In today’s Tax Tuesday episode, tax experts Toby Mathis, Esq., and returning guest Jeff Webb, Esq., CFO of Anderson Business Advisors discuss a number of common tax topics including IRA to Roth conversions, real estate depreciation deductions, LLC’s, S-Corps and Sole Proprietorships, gifting vs. inheriting property, and the title question about structuring your real estate business. Submit your tax question to taxtuesday@andersonadvisors.
Highlights/Topics:
- “If I move money from my SDIRA, which stands for self-directed IRA, to a Roth self-directed IRA, can I use bonus depreciation from real estate owned outside of my IRAs to offset the taxes I owe from the Roth conversion?” – It’s really going to depend on where that depreciation is coming from.
- “I’m new to real estate investing and haven’t purchased the property yet. Do I need to have an LLC to claim deductions this year on real estate–related expenses already incurred?” – An LLC really has nothing to do with taxes. It is strictly for liability protection, and asset protection.
- “I’m a small business owner with three other employees working for me. I’m trying to open a solo 401(k) or some other retirement plan for myself as an owner. I believe I need to offer the same to my employees as well, which I can but am not interested in offering any matching contributions to other employees. How does it work? What is the best way to set this up?” – yes, you can open up a 401(k) and have your employees participate assuming they’re eligible to participate. However, you can’t pay yourself a match and not pay them a match. You have to treat everybody equally.
- “I won $10,000 worth of furniture from a raffle or gaming event. How do I report this on my income tax?” – Whoever you won it from should be issuing you a 1099 miscellaneous with $10,000 of other income on it. You’ll record it on your tax return as other income.
- “I’m a realtor operating as a sole proprietor. Should I be operating under a different entity to minimize taxes and liability? Over the years, I’ve received conflicting information and just don’t know.” – the math is 14.1% in addition to your state income taxes, in addition to your federal income taxes. The way you nix that is you run it through an S-corp or an LLC taxed as an S-corp.
- “At what point in my real estate operation should I move from a single-owner LLC to S-corp for tax purposes?” – If we’re talking about investment real estate and rental properties, you don’t ever want to put them in an S-corporation. It’s a bad idea.
- “If I transfer my rental property into an LLC for the purposes of depreciation, will the LLC get a step up and basis to the current market value of the property? Or will the LLC inherit my lower basis? – If you contribute property to any kind of entity that you own, it gets your basis.
- “Do unrelated businesses have to have separate schedule Cs or LLCs, or can I rebrand myself on my Schedule C, DBA, JL Enterprises, and put everything together? What are the advantages or disadvantages?” -…most times I don’t see a whole lot of advantage to grouping unless it’s a real estate activity with an operation or something like that.
- “In my father’s will, he’s leaving me a house.” Yes. “I’ve been living in it for nine years.” “If he puts my name on the title now along with his name, will I have to pay more taxes? I prefer to do that now. What would the difference be? He does have a living will.” – He would have to file a gift tax return for his basis in that half, or actually its fair market value on that half. I’m not a big fan of mixing things up under these circumstances…
- “We are fixing the downstairs area of our home to rent out as a short-term rental. Are there any expenses that can be used in tax deductions? Should we run it under an entity?” – The repairs that you’re doing down there would be deductible. If you’re doing improvements to the property, it would be depreciable.
- Send us your questions, and check out the event schedule listed in the resources section.
Resources:
Tax and Asset Protection Events
Full Episode Transcript:
Toby: Welcome to Tax Tuesday. My name is Toby Mathis.
Jeff: I’m Jeff Webb.
Toby: And we are doing our best to bring some tax knowledge to the masses. Today is going to be no different. We’re going to dive right in and let everybody fill up the room. Let me see if I can actually see how many people are coming in. There we go. We see you guys coming into the room. If you’re on YouTube, we’re probably just live streaming to you. We’ll give it just a second to let everybody get going. That’ll be the fun part.
Let’s go over some of our house rules. You can make comments in chat. For example, hey, where are you sitting today? What city are you in? I already see that there’s Joe from Mooresville. Delaware in the house. David says, hello, guys. Jermaine says, hello, Minnesota, Norman, Oklahoma, Austin. We have people from all over the place.
Maryland. Maine, Henderson, Nevada. You’re just right down the street. Florida, Florida, Florida, Idaho, California, Austin, Rohnert Park, California, Dave from Dayton, Ohio, Virginia, Clermont, Florida, New Jersey, Kentucky. We got people from all over the place. It’s always so much fun.
That’s how you use the chat. If you have a question like, hey, this is a situation I’ve run into. How is it taxed? Somebody just says, can you roll a personal IRA into a nearly set up solo? That’s where you put that into question and answer. That’s perfect. There’s Sherry. Hey, Sherry. I don’t think I need to call you. Anyway, we had all sorts of fun. Lacrosse, Clearwater, we got people from all over the place. Tax hell LA, California. Yes, you are there with Lucifer in California.
If you have questions when we’re not having one of these sessions, you can just email them in at taxtuesday@andersonadvisors.com. That’s where we pick up the questions.
Jeff and I did not pick any of the questions today. We’re going to blame it on somebody else who’s not to be named. We just looked at it and we’re like, cremini. People like to do that to us. They just like to give you a little knuckle.
If you need a detailed response or you have something that’s really specific to your situation, like we’re going over from just giving you commentary and giving the rules to giving you advice, then you need to become a client. You can become a client in Platinum, and you could ask all the questions you want.
We even have a tax hotline now where you could ask all the questions you want as part of your Platinum membership. It’s absolutely fantastic. You can talk to lawyers and accountants all day long if you want to, if you’re platinum. No, there’s no hourly on that one.
Jeff: Can I do a little promoting there?
Toby: Yeah.
Jeff: The tax line is for general tax questions, they’re not for detailed tax questions. They’re usually 15 minutes or less, the calls are. For more information, you can look on our website. There’s a phone number for that hotline. Also, if you need a tax counsel, this is a great time to get in.
Toby: Do it now.
Jeff: Do it now.
