Several years ago my office building was burglarized. Two young men used a tire iron to break a window and enter the building. Tax offices do not have a lot of stuff worth stealing so they settled on two monitors and an old safe with an empty coffee can in it. People pay their bill by credit card or ACH in the majority of cases; a few still pay by check and cash comes in during tax season and is removed each day.
The young men caused thousands of dollars in damage for the massive haul of two monitors worth maybe $20 each. (New monitors are under $100.) So what were they geniuses looking for? Well, it seems they remembered I had a soda machine outside my building a decade ago and they assumed I moved the machine inside the building. Yes, they burglarized my building for some of that lucrative soda machine money.
They did not find the soda machine. I retired the machine years ago. The police were so excited to gather evidence. A few days later the young men were in custody. The police and district attorney informed me I was a victim. I replied ‘I am not the victim. My building is the victim; they kicked the shit out of it.’ For some reason I did not feel violated; I can’t speak for my building since I was not the one sodomized.
The damage was repaired the same day and life went on as normal with one exception: the district attorney’s office keeps sending me ‘victim’ mail. Anytime a court date approached I was invited to ‘get involved’. I never went. The two men were convicted and sentenced to a combines 10 years in prison. Now I felt like a victim! It costs $40,000 a year to house a prisoner. The government in their infinite wisdom squandered nearly a half million dollars protecting my three thousand bucks of building damage. Really?
Before sentencing I was asked what I thought would be a fair sentence. I responded. These two young men needed money to fund a drug habit. I gathered that when they said they were looking for a haul from an imaginary soda machine. Prison would not solve the problem. They needed drug treatment and a new set of skills. I informed the court I thought requiring successful drug rehabilitation treatment and a thousand hours of community service would go a lot further than taxing me more to fill the prison a little bit more. I recommended the community service be served working with Habitat for Humanity. My thought was, clean these guys up and teach them a trade.
The court disagreed. The judge and prosecutor felt a deep desire to protect the community. The truth is soda machines everywhere rose up and demanded justice. They never seriously considered my recommendation and $400,000 of hard-earned taxpayer money was pissed down the drain. Most people say ‘put them in prison’. I prefer a more logical approach that does not include wasting money. You know what we think about wasting money around here.
Enter the Stoic
Why do I tell this story? I think about it a lot. I wonder about the two men raped by the system. They did some really stupid stuff. Who hasn’t? I wonder if they have made changes in their lives for the better. Will society be safer when they get out? I doubt it.
Most of all I wonder why I did not feel violated. The police wanted me to know they will keep an eye on the place and protect me. I shrugged my shoulders. The DA’s office sent me huge packets in the mail informing me of my rights as a victim. I was not the victim, the building was. Nobody would listen so I stopped explaining myself.
My emotions over the break-in are puzzling to many people. I examined my thoughts to figure out why I felt the way I did. After a short time of reflection I came to the conclusion my stoic nature was to blame for my settled mind. From a young age I had stoic tendencies before I knew what a stoic was. Later in life I discovered Epictetus and Marcus Aurelius. One of my favorite books is A Guide to the Good Life: The Ancient Art of Stoic Joy.
For the first time I realized I had internalized the truth about stoicism. Little things did not bother me. Beating the shit out of my ‘stuff’ was not a concern; I should downsize anyway. Of course, I still have feelings and emotions; a stoic is not dead inside. Events that cause most people to worry were water off a duck’s back for me.
A practicing stoic knows he is never perfect. “Stuff’ does not bother me; serving my clients does. I take serving my clients very seriously. I am bothered if I am unable to help all the people I promised to help.
It all comes down to focus. I live at a time in history where people have it really good in Western countries. I can walk/bike/drive millions of miles of roads for free. Do you know how many books I can borrow, movies, music CDs, and internet I can play with all for free at my local library? It is humbling to know I have millions of dollars of knowledge and entertainment all available for free at the library. How awesome is that?
Enter the Zen Master
I read a small number of blogs on a regular basis. Mr. Money Mustache and Zen Habits are my two favorites. Both blogs teach about living life right. I have talked about Pete over at Money Mustache already. Today I want to introduce you to Leo Babauta. Unlike Pete, I have never personally met Leo. Just like Pete, Leo seems like a hell of a nice guy.
Leo talks less about money than Pete does. Leo has taught me to relax, instead. For an excitable wealthy accountant with OCD that is saying a lot. Learning to breathe is a lesson more people need to learn, especially me. To the best of my ability I take one piece of Leo’s advice: upon waking in the morning I drink a full glass of water and then sit and meditate for 5 minutes, eyes closed. Only then can I enjoy a cup of tea.
Water cleanses the body; meditation cleanses the mind. I tell people I am retired in a convoluted sort of way. Outside tax season I have a lot of free time. I take on projects that appeal to me. I keep busy in my retirement. My desire for knowledge and experience is vast. Everything interests me. However, no one can have every experience or learn everything there is to know. I have to pick and choose.
In a world of never-ending distractions, focus is a commodity. Zen meditation, as taught by Leo, has helped me focus. The added focus has allowed me to experience more, learn more, enjoy more. The world of distractions will not end. The phone will ring, friends will visit, email will call and text messages will interfere. By practicing your stoic skills and Zen meditation you can find meaning in the life you live, as I have. When you focus you see, sometimes for the first time, the beauty all around you. Enjoy the simple pleasures: the smell of fresh mown grass, the singing of birds and the color of the sky. Take a moment every day to relax for at least five minutes. Don’t let the small stuff worry you. Focus on the important and enjoy the wonderful life granted you.
