Skip to content

Posts Tagged ‘rental profits’

Final 199A Regulations

The Section 199A deduction requires you to be a trade or business. Follow these rules to take advantage of this generous deduction on your rental properties.

The Section 199A deduction requires you to be a trade or business. Follow these rules to take advantage of this generous deduction on your rental properties.

The IRS released final regulations on 199A. The Kiplinger Tax Letter said it best: “Final regulations provide limited guidance, but IRS gives a safe harbor.”

In this post we will discuss the safe harbor as it relates to “trade or business” with special emphasis on application with rental properties. The safe harbor doesn’t apply to all taxpayers and the trade or business designation is still possible without meeting the safe harbor parameters.

The final regulations run 248 pages. I will follow this post with a detailed post on 199A tiers with several decision trees. Due to the length and complexity of the regulations we are forced to remain focused on one aspect of 199A. Taxpayers with a sole proprietorship, partnership, S corporation or investment property may wish to seek the services of a competent tax professional until more clarification is reached through more regulations or from the Tax Court.

Links are provided at the end of this post to the entire 248 pages of regulations released and Notice 2019-07 (only 10 pages!) dealing with the trade or business safe harbor for real estate issues for your further research.

 

Remaining Problems with the Final Regulations

The final regulations refer to Section 162 (as previous releases have). Section 162 generally governs the deductibility of expenses for a trade or business. But Section 162 is unclear when it comes to rental activities. 

The reason for the vagueness is because the facts and circumstances of each taxpayer differs. Whether the property is commercial or residential, the lease terms, services provided, how many properties owned  and day-to-day involvement in the activity all play a role. We will touch on each of these throughout this post. 

The biggest problem with the final regs is that they were issued after 2018 was in the books. Nobody knew they needed to keep track of time spent in the activity, nor did they know they were required to keep a separate bank account for the rental activity.

The IRS, aware of this, has granted some leeway for the 2018 tax return as it regards contemporaneous records.  However, for tax years beginning after December 31, 2018 you must follow the new regs for record keeping. Ignorance is not an excuse.

Once the IRS laid out the safe harbor for a “rental real estate enterprise” they state: 

Failure to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of
section 199A.

This means the safe harbor isn’t the only way to take advantage of the generous 199A deduction. 

If you use the safe harbor you must include a statement to that effect with the tax return. Qualified pass-through entities (RPEs) can also use the safe harbor and provide the taxpayer with the required statement that application of the safe harbor was used as outlined by regulations. This is attached to your return.

 

Safe Harbor

The new deduction for rental property owners is no game. Get your deduction today.Rental Real Estate Enterprise: For purposes of the safe harbor the IRS uses the term rental real estate enterprise, defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties. 

The individual or pass-through entity relying on this safe harbor must hold the interest directly or through a disregarded entity. This means you can only use the safe harbor if you hold the property personally or as an LLC treated as a disregarded entity. If you hold the property in an LLC electing to be treated as an S corporation (and there is no reason to ever hold real estate in an S corp) you cannot use the safe harbor.

The taxpayer must treat the property (or group of properties) held for the production of rents as a separate enterprise. This means you hold each property or group of properties as a single enterprise. Which means you have a separate bank account and name for the enterprise. Those with multiple LLCs could experience issues with qualifying for the safe harbor. 

Commercial and residential property cannot be part of the same enterprise. Yes, this can cause real confusion when you have mixed property under one LLC and/or business name. As I read this regulation you would need to qualify for the safe harbor for both the residential and commercial property.

Once you establish a treatment for your properties (which properties belong with each enterprise) you must continue with the same treatment unless there has been a significant change to the facts and circumstances (sale or purchase of property, for example).

Safe Harbor Defined: For the Qualified Business Income Deduction only, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

  1. Separate accounting of income and expenses are maintained for the rental real estate enterprise.
  2. 250 or more hours of rental services are performed for taxable years beginning prior to January 1, 2023 with respect to the rental enterprise. 
  3. For taxable years beginning after December 31, 2022, 250 or more hours performed in respect to the rental real estate enterprise in any 3 of the 5 prior consecutive years.
  4. Contemporaneous records are required, including: time reports, logs and similar documents regarding the following:
    1. hours of all services performed
    2. description of all services performed
    3. dates services were performed, and
    4. who performed the services

Of course, contemporaneous records are a bit hard to produce when the rules were not in place until after the tax year concluded, and therefore the records do not need to be contemporaneous for tax year 2018. I recommend going over 2018 ASAP to create a log of all services performed.