Toby: Because in about a month, it’s all hell breaking loose. Speaking of all hell breaking loose, we got a lot of really good accountants, tax attorneys, and CPAs on board. I got Troy, Tania, Ross, Kurt, Jared, Eliot who we’re mad at, Dutch, Dana. There’s Patty and Matthew. We have a ton of people to answer your questions. Speaking of questions, let’s go over the questions we’re going to be answering today.
Let’s start with the first one. It says, “If I move money from my SDIRA, that stands for self-directed IRA, to a Roth self-directed IRA, can I use bonus depreciation from real estate owned outside of my IRAs to offset the taxes I owe from the Roth conversion?” Great question, we’ll answer that.
“I’m new to real estate investing and haven’t purchased property yet. Do I need to have an LLC to claim deductions this year on real estate–related expenses already incurred?” We’ll answer that one, good question.
“I’m a small business owner with three other employees working for me. I’m trying to open a solo 401(k) or some other retirement plan for myself as an owner. I believe I need to offer the same to my employees as well, which I can but am not interested in offering any matching contributions to other employees. How does it work? What is the best way to set this up?” Great questions so far, Jeff. What do you think? Let’s keep diving into more.
“I won $10,000 worth of furniture from a raffle or gaming event. How do I report this on my income tax?” Maybe it’s The Price Is Right.
Jeff: Good. I didn’t even think about that.
Toby: I don’t know. “I’m a realtor operating as a sole proprietor. Should I be operating under a different entity to minimize taxes and liability? Over the years, I’ve received conflicting information and just don’t know.” We’ll answer that too.
“At what point in my real estate operation should I move from a single owner LLC to S-corp for tax purposes?” Why are you guys asking some pretty good questions? We’re not going to be mad at Eliot too long. These are actually pretty decent.
Jeff: Not that he’s the one to pick the questions, but…
Toby: Yeah. “If I transfer my rental property into an LLC for the purposes of depreciation, will the LLC get a step up and basis to the current market value of the property? Or will the LLC inherit my lower basis? Do unrelated businesses have to have separate schedule Cs or LLCs, or can I rebrand myself on my Schedule C, DBA, JL Enterprises, and put everything together? What are the advantages or disadvantages?” That’s going to be a long one, but we will answer it.
“In my father’s will, he’s leaving me a house.” Yes. “I’ve been living in it for nine years.” You’re pretesting your inheritance. “If he puts my name on the title now along with his name, will I have to pay more taxes? I prefer to do that now. What would the difference be? He does have a living will.” Fantastic. Good to see somebody actually do some planning, living will or living trust, by the way. Living will is for end of life decisions, hopefully as a living trust.
“I want to pay my 14-year-old to help me with my real estate business.” Great idea, by the way. “How do I pay her and legally claim it on my taxes? Do I pay through QuickBooks and just take taxes, or just Venmo?”
“We are fixing the downstairs area of our home to rent out as a short-term rental. Are there any expenses that can be used in tax deductions? Should we run it under an entity?” Great questions thus far.
Speaking of great questions, you can always go in and get answers to questions by jumping on our YouTube. This is my YouTube channel. Probably 612 videos. I was going to say close to 600 videos. That is pretty darn close. That’s just over 600 videos on just about every topic you can think of.
By all means, join. It’s absolutely free. If you subscribe and put the little bell, that little icon there that looks like a bell, it’ll let you know when new videos are put up. It will not spam you.
My partner Clint Coons does a great job on real estate asset protection, too. His channel is very popular on YouTube. I would suggest that you go there as well. It’s never a bad idea to continue to learn, invest in yourself–type thing. Speaking of which, there’s the YouTube channel. I think Patty already sent it out.
“Great channel, set aside time to watch weekly.” Thank you, John. Maybe he’s talking about Clint’s, but I’ll just say thank you no matter what.
All right, “If I move money from my self-directed IRA to a Roth self-directed IRA, can I use bonus depreciation from real estate owned outside of my IRAs to offset the taxes I owe from the Roth conversion?” What is he talking about here, Jeff?
Jeff: He’s going to convert his traditional IRA. Let’s just drop the self-directed part. It doesn’t really matter. He’s going to convert his traditional IRA to a Roth IRA. When you do that, you have to pay tax on that conversion, the entire amount that you’re converting to the Roth IRA.
Toby: Yeah, because the Roth, you’re not allowed to take a deduction on going in, but then you never pay tax on any of the growth or the money coming out as long as you follow the rules.
Jeff: Exactly. After you do this conversion, any growth after that in the Roth IRA is not going to be taxable to you.
Toby: Yeah. People may say, hey, why do you have to pay tax? I put it into an IRA. Why do I have to pay tax if I put it into another IRA that just happens to be a Roth? The reason is really simple.
You took a tax deduction when you put it into the traditional IRA, and you don’t get the tax deduction when you put it in a Roth. If I move it into the Roth, they allow you to convert it, but you have to pay tax on the entire amount that you convert in the year that you rolled it. That’s it.
Can they use bonus depreciation? What are they talking about there?
Jeff: Possibly, it sounds like they’re talking about doing a cost segregation on real estate, or maybe they have short-term rentals that they want to take the short-term depreciation on. It’s really going to depend on where that depreciation is coming from.
If you’re a real estate professional and have losses in your real estate coming from depreciation or cost segregation, you’re going to be able to apply that against any other income, including this Roth conversion. Same for the short-term rental. If you’re materially participating, you’re going to be able to deduct anything coming from a cost segregation or let’s just say a loss in general on your real estate property.
Toby: Yeah. It’s the passive activity loss rules if it’s investment real estate. If these are rentals, then there are two ways to write them off. That’s active participation, and you make less than $150,000 a year. It phases out between $100,00 and $150,000, so I’ll just say $150,000 and less. You’ll be able to use some of that.
Or you’re a real estate professional. Or as Jeff pointed out, the real estate is short-term rental, and it’s not considered investment property. It’s just considered ordinary business loss. If we do the bonus depreciation with the big loss, yes it could wipe out our conversion, so long as you materially participate in that short-term rental.
