2023 Tax Update with Thomas Castelli, CPA

Strategies. But when you do use those types of strategies, you just want to make sure you rethink all your T's cross and your eyes dotted so that if an audit ever does come, you're ready, you're ready to go.

Welcome to the Next Level Income show where it's our goal to take your income, your investments and your life to the next level. I'm your host, Chris Larson. If you haven't yet, get a copy of our book for free at our website, Next Level Income.com. that's www.nextlevelincome.com. just click, click on the book link and I'll even send you a copy if you put your address in. On today's show, we welcome back my friend Thomas Castelli. Thomas is a tax strategist and a real estate investor who helps other real estate investors keep more of their hard earned dollars in their pockets and out of the governments. Today we're going to talk about some updates to the 2023 tax code as well as strategies that you can use to keep more of your own money. Thomas, welcome back to the show.

Hey Chris, thanks for having me. Always a pleasure.

Yeah, no, it is a pleasure and you know, it's more of a pleasure to see you than to, to write checks to the IRS like, like a lot of people are getting ready to do here this next week. And you know, always love having you on to talk about updates that we're seeing, but more importantly, how we can proactively address our tax situation. I think a lot of people say, oh yeah, I got a CPA or you know, I have an accountant that does my taxes. And I often talk about, Thomas, how people, especially investors at a high level, really need a tax strategist. So if you wouldn't mind starting out telling us a little bit more about the background of the real estate CPA and what you do and how you're different than just a typical quote unquote accountant.

Right, right. So the real estate cpa, we're an accounting firm where we, where we only work with real estate. So all of our clients are investing in real estate in some way, shape or form. Some of them are investing in single family rentals, Some of them are doing multifamily, some of them are syndicating deals, some of them are fun, some of them short term rentals, all types of all types of different things. So that's the one string that holds the real estate CPA together is that commodity. And I think also what we do differently is we focus on advisory first or like tax planning first, for example, because we realize that that's what actually moves the needle. All right? It's, it's when you have your tax return, all that is, is a report card of what happened in the prior year. So really, when you, when you go through tax strategy and tax planning, you're starting to look at, okay, well, what strategies can you use, what tactics can you implement this year so that when it does time to file your tax return come tax season, you're actually impacting the needle. So that, that has been tremendous for our firm in terms of the ability to work with clients in a different way. But we've also been able to save investors thousands and thousands of dollars in taxes every year for many years now. So it's been very exciting. And I think that that's, that's kind of what separates us. Now. What most CPAs do, or most accounting firms do is they just file the tax return. So you go see here, they'll file your tax return and they'll say, you owe this to the IRS or you're going to get a refund. Congratulations. And that's about it. They never really tell you to do in terms of how to minimize taxes. And so that, that, that, that is key. If you want to minimize taxes, you have to be proactive. You have to get with an advisor going to be able to help walk you through it, or, or go ahead and implement those strategies and be able to impact your, your tax situation.

Yeah. And look, I can say from a testimonial perspective, first off, I'm, I'm one of your clients, and you have helped me and my coaching clients save literally hundreds of thousands of dollars here. You know, just, just since we started working together in the past couple years, it's probably, I wouldn't be surprised if it's over seven figures at this point. Just with, with that small group. And listen, you know, one of the reasons people might say, well, why are you having Thomas on now? It's April. Like, we're already in tax season. The reason is you've probably, if you filed your taxes on time, you probably know what your tax bill is, and you're probably thinking, okay, what can I do going forward? And in my opinion, it's 20, it's April. It's the best time to look for forward and say, okay, what are some different things that we can do? You know, before we get into that, Thomas, you know, we've had some changes here, specifically when it comes to real estate. And, you know, one of the big things was the 2017 changes that occurred under President Trump, some of those have changes such as depreciation. Do you mind sharing a little bit about, you know, the, the updates, the changes, what that means to investors and anything else that is really materially changing in 20.

Right, right. Yeah, that's, that's a, that's a great question. So start here. So way back in 2017, they implemented tax cuts and Jobs act and with that came 100 bonus depreciation. Basically properties that were placed in service from September 27, 2017. Random date? I have no idea. Through December 30.

