Posts Tagged ‘investment property’

Finding a Good Accountant for Your Income Properties

Vetting a tax pro before you hire her is the most important task you have. The right choice will save you thousands while reducing stress and problems. Here are the steps and questions you need to ask when vetting an accountant. #questions #taxpro #CPA #EA #enrolledagent #IRS The Tax Code has gown in complexity the last few years. Finding a qualified tax professional who understands the nuances of taxes is harder than ever. Without proper vetting you can overpay for service and end up with subpar results.

The growing complexity of the Tax Code has more tax professionals specializing. This is a good news/bad news situation. The good news is that when you find the best tax professional for your situation you should achieve maximum results. The bad news is that prep fees reflect the higher competence level.

And if you are going to pay more you want to make sure you are getting the best value. 

All tax professionals are required to work outside their area of specialty. An accountant focusing on investment properties still has to complete the remainder of the tax return. You need a tax professional who understands how decisions made with investments affects the remainder of the return.

The meat of the value when hiring a tax pro is finding one specializing in the most difficult or complex area of your return or the portion causing the most tax. 

For example, income properties are a part of many tax returns. Those looking to retire early may use rentals to supplement their income. Income properties can also supplement part-time income. The tax professional you need should understand the basics of an individual tax return. The accountant should also understand the fundamentals of the various retirement accounts and the implications of using each for your situation. But most important of all, you need a tax pro focused on the rules surrounding income property.

Desperation is a bad guide. Just because an accountant accepts you as a client doesn’t mean it’s a good fit. You need to vet your choice before signing the engagement letter and committing to her services.

Today we will focus on how you can vet a tax professional (enrolled agent, CPA, attorney or other tax professionals) to handle your investment properties. Asking the right questions is vital. Knowing what answer you should get is even more important. 

 

Vetting a Tax Professional

Each situation requires a different set of questions. We will focus on a individual with income properties. Small business owners will have different questions. You will need to do some research to prepare a list of questions specific to your needs before visiting the accountant.

The answers the accountant gives is less important than how they handle the questions. First, you probably don’t know all the details of taxes surrounding your situation. Therefore, you may not know the accuracy of the answers given. 

You don’t want a know-it-all tax professional. It is okay for her to say she doesn’t know the answer and will need to look it up. This is normal! If the candidate never needs to research they are either a prodigy or an idiot and I’m not betting on prodigy.

You also want the accountant to add something to the mix. Your questions and situation should jar some additional ideas from the tax professional you didn’t think of. That is why you are hiring her!

The accountant should care and be interested. Smart isn’t good enough. This is a long-term (we should hope) relationship. As the accountant knows you better she can provide better and better service. Her value should grow each year.

I’m putting a lot of weight on the accountant. I fully expect the tax professional to charge accordingly. No one should work for less than the value they provide. You should be willing to pay more if you expect more.

Expect more. It’s a better deal.

Let’s run down the vetting process and questions you should ask a tax professional if you own or plan on owning income property.

 

Should I have an LLC?

LLCs are organized on the state level. I can’t think of a state where have income properties in an LLC would cause an issue. The accountant’s answer is important here. You may need an attorney to set up the LLC if their are issues.

Under no circumstances should you hold real estate in a regular or S corporation or LLC electing as such! There is no added benefit to doing so and many, many problems associated with it. 

The accountant should point out that the income properties held by the LLC will have no tax effect as you will be treated as a “disregarded entity” for tax purposes. This means if you own the property/s solely you will report on Schedule E of your personal tax return and if there are two or more owners the LLC defaults to a partnership. For income properties, the LLC value is for legal purposes only.

If the accountant wants to deviate from my answers they had better have a really good reason. There are not many and I have never seen a qualified tax professional or attorney recommend putting real estate inside an S corporation. 

This is a warning to all the DIYers setting up their LLC. Too many think they save money by putting the properties in an S corporation and it really only causes problems.

 

Recordkeeping

Next you should ask how the accountant want your records. This is a personal preference. As long as your are comfortable presenting your data in the format asked for the relationship should run smooth.

This is also the time to discuss bookkeeping services if you need help in this area. If you know you’ll struggle with the recommended bookkeeping process requested by the accountant consider spending a few extra dollars for a quality bookkeeper. As hard as it is to believe, good books save you money, reduce audit risk and lower your taxes.

 

Deductions and Other Tax Advantages.

Now we turn to a variety of unique tax deductions and benefits owners of income property enjoy. The normal deductions should be obvious: property taxes, mortgage interest, depreciation, supplies, repairs, advertising . . . 

I want you to ask difficult questions on unique issues when vetting a tax pro candidate. The accountant should understand these issues or be willing to research them. 

This list is not exhaustive. The issues I want you to ask about I see constantly so you want an accountant versed in these issues. It is where the tax savings reside.

 

Travel

Ask about mileage. The accountant should explain what is allowed. She should also explain if the standard mileage rate or actual expense is better.

 

Other non-cash deductions

I consider the mileage deduction a non-cash deduction. There are a few others worth noting. 

Before taxes become a problem you need to ask your accountant these questions. #accountant #CPA #EA #enrolledagent #taxpro #tax First, you can use a per diem when you travel. If you attend a real estate investing seminar you can deduct the hotel, airfare (or miles if driving), the cost of the seminar and a meal and incidental expense allowance (M&IE). 

Hotels and other travel expenses require a receipt for substantiation (in case you get audited). However, meals are a different story.

You can deduct actual meal expenses if you want or you can use the M&IE per diem rate. You can use a chart to deduct based on the city you are visiting or the hi-low rate. You must use the same method within each business trip. However, you can switch between different business trips, using actual expense on one and the per diem on another within the same tax year.

Second, if you use actual expense when traveling you do NOT need to keep a receipt for meals under $75, including tip. Your accounting records of the meal expense along with the business purpose of the meal and who you were with is sufficient for a tax deduction.

You can not use the per diem for non-travel business meals. However, the $75 receipt rule still applies.

 

Tangible property rules

Some things are deducted and some need to be capitalized (depreciated over a period of time). Not long ago this was a real pain for income property owners because asset expensing (Section 179) is not allowed on income real estate and its components (appliances, for example). 

Under the new tangible property rules all items $2,500 or less can be deducted regardless. That means most appliances are now deducted versus depreciating over 5 years. Curtains, carpet and other minor items are also currently deducted. 

An election is required so ask to assure the accountant you are vetting understands this.

 

Repair regs

Improvements have always been a serious issue. Improvements are depreciated over 27.5 years for residential property and 39 years for commercial. You still pay the expense up front.

Improvements are defined as increasing the value of the property. Many improvements therefore are really deductible repairs under regulations. 

Find the best tax accountant possible by asking the right questions. As long as you are paying the bill your deserve the absolute top level of service. #CPA #EA #enrolledagent #taxpro #investments #realestate #incomepropertiesFor example, flooring is usually not an improvement since it only restores the property to its original value. Roof replacement can also be considered a repair, even if it is really expensive. Cost does not automatically cause a deductible repair to become a capitalized improvement! 

Generally (and this is why a detailed conversation with your tax pro candidate is so important), if flooring is replaced with the same type it is a repair as long as floor boards are not replaced or reworked. The same applies to roofing. If the same roofing material is used to replace an old roof it probably qualifies as a deductible repair as long as roof board are not replaced. 

However, the previous paragraph (flooring/roofing/other repairs) only qualifies for a deduction if you own the property as an income property for 5 or more years. It is assumed by the IRS that if you owned the property for a shorter time period the property didn’t have enough time to deteriorate so the repairs are actually improvements. Planning with your accountant is vital.

However!

There is still one more really big out. If you have an improvement of $10,000 or less you can elect to deduct the improvement as a repair expense. 