If you have questions on this, guys, come to our tax and asset protection events. Peruse the website. There are plenty of places that they go over the short-term rentals. I’ll probably do another video on it here in the next couple of weeks. Be on the lookout because it is a very hot area right now.
Jeff: One thing I wanted to go back to is this Roth conversion. This is probably the least planned event that taxpayers do, and actually should be one of the most planned events. When’s the best time to do a Roth conversion? When your other income is low.
Toby: Yup. You want to have a bad year, and you want everything to be depressed, then roll it. You should have rolled it last year when the market took it’s big […] and you’re like, oh, we’re down. That’s the time to convert it to Roth. Here’s the math, it takes about 30 years to offset the tax deduction you get when you’re doing a traditional plan.
The rule of thumb that I use is if your taxes are going to go down when you retire, then you should be taking a deduction when you contribute to a plan. You should be doing what’s called a defined contribution or a defined benefit plan. You should be taking the deduction if your tax bracket’s going to go up when you retire or you’re really young. Under 25, you can just pretty much say, there’s so much time, it’s going to be cooking. It takes about 30 years to level out.
If you’re going to be retiring, obviously if you’re 25, 30 years who’s 55, chances are you could be leaving that money in there for 60 years, then you do the Roth. Maybe do that, but I see these folks that are in the highest tax brackets. They’re making $500,000–$600,000 a year. They’ll do a conversion and I’m like, what are you doing?
They’re like, oh, I got some really great investments. I’m like, you just lost half your money. When you lose half of your money, you have to get 100% return to make it back. It takes a long time. It’s like, stop that.
Jeff: Another thing to consider on these Roth conversions is people seem to think, well, I need to take my entire IRA and convert it. No, you don’t have to do that. You do small bite-sized chunks.
Toby: Jeff is right, Jeff is not wrong. He is absolutely right. How about this? Get your pencil out and just do it thoughtfully. I always love the people that are like, I converted my IRA. How much was it? $300,000. What’s your other income? $300,000. You’re going to be really angry.
Anyway, “I am new to real estate investing and haven’t purchased property yet. Do I need to have an LLC to claim deductions this year on real estate–related expenses already incurred?”
Jeff: An LLC really has nothing to do with taxes. It is strictly for liability protection, asset protection.
Toby: But they don’t own any real estate.
Jeff: You don’t own any real estate, so I’m not worried about you having an LLC at this point.
Toby: I’m like, they don’t have any real estate, so what are your real estate expenses? Thinking about real estate if I have a KitKat.
Jeff: If you’re going around looking for properties and not finding them and stuff like that, and doing research, none of that is probably deductible this year.
Toby: But it gets added to your basis of your property. You don’t lose it, but you don’t get to write it off. In other words, there’s a great case that it was Woody. That case was Woody, but he had gone, he did a bunch of training, and he had spent a bunch of money on training.
We’ll tell you, if you’re going to do that, we were going to set up a C-corp because it’s going to be in business the day that it sets up. Otherwise, you have to actually have real estate in order to take deductions. You’re not in the business yet. You’re not an investor yet until you own real estate.
This guy ran up $40,000 worth of education expenses, tried to write it off, and didn’t buy the property until right at the beginning of the next year. The court correctly held, no, you don’t get to write it off, you get to put it as basis into your first acquisitions. It’s absolutely bonkers.
Somebody says, “What’s the math on your statement that it takes 30 years to benefit from a Roth conversion?” It’s like this. Let’s say that I put in $5000 and I get a tax deduction. Let’s say that my tax deduction is 20%. It’s a thousand dollars that it saved me. My $5000 contribution is really $6000.
On the same token, I put money in as a Roth, and I ended up paying tax on the $5000. There’s $1000 makeup there that I miss out on. $6000 benefit versus $4000, and it takes about 30 years at 7% or 8% before they align themselves.
You actually just go put it into your little calculator, because I get so much more bang for my buck when I get the tax deduction as well. That’s the statement. You can go in there and just test it out. There are conversion modelers that you can go look at. That’s the math on my statement.
Toby: Anyway, going back to this actual question. Somebody who’s new, chances are, it depends on what your expenses are, a lot of times, we’re going to suggest that you set up a corporation to capture a bunch of expenses.
It really depends on how large the amount is. It might be worth it. Or you just kick it down the road and you say, when am I going to invest? If you invest before the end of the year, you’re putting it into the property anyway, you’re going to get that deduction over time because it’s still going to be part of the basis.
Jeff: One thing I will suggest is if you do find a property you want to purchase, you form that LLC first. That also provides you with a bit of anonymity on top of the liability protection.
Toby: Yes. If you’re buying an investment property, you try not to have your personal name on title.
Jeff: We often see people buy it in their name and then transfer it in LLC. I just assumed you buy it in LLC.
Toby: Buy it in the LLC if humanly possible. Sometimes if you’re getting traditional financing, they’ll say we want to close it in your name, and then you’ll put it in a land trust and assign it to the LLC.
Again, if these are new concepts for you, please join us at the tax and asset protection events. We teach them on the weekends. Almost every weekend, we have one going on. You can learn all about land trusts, LLCs, corporations, and why you use them and how they’re used. Fun one.
“I’m a small business owner with three other employees working for me.” Congratulations on being a small business owner and an employer of three other people. “I’m trying to open a solo 401(k),” or some retirement plan because you’re not going to get to do the solo; solo means just you, “for myself as an owner. I believe I need to offer the same to my employees as well, which I can but am not interested in offering any matching contributions to the other employees. How does it work? Or what’s the best way to set this up?” What do you think, Jeff?
Jeff: A 401(k) is a fringe benefit that has discrimination rules all over the place. That means, yes, you can open up a 401(k) and have your employees participate assuming they’re eligible to participate. However, you can’t pay yourself a match and not pay them a match. You have to treat everybody equally.
It might be based on compensation. You might be paying yourself a half a million dollars and then $10,000 a year. That match is going to vary depending on the circumstances. We often see that, especially in profit sharing plans. It’s going to be based on a percentage of compensation.
Toby: What if the employee says I don’t want to contribute. I don’t want to participate at all?
Jeff: They can opt out, and I believe that opt out is a forever opt out.
