Mike Murphy of the CPA firm Murphy, Murphy, & Murphy is one of the lauded experts invited to speak at the 2014 version of Meet the Masters of Income Property Investing back in January. The topic is one near, dear, and feared by property investors – real estate taxes.
There’s an old saying, “Nothing is certain but death and taxes.” Taxes are a fact of life. Although the prospect of dealing with taxes is not especially appealing, Jason has been extolling the tax benefits associated with rental real estate for years. As America’s most tax-favored asset, it can put money back in your pocket (or keep it from ever leaving in the first place) better than anything else.
In episode #367 of The Creating Wealth Show, listen as Mr. Murphy delves into a topic that often confounds our best attempts to understand it. According to current U.S. tax laws, virtually any funds an investor directs toward maintaining or improving an investment property can be tax deductible. Some deductions can also apply to periods of vacancy – the so-called Passive Activity Loss Break – as well as non-cash write-offs for the simple depreciation of the structure itself, calculated over the period of almost three decades.
An important point Murphy makes early is that an investment property is broken down into two components: land and the structures on the land. While the cost of the land itself isn’t tax deductible, the structure is, which means the residential building you buy in order to rent out to a tenant. Tax breaks flow from the structure, and here are several you need to understand as an investor.
If you ever wanted a crash course in real estate taxes, here’s your ticket. Just download and listen to this episode.
In This Episode:
- What is depreciation and how can it save you thousands every year
- How the IRS distinguishes between a real estate professional and non-professional, and why it makes a difference on your tax return
- Why “active material participation” so is important
- The down and dirty details of Jason’s IRS audit
- Why is the IRS interested in real estate professionals all the sudden?
- 1031 exchanges and taxes
- What the IRS thinks about property management companies
- How to prove you ARE an active property manager
- The value of a home-based business, even to hourly workers
- Much, much more…
Links:
Mike Murphy’s CPA Firm
Check out this episode!
(Image: Flickr | 401(k) 2013)
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ANNOUNCER: Welcome to Creating Wealth with Jason Hartman! During this program Jason is going to tell you some really exciting things that you probably haven’t thought of before, and a new slant on investing: fresh new approaches to America’s best investment that will enable you to create more wealth and happiness than you ever thought possible. Jason is a genuine, self-made multi-millionaire who not only talks the talk, but walks the walk. He’s been a successful investor for 20 years and currently owns properties in 11 states and 17 cities. This program will help you follow in Jason’s footsteps on the road to financial freedom. You really can do it! And now, here’s your host, Jason Hartman, with the complete solution for real estate investors.
JASON HARTMAN: Welcome to the Creating Wealth Show! This is your host, Jason Hartman, and thank you so much for joining me today. We’ll be back with today’s guest or segment in just a moment.
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ANNOUNCER: What’s great about the shows you’ll find on www.jasonhartman.com is that if you want to learn about some cool new investor software, there’s a show for that! If you want to learn why Rome fell, Hitler rose, and Enron failed, there’s a show for that! If you want to know about property evaluation technology on the iPhone, there’s a show for that. And if you’d like to know how to make millions with mobile homes, there’s even a show for that. Yep, there’s a show for just about anything. Only from www.jasonhartman.com. Or type in Jason Hartman in the iTunes store!
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JASON HARTMAN: Let me introduce CPA Mike Murphy; his company is Murphy, Murphy, & Murphy, and they’ve been in business for many years. You can tell they probably have an Irish background, okay? [LAUGHTER]. And they are a big company; they’re located right here in Cyprus, not too far from us. They have year round about 50 employees or so, and then during the crunch times, they swell to about 80 employees. So, big company, I’ve been to their offices many times, and it’s interesting, because I don’t know if you remember this, but I took a picture last time—I don’t know, I don’t think it was the last time I was at your office, but when I was at your office about a year ago. And you brought out all my files, and they were about two feet tall, and I put Coco, the little puppy, on top of the files when she weighed, I don’t know, about four or five pounds. And here she is today, so it’s pretty interesting.
But, Mike does a great job; he—one of the things he said to me a long time ago is he said, you know, Jason, even if someone comes in here and they’re just doing like a $400—meaning, that’s his charges—tax return? Just a really simple H&R Block-style return, he tried to just get them out of any possible tax he can, and ideally not pay the government. So, he’s gonna talk today for about 30, 40 minutes, and take a lot of questions, too. So we’re gonna get a lot of questions in here. So give Mike a big hand.