There is some gray area here. The $10,000 repair reg rule is per building, kind of. If you remodel a kitchen and bathroom in the same apartment it must be $10,000 or less combined to use the repair reg election.

The same probably applies in multi-unit buildings. Tax professionals differ here. Many tax professionals consider all improvements in a duplex. This means all improvements in both apartments must be $10,000 or less to qualify under the repair regs. 

But in larger multi-unit buildings it gets more complicated. Do you count all bathroom remodels , et cetera in a 20 unit complex? This accountant looks at each situation before making a judgement call. (I also research this a lot based on facts and circumstances when it comes up.) 

You need a serious discussion on this issue when vetting an accountant because it is only a matter of time before it comes up in real life.

 

Cost segregation studies

Sometimes you can super-charge your depreciation with income properties. Cost segregation studies can generate ~ $400,000 in extra deductions the first year on a $1 million property, depending on the facts and circumstances. Costs segregation studies work on properties as low as $300,000.

You can read more about this powerful tax strategy here. 

 

Grouping

Sometimes it is advantageous to group certain properties/activities together to maximize tax benefits. Grouping is less common so many tax professionals need to review the facts and circumstances before committing to an answer.

 

Qualified Business Income Deduction (199A)

This new deduction created by the Tax Cuts and Jobs Act of late 2017 is complicated. To make matters worse the IRS has issued several batches of regulations as it relates to income property and several issues remain unresolved. 

You can read more about the QBID and how it relates to income properties here. 

Be sure to discuss any recent changes with your tax professional. Again, they can pass the vetting process with less than perfect answers because perfect answers don’t exist. But they need to understand what has been clarified and have good reasons to take the position they do in unclarified areas.

 

There are other questions you will want to ask.

Finding a qualified tax professional takes time and work. It is all worth it in the end. The best tax professionals are selective in who they take on as clients so you will be vetted at the same time you are vetting. This is a good thing as you want a good fit for all parties involved because it is your investment and money is on the line.

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

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.

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.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

The Best Rental Property You Can Buy

Fool-proof real estate investing. Investing in real estate is easy and profitable if you know a few secrets to success. Buying right is the first step. Real profits are found by renting to the right tenant and keeping them.It’s official. I’m back in the real estate business!

Before you get too excited, let me explain. Waaaay back in the day I was a third owner of a real estate partnership with my dad and brother. We bought investment properties of all kinds. We specialized in single-family homes, but owned plenty of multi-unit buildings, storage and rooming houses. 

My partners were more along the lines of the silent kind. I, of course, could bounce ideas off them, but the workload fell on me. I hired maintenance staff and crews and was always interviewing potential property managers. Before we closed shop we had taken an interest in 179 buildings (not all at once). At the peak we had somewhere north of 80 units scattered all over NE Wisconsin.

We sold properties frequently once our inventory grew. We held some properties longer — our first property was one of the last to be sold.

After we were in the business a few years we gained a reputation for renovating run-down properties. I used these as a way to generate cash for long-term real estate investments.

Eventually a few local cities had us on speed-dial when they condemned properties. We picked up these rat-traps for pocket change ($5,000 or less). Spent $40,000 or so renovating and sold for $70,000 or so; rinse and repeat.

Buying and selling (and managing) so many properties eventually caused me to burn-out. It was a good (if not sometimes a dirty) business. I washed my hands of investment properties and sold en masse.

For years we were buying and selling multiple properties per month. Now I was just selling. 

 

Investing with a Purpose

The last rental property in the partnership was sold in the year 2000. I never thought it was more than a passing phase of my life. I did the real estate thing and was content. 

Except I wasn’t really out of real estate.

When $40 million of real estate transactions cross your desk in 12 years you learn a few things:

  1. Real estate agents are full of schmoo. They are in the business of selling real estate and will say whatever necessary to earn a commission. (I have changed my opinion on this and think agents are vital in the buying, selling and managing of RE.)
  2. Real estate investments are “passive” only in the Tax Code! Buying the right property takes work. Maintaining properties — even with a property manager — also takes work. Index funds are truly passive.
  3. Real estate isn’t a free ride to wealth.
  4. Tenants are people and people are not always fun to work with, especially when they owe you money and while they live in your property.
  5. Good tenants are awesome and should be considered for inclusion in the next family reunion.
  6. Bad tenants cause normal accountant’s to reconsider bringing back debtor’s prisons.
  7. People are destructive, especially when they don’t own it.
  8. No money down deals are not the best deal going unless you’re selling a real estate investment course on late night TV (back in the day) or on Facebook (today’s version of late night TV).
  9. Work doesn’t get itself done so stop crying.
  10. All this said, RE can be a powerful income source with plenty of wealth building qualities. And that is why I am back.

The Best Tenant

As I alluded to earlier, I never really got out of the RE business. In 1995 I bought the current office building I rent to my tax accounting practice. This building generates $36,000 of annual rental income and the tenant is the best I ever had! For some reason the tenant and I always agree. Go figure!

How to find the best and most profitable tenants. Buying a rental property is only the first step. Finding an keeping the best tenants is vital to success. Supercharge your real estate profits and make it fun at the same time. #realestate #investmentproperties #tenants #rentals #profitsSo, the best tenant you will ever have is you. But if you don’t have a business (treated as an S corp, I might add) this opportunity is unavailable.

There is a runner up option nearly as good, however.

To understand this second option I need to explain my mindset. When researching an investment (or tax deduction, or investment or. . . ) I prefer more than one out.

What do I mean? More than “one out”.

As an example I recently commented that I prefer more than just a deduction for my retirement contributions. This means the tax break isn’t enough on its own. When planned correctly, a retirement plan contribution can open up additional tax breaks. This is the doubling and tripling of benefits I call more than “one out”.

In real estate it is the self-rental concept that provides multiple values: a dream tenant, fills a business need, rental profits and tax benefits all go to my best friend (me) and no bad tenants. Under the Tax Cuts and Jobs Act of 2017 it also opens the opportunity for more of a Qualified Business Income deduction. 

 

Another Awesome Tenant

This Sunday my oldest daughter, Heather, graduates from college. She had a lot of false starts as she found her way and daddy refused to provide a free ride. (The first test of college is getting there. Loans and daddy are not a part of “getting there”. Scholarships, a job or business and hard work are.) 

The best and most profitable investment properties to buy. No matter how high real estate prices climb, profit is made by renting to the right tenant. This fool-proof method of property management can send your profits to the highest ever while virtually eliminating problems. Make being a landlord fun. #landlord #rentals #profit #realestate #investmentpropertiesHeather won several awards along the way and served as an officer in PTK this last year. She has matured a lot.

She also fleshed out a business. She is returning to China this summer after finishing a tour in South Korea teaching English as a second language. 

Her business involves tutoring and she has several product ideas and services coming online. And, smart girl she is, tested everything and never quit just because an idea failed. She learned and grew with each step. And now it is time to move out and tackle the world for real.

And this is where my renewed RE adventure begins.

Heather tried living near the campus while in college, but got an eyeful of the idiocy of the average young adult. She also experienced bad landlords and roommates.

So Heather took control and decided she would pick her roommates this time versus the school or landlord. She wants to keep costs low, sharing the expenses of renting with a roommate, while being closer to her clients (she’s been invited to several local schools and universities to teach). 

She found the right roommate after screening out several. Then she started researching accommodations and running numbers. 

Then she told daddy. Daddy almost lost it!

Rent has changed in the last 20 years! (God, I’m getting old.) Rents were from $850-$1,200 per month on average and they were nothing fancy either. (Yes, we live in a pretty reasonable market yet.)