Back when I was in high school I started down the road to OCD, I mean toward being a wealthy accountant, by recording everything I did. Every penny that came in and every penny that went out went into the columnar pad. Tracking my progress was so important to me I refused to go to bed at night unless the “books balanced”.
Once I reached adulthood I continued recording my financial progress and expanded it to other areas of life. For decades I have recorded my daily electrical usage. No fancy devices are used because that would cost money and you know how we feel about spending money around here. Except for vacations, I can tell you how much electricity I used on any particular day for the last twenty years or more. (In the near future I will share how my electricity usage obsession helped me reduce my utility bill 80% for the farm and 65% for the office.)
Such anal obsessions may sound like a sickness. When running a business the obsession frequently is the difference between survival, failure or massive success. I keep two sets of books in my accounting firm. Before you scream to the IRS that I am cheating on my taxes I ask you sit down and listen first.
There are some things QuickBooks does not do. I track my income and expenses in QuickBooks and on an Excel spreadsheet. The Excel allows me to also track non-financial items, too. Like my electricity usage, I can tell you how many tax returns I e-filed back to 1990. (Yes, they had federal e-filing way back then. I was an early adopter.) The Excel worksheet also allows me to review my business over long periods (decades) in a different way from QuickBooks or any other accounting software.
My massive Excel grows each year as another year of business is added to the data fields. For over twenty years now I have had enough data to make predictive models. I can tell you will great accuracy how many people will walk through the door on any given day during tax season. This allows me to micromanage employee hours, thus saving me money and reducing employee stress during tax season.
There is an occupational hazard from all this data. While I hate budgets and never used one, I always have my eye on one number: last year’s results. My goal: beat last year. It does not matter how much I outdo last year by as long as it is a win. Sometimes I fail, most of the time the numbers continue on an upward climb.
Sounds like a fun game, doesn’t it? It is as long as you understand how the game progresses after several decades. I never lusted for a massive accounting firm to stroke my ego. Still, after decades of growth, financially and in the number of clients served, the numbers began to take over my life. By the early 2000s I was preparing over 2,000 tax returns a year in a small office. To justify my goals I decided to focus on business returns and reduce the total volume of clients, thereby allowing my ‘numbers’ to continue climbing on the financial side of the ledger.
The Sickness Within
By 2008 my e-filed returns dropped to the low 700s and then started climbing again. The financials never skipped a beat. I would pound my chest over my awesome management style if it were not for other, not so ego-thumping, issues. I fell for the worst fallacy of all: growth for growth’s sake. It was never about the money. My lifestyle would not change one bit. It is a sickness inside that compels me to keep pushing for better numbers each year.
It is unhealthy to be so unsatisfied. The drive to beat “last year’s numbers” requires greater and greater amounts of time to meet the goal. Yes, I hired more people. Managing people takes time. Running a business is “…constant worry” according to Steve Jobs. The constant demand on time and mind takes away from the illusion of early retirement.
The Countdown Clock
Long about 2005 I started a countdown clock to my ‘real’ retirement. In three years I planned on selling my practice and living a ‘real’ retirement lifestyle. As I pulled back I had more free time to play on my farm. The ‘ol OCD sickness raised its ugly head fast. I went from a handful of steers to 50 and started butchering 400 chickens a year Amish-style. My time was now consumed by a different business: farming.
The office manager, Karen, discovered my countdown clock and started harassing me about it. She wanted to know what the hell I was up to. I kept tight-lipped until the clock ticked below one year. Karen guessed I was looking for the door and would not let it rest. She offered to make my life easier by managing the company for me. (Try running that one past a successful businessman with OCD.)
As you already know, the countdown clock was put to rest and I did not sell. A lot of local competitors were licking their lips thinking of the jewel they were going to get a chance at acquiring. I still dream of selling. However, Karen runs the office so well I spend nine months a year with a small workload. I love tax work so I put in serious hours during tax season. I found balance (sort of).
Live Retirement Right
I never subscribed to retirement as a beer in one hand and the remote in the other. Retirement should be the opportunity to do what you enjoy most. I still track my income, expenses and e-filed returns religiously. I try hard not to get caught up in “beating” some invisible ghost expressed in “last year’s numbers”. I came perilously close to working for “money” as a sole goal when I act the way I do. Stephen King calls that a “… chump’s game.”
Early retirement is only retirement if it is a balanced life. Come to think of it, you should have balance in life whether you are retired or not. I cut back on the farm, struggle with balance in the tax office and now have a blog to write. I work too hard and I suspect you do the same. Your methods are different than mine, for sure. It is still a sickness you and I need to manage.
There are things you can do to increase your quality of life. The tax office is filled with clients who have retired and either have no idea what to do with themselves or fill their life so full they don’t have time to enjoy retirement. Balance is hard. Once you have enough money to choose your path in life, you are retired. Do you keep pushing for more? Does your lust for more consume your life, forcing you to keep working to pay for your fear of retirement? That’s right, your fear of retirement. We fear retirement because we will no longer be recognized for what we do. We are scared because of the unknown. Deep down we know retirement is not like one big long vacation. Retirement is how we will live the rest of our life. Where will we find meaning in that new life?
It all comes back to balance again. I should talk. I tend to bite off more than I can chew and run with it. I thrive on the challenge. It defines me, gives me purpose, makes me feel alive. Taken to an extreme it is unhealthy and is unfair to family, friends or the community. Let’s call it what it really is: selfishness.
I work too hard; I get it. So do you. No accusation intended. Anyone of us can pay the rent on only a few hours of work a week. Modern technology grants us the freedom to live well without busting our ass in the hot sun from sunup to sundown. The human body was never designed to sit in a chair for 40 hours a week, either.
