Avoid Tax Traps: Attorney Shares Essential Tips For Rental Property Owners

- Hey guys, Toby Mathis here, and I'm joined by Amanda Wynalda, a Tax Attorney with Anderson Business Advisors. And who do you primarily work with? - We primarily work with real estate investors, small business owners.

- All right. And we are going to be going over how to avoid some tax traps and essential things that real estate rental property owners need to know. Is that correct?

- Yeah. Some of the big mistakes that people make. - Let's dive in.

What's number one? - Number one is really not taking depreciation. - Why would somebody not take depreciation?

- It's funny because people hear, oh, when if I sell a property and I've depreciated it, I'm going to have to pay depreciation recapture, and depreciation recaptures tax at a higher rate up to a max of 25. So they think, if I sell a property, I don't want to have to pay depreciation recapture, so I'm just not going to depreciate my property while I'm renting it out. Unfortunately, you have to pay depreciation recapture even if you don't depreciate your property during that time.

- Yeah. So the rule is if you could depreciate it, you must recapture, you may take that loss. Why would somebody not.

. . Like what's the argument for somebody that says, oh, I didn't depreciate my rental property, I wasn't making any money, or I was just creating loss, or what would be the reason?

- Yeah, it's usually because they're creating an excess loss that because rental real estate is a passive activity, they can't take that loss and offset say, W2 or 1099 income. So that loss just accumulates more and more every year. - So make sure you take your depreciation.

So we'll call that number one. What's number two? - Well, not accelerating that depreciation when possible, or taking bonus depreciation.

- Oh, I like the sound of that. So what's accelerating it? What is that called?

- So essentially you're going to have to do what's called a cost segregation study. So if you have residential real estate that's depreciated over a 27 and 1/2 year timeline and commercial real estate's depreciated over 39 years. So you essentially take your basis and divide it by that amount.

You back out the land, 'cause land doesn't depreciate, but the structure and you divide it by those time periods and you take that small piece every year and most people look at their tax return and kind of thinking that, that is equivalent to deducting like the mortgage payment. And so when you're calculating your income in and your expenses out, it gives you an expense that's not coming directly out of your pocket. But with bonus depreciation rules what you can do is hire a specialized tax firm that will go in and separate out all of the property into 5, 7, 15 and 1/2 year property or 15 year property.

And so that's things like the HVAC system, the plumbing, the carpets. Carpets aren't going to last 27 and 1/2 years so why should you depreciate it out over that extended period of time? Let's do it over 5 years, 10 years, seven years.

- And then once you do that, so let's say it is cost seg study. Now I've broken my property down into 5, 7 and 15 year property, then what else could I do with it? - You just accelerate it.

You use those bonus depreciation rules. And so instead of waiting five years to fully depreciate five year property, you can take it all in the first year. You can spread that out over the first three years depending on what's other things are going on in your tax return and what other income's coming in, you can get really, really creative to get the best tax benefit.

- So the moral of this story is, you don't have to wait 27 and 1/2 years or 39 years to write off a property, you can accelerate it and the first step is cost seg, break it into 5, 7, 15, and the second step is let's accelerate that depreciation even further. Boom. Alright, perfect.

So we've hit two, what's number three? - Alright, so not claiming real estate professional status if you can. So you might be thinking, okay, well real estate is a passive activity and now I've accelerated all this depreciation that's just building up more passive activity losses that I can't use to offset anything.

Well, if you actually work in a real estate trader business for more than 50% of your time and you reach certain markers on terms of hours, then you qualify as what's called a real estate professional. So you make that election on your tax return and that's suddenly turning all of those previously passive losses into active losses and those can offset you or your spouse this W2 income. - So if somebody may be sitting there and is it something you have to elect?

- It is. - So you may be entitled to this and you have no idea that you actually could do it. And so it's 750, 50%?

- Yes. It's more than half of your personal services. So it is a little hard if you work a full-time job.

If you work 40 hours a week then you need to work 41 hours in your real estate trader business. But if you are doing something that's part-time, we see a lot of. .

. Or your spouse, we call it a non-working spouse, but really it's a spouse who's typically working in the home who, if you're really thinking about it, that job never ends but the IRS just doesn't give it its due respect. And so if you have a spouse who is a homemaker or works inside the home, they can actually qualify.

And so you need to meet that 750 hour a year rule, and that's only about 14, 15 hours a week, it's really not a lot. - And then you have one more step, right? You actually have to materially participate with your rental properties, which if you have rental properties, you can, what?

Aggregate 'em all as one activity and boom, use that. So that creates, and for those of you guys who are unfamiliar with passive activity loss, generally passive losses can only offset passive income. So like sometimes you have these big rental losses and you can't use 'em, you carry 'em forward and eventually they get released when you sell the property but I can't use it against my W2 income for example.

