Income property is the most tax-favored asset in the world, and to explain how, Jason Hartman was joined in this Flashback Friday episode of the Creating Wealth podcast by Diane Kennedy, a CPA and New York Times best-selling author. Together, the pair covered the tax benefits of income property that are presented to investors.
Kennedy explained that qualifying as a real estate professional brings about several benefits, and she covered the several ways an investor could qualify to pay almost no taxes in completely legal, government incentivized ways.
The Government Doesn’t Take a Big Cut of Tax Benefits of Income Property
Jason Hartman is joined in this Flashback Friday episode of the Creating Wealth podcast by Diane Kennedy, a CPA extraordinaire. Together they aim to focus on life’s largest expense, taxes, and how to avoid them as much as legally possible.
Income property is the most tax-favored asset in the world, Jason explains, and adds that he’s currently engaged in some 1031 exchanges. These aren’t used or spoken of enough, because people only really use them when they’re selling a property. He mentions that you don’t get this kind of tax-favored treatment in stocks, where you have to pay to gain. Keep in mind, the government is also taking a big cut out of what you sell, so you’re paying them before you can put your money back to work. With income property, you have the ability to put all of your money back to its highest use, not to mention the tax benefits of income property.
Kennedy explains that there’s a term for this called a “tax drag”, and economists use it when they’re comparing countries’ potential for economic growth. Let’s say you sell a stock, she says. You get capital gains, but you’re still paying taxes at 24%, the highest rate. This means that you only receive about ¾ of your money to reinvest.
In reference to 1031 exchanges, Kennedy mentions that she had an email from a guy about a month ago who’d heard about it. He had a deal on a property and his profit was around $500,000. He’d just closed escrow and wanted to know if he could 1031 exchange the property, which he could not because it was too late. Escrow already closed, and 1031 exchanges must be set up beforehand.
Returning to the tax drag, Hartman explains that if you live in California or other high-tax states, you’re getting even less than ¾ of your money back for reinvestment. Even if you don’t live in California, and the Fed is the only one taking some of your profit, you’re still losing money. Over the course of a decade, when you’re buying and selling stock or precious metals, you lose money. Compare this with income property where you get all of your money back to reinvest. He adds that when you die, your heirs can receive a lot more fortune to fight over.
Kennedy states that income property also steps up to market value, which is called a “stepped up basis.” She explains that, for example, you might have paid $500,000 for a property, and over time you’ve depreciated it to a book value of $250,000. If the property is worth $1 million when you pass away, your heirs start off back at $1 million.
Hartman adds that there is no depreciation recapture, which is phenomenal. Your heirs don’t recapture anything, and you can trade the asset all of your life tax-free, as many times as you want. When you pass it onto your heirs at the stepped-up basis, they pay no tax on the asset which is just another of many tax benefits of income property.
Kennedy on Charitable Remainder Trust
Kennedy explains that it’s important to look at the charitable remainder trust, the CRT. If you’ve got a lot of property that has really depreciated, and you’re performing a 1031 exchange. The basis keeps reducing as you continue to depreciate. She mentions that if someone is getting older, looks at their properties, and does not really want them anymore, they can put them into a trust. The idea is that the beneficiary is considered a charity.
Because the properties are in a trust, they’re able to be sold with no tax, and the trust can be set up in a way to where the income flows to you. This way, you can continue to make money off of it without the tax drag. Later on down the line, you can also buy life insurance paid through that trust. For the right property and the right age, it’s a real gift, Kennedy says.
When asked if she believes in life insurance as an investment, Kennedy explains that she bought a policy twenty-five years ago. It was a whole life policy with low premiums, and it had a guaranteed return. After paying on it for three or four years, she never paid another premium. The policy has cash value and is completely tax-free as long as loans are taken out. It’s another form of asset protection but doesn’t work as well as income property.
Three Tests to Qualify as a Real Estate Professional
Hartman states that when it comes to real estate professional status, he receives a lot of questions. In his opinion, this is the holy grail of tax benefits, with nothing better under US law. He adds a couple of points, mentioning that you do not have to be in his business or have a real estate license to reap the tax benefits. It’s necessary to spend a certain amount of time investing in real estate to qualify, and it might be worth changing the way that you or your spouse work at your own careers.
Kennedy explains that with real estate, there’s a lot that you can do to where even though you’re putting cash in your pocket, legally you can claim a tax loss through depreciation. If you make under $100,000 per year, you can take a write-off of that real estate against your other income, up to $25,000. If you make more than $150,000, you can’t write anything off, she states.
She adds that if you’re qualifying as a real estate professional, you can take 100% of your real estate losses against your other income, no matter how much the loss or income is worth. There are several ways to do this incorrectly and only one right way.
She explains that there are three tests used to determine qualification.
First, at least 750 hours’ worth of real estate activities are required. This could be obtained by having a real estate license, working construction, or managing your own properties. You’ve got to spend more time doing work on your property than any other job or profession. Either you or your spouse are able to meet the requirement.
