The 5 Most Overlooked Strategies for Real Estate Investors That Will Add Thousands to Your Bottom-Line
By Kathy KennebrookReal estate is one of the safest and quickest ways to build wealth. It also yields the best tax-saving opportunities to accelerate your wealth building even further. Unfortunately most real estate investors (and CPA’s) are not aware of these golden opportunities. Here are five of them
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Albert Aiello, CPA, MS Taxation, RE Investor
1. Set up an LLC. Do this not only to protect you, but also to support tax deductions that typically would be more aggressive if taken as a sole proprietor. With an entity, such as an LLC, you can use corporate-like documents (such as an operating agreement, minutes or resolutions) to authorize and thus support deductions. Here, you have this statutory LLC entity (separate from its members), via legal documents (such as an operating agreement), authorizing tax saving deductions and strategies. This is excellent documentation, especially with IRS hot spots such as active participation for avoiding passive loss limitations; auto, travel, meals, entertainment; travel to find property; educational tuitions for seminars and boot camps; travel to such educational events; avoiding dealer status and the like. Kathy Kennebrook has used LLCs for her businesses since their inception.
2. Substantially increase depreciation deductions (and cash flow) with componentizing. Deprecation is the most powerful deduction for the real estate investor because you claim the deduction without expending cash, yet it creates cash flow in your pocket via tax savings. For example, a $20,000 depreciation deduction in a 30% bracket, you save $6,000 in taxes with no cash out. The $6,000 as a 10% down payment can allow you to buy an additional $60,000 worth of real estate, which, at a 20% yearly return, would be $12,000 more income every year. So how can you make this already valuable deduction save you even more money? Componentize!
With componentizing (or Cost Segregation Analysis), you break out components, from the property cost, that allow you to use shorter recovery periods with the result of much larger deductions and savings. For example there are many items that can qualify for personal property and be rapidly written off over 5 years (double-accelerated) instead of slower building depreciation of 27-1/2 or 39 years straight-line (or 6 times faster than the building). There are land components that too can be rapidly written off over 15 years (accelerated) instead of 27-1/2 or 39 years straight-line (or 2 to 3 times faster than the building). Furthermore, you can also fully deduct the remaining basis of components that are replaced. For example, if you replace existing property components with a remaining componentized cost basis of $30,000, you can claim the entire $30,000 as a full ordinary deduction. In a 30% bracket this puts $9,000 of savings in your pocket, yet you did not have to expend cash for the deduction!
So how much extra did you pay in taxes not using componentizing because your CPA did not know about this incredible legal strategy? Kathy Kennebrook agrees that having a CPA who knows the real estate investing business will be one of your greatest assets.
3. Deduct unlimited property tax losses even if over $25,000 or your income is over $150,000 by being a real estate professional. With the above non-cash componentizing deductions piling up, your properties are going to be throwing off paper tax losses which you want to fully deduct against your other income.
Except for $25,000 of losses, rental property losses are subject to passive loss limitations. This means real estate investors cannot deduct property tax losses against non-passive income such as salaries, business income, gains, IRA distributions, etc. If the investor’s adjusted gross income (AGI) is above $150,000 they will not even be allowed the $25,000 annual “active” exception for deducting such losses. Moreover, even if the investor is eligible for the above exception, but has over $25,000 in property losses, the excess over the $25,000 is still subject to the limitations. Being subject to these limitations means the investor cannot currently deduct the losses in the year incurred. The losses are “suspended” and must be carried forward until the property is sold. The savings from the losses are also delayed as well as the investment use of such savings.
What to do: To avoid being subject to these limitations, the investor must document at least 751 hours (or an average of about 14-1/2 hours a week) with the majority of their time in the real property business. A “real property trade or business” is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. This includes real estate investors who do rentals, management, rehabbing, wholesaling, retailing, foreclosures, short sales, self-storage and other types real estate activities. With the right planning and documentation even those with full time jobs can meet these requirements.
