Jason invites Diane Kennedy on the show to talk about taxes and how to save you money. Diane is an experienced CPA and helps her clients all over the world with their taxes, accounting, and investing. The main subject of today’s focus is why you should get real estate professional status, the benefits it provides, and what you need to do in order to qualify.
Key Takeaways:
2:40 – The government takes a big cut whenever you sell stocks and precious metals, but that doesn’t happen with income property.
7:40 – Diane explains what the charitable remainder trust is.
13:05 – There are three tests you need to qualify in order to get the real estate professional status.
20:00 – What is the an aggregation election? Jason explains.
29:50 – If you have a property manager, it’s going to be hard for you to qualify. It is best in this case to self-manage your properties.
34:15 – This stuff is complicated! Get advise from a good CPA and attorney before it’s too late.
36:00 – Why do you even want to get real estate professional status? Jason breaks it down.
42:30 – The government wants you to own property. They are even incentivizing you for it.
Tweetables:
“If I got a manager who is not that great, I just get rid of them and I’ll self-manage that property.”
Mentioned In This Episode:
USTaxAid.com
Transcript
Jason Hartman:
Welcome to the Creating Wealth show. This is your host Jason Hartman. This is episode number 491. 491. Last episode number 490 we had Peter Sage on and as you now every 10th episode we go off topic and do something of general interest. So I hope you enjoyed that, but here we are going to focus on life’s largest expense and how to avoid as much of it as possible and what is life’s largest expense? It is taxes, taxation. And income property is the most tax favored asset class in America, so we have CPA Extraordinaire, that’s the title I’m giving her, and that is Diane Kennedy with us again. Diane, welcome, how are you?
Diane Kennedy:
I’m doing great. Thank you, Jason. I love that title. That’s awesome. Thank you.
Jason:
You can use that one, I’ll license it to you.
Diane:
I’ll put a little TM after it.
Jason:
Yeah, there you go. Exactly. CPA Extraordinaire Diane Kennedy. So, Diane, you know, income property is so tax favorites in so many ways. I am engaged in a couple of 1031 tax deferred exchanges right now and that’s one of the seldom. I mean, I guess it’s talked about a lot, but you know, it’s not used a lot, because we only use it when we sell a property, but it is an incredibly beneficial thing and over the course of several years, you know, if you’re trading stocks, if you’re buying and selling businesses or you’re starting a business and you’re selling it, you don’t have this tax favored treatment.
You know, you sell stocks, you gotta pay the game and when you look at it over the course of time and I love to do some pro formas on this, but we haven’t. If the government is taking a big cut out of it every time, if you’re selling stocks, if you’re selling precious metals, if you’re selling your business, you’re paying the government before you get to put that money back to work into something else. With income property, ha, you can put it all back to work and further gain indefinitely.
Diane:
You know, it’s great. In fact, there actually is a term for that. It’s called tax drag and it’s something economists look at when they’re comparing countries and there are a potential for economic growth. You have to look at what the tax drag is. So, just as an example you just using there, let’s say you sell a stock and you get capital gains, hurry, you get a lower tax treatment, but right now that’s almost 24% you’re paying at the highest rate, so that means you only have approximately 3/4s of that money that you get to then re-investing and absolutely that’s something that hurts you.
I have to comment on the 1031 exchange that you were just mentioning. You would just die, Jason. I got this email from a guy about a month ago and he said he heard about the 1031 and he had a deal and his profit was about half a million dollars on a property and he said, “Yeah, we just closed escrow a couple of weeks ago and now I’m wondering if I can 1031 it into something.” You know what the answer to that is – no, he couldn’t. It was too late. He closed escrow. I was just like, “Oh! Why didn’t you talk to me three weeks ago.” Because it was so close and he said, “Well, I still have the money in the escrow company. Couldn’t we do it?” It’s like, no. It had to be setup before hand.
So, the 1031 exchange that is something that if anybody is listening to this and you’ve got a property that’s got a lot of gain on it or maybe you’ve held it for a long period of time, so you have a lot of accumulated depreciation, that means a lot of tax. If this is something you’re interested in, check it out now. Don’t wait to let the thing close, because then it’s just too late.
Jason:
Diane, you know, that tax drag that you mentioned, that’s a great, great term by the way. The tax drag and all the other investments, when Einstein called compounding interest one of the great miracles of the universe or something like that. He has some quote like that, you know, it really is amazing, because you’re re-investing and if you live in a place like the socialist republic of California or New York, you know, you’re re-investing even less than 3/4s of it, but say you don’t live in one of those states and only the feds are taking their cut or most of the cut is from the feds, you’re only re-investing about 3/4s of that money.