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MIKE MURPHY: Okay, we’re going to pull up the PowerPoint, just to take a look at it, and kind of just go over some of the key issues. I got a little frog in my throat, so we’re gonna have to play with that. But I want to go and hit some of the key issues that people are talking about, and maybe even take a little census on what people would prefer to talk about, and then leave it open for questions and answers, because there’s always a lot of questions and answers. There’s been some tax law changes. Some of that doesn’t affect the real estate owner, but certainly real estate professional’s a hot topic out here, for all of us here who are either married, or working, or having multiple properties.
The other—some of the other hot topics in the past have been short sales, although those are cooling down now, so that might not be as hot a topic. So, how many people are familiar with real estate professional, and either are considering using it, or are using it today? Can I have a show of hands? So we’ve got about a dozen, or 15 people on that, and that’s kind of important. So for those people, maybe we’ll take some time to go over that. How many people are involved in short sales? That’s a lot less. A year or two ago there’s a lot of people involved in short sales on one side or the other, so maybe we won’t go through short sales as much, or cancellation of debt. Okay? And so, I’m gonna be available after our talk here, and anyone who has questions, feel free to ask me questions.
Underwater mortgages would probably be a possible short sale, or forgiveness of debt, which could create income from cancellation of debt. And so that’s—since we don’t have a whole lot of that—I could spend 45 minutes on that alone, but if you have some questions on that, feel free to ask me after the—at the break, okay? So, first of all, Jason’s already brought up the fact that we’ve got—one of the benefits of real estate is that we have—when you do buy real estate, you get a tax—I mean, a cash—a non-cash expense, and that’s the depreciation that Jason was talking about. Somebody asked me that on the break. Let me just kind of go over that a little bit, because there’s a benefit where you actually get a deduction without having to fork out any cash for depreciation. So, when you buy a piece of real estate, you have to divide it between land and building. The land is not an appreciable asset; that just stays the same. But the building on top of the land depreciates over the years. It might change over it.
So, in current tax law, if you buy a residential property, you take the building portion of that purchase and depreciate it over 27½ years. So let’s make it easy. Let’s say we buy a house—we buy a place for $350,000. $75,000 is land, $275,000 is building. Then we would take $10,000 a year off in depreciation, which is $275,000 divided by 27½ years, and we get $10,000 to write off against our income each year for the next 27½ years.
JASON HARTMAN: And Mike, that would be a fourplex in any of their eyes.
MIKE MURPHY: Yeah, I just use those words—
JASON HARTMAN: You’re talking very California right now.
MIKE MURPHY: Yeah, I used those numbers because it’s easy to divide $275,000 by 27½ years. That’s why I used those numbers. So, it’s easy to see that—now, you aren’t necessarily paying $10,000 a year for that depreciation, but you’re going to get $10,000 worth of write offs. And so that is an added expense to your other operating expenses. You offset against your income to calculate your net income or loss from the real estate. And then from there, you go forward to see if you can use that deduction where it’s going to be a carry forward deduction based on the past activity, loss rules, it gets more and more involved. And that has to—so, everyone is probably familiar with the fact that everybody can write off up to $25,000—if you’re not a real estate professional, you can write off up to $25,000, and the balance gets carried forward into future years, as long as your income is $100,000 or less, your adjusted gross income—$100,000 or less before your rental income or loss.
So, once your income is over $100,000, that $25,000 drops 50 cents on the dollar until you get up to $150,000, and now you don’t qualify for anything, and your entire real estate loss would be carried forward into a future year against future real estate income, or against properties—when you sell the property. So everybody’s probably pretty familiar with that, right? More of less? So there’s an equation that you go through, and if your income is under $100,000, you have anything less than $25,000 worth of deduct—worth a loss, you can write that off. No, yeah. The depreciation gets calculated the same way no matter what, that was one question that I had. So, when you’re calculating your loss from real estate, for instance, you calculate the entire loss from real estate before you apply real estate professional rules, or passive activity limitation rules. So, you calculate your income, plus all your operating expenses, your interest, your taxes, repairs, maintenance, association dues, etcetera, etcetera, and depreciation expense.