It was a random date. Probably, probably to satisfy some senators, you know, purchase or something like that. It was like September 29th or something. It was crazy.

It was just so random. I'm like, I don't why they picked the date they did. So it's like, okay, from like the tail end, maybe like, like the tail end of 20, 20, 2019, excuse me, 2017, all the way through December 2022, if you place the property in the service, you were able to get 100% bonus depreciation. And what that meant is that the, with the 5, 7 and, excuse me, 5, 7 and 15 year class life could be 100% depreciated or expensed. In other words, in that year so that you acquire the property. And that's been significant for taxpayers. Just to give a quick example of what that might look like. Let's just say you had a $500,000 property just going to go right down the middle. Let's say that 25% of that property can be reallocated to that five, seven to 15 year property. I mean, we're looking at.

Thomas, real quick. I, you know, I apologize to interrupt you here. So just, just to kind of pause for a second. So commercial real estate is typically depreciated on a straight line basis. That's an equal amount every year over 39 years. Correct. And then residential is over 27.5 years. But what you're referring to is other is, is property inside the property, which, like what's a couple examples of five, seven.

Yeah, so, so great example. Five year property that's considered tangible. Personal property would be like appliances, certain types of carpeting, laminate, floor flooring, a, certain types of cabinetry, fixtures, things, things, things of that nature. Now when you're looking at seven year property is usually undefined. So just random stuff you might find in there. I don't have any examples offhand, but.

What about like landscaping? Where would that fall? Like plants and stuff like that question.

That'S the 15 year property, that's land improvements. So that would be like, like landscaping, pool decks, outside plumbing systems, things of that nature.

Gotcha.

So basically what happens is that they kind of, I guess take a step back here. You bought property, it's going to be depreciated over 27 and a half for residential, 39 for commercial. Then you can have a cost segregation study performed. And when you have a cost segregation study performed, typically an engineer comes down to your property, like, surveys the property, inspects it, comes back with a report and says that, okay, this is the amount of property you have, the amount of seven year property, if any amount of 15 year property you have, and then here's the amount of 27 or 39 years. So basically they're taking a portion of the property that would have been depreciated over that longer schedule at 27 and a half or 39 years and saying, okay, it really falls under this five, seven or 15 year category.

Gotcha.

And that, that in and of itself can, can increase. Well, that in and of itself does increase your depreciation expense annually for at least five years. Right. Five, 15 years. But basically what that Tax Cuts and Jobs act said was that you could basically take that as an expense all in one year for that five, 15 year property. So rather than having to spread that out, you're just taking it all at once, which is substantial.

Yeah. So back to our regularly scheduled program. So you were saying, so for a $500,000 property, you were giving us an example of what that might look like. Right, right, right.

So just for anybody who's listening, this is an example. You have to go and speak to a cost segregation provider or your CPA to get a more accurate read for your specific property. But let's just say it's a $500,000 property. About 25% uncommon is reallocated. That five, seven and 15 year life, that's about $125,000. And that would be a deduction in the first year use, percent bonus depreciation. So you can imagine how powerful that could be, you know, to say you're making. Let's just say you're making $250,000 a year. You're able to get a deduction like that. You're paying taxes on $125,000 of your income, and that could save you substantial amount of money in taxes.

It's massive. It's massive. So now a lot of, a lot of investors that are listening are saying, yeah, Thomas, that's great, but that doesn't apply to me because, you know, I've talked to my accountant and I make W2 income. I got a job, so I have, I have all this depreciation. But if you're making money off of your piece of real estate, that depreciation. So let's say I make $20,000 off of that $500,000 property. So I have a $20,000 gain that year. I have $125,000 loss. What happens to the rest of that depreciation, that $105,000 in this example? Right.

That's a great question. It depends on your situation. Um, so if.

Great answer.

It's, it's, it's, it's a good one because it, that's what happened. Right? So we have. So if you're a passive investor, meaning you're not actively involved or you don't have an exception, this loss will that basically say you thousand dollars of, of rental income, I believe you said, right, 20,000.

20,000. Yes, sir. Yeah.

