Best Tax Write-Offs for Real Estate Investors (Explained by CPAs) 1031 Exchanges, Depreciation, etc.

Essentially, the home office is if somebody's got a dedicated office space at home that they're working from, you know, a dedicated space that is not shared as a kitchen or a dining room table or something, then they would be eligible to take a write off for a portion of the things that they don't otherwise usually get the write off.

It's my pleasure to welcome Amanda Hahn and Matthew McFarland. They are the author of two great books on tax strategy and one, the most recent, is the book on advanced tax strategies. And we're going to talk about several things that apply to real estate investors today. And Amanda and Matthew, welcome. How are you?

Good. Thank you for having us.

Yeah, we're so excited to be here.

It's great to have you. So I really enjoyed your book, first of all. And there are just not enough competent people out there in the tax world that really kind of focus on real estate especially. And that's why we're excited to have you today. And there's so much we could talk about as we discussed before we started here. You know, we could talk about self directed IRAs, we could talk about a zillion things. But we do have an election coming up and some pretty significant changes are in the wings if Biden wins. If he doesn't win, I think we'll just see, you know, more of what we saw couple years ago. But my biggest fear is the 10:31 exchange would go away. A lot of people are talking about that one. Biden wants to get rid of it. He stated that. Do you have any thoughts on that and its impact?

Yeah, that's an interesting one because actually under the last tax reform, the Tax Cuts and Jobs act, there was a big change that was already made to the 1031 exchange where it used to be eligible for other assets, but. But now it's only specific to real estate. So I guess I think it's not hard to imagine it just going away altogether. And that would be unfortunate because real estate has done so well in the past couple years. And you know, in our office, I don't know how many 1031 exchanges do we see on a daily basis now.

We joke with our staff. It's like, hey, we've got another one.

You know, so, yeah, so many exiting California, going to other states or exiting one state to another. We see that all the time.

Yeah, it's really something. I think that would be very bad for the economy if the 1031 exchange went away. I think it would discourage investment. It would also make the market More stagnant because people that would otherwise sell and create income for so many people, accountants, of course, but 1031, exchange accommodation companies, the lawyers, the tax experts. When people buy a property, they typically improve the property because they have different ideas for it. So all those contractors, all those appliance companies, et cetera, it would really change. So let's hope that that doesn't go away. But why don't you go ahead and share your screen and tell us some of the other stuff you're thinking about.

We wanted to put up a slide first of what the current tax rates look like, just so we get an idea. And you can see the current tax rate and you're at the highest level.

So you can see that.

Yeah.

So go ahead. And for those of you who aren't watching on video, if you're listening, only try and elabor rate on the slide. So someone with audio only could understand them, but they will be on our YouTube channel. Go ahead.

So, yeah, the first thing we kind of just touched on real quick is just looking at, we've got a picture of tax rates at advance right now. So we've kind of put some colors to this where you can kind of see if you're a single person, you can look at your income range on the left or you're married, you can look on the right. But you can obviously see the highest tax rate right now is 37% for the IRS. And we've got the capital gains rates broken out. But what's interesting about this is that, you know, as you were kind of talking about, you know, maybe potential changes. You know, I think Biden wants to Biden's plan involves increasing the highest rate back up to 39.6%, which is what it was two or three years ago before the Tax Cut and Jobs Act. So, yeah, it'd be interesting to kind of see what, what comes of comes to the election or what comes of any potential tax changes.

Yeah. And also part of the, you know, potential proposed change would be capital gains. You know, right now our capital gains, the highest rate is 20%. So there are talks of that even increasing back to ordinary income tax rate, which could be as high as 39.6. And, you know, this is just on the federal side. And I know, Jason, you used to be from California, right?

Yes. Fortunately, I'm not. But if California gets their way with that back taxing people for 10 years, they would get the last year I was there because I left in 2011. So I could see, I read that be liable for tax. I can't imagine that's constitutional, but that's, that'd be a long discussion, so let's move on.

Yeah, so, yeah, so we talked about, you know, that's what's unknown. We don't really know what the future of tax rates and deductions are, what's going to go away. But what we do know now, as of today, is that there are still a lot of great tax benefits for real estate investors, specifically for this year. And so those are going to be the main things that we touch on.

Yeah.