And then that’s your net loss, and in our example from real estate. Then you decide, can I lose that loss in today’s current tax return, or does it have to be carried forward? You never lose the loss. You have to further, forward—you can’t use it in the current period. So that $25,000 limitation amount is calculated based on your other income on the return. Yeah, you can recapture that when you sell the property, or when you have other income from—let’s say you have another piece of real estate, or that real estate turns into net income. You offset it against the referred loss carry forward. That’s correct. That’s correct. So, now, let’s say that you sell one of the—let’s say you start accumulating 10, 15, $20,000 a year, for five years. So you have $100,000 deferred past loss carried forward.
When you sell one property, if you make a $50,000 gain, and the carried forward on that property is only $15,000, you can still take all the other losses up to that gain. So you can actually use $50,000 worth of past loss carry forward against. Right. So provided—if you have gain from the sale of property, you can also offset that against your past loss carry forward. What’s in many cases you have a gain that might be taxed at 20%, and you have a past loss carry forward that is considered a rental operating loss, which goes against your tax rate, which many times can be higher than 20%. So even though you might have $50,000 worth of gain, and $50,000 worth of past loss, you think that’s [unintelligible] on the return, that’s actually a benefit on your return. It beneficially helps you, because you’re having a [unintelligible] at a higher rate, and you’re paying tax at a lower rate on the gain.
I’m not trying to confuse you and get too technical on that, but that is a usable gain against future income or gain on other pieces of—on all your property. Correct. Unless your income’s under $150,000, then you can be taking a piece of that up to $25,000. So if your income’s under $100,000, you can take up to $25,000 every single year. So, if you have a $27,000 loss, you would take $25,000 and carry $2,000 forward. If you had a $23,000 loss, you’d take the entire thing, if your income’s under $50,000. Then you go through that calculation between $100,000 and $150,000, which shrinks that $25,000 50 cents on the dollar, until once you get to $150,000, then your $25,000 is zero, and the entire amount will get carried forward.
AUDIENCE QUESTION: So, now you got $50,000 that you can recover. Let’s say you sell one property, and you gain $100,000, but you’re still making over $150,000 a year. Well, what benefit are you getting here?
MIKE MURPHY: Okay, so, you’re accumulating a past loss carry forward of $50,000 that you have not used, that you can have on the books and are carrying forward. We sell one of the properties for $100,000.
AUDIENCE QUESTION: Gain.
MIKE MURPHY: Sorry. For $100,000 gain. So that $100,000 gain, you could reach back into your deferred loss bucket and take up to $100,000 of gain—of past loss—against that gain, since we have $50,000 accumulated, we’d take that entire $50,000 in the year that you sold that property. And then your carry forward would be zero. You’d take it all in the current year, because you have $100,000 of passive gain, or real estate gain, that you could offset against that carry forward real estate loss.
AUDIENCE QUESTION: So at that time, all the loss that you carry up to that point gets zeroed out?
MIKE MURPHY: From all the properties, right. You can suck in all those.
AUDIENCE QUESTION: Awesome.
MIKE MURPHY: You can carry forward for as long as you own the property, or your entire life. There’s no limitation on it. That’s a good question. Okay, so, that’s the passive activity loss carry forward, and that’s something just to be aware of. It’s a calculation; you can work closely with your CPA or tax preparer with that. And also it’s good to look when you’re planning for that, because some of the discussions we have is, if we’re going to be buying a property, and we have income from the property, or maybe we have cash flow positive, but because of depreciation, we actually have a rental loss—that might affect which property you want to buy, depending on what your particular tax situation is in. Occasionally I get a client that makes over $150,000, and he may create a $10,000 or $15,000 loss on a property, or on a duplex or something, and they can’t use that loss. So they’re thinking okay, it’s a little bit negative, but I’ll save it in taxes—they’re not gonna save it in taxes. It’s a little bit negative; they’re going to have to feed that, and accumulate that loss until either their income comes under $150,000, or they sell property or have another gain on other pieces of real estate. Yes?
AUDIENCE QUESTION: So, sticking with that passive loss carry over, can you use that carry over to counter against, say, an IRA conversion, or some other taxable event? Maybe that, or say a long term capital gain on equities, or something?