 

What Counts for the Safe Harbor

Not all activities count toward the 250 hour requirement for the safe harbor. 

Rental services performed by the taxpayer or by employees, agents, and/or independent contractors of the taxpayer all count toward the 250 hour safe harbor requirement. 

Rental services for the rental real estate safe harbor include:

  1. advertising to rent or lease the property/s
  2. negotiating and executing leases
  3. verifying information from prospective tenants
  4. collection of rents
  5. daily operation, maintenance and repair of the property/s
  6. management of the property/s
  7. purchase of materials
  8. supervision of employees and independent contractors.

Keep in mind the time supervising employees and/or contractors only includes your time supervising. The hours performing services by employees and independent contractors do not count toward your hours.

 

Activities that Don’t Count as Rental Services

Several activities do not count as rental services as applied to the 250 hour requirement:

  1. travel to and from the property/s
  2. financing activities
  3. investment management activities (financial statement review; property search; and procuring and planning, managing or constructing long-term capital improvements)

Generally, things that are easily fudged are disallowed. Saying you spent many hours reviewing the books or driving to the property will not benefit you. Saying you spent x number of hours planning capital improvements to the properties also do not count toward the safe harbor.

 

Other Exclusions

Real estate is better than ever with the new tax laws. Discover the advantages to 199A. Get your tax break today.Several situations are excluded from using the safe harbor. 

Any personal use of the property during the year excludes use of the safe harbor.

Triple-net leases are also excluded from the safe harbor. A triple-net lease is defined as a lease agreement that requires the tenant to pay for all or part of the taxes, fees and insurance, and the tenant is responsible for 

maintenance requirements in addition to rent and utilities. Since most commercial property is leased triple-net, the safe harbor option is unavailable, but may still qualify as a trade or business as shown next.

 

How to Still Claim as a Trade or Business

Since so many tax dollars are riding on the line it is important to determine if you qualify for the 199A deduction. The safe harbor is just that, a safe harbor. Just because you don’t qualify for the safe harbor does not mean you do not have a trade or business.

There are some similarities in this safe harbor with the material participation tests under the passive activity rules. While the numbers between this safe harbor and the material participation tests are different, we can still gather guidance by reviewing the facts and circumstances in determining if the activity is a trade or business.

Earlier last summer while waiting for the IRS to provide guidance on what a “trade or business” is, I decided to build a policy for my office. My conclusion was that investment property (reported on Schedule D when sold) was not a trade or business and property that is treated as a sale of business property when sold (reported on Form 4794) is a trade or business. With the recent IRS guidance I am forced to tighten my definition of a trade or business in situations not covered by the safe harbor.

The IRS actually uses the words “trade or business activities” in their material participation tests. In other words, they say:

You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:

Whereas the safe harbor for 199A rental services say you need 250 hours, the first material participation test says 500 hours. I think it is safe to say we can use 250 hours when not using the safe harbor as well.

But you can still be a trade or business if you put in fewer than 250 hours if the material participation tests are a valid ancillary. 

Material participation test #3 says if you put in 100 hours, and is more than anyone else in the activity, you pass the test and materially participate.

According to test #2, if you put in substantially all the participation in the activity you pass.

There are additional tests to determine material participation. For trade or business issues I think it is reasonable to use the material participation guidelines, whether it be a small business or rental property. The safe harbor is a bit easier to pass for 199A based on hours, but if you meet the guidelines in any of the material participation tests you have substantial grounds for claiming you are a trade or business since the IRS already recognizes this in another area of tax application.

 

Final Considerations

Section 199A, the Qualified Business Income deduction is one of the most complex pieces of legislation to hit taxpayers in a long while. I dealt with one narrow subsection of the regulations. 

It might be a good idea to hire a tax professional for at least one year if you own a business and or rental property to deal with the litany of tax issues surrounding 199A. Even if an extension is required and your taxes are not filed until later in the year.

Here are a few issues not covered in this post that you will want to discuss with your tax professional:

  • Tier #1, #2 and #3 for small businesses
  • Specified service trades or businesses (SSTB)
  • Form 1099 (If a rental in not a trade or business then Form 1099 reporting can sometimes be avoided. However, you want to be a trade or business for 199A reasons so if you don’t file Form 1099 with contractors the IRS may disallow the deduction because you didn’t act like a trade or business)
  • Contributed property to an entity has special rules
  • Special rules apply to like-kind exchanges and involuntary conversions
  • Special considerations for basis of inherited property
  • Net operating losses affect 199A
  • Capital gains and losses may affect 199A
  • Amended returns are not allowed to initiate aggregation, but aggregation can be used in future years
  • SSBTs are better defined in the final regulations
  • and more. . . 