You might have other expenses that come in there, but let's just assume depreciation was your only expense. You would have this ton 5k loss, and this loss will be carried forward in the future years, so it's going to offset your income. If you had other rental properties that had income or other passive activities, this is, that you may not be actively involved in. Like a silent partner, for example, would offset all that income, and then whatever is. Would be carried forward to future years where it could be used to offset your passive income in future years.

Yeah, I love that. You know, it's one of these things where I like to say, if you're doing real estate right, you shouldn't be paying taxes if you're taking all these advantages. Now, obviously there's, you know, that's a, that's a really broad statement, you know, and it's, it's interesting. You know, you start off, real estate's a real long game. And, you know, you start off, you're like, okay, I'm making a little bit of money every month. You know, maybe I have a residential property or a syndication that I'm a part of. You see these big losses and you're like, well, I'm not making a ton of money. I can't take advantage of these things. But over time, 5, 10, 20 years, in my understanding, and you can again, I'm not, I'm definitely not a cpa. These, these start to layer on top of one another. So, you know, for instance, and this is something that you and I have discussed at length and under, you know, in kind of in different forum. But you may have that loss. So you might not be able to use it in one property. But you were saying is you may have another property with the substantial gain or substantial income and you can layer the losses from those, those properties that fall in the same category. Is that right?

Right. Right. So the passive losses can offset passive income. So if you have activities that are passive for many real estate investors, just other rental properties they may have, those losses can offset the rental income, for example, from your other rental properties, or if you sell a rental property, you can use those losses to offset the gain on the sale of, of that other rental or even the rental property that generated the loss in the first place. So that, that, that's.

Can you say that, can you say that one more time? Because this is something that I think is, is not well understood. And I actually took the article that you all published in the video and shared this with our community. So what if you don't mind repeating what you just said. So if you have a loss from one property and you have a gain on sale of another property, you're right.

Right. Yeah. So, yeah. So if you have a loss on say property A and you sell property and you have a capital gain, that loss from property A will offset the gain from property B. And wow, it's kind of been coined as like the lady, excuse me, the late 1031 exchange. And you'll see people, they'll look at, they'll sell, they're gonna, they know they're gonna sell a property. They'll look at their form 85A, which is where they'll find their past losses, and they'll say, okay, great, I have enough passive losses or I'm anticipating enough, set the sale, I'm good to go. Nothing I have to do. Other times I say I don't have enough passive losses. So what I'm going to have to do is I'm going to have to take those losses, I'm going to have to go invest in another property. So maybe they invest in another rental and they do a cost segregated study, generate losses and then those losses can offset the sale. Or they might invest in a syndicate as a limited partner, take the losses from that and do the same thing.

Gotcha. Yeah, and that's, this is where having a tax strategist really, really makes a big impact. Because I think, you know, a lot of people that are used to investing in the stock market or, you know, kind of your Traditional investments. There's not a lot of tax planning that goes along with that. But if you start to layer on these circumstances, and I talk about this in my book, you use 1031 exchanges, you. You start to layer different investments and losses and gains. Through proper tax strategy, you can really amplify your, your after tax returns.

Absolutely. We see it all the time.

I know you guys do. So. All right, so kind of playing devil's. Devil's advocate. So, you know, we got, we got a listener on and they're saying that's all great. Thomas and Chris, you know, you guys, you guys are, you know, bragging about how you can save all these taxes, you know, with your real estate, you know, losses and gains and all that. But I'm a W2 employee. Like what, you know, that's well and good. What are some strategies that your, your typical W2 employee can use, you know, alongside with their investment strategy, Thomas, to help offset, you know, some of these, some of these gains that they have or start to blend them in? Because I know you guys have some phenomenal resources on your website. And real quick, we'll say this again at the end of the show. What's the, what's the best place to, to, to check out some of these resources that we're talking about?

Yeah, so if you go to taxsmartinvestors.com, you could. We have a bunch of courses. We have an, we have an insiders group. And you can learn a lot of this stuff within the, within that group, within the community, get answers to your questions. We have live Q and A's. So if people have questions, it's a great place to kind of get answers to.

Awesome. That's taxmartinvestors.com we'll have the link in the show notes. We'll also mention that again at the end here. Very good. All right. Yeah. So W2 employee average. What is there anything that your average W2 employee can do that doesn't qualify as a real estate professional or have a bunch of other, you know, options when it comes to their, their losses when it. For tax purposes.