And it should come as no surprise, but obviously people with, you know, the same amount of income are, can and do pay very different level of taxes. And you know, that's going to be. That was the case three or four years ago. That's still the case. It's probably going to be the case a year from now, depending on what happens. But, you know, just because you made 200 grand and your neighbor makes 200 grand doesn't mean you pay the same amount of taxes, obviously. So I think a lot of people know that, but I think some people do forget that, actually. So.

Yeah, and that's one reason you need a good tax preparer and you need to have your own knowledge about taxes as well so that you can talk intelligently with them. Okay, good.

One of the reasons that we see real estate investors continue to overpay their taxes, even though they already are investing in real estate, is that, you know, they're not viewing themselves as a business owner when it comes to taxes. So, you know, everybody knows, like, hey, as a business owner, you get to write off all sorts of things. And what we have on the slide now is home office deduction is one of them. Right. People know business owners can write those off. But a lot of times real estate investors don't think of themselves as business owners. So they maybe think, oh, well, I can't take that deduction maybe because I don't have an LLC or I don't have a corporation or I'm not a real estate professional. And all those things are actually incorrect. So as a real estate investor, you are a business owner in the eyes of the irs. So for the vast majority of deductions that you hear people talk about, you know, as an investor, you are able to take a bit whether or not you have a legal entity, whether or not you're claiming real estate professional, these are all still legitimate businesses. So let's touch on home office first, because I think that one, most, if not all investors we know have an eligible home office.

Yeah. I think this is also one that gets, unfortunately, overlooked a lot just because people either, you know, don't know enough about it or maybe even don't even think it adds up to be enough of a deduction. But, you know, obviously, based on our experience of preparing hundreds of returns every year, this can add up very quickly to two $3,000 deductions. So it can provide a lot of savings. So essentially, the home offices, if somebody's got a dedicated office space at home that they're working from, you know, a dedicated space that is not shared as a kitchen or a dining room table or something, then they would be eligible to take a write off for a portion of the things that they don't otherwise usually get the write off. Because we all know as real estate owners, investors, your primary residence, you know, you're writing off your mortgage interest, usually, your property taxes, usually. But it's the other things that now you can take a percentage deduction on your utilities, your insurance, HOA fees, repairs and maintenance, cleaning, things like that.

Yeah. And, you know, I don't know if you've heard this before, Jason, but we always hear clients tell us like, oh, my CPA said I can't take this because of the huge audit flag, and it means I will be audited. And we've actually seen no truth to that at all. You know, we have so many clients that claim home office really haven't had one that was audited for home office deduction purposes. And nowadays everybody's working from home. Especially.

I think in the current environment, the home office will not be very scrutinized at all going forward. So. Good. Let's move on from the home office.

Yeah. I think another area that we kind of help our clients or look at them focusing on is what we call income shifting. But really it's a way to incorporate your kids or other family members into your business. Because we get the question a lot, how do I deduct my kids? Well, it's probably not phrasing the question the right way. Right. It's like, how can I pay my kids and take a tax deduction is kind of the better way to look at it.

Right.

And you know, you can do that by incorporating them in your real estate business. So it can be having them help you with advertising for your rentals or putting flyers out or doing Internet research or whatever that is that they can do to help you in your business. It's a way that you can start paying them to take a tax deduction for it. Save money as a family, because we all know that you're obviously giving the money to your kids anyway already. Now it's looking for ways to get a tax deduction for doing that.

Yeah, I think the older the kids are, the more expensive they get. When they're younger, you get them little toys, they get older, they got cars, they got tuition. So it's a really great way because if you just bought your child a car, generally it's not deductible, but if you instead pay them to help out in your real estate business, then that's a deduction. Then your kids can take that money and pay for their own car or, you know, pay for their college and all those good things.

And you're also hopefully teaching them some worthy life skills. Right. So that's good.

Right? I mean, I like to think in this picture that this kid is showing the dad how to use zoom. You know, first you're like, hey, maybe the dad's teaching the kids something, but I don't think so.

Yeah, your tech consultant. All right, what else? Let's make sure we touch on real estate professional. I know that's a big one for a lot of our listeners.