MIKE MURPHY: That’s a really good question. The answer is no on that, because now, in the current tax law, we have all these different buckets now. So, one of the buckets is the real estate bucket, where you have the deferred loss. A different bucket is your gain on an investment, like on your portfolio. So that doesn’t offset each other. If you had a gain on a passive business investment, then that may do that. So, if you rolled over an IRA, and took the income, that would not offset the deferred loss. That’s a good question though. You have to make sure you plug that in, so you get the right answers, so when you’re making a decision, you make a good decision. Yes?
AUDIENCE QUESTION: Can you repeat that question?
MIKE MURPHY: Okay. If you sell your—you buy a piece of property, and you actually sell it at a loss, in the year that you sell a property, all the loss, and all the accumulated loss for that property, is taken in for that year. Yes, you can. So that’s a good question. So, let’s say that you’ve accumulated—that’s interesting, make it easy—have one property you’ve had for six or eight years, and you have $8,000 a year that you’re not able to write off, and you accumulate those $64,000 over eight years—$8,000 a year. And when you sell that property, you can take the accumulated loss from that property, as well as a loss on the disposition that you had a loss as well. So, you can take that. So sometimes someone’s gonna get a big hit to income for some reason, they may have an executive bonus, or something else that might come in, and they’re toying with selling their property, and it has $84,000 worth of past loss carry forward that’s sticking with that property, that’s a good year to sell it. Take all that loss in that current year.
AUDIENCE QUESTION: Mike, if you’re deferring losses every year, and you’re filling that bucket, even if you don’t sell a property, couldn’t you empty that bucket in the first year you qualify as a real estate professional?
MIKE MURPHY: No, you can’t. That’s also a really good question. His question is, let’s say you’re accumulating these losses on four or five or six properties, and then you become a real estate professional in year six. Then you have x amount of dollars accumulated in deferred past losses that you haven’t used—that still stays with the property, and when you’re a real estate professional, you can’t pull that into the current year. You can take the current year’s losses, but the old stuff, you still have to sit and apply the same rules to when you sell a property or when you have other passive income.
AUDIENCE QUESTION: So I guess the strategy would be, if you don’t have any deferred losses in this bucket, you would 1031 exchange, but if you do have some deferred losses you can offset a gain, then that would be a good year to just sell, right?
MIKE MURPHY: Yeah, so sometimes you don’t—tax free exchanges are great, especially when you have a lot of gain in the property. You’ve got a depreciated property that’s appreciated quite a bit, maybe you’ve taken a lot depreciation, but it’s appreciated quite a bit through the market. Tax free exchanges are great, but occasionally, you’re gonna have tons of this past loss carry forward, you can go ahead and not have to worry about the [unintelligible] of tax free exchange, and just utilize the passive activity loss. When I say that, that’s a real estate loss. And dump it in the current year to offset it. Or you can do a partial. You can do a tax free exchange where the whole thing doesn’t have to drop in. You can mix it and match it if you plan it right, too. Okay, let’s take a minute and go over the real estate professional, because there’s at least 15 people that want to be familiar with that.
So they’re either in that, involved in that, or not. And it’s a really high tech area, and the IRS is auditing the, excuse my French, hell out of real estate professionals right now. They just pick them up, and they—I got a real estate professional audit about two years ago, I think I bought something last year, and I went out to Santa Ana, we usually have everything transferred to the Long Beach office, but the guy said, we’ll just come out to Santa Ana, we’ll go over this. So I sat down with this guy. He was an older gentleman, nice guy. He said that he’d done 200 real estate professional audits. Him alone. So I said, are you the office expert? He goes no. There’s other people who are doing it too. Because what they did is about five or six years ago, they didn’t audit real estate professionals at all. I got zero audits on real estate professionals for—since it was available, all the way to maybe 2005 or 6.
And then there’s a couple of them you heard through your CPA association, they’re starting to pick up. So they start doing a little study, start picking up these real estate professionals, and I’ll see on that enough adjustments where they actually focused on real estate professionals. So if your income’s over $150,000 and you have losses from real estate that are significant, and there’s different things that they look at, you have a much higher chance of getting audited for that particular thing. One of the things that they changed on the tax forms themselves, is they used to just put in alpha, the address of the property. Description of the property, single family dwelling, address, blah blah blah, Alabama, right? And so, the computer can read that—it was just alphanumeric data. It was just data. Then they changed about three years ago, after they did this study. They actually changed the forms to put—you have a separate box for the city, and a separate box for the zip code, so the computer, the big computer in the sky, can read that and identify that you’re in California with your zip code, which is a separate box on your address also now. And your real estate property is in Alabama, Louisiana, South Carolina, whatever.
