Real Estate Investors… How to Protect Your Wealth from Being Drained by Taxes!
By Kathy KennebrookAlbert Aiello, CPA, MS Taxation, RE Investor
Here is a quick overview…
AVOID INEPT CPA’S, LIKE THE CURSE OF HELL!
Bad tax advisors cause more investors to pay more taxes than the IRS can ever dream of. Ask your follow investors for some good prospective CPA’s who specialize in real estate. Get references and carefully screen them out. NO CPA? Like a bad tenant…having NO CPA is a heavenly dream next to having a bad one. Many of my students do not have a CPA or use one on a very limited basis. Instead they use a good home study course on real estate tax reduction along with tax preparation software such as TurboTax. They rave about how they legally save more money than they did previously with a CPA, but without the high fees. Now this is not for everyone. But if you do use a CPA, make sure that you have at least a general understanding of real estate tax law and that the CPA is working for you; because no one cares more about your money than YOU!
AVOID IRS, LIKE THE BUBONIC PLAGUE!
Reduce your changes of audit by filing extensions and staying off heavily audited schedules such as Schedule’s C or E. File as a partnership, form 1065, which is much less audited. If you want the asset protection of an LLC, then a two or more member files the lesser audited partnership, form 1065.
CREATE VALUABLE “PAPER” DEDUCTIONS
That is “paper” deductions that do not require you to expend cash for, yet it creates cash flow in your pocket via tax savings – Depreciation. A very profitable system of depreciation is componentizing (also called Cost Segregation Analysis). Componentizing is something that I have been using for over 25 years to dramatically increase my cash flow (and wealth) via tax savings from much larger non-cash depreciation deductions. And so have my students. With componentizing, 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 (gutted out). 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!
AVOID PASSIVE LOSS LIMITATIONS – FULL DEDUCTIONS
Except for $25,000 of losses, rental property tax losses are subject to passive loss limitations which means real estate investors cannot deduct rental property losses against other ordinary income such as W-2 income, 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. The losses are “suspended” and must be carried forward until the property is sold. To avoid being subject to these limitations, the investor must document that they incur enough hours in the real estate business at a minimum of 751 hours, which is an average of about 14-1/2 hours a week.
TOTALLY AVOID THE TAX DRAIN OF BEING A “DEALER”
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.
SELL PROPERTIES TAX-FREE – YOU KEEP ALL THE PROFITS
One of the best strategies to avoid all tax liabilities on the sale of investment property is a 1031 exchange. 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.
SELECT THE RIGHT ENTITY
Start off with right form of ownership entity. 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 bypassing passive loss limitations; avoiding dealer status, as well as deductions such as auto, meals, entertainment; travel to find property; educational tuitions for boot camps; travel to such educational events; and the like.
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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 real estate investing and tax savings, visit Kathy Kennebrook’s website at www.marketingmagiclady.com
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