This caused my accountant mind to start shaking out the rust and think about this situation a bit. It became clear, after a cursory review of available local duplexes and 4-plexes, that it would be better if I bought a property and rented to Heather and her friend. 

And that is where we are at. I’ll purchase a property this summer before Heather returns from her South Korea/China trip and her friend starts her next semester of classes. Both have jobs and adequate income. 

 

Doing it Right This Time

All this assumes you have a responsible child. There are plenty of horror stories of parents buying a home for their child and getting killed financially. 

I would not have considered this even a year ago. (She could have remained living at home with mom and dad if necessary.) But Heather has finally reached the tipping point. Her business has reached critical mass and she has a waiting list looking for her services. 

Heather was ultra picky when vetting potential roommates. She wanted two roommates, but could only find one worth keeping. For now.

You might be tempted in a situation such as this to have your child manage the other units. It’s an insane thought so drop it fast! Heather is a teacher and business owner with no skills in — or desires for — property management. 

Heather and her friend will pay rent to me with a regular rental contract like any other landlord/tenant relationship. We do it by the book.

The remaining unit/s (I have my eye on a 4-plex, but will settle for a duplex) will be managed by a professional property manager.

I have no interest in managing RE ever again so a manager is a must. The only advantage of having my daughter live there is the updates on the needs of the property (something needs fixing or updating). Unless she says anything, the other tenants will not know her relationship to the landlord. Squeak, squeak. 

 

Final Notes

This wasn’t a numbers post on how to buy the right property at the right price; I did that previously

This post should help you start thinking about the additional benefits of RE ownership beyond the mere rental income (the doubling and tripling of benefits). 

Renting to your own business is a no-brainer in most real estate markets. The high-priced coastal cities of the U.S might be an exception, along with Denver. Of course that could change over time.

Rent has an element of profit (or at least it should). Slumlords take shortcuts to keep their rents lower, but you don’t want to live there. Good properties, good apartments, cost money. And good landlords are as hard to come by as good tenants. There are plenty of them out there but they are already renting their apartment from a good landlord and have no intentions of leaving anytime soon.

The next best option is renting to a responsible family member. This isn’t an easy road. My youngest daughter isn’t close to being there. Heather made the leap recently which gave me the idea and hence this post.

Doing it right means buying the right property that cash flows out of the gate and having a property manager handle the rest. 

Heather may find additional tenants for me from her work, but it still will all go through the property manager. I’d rather pay a fee than spend time managing the property

It’s the right thing — and profitable — thing to do.

And, of course, this assumes you buy a quality piece of real estate and maintain it.

 

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

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.

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.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation studies work and how to get one yourself.

Worthy Financial offers a flat 5% on their investment. You can read my review here. 

Your Share of Passive Income

The biggest risk most people have when it come to building wealth is putting all their eggs in one basket. Having one full-time job supplying you with 100% of your income means you are either doing well or in a crisis.

Wealthy people and large corporations have multiple streams of income and continually work to develop more. Sometime the failures are huge. New Coke might be an example. In my practice I’ve had ideas cost serious money go down the toilet. I’ve also had spectacular successes.

Multiple streams of income are the only way to protect your wealth creation program. The same applies when you reach financial independence and decide to retire. All your eggs in one basket is a bad idea. Imagine busting your tail for a decade and having all your money in Enron.

Another problem revolves around active and passive income. Active income comes from work you do yourself. A job or small business is an example. There are only so many hours in a day to sell for income. You can work hard to increase your productivity earning more per hour, but you remain a slave to working for every nickel you earn.

Business owners have an advantage. Once the business begins operations employees become part of the mix. Part of what employees do end up in the owner’s pocket. If it didn’t, why would the own bother with the headache of hiring/having employees. Even though the IRS considers business income ordinary income, there is still a passive nature to the income stream.

Danger, Will Robinson! Danger!

The problem with working for every dollar is risk. If you become ill the income stops. Insurance can provide a backstop, but that is a limited solution you have only minor control over. A business owner can suffer catastrophic loss due to weather or other events. When the business suffers, profits evaporate. The worst case for a business owner is they are forced to choose between closing the business or feeding it to keep it alive.

The solution to these wealth building and preserving risks is diversification. More accurately, diversification into passive forms of income. Whereas, you have only so many hours in a day to trade for income, you have an unlimited ability to create and increase passive income. The best part about passive income is that most sources of such income reproduce automatically.

Mutual fund dividends and capital gains are easily reinvested. Rent can either be used to reduce leverage (mortgage debt) or to buy more properties. Interest breeds more interest.

Without a business your options are limited. Your main source of income is extremely top heavy with wage income. Even a business owner has risks. A handful of clients can make up a large portion of the profits. A large book of clients is a buffer between normalcy and disaster wage earners don’t have the luxury of. However, if you are in the retail music business things might be as bad as or worse than that of a wage earner. CDs and vinyl records don’t have the market they once had prior to digital music on the internet.

Passive Income Sources

There are a thousand sources of passive income. We will only focus on the big four today with an honorable mention to profits in a small business with employees running the place.

Dividends and capital gains are treated favorably by the Tax Code. Rent is considered derived from a passive activity and treated as ordinary income, but income property enjoys depreciation and other tax benefits. Interest is treated as ordinary income, but as we will soon see, a lot of interest is also treated favorably by the Tax Code.

According to Zillow, renters paid $535 billion in rent in 2015 in the United States. And the number is rising. There are about 125 million U.S. households and 43 million households rent. The U.S. also has about 250 million adults (adults, not the entire population).

Some simple math reveals an astounding amount of rent paid by renters/received by landlords. If the $535 billion in rent paid were paid evenly among all U.S. adults it would amount to $2,140! That’s right. Every U.S. adult would receive $2,140 of rent if it were divided evenly. If rent were evenly divided between all households it amounts to $4,280 each for 2015! Since renters probably don’t own income properties we can divide the gross rent paid by the approximately 82 million non-renting households and we get $6,524.

Most people don’t own income property, so the ones that do generate a very large amount of passive income. Of course, rent is not all profit. The mortgage requires servicing, maintenance is ongoing, and property managers need to be paid. Still, this is a staggering amount of passive income many people neglect. (Never mind my reality check on income property versus index funds.)

In the arena of passive income that takes effort is business income which we discussed above. Business income is “earned” for tax purposes. There are instances where it may be considered “unearned” and goes beyond the scope of this post. As mentioned above, a business can distribute massive amounts of money to owners. A manger running the day-to-day operations makes the income passive in reality, if not for tax purposes.

Work-Free Passive Income

When most people think of passive income they usually think of things you do once and then receive a long-term stream of income. Real estate can do just that if you have a good property manager. Real estate lacks diversification unless you invest in a security holding real estate. With a large amount of money you can invest in multiple properties around the nation to avoid regional economic risks. Or you can take on partners to spread risk, but partnerships have risks of their own.

True forms of passive income include dividends and interest. Before you roll your eyes, I want to share the incredible amount of dividends and interest paid out each year.

Before we continue, the statistics I’m using comes from the IRS, one of the most respected institutions of the United States. (Pardon me a moment while choke down that hairball.) There are other sources of information, but all are estimated using different methods of information gathering. The IRS data, while more accurate, is gathered based on reported income. Not all income is reported. However, reporting requirements (Forms 1099-DIV and 1099-INT) make the data reasonably reliable. Some dividends are so small they go unreported and older taxpayers may not have enough income to file. Interest is another animal. Form 1099-INT may be issued to most recipients of interest from banks and other large organizations, but land contracts and other similar devices may go unreported.

