Boosting Wealth Through Real Estate: Insights for Painting Business Owners

Welcome to the Profitable Painter Podcast. The mission of this podcast is simple: to help you navigate the financial and tax aspects of starting, running, and scaling a professional painting business. From the brushes and ladders to the spreadsheets and balance sheets, we've got you covered. But before we dive in, a quick word of caution: while we strive to provide accurate and up-to-date financial and tax information, nothing you hear on this podcast should be considered as financial advice specifically for you or your business. We're here to share general knowledge and experiences, not to replace the tailored advice you get from a professional financial advisor or tax consultant. We strongly recommend you seeking individualized advice before making any significant financial decision.

This is Daniel, the founder of Bookkeeping for Painters.

And this is Richard, tax director with Bookkeeping for Painters. And we got a pretty— it's, it's going, it's going good. It's going good.

I was going to say, we get a good— Yeah, you're trying to skip the small talk. I think I am.

I'm like, I'm like, this topic is so important that our listeners do not need to hear me go on and monologue about the weather or anything like that. They want to jump into it. This is a hot topic and something that I'm kind of excited about. So yeah, if it's okay, Daniel, let's just go ahead and jump into it. We're going to talk about See, I'm not even waiting for you to respond. I'm just right into it. Let's talk about real estate.

Let's do it.

Real estate. Yeah, let's do it. So this is anecdotal. This is just my observation. But when I am doing tax planning with my clients, I find that, that 90% of the time when a painting business owner, his business starts to get some traction and they start to get some cash, the first place they're going to invest is their own business. But once they have more money than the business can reasonably use, the next thing they want to do is usually some kind of a real estate investment. And I think, I think it's wonderful. I strongly encourage it. Real estate is one of the best investments out there for a few reasons. You know, one is that you get steady appreciation over the long term. Most assets that you buy are depreciating assets. Your new Tesla, your private jet, they're awesome, but they lose value every year. Where real estate is the opposite. Almost always real estate is going to appreciate over time. And even if there's maybe You know, like we saw with the, with the housing market crisis in 2006, 2007, you know, prices dropped, but then within 5 or 6 years they were higher than ever before. So real estate has a great track record of appreciating over time. Plus, you—

all the billionaires, that's what they're doing. Uh, I know Ted Turner, he like bought half of the Midwest, and I think Bill Gates is on a a land grab right now, all the farmland he's been buying. So it's a common, common tactic of the wealthy.

Yeah, for sure. For sure. Wealthy people almost always have at least some kind of real estate in their portfolio. And another reason is because of tax-deferred growth, right? So normally when you make money, you pay taxes on that money in the year that you make it. But when you have what they call capital appreciation, in other words, a house or a piece of land that is gaining value, you don't pay taxes on that gain until you actually sell it. So you could be sitting— I mean, we see this with personal homes all the time, right? A person could be sitting on hundreds of thousands of dollars of equity in their home and they're not going to pay taxes on that money until they sell it. And that gives you time to control how that's going to happen. You know, maybe you choose to sell when you are in a lower tax bracket or living in a tax-free state, or maybe you do one of my favorite strategies, which is buy, borrow, and then die and let your heirs inherit your property at stepped-up basis, which we'll talk about a little bit more too, I think. So there's that. And when you do sell it, it's not even taxed at ordinary tax rates, right? It's taxed at the preferred capital gains rate. At least this is how the tax code is written now. I mean, there's, there's been some talk about possibly changing it. I think that's a really heavy lift, and I'd be very surprised if, if we saw significant changes to that. But as of now, tax-deferred growth and either 15% or 20% capital gains rate when you do go to sell, you know, another thing that people like to do is, you know, they cash flow these things through renters' payments. So kind of imagine, if you will, you know, you have this asset that is growing in value. You don't have enough money to just go and buy it outright. Not a problem. As long as you've got 20%, a bank's going to probably give you a reasonable mortgage. So you're, so you're buying a lot more asset and only outlying maybe 20% in cash. Then if you can get a renter into that property, you're getting cash flow off of that asset and using that cash flow to pay down your mortgage. So it's kind of like you're getting tax-free cash flow because the income you're getting is being offset by the depreciation in the house. And when you're all said and done here, you have this very valuable asset that you only put out maybe 20% to pick up and it's grown, you know, in value, it's doubled. 1, 2, maybe 3 times in value over the next 20, 30, 40 years.

