millions of dollars. The tax ramifications were over a million dollars and the kids were really pissed off the accountant.
Jeff: The other mistake I’ve seen is where people will either gift their assets or put them into a trust to protect their assets from Medicare not realizing that Medicare has a five-year clawback.
Toby: I’ve just dealt with that one.
Jeff: Right. My example is I put all my assets and we’re talking about an irrevocable trust.
Toby: Or an annuity.
Jeff: Or an annuity or I gift it to my kids. Medicare can look at those assets in the next five years.
Toby: That’s somebody who’s going to have medical expenses and they don’t want to pay for them themselves. They don’t want to deplete their estate. Medicare doesn’t let you just do that. They look back at you and go, hey. Is it Medicare or Medicaid?
Jeff: It might be Medicaid.
Toby: I think it’s Medicaid. You’re qualifying and they’re giving you this benefit. In order to qualify, you have to be below a certain asset threshold or an income threshold. If you do it by giving your stuff away, they look back and say, if you did that within five years, there are some pretty big penalties. You’ll be denied benefits and you’ll end up with some ramifications for doing so. So you always talk to an elder law lawyer when you’re doing that.
All right, we’re getting towards the end. Subscribe to our channel on YouTube. Patty will also put up Clint’s. We actually have two. Clint, myself, we have Coffee With Carl. We have Pia for Infinity Investing. We have Infinity Investing.
We have lots of YouTube channels out there. The two main ones that will get you everything you need to know on tax and asset protection is Clint’s, which again, Patty will share, and my channel which is the Anderson channel.
You could see lots and lots of fun stuff. You could also see the Tax Tuesday. If you want to live stream it online on YouTube, you could certainly do that. We obviously put the recordings up on the channel. If you guys like that stuff, it’s actually a kick in the pants.
If somebody’s a first time listener, it’s a little different, huh? We answer a lot of questions. We try to give you guys back. It’s always like that and we try to pick questions. There’s not much rhyme or reason. The people that are picking them, is it to be, really? But I try to just pick a wide variety that allows us to dive into certain issues.
That’s what’s on their lookout, things that aren’t just straightforward yes or no, but allows us to expand at a point so we can continue to increase our tax knowledge, so that it’s not so fearful for you guys. It’s not so scary and you’re able to actually put some things into place because we believe you’re better stewards of your money than the government is.
I think we’re right. You might agree. I’d rather you guys keep that money and do good stuff with it than give it to our government who God knows what they’re doing. Apparently, we give it all away.
All right, questions. If you have questions that you want answered, taxtuesday@andersonadvisors.com. There’s no cost. By all means, ask away. Ask away and then visit us at andersonadvisors.com. Jeff, anything you want to say?
Jeff: No. I kind of felt like I went over a bit on that last question. I’m going to give you credit for getting done on time.
Toby: It’s 4:04. We’ve just missed it, but there’s an over/under. I think I still win. I’m always been on the over. All right, guys. Again, questions? Shoot them in there. You’ll see that we respond whether you’re a client or not.
Join us again in two weeks. Every other week, we’d do the Tax Tuesday. If you can’t make it, you can always listen to the recordings. They’re out usually within a few days, we’ll make sure. We’ll take care of you guys. Thanks again for joining us and we’ll see you next time.
As always, take advantage of our free educational content and every other Tuesday we have Toby’s Tax Tuesday, a great educational series. Our Structure Implementation Series answers your questions about how to structure your business entities to protect you and your assets.
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