I mean, over the course of a couple of decades. I mean, that is a major difference when you’re buying and selling stuff and wow, that just kills you. I mean, compared to the income property, you get to re-investing it all and let it all keep growing and then, even better, when you die, which who would think that’s better, but for your greedy unwashed heirs, you know, they can fight over your fortune. You can really leave them a lot more. Tell us what happens when someone passes their wealth on to the next generation? I mean, with income property it steps up to market value, right?
Diane:
Exactly and so what we have – that’s called a stepped up basis in the value of the property, so let’s go back to that building. You may have paid half a million dollars for it and overtime you depreciated it to where it’s maybe only showing up as a book value of $250. You’ve depreciated half of it, but maybe that property is now worth the million. When you pass and your heir picks it up. They start all over at a million. It doesn’t matter how much was appreciated, it doesn’t matter what the basis was when you bought it, it just steps some basis.
Jason:
So, in other words that means you have no depreciation recapture.
Diane:
Correct, yeah.
Jason:
Okay, so, that’s phenomenal. So, you can basically, this by the way is not really the topic of the show, we’re going to talk about real estate professional and depreciation using it now, but because I’m involved in a couple of 1031 tax deferred exchanges myself currently and we were, you know, talking about it on Facebook. Some people were asking questions about that. It’s just a phenomenal deal. So, what happens there is your heirs get that. I mean, they don’t re-capture anything. It steps up to – wow, you can trade it all your life basically tax free, technically tax deferred, but it’s tax free if you don’t sell it and you always exchange it, it’s always tax free. You can do it as many times as you want, so it’s not like you get to do it only two times. You can just keep doing it your whole life and then you can pass it on to your heirs and you pass it on at the stepped up basis so they pay no tax. I mean, there’s nothing else that does that, right?
Diane:
You’re absolutely right. You know, the other part of this though is there’s a step in between. Like you said, I know this isn’t the topic..
Jason:
But I always get off into tangents, my listeners know that.
Diane:
It’s called a charitable remainder trust.
Jason:
Oh yeah, the CRT.
Diane:
The CRT, oh boy. Real quickly the way it works if you have a lot of property that’s really appreciated and you’ve been doing 1031s and the way that works is you roll over your basis of the prior property, so it’s not really tax free, it’s just tax deferred, and so the basis keeps reducing as you continue to depreciate and you do a couple of rolls and let’s say somebody gets older, they’re now looking at these properties that are all depreciated, maybe they don’t want them anymore. W
ell, the idea, so you don’t have to do another 1031, is you can put it inside this type of trust and the charitable remainder trust, the idea is the beneficiary eventually is a charity, something that’s a 501c3 or 501c9. Something that recognizes a charity, then because it’s inside that trust. You can sell it. There is no tax at all and you setup the trust in a way that the income flows to you.
So, you can continue to make money without that tax drag we talked about and then down the line typically what happens is you also buy life insurance as paid through that trust, so that your heirs don’t end up with any, you know, nothing, because you’ve given it to a charity. For the right property and at the right age, that’s just, it’s an absolute gift with something like that, because when you donate it you also get this huge right off, so as I’ve said, you’re getting older or you have parents maybe that are a little older with a lot of appreciated assets, this can be a great thing to put them in, because they have a lot more money then.
Jason:
Do you believe in the whole life insurance as an investment concept? I remain skeptical even though I did buy a policy, you know, I mainly did it for asset protection. I’m still not convinced about the investment angle, really.
Diane:
Personally, I bought a plan 25 years ago and so my insurance premiums were quite a bit lower and it was a whole life policy and I have to say, I don’t even know – I don’t sell insurance, I don’t know what the plans are like now, but it had a guaranteed return in it and it after, I don’t know, 3-4 years of paying it, I’ve never paid another premium and there is a cash value that’s built up in that that I’ve actually borrowed, you know, to go buy a car. So, it’s my own money that’s in there and I’ve been able to grow it and it is completely, I mean, as long as I take loans out it’s tax-free. So, is it the best investment there is? Absolutely not. I make way more money on real estate, but is it another way of some asset protection? Perhaps, but I think you need to do this when you’re younger. I mean, if you’re waiting till you’re 50 to go get a life insurance policy, your premiums are going to be higher. So, I think it needs to be earlier.
Jason:
Let’s dive into the actual topic of today’s show, okay. I want to talk again and we’ve done episodes on this in years passed about the real estate professional status, because it is the thing we just so many questions on. I know Diane you get many questions on it and I will just say in my opinion is the holy grail of tax benefits. It is awesome. It is phenomenal. I don’t know that there’s any thing better under US law in terms of tax benefits than the real estate professional tax benefit.