Yeah. And, and what, you know, obviously we work with painting businesses, you know, exclusively, but because of that, we're pretty much tax experts on rental properties because everyone is doing this strategy, like all our most successful, like, tax planning clients that are painting business owners. Pretty much most of them have some sort of rental property going on and putting that extra cash into rentals or rental property to take advantage of these things.

Yeah, yeah, absolutely. It's one of the most popular strategies and you can see why, right? There's just so many benefits to it. So let's say you've got your painting business and you have grown it and you have worked very hard to make sure it is tax efficient. So you've got your S corp set up, you're paying yourself a salary, and now you want to buy some property and you're thinking to yourself, hey, my S corp does a great job at helping me avoid excess self-employment tax, so why not just have my S corp buy my rental property? Heck, I mean, I might even buy the shop that my business is operating out of. Wouldn't it make sense to have the company own it? And I can understand, you know, the thought behind that, but almost always I'm going to recommend that you do not have your rental properties or any major asset for that matter inside of an S corp. And I know that sounds— that's sounding weird, right? Like, no, S corps are good and S corps are awesome for operational activities, for, for business activities, but they have some serious drawbacks when it comes to owning assets. So the, the first major drawback is we need to keep in mind that a corporation, an S corporation or a corporation, is its own entity. It's its own animal as far as, you know, the IRS is concerned. So if your rental property is inside of your S corp and one day you decide to sell your shares of the S corp, you're selling your rental property along with the business and you may not want to do that. You know, some of these great benefits of rental real estate has to do with holding it for a very long time, holding it until you pass away and your kids inherit it. And, you know, you don't want to wave goodbye to your rental property when you sell your business. Another thing has to do with the concept of stepped-up basis. So, you know, we mentioned this. If you— let's say you buy a property for $100,000, you hold on to it for 40 years, and that property is now worth $500,000. Well, if you sell it, you pay capital gains tax on the $400,000 of appreciation. But if you pass away and your children or your heirs inherit it, they get stepped-up basis. So now their basis in the property is whatever fair market value is when you passed away. They could sell it the next day for $500,000 and pay zero tax. So that, that's enormous, right? That does not work. If it's inside of an S corp, because if it's inside of an S corp, your kids don't inherit rental property. They inherit shares of the S corp which do not benefit from stepped-up basis. So that's— and then the third reason you don't want to put it in your S corp has to do with asset protection. So let's say, you know, heaven forbid there's an accident, somebody gets hurt. On one of your job sites and they win a lawsuit against you. Well, if your real estate is inside the S corp, it's vulnerable to that lawsuit. If they win a big enough judgment and your insurance doesn't cover everything, a judge could force you to sell that rental property to pay off the lawsuit. Whereas if it's outside of the S corp, there's that corporate veil. It's now protected from judgments. So, so 3 good reasons not to put it in an S corp. Now, there are some issues that arise, right? So one has to do with the passive versus the non-passive rules. And I'll try really hard not to get in the weeds here, but the IRS basically categorizes income into 2 buckets. One is passive income, and that is income you receive from a piece of real estate or income you receive as a limited partner in a partnership. They figure it's passive because you don't have to actively work to earn it. It comes to you every day regardless. And then non-passive income is pretty much everything else. So your W-2 wages, your K-1 income from your S corp, even some of your investment income would be considered non-passive. So there are these two buckets and a wall between them. And what that means is if you have losses from your rental real estate, those losses can't cross that wall and offset your income from your business. So what this might look like is say you depreciate your real estate where you put a whole bunch of money into building it out, making repairs, and you have a $50,000 loss. Well, you've got $100,000 of business income and they can't— they can't net. You pay taxes on the $100,000 of business income and the $50,000 of passive losses stays on the passive side. It doesn't get thrown away. It, you know, gets collected in like a bucket of losses, so to speak. And, you know, when you do have profit from the rental real estate, you'll be able to use it. But oftentimes you never really get there and you kind of fall into that trap. Yeah, so there's ways around that.