With the caveats in place, the IRS lists $254.7 billion in dividends for 2014. That works out to $2037.60 per household. It doesn’t sound like much, but two massive issues are missed here. One, most people have zero dividends, so those who do have a lot, and two, most dividends are paid to retirement funds or other corporations and aren’t included in these numbers.

Let me share a secret from the tax office. Most people have zero dividends to report. A few have a couple dollars to report and even fewer have up to $100 of reportable dividends. Then we get the people who receive real dividends. These folks report $87, 904 in dividends received from their non-qualified accounts alone. This number become more astounding when you realize the total market throws off about a 2% dividend yield. That means the value of their account is worth 50 times as much as the reported dividend!

These are normal people who invested and kept their fingers off it for a very, very long time! There is no big secret. Most never owned a business or inherited a substantial amount of money. They consistently invested with each paycheck and let it ride. Time did the rest.

It sounds like a lot, but a million dollars invested in a broad index fund should generate ~ $20,000 of dividends growing 5 – 7% per year. Starting is the hard part. Even harder is leaving your fingers off it. But for people just smart enough to invest consistently and refuse the temptation to play with their money, thinking they can outsmart the market, will do extremely well.

Interest in retirement accounts face the same issue dividends do. Much interest will not show up in IRS data. We’ll go with it anyway to see how much we can get ourselves.

The IRS reports taxpayers listed $93.9 billion of taxable interest and $62.5 billion of tax-exempt interest. This works out to $751.20 of interest income per household without consideration to interest earned inside retirement accounts and $500 of tax-exempt interest. Considering the low rates of interest today, this means the account values are at least 100 times larger, probably much larger!

Remember, this isn’t all the interest and dividends paid in a year. Corporations, banks and insurance companies earn tremendous amounts of income from these sources and are not included in the amounts. The numbers above are from individual returns only! The real total of passive dividends and interest paid is staggering.

Another difficult number to track is capital gains. The IRS says just over $705 billion in capital gains were reported in 2014. But how large is the amount of unrealized capital gains? It has to easily stretch into the trillion dollar arena!

Not only are you at greater risk when all your eggs are in the wage earning basket, but you get taxed hard.  Wages suffer income tax at ordinary rates, but FICA taxes as well. Rent, dividends, interest and capital gains receive varying degrees of preferential tax treatment when calculating your income tax, but they all avoid the FICA tax.

Remember the $535 billion in rent paid from above? Well, the IRS records show only $75.2 billion was taxed or a bit more than 14%. (Here’s my handkerchief. I know how much it hurts.)

Now I’ll add up the averages in non-qualified (non-retirement) accounts alone. Take the $4,280 of rent you should receive on average (only $1198 of which is taxed) and add $2037.60 in dividends and $751.20 of interest and $500 of tax exempt interest and the $5,640 of realized capital gains and we get $13,208.80.

Again, this seems like a small amount to the average reader of this blog. But these numbers don’t include earnings from retirement accounts. It also doesn’t include we can invest more and take a larger share from corporations, banks and insurance companies.

The real secret is in the value of the underlying accounts which reveals the staggering level of unrealized capital gains. In today’s low interest, low dividend environment, the average household holds north of half a million dollars! That means a lot of people are doing really well considering how many are doing so poorly.

And I never said a word about how much is stored in trust accounts!

Wealth is not a complex process. Consistency is the most important factor. Long-term investments in index funds have enjoyed superior performance historically. The amount of passive income to be had is large enough for everyone to do very well with only an average slice of the pie.

The question now is: Where are you on the scale? Average? Below average? 🙁 Above? 🙂

If you don’t like your level of passive income it might be time to do something about it now that you know where the money is.

Applying Cost Segregation on a Tax Return

A few weeks ago I wrote about the massive tax benefits to investment property owners and business owners who also own commercial real estate using a cost segregation study. Some of you took me up on the offer and now are up for a significant tax reduction. Then the problems started. I didn’t anticipate the large number of tax professionals who didn’t know how to handle cost segregation studies on a tax return.

Before you call your tax preparer bad names, know most tax professionals rarely, if ever, see a cost segregation study in their office. When the rules changed a few years back I doubt 1 in 100 accountants handled their client tax returns correctly as it pertained to the repair regs and tangible property rules. The good news is the changes only required certain actions in the first year of accounting method changes. The bad news is that most tax professionals don’t know how to handle a cost segregation study on the actual tax return when a client comes in with one. Not to worry. Your favorite accountant will spill the beans on how to get it done right.  No picking on your accountant either. This is advanced tax planning and tax law can be miles from tax application at times.

Tax professionals will find this helpful; taxpayers should find value, too. Knowing of a tax advantage is only worth something if you can apply it. There are two major issues surrounding cost segregation studies: tracking the components/elements listed by the study and taking full advantage of the additional depreciation allowed.

Reading the Cost Segregation Report

When you get your report it will list the building components by item and class. In most cases you will see components listed under 5-year, 15-year, and either 27.5- or 39-year property, depending if it is residential or commercial real estate. Sometimes a component will also fall under 7-year property.

It is important to add each item separately to the depreciation schedule, even the 27.5- or 39-year property. The 5- and 15-year property accelerates the current depreciation deduction. But even the long end of the depreciation schedule has value. The roof, doors, electrical, plumbing and painting eventually need upgrading. When you upgrade any component you deduct the remaining undepreciated basis left in the replaced component.

The same applies to short end of the depreciation schedule. The parking lot, sidewalk and landscaping are 15-year properties. A replacement of any of these will trigger the remaining basis for deduction of said component.

The original estimate of tax savings from a cost segregation study underestimates the benefits as it assumes only the increased depreciation expense related to the 5- and 15-year property. There are only a few components that are not replaced prior to the component being depreciated. The foundation is one such item. But even things like plumbing and electrical are likely to need an upgrade before 39 years!

The advantage of the cost segregation study is the separate listing of components. The additional deduction from the old component (when replaced) helps offset the cost of the upgrade. Coupled with the repair regs, investment property owners and businesses with commercial real estate are better able to match deductions with the outlay of capital. A difficult issue in business and with landlords is the outlay of cash to improve a property only to wait up to 39 to get a tax benefit. Without a cost segregation study the cash is spent on the improvement and also taxed currently, increasing the cash needs to undertake a project. Cost segregation and the repair regs help eliminate some of the problem, allowing more projects to move forward.

Preparing the Tax Return

The concept of the cost segregation study is easy to understand. Then you run into the issue of application. Accelerated depreciation causes problems unless you make certain elections on your tax return.

Investment property owners need to consider passive activity rules. Once income reaches six figures, passive activity rules suspend some or all losses until the passive activity has a gain or is disposed of.

The normal structure of many small businesses makes passive activity rules an acute problem. It is common for small businesses to conduct business as an S corporation or an LLC treated as an S corporation. Real estate should never be held inside an S corp. Therefore, real estate is usually held in a second LLC treated as a disregarded entity by the same owners. In many instances this real estate does not generate enough rental income to handle all the additional depreciation from the cost segregation study. Passive activity rules kick in and undo all the cost segregation advantages.

This is where grouping comes in. The IRS says you can group activities using any “reasonable method”. This is a wide road to travel. It isn’t a free-for-all, but as long as the group of activities constitutes an appropriate economic unit the grouping should be allowed. The implications to passive activity rules are significant.

There are five factors in determining if a group constitutes an economic unit: 1.) similarities and differences in the activities; 2.) extent of common control; 3.) extent of common ownership; 4.) geographical location; and 5.) interdependencies between the activities. Once a grouping is made it cannot be changed unless the original grouping was inappropriate, the facts and circumstances change, or the IRS disallowed the original grouping.

Because of the interrelated nature of the real estate used by an entity to conduct business, grouping of the two activities is a reasonable step to take. Landlords can also group activities in a similar fashion.