Toby: Yeah. They’re going to say, hey, I don’t want to be part of your 401(k). It’s weird, but people do it. Here, we have over 550 people now. Still, not everybody participates in the 401(k) even though we do at matching.
Jeff: It’s possible that you may have people who are not eligible, but that’s since they changed the laws regarding eligibility down to anybody who works more than 500 hours in a year is eligible. It becomes really difficult to do that.
Toby: Absolutely. You’re going to get your pencil out. Let’s say you’re doing a traditional 401(k) or defined benefit plan, especially if you’re a high income earner, you might want to look at the defined benefit plans because we can put hundreds of thousands of dollars into those plans on an annual basis on your behalf.
What you do is you look and say, what’s the amount that I have to contribute for the employee? If 90% of the benefits flow into you, then all you’re doing is you’re saving a ton of money, and you’re still benefiting your employees. Don’t look at it and say, I don’t want to participate, and they don’t want my employees to participate.
Look at it a little bit differently because we can put vesting schedules in. You can do a whole bunch of different things when you’re putting together a plan. Look and say, what’s the benefit, what are the costs? And just see whether the juice is worth the squeeze. You guys probably heard me say that before.
I usually look at a 7X return. If I’m going to spend a dollar, I want $7 in return. If I’m going to spend some money doing a plan, I want to make sure that that benefit is mostly to me. If that means that I’m giving money to my employees, God bless them. That’s it, it works.
Jeff: This is a great benefit. If you really like your employees and want to keep them, this is a great benefit to give them. It doesn’t have to be that expensive.
Toby: If you don’t want to, then there are still traditional IRAs that you can still do. If you just don’t want to have a business retirement plan, there are other vehicles you can use. You can use an HSA, you can use an IRA. There are other vehicles that you can use that will provide you with some certain benefits. You can do non-qualified plans like IULs, where you’re dumping money into those as well, where you can discriminate.
There are other options for you. But if you want just the typical, hey, I want to have a 401(k), and I want to be able to push money into it, but I don’t want to pay too much for my employees, then you really just want to take a look and see, all right, what are the rules that I can impose? How do I avoid having discrimination rules?
They have what’s called a safe harbor where you might have to make contributions on their behalf so that you don’t become top heavy in your plan. This is why you hire experts on it. Don’t come in with a decision already made in your head like no, I will not benefit my employees at all. But if you give a dollar and it saves you seven, you probably take that action even if it is benefiting your employee.
“I won $10,000 worth of furniture for my raffle or gaming event. How do I report this on my income tax?” Jeff.
Jeff: Whoever you won it from should be issuing you a 1099 miscellaneous with $10,000 of other income on it. You’ll record it on your tax return as other income. It will be taxed at your ordinary rates. If you’re in the 22% bracket, you’re going to pay $2200 of tax on this.
Toby: But no employment tax?
Jeff: No employment taxes.
Toby: That might be a really nice couch nowadays. If you won it at Restoration Hardware, it’s a couple of pillows.
Jeff: This is exactly how a lot of people get in trouble by winning prizes on game shows and all, where they were getting all these taxes.
Toby: We had one. I’m not going to say who it was, but she won a car. The taxes on the car were like, I don’t want the car, just give me cash because I have to pay the tax. I won a $30,000 car, you may as well just added $30,000 to your income. You’re like, wait a second.
You’re going to pay $7000 or $8000? Man, that sucks. I don’t want the car anymore. You just keep it. I’ll take the furniture unless it’s horrible. If it’s Paisley, I don’t want it. You just go out and sell it.
“I’m a realtor operating as a sole proprietor. Should I be operating under a different business entity to minimize taxes and liability? Over the years, I’ve received conflicting information and just don’t know.”
Jeff: I’m going to go back to the very first part of this question. When you say you’re a realtor, you’re either a real estate agent or a real estate broker.
Toby: They’re that realtor that little TM. You can be a realtor.
Jeff: Why there’s a difference in the real estate agent and a real estate broker is I think it has more to do with state laws and what other real estate brokers are willing to do for you.
Toby: Somebody says, I just won a car. Yes, Bridget. Now you got the tax bill on it. I’m sorry, I’m just obnoxious today. You won a car. Bridget says she won a car. Yeah, Bridget won a car. You guys can’t see this, but I’m very excited for you, Bridget. It must be fun unless it’s a Hugo. Don’t drive the Hugo.
Jeff: The problem with the real estate agent side of it is it’s not a tax issue. It’s a state law or what your broker is willing to do with you. A lot of brokers won’t work with S-corporations, which would be if you’re making good money as a realtor, I want you in an S-corporation.
Toby: Yes. Here’s the deal. There is a way. Even if your broker will not pay your S-corp, there’s still a way to get it in there. I always forget the name of the case, it begins with an F, and I always screw it up. It’s like Fleming or something like that.
There’s a case on point where if you have a shareholder agreement or employment agreement with your S-corp, and your S-corp lets the broker know that you’re under their exclusive control, then you’re operating on behalf of the S-corp, which you’re doing for yourself, if it’s an S-corp. Even if they make it to you, the IRS is going to allow you to deposit that into your S-corp account.
The other way is a lot of accountants—and I’m just going to say this in front of Jeff because I’m sure he’s either going to say yay or nay—that I’ve worked with over the years just take it all on a schedule C and expense it all directly into the S-corp anyway. They’ll just be like, okay, here’s the work around. I got $30,000. I’m going to subtract off $30,000, and then I’m going to report $30,000 over here on the 1120-S.
Jeff: And we will probably have to do that in your first example, where you’re saying you’re an employee of an S-corporation. If they’re issuing a 1099 still to you rather than the S-corp, we’re probably going to have to do something like that. One thing we generally want to do is if we get any tax document, we want to make sure that ends up on the tax return, even if we’re just taking it right back off.
Toby: Yup. Here’s the whole deal. Let’s say your typical realtor. I think the average realtor was around $70,000 last year. It might be a little less than that, but let’s just say $70,000. You make $70,000. Let’s say you had some expenses, so it got down to $50,000. You’re going to pay old age, death, survivors, and Medicare on that entire $50,000.