Here are a few ideas I use to create balance while still doing the things I love doing:
- Every morning and every night I kiss my girls on the cheek and ask about their day. My children come first, no matter what. My wife gets a smack square on the lips and I inquire about her day, too.
- Drink water. Sounds simple. During tax season the hours get long and I tend to drink a lot of tea. I find I feel better if I start the day with a large glass of water to cleanse the body.
- Stop considering a few quiet moments at work or home a crime. A few moments to reflect can do wonders for the spirit.
- Know when to stop. There is always work to do in the office during tax season and the work never ends on a farm. That is not a reason to kill yourself working. It is okay to close the books and go home. It is okay to go for a walk during the workday. It is okay to leave work for tomorrow. It is also okay to take a pass on work sent your way. With rare exception, most work can wait for another day. We call that an extension in the tax world. You are not a wealthy accountant if your soul is unsettled.
- Find time to read good books.
- Spend time with friends talking about things not work related. Don’t fall for the busman’s holiday.
- Remember what retirement is: the ability to do what you enjoy most. Don’t play Stephen King’s “chump’s game”.
- Enjoy nature. Go for a walk in the park or woods. Your spirit requires the solitude to remain healthy.
- Tell people you love how much you do love them. It ends sooner than you think.
- Eat healthy. Garbage in, garbage out. A poor diet destroys happiness faster than you ever imagined as you lose the ability to do the things you value most.
- Eat, drink, play, and work in moderation. Too much of any activity in unhealthy. Enjoy a drink if you want. Eat delicious foods. Play. Almost anything you do becomes harmful when done in the extreme so use moderation.
- When did it become a crime to take an afternoon nap? Adequate sleep in imperative.
- Every day close your eyes and focus on your breathing for at least five minutes. It is so relaxing.
- Your body needs to move, lift and run.
Like me, you will not be perfect in these matters. It is the journey, not the destination that counts. The destination is death. Don’t worry; you will get it right the first time. I never met anyone who did not die the first time they did. Life is about the journey. Learn “to sit quietly in a room alone” as Blaise Pascal taught us. I pray we cross paths on this journey we call life; it is only meaning life has, the only reason to be.
Several years ago while surfing the web I ran across a guy called Mr. Money Mustache, written by some crazy guy out in Colorado*. His claim to fame was that he retired at age 30, to which the Internet Retirement Police took him to task, claiming he did not ‘really’ retire at age 30. Not me. I sat back in my chair and wondered: What took him so long?
Fast forward to last weekend where my 21 year old daughter, Heather, complained about issues with her supervisor at work. It was the perfect opportunity for me, dear ‘ol dad, the Wealthy Accountant, to share some golden nuggets of truth.
The people living with me, sometimes known as family, are quite accustomed to my rants on how to live life, sometimes known as ‘dad’s little psychotic episodes’. The good father that I am, I share my lifetime of experiences liberally and sometimes even add a modest amount of BS. Let me be 100% clear here; I never lie. Ever!
Last weekend I had the perfect opportunity to explain to Heather how she can retire by age 25, younger than Mr. Money Mustache, and live the life she wants. The best part with my plan is she only has to work a half day three months a year followed by a nine month vacation.
Here is my, once again, flawless logic. Take a page from dad’s book. You see, dad, the Wealthy Accountant, started his business as a tax preparer only. In my mind there was no better job. For three months I work out of my home preparing taxes and for nine months I horse around. By working out of the home, overhead is almost zero. With a small amount of training, a computer and tax software you can bang out a couple hundred tax returns each spring filling your coffers with $30,000 – $50,000. Now you can enjoy a well-deserved nine month vacation after working that grueling part-time job for two and a half months. How do you do it?
Enter George Carlin
As much fun as I had with my daughter’s plight, there was a serious grain of truth to my reasoning. George Carlin was the best comedian to ever live. What made George so good was how he made us laugh. He told few jokes. What he did was show how the world really is until we saw the absurdity and started laughing.
The world could use George Carlin’s flawless logic right about now. The old paradigm of working 40 or more hours per week as the only way to get ahead is dead wrong. Have you ever noticed how many hours a day you really work? Filter out the bathroom breaks, socializing, checking email, picking your nose and scratching your butt and you will find you actually work four or fewer hours per day while the boss coughs up a hairball for a full eight hour workday. Even is the dead of tax season when I am hyper productive I noticed I only really working maybe six or seven hours per day. The stress of such productivity eventually wears me out and kills my productivity. Few people can remain productive for more than a few hours at a time.
Somewhere deep within these thoughts are nuggets of truth for living life. Technology has made our life even easier. The income you produce from ten to maybe as high as twenty hours a week covers all your needs and most of your wants. All the extra hours at the office are filled in to satisfy the clock.
Your personal life is no different. Bills, income and investing can all be set on autopilot. Computers do all the work for you. Machines make our lives so easy we now run to the gym so we can lift something and improve our health. That problem did not exist 100 years ago.
I challenge you, as I challenged my daughter, Heather. When you work, work. Get the work done and move on to enjoying your personal life. Back on the farm we have a saying: push, shove or get the hell out of the way. And talking about farming; I grew up on a farm. There were always breaks between unloading each wagon of hay. We worked hard in spring and fall, enjoying more free time (fishing anyone) the remainder of the year.
Heather has no desire to be a tax accountant. Maybe I can talk you into it. According to Robert Half (a temp agency for accounting professionals) informed me recently that during the Great Recession the unemployment rate in the accounting/tax industry reached a whopping 1.9%. It currently stands at 1.2%. We could use a few more good men (and women) in the field. The work is fun and you meet wonderful people. The best part is you can make a difference in so many people’s lives. A massive number of accounting firms would love to hire you full-time during tax season and reduce your hours to twenty or so hours a week the rest of the year. Heck, many would hire you for three months of tax season and give you the rest of the year off if you want. Or, you can work out of your home and set your own hours.