Grouping allows the business and the real estate profits to be combined. The real estate fair rental value paid by the business may not be enough to generate a gain and passive activity rules then limit the loss. By grouping the business with the real estate used by the business, the accelerated depreciation resulting from a cost segregation study is now possible to currently deduct.

One final note: A disclosure is required when grouping activities. The structure of your business determines the type of disclosure required. Partnerships and S corporations already have rules in place requiring a disclosure attachment to Schedules K-1.

Form 3115

There is one more monster in the room: Form 3115, Change in Accounting Method. Form 3115 has been revamped over the last few years and is now down to 8 pages. Not to be afraid. You only fill out the portions of the form applicable to your situation. If time permits, I will write a post this summer with a filled-in Form 3115 as it applies to cost segregation studies. The best news of all is that if you do the cost segregation study the first year the property is owned there is no need to file Form 3115. You only need to file Form 3115 to catch up on depreciation you should have used all the prior years.

This is a complex area of tax code. I recommend hiring a tax professional to handle grouping issues. Your accountant may not work with grouping often, but she has all the books and resources available to prepare the tax return properly with all regulations considered. And they will are more likely to make the required elections and disclosures, protecting you in an audit.

Get a $100,000 Gift from the IRS Using Cost Segregation

In the past I shared ideas that saved you $10,000 or more per year. I also shared numerous other ways to reduce your tax burden by smaller amounts. And, of course, retirement accounts and the Health Savings Account provide plenty of tax reducing power, too.

That is all small change compared to what I share today. Today the gloves come off. Today you will learn how to peal massive amounts off your tax bill. I am talking about taking six figures and more from the IRS and putting it into your pocket legally. No jail required.

This program applies to investment properties and businesses with a building. All other can safely skip today’s post. Or you can read it and share it with someone who owns rental properties or a commercial building. You will make a lifelong friend if you do.

What is Cost Segregation?

The risk I take is getting too technical. You don’t need to understand all the deep tax terms to use this strategy so I will avoid technical jargon as much as possible.

The first thing you need to know is that cost segregation only works on buildings with an original cost basis (purchase price, plus additions) of $250,000 or more. Residential income properties, commercial properties, additions and build-outs all work. This does not include the value of the land. Example: You but a property for $450,000. Land value usually comes in around 20% of the purchase price. Therefore, $360,000 is for the building. Cost segregation works on the building portion of a property only. Also note, the higher the value of the property, the more tax benefits cost segregation provides.

The IRS says you have to depreciate a residential rental property over 27.5 years and commercial property over 39 years. This means you put a lot of money down upfront without a tax benefit.

The IRS says you can use cost segregation to separate the components of the building for faster depreciation. A typical building under cost segregation may have about half the value reclassified as 5-year property, 20-25% as 7-year property, and the remainder as either 27.5- or 39-year property.

Pictures around this post show some illustrations of tax savings with cost segregation.

Tax Benefits of Cost Segregation

By depreciating a building significantly faster you cut your tax bill by a massive amount. In our example above, a $450,000 property with a building basis of $360,000 could see $180,000 moved from 39-year property to 5-year property. (We will disregard the rest. Review the photos for additional details.) $180,000 depreciated over 39 years allows a $4,615 deduction each year for 39 years. As 5-year property it gets a $36,000 deduction the first year (without considering any bonus depreciation) and the whole $180,000 in depreciated in 6 years. (I know taxes are wacky. It takes 6 years to depreciate a 5-year property.)

The additional $31,385 is a current deduction at your ordinary tax rate. You will see why this is important later. Assuming a 39.6% tax bracket and ignoring state tax benefits, your tax savings are $12,428. And that is only the 5-year portion. There are still more benefits from the 7-year reclassified property.

Here is where it gets really nice. Let’s say you owned a commercial or residential rental property for 5 years and want to sell the property next year. The IRS says you can go all the way back to the beginning when you bought the property and take all the depreciation you did not claim. No amended tax returns required. Just one form.

That means our example above would take the entire 5-year property as a depreciation expense currently; the full $180,000! Why does it matter if you are going to sell the property next year? Simple. Ordinary tax rates are higher than long-term capital gains rates. The top ordinary tax rate for individuals is 39.6%. (You could receive additional tax benefits from a lower Alternative Minimum Tax and avoiding/reducing Affordable Healthcare Act taxes.) The top LTCG rate is 20%. Get it. You deduct depreciation at 39.6% and pay tax later at about half that rate.

Who Should Consider Cost Segregation?

There are a few things to keep in mind with cost segregation. First, you need to have a tax liability for it to work properly. The higher your tax bracket, the better it works.

Rental property losses can be limited. Cost segregation increases depreciation deductions and could limit the value in some cases. The deduction is not lost, only suspended until you have a gain to offset the loss or you dispose of the property.

The best part of cost segregation is you can choose when to do it. All depreciation the cost segregation study reveals is deductible currently. This means you can plan when the deductions take place.

Preparing a Tax Return with Cost Segregation

This is the easy part. When you buy a property you enter the building into the tax software for depreciation as either a 27.5-year or 39-year property, depending if it is commercial or residential rental. With a cost segregation study you do exactly the same thing, except you have three, instead of one, entry. The 27.5-year/39-year property amount is reduced and an entry is needed for the 5-year and 7-year property. The computer does the rest. Simple.

If this is not the first year for the property a Form 3115 (Change of Accounting Method) is filed with the tax return and with the Washington D.C IRS office claiming all the accumulated depreciation you should have taken. Go back into your software where you have your depreciating assets (usually a 4562 screen) and override the computer’s automatic depreciation calculation with the new higher amount. It is a one-year adjustment. Depreciation will pick up where you left off. Remember, you need to separate the 27.5/39-year property into 27.5/39-year, 7-year and 5-year property. You may need a professional tax preparer for one year if you normally do your own tax work.

The entries are simple for most accountants to do. Form 3115 scares many people. Don’t let it. The form has more bark than bite. I have a solution if you want the whole thing done for you for the one year the adjustments are made. A small investment can pay large dividends. Then you can go back to what you always did preparing your tax return.

How Do I Start?

You need to hire a firm that specializes in cost segregation studies. How do you do that? Well, there are a lot of firms taking shortcuts with their cost segregation studies and the IRS has noticed. These companies use estimates that should be reasonably close and then wait for the audit to come in to handle actual adjustments. Life is too short for that BS.

I built a relationship with Equity Solutions for cost segregation studies. No shortcuts! We do it right the first time or we walk. Better still, they will handle the Form 3115 if your accountant is unfamiliar with the form. Many are.

Randy Leppla is your contact at Equity Solutions. Mention The Wealthy Accountant blog and receive a $100 or 5% discount, whichever is greater! Randy’s email is: randy@rjl-equitysolutions.com. His phone is: 608-852-6772.

Randy is located in Wisconsin, but they have offices over the entire U.S.

If you want, Randy can send me your information for review. There is no cost for an estimate of tax savings. You will be asked for your depreciation schedule and your tax bracket. If I review your account I will definitely need your tax return. I’m picky that way. My involvement is small if I am not preparing your tax return. I only need to verify you will reap the benefits anticipated.

Cost segregation is a powerful tool to reduce taxes. Contact Randy if own property used for business or as a rental and the building has a cost basis (generally the purchase price) of $250,000 or more. Or comment below. I see comments faster than I see emails at times during tax season.

Deal Breakers for Investors and Business Owners

The most dreaded words a salesperson can here are, “I need to talk it over with my accountant.”

Accountants have a reputation for breaking deals. Behind the scenes we are actually called ‘Deal Breakers’ as a derogatory term. But the name isn’t fair. What we really are doing is protecting our clients.