Right. So I think everybody who, if you, if you do have a W2 job, you can absolutely use what we just discussed. That's like the, that's like the pillar. But if you want to, if you want to start use losses, if you don't want to necessarily be carried forward in future years and you actually want to start using those losses to offset the income you're earning from an active business or W2 job. What can you do? You can use the short term rental loophole. So I'm going to try to give the Cliff Notes version of how this all works. So back in, in 1986, before 1986.

You were able to start 1986, we got a lot of listeners that weren't even born then.

Yeah, I mean it was way back. So like before then you were able to just buy a rental property, a long term rental property, whatever, and just use those losses that we just talked about to just offset your W2 income. No, no problem. That became very controversial. People really didn't like that. So the tax Reform act of 1986 made all activities passive by default. And that's where that, you know, passive losses can only offset passive income came about. Now ultimately did a few years later, about eight years later or so, they implemented the real estate professional status which allowed people who work full time in real estate to take the losses from their rental properties and use it to offset their active income. And there's a whole argument about why that is, but that's what happened. The problem is with the real estate professional status is that you have to full time in real estate. So to qualify, you spend more than 750 hours and more than half your total work time in a real property trader business. And if you have a W2J or you're running an active business, this is likely not going to be feasible. There's hundreds of tax court cases and no one's really ever made it through having a full time job. So what this implement this introduces a great, a great strategy called the short term rental loophole. It's referred to and the short term rental loophole has, is an exception to the definition of rental activity. So all rental activities are passed by default. However, you know your traditional business, it could be passive if you don't materially participate. But if you do materially participate, and I'll get into what that means in just a second, then it is, then it becomes non passive. You can use the losses. So if your property has an average customer use of seven days or less, it is rental activity. If it has.

So this would be like an Airbnb, is that right?

Like exactly. Okay, exactly. Now there's another exception that's somewhat into. It's if your property has an average stay of 30 days or less and you provide significant services and that's things like daily cleaning, daily meals, maybe vouchers and tours and vehicles that they could use for free and things like that. So things you'd find in a Hotel. So if you can meet one of those two exceptions, well, your property is now not a rental activity. And if you can materially participate. And to materially participate you can meet. There's seven tests. But let's go through the top three. Most people want to qualify for is you spend more than 500 hours on your short term rental property. You spend or do substantially everything yourself, which means you're pretty much a one person show. And the third one is you spend more than 100 hours on the activity and no one else more time than you. So if you can meet one of those three tests and your property is that average stay of seven days or less or that they're less insignificant, services are provided, the losses are non passive.

That's awesome. And that's, I was going to ask you, you know you have seven tests, you have to pass all seven. The answer is you just have to pass one of the tests to qualify. Right. And so I think this is if you're listening and you're a professional, I've seen, I have friends that are doctors, that are surgeons, that are professionals. I won't name any names, but I know we, we, we know some in common here whose spouses have, have gone and taken advantage of this because they have intentionally gone and structured this where they have a short term rental business and they were making you know, money working, you know, part time or doing another job and now they manage this portfolio. And what that means is that the couple now is able to take losses from their real estate portfolio and offset their W2 income.

Yeah. So there's kind of two things going on. Yeah, there's kind of two things going in, going on there. So real estate professional status. Like what we, we've seen a lot of people who have the long term rentals they'll have if one spouse qualifies, meets that 750 and more than half their total working time test. Yeah, if one spouse qualifies and they're both real estate professionals. And now that, that is for a long term rental property.

Different.

Yeah.

So. Gotcha. Gotcha. Okay, thank you for, thank you for clarifying that.

No, no, no problem. Just because I know people, people out there, they, they, when they hear this stuff, they running with it and I just gotta make sure.

Yeah, stop. Call Thomas. Reach out. Yeah, yeah. Don't, don't, don't try this at home. We should have a warning.

Right, right. Proceed to proceed at your own risk. And then, then you have the short term rental side and if, and that, that you don't need to work full time in real estate. Which is why, is why a lot.

Gotcha. Okay. Yeah.

Because in the real estate professional says, say I'm working full time. Right?

Yeah.