How Young Will You Retire
Once you have enough money to live you are working only to work, a fool’s errand. It is a lesson I still need to learn. I love my business, employees, clients and my work so I continue growing my practice. Pete, over at Mr. Money Mustache, thinks I’m “insane” to be working like I do at my age. My only retort is, “I am happy.” The reason I am happy is because I do what I love and have plenty of time off three quarters of the year. In my mind I make a difference; it is all that matters to me.
I told Heather she could retire at 25, younger than Mr. Money Mustache. I was only half joking. You don’t need to work 40 hours a week anymore to live ‘right’. Living ‘smart’ is better. Reduce your wants and enjoy all the best stuff life has to offer: family, friends, and walks in the park, sunrise, sunset and more. Go for a bike ride with your significant other. Meditate. Just relax. Yes, I know; I need to practice what I preach. I invite you to join me on my journey. I have walked a bit of it already so I have experiences to share.
* Mr. Money Mustache and I know each other. Do not consider my warped humor a rude retort.
People serious about early retirement turn to rental real estate to turbo-charge the process. Saving and investing can get you to retirement fast. With real estate you can go from zero to retired in a few years. It does require careful planning to make it work.
There are three steps in successful income property ownership: buying right, management and taxes. Over the years I have seen many people lose money, even go broke, due to rental properties. I have also seen ordinary people make more money than doctors or lawyers with real estate.
From the late 1980s to the late 1990s I owned well over 100 pieces of property in a partnership with dad and brother. Real estate is a passive activity according to the IRS. In reality it is planning and work. The number of rental properties required for a comfortable retirement is not all that large. I currently own two properties (other than my homestead) generating over $36,000 of passive income a year. This is profit, not gross rents.
You need to buy the right property at the right price if you want to make money. The lowest price is not always a good idea. The oil patch of North Dakota is a good example of a rare market to avoid due to the freefall of oil prices. Most communities, however, have opportunities to purchase quality real estate.
It is all about the math. Any income property you buy must cash flow from day one. Don’t let a Realtor (or anyone else for that matter) talk you into buying a property with the hope of future appreciation. The right property at the right price will have a positive cash flow before any tax advantages from day one.
Find a good accountant with experience in real estate. Sometimes accountants are called deal-busters. What we really are is a professional willing to review the facts with brutal honesty. You might get caught up in the hype of buying a piece of property; a good accountant will not. My wealthiest landlords pay me to review every deal before they make an offer. My job is to point out what can go wrong. Your accountant should be your best friend in business.
When researching a property, use caution when assuming rents. Sellers frequently like to tell buyers the rents are low and can be raised. Buyers then use inflated rent rates in their analysis. When I consider a property I use the current rent rates only. If you raise rents too much (because the seller said you could) you may lose tenants. Also, build in a reasonable vacancy rate and an honest maintenance budget into your analysis.
Real Estate Management
There are two choices when managing your properties: do-it-yourself or hire a property manager. I have seen both methods work. Managing your own properties will keep more money in your pocket. You must educate yourself by joining/attending your local apartment association. Each state and some cities have their own set of rules/laws. Running afoul of these laws can result in expensive lawsuits and/or fines.
The same care is needed when hiring a property manager as when you bought the property. Not all property managers are qualified. A good manager will pay for themselves many times over. With a manager you will have only a small amount of time invested into your rentals. Most management firms collect the rent, subtract expenses (mortgage, property taxes, insurance, maintenance, etc.) and send you a check for the remainder. The manager will also fill your vacancies and handle non-paying tenants.
You can handle some of the maintenance and repairs to save money (and give yourself something to do while retired). Know your limits. I handled most minor repairs myself with my properties, but left bigger projects to the pros. For example, I never installed carpet. (Okay, I installed carpet once. It was not pretty.) I enjoy painting, light plumbing and minor electrical work. Depending on the project, I may handle the job myself or hire a helper or even work with a plumber or electrician.
Now to my favorite part of the story. Buying the right property at the right price and management are local issues determined by the community you are buying in. The tax laws cover the entire United States. Most states are what I call “me, too” states; whatever the federal tax code does, the state says “me, too”.
The tax issues involving rental real estate are significant. By understanding what you can deduct and what must be capitalized (a fancy way of saying the expense must be depreciated over a number of years) you can pay down the mortgage you have faster and greatly increase your cash flow after tax.
We will start with the basics. Rent is reported as income; the security deposit is not. If you keep some or all of the security deposit after the tenant moves out for back rent, damages, unpaid utility bills, etc., you recognize the retained portion as income at that time.
Expenses are harder to understand. Things like property taxes, mortgage interest, mileage and utilities are deductible when paid. The two complex areas we need to address are repairs/maintenance and depreciation.
About once a year a new client comes to my office with rentals he did not depreciate. They mistakenly believe if they don’t take depreciation they don’t have to worry about recapture on sale. Wrong! Depreciation is “allowed or allowable” with real estate. This means if you don’t take depreciation you must act like you did when you sell, causing double taxation on the depreciation amount. If you are reading this and discover you depreciated wrong, don’t worry. You can fix the error by filing Form 3115. You claim all the missed depreciation in the current year; no need to amend back tax returns. Also, you must fix the mistake before you sell the property.
Depreciation of your property causes your tax return to show a lower profit than your cash flow. In my experience investors are reluctant to depreciate a building while angry when they can’t deduct remodeling or other repairs to their building. We will now turn our attention to deducting all the things we did not know we could.