Do this and fully deduct your rental loses without limit, save a ton of taxes, and increase your cash flow every year!
4. Avoid being a dealer. When you start to get into “selling” scenarios
(such as wholesaling, retailing, options, lease-options), the IRS (or your CPA) very may try to classify you as a dealer. Being tagged as a dealer could be a financial disaster because, unlike an “investor”, you are subject to the highest ordinary income tax rates, plus Social Security taxes, and possibly alternative minimum taxes. Thus, 50% or more of your hard earned profits could be drained by taxes. Moreover, dealer profits (cash or paper) are immediately taxed in full and cannot be tax-deferred in any way including not being able to use a 1031 exchange, installment sale reporting, a self-directed IRA, etc. Being tagged as a dealer could wipe you out! On the other hand, if you demonstrate status as an “investor” you can avoid these expensive pitfalls of being a dealer.
First off, just because you start to flip\sell properties does not mean you are a dealer. Based on numerous tax courts cases (including a Supreme Court Case); actual IRS audits; and my extensive research; with planning, even a very large number of sales (in one year) could avoid dealer status. Altogether, there are over 30 strategies to avoid the costly consequences of a dealer. My experience indicates that one of the best ones is to demonstrate that the primary purpose of the resale profits is for investment purposes and not sales speculation. For example, the primary purpose (or purposes) of the profits can be for a number of “investment necessities”, such as down payment funds to acquire long-term investment keepers, or working capital for property investment operations including preventive maintenance.
Accordingly, as employed here, these flips are non-dealer, investment transactions with solid economic foundation. This is a very powerful defense against any IRS attacks. Consequently, there are numerous cases and scenarios, some of which I have had firsthand experience with, where even a huge number of sales in one year did not cause costly dealer status.
Real estate entrepreneurs can bypass being a dealer by planning in advance with dealer-avoidance strategies (especially investment intent); avoid inept advisors; and go for it!
5. Sell your properties tax-free, pay no capital gains. First off, there is the 15% myth. In most cases the “total” capital gain rate is not just 15% (as if that’s not enough!). The 15% is just the federal capital gain rate, but there is also federal depreciation recapture which is at higher rates, there is also federal AMT at higher rates and other hidden federal tax liabilities along with state or local taxes. Thus, your total rate on gains could be 25%, 30% or even higher. Once you avoid being a dealer there are numerous legal strategies to sidestep paying taxes on the sale of investment property.
For instance, a 1031 exchange can totally avoid all of the above tax liabilities (including recapture) so you can keep all of your equity. Understand, 1031’s do not just defer taxes, but by having the interest-free and payment-free use of the tax savings, you have more buying power for the replacement property. For example, if you save $20,000 in taxes by doing a 1031, as a 10% down payment, $20,000 empowers you to buy another $200,000 worth of real estate. In fact, many times, the 1031 savings, combined with leverage, is the difference that makes the difference in doing the deal. My students like to use the higher untaxed equity from a 1031 exchange to roll over into property they intend to keep so they can reap the cash flow, equity buildup and tax deductions (esp. depreciation) you get with keepers.
Another vehicle I like is the self-directed IRA (SDIRA), especially for quick flips. Understand, you want to use the SDIRA for real estate transactions that generate immediate (or almost immediate) taxable income (such as flips or options) and generally not keepers that already shelter other income. Kathy Kennebrook has been buying properties into the SDIRA as a means of saving for retirement.
You will never build up a huge portfolio when you pay too much taxes as it will take you an extra 10 to 15 years. Saving taxes is foundational to wealth building.
The above are excerpts from The Real Estate Investor’s Goldmine of Brilliant Tax Strategies, A Tax Reduction System And Special Forms Software Package, by Albert Aiello. For more information on all your Real Estate Investing Tools, visit Kathy Kennebrook’s website at www.marketingmagiclady.com or call their office at 941-792-5390
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