So what Amanda is acutely pointing out is that now we can, we can use it against our W2. So if you have like a. .

. Do you have any examples of like a situation? - Yeah, so we have a lot of clients who are high earning professionals like doctors anesthesiologists, that's a good one.

And so they are earning this high W2 salary mortgage brokers for a long time, over a million dollars a year and we don't want to be paying taxes on a million dollars a year. So they have either. .

. You typically it's their spouse who's then investing in real estate. They're picking up a few properties a year.

They're using this cost segregation strategy to create loss against that rental property income. And then because the spouse qualifies as a real estate professional, that turns that formerly passive loss into active and then it's offsetting that W2. - It can have a pretty big impact on your W2, I imagine.

All right. So is that number three, if I'm not mistaken? So let's go to number-- - Number four is very similar if you don't qualify for real estate professional status, 'cause you just can't meet that personal services 50%, maybe you're working full time.

There is another strategy that can transform those passive losses into active, and that's known as the short-term rental loophole. - I like the sound of that one. What is that one?

- So the short-term rental loophole is kind of exactly what it sounds. You need to have a short-term rental. And what qualifies as a short-term rental is a property that you're renting on average for seven days or less.

So you're taking the total amount of time you've rented it, the total stays, and as long as that's divided by the number of stays and it's less than seven, then you're going to qualify. - So if you have 50 rentals during a year and they averaged, like you rented your house for 150 days total, you'd take 150 divided by 50, it'd be three, and that would be considered short term rental. And what's the magic thing about short-term rentals?

- It's that then you materially participate, and material participation, there's seven tests. The ones that you're typically going to go for is spending at least 100 hours working on that property, property managing, cleaning it of you're close by and more than anyone else, you can run into an issue because with short-term rentals, there's a lot of turnover. So you need to get in there and clean between each tenant.

And so you don't want to have a cleaner who's working more than you are, 'cause that's going to negate that material participation test. So typically you're going to have to swap out the cleaners, use different companies, but as long as you're working a minimum of 100 hours and more than any other third party, you're going to qualify. Now if you don't, you can still qualify for material participation you just have to hit 500 hours.

- And it's the activity, it's a whole like, so you could take all your short-term rentals and treat 'em as one big activity. So if you have three or four, and maybe two are out of state and two are in state, you could actually aggregate that. And then that is also both spouses, right?

We're adding up both spouses time. So if one spouse spends 70 hours and the other spouse spends 40 hours, you'd still qualify, right? - Yep.

- That's pretty potent. And again, that loss could be used against your W2 income. - Yeah.

So you're doing. . .

Then you're rolling back into those same depreciation strategies, doing a cost seg analysis bonus, ex depreciation, and accelerating that depreciation, so you're offsetting your W2. - All right, what's the next one that they missed? - All right, so the next one I've got is not using a property management C corporation.

And this one kind of scares people because you think, oh, a C corporation, that's, oh, no double taxation. Oh no. But with the tax cuts and Jobs Act, it dropped down the tax rate for corporations down to 21% ,down from the tiered structure it used to have.

And so if your tax rate is higher than 21%, why not shift some income over to an entity where you can be using and spending less tax? - Absolutely. And realistically, how many C corp do you see being profitable with small business taxpayers?

I mean, most of the time, - Usually, none. - Yeah, most of-- - And that's the idea though, right? - You're getting the money out or you're expensing it and there's a ton of tax benefits with C corps that don't exist for anything else, including the health medical benefit where you can reimburse 100% of your medical, dental, and vision expenses, write it off and not have to include it as income to yourself.

There's accountable plans, there's a whole bunch of fun stuff, but we're zeroing those puppies out. - Oh yeah. That's the idea, is that you're taking 10, 15 up to 30% of the income that's normally hitting your Schedule E for rental properties or even trading income.

You can use a C corp as an asset management company, you're shifting it over to that corp and then you're turning around and pulling it out with tax free reimbursement. So tax free money, bounce through the corp right back into your pocket. - All right, so I'm liking these.

I think we've done five now, but like those are really potent. What's next? - We're just getting started.

- Just getting started. - We're just getting started. - There probably are a bunch of those.

- So one big mistake that rental property owners do is selling their rental property and buying more rentals. And you're maybe thinking, well, isn't that kind of the point? - Yeah.

Yeah. - But you need to do it in a tax wise manner. So if you haven't heard about this strategy, it's called a 1031 exchange.

And it sounds. . .

We work with real estate investors all day every day, so very rarely do we come across someone who hasn't at least heard of it, but it still happens. I've talked to a client even just a couple months ago who had 10 rentals and they still had never heard about what a 1031 exchange was. - So what is it?