Now, a couple of things before we dive into it. I want to say, number one is you don’t have to be in my business. You don’t have to go get a real estate license, although that may help you, it probably wouldn’t hurt, but it doesn’t mean you’re in the business of real estate as the way you’re probably thinking of it, dear listener. It means it’s an IRS designation of being a real estate professional, which really means that you spend a certain amount of time investing in real estate and this is I want to say may actually be worth changing the way you or your spouse engage in your own career if you’re going to take real estate on as a serious thing in your life and it’s pretty worth while to do so. So, tell us what it is, how it works, and how someone might qualify for it, Diane.
Diane:
Sure. Let’s start off with why we care. First of all, the way it works with real estate is there’s a lot of things we can do that even though you’re putting cash in your pocket on paper, perfectly legally, we can say we have a tax loss and that’s through the magic depreciation.
Jason:
Beautiful.
Diane:
I love that. Phantom expense, we love depreciation. Phantom expense, because it doesn’t cost you cash. However, if you make under $100,000 dollars, adjusted gross income, you can take that right off of that real estate against your other income up to $25,000. So, as long as you have less than $25,000 dollars in real estate paper loss recreated and your income is lower than a 100, you’re fine. However, if you make more than a $150,000, then you can’t write anything off, between $100,000 and a $150,000 is the amount you can write-off phases out.
This is where that magic of that real estate professional status comes to play, because if you are qualifying as a real estate professional, then you can take 100% of that real estate paper loss against your other income no matter how much the loss is, no matter how much your income is. So, that’s why we want to do it. Now, there’s a million ways to do it wrong and it’s only one way to do it right.
Three tests, the first is you need to get at least 750 hours in real estate activities and that could be just like Jason was saying, that could be you have a real estate license or maybe you’re in construction, that counts as well. Maybe you’re just managing your own properties, that counts too. At least 750 hours a year and you have to spend more time doing that then any other job or profession that you have.
Jason:
That’s the hard part, okay. So, let’s review. Just review that. Say it all again, because it went by quick.
Diane:
Okay, so remember again. Three tests, number one is that you and, by the way, if you’re married filing jointly, you or your spouse can meet this qualification and you get this benefit on your tax return, so you or your spouse have at least 750 hours a year and more hours in that real estate activity or real estate profession than any other profession.
I have a story, a client of mine came to me and he was a very highly paid – he was a cardiac surgeon, tried to remember what his profession was, and you know those guys make, I mean, he was making about half a million a year, net. He’s wife worked part time like one or two days a week as a nurse, because she wanted to keep doing something and they were buying a lot of apartment buildings and they tended to buy stuff that needed to be fixed up and she spoke Spanish, so she was really good at going on and making sure the crews were all working. This was down in Miami area and then they’d rent it up and they were making good money plus they had phenomenal write-offs, but because of his income, they couldn’t take those write-offs and the way it was, because of where she was working as a nurse. She didn’t have enough hours in real estate activities to qualify as a real estate professional. So, the first thing we did is had her quit her job.
Jason:
So, that’s what I’m saying, Diane. It may actually be worth it. This is one of the, it may actually worth getting married if you’re single, like literally just for this, because only one spouse needs to qualify for it. I mean, literally this is, if you have, you know, if you got 8-10-12 properties or more and I’m talking, when I say properties I’m talking about single family homes or if you have an apartment building or something. This literally could be worth changing your career and honestly, it could be an incentive to get married.
Diane:
Get a prenup! Okay, but anyway. So, she got really excited and they started working in this and immediately because of depreciation, because we also got great tax credits, she was providing low income housing, we got low income housing tax credits that went directly against the tax they paid within, I mean, the first year their taxes were cut in half and the second year they weren’t paying any taxes at all. Now, half a million dollars, we’re talking about, about $250,000 and about $150,000 in taxes wiped out! By the end of five years, they had so many properties that they damasked, they made as much cash flow off of those as he did working as a doc. You make an extra $150,000 a year, you can put that right back into buying more real estate.
Jason:
Yeah, it’s just amazing. I mean, this is a big deal. So, only one spouse needs to qualify. 750 hours total per year, which is only about 15 hours per week, that’s not that big of a deal, really, and 500 hours of material participation, right?
Diane:
That’s test number two and that test is that you have to have material participation and there’s actually three different ways you can get it, but I know Jason you ran into this one, because you have..
Jason:
Yeah, because I was audited over it.
Diane:
Yeah, and you had the auditor counter from hell there.