If I would have, if I were to have my wife say, for example, she qualifies a real estate professional, then we would both be real estate professionals. But I would have to, in my scenario, I'd have to be married and do it. But let's say that I can't do that. Right? Well, I can. You still use the short term rental loophole. Because all I need to do is materially participate. I, I don't need to spend half of my total working time in real estate. And that's what makes the short term rental loophole so, so lucrative is because it allows you to buy properties, operate these properties in substantial losses and offset your income without having to be full time in real estate.

That's wild. And you guys, you have a book or a resource on this, don't you, on your website?

So we, yeah, we have, we have a guide, the ultimate guide to the real estate professional status. And within that guide, we do discuss the short term rental aspect of it as well. So that's 1200 word comprehensive guide. You know, if you're going to go and use one of these strategies or you just want to learn more about it, definitely worth checking out.

Yeah, let me, what I'll do is I'm going to go ahead and pull that link up right now and make sure we have that in the show notes as well for everybody if you're listening along, because it is, it's, it's really interesting. I think you made an interesting point, Thomas, you said in 1986. So this goes back to when they formed the tax law around hospitality and that's where short term rentals now kind of fall into place. So you call it a loophole because it's this space that is applying to the hospitality industry, which has transformed massively over the last 10 years.

Right, right. What ended up happening is I imagine the lawmakers who wrote this foresee Airbnb becoming a thing. And you know, back then, there's no Internet.

Back then.

Yeah. I mean, how are you. They probably didn't, you know, back then it was going to take an effort to run a property at seven days or less and usually only like motels, hotels or like true Airbnb business. Not Airbnb, excuse me, true BNB businesses. We're going to be able to do it. Your average person wouldn't be able to go buy the property. Down the block, for example, and put it on Airbnb and do. And rent it out for seven days or less.

So. Yeah, yeah, no, it's. It is, it is wild. I remember when you first told me that, I was like, oh, okay, this kind of makes sense now. Now. All right, now I'm going to play devil's advocate a little bit. So we've talked about some of these tax strategies that the people can use when it comes to real estate. But last year was it. Last year we found out we're going to have how many, how many new IRS agents run around out there?

I think it was 87,000.

87,000. That's. That's. To me, that sounds like a lot of IRS agents. I don't know what the percentage is. I remember reading stuff online. They're going to be armed and all this stuff. So it's like you have these images of, you know, the irs, like, popping up, you know, out of your bushes with guns and saying, like, hey, you know, give us your, you know, give us your receipts. Should, should people be worried about that and why? You know, this is kind of a leading question, but why or how can people be a little bit more confident about, you know, applying some of these strategies that you're. You're using?

Yeah, so the, the big thing there is you want to document everything very thoroughly. You want to, like, have an airtight case. So like, say, for example, if you're using the short term rental loophole, or the exception as some people call it, you would want to make sure that you a, have document showing that your property had an average stay of seven days or less, for example, when have that clearly and readily available. And I know with like Airbnb and vrbo, it's relatively easy to get that information. So you want to go ahead and download that, put it a file somewhere safe so you have that for your records. Because audits don't always take place right away. It could take place a few years down the road and you might not remember anything by then. So you just want to have that ready to go.

How long, how long should we keep receipts on that note?

So three years is the typical recommendation. Three years, okay, that's like the audit window. So, yeah, within. Usually for three years. You want to keep.

Okay, terrific. All right, so. Okay, so keep, keep good receipts. And then you're about to say something else there as well.

Yep. So you want to have that and then you also want to have your time log. So if you're using the short term rental strategy, or losing the real estate professional status. You want to make sure you time log. One of the biggest reason why people lose cases is because their time log is either non existent or not. It's usually not credible because they don't have one. And then when they get audited, you know, a year or two down the line, they have to go make it up. And I don't know about people listening, but I don't remember it always exactly what I did three or four days ago, let alone years later. So you want to make sure you're keeping a proactive time log of your hours so that, you know, you could prove you met one of those materialization tests and that you could, that if you do get audited, you just, you could generate that, hand that over to the IRS and, or you know, work with your tax professional before you do that. But you want to, you want to just have that ready, available. That's, that's the biggest thing you could. You, at the end of the day, you shouldn't necessarily shy away from more advanced strategies or more complex strategies. But when you do use those types of strategies, you just want to make sure you everything, all your T's crossed and your eyes dotted so that if an audit ever does come, you're ready, you're ready to go.