It doesn’t sound like a lot, but the math is 14.1% in addition to your state income taxes, in addition to your federal income taxes. You get a little whack right in the head. It just doesn’t feel good. When you’re like, hey, wait a second, I only made $50,000. Why am I paying 30% of it over to the IRS? The way you nix that is you run it through an S-corp or an LLC taxed as an S-corp.
A lot of the sole proprietors I meet out there that are real estate agents are actually LLCs. You’re one document away from making that into an S-corp. It’s just a 2553 you file on behalf of the LLC.
You could just take yourself a little salary. You could defer the entire amount of that salary at that level directly into a 401(k) if you want to. You could just immediately turbocharge your retirement plan. And then the rest of it is not subject to Social Security. At a minimum, you might save yourself.
Let’s just say that under that scenario, we had $50,000 of net income. Let’s say we paid ourselves $15,000 of it. All we did was pay ourselves $15,000. Okay. The remaining, what would that be? $35,000 times 14%.
I’ll get my little calculator out. I’ll tell you exactly what it will save you. It’s 14.1 times $35,000. It’s going to save you just right around almost $5000 a year. That’s what we want. Plus, you get to do an accountable plan. You’re actually going to lower your taxes further because you get to write more things off than you do as a sole proprietor.
You can do an administrative office for your house. You can do the 280A. I can reimburse my entire cell phone instead of just its work portion. The last year that we had the data from the IRS, the audit rate for sole proprietors making was right around the $100,000 mark. I think it was 2.4% versus the S-corp was 0.2%.
We’re talking about 1000%. It’s a massively different increase in the amount of audits for sole proprietors versus S-corps. Plus when sole proprietors get audited, they lose. As of last year, it was 94% and 95% of the time, depending on whether it was a field audit or a correspondence audit, which means you were a punching bag for the IRS if you’re a sole proprietor.
That’s why you’ll hear guys like me saying, no, I don’t want to be a sole proprietor. Even though 70% of the people out there are operating a sole proprietor, the small businesses, bad idea. You’re putting a big old bull’s eye on your head, and you’re going to lose your audit because you’re not doing the things that are necessary.
The IRS does not say, oh, you’re a sole proprietor, you only have to keep these records. You’re an S-corp, you have to keep more records. No, it’s identical. People get confused because I hear people say, there are less formalities when you’re a sole proprietor. That is not true, 100% falsehood.
What they’re saying is you don’t have to do anything in order to be a business. Therefore, they think it’s easier. The problem is the IRS doesn’t care. You have to do the who, what, where, when, and why on all your expenses, and you have to show it’s business-related.
When you are operating as a sole proprietor, most folks have one account, everything goes in and goes out. They’re buying their groceries out of it, they’re paying expenses out of it. And the IRS says, okay, you’re going to write off a portion of your cell phone, what were the business calls? Let me see your log. You want to write off part of your car? Let me see your mileage log. You’re like, what’s that? What are these things you asked for? And you just get torched. Jeff, you’ve been doing this for 37 years?
Jeff: Yeah.
Toby: Yeah, a long time. When you’ve had to deal with sole proprietors, we’ll do the reverse, how often are their books actually in order?
Jeff: Not very often.
Toby: Yeah. The IRS beats you like a drum 94%–95% of the time. What I say is, let’s stay out of harm’s way. Do this as an S-corp. It’s not even a question. The only question is, will the broker pay the S-corp? Even if they won’t, we still have a work around, and you’re going to save money. It’s going to put money in your pocket. It’s going to save you.
Again, if somebody says, hey, $5000 a year, and all you got to do is an extra tax return, by the way, that’s not even really true because the Schedule C in the 1120-S that you file as an S-corp, Schedule C is what you file as a sole proprietor on your personal tax, they’re almost identical. It’s the same information you’re filing.
Again, that’s why I get so frustrated with these folks that say, oh, the formalities are not nearly as I was a sole proprietorship. Yeah, they are. They’re every bit as hard. From a tax standpoint, there’s no real distinction. But I get to save a whole bunch of money if I make money.
I’ll take $5000 a year on $50,000. It usually is right around 7%–10% that it saves you. I’ll take that action all day long. I’ll work my butt off and I’m trying to get a profit. If I can double my profit just by the type of entity, I’ll take that in a heartbeat. That’s a really nice vacation every year if you’re getting extra. I’ll do that all day long, even on Sundays.
“At what point of my real estate operation should I move from a single owner LLC to S-corp for tax purposes?” What do you think, Jeff?
Jeff: If we’re talking about investment real estate, rental properties, you don’t ever want to put them in an S-corporation. It’s a bad idea.
Toby: If you are investing in real estate, I’m just going to reiterate that, do not put it into an S-corp. There are tax consequences. It’s rare that you do it in S-corp, I’ll just put it that way.
Sometimes when you buy your own house, and you’re doing it on an installment sale, you’re trying to get your 121 exclusion, you opt out of the installment sale, and you have a big depreciable asset, say an S-corp, that’s really the exception to the rule. Otherwise, what Jeff just said, write it, put it in big bold letters, and circle it. Don’t put your real estate investments in an S-corp.
Jeff: You could put them in a partnership. One of the advantages we’ve talked about in the distant past is bankers or lenders tend to look at rental income from a passthrough entity more favorably than they do your standard Schedule E rentals on your 1040. I’m not sure why, but they do.
Toby: Here’s the reason. A lot of times when you’re underwriting, Freddie and Fannie will say, here’s the rule. If it’s on page one of your Schedule E, which means it’s a disregarded entity and it’s flowing onto page one, what they said here is a single owner LLC and they have rental properties in it, they only use 70% of that net income. Versus if it’s on page two, they’ll use 100% of that income. It’s small distinguishing, but it makes getting loans and levering those assets a little bit easier.
We’ve seen that, and then the other thing we’ve seen is, especially if you’re selling real estate that requires financing, I see this mostly in commercial, but if you don’t have a separate tax return for that particular property, it makes underwriting next to impossible for somebody who’s acquiring it.