 

As promised, here are the reports from the IRS. You can read Notice 2019-07 as well as I. It is a short 10 page document and worth a read if you have rental properties. Less readable is the final regulations on 199A, coming in at 248 pages.

If you ever have trouble falling a sleep one evening just pick up the final regs. You’ll be out cold in minutes.

 

 

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. 

Create Your Own Basic Income

The universal basic income doesn’t solve all inequality problems. It might even make the problem worse.

I don’t know who first came up with the idea of a universal basic income. My earliest exposure to the concept was from Sinclair Lewis’ 1935 novel It can’t Happen Here. There is no doubt the idea was around much longer.

It’s an age old story. Mechanization and technology will destroy all the jobs. Computers and machines will do everything so people will be left with nothing to do but wander around the cities and countryside with dazed stares.

The solution is to provide a basic income to everyone so income inequality is reduced. The cause is noble; the solution fraught with problems. If you have freedom, you have inequality; if you have equality, you have no freedom. The real question is: how much inequality will society tolerate?

In the United States we have a modest solution in our tax code called the Earned Income Credit. People with a low income qualify for a refundable credit to compensate for their poverty level earning. It also happens to be the area of the tax return with the most fraud.

Around the world experiments with a universal basic income are in the planning stages, ready for implementation on an experimental scale or recently concluded, as we saw in Finland.

What is certain is that more people than ever are ready to try a universal basic income. The Finland experiment was concluded early without plans for a wider roll-out. I take this to mean the results were less than hoped for. If anything, it probably exacerbated inequality problems as it encouraged more people to work less.

This isn’t a debate about the merits of a universal income. The video below is one of many discussions on the issues. I don’t agree with all the comments in the video, but they do provide ample starter fuel for an argument discussion. We will focus our attention on something more important today: creating your own personal basic income.

Back to Basics

At times I will sound like a rabid liberal when discussing universal basic income and an unrepentant conservative at other times. I am neither. Rather, the issues are complex and it is nearly impossible to stand firmly on one side of the aisle at all times.

The FIRE (financial independence, early retirement) community is a perfect example. These people (most people if we are honest) look forward to the day when they can either retire or live a semi-retired lifestyle. There is nothing wrong with such an attitude. I even argue it’s a healthy one. A universal basic income will only make it easier for people to achieve their magical goal. An extra thousand dollars a month can do wonders for those determined to build a nest egg large enough to retire early.

Unfortunately, it also encourages disengagement. If a basic income doesn’t work as planned in a place like Finland (where many feel it was a failed experiment) then it is unlikely to work anywhere at all. Higher taxes to pay people not to work will not bring the best out of a society. Social safety nets are necessary for a moral society, but there is a difference between feeding hungry people and providing unemployment benefits and giving everyone a handout.

All that said I still love the idea of a basic income. Notice I didn’t say “universal”. Don’t take this to mean I think people should be left out. Quite the contrary. Anyone who really “wants” a basic income should be allowed to have one! And I’m going to show you exactly how you can get your very own basic income.

Perception

In its broadest terms a universal basic income provides everyone in the community with a minimal amount of money every month just for being above ground. The cost is prohibitive, but if machines do all the work due to increases in technology and automation, there is nothing left for people to do to earn the money needed to buy the stuff automation is producing. The idea is to tax the crap out of the automation processes and spread it around.

Since this story has been around in one form or another since mankind decided to move from manpower to draft animals, we have plenty of reference points to learn from. The most import thing learned is that people over blow the consequences. In 2008 the world was coming to an end and now we are at full employment and then some. The next economic slowdown will bring the basic income idea front and center again. Don’t fall for it.

But if you are anything like me you wouldn’t mind a juicy check showing up every month like clockwork as a base line to the household budget. The universal basic income is always some modest payment sure to bankrupt the government while providing modest improvements (if any) to families. What I propose is far more draconian. Rather than few hundred or a thousand dollar per month, I suggest something a bit north of there.