So they can see that. They also have a separate box for management fees. So, they see management fees—so, the computer—they can program the computers, okay. So we’ve got some of those over $150,000, they’ve got management fees on the properties, all the zip codes are outside of state of their current address, and it increases the possibilities. Now, I do have some people—
JASON HARTMAN: And Mike, what’s the significance though, of having the property out of state? What does that mean to the IRS?
MIKE MURPHY: That’s good. So, in a real estate professional, and I’ll go over that in a minute here—real estate professional, they want to see that you are involved in the active participation of managing that property. So you’re involved in the property. If it’s in your own backyard, you’re gonna be going to it, you’re gonna be maybe collecting rent, you’re gonna be discussing stuff with the tenant, you’re gonna be checking the gate that’s broken, blah blah blah blah. If it’s out of state, then it tends to be that you may have someone do that for you, or you may be handling it a lot more telephonically. And so, they want—what the IRS wants to do is prove that you’re not a real estate professional, which means you have someone else doing a lot of the work, and you’re just in the back, kind of passively, actively managing it. That’s what they try to hit you for.
JASON HARTMAN: So, this is what we talked about yesterday, about the 750 hours, but 500—750 total hours, about 15 hours a week, which you can do that—but 500 of those have to be material participation. Now, I’ve mentioned this before many times, but maybe some of you didn’t catch it on the podcast, or you weren’t at the last Masters. I was audited for real estate professional, if you can believe that. I live, eat, and breathe real estate—what else do I do, right? And Mike handled the audit. He represented me, and I won!
MIKE MURPHY: That’s a good indication. Jason’s income was high enough, and his write offs were high enough, and so they flagged him and tried to create—he’s in the real estate industry, he’s definitely a real estate professional, but they said yes, but do you have—what they tried to nail him on was 500—you don’t mind me saying this, right?
JASON HARTMAN: Yeah, yeah. It was no problem to have the 750. It was the 500 of active—
MIKE MURPHY: So the 750, we could show that all day, right? But this is where they’re trying to tag the people on, because 750, you can be working, paying bills, calling your real estate management company, doing all—investing activities is outside the 750, by the way. But you can do that, but this is where the IRS came in and honed in on it. Yes, you have to have 500 hours of active participation.
JASON HARTMAN: And the problem was, at that time, for the year they were auditing—I think it was 2007 they were auditing me for—I had all property managers. I didn’t self manage anything. So, they were claiming that well, you know, you didn’t participate. And what we produced is a bunch of emails I sent to property managers giving them instructions, and showing that I was engaged and involved.
MIKE MURPHY: So what we did, and a good CPA is gonna help you do this, is getting so active. So, think of—you know you’re smarter than a 5th grader, or whatever, think about 5th grade English class. We have verbs, right? And we have passive verbs, and we have action verbs. Action verbs are things that you’re doing something. You’re making decisions, you’re meeting with people. And passive verbs are more like, discussing things. Or reviewing things, or paying bills. So, what they’re trying to do is saying, they’re trying to find as much passive activity—passive actions, say well that’s, okay you have 750 hours, or 1000 hours, but you only have 400 hours or 450 hours that are active, where you’re actually involved.
So for Jason, he was talking real estate to property managers, making decisions on what type of repairs needed to be made, who the renters were gonna be, should we tell renters they have to leave, leases that had to be—so we just showed a lot of activity for 500 hours. And here’s the weird thing, for real estate professional, it’s not an allocated amount. If you’re at 449, you’re out. If you’re at 500, you’re in. So it’s an all or nothing type thing. So it just being smart, just being smart, and you could look at bills that you pay, email that you do, and so you’re trying to just not say hey, discuss reviewed income expenses with the property manager, 2 hours. That’s gonna—that could be added to your 750 hours, but that’s not gonna be part of your 500 hours, and that’s where they’re getting the bulk of their benefit.