- So it's a way, it's under IRS code section 1031, shockingly. And it's a way for you to exchange your rental property for what's known as like kind property. And that actually used to be one single family rental for another single family rental.

But the rules have expanded to incorporate any type of rental property. So you can take a commercial property and exchange it for raw land, a ranch and exchange it for an apartment complex. It really just needs to be property use for rental purposes.

And what you do is you sell that property and then you use what's called a qualified intermediary to hold the funds. And then you have a very specific amount of time to identify what's known as a replacement property, so essentially the other new property you're going to roll into and then close on that. And as long as you never touch those funds, they never get sent back to you.

They just go directly to the new purchase. You do not pay any capital gains or depreciation recapture, you get to defer 100% of that tax. - And it goes into the new property, right?

Do you have to buy just one property or can-- - You don't, I'm glad you asked Toby. You don't, you can actually sell a single property and roll that into multiple properties - And vice versa, right? - And vice versa.

- We could sell a bunch and buy one. Yeah. So really effective tool.

I like that you have that on your list. What else? - What else?

All right. So in terms of rental properties, one big mistake that clients make or that people can make is turning your personal residence into a rental. And it's not that you shouldn't do that, it's that you should do it in a specific way.

- Tell me about that. - So when you sell your primary residence, you have what's called a 121 exclusion. And that allows you to exclude up to $500,000 of gain on the property.

So you could sell your home and if you sold it for $500,000 more than what you bought it for, you would pay 0% in tax, zero tax. So if you're turning it into a rental, you can actually sell that home to an S corp that you own and take advantage of that 121 exclusion while also increasing the cost basis of the property. So remember that depreciation deduction that is based on the cost of the property.

You're now taking that and giving yourself $500,000 of increased depreciation expense. - Who would do this? Like why would you do that, under what circumstances?

- Who wouldn't do it? Well, first you need to own your primary residence for three of the last five years. And this does not need to be consecutive years.

You need to own and live in it for three of the last five years. So you could live in it for one year, move out for a few years, move back. My husband and I have actually done that during the pandemic, moved back and forth a few times, as long as it's two out of the last five years.

But the other reason-- - Two, right? You were clear, right? - I did say three, didn't I?

- Yeah, it's-- - Two of the last five years. So the other reason you would do it is if your primary residence has increased in value substantially over the time that you've lived there. Because remember, your cost basis is the amount that you purchased the property for, plus any capital improvements, and that's what your depreciation deduction is based off of.

- So if you're somebody who's had a lot of appreciation in a home, and you're going to move out of it, but you're going to make it into a rental property, then you basically, it's two out of the last five years, so you have three years basically. Move out. I have a five year stretch I'm looking at, 24 of those months needs to be my primary residence that I owned it.

So I have three years basically to sell that and capture the tax-free gain. - Yeah, that's true. Even if you have already moved out of the property and are using it as a rental, you can still sell it to your S corp and start the strategy.

- And the reason I would do this is because I get the tax-free gain, it increases my basis now for the entity that purchases it. Yeah. So I hope that's fitting in.

There's a kissing cousin to that one when we take a property and turn it into an investment property to 1031 exchange it too, so you can use your 121 exclusion. But that's a pretty potent comment there. And that is something we do see quite often.

People don't realize that they're literally leaving-- - A lot of money on the table. - A lot of money. Like hundreds of thousands in some cases.

- Yeah, you could be paying no tax. You should be paying no tax on your rental property income. - Especially our California friends.

Like we've seen that over and over and over again. They move out. They don't know the strategy exists.

They end up making it into a rental. Three years goes by, they lost that $500,000 exclusion. It's gone.

Bon voyage. It's never coming back. - All those Californians moving to Vegas, you got to do it.

- Yeah. They do like to move here. - They do (chuckles) - We love them.

- I am one of them (laughs) - We love you Amanda. All right guys, what's next? - All right, so gifting your property to your kids, this is a big mistake.

And it's not that you don't want your kids to inherit your wealth, it's that you want them to do it in a certain way. And this came up a lot with, I believe it was Prop 19 in California that changed a couple years ago. It was changing the amount that you could keep a tax basis in your property for property tax purposes.

And so we had lots of California clients calling saying, I need to transfer my property to my kids right now while I still am grandfathered into this old rule. And ultimately, when you're transferring property to your heirs, you do not want to do it while you're still alive. - Why not?

- And that's because what's called the step up in basis. So if you transfer your property to your children or to whoever while you're still alive, it's called an inter vivos transfer, and they get a transferred basis. So that means whatever your basis in the property was, that becomes their basis in the property.