A universal basic income is small thinking. It doesn’t do enough to really solve the problem. But if $3,000 or more shows up each month early retirement is in the cards! So how do we get the government, anyone, to send us $3,000 or more each month?

A Multitude of Basic Incomes

The small thinking mindset requires the government to tax and redistribute massive amounts of money. Worst of all, the beneficiaries of the basic income are reliant on one source for their bonus. This is just plain stupid.

What you need is multiple sources of basic income flowing into your bank account on a regular basis. The source of your basic income should also be more secure than the next vote in Congress!

Here is the secret. The wealthier you are the more likely you are to be receiving the multiple payments of basic income. In fact, the total of all these streams of income aren’t so small. Now I, as a wealthy accountant, will share the secret to the crowds. If you read my body has been found in a ditch somewhere you’ll know the bourgeoisie got to me. Too bad the word will already be out.

By now I’m certain you figured out what I’m talking about. Multiple streams of income are the hallmark of wealthy people. There is nothing preventing you from engaging in the same activity regardless your economic status. A lower income means you start slower, but you can still start.

Sources of Basic Income

Sources of basic income are everywhere. Index funds provide an income stream in the form of dividends. A side hustle can line the household budget nicely.

Passive income is where it is really at. Dividends and interest are nice. Rental income can be much larger than dividend income with a smaller investment. Income property can provide a steady passive income stream without hardly any net worth! (I recommend you pay down the mortgages as fast as possible for a margin of safety.) The trick is buying the right properties.

Free money! Woo-hoo!

I’ve provided plenty of ideas in this blog for generating additional income. A side hustle as a forensic accountant is a fun part-time job that pays like a full-time job. Selling tradelines on the side is another way to feather your personal basic income program. No tax increases required. Here is one last link to an article on a dozen high income part-time seasonal jobs.

The ways to produce passive income is nearly endless. You should always maximize retirement plans for maximum tax benefits. Even in a nonqualified index fund dividends and capital gains are taxed at a lower rate than ordinary income. Income properties generally have higher cash flow than reportable profits on a tax return.

The universal basic income is a grand idea whose time will never come. When machines and automation destroy jobs, new opportunities arise. People in the vinyl record business lost their job in the 1980s. More jobs were created than lost in the CD business. Digital is doing the same today. Yes, the horse industry died when the automobile showed up, but the automotive industry is the largest employer in the U.S. today. And it’s not just the manufacturers. Repair shops, gas stations and the oil industry have more than made up for the lost jobs raising, training and feeding horses.

Technology and automation increases efficiency which means we have a better quality of life and standard of living. This is a good thing and not to be feared! I know it seems scary out there, but remember all the Chicken Littles frantic the sky is falling. The sky is fine. And brighter than ever, I might add.

Social safety nets are the moral thing for a society to provide. A constant struggle for the “right” amount of safety net will drag on until the end of time. What you need to understand is a basic income is yours to have. You decide the amount.

Your personal basic income will start small with one rent check, one dividend payment, one tradeline sale. Reinvesting your great fortune only grows your basic income larger each month. Soon, you can have a basic income greater than your financial needs. Then you can step back and let the next person enjoy your old job while you live on the multiple streams of income. In the new basic income world, fewer people will need a traditional job. But you will still provide value to society without working yourself to death.

 

 

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?

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.

A cost segregation study can save $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. 

Peer Street Review

Show me the money!

Note: I no longer recommend Peer Street. This post is only for reference.

Building wealth is simple when you understand the rules. Spending less than you earn provides seed capital for investments. Index funds provide the opportunity for superior growth with reduced risk due to diversification across the broad economic spectrum.

Once you have the basics it becomes clear you need additional cash management tools to serve your financial needs. Short-term cash for emergencies or living expenses are best held as bank deposits or in high-yield accounts like Capital One 360 or Discover Savings.

With long-term investments set in index funds and short-term needs covered by liquid money market type products it’s time to fill in the remaining gap. And there are some reasonable alternatives paying a respectable rate of return.

Business owners understand the need for liquid fund to cover seasonal fluctuations. In my office tax season fills the coffers used during the slow times of the year. November and December are traditionally slow in the tax industry while expenses tend to be high. Some year-end tax planning brings in some revenue, but the cost of mailing organizers, employee training and property taxes take an ax to the budget. This is the gap I refer to above.

Individuals face the same gap. Planning for a vacation or allocating funds for property taxes are an example. Individuals may also become uncomfortable with the level of the stock market. Selling index funds to store in a money market at a percent or two doesn’t make sense and becomes painful when the market continues climbing.