If you already own rentals you know some expenses are not deductible. Well intentioned accountants tell their clients they must depreciate remodeling, roofs and carpeting. The recent repair regulations have made significant changes for landlords. Landlords never had the ability to expense assets like businesses under Section 179. Now, with the new repair regs, landlords have the ability to deduct more than ever before.
The de minimis safe harbor for a current deduction is $2,500. This means all those stoves and refrigerators under $2,500 no longer have to be depreciated. A computer, desk or other property used for the rentals is now deductible as long as the item costs less than $2,500.
Another problem area is remodeling, repairs, roofs and flooring. You can now make an election on your originally filed tax return to deduct up to $10,000 for repairs, maintenance and improvements to qualified buildings. There are ways to deduct even larger amounts in limited situations which go beyond the scope of this post. This means an $8,000 bathroom remodel can be currently expensed rather than depreciated. Same for a $10,000 roof replacement or a $4,000 carpet upgrade. (Note: this strategy only works for taxpayers with gross annual receipts of $10 million or less.)
Tangible Property Rules
Now that you are making a good profit on your rentals, you need to roll up your sleeves to reduce your tax liability. Once you own properties for a few years the rents go up, the mortgage goes down and profits start to exceed depreciation. Now you start paying tax on part of your cash flow. It does not take long for profits to explode once you reach this critical mass.
Enter the repair regs again and the tangible property rules. This is a complex tax maneuver and requires a seasoned tax professional. I will give you the Reader’s Digest version.
If you have a property with a building basis of $250,000 or more you can call in a firm to do a cost segregation study. In laymen’s terms this means engineers come in and break out the building elements. When the study is completed the components of the building are depreciated at their class life. A rental property is depreciated over 27.5 years. After the cost segregation study, a large part of the building is depreciated over 5 or 7 years with a small portion still depreciated over the longer 27.5 years. This also works for additions to existing properties.
There is a case study in my office where a $15,100,000 apartment complex created a $570,288 tax savings. Of course I cherry picked the example. What I want to convey is the possibilities of reducing taxes for landlords and businesses with real estate.
As the years go by you may want to sell some of your investment properties. The capital gains can be large as the years add up. A property bought for $500,000 twenty years ago and is now worth over $2 million will generate a significant tax bill. Enter the Like-Kind Exchange, otherwise known as a 1031 Exchange.
The Like-Kind Exchange allows you to transfer the profit on the property given up to the replacement property purchased. In the future I will deal with Like-Kind Exchanges in more depth.
Step Up in Basis
All those unrealized capital gains and unrecaptured depreciation are real tax problems. You can avoid these taxes if you keep the properties (and profits) for life. Investment property throws off a generous stream of income if there is no mortgage. A property manager can handle the work while you enjoy your retirement. Why sell the property and kill off the goose that lays the golden egg? By keeping the property, you enjoy current income, and when you leave this world, your children can take over. They get a step-up in basis when you die. Remember all the crazy stuff you did to lower your taxes because you read a blog from some accountant over in Wisconsin? Well, since you decided to keep the money flowing into your account your entire life (a man has to eat), you passed from this world to the next while owning those wonderful cash cows. Now the kids get to start depreciating those properties at what they were worth when you died. All the capital gains and depreciation from your lifetime goes away and we start all over as if the kids bought the property themselves on your date of death at full value. Not only did you manage a life-long stream of income, you gave your heirs a heck of a financial boost, too.
Real Estate Professional
I see a few people moaning in the back of the room. All these ideas are great if you have a profit or your income is lower. What about people with higher incomes? I’m glad you asked.
Loses on your investment properties are limited to $25,000 per year if your income is below $100,000. The $25,000 loss limit begins phasing out at $100,000 until it is completely phased out at $150,000. Don’t worry. The losses are only suspended; you will use them eventually.
There is a way to use them now. The IRS considers you a real estate professional if you spend half of you time working on real estate and at least 750 hours per year. A real estate professional can deduct all investment property losses, regardless of income.
A Few Good Tax Men
I threw a lot of stuff out there for you guys. I only scraped the surface. This post is meant to give you an idea of what questions to ask your tax pro. The complex nature of tax laws relating to income property requires a tax professional well versed in the tax issues relating to real estate. I have written several articles on the subject in the past. If you want more information on real estate professionals, passive activity rules or material participation rules, use the hyperlinks to view my past articles on the subject.
I grew up on a small farm in rural northeast Wisconsin. We lived in a shotgun shack which is more familiar to the U.S. South. If you don’t know what a shotgun shack is, it is a home with so many holes you could shoot at it with a shotgun and the pellets would pass right through without hitting the building.
A shotgun home in NE Wisconsin has problems in the winter months. The small furnace kept the pipes from freezing and not much more when the temperatures dipped below 0 F. My upstairs bedroom had no heat. As luck would have it, I had an electric blanket. There was one more advantage: I kept ice cream under my bed for two or three months a year and it would not melt. Those are wonderful memories.
Things changed. My parents started an agricultural repair business and started to flourish. The homestead was remodeled and filled with comfortable warmth. So I moved out. (Hey, I was an adult and needed to spread my wings. Besides, all that comfort was making me weak in the middle.)
Years later I bought my own homestead complete with my very own shotgun shack. Now married, I had other considerations and plenty of training to do. Not everyone takes to a shotgun shack as fast as I do. The homestead was remodeled before we moved in. (The softness stuck with me.) When we bought the homestead (10 acres) the furnace and water heater were caput and there was no air conditioner. (I never had air conditioning growing up so I avoid the unnatural cold air whenever I can.) We installed a geothermal heat pump (this is back in 1995 and still have the same heat pump) which replaced the furnace and hot water heater. As a bonus we had air conditioning.