The investor or business owner already thought of all the things that can go right. Accountants throw cold water on the deal by examining the numbers. They don’t always stand up to the hype.

And then there is my last blog post where I play a Sad Gus with robo-investing and Betterment. I think a lot of people really believed the tax benefits were much higher than they really are. There are real benefits, just not as many as some would have you believe.

That is where accountants shine. If you are going to serve your client you had better have the stomach for laying the truth on the line, even if the client doesn’t want to hear it.

Endless Victims

The most common deals I review involve real estate. Multi-million dollar commercial properties or multi-unit residential properties need a second look by a trained eye before signing your name. Over half the deals I review get a thumbs down. All the work to get to that point is wasted. At least the money is preserved.

Usually the client accepts my analysis and cancels the deal. The sales agent thinks nasty things about me and my parentage. They dread the next deal I review.

Then there are the times the client goes forward anyway. In a few years I am hired to clean up the mess. And quite a mess it is. Money is lost. Lots of money. It is rare for an investor or business person to beat the odds when they are against them.

The numbers don’t lie. My goal is to help the client make a good decision. Too often, small business owners and investors see things with rose-colored glasses.

Once or twice every decade I am proven wrong. It happens. But two deals working after I raise serious concerns does not trump the 100 deals that sour. Accountants are sometimes wrong, but it is rare. Investing and business ownership is all in the numbers.

Business as Usual

Business owners and potential business owners have it worse. More real estate deals get my approval than existing business purchases. Business owners want too much too often when they sell. So I break the bad news to my client.

You would be surprised at what I find upon review of the books. Business owners think they can hide certain things, but there are ways to ferret out the facts. The seller wants to get top price, but wants to use her books instead of the tax return where she didn’t report all the income. Too bad. We use the tax return and verify it was the return filed.

Buying a business has problems all their own. Sometimes clients leave. Sometimes there is a learning curve for the new owner. It isn’t easy picking up where someone left off. Nothing is more common than the new owner of a business pissing away a profitable enterprise.

Investor Beware

Investments are the worst of all. Even good ideas can turn bad. It has happened even to your favorite accountant. When you think you are smartest is when you get your head handed to you.

Affiliate programs change your view of a product no matter how honest and honorable you are. I am not immune. This blog needs to turn coin to pay the few bills blogs have and compensate me for my time. I could be doing something else, you know.

Payment changes how we think. A client paying me to review a piece of real estate or a business will get a thorough review, even better than I might review my own deals. In fact, reviewing my own deals is when I take the greatest risk. I am not better than you or any investor or business owner. I am just as capable of self-delusion as the next guy.

Bloggers have offers pour in as their traffic rises. Most offers are pure junk. Fortunately, I have a sizable nest egg to live off of if all goes south. A younger—and poorer—version of me might be tempted. Or worse, totally deluded. Except, older does not mean wiser. I am just as human now as I was twenty or thirty years ago. I am only slightly less prone to delusion than I was years ago due to experience.

A Gift for You

And then the gifts show up. I am a sucker for t-shirts. Love’em! I’d live in t-shirts 24/7 if I could. A few days a year I wear a dress shirt just to remind me I am supposed to be a professional.

If my research works out I’ll be using a new product in my office to handle a facet of my business. Then I will share it with you guys. Of course, an affiliate program will be involved. They sent me several t-shirts. So, how do I tell if I am doing it because of the affiliate program or because it really is the right thing to use? My policy is to always review the product as if it was for a client and I am paid to conduct the review. Then I use the product in my practice and if it still passes the sniff test I will present it to you.

So far I haven’t been invited to a company’s headquarters where they can put the heavy sell on. Other bloggers might accept what they see and hear. The accountant in me believes everything is bullshit until proven otherwise.

The last few years business owners have come to me wanting to organize as an S corp because they saw me on other blogs doing just that with great success. They come to this blog and read more of what I offer. I can hear the disappointment in their voice when I tell them they are not ready for an S corp or would be better served by a different strategy.

Selling My Soul

Sometimes I am disappointed in the financial results of this blog. My traffic is good and growing, but as a good accountant, I record everything. The numbers don’t grow fast enough at times. The Wealthy Accountant turns a profit because there are no real expenses to speak of. Unless you consider my time. Then it is a big, fat bust.

I spend a lot of hours writing this blog. Like any business, it takes time to hit a critical mass. Where the blog kills it is new tax clients. There it is a resounding success. Affiliate revenue, not so much.

Writing is something I do regardless so writing this blog is no big deal. No matter how big the numbers get, I will always review and examine the results. I am a hands-on type of business owner. It’s not about money. It’s about the game of business. The scorecard is money. The wealthier you are the more you will understand what I just said.

It also requires caution. When my accounting practice started I tracked every detail of the business. Still do. Budgeting and goals are not for me. My goal each year was to beat last year. That’s all.

It sounds simple, but after a few decades those numbers become daunting. Stuffing more business into the same building gets harder each year. Expanding to multiple locations was never in the cards for me. I like things just the way they are.

But never underestimate the ingenuity of a country accountant. I found ways to expand the business without hiring half the county’s tax professionals or opening new locations. I added payroll and bookkeeping to the mix. Now I am selling those departments of the business. I found a way to grow without doing more work myself or expanding the structure of my practice.

Now The Wealthy Accountant is on the scene. I can leverage the entire business like never before. The ability to grow the practice while staying put in one location is possible. The contortions I must go through to manage this feat is entertaining at best.

And then I start thinking. If I were to review this idea for a client, what would I say? I’m afraid to ask.

The Right Way to Own Investment Properties

During the 1980s and 90s I owned a lot of real estate. It started slow and exploded into a 176 building pain in the ass. To be fair, most of the investment properties we owned were either single family homes or duplexes. A few multi-family buildings, a boarding house and a storage facility rounded out the mix.

With so many properties running through my personal accounts and a partnership with dad and brother, I learned a few things along the way. One hundred seventy six buildings is a lot of buildings. Good thing I didn’t own all of them at the same time. Mistakes were sure to happen.

By the early 2000s the real estate empire was gone. I was burnt out and sick of working with tenants. Countless property managers helped us over the years, but it was not enough. Managing over a hundred units much of the time over a footprint covering most of NE Wisconsin took its toll. To complicate matters, I also ran my accounting practice with double the employees I have today (during tax season).

Starting slow was my greatest idea. It felt good to see the passive income filling the checkbook. Our teams of contractors allowed us to buy fixer-uppers and increase the property values significantly. Our best deal was the purchase of an upper-lower duplex in my hometown for $8,000. Hard not to make a profit on those.

The Pain of Gain

The first 10 properties were fun. I still remember the first one. (Isn’t that true for most things?) 833 E North Street in Appleton, Wisconsin. A beautiful front-back townhouse. Bought it from the bank for an even $50,000. The combined rent was $980 a month without a day of vacancy and the rents rose rapidly. Ah, those were the halcyon days. Two years later I sold it for an even $75,000.

The first 10 were easy so I managed them myself. But with profits like this, I decided to make hay when the sun was shining. Before North Street was even sold we were buying up to 10 new properties a month and selling 2-3 per month. The last business day of the month was almost always spent at the title company, where we handled all our closings.

More properties over a larger geographical area required property managers. And so we did. I went from managing properties myself to managing managers. That was fun at first, too.

Finding good property managers is just as hard as finding good tenants. They are out there. Back in the 1990s they were harder to find in my area. Most property mangers back then handled large apartment complexes only. The few who handled stuff like I had were not always connected with real estate firms (where I found most good managers to exist).

The weight of too many properties took me away from what I loved most: taxes. The fun was sucked out of the whole process. Now I spent the last day of the month at the title company selling more houses than we purchased, and soon we were only selling.