I never encourage market timing. However, there are times to take some chips off the table. Example: As you approach retirement (or if you are in retirement) I always recommend keeping about two years of living expenses in cash. If the market keeps climbing you can fund living expenses with dividends or small index fund sales. When the market has a temporary setback you can use the liquid funds to live. This assures you never have to sell at a market low! If the downturn becomes prolonged you can stop reinvesting dividends and capital gains to fund expenses. The goal is to never find yourself forced to sell in a down market.

Investing Gap Funds

Money market funds and online savings accounts at Capital One and Discover are good tools to store excess funds in retirement, for future investments or to pay large one-time expenses. The interest rate is low, but better than nothing.

For several years I used Lending Club and Prosper (notice I don’t include links because I no longer recommend these options) to serve as a high-yield investment for such funds. Then we had the Lending Club fiasco I was out the door. Where there is smoke there’s fire. I could be wrong, but I’d rather be a living coward than a dead hero.

Enter Peer Street.

Another bright idea.

Lending Club and Prosper issue unsecured loans you can invest as little as $25 in. The goal is to spread your investment over as many loans as possible to avoid one bad loan destroying your portfolio. There are lots of loans that default as borrowers have no skin in the game.

Peer Street offers loans in a similar fashion to the Lending Club/Prosper model with a few notable exceptions. Peer Street loans are backed by real estate with loan to value (LTV) typically below 75%. Borrowers have skin in the game!

The minimum investment is $1,000 per loan. This is still a micro loan, but not nearly as small as the $25 minimums at Lending Club or Proper. Since there is something backing the loan (real estate) the risk is likely much smaller. (Loans backed by assets default at lower rates than unsecured loan with rare exception.) You can still—and should—spread your investment funds over several loans to mitigate risk. (More below.)

Most Peer Street loans are short term (6-24 months) and generally yield 6-12% over 12 months. Peer Street periodically has very short loans (one month) that yield a lower rate, but more than Capital One or Discover currently. This can be a powerful cash management tool.

The short-term nature of the loans makes it easy to ladder your portfolio for consistent cash flow and liquidity. A small investment can provide a steady stream of available cash while earning a higher than average yield.

How I Use Peer Street

I don’t like to over-commit to any investment. My style is to dip my toe in the waters first and then stepping slow into the shallow end until I’m comfortable.

I started investing in Peer Street a few months back. Every loan I invested in is for the minimum: $1,000. So you understand my style, I currently have $6,000 invested with intentions of reaching $100,000 over the next year or two. As long as the wheels don’t fall off (remember the Lending Club issues) I’m happy. I’ll never put everything into Peer Street, but I will invest enough to move the needle eventually.

Every week or two I’ve been adding another $1,000 or so. Peer Street reports interest income and loan maturity funds on the 15th and last day of the month. The money appears in my account a few days later. I use this opportunity to add new funds to my account to bring the cash balance back to $1,000 so I can invest in another loan.

My slow approach is for two reasons. First, I can sample how Peer Street works before committing a level of funds that would hurt if I misstep. This allows me to acclimate to the investment. Second, the slow approach means I have loans spread out over a wide range. In a few months I will have loans maturing practically every month. Coupled with the interest stream I’m in a good position to benefit from the investment.

Investing in income properties can be a lot of work with plenty of risks. Peer Street makes real estate investing easier, smoothing the income ride along the way.

Taxes

Interest income is taxable. Landlords have several tax advantages due to real estate ownership. Peer Street investments are loans and income is treated as ordinary income. If you are familiar with Lending Club or Prosper you will find reporting Peer Street income looks a lot the same. The main difference is loan losses. Lending Club/Prosper have a lot of loans that default. This can play havoc on your tax return in some instances. Peer Street has had a few loans default, but according to a conversation I had with a Peer Street consultant on the phone, investors lost no money. The LTV metric does offer a level of protection to investors. (Loan losses would be handled in a similar fashion to Lending Club should they occur.)

Recommendations

Time for a reality check. Most loans offered on Peer Street hover around 7%. Yes, the sales literature says you can pull up to 12%. Real world experience says you will have plenty of opportunity to invest with a 7% return. Some loans are lower, more are higher. Loans paying 8% or more require a strategy.