The IRS has—I look I’ve got some copies of the IRS has like a workbook that they train their agents on, saying that active is, if they see management fees, they automatically think the manager’s making all the active decisions, and that you’re just, they’re just reporting to you. So then you gotta show that you’re actively involved in making those decisions and reviewing the bids for the garage door repair work, or whatever. So, if you’re looking, if you’re just, let me give a description of passive, because this is where everybody messes up, on the passive. Discussing things, reviewing things, looking at month end statements, paying bills, opening mail. That’s all part of your 750 hours, but that’s more passive management. Active is when you’re involved in the operations of that rental property. So you’re actively involved in making decisions on who you’re gonna pick for the bid for the repair work.
Do you—this is a new roof that we need. Evaluating the five potential tenants that are gonna lease this place from me. So you’re much more involved in the operations of it, not passively reviewing stuff after the fact, or bill paying, or things that are kind of outside the property.
JASON HARTMAN: Here’s two things you can do. One is, and if you’re a member where you pay $120 a year and you have the back end of it and you get the monthly conference calls and all that stuff—I’ve done some monthly calls on self management, and the property managers in the room may not like me talking about this—sorry. But I think the self management thing works pretty great, honestly. I really like it. I don’t get with my calls, never happened in all these years, blah blah blah, I know you hear those stories. But the worst thing, like I mentioned last night, that ever happened with self management, was that air conditioning guy in Houston, right? He got kind of mad at me. But wait, there’s one other thing. So, self management you can do, and then you are definitely active, if you don’t have a manager.
MIKE MURPHY: Yeah but again, if you’re reviewing bills or paying bills, that’s gonna be part of your 750, but that’s not gonna be part of your active, material participation.
JASON HARTMAN: But if you directly deal with the tenant, you are active. For sure, there’s no question. The other thing you can do, and this I would recommend anyway, regardless of whether you want to be a real estate professional or not, and the property managers may not like me saying this either—but, they all put clauses in their property management agreements that you sign with them, that say we have the right to spend $200 a month, or per incident, maybe, it might be written either way, for repairs on your behalf, without your approval. Now, I’ve been annoyed by property managers spending too much money over the years, and so I’ve really made that lower. I make it a hundred bucks a month, and some managers that I got, that ultimately ended up firing me, if you want to get fired and you don’t like your manager, say no authorization whatsoever. You call me if—email me about everything. And they might object and say well, you know, that’s impossible. What if we can’t reach you? Are you kidding me? With this little phone, I can be anywhere on planet earth. And I don’t know about you, but I love being connected. I don’t get these people that want to go on vacation and like disconnect. That’s overrated, okay? I check my email like every 20 minutes, okay? And you know, it’s just—you can get me. It’s easy, it’s just an answer like yes, no. It’s not like a complicated paragraph—
MIKE MURPHY: So for those people who do use property managers, which a lot of us do, that’s okay, but just be involved and active, and keep track of more than discussion, but more of the decision making that you’re doing. And if you’re getting tenants or looking, have them emails you the tenant stuff. Email back saying I don’t like the first one, I don’t like the second one, I like the third one. You make it three or four different emails or whatever, but show that activity, and what would I do as far as for all my real estate professionals, under the manager’s fee, I never put it under the manager’s fee box. I never put it under the management fee box. I always put it in a different category, okay, so I never let that show the computer that that’s the case. And some of my clients, we even discuss the zip code of the property saying well it’s really being managed by my zip code where I’m at so we sometimes do that a couple times too but for the most part they can’t say anything about that if they audit it, but it’s certainly not tipping your hat to the computer to help it out.
AUDIENCE QUESTION: Do you know if you’re likely to be—like, Jason was audited for the 2007 tax year. Are you more likely to be audited in the same year as you filed the return, or years later, or do you see any correlation?
MIKE MURPHY: Normally an audit—like right now, we’re just finishing the 2011 audits, and they’re just starting 2012 audits. So, they don’t really start the audits for like a year after you file them. An April 15th audit, an April 15th filed return might get pulled by the end of the calendar year. Question?
AUDIENCE QUESTION: Do you have to show consistent activities? So for instance, in every month activity? Or is it okay if they’re bunched up into a couple three months of the year?
MIKE MURPHY: It’s supposed to be consistently through the year. So, and it’s actually beneficial to do that. And you know, you can keep track of it on your calendar of activity or maybe with your emails, and try to create some of that. And I’m not saying that you have to have this perfect book that you bring to your CPA or your tax professional. If you think you’re close, have a discussion. If you don’t get audited, save your time, enjoy the ballgame. But if you do get audited, then you might have to go back and pick of some of that and reconstruct that, and work well, very close with your tax professional, and they’ll help you organize it, and if they’re not familiar with it, give me a call and I’ll help you with it to coordinate just a log to make sure the activity’s there.