Today I do not consider myself in real estate, but still own close the seven figures in RE value with only $111,000 in mortgage on my farm. It is not fair to say I am a landlord. I rent my commercial property to my practice, which is an S corporation. I have one property sold on land contract where I hold the paper and the farm, 10 acres of respite in the backwoods of NE Wisconsin.

 

The Itch is Back

 

I have been out investment properties now for over 10 years. Part of the reason for selling way back when also included my realization rents were not keeping up with real estate values in my market. Sometimes it pays more to take a profit and go home. Coupled with burnout, it was a no-brainer.

Itch or no, I have to review mistakes I made decades ago and review how the investment property environment has changed over the decades before diving back into the investment property markets

Mistake #1: I managed too many properties on my own to increase margins. In hindsight, my profits would have been higher if I would have hired all the management work done and focused on the financials only. When they said—Jack of all trades, master of none—they were thinking of me. Now you know.

Mistake #2: I got addicted to owning real estate. Younger and with a larger ego, I enjoyed the stroking I received when people mentioned the amount of property I owned. Toward the end I was buying properties that did not have the potential of earlier investments. My goal no longer focused on quality properties, but volume. Dumb, dumb, dumb! With rents stagnant, margins came down. Too much work sucked the fun out of the whole project; lower profits killed any love I had for more real estate.

Mistake #3: I stayed close to home. I bought almost all properties within 100 miles of home base. No properties were purchased outside Wisconsin. The NE Wisconsin market was no longer a great place to invest. Only the rare prize would make an investment locally worth pursuing.

After all these years the itch is back. I want to add real estate into my investment mix. Next I am going to show you how I plan to make these investments. Having learned from my mistakes I may end up with investment properties the rest of my days. You can use my template as a guide. You have to decide how you will handle your investment properties. Learn from my mistakes and successes. Real estate is a great way to build a steady flow of passive income. A small amount of money invested in the right properties can allow you an early retirement. More to the point: $100,000 invested in five good properties ($20,000 down each) could be enough to retire in some areas. If you do it right.

Buying Right

You have to buy right for this to work. Never chase a property and never rush. My second mistake above was I started to rush the process and it showed.

There is a lot of advice on how to buy properties floating around. They are not my concern. My accountant mindset thinks differently. I don’t care about the 1% rule for rents or, fingers-crossed, potential appreciation of the property or tax advantages. These things are used by real estate agents so it is easier to sell the property. Just because rents are 1% of the purchase price does not make it a good buy. Future appreciation is hope and I have an adage about hope: Hold out both hands. Wish in one and shit in the other and see which fills up first. Sorry to be blunt, but you never consider any appreciation in the property value when buying an income property. (Okay, there might be a few instances. You are on your own in those cases. Leave me out of it.) And tax advantages are a stupid reason to buy a property. If you want to buy for tax deductions, I have a bridge I would like to sell you. Cheap!

Rule #1: When I calculate the profitability of a property, I do so as a no-money down deal even though I will put money down. Here is why. If I put enough money down any property will turn a profit. But what about your investment? My rule is simple: My investment must return at least as much as the cost of capital. If the bank has a 4% mortgage rate, then my investment sure as hell better do at least that good.

Therefore, I use a mortgage payment as if I financed the whole darn thing for my illustration.

Rule #2: Allowances must be made for vacancies and repairs. The market the property is in and the property’s condition will determine the vacancy and repair allowances.

Rule #3: The cost of a property manager must be included in your expenses. If you don’t you are valuing your time at zero. Stupid! As you will see below, I will never manage investment properties again. My time is too valuable for me to do something I really don’t like doing.

Example: Let’s run some numbers to see if we can add a certain property to our portfolio. I live in a part of the country where you can buy a small home in livable condition for under $50,000, so play with me.

You found a nice 4-plex (multiunit buildings usually have a lower cost per unit, making it easier to cash flow) for $120,000. A 15-year mortgage at 4% gives you an $888 per month mortgage payment. In Wisconsin we have high property taxes so we will say this property owes $3,600 per year in local taxes. Rent is $500 per unit.

Time to plug some numbers (per month):

Rent: $2,000

Mortgage Payment: $888

Property Tax: $300

Insurance: $75
As you can see, the 1% rule would be a disaster in most Wisconsin markets for several reasons, property taxes being the most notable. $1,200 in rent would not cover the most basic cash flow needs.

Now we add other expenses. Some of them are non-cash most months, but significant when they show up. Vacancy rates, maintenance costs and property management fees are generally low in my area.

Repair Allowance: $200

Vacancy Allowance: $50

Property Management Fee: $50

Of course I picked a deal that would work. If my mental math is right, I’ll make $437 per month on a no-money down deal with a property manager doing the day-to-day work. Any down payment will increase the cash flow and the expected monthly profit. Certain expenses (repairs and vacancies) could be higher or lower.

This illustration is not to show you what to buy, but rather, the mechanics of the accounting I do prior to buying. Yeah, I know, most properties don’t make the cut.

Rule #4: Your local market is almost certainly not going to be the best place to invest! It sucks, I know. But on a brighter note, if you buy in a different market you will be more motivated to hire a manager.

For now I would stay within your own country to keep things simple. If you educate yourself, you may consider properties in world markets. The tax preparation surrounding most investment properties is generally small, even when you own in multiple states. The worst market in the U.S. is New York City for preparing taxes. Any rent controlled cities are also more problematic from a management perspective.

Dirty Little Secret the Wealthy Accountant Knows

As an accountant I see what works and what doesn’t. Of all the bankruptcies I see in my office, the most come from landlords. Landlords are also one of the wealthiest groups of people in my office. What gives?

Investment properties have risks many people ignore. They think it is all easy money. Seminars around the U.S. charge massive sums to teach people how to flip houses with no work and zillions in instant profits. It ain’t so. Good investment properties take time to find. Not every property fits the bill and flipping is a tough game. When you flip a house you make a quick profit, but an investor will hold the property for years, collect rent, watch the property increase in value and pay less in tax than the flipper. And don’t start with the like-kind exchange BS. If I buy a property for $100,000, collect $200,000 in rent over the next 10 or so years and sell the property for $220,000, I will make more than the pittance you made flipping.

Flipping is the mindset of losers! Not that I never flipped a house when the price was right, but short-term thinking is not the path to riches. In over 30 years as an accountant I never once had a client with a consistently high income flipping house. Many declared bankruptcy, however.

Now my landlord clients, they are a different story. Some of those guys went broke too, usually because they leveraged too much. I also have numerous success stories of clients hitting it out of the park that owned and managed investment properties. A steady stream of passive income beats a quick lump of cash any day. In the end my income stream beats the tar out of your flipping and while you are hunting for the next flip, I am reading a book at the beach (if I did that sort of thing).

 

Owning Right

Buying the property right is the only way to win the investment property game. But buying is only a small part of the process. Now that you own the property you need to manage it. The temptation is to save a few dollars and manage the thing yourself. With the many rules ever changing, I recommend against doing it yourself. You can remind me I am a hypocrite in the comments below. But my days of busting tail doing it all alone are over. I learned my lesson. The question now is: Will you learn from my mistakes or experience the same groin kicks I did?

Rule #1: Get a property manager. The rules are different is every community. A property manager does this stuff for a living and has all the forms in-house. They also have a steady stream of potential tenants. Besides, when you buy income properties, are you looking to create a job for yourself or an income stream? Good. Then hire the manager.

Property managers are everywhere. Good ones usually work in a Realtor’s office. Many states require property managers also be licensed real estate agents. Those ladies already work this stuff every day and know what they are doing. Let them do it! They are worth every penny you pay them. They also know the right rent to charge. Do you?