Jason:
Yep.
Diane:
They were asking you..
Jason:
But, I won.
Diane:
But you won! You were tougher than the dogs from hell.
Jason:
Well, you know, they wanted me to just give in and, you know, there’s a matter of principle I’ll just fight to the end. I’m just not going to give end to that type of thing, because I kind of figure and this is a little tangent, I kind of figure how many people is the IRS doing this to, right? I sort of kind of view it as my duty as a citizen, you know, as a psychotic as this may sound to spend $30,000 with my accountant to fight the IRS and I didn’t know I was going to win. Now that I did win, I mean, it was well worth it, because I got way more back than that, but you know, I just viewed it as my duty for other citizens who were going through it, because if the IRS, they view things like a business too and they don’t want to spend a fortune auditing people. It costs them resources and time and money and so forth to do it, so I just figured I kind of had to do it to send a message. Yeah.
Diane:
So, the material participation. I mean, the one they were trying to hang you on was that 500 hours, but you can also qualify in a couple of other ways. One is that you have at least 100 hours a year on that property of material participation.
Jason:
On multiple properties or?
Diane:
Yeah, that’s kind of when we get into test three, but in this case we’re just talking about per property. It is possible to arrogate them and I’ll talk about that in just a sec, but that 100 hours and more than any other person and this is where the IRS gets kind of upset, because they figure you’re not doing as much as a property manager is. You can win that. You don’t necessarily have to get the 500 hours as long as you can prove you’re spending more time than the property manager is and then the third one is that you’re spending more time than everyone else combined and there is no limit on that. In the case that I was just talking about, my client she absolutely spent more time doing that, because she was out there on the construction sites and was making sure, you know, picking out the colors and doing everything as they were rehabbing all of these apartment buildings.
So, it’s possible to do one of the other three, but the other part of this and this is step number three of part three of this test is that you have to have that amount of hours in each property unless you make an arrogation election and that’s an election you actually make with your tax return and say that we’re electing to treat all of these properties as the same.
Jason:
I did that as a single entity. My account did that for me years ago. So, you call that an arrogation election and all that says is that if you have a portfolio of a dozen single family homes and there’s that 100 hour rule you mentioned where you’ve got to spend a 100 hours on, you said, that property and you also said something like more than anybody else, right. So, what you want to do if you don’t have one big property, but you have a dozen small properties, a dozen single family homes for example, is you want to take the aggregation election and all that is, because I saw it on my own tax return, it was just a page, a piece of paper, attached to the return that says, tax payer elects to treat all property as a single entity. I think that was the words he used, does that sound right, Diane?
Diane:
That’s exactly correct, yep. Just a little tidbit here, I’m trying to remember exactly when this came about. It might have been right about the time you were having your audit. It used to be that the IRS did not let you go back and make that election, and so this was one of the little ‘gotchas’ that oh my gosh, I didn’t realize I had to do this election and you never did so you’re in trouble, but they now, there’s been a case law where they have to allow you to go back and make that election, so if you happen to get audited and you’re going, I never even heard of this until this podcast, don’t worry about it. You can go back and do a retroactive election on this.
Jason:
How far though can you go back?
Diane:
You actually, you can go back as long as the year is open and by definition, you know, the statute of limitations is really, by definition if they’re auditing you, it’s an open year, because they can’t go back and audit a closed year.
Jason:
Okay, but you can only, you can only go back a year or..?
Diane:
No, the statute of limitations for the feds is three years, so it would be and that’s all they would be auditing you. They can’t go back further than that. So, if there are auditing you, it’s an open year and you can make that election.
Jason:
Out of everything you’ve said, if someone’s a, you know, if someone is not a tax professional like yourself. What are they just going to miss about what you said. I just want you to kind of review again, because I know people are thinking aggregation election, 500 hours, 750 hours, more than anyone else, you know. One of the ways that will help you, by the way, to qualify for this is if you self-manage your properties or at least if you self-manage some of them.
Let me just share my own rule and experience on that. I’ve talked about this on many prior episodes, but several years ago I was surprised to learn that I could self-manage effectively a property I’ve never seen, a tenant I’ve never met, and it was 2,000 miles away from my home. I never really thought that was possible until I actually did it. It happened to me by accident. What happened was the property manager got out of the business, he sent me a letter, and in typical Jason Hartman fashion, I was busy and I didn’t get around to hiring a property manager and suddenly the rent check comes in with a nice note from the tenant: hey, I hear the property manager isn’t in the business, so here’s my rent.