Peer Street allows for automatic investing of funds in your account. What I do is keep $1,000 in the account and set the parameters of the auto-investing feature at 8% or higher, LTV up to 75%, loan term up to 60 months (I don’t mind a longer term investment, but you may wish to tighten this parameter) and $1,000 max per loan.

Peer Street sends an email when they invest in a loan automatically. If you don’t like the look of the loan you have 24 hours to cancel from time of notification.

New loans are available most business days. The higher interest loans usually are filled with automatic funds. The 7% and 7 ½% loans are frequently available for manual investing.

 

There you have it, kind readers. No fancy stories today. This is an idea I’ve been working personally on a small scale for a bit and wanted to share it with you. As a reminder, the links in this post are affiliates. Peer Street graces your favorite accountant with $30 for every new account I send their way. I have affiliate links for Prosper and Lending Club, but do not include them because I no longer support their programs. I’d rather be safe than sorry.

I can’t make a real recommendation for you personally since I don’t know you personally, along with all the relevant facts. My only recommendation is to take it slow if you find Peer Street appropriate for your portfolio. No heroes; just another nice product to handle funds living in the gap.

2017 Tax Bill: Small Business is Punished for Raising Wages

Normally I don’t like to comment on a tax bill before it becomes law, hence the reason I’ve only commented once on the current bill as it wound its way through the halls and committees of Congress. Now that the bill is sitting on the President’s desk awaiting his signature I’m comfortable opening a dialog on some of the issues I see the regular press has missed.

Since the beginning I’ve called this a Swiss cheese tax bill because it has so many holes in it I can drive a truck through with my eyes closed without a worry I’ll hit a wall. I suspect many of these holes will be closed in time. Until then, fuel up the truck fellas. We’re going for a ride.

The Missing Link

Pass-through entities don’t pay taxes at the corporate rate, instead, passing certain items, including profits, to the owners to be reported on their personal tax return. Income is generally taxed at ordinary rates.

The current bill reduces the tax rate for regular corporations (C corps) to 21% while individual tax rates top out at 37% for individuals. To level the playing field between regular corporations and pass-through entities (S corps) the bill included a 20% deduction on pass-through business income.

The deduction is limited to $315,000 of eligible income for married couples and $157,500 for single filers. However, a last minute change greatly enhanced the advantage!

A formula was inserted which will allow the 20% deduction of income on amounts greater than the income limits. The formula for the deduction is the greater of: 1.) 50% of wages, or 2.) 25% of wages, plus 2.5% of the value of qualified property at purchase.

Real estate is the target of this formula. It will allow for massive deductions for certain real estate investors at rates tremendously higher than many other small business owners will get.

But that isn’t what I want to talk about today.

A Load of Swiss Cheese

Traditional news outlets will give you the basics of the tax bill. I’ll touch on the same issues in the near future. For now there is a pressing issue we need to discuss instead.

The above business deduction for pass-through entities makes current year (2017) business deductions more valuable than if taken next year if you are under the income limit! This includes real estate investors where the deduction can be much higher.

As I read the bill, my interpretation is the deduction extends to sole proprietors and small landlords. When the IRS provides regulations on how the new deduction is handled I may have to give updated advice later. It’s unclear if small landlords and sole proprietors get the deduction without creating a pass-through entity. As I read the bill it is allowed without the extra paperwork. But the IRS may disagree and it might be necessary to hold real estate in a partnership, or if there is only one owner, an S corp. (Gulp! Did I say that?) I’ll keep you up to date. As soon as I have more clarity I’ll pass it along. Either way, there should be a way for owners of income property and sole proprietors to take advantage of the new deduction.

There are two reasons for business owners/landlords to accelerate expenses before year-end: 1.) Tax rates are declining slightly for many individual taxpayers, and 2.) A deduction is worth less next year.

This might seem counter-intuitive, but Congress may have passed a tax bill that discourages pay increases and capital expenditures by small businesses and investors of investment property.

Deducting as much as possible this year makes sense with rates going down in 2018. Buying an asset and expensing it, if possible, is worth more now than it will be in a  week and a half after publication of this post due to the lower rates AND the business income deduction!