Property managers usually work this way:

They rent out the property, collect rents and the security deposit, pay the mortgage out of those funds, handle necessary maintenance, pay all other expenses out of funds received, subtract their fee and deposit the remainder in your bank account. Now you know how people retiring early can travel the world while owning investment properties. The biggest issues are buying right and management.

Note: If a major expense arises (roof, furnace replacement) you will need to provide funds to cover those costs as the monthly revenue will not be enough. Might I suggest paying these expenses with a credit card that has a large cash back bonus?

Property managers don’t want extra work, either. Good managers keep on top of maintenance issues so you can plan accordingly and they don’t have to field late night calls from tenants.

Real estate is like any other business today. Only the crazy people (anyone thinking perhaps of a crazy accountant from Wisconsin) handles every facet of the process themselves. You’re the investor! You buy the properties right. Let the management pros do their job. They are better at it.

Now you can start looking for the next awesome deal or maybe travel a bit.

(Final recommendation: I would consider keeping the repair and vacancy allowance in a money market account. Then you will never be short when the need arises. The more properties you own, the easier it is to spread costs around. If your finances can easily handle any repair expense then you can disregard this suggestion.)

 

More Wealth Building Resources

Credit Cards can be a powerful money management tool when used correctly. Use this link to find a listing of the best credit card offers. You can expand your search to maximize cash and travel rewards.

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.

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.

cost segregation study can reduce taxes $100,000 for income property owners. Here is my review of how cost segregation 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!

 

Do You Know a Good Attorney?


Over the years I have used attorneys for a variety of needs. When I started a hedge fund the initial deposit was $25,000 and I was happy to pay it. We laugh at lawyer jokes and sometimes lawyers deserve the bad rap they get, but most of the time attorneys are a powerful part of your team preventing expensive problems before they happen. There is a reason why they are called counselors.

I encourage landlords and business owners to keep a relationship with an attorney. Buying and selling a property requires an attorney in my opinion and landlord/tenant issues can be reduced when a lawyer is consulted before actions are taken. There are also the surprise attorney needs. Who do you call when arrested for a DUI? (The first person who says Ghostbusters will be escorted out the door.) You don’t plan on certain events in life; they just land in your lap. Business owners and landlords have greater legal needs, but the average guy on the street finds himself in need of professional help a time or two in life as well (wills, probate, trusts, sale of property, et cetera).

Doctors, attorneys, and accountants know all kinds of stuff (a technical term only used inside the industry) people need at the most important junctures in life. Finding a doctor is as simple as a call to your health insurance provider. Most people see an accountant on a regular basis, while the legal eagle is only required periodically. Worse, even if you know a lawyer, your need may be in an area he does not practice. The logical place to ask for a referral is from your accountant. The contacts an accountant has usually means he has a list of attorneys available to share in your time of need.

DIY and the Wealthy Accountant Roll-A-Dex

Like magic, my client list is now over 50% outside my state. The number of clients living more than 200 miles from the office doorstep has climbed steadily for more than a decade. The last year caused a major spike in out-of-state clients until fewer than half my clients actually walk through the door anymore. It is strange to see my parking lot with eight or so cars in it and no clients in the building, only employees busting tail to keep up with the work coming in electronically (what I call “over the transom” because many are sent without prior agreement).

Clients from out-of-state and people who do their own tax work sometimes need an attorney, too. I am happy to oblige when they ask my help. As more clients live further away I have fewer recommendations, until now. Sure, I have a full-time attorney on staff in my office; sure, I have a legal group with a retainer on file; sure, I lave legal teams in most states beckoning back to my hedge fund days. All this does not matter if I don’t have a qualified local attorney to help you in your particular need.

Most people do not need a legal team on speed dial with a retainer on deposit. What you need is an attorney to meet your specific needs. I have the perfect solution.

LegalMatch

LegalMatch is a referral service for all your legal needs. The best part is the referral service is free. Each attorney will have their own set of fees, but you can get a comfortable number of lawyers to review before engaging at no cost. LegalMatch covers all areas of legal practice I could think of. What I like best about LegalMatch is their extensive help libraries to help you understand your legal situation better regardless if you have an attorney.

Here are some areas of law covered by LegalMatch:

  • Landlord/Tenant: The rental business is a great opportunity for passive income. Even with a property manager you may find yourself in a situation where you want a lawyer you vetted on your team. You may own real estate in different parts of the country and having a legal contact in each locality is a powerful advantage.
  • Business Law: Business owners have multiple issues to consider. Starting a business may require entity setup (LLC, LLP, corporation, et cetera). If you decide it is best to organize your business in a state other than your domicile for legal or tax needs you will need a registered agent. Many attorneys fill the registered agent needs if they are in the practice of entity creation. Example: My hedge fund was organized in Delaware. The laws of Delaware were superior in multiple ways over Wisconsin, my home state. I found the right legal team to organize the optimum entity solutions. Each situation is different. LegalMatch can help connect you with the right law firm for you.
  • Marriage/Divorce: Readers of this blog tend to have a frugal mindset and divorce at a significantly lower rate than the national average. However, the hyper-savers/investors who frequent here also know with a massive nest egg certain precautions are necessary before you get married. A pre-nuptial agreement might be in order if one spouse has significantly more assets than the other.
  • Estate: Most readers here need an estate lawyer. Building a large net worth requires a few simple legal procedures to protect your hard-earned gains. Wills and probate are a start; trusts are a major consideration for tax reduction and asset protection. Serious legacy planning starts in an estate attorney’s office. Your needs may be limited to consultation only all the way to full-blown trusts used to determine who gets what and when. You can protect a surviving spouse and children, even from multiple marriages. Estate laws are complex, especially when you are married in one state and move to another. The transient nature of our society makes a competent estate lawyer an absolute must.
  • Bankruptcy: It can happen to the best of us. The Wealthy Accountant does not believe there is such a thing as a DIY bankruptcy.
  • Personal Injury: You don’t plan on an auto accident or other injury, but it happens. You need an attorney when the medical bills start pouring in and the injury is the result of negligence. An initial consultation with an attorney can help you determine the correct course of action.
  • Criminal: The United States is the most incarcerated society in the history of the human race, per capita and per volume. The next closest country to the U.S. is South Africa at half the U.S. rate. Either we are a failed society or the cops are looking for job security. Guilty or not, a criminal attorney is worth their weight in gold. I have seen some crazy stuff in my office over the years. LegalMatch is a perfect place to find an aggressive and competent criminal attorney fast.
  • Employment, Liability, Immigration, and Intellectual Property: I have covered the more common attorney request I receive, including the areas of legal practice in this bullet point. There are areas of law not covered in this post, but probably covered by LegalMatch.

How Do I Get Started?

To get the most out of this free service you will need to accurately communicate your legal situation. It might be as simple as: I was arrested for DUI. HELP! Or it could be involved, such as in a landlord/tenant dispute or a business transaction.

You can start your attorney search with this link or by clicking one of the banners for LegalMatch on this page. Enter the geographic area you need a lawyer. For example: If you live in New York, but have a rental property in Florida where the legal issue exists, you enter the Florida ZIP code or city and then choose the legal category. Provide a detailed account of the legal issue. You should receive a response back from lawyers within a few hours in most cases. Remember, there is no cost for the referral, but the law firms will have their normal fees. As a disclosure: The Wealthy Accountant may receive referral compensation from LegalMatch, but never from the law firm.

It might be a good idea (if you own a business or investment property) to review attorneys for future reference. Since the service is free it is nice to have a relationship with a law firm before disaster strikes.

Feel free to share your legal experiences in the comments below.