I know that Clint had a client that came in. I think they were in two failed transactions, and they were trying to figure out what was going on because they had buyers, but the buyers couldn’t get through underwriting. Clint spotted it pretty quick. He said, is there a K-1? Is there a 1065 on this business? They said, no, it’s just me. It’s going to my personal return.
It was an LLC, single owner, disregarded, going on to the individual’s tax return. We figured out pretty quickly that in underwriting, they were requesting the tax returns for the particular property, and there were no tax returns that they could provide because it was going on to a 1040. The person wasn’t going to give them their 1040.
Let’s say it’s an LLC, we’re not going to make it an S-corp. We’re just going to make it a partnership. We could just add another spouse, or we could add another trust. We could put something else in there as an owner. Even if it’s flowing on your return, it’s okay.
What we care about is that we have a 1065 that is being filed with that property, especially if it’s highly valuable, especially if it’s a property that’s going to require some financing for a buyer, because it’s going to make their life easier, which makes it more valuable to you when you go to sell. You never want to be that person that’s got something done. And for whatever reason, the way that you’ve set your situation up, that is causing them to fail in their underwriting so they can’t buy your property.
Even though they want to, they can’t get it done simply because they’re missing a simple piece like a tax return. Or underwriting can’t underwrite it because there’s not enough income on a return. Or you find that out like you’re trying to buy a house, your personal residence even, and they’re like, hey, you don’t make enough money. You’re like, but wait a second, I have all this income. They’re like, yeah, but we can’t use it all, we can only use 70% of it. Anything else you want to add to that?
Jeff: One of the things that we seem to deal with constantly is I want to refinance my property. It’s in an LLC or a partnership, which is even worse in this case, and the bank wants you to pull it out.
Toby: Pull the property? Yeah.
Jeff: Pull the property out of the LLC.
Toby: If it is an S-corp, this is catastrophic. If you have to take a property out of an S-corp, it’s considered a payment. It’s like a distribution. You get to pay tax on that. People are like, no, no, I’m just going to take it out, refi it, put it back in. The act of taking it out as a taxable transaction.
Jeff: If it’s in a partnership or in your name, yeah, you have to take it out.
Toby: It’s okay. Your name, single owner LLC, partnership LLC, you could take it out, refi it, put it back in, non taxable transaction. S-corp, C-corp, LLC taxed as an S-corp, LLC taxed as a C-corp, taxable transaction to take it out and refinance it.
Jeff: One thing I’ve noticed, Toby, is a lot of people go to one mortgage broker, bank, or whatever, and it doesn’t feel like they shop around. The bank starts making it hard for them. They don’t seem to say, well, I’m going to go check out my other options.
Toby: Local banks are great and then people that actually understand real estate. We have them. If you’re an Anderson client, you already have Anderson’s funding department. We have lenders that will lend just to the LLC. They’re non recourse loans. We have lenders that do portfolio loans in the funding community. We have plenty of folks that love real estate, and they know it’s a good bet.
Jeff: You said non recourse loan, and I don’t know if people realize how huge that is. That means the LLC is on the hook for that loan.
Toby: And you are not.
Jeff: You are not.
Toby: Yeah. The holy grail of real estate investing is when I don’t have to worry about it. It’s like Donald Trump. I think he famously said, you only borrow a little bit from the bank, it’s your problem. You borrow enough, eventually it’s the bank’s problem. We want to make sure that they’re not looking at me, that I’m not on the hook for it. You want to make sure that it’s just the asset.
There are lots of asset-based lenders that once they get to know you and they know what you’re doing, they will loan on just the asset, and they won’t hold you responsible. Again, you have to create a relationship with these folks, and they’re very specialized. You’re not going to get that going to your local bank, unless it’s maybe a credit union or a very small local regional bank. Boy, those guys have been under fire lately, so lending right now is tough.
“If I transfer my rental property into an LLC for the purposes of depreciation, will the LLC get a step up and basis to the current market value of the property, or will the LLC inherit my lower basis?” This will be question number one. It looks like there are two questions. “What does the LLC receive? If I contribute property into an LLC, does it magically get to start depreciating this thing at a higher amount, or are they stuck with whatever the basis was that I bought it at?”
Jeff: If you contribute a property into any kind of entity that you own, it gets your basis. If I contribute my house that’s worth $350,000, but I only paid $100,000 for it, $100,000 is the LLC’s basis. There’s another rule we don’t ever talk about because we haven’t seen it happen so long is, if I bought a property for $200,000, and when I put it into service in my LLC and it’s only worth $150,000, your basis is now $150,000 in that for depreciation.
Toby: The fair market value or the depreciable basis, whichever one’s last, right?
Jeff: Yup.
Toby: Here’s the thing, this is very simple. The LLC isn’t inheriting it. It’s not going to get a step up in basis, it’s just going to get your basis when you contribute it to the LLC.
Question number two, “Do unrelated businesses have two separate Schedule Cs or LLCs, or can I rebrand myself on my Schedule C, DBA, JL Enterprises and put everything together? What are the advantages or disadvantages?”
Jeff: We can talk about grouping, but most times I don’t see a whole lot of advantage to grouping, unless it’s a real estate activity with an operation or something like that.
Toby: Active businesses. In this case, let’s say that one’s a pizza shop and one’s a plumbing business. You wouldn’t put those on one Schedule C. Technically, they’re separate. Could you do a DBA? For you? Yeah.
Could you do two businesses? Let’s say that I had a pizza business and I have two locations. One is Summerlin Pizza and the other one is Southern Island Pizza. I could set up two DBAs. There’s no problem doing that. I wouldn’t because we don’t like sole proprietorships, so stop it. We want to make sure that it’s some sort of business.
There are other options that you still have available to you. Like you mentioned, LLCs, it looks like disregarded LLCs. But if you’re going to have an active business, you might want to make it into that S-corp again. That S-corp could have something called QSubs, which are qualified as subsidiary LLCs or Incs that are all ignored and put onto one tax return, regardless. Or you could just have disregarded LLC, and you could have different businesses, different locations, whatever not. You could have one parent, and that’s a holding company again.