I’m like, oh, well, I guess I’m suddenly managing this property myself now and he, you know, included his phone number and he said if you need anything let me know. I’m thinking, wow, the tenant is saying this to me. Isn’t that a turn of tables? Like I, you know, we sort of expect the tenants to say, I need something, you help me, but this guy was so nice and his name, I think his name was Tony by the way as I recall. He’s not my tenant anymore, but he was for several years after that.
We had a very fine relationship as a self-manager and one of the things, Diane, that I discovered that amazed me. Is that when, now I have many self-managed properties around the country. Tenants I’ve never met, properties I’ve never seen, can’t believe it’s even possible and do-able, but my criteria is that if the manager is good, I just keep him and everything is fine, leave well enough along, but if I got a manager who is not that great, I just get rid of them and I’ll self-manage that property and that’s sort of my decision maker. The manager basically makes the decision for me based on how good or bad they are.
What I discovered as a self-manager though on the properties I self-manage is that the tenant, when you self-manage, doesn’t seem to ask for very much. I think the reason is is that when it’s a management company, they view it as this big faceless entity and it’s not a person and they’ll just ask for lots of stuff, they’ll say hey, come over and fix this petty thing, but when it’s you, you’re a real person and they have the pressure, the social pressure of sort of wanting to maintain a good relationship with you, they won’t bug you for stuff. They’ll fix things themselves. It kind of amazed me, it’s been a pleasant surprise.
Diane:
You know, we actually self-manage too, so it’s interesting to hear your story.
Jason:
Do you self-manage long distance, though.
Diane:
We do, yeah. We’ve got Phoenix properties and we live in Reno. We don’t right now, but we’ve also had properties in Colorado in the past. Yeah, we’ve been kind of all over properties too. So, the only thing is for us is getting them rent, but once they’re rented, it’s, you know, you find some people that are good to just take care of your maintenance and there you go.
Jason:
I just use a local real estate agent to rent them in between or a property manager to rent them. They’ll do the walk through of the tenant on the way out and the tenant on the way in. They’ll send me pictures and I’m like, you can really do this without a manager. It’s amazing!
Diane:
Kind of putting it in the whole context of what we’re talking about it, how easy i can be to qualify for this. So, the real estate professional status. This is the part where people get confused. There’s two different tests. One is that 750 hours or more than anything else and that’s any kind of real estate activity. It could be taken care of your properties or it could be doing something else in the real estate field.
Jason:
Can it be listening to Jason Hartman’s podcast?
Diane:
Well, okay, now this is interesting, because if it’s getting you ready..
Jason:
Well, we know it’s interesting, Diane, it’s a great podcast.
Diane:
It’s a fabulous podcast! They have to take action first. So, if they’re an action taker and now they’re already doing this and now we’re just listening to Jason Hartman to hone our skills so we can be better at what we’re doing so we can grow up and have a Swank Life, then that counts.
Jason:
You’re funny.
Diane:
Then that would count, but you also need, I mean, if all you’re doing is listening to Jason Hartman, the IRS is going to get a little upset, because they want to actually see you putting that stuff into play.
Jason:
They’re just mad because Jason Hartman won that audit with them.
Diane:
That’s right!
Jason:
And they wasted all that money. Oh gosh, I’m teasing. You know, probably teasing the IRS is not a good idea. I apologize. Don’t come back and audit me again please. That was a real hassle, even though I won, it was a big hassle.
Diane:
Avoiding the IRS audit is definitely the best thing to do, but on the other hand, you know, do it right so you don’t have to be afraid as you get through it, but the part that gets confusing and I’m not even sure the auditors always get this part right, but it is separate. The 500 hours or 100 hours or whatever material participation, that’s for the property, but the real estate professional could be for the property or it could be for a whole bunch of other things. It could be getting a real estate license and showing other people property. It could be doing construction work. That’s a great one. I have a lot of contractor guys who qualify as a real estate professional and then they’ll buying stuff to fix up and hang on to too.
Jason:
So, the self-management will help you. Now, one of the questions we get occasionally, does it matter or does it help if I have a real estate license? It’s pretty easy to get a real estate license in many states, unfortunately I’ll say, does that matter?
Diane:
If that is what you’re going to do and you’re actually spending time doing that, you’ve got clients, you’re driving around looking at properties, doing all that, absolutely that counts toward that 750 hours.
Jason:
If you’re a realtor, then if you’re a full time realtor, you just automatically qualify as a real estate profession in the IRS’s eyes? No?
Diane:
Well no, you got to meet those hours.
Jason:
But, if they’re a full time realtor and assuming they work a 40 hour week, you know, 2,000 hours a year..
Diane:
Yeah, they qualify.