And we ran into this with my grandmother. She was moving into a home, she's 95. I've had three grandparents make it past 95.

And they live about five miles from Disneyland. And they bought their home right after World War II for $26,000. And it is worth well over 800.

And so when she was into a home, my mother and her five brothers and sisters were thinking, oh, well let's just put our names on title. I was like, no, no, don't do that. Don't do that.

Because then if they needed to sell it or they wanted to sell it, they would turn around and pay tax on the difference between 26,000 and 800,000, that's a lot of tax. - Grandma would lose the 121 exclusion too if she changed-- - Oh, 100%. - Yeah.

She could still keep it now, but chances are grandma passes the property value for tax purposes, the basis is now whatever the value is, so 800,000. And if your mom and her siblings, your uncles and aunts sold it, they would pay zero tax. - Zero tax.

- Zero tax, so that's how you destroy your zero tax as you transfer your. . .

You jump the shark and you end up-- - Yeah. And the best way to do that is obviously going to be through a revocable living trust. - Yeah.

Transfer. That's a topic for-- - And that gives grandma, you, control over the property and then distribution control even after you've passed away. - And if you have questions about a living trust, look on my channel, there's a million videos on living trust.

All right, what's the next one? - Alright, so holding appreciable property in an S corp. And I know that sounds kind of weird 'cause we just told you to sell your property to an S corp.

So a lot of these strategies, you've kind of got to combine them. You've got to really think ahead of what you want to do. If you're selling your primary residence to your S corp, the idea is to hold it there until, what did we just talk about?

Your heirs can inherit it - Pass away. - After you pass away. But if you are just a new investor and people are saying, oh you need to set up a corporate, you need to set up an S corp to hold your rental property, you need that asset protection.

There's all kinds of tax benefits with an S corp want you to stop before you do that. An S corp isn't necessarily going to be the best way to hold your property. For legal purposes, there are other options.

Typically we're looking at disregarded LLCs or even partnerships. The reason you don't want to hold your property in just an S corp is there's a lot of times where you need to remove your property from your legal entity for financial reasons, for-- - Refi. - Refinances.

Maybe you've escaped some sort of lawsuit. So you just want to switch up your structure a little bit and go in a different direction. If you pull that property out of your S corp, even if you put it in, it's treated as a distribution to you as a shareholder.

- As a taxable, right? Like you're going to end up getting a tax hit. Ouch.

So you better have a lot of benefits if you're putting that in there. Well again, like you just said, if you're selling your house to it it's because you're doing so mindfully so you can capture a massive amount of deduction you'd otherwise lose and you're depreciating, so you're getting a bunch of tax benefits which outweighs the negative consequence if you do have to take it out, hopefully you don't. But for everybody else, yeah, we see that.

It's always kind of crazy to me. I'm always like, how do you say I'm an accountant that doesn't know real estate without saying I'm an accountant that doesn't know real estate. And usually it's 'cause they're buying a whole bunch of properties or advising their clients to put 'em in S corp.

Okay, what's the next one? - So similar to that, holding appreciable property in your C corporation. C corporations are great for income shifting and for management companies 'cause you can pull that out tax free, but you're typically not going to be able to pull out 100% of your rental income tax free.

The real kicker is when you actually sell the property. - Oof. - When you sell property out of a C corporation, you're going to have that flat 21% tax rate, which sounds pretty good.

If you have a 34% tax rate, that sounds good. The problem is, is that the government actually gives you preferential tax treatment to long-term capital gains like rental property and that's zero, 15 or 20% depending on what your income is. So even best case scenario, you're going to be paying more tax if you're selling it out of the corporation.

- And then if you want that money that's in that C corp, you're going to have to get it out of that C corp. And it might be wages, reimburse your good, you get reimbursements. But a lot of times it's going to be a dividend and dividends are taxed, long-term capital gains as well, so you're getting a double tax.

That's why a lot of accountants, when you say C corp, their immediate refrain is we don't like 'em 'cause you have to pay a double tax. So generally speaking, you're going to zero that puppy out. But in real estate and you have a big gain, there's no hiding that puppy.

It's going to be in there. If you're going to take it out, you're probably going to be paying the piper. - I've lost count of how many we've done.

Do you have any others? - I have no idea, but I know that this has been very, very fruitful and that there were a ton. Are there any others?

- I don't have any more. Not for today. - Well, I think that you just like-- - I don't want to blow everyone's minds completely off of their head.

- I think you did a really good job of pointing out the big tax traps for rental property owners. Thank you. - You are welcome.

- If you guys have questions, put 'em in the comments. And if you could do me a huge favor and like, and subscribe and even better yet, share this with somebody that you know that's a real estate investor, owns rental properties or is a landlord who could benefit from this information. Thank you guys.