Yeah. So for. And I know you talk a lot about depreciation or you have in the past with respect to that being a great benefit for real estate investors. And you know, one of the things I think a lot of people are confused on is for depreciation. One of the things we love about depreciation is that it's a paper loss, but it's not just on the down payment that you make to a property. It's actually based on the purchase price. So we like to look at it as, hey, you're getting a write off on the bank's money today. So if you buy $100,000 property, it's the same depreciation whether you paid $100,000 cash or it was 100% leveraged. And so when we have clients that have high incomes. Okay, well, how do you wipe out the income? With a lot of write offs. If I have $100,000 to invest, if that could turn into a $300,000 property or $400,000 property, the tax deduction could be three, four times what it would otherwise be if you're just doing all cash. Deal.

Amanda, I'm so glad you said that, because the depreciation, number one, in my eyes, it's the holy grail of tax benefits. I mean, it's a non cash write off. Like you said, it was a paper Loss, I call it a phantom deduction, whatever you want to call it. But you also get the le advantage of that, meaning that if, you know, if you put 20% down on the property, you get to multiply that depreciation deduction times five. Because it's not only the money you put into the deal, but it's the 80% the bank put into the deal. So you get to depreciate all of that and again, as long as you can, 1031, exchange it and never recapture that depreciation. That is a beautiful, beautiful thing.

Yeah. One way we like to look at it too is, you know, it creates tax efficient cash flow, Right? Like, the goal is obviously get positive cash flow and then. But if you can use depreciation and, you know, home office income shifting, all these other strategies, the idea is to get enough deduction to bring that at the very least down to zero. So you got tax free money in your pocket.

Right.

So, but, you know, obviously with depreciation, kind of the standard way of doing it, you know, a lot of people know, some people know residential properties, they write it off evenly over 27 and a half years. Non residential, you write it off for 39 years. But there are ways to kind of what we call, you know, almost supercharge it, right? Like, and that's using a cost segregation study. So a cost segregation study is just, you're going into the property and looking at how do we break out the components of the building so that I can take faster depreciation or shorter depreciation lives. So I can, you know, write it off over 5 years, 7 years, 15 years. Over the life of the property, you're getting the same amount of depreciation. It's just the goal is how do we take more of it sooner than later?

You get to accelerate that depreciation because different components of the property depreciate on different schedules. So the appliances are on a faster schedule than 27.5 years, for example. Now, the reason you do the cost segregation study is because you're segregating out these faster depreciating items and then you can write them off more quickly. But the problem has typically been that this is economical on a larger property. It's been, you know, commonly used in large commercial properties. I've used it on a couple of apartment complexes that I've owned. And, you know, I remember the last time we did one, we paid $28,000 to have a cost segregation or cost seg study, and it was worth paying $28,000 because the tax benefit was much bigger than that. But on a single family home, you know, I have done some shows, some episodes where I've had people on that charge between 500 and $1,000 to do a cost seg study on a single family home. And with that, you can save more money than you spend on that study. And that's great. And you say you know, some others. Again, this is a pretty small world of people providing these cost SEG studies on single family homes, at least economically. So please send those over to me and I'll put them in the show notes and everybody can look at them on the show notes for this episode. Okay. If we get them in time. So that. That's really great.

Yeah. And I think it's a common misconception. We have clients who, you know, own five, six, or a dozen single family rental properties, and they're under this assumption that, hey, those only for multifamily, large multifamily doesn't give me a benefit. At the end of the day, like with anything else in business and investing, it's a cost benefit analysis. Right. If you have five single family homes, each costing, you know, 3, 4, $500,000, that building basis might be much larger than one apartment that you own in Ohio. Right. So it's all based on we know what the purchase price of the property is. So we put together just an example of what cost seg can do, especially in this year where we have bonus depreciation, meaning not only can you accelerate some of these assets into shorter lives, but you can actually claim an immediate deduction for a big part of the purchase price of that building. So, you know, so for our example, we say, okay, let's say you purchased a rental property for $300,000 as a $60,000 down payment. Again, we don't care what the down payment is, but we bought it for 300,000. And let's say the building value is 250 with cost segregation, meaning the land is 50,000. Right. And you know, that's not a California property.

Right, right, right. Obviously. But we don't recommend investing in California properties anyway because they're too darn expensive. So you've basically got a $250,000 improvement value, or building value, 300,000 total price, meaning by deduction, the land is $50,000. And you put 60,000 down. And you're saying the first year with a cost segregation study, you could potentially get up to $75,000 in deductions for depreciation. Right?

Correct. So your write off is more than your down payment right now.