Jason:
That’s not really in the field of investing, though.
Diane:
Yeah, they would qualify under that real estate professional part of it, that test number one, but do they qualify then on test two, which is material participation on the properties.
Jason:
Oh, yeah, because if they’re a real estate agent and they have one property, they’ll never going to be able they say they spent 500 hours per year managing one property.
Diane:
Boy, that would have to be a hard property, but that’s a case they have to single manage..
Jason:
They got to self-manage.
Diane:
Self-manage, there we go. They’ve got to self-manage it, because then they can have more hours than anybody else.
Jason:
So, there’s the next question and I know there’s no actual number on this, but how many properties does someone need to have in order to make those hours legit? You know, 500 hours of material participation, 750 total per year, so you know, think about it. That’s approximately 10 hours per week of material participation and 15 hours per week of total involved in the real estate investment business and you’re not going to be able to qualify with four properties. There’s no way the IRS will believe you. When I say properties, I’m just assuming single family homes, okay.
Diane:
You know, actually I think I would disagree. As long as you’re getting that 750 hours – I know, I disagreed with you, but..
Jason:
Well, I’m glad. I mean, I want to lose this debate, but I don’t think I’m going to.
Diane:
Well, the real estate professional status will be the key. I mean, if all you’re doing is taking care of these four properties and trying to claim real estate, that 750 hours, that’s not believable, but if you’re doing something else that’s in that real estate field and that’s a case where maybe it makes sense to get your license and be a licensed property manager or be a licensed agent where you’re out looking at properties, but I don’t think that the 500 hours necessarily has to be a concern, because of that other one in that material participation where you prove that you’re self-managing and then you’re doing more hours than anybody else, so it doesn’t have an hour requirement, but it’s hard with a property manage.
Jason:
Yeah, the property manager is going to make it hard to qualify. So, let’s talk about whether and the great thing is if you’re married, only one spouse needs to qualify for both to get the benefits, right? Does that matter if you’re filing jointly or filing separate or tell us about that.
Diane:
You have to file jointly. If you file separately you just lose the opportunity completely and it’s not like one person gets to take it or anything, you just lose it. It’s got to be married filing jointly. You’re single, it has to be you.
Jason:
Okay, that’s good to know. So, what about if, say you, you know, say you’re sort of semi-retired and you have a part time job, but you spend most of your time managing, well, maybe not most, but – well according to the IRS it’s got to be most of your real estate portfolio. So, if you have a job where you’re working 20 hours a week or your spouse maybe who isn’t the major breadwinner has a part-time job and they’re working 20 hours a week, that’s pretty easy to qualify, right?
Diane:
Well, it’s possible. The place I see people kind of getting in trouble with that is maybe they have a business and they might be making a big income and not really working that hard anymore and the IRS might challenging on that. It’s like, yeah, I make $200,000 a year, but I really only work 10 hours a week and that’s possible. I’ve got clients that do that, but in that case what we want them to do is track their hours that they actually work at their job, so that they can prove that. It’s like you have to have two journals. One to prove you’re a real estate professional, one to prove I’m really not working that hard for the money I get.
Jason:
Okay, well, that’s what they say about business owners. They always have three sets of book. One is the real set of books, the other is for the IRS, and the other is for the buyer of the business, right when they sell it some day. That’s sort of an old cliche. I just know our listeners are going to have questions about this. First of all Diane, give out your website.
Diane:
Sure, USTaxAid.com
Jason:
Anything we didn’t cover, anything that based on our discussion today you know you’re going to get a phone call or email about that we didn’t answer.
Diane:
Actually, I want to through another little thing in there to think about. One of the issues if we’re talking about the material participation, you’ve got to also look at how you’re hold those properties. If you’ve got them in an LLC, you want to have a manager manged LLC where your name does the manager. If you for example had a limited partnership and all you all is a limited partner, well by definition a limited partner means you don’t do anything in that, so you can trip yourself just by the business structure you have for the property.
Jason:
Oh, okay, this is good. I’m glad you brought that up. So, if you invest and this is something we generally discourage, by the way, but it’s one of the things I want to kind of cure with my mastermind group, The Venture Alliance – Your Financial Friends and I’ve talked about that a little bit in the podcast as well and more to come on that, but that’s the idea of investing in a fund, investing in a pooled asset, investing in basically someone else’s deal and there are a lot of apartment groups out there that do this kind of thing. They form an LLC and they’re the general partner and they say, hey, you know, invest 50 grand into this deal and you can own part of this apartment complex or whatever, right. So, none of that stuff will help you with your real estate professional status, I assume right?