The air conditioner rarely gets used. In the summer our electric bill is very low. We use about 20 kilowatts a day and much of that goes to pump water for the steers. The winter is a different story. A geothermal heat pump does not sip electricity, it gulps. Sure, it is more efficient than most other heating methods. It still adds up.
The electric bill in the winter causes me to shutter. We have electric heaters in the barn to keep the water open. Heating tapes wrap the water pipes and the chicken waterer sits on a raised heated disk. Now add the home heating and I am ashamed of my energy usage. (There are several days in the dead of winter where we use over 100 kilowatts a day.)
My childhood memories provided a partial solution. I put on my salesman’s hat and sold my family on a colder house. No more 67-68 degrees for the tough Accountant family. No, we were going back to a 50 degree house during the winter. As I gave my sales pitch I could see I was losing the sale. The look I got from my dear loving family was, to put it politely, rude.
A good salesman does not hear the first “no” or even the twenty-second. I had to reformulate my proposition. I started turning down the thermostat a degree or so. There was push back. However, the clan adjusted. That was my opportunity to cut another degree off the top.
By the time I played out my goodwill with Mrs. Accountant and the junior Accountants, I had the house at 60-61 all winter long. I guess we call that a compromise. I did not get the 50 degree house I wanted, nor did I get a full force revolt. (There were a couple of coup attempts we will leave out of today’s story.)
There were several benefits from the cooler house. We seem to sleep better at night. Of course, the light bill dropped significantly. I even remodeled the barn where the water works were and cut my utility bill further. The barn remodel paid for itself in one winter. The surprise came from our health. We don’t seem to gets colds the way we used to.
We bump the heat when entertaining guests. It takes getting used to and I do my best to treat guests with respect; we turn up the heat to 65. (A man has his limits.)
We have a cold house. It is not about the money. A larger utility bill would not change my lifestyle. It does go against my constitution. Spending money in a wasteful way bothers me to no end. Humans can easily handle colder temperatures. I have not died (yet) from working outside in 20 below weather with a 30 mile an hour wind. The more you practice, the more your body adjusts.
My annual spending hovers around $30,000 per year. A cold environment could bump that number up, but does not for me. When you allow your body to adjust to seasonal weather you are no longer a slave to human modified environments. In the summer we use open windows for air conditioning. We knuckle under when the humidity becomes oppressive. The air conditioning unit of our geothermal heat pump runs two or three times a summer; some summers it never gets used.
Why all this so-called craziness from a wealthy accountant? Simple. When I cut my needs (really wants), my cost to survive becomes low. It does not take much for me to cover the basics. My $30,000 a year lifestyle allows me massive amounts of frivolous spending. If things got tight I could cut to $10,000 – $12,000 before it would really hurt, as I did before and in the early years of my marriage.
The real benefit is the tax-free money. If I spend an extra $1,000 per year over-heating my house because I am too soft, I need to work long enough to earn $2,500 to pay the taxes, pay for the transportation to work, pay for work clothes and any extra cost of not eating at home. A frugal guy like me might get it done for $2,000 and if I bike to work, $1,750.
How long does it take me to earn $2,000? How long does it take you? When you spend time away from your family to earn this money, do you think about what you will do with that money? Would you burn a $100 bill? No? Let me end with one last question: What are you doing this winter if your home is warmer than 60 degrees?
The first week of tax season is in the books as I write this. Most tax seasons bring the same problems with a few notable new ways to mess up a tax return. New employees frequently bring bad habits from previous jobs we work hard to break. A new CPA in my office has reminded me how important it is to address problems quickly.
Communication between accountants in the office and with clients can either make or break the client relationship. Clients will ask for things that will really harm them in the end. Today I want to address two areas of concern: injured spouse and deductions (business and personal).
All too often a client wants an immediate benefit without regard for the future. The most difficult task in training new employees is to get them to think about the effects on all tax returns affected. Clients generally get it when I explain it to them. For some reason the tax pros want to tenaciously hang onto the old destructive habits.
A quick definition: An injured spouse is where one spouse owes back taxes or child support and the other does not. As a result the refund will be seized by the IRS to satisfy the child support arrears or the state or federal back taxes owed. To protect the spouse not responsible for the payments, the injured spouse can file for relief (receive their portion of the refund on a joint tax return). You can even marry into such a situation.
The rules for injured spouse are complex and not the focus of this post. Instead, I want to focus on why it may be harmful to claim injured spouse even if you qualify.
To make this easier I will assume our hypothetical married couple is exactly equal in every regard: both have exactly the same income, deductions, credits, etc. This should result in half the refund due to each.
Our injured spouse is married to a man in arrears on his child support or owes back taxes from before they were married. The IRS will take the entire refund unless injured spouse relief is requested. The question is: Should the injured spouse file for relief and get her half of the refund?
I argue the injured spouse should NOT file for relief in most cases. If the couple is headed for divorce or are separated it is probably a good idea to request relief and get half of the refund for the injured spouse. For a happily married couple, injured spouse relief harms the finances of the household. By taking the partial refund interest and penalties continue accruing (interest and penalties do not accrue on money no longer owed). By claiming relief and getting half the refund, the debt is larger. Over time, the wealth of our married couple is less because they delayed payment of the debt. This can be significant. If the issue is back taxes, interest and penalties can reach and even exceed 18%. And you owe it to the world’s largest debt collector, the IRS (or state taxing authority). Back taxes/child support will probably result in a wage garnishment at some point. The household will have less money (wealth) in the end due to the additional fees!
Injured spouse relief should not be automatic for tax preparers or taxpayers. Too many tax professionals get it wrong. You must have a long and hard talk with your tax pro (and with your spouse) before deciding what is best for you. If you prepare your own taxes you still need to have the same long talk with your spouse.