Yeah. And I, I took a, some people have heard this story. I took a course from a former, former IRS agent when I was, I think I was in grad school at the time, so I was in my early 20s. And the saying that he had, his name was Sandy Botkin. I'll never forget that. And he said, be aggressive and keep detailed records. He said keep detailed records. So I want to be clear that what Thomas and I are talking about, we're not saying, hey, you know, cheat the system, do this. What we are saying is learn the code. And I often say if I was playing Monopoly and you had never played before, it probably would seem like I was cheating because I was so much, I'm so much better. Learn the tax code, take, keep detailed notes, set up your systems. I have, like you were just saying, I have time logs that I use. I was actually just making myself a quick note here to update mine. I have a mileage tracker on my phone. So when I go visit a property, it goes right in there and I can print that out for my cpa, which is you guys to use. I keep all my receipts. And you know how I have a bookkeeper that follows all this. I take pictures of receipts with notes about what those were for. You that the tax law, it can be complex, but it can be simple to follow the rules as long as you learn things and you set it up right?

Yes, yes, absolutely. Yeah, it's absolutely, it's absolutely powerful. And if you, if you know the code, the rules, and you know what to document, you know how to put a bow on everything and keep your, keep your situation nice and tight, then you're going to be in good shape. You shouldn't shy away from strategies just because, you know the fear of the irs. Otherwise you're just going to end up paying more taxes than possible. More taxes than you need to.

Yeah. It's just.

You don't want to do that.

Yeah. And this is, this is a, this is a terrific segue here to kind of put a little positive spin on all of this, in my opinion. Now I see the IRS as a partner. They tell me the rules that I need to follow and how I'm going to benefit if I follow their rules. And then I follow their rules and I, you know, I pay taxes and I also get some, some tax benefits if I do what they want me to do. And then I call you guys and I say, hey, this is what I'm looking to do. And you say, yeah, that's reasonable. This is reasonable. This is, these are the rules you need to follow. And I, I certainly don't want to get audited if any, if any IRS agents are listening. But I'm confident that if, if that does happen at some point in the future, then I'm, you know, following the law appropriately and doing all those things. Now. Thomas, I'm excited. You know, as we were talking here a little while back, you guys are launching a new platform and I wanted you to share that with the audience before we say goodbye today.

Oh, absolutely. Thank you. So, yeah, so we, we launched the Tax Smart Insiders. It's our, it's our, like our private group kind of what we realized was, is that we couldn't help but with one on one tax planning. So we said, how can we help more people use strategies like what we discussed today and make sure they're doing everything the right way so they can minimize their taxes. And we said, great, let's create a community. We have information there live. Q and A's a private forum with our, with our accountants who answer questions. So you can learn more about that@torinvestors.com free gift. And you can actually get like a really cool welcome box. It's going to have a baseball cap, a few, few free books a print version of our newsletter. So exciting. And yeah. Taxsmartinvestors.com freegift to check that out.

Awesome. Yeah, we got that in the show notes here. And look, I can tell you that, you know, I've been fortunate to work with you guys here for a couple years. The resources you guys have on your website's phenomenal. The information you shared with our coaching group is phenomenal. You've certainly saved me, you know, hundreds of thousands of dollars in taxes by by learning the proper tax code and following that. Certainly took me several years to kind of get everything set up. But I love what you guys are doing. I don't know of any other group out there that specializes like the real estate CPA does, Thomas. So I really appreciate what you guys are doing. Thank you so much for joining us again and sharing all your knowledge with our audience.

Likewise, Chris. Thanks for having me on.

Always. We'll be back soon. Hey Chris, here again. I hope you found this episode valuable. Now I have one more thing to gift you. We have a page for my coaching clients where you can get a free copy of my book as well as much more from previous guests on the show. Just check out nextlevelincome.com coaching to get a free copy of my book, audiobook and much more. I'll send you a copy of my book and cover all the shipping costs as a thank you for listening to the podcast. Also, please like share and take just 90 seconds to give us a rating on Apple Podcasts.