Diane:
Unless you’re the guy running it, no, it’s not going to help you. It’s treated just like a passive investment in stock or something like that.
Jason:
But what about when it’s your own property and you put that property into an LLC. That’s really what you were addressing, right?
Diane:
Yeah, exactly. The very safest way to do that is, there’s two different kinds of LLCs you can form. Manager manged or a member managed and just have a manager managed and then in your document name you or your spouse as the manager and that just absolutely sows that question up, it goes away.
Jason:
Does it matter if it’s a disregarded entity or not?
Diane:
Yeah, it wouldn’t matter. Just when you form that LLC, disregarded. In other words, it’s like a single member LLC and you just have it come through on your personal return, but make sure that LLC document shows manager manged.
Jason:
I’ll tell ya, folks. You start getting into this whole business of forming all of these entities and life gets really complicated and there’s no way we can address it here and Diane is not an attorney, she’s a tax adviser, she’s a CPA and of course neither am I. I’m neither of these things, so get advise from someone good, but the problem is, you know, you got the most desirable state to setup the LLC or the other entity if it’s a corporation, but say it’s an LLC and then you’ve got the state in which you hold the property and then you’ve got the state in which you hold the property and then you got the state in which you are a resident and that is complicated as hell.
I’m just going to tell you that gets really complicated and then sometimes the insurance company has a problem insuring you of the properties in an LLC and let me tell you, this stuff in addition to separate tax returns, possibly and separate bank accounts, of course, that’s a must. This gets complicated. So, be careful. It’s never as simple as the promoter makes it sound. The company out there promoting these LLCs, they just make it sound a lot similar than it really is. Would you agree, Diane?
Diane:
Oh, absolutely. I will tell you, I’ve got people now asking about, “Well, what if I have a Panama company in my property.”
Jason:
Oh my god.
Diane:
I know. Now, we’ve added a foreign country and it doesn’t do any benefit as all. I mean, you’re still going to pay US taxes. It doesn’t matter, but you got to be careful on some of that stuff.
Jason:
Yeah, you really do. It is complex, okay. So, good stuff. Well, Diane, thank you so much for talking with us today about this very important subject. We’ll definitely have you back on to talk about other elements of what makes income property the most tax favorite asset in America, but you know, actually, I think there’s a big, a big elephant in the room we didn’t even mention when we started. We just sort of dove into this topic. The whole reason and this is so great, I don’t think we’ve even covered it, so let’s cover it now. Is that depreciation is the holy grail of tax benefits, because, you did say this, you alluded to it, that it’s a non-cash write-off. It’s a phantom deduction and basically, listeners, let me tell you now what I should have said at the very beginning here. Is that, when you buy a property, when you own an investment property and this only applies to income property and not the house in which you live.
It’s really not a single component. It’s two components. There’s the land and then there’s the improvement sitting on the land and that’s the house or the apartment building that sits on the land and the IRS basically and Diane just interrupt me/correct me if any of this is not correct, but the IRS basically says, look, that improvement, that house or that apartment building sitting on the land is an asset that will eventually become worthless, eventually some day it will fall to the ground. It will be economically obsolescent.
So, instead of taking a deduction at that time, we’re going to give you this weird schedule and it’s going to be an arbitrary number, 27 and a half years. It has nothing to do with how long the house will last or anything like that, but we’re just going to say that’s the depreciation rate. So, if the value of that property is – the value of that improvement is $100,000, like a typical deal that you would buy at JasonHartman.com in the property section and it might look something like this, it’ll be $100,000 improvement value, I’m just estimating very roughly here, and a $20,000 land value. This is one of the reasons we like these linear low-priced markets, because most of the benefit or tax value is in the improvement, so you get the highest write-off potentially and that $100,000 can be depreciated. I’m just going to take $100,000 on my calculator here and divide it by 27.5. That means you get a $3,636 write-off every year if you can qualify for it.
The way to qualify for it is either to have an income below $100,000 annually in adjusted gross income or be a real estate professional or there’s two other steps where you get part of this benefit and that is if your adjusted gross income up to $125,000, it phases out a little bit and then up to $150,000, you get some benefit, but over $150,000 AGI, it phases out completely unless you are a real estate professional. So, speak to that if you would, because that’s really where we should have started.
Diane:
So, with depreciation. I love to call it the phantom expense, because it really don’t cost you anything. You know, you buy a property and you’ve got financing with that, the interest is deductible and then you get to take that write-off for depreciation. In the example you were using, there would be a $100,000 that was attributed to the building itself as 27 and a half years if it’s residential, 39 years if it’s commercial, and in this case commercial means like an office building or a strip mall or something like that. If you’ve got an apartment building, it’s residential, so it’s 27 and a half years. You can go even one step further and do what’s called a cost segregation study and in that case, you take the building. Let’s say you’ve got a single family home. In side that single family home are improvement that are depreciated faster, which means more depreciation.