Individuals can use the information/philosophy in this section when considering charitable deductions and the timing of property tax and estimated tax payments. I will write more about those issues in the future. Today I want to focus on a bigger deduction affecting small businesses and rental property owners.
Have you seen the ads out there claiming to review your tax return and get you more money back? Some of these companies charge you a portion of the refund from an amended return they file. This can be a really bad idea. Remember the old adage: figures don’t lie, but liars figure. A bigger refund today can cost you significant future wealth.
Businesses and rental property owners have several options when improving a property or buying a depreciable asset. For most people, getting the biggest refund/lowest tax liability now is the right choice. In some instances it can cause an over 100% increase in your tax bill the following year. I call that a stiff loan. The facts and circumstances determine the correct course of action.
Let’s say you bought a $100,000 piece of equipment for your business. A small business can depreciate the asset, write-off the entire asset under Section 179 (with limitations), or use bonus depreciation (if it exists when you read this). Landlords cannot use Section 179. If the business has a profit, writing off the asset as fast as possible is the way to go. In some cases the repair regulations could allow for faster write-off as well. More in a future post.
A $100,000 piece of equipment with a 5-year class life will generate $20,000 in depreciation the first year. The remaining $80,000 will be claimed in future years. If you choose to claim the entire $100,000 you should consider you tax bracket. Will the full deduction reduce your tax bracket? Will you pay taxes at a higher rate the following year/s if you take the full deduction today?
When accelerating deductions it is important to consider all years affected. A small Schedule C business could reduce the current year tax liability, even creating a loss to be used against other non-business income, taxed at a lower rate. Remember, with a sole proprietorship you pay self employment taxes on business profits. If you accelerate depreciation items causing a loss for the business, you only save the income tax portion when the deduction is applied against other income, such as wages. When you return to a profit in following years you will pay income AND self employment taxes on the profit. In other words, you saved 15% (income tax bracket) and the next year pay 15% income tax on the gain AND 15.3% in self employment tax, effectively turning a deduction into a 100% interest rate loan.
Schedule C business has a $10,000 profit before depreciation and has $20,000 in first-year assets to depreciate. Assume 15% income tax bracket and $40,000 in wages, therefore, this taxpayer could claim the full accelerated depreciation without creating a net operating loss.
Regular depreciation: $4,000
Accelerated depreciation: $20,000
Choice one: accelerate depreciation.
$16,000 additional depreciation over regular depreciation. Business shows a $10,000 loss in year one only; no depreciation in future years.
$10,000 avoids SE tax = $1,530
$20,000 avoids income tax = $3,000
Choice two: Use regular depreciation only, $4000 per year (will use straight line for easier calculation).
Business never shows a loss. Instead, business shows a $6,000 gain each year.
$20,000 avoids SE tax = $3,060
$20,000 avoids income tax = $3,000
Because the accelerated depreciation causes a loss to the business, the additional SE taxes in years after year one increases the tax liability by $1,530. A wealthy accountant will forego the extra tax deduction in year one for the total tax benefit of $1,530.
You can see why communication between a tax professional and client is so important. The tax savings can get large fast. Taking a quick benefit can cost you significantly more in time. The same process can apply for charitable contribution or estimated tax payments, too.
Injured spouse relief can help in some situations, but can cause harm in others. Business planning requires consideration of all tax years involved.
Use this guide if you prepare your own tax return. If you have a business you should consider a tax professional. Not all tax pros are created equal. Just because they have letters after their name does not make them competent. CPAs are accounting professionals; attorneys are legal professionals; and EAs (enrolled agents) are tax professionals. All these professionals have a strong presence in the tax industry. Let’s forget about the unlicensed guys.
Question any tax pro you hire. If they can’t give straight answers, find someone else. Your retirement, including early retirement, is on the line. It is all about building wealth.
I accept a limited number of new clients per year in my office. I practice a quasi-retired lifestyle (for about 20 years now) and run a small tax office. If you have a unique or difficult tax situation, use the Contact page to send me a message. I generally do not answer specific questions due to time constraints. I’ll reply if I have an opening for a new client. Also, you are welcome to use my services for one year only to get you on the right course. Then you can go back to a local accountant or prepare on your own return with my template.
I understand this is a complex tax issue and probably not the wisest choice to start this blog since I want to focus more on lifestyle (living life right) rather than bog down in deep tax issues. However, it is important to minimize taxes to build net worth. The tax code can help you retire early and live better in retirement. It is really about having the freedom to spend more time with family and doing the things you want.
Out in the boondocks where I live the garbage is picked up every two weeks; recycling once per month. Until a few months ago this arrangement worked well. Garbage was placed in a large barrel the garbage truck could automatically empty into the truck hopper. Recycling was placed in blue plastic bags with paper and cardboard placed in either a box or tied in a bundle. A few months ago the system was changed for recycling. Bags were replaced with a blue barrel the same size as the garbage barrel. I understand why the change took place. Under the new system the recycling company could run the route with only one employee. The truck has a lift (like the garbage truck) to grab the barrel and empty the contents.
The problem comes from the amount of recycling I have. All the recycling from my office, farm and home went into the barrel and it was not big enough. It was hard to believe I had so much crap every month. The garbage barrel was almost empty; we have one small kitchen garbage bag for disposal every two weeks. But the recycling did not fit. At first I wanted to blame all the stuff (a technical term used by hard-core wealthy accountants) on the office and farm. Certainly, they played a roll, but personal recyclables still would fill the barrel monthly.
Whenever I see stuff going to the landfill or recycling center I start thinking. Why am I buying all this stuff only to throw it away? The only way to understand a problem is to research it. I had to know where all the recyclables (waste) were coming from.