Kennedy shares a story about a client she had, a highly-paid cardiac surgeon. He made about $500,000 per year, and his wife worked part-time as a nurse. The couple was buying apartment buildings and the wife would spend time with the crews overseeing the work being done. The client’s income didn’t allow the great write-offs available, and his wife didn’t have enough hours logged as a real estate professional, so she quit her job.
Because the couple was dedicating the hours, and providing low-income housing, within the first year their taxes were cut in half. The second year, they had no taxes. Five years in, they had so many properties that they made as much cash flow as the client made as a surgeon.
Kennedy adds that another requirement is 500 hours of material participation, which can be done in three ways. You can get away with spending at least 100 hours per year on the property, and you won’t need the 500 hours if you can prove that you’re spending more time working on the property than anybody else. There is no limit to this.
The number of hours is necessary unless you make an aggregation. That must be done on your tax return to elect that you’re treating all of your properties as one entity. This is called an aggregation election.
Hartman explains that if you have a portfolio of a dozen single-family homes and you have to spend 100 hours on your properties, as well as more time than anybody else, it’s a good idea to put your smaller properties into an aggregation election. This is simply a page attached to your return that says you want to treat your properties as a single entity.
Kennedy agrees, adding that that the IRS used to not people to go back and make the election. Now, case law has allowed it. You can go back and perform a retroactive election as long as the year is open. If you’re being audited, by definition, the year is open because the IRS cannot audit a closed year. Three years is the statute of limitation for the Fed.
Self-Management Will Help You Qualify
Hartman mentions that something that will help investors qualify is self-managing their properties. He states that several years ago, he was surprised to learn that he could self-manage a property that was 2000 miles away, and never thought it was possible before. His self-management adventure started by accident when his property manager got out of the business and he never got around to hiring a new one. He received a note and rent payment from the tenant and took it from there.
He states that if a property manager is good at their work, he keeps them. If he doesn’t like how they do things, he will self-manage instead. The manager makes the decision for him based on their work. He has discovered that in self-management situations, the tenants do not seem to ask for much. The reason is, they see you as a person rather than a corporation.
Returning to the qualification tests, Kennedy reiterates that 750 hours annually are required, and they can involve any real estate activity. As long as the activity is an action-taker used to hone skills, it counts. Material participation hours can get complicated, even for auditors.
When asked if it helps to have a real estate license, Kennedy explains that it does, but you still have to meet the hour requirement. If you’re a real estate professional, you might qualify under test one, but not under test two.
Even with only four properties, it’s possible to qualify as a real estate professional if you manage to meet all of the real estate requirements.
Hartman adds that if you’re semi-retired with a part-time job, and you spend a lot of your time managing your properties, he wonders if it’s easy to qualify.
Kennedy explains that you might qualify but adds that people often get caught up if they have a business because they might be getting a big income, but they’re not working as hard anymore. The IRS might try to challenge that, but it’s possible. You have to be able to prove your hours.
Tax Topics Are Complicated; Seek Professional Help for Tax Benefits of Income Property
Kennedy explains that with material participation, you’ve got to look at how you’re holding your properties. If they’re in an LLC, you want them as a manager-managed LLC with yourself named as the manager. Being a limited partner means that you don’t control anything. Business structure is very important.
Hartman states that when you start getting into entities, life can become very complicated. He adds that neither he nor Kennedy are attorneys.
He mentions that it can also get complicated when it comes to setting up your LLC, the state where your property is held, and the state where you reside. If they’re all different, sometimes insurance companies will have a hard time insuring you. These situations are never as simple as a promotor makes them sound. Make sure you are talking to a professional so you get all of the tax benefits of income property available to you.
Another Reason for Real Estate Professional Status
Hartman explains that depreciation is the holy grail of tax benefits as it is a non-cash write-off. When you buy an income property, it isn’t a single component. It’s composed of both land and improvement (the house or building). The IRS basically says that the improvement or home is an asset that will one day be worthless. Instead of taking a deduction for it at this time, they will give you a number as a depreciation rate. For residential homes, this number is 27.5 years.
If the value of the property is $100,000 in improvement and $20,000 in land value, most of the benefit is in the improvement. That $100,000 can be depreciated by 27.5 years and you will get to write it off if you qualify for it.
Kennedy adds that depreciation is a phantom expense. Beyond the depreciation write-off, you can also perform a cost-segregation study, as inside single-family homes there are improvements that depreciate faster.
These can be done by oneself with standard guidelines. Front-end load the depreciation, and if you’re planning to buy more properties every five years it will be a good step. She adds that if she has a client that has had properties for three or four years and they suddenly qualify as a real estate professional, she can perform a catch-up depreciation.
She adds that if you’re a real estate professional and you’re paying taxes, you either do not have enough properties or you don’t have the right CPA working with you.
The Government Wants You to Own Property
Hartman adds that the government wants you to own properties and provide housing for people. They even incentivize you to do so. It’s important to align your interests and goals with governments and central banks.
For more information about Diane Kennedy, visit www.ustaxaid.com.