AUDIENCE QUESTION: Mike, if you are not a real estate professional, does that $25,000 passive loss require material participation?
MIKE MURPHY: No. If you’re not a real estate professional, basically if you own more than 10% of the property, you’re assumed to have to qualify for that, for that $25,000.
AUDIENCE QUESTION: Hey Mike, I’m presuming a few people in the room just went, oh, I’m not going to be a professional. What’s the next best thing? Can you become an S Corp or something? What’s the next best?
MIKE MURPHY: That’s a great question. Actually, no. Because if you’re an S Corp or an LLC, and you’re not a real estate professional, when you get your K1 from that entity, it gets passed through to you individually, and there’s on the K1, there’s operating income, and then there’s real estate income or loss. So that goes through on your return, showing it as passive activity, and then you still gotta do the qualification. You know, a lot of times—remember, if you’re gonna be a real estate professional, you have to have over 750 hours, 500 have to be actively, materially participation, and you cannot work another job more than you work in your real estate.
JASON HARTMAN: In hours.
MIKE MURPHY: In hours. So Jason’s fine, because he’s already working in real estate, so that all goes in the same big bucket, right? But for a lot of us, we have another profession. So if I work 2080 hours, which is 40 hours a week times 52 weeks, then that means I have to work 2081 hours in real estate in order to be a real estate professional. So it’s pretty tough to do that. The other way to do that is if you have a spouse, a non-working spouse, or a part-time spouse, then you might be able to qualify that way.
[AUDIENCE LAUGHTER]
MIKE MURPHY: That might be more fun too, besides real estate professional—
JASON HARTMAN: If you do that, I would definitely be married.
AUDIENCE QUESTION: You said it’s all or nothing, right? So 450 hours of active you don’t count, 500 hours you count. How do you prove how many hours off of emails?
MIKE MURPHY: You’d have to put together a log. So I have a log that I usually shoot over to my client. It’s in excel, so they can kind of go through it and fine tune it and see, or you can kind of quantify it as you’re going up, 450 hours, I’m at 510 hours, I’m at 530 hours, or whatever. So, you know, if you—if anyone ever gets audited for that, and they need a log, and they haven’t put that together—email me. I’m Mike—I should put this up. I’m [email protected].
JASON HARTMAN: 3’s a number.
MIKE MURPHY: Good Irish Catholic firm, Murphy 3, because Murphy—[email protected]. You can email me or you can call me. We’re Murphy3—our website is www.murphy3.com. So give me a call, and I’d be happy to forward you an example of that log. And you can fill that up. A lot of times, like I said, if you just kind of keep a good calendar, and a good—your email goes into one file, something like that. If you think you can qualify, then go ahead and do that. I don’t want you to spend 100 hours on a log that you just file away and three years from now you toss it, and you could have spent that 100 hours with your family, or your part-time spouse or whatever.
AUDIENCE QUESTION: This is a question for maybe both Jason and you, Mike. Jason, you mentioned in passing a few minutes ago about if you’re not—if you’re an active, and you’re not a real estate professional, you mentioned to start a business—what do you mean by that, if you’re not a real estate professional?
JASON HARTMAN: No, I didn’t mean it relating to real estate. I just meant, I think everybody should have some sort of home base business, where they can pass a few more expenses into the write off category. So, maybe some of your auto mileage—like, if you’re a W2 person, and you don’t have any business of your own, I highly recommend you have some business of your own. Underwater basket weaving business, whatever you want. And I don’t know how long you’re allowed to lose money on something. Maybe not very long. Maybe three out of five years.
MIKE MURPHY: Yeah, three out of five years. There’s a hobby law saying, hey, you’re just in business for the fun of it if you lose four years in a row, they say you can lose three—you can have a loss three out of five years, and you’re considered okay, but if you have it more than three out of five years, they’re going to consider it a hobby—that you’re just in business to have fun, and the profit motive’s not there, and they can take it off your insurance.