Yeah, yeah, I was gonna say, I think a lot of folks misunderstand this piece is the passive versus non-passive, and I think a lot of TikToker tax planners also probably say this wrong, but if you have losses on your real estate and it's passive, then it can offset your, your painting business income. So that there are ways to, to offset the two, uh, if both are in the same bucket, so to speak, both are non-passive. But in a lot of cases they're not. So you just got to be really careful on what type of bucket your, your real estate is, is in. Is it in passive or is it a non-passive? It's in passive, then it's not going to be able to offset those, those painting business net income.

Yeah, I'm glad you brought that up because I think one of the biggest things on TikTok and social media right now has to do with cost segregation. It's kind of a buzzword and, you know, used properly, cost segs are awesome. They're super powerful. But in a nutshell, cost segregation allows you to rapidly depreciate your real estate. And so there are people who have spent thousands of dollars on cost segregation studies and rapidly depreciated their real estate, only to find out that none of that depreciation can cross the wall and they're still paying normal taxes on their ordinary income. And imagine how disappointed they are because they didn't— they weren't given, you know, good advice. So, so So we have to understand that obstacle, right? So we know there's an op— Yeah.

A quick, quick side note. I don't think cost segregation is trending on TikTok. I think that says more about what you're looking on at TikTok, which you're searching on TikTok rather than what is actually trending on TikTok. I've been on TikTok before, never seen anything about cost segregation. So I'm pretty sure that's a— Custom algorithm that you're seeing there.

Wow. See, I thought everyone logged on and they saw people doing TikTok dances to cost segregation studies. And now I'm finding out that I'm truly an accounting nerd. And yeah. Okay, well, do me a favor. If you're listening to this and you've seen cost segregation mentioned on TikTok, let us know in the, um, in the Facebook group, because, because I, I, I feel like I, um, like I, I just took the red pill and now the Matrix is open to me or something like that. But anyway, um, all right, so you got, you've got these losses. What are you going to do? Okay, step, step one: if you make less than $100,000 a year the IRS will throw you a bone and say, okay, you make less than $100,000 a year, we'll let you take $25,000 of passive losses against ordinary income. It's an exception to the rule. Just go ahead and bring it over and we'll give that to you. That's, that's great. If you, if you have less than $25,000 of losses or you don't, you know, or if you make less than $100K, But most of us are going to need more than that. So the next idea is, well, what about real estate professional? And Daniel, correct me if I'm wrong, but this gets talked about on TikTok, doesn't it? Like right along with the cost seg studies? Or is that just me again?

Probably just you, but just me.