To make for fair research, I excluded the loads of junk mail and other paper from the office and feed bags from the farm. My goal was to understand my personal waste. My garbage waste is so small I don’t think it pays to spend much time reducing the small kitchen bag of garbage. Mostly, we change the kitchen garbage every two weeks whether it needs it or not to prevent odor. But how in the heck do we fill a recycling barrel to overflowing monthly?
First off, I notice we have a lot of plastic jugs. I mean lots! We could mention the whisky bottle, but we will not go there to protect the reputations of the not so innocent. (Mrs. Accountant does not drink whisky… that I know of.) The real mass of plastic is dominated by juice bottles and milk jugs.
I prefer drinking fresh, home-grown juice. Sometimes I buy apple juice at a local orchard in the fall. I drink milk, but not often. So I can place all the blame on Mrs. Accountant and my two Jr. Accountant daughters. Except it would not be fair.
Milk containers collapse down and don’t take a lot of space, but we guzzle three gallons a week. Juice containers are more rigid and collapse to a point. The barrel would fill slowly each day. There was also one other bulky item that consumed a lot of space other than office paper, feed bags and plastics.
Before I tell you the criminal in the recycling barrel I want to defend the Accountant household. The item causing all the problems came mostly from the office with only a few coming from the household. The culprit: packaging (cardboard boxes).
Food packaging is the worst. The ladies at the office love to ship in lunch on a regular basis. Example: one of my employees had a birthday recently so it was decided the boss would pay for lunch. (We have a petty cash account for special treats for the staff.) I had no say in the purchase. They decided on Subway. The plastic container holding all the sandwiches was huge! I had no doubt more cost went into the plastic packaging than the amount of food purchased. Two lessons here: 1.) the plastic package did not collapse down well so it took a lot of space, and 2.) the cost of the food was probably less than the cost of the packaging which was purchased for no other reason than to throw it away.
Since we know packaging is not free, we have an opportunity to reduce costs in our life without sacrificing lifestyle. I am on a mission at home and at the office to reduce recycling waste. Stuff tossed in recycling is still waste! And you paid for it; just as much as you paid for all your regular garbage. If we can find ways to reduce all waste, including recycling waste, it would do wonders for our personal bottom line. Call it frugality without giving anything up.
A Few Solutions
When you have a farm, office building and a large home you need a fair number of light bulbs. I use LEDs in all my buildings. Some LEDs are packaged with so much plastic I have to visit the shop to pry open the packaging. I discovered some LEDs use less packaging, especially when multi-packs are involved. I visited a few local stores to see if I could do better when buying stuff, LEDs in this case. Using my trusty pocket calculator I determined multipacks were a much better deal and used a significant amount less packaging. Lesson: More packaging equals either a higher cost or a lower quality to cover the packaging cost.
Packaged food is bad for your health and pocketbook. All the boxed foods my kids love (and I eat right along with them) are hurting my body while wasting a lot of money on packaging. Fresh fruits and vegetables can be somewhat more expensive, but after considering health they are a bargain. I have a plan to buy more in bulk to reduce packaging costs and to reduce prepackaged foods like cereals. In my defense, I eat eggs every morning and I get them from my barn. When I say ‘Farm Fresh’ I mean it. My breakfast: laid this morning. (BTW: you can buy my eggs (brown eggs) if you stop in the office. First come, first serve.)
On the farm I buy egg mash in 50 pound bags. I will move to bulk delivery without any bags and store the mash in a spare gravity box. I use about a ton of mash a month and when I checked it is cheaper for the same exact product. Savings: $40 per month. Farmers are noted for their frugality. I still cannot explain what took me so long to figure out I could save $500 a year with this simple change.
The accounting office will be a tougher nut to crack. I don’t always have control over the waste flow. Junk mail will keep coming no matter what I do. Boxes from Amazon for supplies or paper take a lot of space and cannot be easily replaced.
I reuse many plastic containers and cardboard. The cardboard works on the farm around trees or in the garden to control weeds and protect soil moisture. Juice contains store homemade wine well (ahem). In the end it will end up as either garbage or recycling, but used many times before discarded.
I saved food waste for last. We don’t have food waste in our house. What the chickens, steers and barn cats don’t eat goes into the mulch bin. It is estimated 50% of all food grown is discarded from farm to the table. We certainly have waste in the Accountant household. Garden waste is common during the summer and fall. Not all things grown should be eaten. Unfortunately, there is waste from the kitchen as well. Wasted food is going to happen. Things sitting in the fridge too long have to be tossed. Unless you have a farm you will have more food waste going to the landfill than my household.
Make a Difference
Every household has different waste/recycling issues. Any waste bothers me; it goes against my upbringing. My paternal grandmother used to remind us kids that during the Great Depression they ate lard sandwiches “and liked it”. We joked back that today we have Butter Flavored Crisco. Truth is it is not funny. Waste delays retirement plans as money funneled to retirement investments get a ride to the landfill or recycling center. Waste reduces quality of lifestyle. It also feels really good knowing you are acting as a responsible steward of the gifts life has granted you when reducing waste. Be vigilant. Whenever spending hard earned money (or easily gotten money, too), pay attention to the waste products you are buying with the stuff you want. It’s how wealthy accountants roll.
More Wealth Building Resources
Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?
Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.
Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.
PeerSteet is an alternative way to invest in the real estate market without the hassle of management. Investing in mortgages has never been easier. 7-12% historical APRs. Here is my review of PeerStreet.
QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.
A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregations studies work and how to get one yourself.
Amazon is a good way to control costs by comparison shopping. The cost of a product includes travel to the store. When you start a shopping trip to Amazon here it also supports this blog. Thank you very much!