So it depends on your tax bracket. Now, so here in this example that we're looking at on the slide, if you're seeing the video on our YouTube channel, it's a 37% tax bracket, meaning you would get a first year tax savings of $28,000 when you put 60,000 down. So you get like half your down payment back. Right. Which is pretty awesome. But what if you live in, and no offense because I used to live there too, most of my life. The Socialist Republic of California. And you. And you pay say 13.3% in state taxes, do you get an additional deduction for the state tax component or no?

No. Unfortunately, California is one of those few states that does not allow large rental losses. California does not recognize real estate professional.

It also doesn't recognize bonus depreciation. So that's one of the big, big issues.

So that's the reason in our scenario, you see, we didn't include the state. But of course, if you live in another state, maybe that's more reasonable. Right. The tax savings could be federal as well as state tax. So it's huge when you kind of add layers upon layers of different strategies to see what the potential tax benefit is going to be.

Okay, very good. All right, keep going.

Yeah, and I think you kind of alluded to this earlier. I think we think based on our experience, cost segregation and real estate profession, when you can combine them together, that really is the holy grail of tax planning for real estate investors and real estate professional. What we're talking about is a lot of people may not know if you're generating losses from your rental properties. And when we say losses, we're talking about paper losses. Right. We're hopefully you're not losing money on your cash flow, but if you have losses from your rentals, the goal would obviously be able to use those losses to offset your other income. Now, the IRS says you can do that to some extent if your income is below 150 grand. But if your income is above 150, then what do we do? Right. Well, that's where a real being a real estate professional can come and play. Because if you or your spouse have been married, if one of you can qualify as a real estate professional for tax purposes, then any losses you generate in the current year from your rentals can be used to offset all of your other sources of income without limitation. So if you've got W2, you've got interest, dividends, business income from other businesses.

So let me just explain that a Little bit more for people. So basically, if you are designated by the IRS as a real estate professional. Now don't confuse that with being a realtor or selling real estate for a living. I think, you know, it just basically means you're a professional investor. Right. And there are some hurdles to jump through to get that. Not everybody will be eligible. But normally the passive loss, mostly depreciation, we'll just call it depreciation tax benefit phases out when your adjusted gross income is above $150,000 per year. Correct me if I'm wrong on any of this, okay? You guys are the experts. I'm not, but this gives you a way, if you're a real estate professional, if you have that classification like I do, okay, then you can take unlimited deductions regardless of your income. You can make $10 million a year and take just an unlimited amount of deductions on these passive losses or mostly depreciation. Right. So did I say that correctly?

Yep.

Okay, good. So the question is, how does one qualify to become a real estate professional? And I know, look at, we've done episodes on this before with other CPAs and, and so forth, and this can be a bit complex. Okay? So, you know, we don't have an hour to discuss it right now because there's ifs, ands or buts. But just basically tell us how that works, if you would. In a nutshell.

Well, I think you hit it on the nail. People are confused with being licensed. So having a license or not really has no impact whatsoever. It's strictly an hours test. And so the key criteria are that this individual, again, whether you or your spouse have to spend at least 750 hours in real estate in general. Okay? So at least 750 hours. That's the first hurdle. Now the other requirement is that you have to spend more time in real estate than your other income activities. So if you have a job, you have an S Corp, right? Then we look at how many hours are you spending in those activities collectively, and you have to spend more time in real estate than that. So if you have, you know, another part time job you spend a thousand hours on, well, you need 1001 hours in real estate to then be a real estate professional.

Amanda, by the way, I just want to make sure I got this. Did you say 150 hours? Or was that a. Did you misspeak or was that. Or did it choose 750?

Yeah, 750.

Yes, that's the number. I know, so 750 hours. But the kicker is that at least the way it used to be. Unless it's changed, 500 of those 750 hours have to be considered active participation. Right.

And yeah, yeah, the term is, the term is material participation.

Material participation, yeah.

Essentially you need to be kind of boots on the ground and you know, involve, for lack of a better term in the day to day operations of your own rental properties.

Right.

Get to that 500 hour mark. And then, you know, if there's other things you're doing for your kind of your real estate business, you can use that to get to your 750.

Like with your 750, you can consider education to be part of that. Right. If you go to a conference or attend our conference on Zoom. Right. You know, you can call that part of your 750, but it won't help for your 500. Your 500. Material participation.