Jason:
That’s what’s called a cost segregation analysis. Here’s a question for you. We got another tangent, but why did you bring that up, Diane? You’re complicating this ting. Is that even worth it to do on single family homes? It’s worth it on a big commercial property, you know, you hire this firm that does these cost segregation studies and you pay them kind of a fortunate actually, you know, it can save you more than they cost in taxes and that’s the idea, but on a single family home, I mean, the appliances you can depreciate over what, five years or seven? The air conditioning, the HVAC?
Diane:
Yeah, usually about five years. You can do it yourself. That’s the other part of this and there’s some standard guidelines you can use. Just in the example I was doing quick little scribbles, what you do is you don’t create more depreciation, you just front-end load it. That would give you approximately $5,000 a year or more depreciation for the first 5 years. So, that’s a great strategy if you’re going to be buying more properties. Every five years, you got to figure you got to buy another property, because the depreciation falls off. You front end loaded it and now it’s going to be much less, so as long as you’re building property…
Jason:
Well, that’s not the whole property, that’s just the appliances.
Diane:
No, no. Correct. You go from having a depreciation of $8,500 a year to many $2,500. That’s a guess. I don’t know if that’s the right numbers, but because you front-end loaded it, the rest of the time it’s going to be much less on the depreciation. It becomes a way to – I’ll tell you the place we can use that is if I have a client that’s maybe had properties for 3-4 years and all of a sudden they qualify as a real estate professional, it’s like okay, great, you’ve had some income, what we can do is do the cost segregation retroactive and we do what’s called catch-up depreciation. By the way, we’re getting really fancy with taxes here.
Jason:
Right. This is some pretty complex stuff. You don’t need to worry all about this folks, this is what your account is suppose to worry about, okay.
Diane:
Let me just say, if you are a real estate professional and you’re paying taxes, you either one, don’t have enough properties or two, don’t have the CPA working with you with this, because you don’t need to pay taxes if you have enough property.
Jason:
Income property just rules the roost. Taxes are largest expense anybody will have in their life and income property was the most tax favorite asset in America and there’s so many other reasons it’s great besides taxes, but don’t get bored with this tax stuff. It really is important. Think about how much faster you can build wealth if you’re not giving away, you know, 35% to 45% of your wealth, of your income, every year to the government. I mean, you can just go leaps and bounds ahead of everybody you know if you can take that money and re-invest it and not pay the government.
Look, this is what the government wants. They’re incentivizing you to do that. This is the most patriotic thing, you know? The government wants you to provide housing to people. Do what they want! This is my philosophy with everything. Align your goals with the goals of the most powerful entities on earth – governments and central banks and that’s why I talk about inflation induced debt destruction and I talk about, you know, gold and precious metals and comparing that to real estate and Bitcoin, because those things are not aligned like income property is, you know, you want to do package commodities investing, another one of my big philosophies, one of my big philosophies, look up the prior episodes on this. You can go to JasonHartman.com and just search these terms and you’ll find all the prior episodes where I’ve talked about this stuff, but align your goals and your strategy with the most powerful entities on earth. That’s what you’re doing here. That’s what I’ve been talking to Diane about here. So, Diane, just great stuff. Your website USTaxAid.com, right?
Diane:
Yes, that’s it. Thank you. This is fun talking about it, isn’t it?
Jason:
It really is. I get so passionate about this stuff. I love this stuff. It’s just so great. Any final thought? Anything we didn’t cover? Please don’t go down another rabbit hole, though.
Diane:
We’re not going to open any more rabbit holes. You know, the bottom line I got to say is just when you’re involved in real estate, when you’re buying it. Just remember that one of the three benefits you’ve got besides cash flow and appreciation is tax savings. So, do what you need to do to take advantage of all of those things.
Jason:
Good stuff. Diane Kennedy, thanks for joining us. Folks, go to JasonHartman.com. If the show is valuable to you, please write us a review. Go to iTunes, go to Sitcher Radio, SoundCloud, where ever you listen and write us a review on the show. We really love to hear from ya. Go to JasonHartman.com for properties, home study courses, anything else you need, and of course we’ve got 490 prior episodes you can listen to as well. Those are all free. So, check them all out at JasonHartman.com. Thank you so much for listening. Diane, thank you for this great advise. Good topic today.
Diane:
Thank you.
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