Okay. Well, the idea being is that if you are a real estate professional, then you can kind of tear down that wall, right? Like, like Ronald Reagan, Mr. Gorbachev, tear down this wall. But you have to qualify. And it's not easy to qualify. I'm just going to put it out there. You have to have at least 750 hours of work as a real estate professional. You have to be able to document it. And the truth is, if you have a full-time job somewhere else, you're never, you're never going to be able to get this through, right? Like the IRS is not going to buy it. So qualifying as a real estate professional is probably not going to work for you unless maybe you have a spouse who is not working in your business and maybe they are a real estate professional, then that could be a little bit of a loophole because a married couple files jointly and they're viewed as, as one. So sometimes, sometimes that can work. Another option has to do with the short-term rental loophole, and I won't, I won't dig into it too deeply. But if you have a bona fide short-term rental and there is specific criteria for this and you have what's called material participation and you meet one of the 7 tests that the IRS has for material participation, you may be able to qualify your rental activity as non-passive and have those losses come over. But before you try this on your own, I strongly recommend you talk to not just any tax professional, but someone who is well-versed in the short-term rental rules, because a lot of people get this wrong. And if you get audited, it could go south real fast if you don't have, you know, all your i's dotted and t's crossed. So that's passive versus non-passive. It's not— I'm not saying this to discourage people from buying real estate, but just letting folks know that you need to understand how your different income is going to be taxed. And if you plan on taking huge losses on your real estate, make sure that you can actually offset your non-passive income with them or be prepared to hold them in that bucket. And that's not a bad plan either, right? Because one day you're going to sell the property and when you do, you're going to empty out that bucket of losses and your capital gains is going to be much less. You know, if your plan is to hold on to the property and have your kids inherit it one day, then that bucket becomes less valuable. But there's different, there's different plays here. All right. So you got your, you got your shiny new piece of real estate. It's not in the S corp, thank goodness. You understand the passive versus non-passive rules. Now, what are you going to do to hold that property? I recommend at least some minimal asset protection. And what I mean by that is an LLC that is used as a holding company to hold your real estate. The reason I recommend this is because of that corporate veil. If you hold the real estate individually without any kind of entity around it and you get sued, or worse yet, somebody hurts themselves on your property and sues the property, now your personal assets are vulnerable. Not only can they go after the rental property, they can go after your private home, your 401(k), your business. We don't, we don't want that. So a simple LLC that is registered in the state in which the property exists is going to give you a measure of protection. So, so what that means is if you've got rental properties in multiple states, make sure that whatever LLC they're in is either formed in that state or domesticated and registered in that state. Because if your, your, your Utah property gets a claim against it and it's held by an Illinois LLC, the judge isn't going to care. It's, it's practically worthless. So make sure that LLC is domesticated and registered in Utah. To that end, I like to recommend that you don't keep more than $300,000 to $500,000 of equity in any one LLC. So if you've got 3 properties worth $100,000 each and now you're going to look to get a 4th one, maybe it's time to form another holding company. And what this is doing is creating little bubbles around these properties so that if one of them gets sued, that lawsuit can't exit that bubble and go after other properties. It's just compartmentalizing your assets and giving you that protection. And of course, you know, do your corporate maintenance, treat your LLCs properly, form them correctly, have your, you know, company minutes, do all the things that, that strengthen that corporate veil. Don't commingle your funds. We could do a whole episode on, on just running like a real clean company, you know, for asset protection. All right. So what if you want to get into real estate? You're like, you're really excited about it, but you're like, man, I just— I just don't have the cash. Not yet, at least. Are there other ways for me to enjoy these benefits without actually, you know, finding a for sale sign and contacting a realtor and buying a physical property? Well, there are. One really popular and easy way to invest in real estate is through what's called a real estate investment trust, often called a REIT, R-E-I-T. And these are securities and/or stocks that consist of real estate properties. One of the highest paying dividend stocks in the last several years is a REIT that owns hospitals and medical centers and doctors' offices. And you can buy into this fund and enjoy some of the dividends that come from this without actually having to go and sign, you know, real estate contracts. You can enter, you can exit whenever you want, and you can kind of benefit from some of these things without actually having to put up large amounts of cash. Another possibility is that you might look into funding commercial real estate construction projects. I know it sounds really complicated, but there are companies out there that can put you in touch with builders who are looking for funding. You can buy in for, you know, as little as maybe $10,000 and help fund a construction project that is secured by that real estate. So if the construction project goes belly up and now the contractor can't pay you back, the real estate is sold and the investors are paid back from those proceeds. Obviously, there's going to be a measure of risk in any of these things. So, you know, talk to your financial professional, your tax pro, figure out what you're comfortable with. But there's just— there's alternative ways of investing in real estate without physically buying a property. But yeah, it's, it's definitely something that you should look into. You know, a great goal is to try and maybe purchase one property a year or one property every 5 years, depending on, on where you're at. These are investments are going to have very low risk. They're going to have a great rate of return. And it's something that is very tangible, right? It's kind of like, like it's, it's easier to understand. It's kind of visceral. Like you can see it, you can feel good about owning it. And you can do this either, you know, in a fully taxable account or some folks have gone and done real estate investing inside their IRAs or their 401(k)s. And we've done episodes about, about that, uh, self-directed IRAs. Um, so a lot of different options out there, but, but real estate really should be a part of everyone's portfolio if, if possible.

Yep. And there's a lot of good tax opportunity, tax saving opportunities. Just got to make sure you understand the rules and implement them accordingly. But love to hear your thoughts on this episode. Are you investing in real estate? What strategies are you implementing? If you go to Grow Your Painting Business in Facebook, love to hear, hear you join in the discussion. And with that, we will talk to you next week.

Yeah, thanks for listening, everyone.