JASON HARTMAN: Yeah. So you can have a windsurfing business. I’m joking a little bit. But there’s a lot of stuff you could do. All these online things, and whatever. Just have a little side thing so you can write some expenses off, that’s all. You know, like some of your cell phone bill, your Internet access. Maybe a home office deduction.
AUDIENCE QUESTION: So, going back to that real estate professional, one question I have is, I’ve saved a lot of stuff out of state. Would it make sense then if I had purchased a property in state that I can manage locally, and I do manage that one as part of it, and then that could kind of be my primary focus, even though you’re not gonna get that many hours out of it, it does show that I’m an active manager?
MIKE MURPHY: Yeah, that’s a good point. You can—all my real estate professionals group, did make a grouping election that says all the real estate together is combined to make up that 500 and 750 hours. So yeah, let’s say you have one that you can go back and forth, go to the tenant, meet the gardener—you can add a lot more hours on that one property than your out of state properties, that’s correct.
JASON HARTMAN: It kind of seems like this is a little bit like communism. Doug likes to always say this saying, you know, we act like we’re working, and they act like they pay us. You know, you kind of want to sort of show that you’re doing these things, you know.
MIKE MURPHY: And if you do that—if I ever send you that log, I’ll have suggestions on it, you’ll see where it says description of what you’re doing, I have action words in the active part, and the other part’s gonna be review words, and if I do a select and sort, I can add up—I make sure that it’s over, before I send it back in, it’s gonna go the IRS with over 500 active participation rule hours. Okay, go ahead?
AUDIENCE QUESTION: So, am I correct in thinking that if you were to actually tell all of your outside managers to refer virtually all decisions to you before they’re made, that could easily come up to 500 hours per year. Then it’d be a no-brainer, you’d get—
MIKE MURPHY: Yeah, actually what Jason says is a good idea. You could even have a separate agreement to say, I want all active decisions being made by me before anything’s repaired, so I want to run by things, I want to understand what repair work needs to be done, I want to look at the vendors, I want to see who the best repair man’s gonna be, and I want to make the decisions. That’d be excellent. You could almost draw something up and have them sign it, and say look, I’ll still let you make some of the decisions, but as far as cosmetically here, we’re just gonna show that.
JASON HARTMAN: And the other strategy here is, do a lot of your communications via email, so there’s a paper trail, and it shows that you really were doing something.
AUDIENCE QUESTION: This is not really a question, but Mike, you work locally here. do you work with clients all over the US?
MIKE MURPHY: Yes, I do. I have clients all over the United States, probably two-thirds are here in Southern California, the other third are spread all over the other 49 states.
AUDIENCE QUESTION: In the area of tax write offs, how do you feel about foundations versus like home based businesses?
MIKE MURPHY: Well, a foundation, you start your own foundation, you can contribute money to that and get a deduction like a charitable contribution. So if it’s your own foundation, it’s limited to 30% of your income for that year. So if you made $100,000, the lowest $30,000 could be the max you’d put in there, and then that goes in your foundation, and then you can decide how you’re gonna divvy it up. The other way we would do it if you had a sweetheart personality already and you wanted to give that much to somebody, you can give 10 or 10, whatever amount, to the charity of your choice, and accomplish the same thing. But sometimes people like to accumulate a foundation—you get the write off for that, but if you put $30,000 in there, it’s not gonna save you $30,000 in taxes. That $30,000, depending on what tax bracket you’re in, might save you—to run your foundation, you need for it, that’s true. Yeah, so, if you can fold that stuff into the purpose and mission statement of the foundation, then you’d be able to utilize some of those expenses you would otherwise have, you’re paying for yourself, you’d pay through your foundation. And then you get deducted for the foundation. Go ahead, Kenny.
KENNY: Yeah, you guys shouldn’t use Mike. He’s like a magician.
MIKE MURPHY: Thank you.
KENNY: He’s really awesome.
MIKE MURPHY: Thank you, appreciate that.
[MUSIC]
ANNOUNCER: This show is produced by the Hartman Media Company. All rights reserved. For distribution or publication rights and media interviews, please visit www.HartmanMedia.com, or email [email protected]. Nothing on this show should be considered specific personal or professional advice. Please consult an appropriate tax, legal, real estate, or business professional for any individualized advice. Opinions of guests are their own, and the host is acting on behalf of Empowered Investor, LLC. exclusively.
* Transcribed by David
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