Jeff: All true.
Toby: You have options. Let’s just scramble them eggs. It is one of those things where you just want to sit down with an accountant or an attorney that knows what they’re doing. Do not go to the H & R block. Do not go to some chain thing. Do not go to the person that does not do businesses. Go to people that actually deal with businesses day in and day out.
Anderson is a perfect example. Just talk to us. We do this 20 something years, 25–26 years. Talk to people that actually do it day in and day out because there are nuances to these things, you’ll get all your options, and you can make an intelligent decision, as opposed to just doing what you heard or what AI told you. I think everybody’s using AI now.
Hey, look, there’s Clint. We do the Tax and Asset Protection workshop. I think I mentioned it earlier. It looks like we have several coming up, including a live four-day event, which is going to be really, really cool. We’re going to go over in day one, it’s an Infinity Day, which means we’re going over stock trading, real estate trading, and even residual businesses, meaning businesses that create residual income.
It’s going to be a fun day. We’re going to be hitting that, plus three days of tax and asset protection. Believe it or not, you’re going to have four days in Vegas. That is September 14th through the 17th. The free live virtual events that we do on the weekends, there’s August 5th and August 17th. Those are great.
If you want to learn about land trusts, LLCs, corporations, S-corp, C-corp, taxation of real estate, and even some legacy planning, we go over it all. If you want to know about bonus depreciation, 1031s, 121s, writing things off, administrative office for the home, all that fun stuff, we knock it out during that event.
It’s absolutely free, and you could absolutely register. Do so. It looks like August 5th, that’ll be coming up here this weekend. By all means, I would jump in there and continue to educate yourself.
Let’s talk about death and dying. Somebody says the father’s will. “In my father’s will, he’s leaving me a house. I’ve been living in it for nine years. If he puts my name on the title now along with his name, will I have to pay more taxes? I prefer to do that now. What would the difference be? He does have a living will.”
Jeff: Okay, we discussed this a little bit previously. What happens here is if he puts you on a joint tenant or right of survivorship, he is actually gifting half of his interest to you. He would have to file a gift tax return for his basis in that half, or actually its fair market value on that half.
Toby: The fair market value on that half is not his basis. You’re right. It depends on the value of it. I can’t imagine a case where it’d be underneath the exclusion. There’s $17,000 a year or $15,000.
Jeff: Yup. $17,000 this year.
Toby: $17,000 that you can give to somebody without having to report it. Otherwise, we all have $12.95 million lifetime gift exclusion and estate exclusion. You could use up some of that if you really want to, but I wouldn’t. There are several things that come into play. Let’s say you want to knock them out.
Jeff: No, go ahead and talk about what jumped out to all of us.
Toby: Yeah. When you gift an asset, the basis of that asset is what you get. You’ve had this house for a long time, it’s probably appreciated significantly. If the father does nothing else and just passes away, you get the new basis. It’s the step up and basis. It’s the fair market value when he passes away.
If you sold that house immediately after he passed, you wouldn’t pay any tax. The way you’re doing it now, your basis is going to be his basis on your half. No matter what, you’re going to end up paying a bunch of tax. You’re going to have gain that you would have otherwise avoided had he not done it.
Number two, I just don’t like joint tenancy on non-married partners. Your dad, again, he gets sick. You’re liable on that. The house can be used to extinguish that debt or vice-versa. If you do something, you could just cost your dad his asset. Because all of a sudden, they can come in and take it if you’re a joint tenant.
I’m not a big fan of mixing things up under these circumstances, I get what you’re trying to do. There’s just such a big benefit in the step up and basis. Last thing I would say is when you say a living will, that’s an end of life decision-making device. That’s not a living trust. I’d make sure that the property is actually in a trust so that you don’t get tied up in any proceeding.
If you did, so you ignore what we’re saying. You say, hey, I’m okay. I’m not going to sell the house ever. I’m not worried about the step up in basis and losing tax benefit. And you decide you want to do the joint tenants with right of survivorship and not a tenant in common, but you say we’re going to be joint tenants, then you don’t have to worry necessarily about the living will or the trust because when your dad passes, you’ll be the surviving tenant. You’ll automatically inherit that property.
I just have to say, I’ve seen this. I saw this with four siblings. Dad was worried that the estate tax exclusion was going to go away. This was 15 years ago or thereabouts. It used to be a million dollar exclusion. When I started, it was $600,000 exclusion, then it went up to $5 million. It’s been all over the place. Right now, it’s really huge.
Dad was really worried about losing a big chunk of his building to the inheritance tax, the estate tax is when he passed away. His accountant put it in a limited partnership and gifted a big chunk of it to the kids. Dad passed away, and it was the year that there was no estate tax. The exclusion was unlimited.
Jeff: 2010.
Toby: Yup. The kids inherited that property, but they didn’t get the step up in basis. It was millions of dollars. They sold it. They came to me and we’re like, how do we avoid the tax on this? Our accountant is saying we’re going to owe more than seven figures. It was a big chunk of money. You can go back in time and yell at the accountant, but he transferred it. You got his basis.
If they had done nothing, they would have paid zero tax. But because of what they did, they ended up paying more than a million dollars in tax. I just remember, this is really not a fair result, but the accountant talked him into doing it, so I tend to be like […].
Jeff: You know what? My mom lived in the same house for a really long time and moved at the age of 89. The reason I bring that up is if you do this joint tenants thing and your dad does decide, now this house is too big, I want to get out of it and all, his section 121 exclusion which would have been pretty important to him, is now very confused.
Toby: Yup. He’s not living in it. The kid has been living it for nine years.
Jeff: I was assuming his dad was living in it.
Toby: Yeah, but maybe the dad’s in there, too. We don’t know, it doesn’t really specify. He’s leaving me a house. It says a house, not his house, so I imagine that it must be […]. The 121 exclusion requires that you live in it two of the last five years as primary residence and that you own the house.
There are some weird little exceptions for married couples, divorces, when somebody passes, and things like that, but that’s generally the rule. You live in it as your primary residence not as a secondary, but primary, and you own the property.