Yeah. The way we look at is that 500 hours really needs to spend on properties you own, you know, not like, you know, education. And those kinds of things are just more kind of overhead related.

Sure.

And it's the same test. Sometimes people are confused and say, oh, I need 750 and 500. No, 500 is part of the 750.

So it's not that hard. But what about income? Like what if someone is, you know, a doctor and say they are not working that many hours and they're not married. Okay. So they don't have a spouse that can qualify. It's just got to be them. But say they make $300,000 a year as a doctor, but they don't work that many hours, so they can still get 750 in. And we're teaching a lot of our clients how to self manage their properties so that they can materially participate in them and people can self manage their properties long distance. It's actually quite easy. We teach people how to do that all the time. Can they qualify with that $300,000 doctor income?

Even though it's not that many hours, there's no income. You know, when you look at real estate professional status, again, it's strictly a times and activities test. They don't really. I've not seen them to take into consideration how much other income you're doing. Now having said that, you know, for this position, their time has to be reasonable. Right. So they made $300,000. In reality, how many hours did they spend? And that would be the number of hours that is compared against real estate professional status.

Okay.

You know, we have a lot of clients that are now involved in short term rentals, we got to know which your clients probably have as well. So there's a little loophole in there that a lot of people might not know with respect to using rental losses from short term properties to offset other types of income.

Yeah. And we have clients that maybe they can't qualify as a real estate professional just based on their, you know, the hours where. But if they, they happen to have a couple short term rentals, if they can meet the short term rentals are kind of treated differently in the tax world. And when we say short term rental, we mean when you look back over the year, if the average customer use is seven days or less, then you've got a short term rental property. So Airbnb, one of those type of things where people are booking for four or five days at a time, that type of thing. But if they can materially participate in their short term rentals and they've got losses on those rentals, those short term rentals, they can use those losses to offset their other income without having to qualify as a real estate professional. And we've got a lot of clients kind of going that route just because they like that marketplace. They like the Airbnb model, if you will, for lack of a better term. But so that's an opportunity. I think they can.

Sure, sure. And we do a little bit in the short term rental world. And I gotta just give a caution. A lot has changed in that world due to Covid, so be careful. Okay. Make sure you listen to our podcast for a lot more on that, but go ahead. Okay. Anything else on Real Estate Professional that you want to share?

You know, I think the key to being real estate professional and claiming it correctly is to document. Right, Document your time. I always recommend doing it throughout the year because normally when people get audited, it's not going to be right away. You know, after you file tax return, it's going to be two or even three years after the return is filed. And you know, if anyone's like me, I can hardly remember what I had for breakfast two, three days ago. Right. So it'll be difficult two, three years from now to figure out what can I do on this particular date for Real estate Professional. So documenting time is sort of, you know, going to be in the insurance policy to claiming it correctly and legitimately.

Good point. Okay, good. All right, so are we done on Real Estate Professional? Yeah, and there's more to it than that, but, you know, we're never done. That could be a one hour conversation.

All right, absolutely.

Yeah.

Yeah. So like we talked about, you know, the current tax law highly favors real estate investors. It'll be interesting to see what happens with the election and whether that changes or not, obviously. But you know, we do tell people all the time it is important to work with their advisor throughout the year, not just, you know, right before April 15th because, you know, if you come to us on April 1st with how do I save tax from last year, your options are severely limited compared to if you're talking to them in October or November for that matter, you know.

Yeah, yep, yep. Tax laws can change anytime. So got to take advantage of it while you can.

Good. Any questions I didn't ask you or anything else you'd like to share and then let's wrap it up.

Yeah, I think, you know, being the time, obviously this is changing times, you know, in the country, but also just my tax perspective too. But one thing is always stands true. You know, Matt mentioned proactive tax planning but you know, before the end of the year is really a great time to do year end planning because this is the, you know, this is the last kind of the last ditch effort was okay, how are we doing on real estate professional time? You know, do we need to buy more rentals before the end of the year so we can get more depreciation? Should we do cost seg. So before the holidays, try to allocate some time, meet with your tax advisor and get some action steps in place so that you know, you're sitting pretty by next April.

Good stuff. Give out your website.

Our website is www.keystonecpa.com. that's K E Y S T O N E CPA com.

All right, Amanda and Matthew, thank you so much for joining us.

Thank you for having us.

Appreciate it.

Thanks Jason.