In this case, the child’s been living at for nine years, but they don’t own it, so they would not get the 121 exclusion. Again, I would just be like, don’t do anything. I would just say, hey, you know what? Make sure that it’s in an estate plan. Use a living trust. Make sure that if something happens to dad, there’s no tax, and it’s so much better.
Jeff: At a minimum, your dad should have a living trust. He can have a living will. Living trust is what they pour over will. The pour over will just pick up all these assets that aren’t.
Toby: Yeah, just put it in the living trust. Fund that trust. All right. “We are fixing the downstairs area of our home to rent out as a short-term rental.” Guys, short-term rental just means average usage is seven days or less. Are there any expenses that can be used in tax deductions? Should we run it under an entity? Jeff.
Jeff: The part I had an issue with was, if this is a house you’re living in, I’m not sure you can put it under an entity just for that business portion.
Toby: Some people do. It’s called house hacking. They’ll put the whole house into an LLC, and they’ll take as much of the equity out of the house as they can so that if there is something that happens, there’s not a lot for a creditor to take. Chances are it will be somebody that’s renting it. Let’s say that they rent the downstairs and they fall down the stairs, busts their head, and they sue you for a gajillion dollars, you don’t want them to take your house.
Number two is if they’re downstairs in a basement area. I can’t see this happening with a short-term. But in long-term, you’ll see people, it’s a moist area, they’re not really cleaning, and they end up getting a little mold. They say, you’ve caused me irreparable harm. In California, those things are seven figure cases.
What you’re looking at on the short-term rental is, hey, let’s put a box around the house, which is an LLC. Don’t worry, it doesn’t ruin your 121 exclusion. Generally, you’d want to look at the state and make sure it doesn’t cost you a homestead if you have one. That’s number one, two is short-term. What is short-term rental from a tax standpoint?
Jeff: Short-term rental is considered a trade or business. It’s ordinary income if you make a profit on it and you’re materially participating. You can also be paying self-employment tax.
Toby: We would depreciate. Somebody says, we’re fixing the downstairs area. The repairs that you’re doing down there would be deductible. If you’re doing improvements to the property, it would be depreciable. You’re going to get to write those things off eventually, even if it’s not this year, but there’s a good chance you’re going to write off a chunk of it on that portion of the home.
Jeff: Yeah, if you’re drywalling, partitioning, putting in a bathroom, that’s all going to be improvements, and you’re going to have to depreciate that. If you’re repairing damage to the home, where you’re just restoring it to where it should have been previously, that’s deductible as a repair.
Toby: Yes. Keep in mind that this is an area of the home. Let’s say we have the basement, we have the upstairs. In the upstairs, you decide you’re going to fix up and improve the kitchen. You can’t write that off to the downstairs. The downstairs is its own little area. The IRS says you just treat it like it’s its own little portion.
If it’s square footage, you could use depreciation based on the square footage of the house. But the repairs and everything else are for that actual work that’s being done, and things that you’ve done down there. You’re going to get a nice tax deduction for doing this. It’s called house hacking, it’s very common. It’s very profitable because it’s just extra space.
By the way, we would solve the housing crisis tomorrow if everybody put their empty bedrooms up for rent. We could fix it, and then you’d have a bunch of strangers living in your house. I always think of stuff like that, and I realize how many people have extra bedrooms. I’m always like, those are little money-making machines if you want them.
I had plenty of clients that did the house hacking and moved because they were making so much money renting the rooms out on a weekly basis in some cases. They eventually bought more properties and did it again. I have one girl, she did three properties and retired herself. She was making $17,000 a month in Tacoma, Washington.
She just kept moving. She was like, this is great, because there’s not a lot of affordable housing up there. She did that with multiple houses. She’d buy four and five-bedroom houses. and keep doing it.
All right. A lot of fun was had today. If you like this type of information, I’m just going to say go to my YouTube channel. We record these Tax Tuesdays, and you’ll see them put up as videos. Usually, it says Tax Tuesday somewhere on the thumbnail. It will say, here’s the topics we covered, and then it will say Tax Tuesday.
If you like this type of information, if you like feeding your little tax-ish, you can go in there, look around, and see, are there other ones that I haven’t attended yet? And go and see whether or not that interests you and if there are any topics that hit you. Somebody says, wow, you really didn’t finish in one hour. We used to do really long ones.
Jeff: Yeah. An hour-and-a-half, two hours. Never ever two hours.
Toby: We have so much fun. I forget how many we’ve done. Hey, Patty, how many of these have we done? Do you remember? Is it over 200? We’ve been doing these for a long time, but sometimes we go a little nutty, 200 next time. All right.
Jeff: I think we used to go longer in the past because you’d have to translate what the accountants said.
Toby: Accountant translator. I took bonus depreciation. I did a $168,000 deduction on the 15-year property only and not the seven and the five. We opted out and I’m like, guys, stop that.
All right. Tax and asset protection event. Make sure that if you haven’t been to one that you do register. They are worth it. They’re fun, and Clint’s a really good speaker. I’m decent. We’re going to hit you up with all sorts of good stuff on land trusts, living trusts, Wyoming statutory trust, Wyoming LLCs, other state LLCs, series LLCs, S-corp, C-corp. You’ll learn all about those.
Somebody says, you have to interpret what I say. Sometimes they go a little quick. All right, if you have questions that come up, if you’re just sitting there with a burning question, I’m going to sell my house and made way too much money on it, how do I avoid tax on that, shoot it on in at taxtuesday@andersonadvisors.com, or just go to our website and visit us there as well.
Thank you to—I’m going to see if I can see all the names on there right now—Dana is on, Dutch is on, Eliot’s on, Jared is on, Ross is on, Tanya is on, Troy is on. I even saw Sergey in there, Patty, and Matthew. They answered over 184 written questions. There are still a few more.
What I will say is this. I’m going to end the presentation now, but we will not kick you all out. If you have a question that’s pending, you go ahead and wait. We will answer all of your questions. We are not going to leave you hanging. I just want to say thank you so much for visiting us, and we will see you in a couple of weeks on the next Tax Tuesday. Thanks, guys.