An example illustrates the disincentive to invest in more capital expenditures and payroll next year. Suppose we have a small business with $200,000 of profits. If the business is planning an investment in a new piece of equipment costing $50,000, the owner’s tax benefit is reduced by 20% in 2018 and after! It looks like this under the new tax bill:

Without equipment purchase:

Income: $200,000

20% business deduction: $40,000

Income reported on personal tax return by owner: $160,000

With equipment purchase:

Income: $200,000

Deduction for expensed equipment purchase: $50,000

Income after equipment deduction: $150,000

20% business deduction: $30,000

Income reported on personal return by owner: $120,000

The equipment cost $50,000, but the reduction in income is only $40,000! The business owner saw a reduction in tax benefits from the increased expense by 20%.

We can debate the method used to deduct the property (expense versus depreciate), but the premise is the same: every business expense is worth 20% less starting January 1, 2018!

Look at it this way. If a small business owner increases wages, as Congress says they are incentivized to do, they will suffer the cost of the higher wages AND a reduction in the new business credit! The business owner will cough up the added payroll expense, plus payroll taxes, and face a decline in the business credit.

If the small business owner REDUCES wages, they are rewarded under the new tax bill! If a business owner cuts payroll by $100,000, she will save payroll taxes AND have a higher income of which 20% is deducted. The $100,000 increase in business income will only have $80,000 subjected to tax.

One last example: Prior to January 1, 2018 it is illegal to deduct 20% of a business’s profits for fake business miles or other non-cash deduction. Starting January 1, 2018 you don’t have to cheat to get the benefit; it’s codified!

Final Thoughts

Congress has sold this massive tax bill as a job creator. Instead of taking time to get a solid piece of legislation written, they rushed it and it shows.

The incentive to small businesses is clear: CUT PAYROLL! This will have the opposite effect of what was intended.

Sure, businesses will need to spend on updating equipment eventually. But the longer they can hold off the better they will fare; they get a 20% deduction off the top before they spend a penny. A smart small business owner will have more incentive than ever to CUT wages and capital expenditures. And for the altruistic business owner, a tax penalty applies in the form of a reduction in the new business deduction if they do increase wages.

Real estate investors tend to hire fewer people so the effect is less. Even still, spending on improvements entail up to a 20% penalty for each outlay as the business deduction is reduced.

My favorite deductions have always been of the non-cash nature; I get a deduction and keep the money, too.

I hope y’all love Swiss cheese because there will be plenty to go around until they change the tax law.

 

Note: This is self-serving as all get-out, but this is one simple example of how this tax bill will harm the economy and the workforce, the backbone, of America. If you can see past my self-promotion, spread this post everywhere: social media, email and links. Don’t forget your elected officials in Washington. Don’t be afraid to expand on the consequences of this tax bill. There is plenty to spur the economy. But there is also plenty to slow the economy as well. With small business employing so many people in this country it is imperative to get the word out so the people who can facilitate appropriate change can take action with this new knowledge.

Real Estate versus Index Funds

As you work toward financial independence the question pops into your head: Which investment is best to get me there?  Index funds usually, or at least should, top the list. Real estate is not far behind. People wrongly believe real estate is a better investment vehicle than a broad basket of stocks.

The first fallacy I hear when I inform clients of this misnomer is a list of all the people who made it big in real estate. The current U.S. President, they argue, made his money in real estate. Except he didn’t. He made most of his money licensing his name to real estate others own. When the President was in the real estate business big he also went through a wrenching bankruptcy.

Then, of course, I hear about the Carlton Sheets, the late night infomercial guy selling courses on how to make it big in real estate without any money down or work! If you bought one of those courses I have a beautiful tower in Paris I’d like to offer you for an unbelievable price if you act now. (By the way, Carlton makes his real money selling courses, not in real estate.)

Real estate isn’t as bad as I’m making it, but the numbers tell a story you should understand when adding real estate to your portfolio. There are decided differences between an investment property and an index fund. We will explore those differences and the historical returns on each.

The stock market has real returns of around 7% consistently over long periods of time. Source: Stocks for the Long Run by: Jeremy J. Siegel.

Index Funds

Jeremy J. Siegel’s work on the historical performance of the stock market over the last 200 years is available in numerous editions of his bestselling book, Stocks for the Long Run. As much work as Siegel put into his research, the evidence is clear and simple to understand. Over long periods of time the stock market has a real return of around 7%, plus the inflation rate. The only time the market went for any meaningful period outside this norm is from 1966 to 1981 when interest rates and inflations were high. When inflation waned the market reverted back to the mean.

The story is an easy one to tell. Invest when money is available, don’t try to outguess the market by trading and wait a while.

Dividends tend to climb at a steadier rate than the overall market. Whereas the broad market can race ahead at times, it can also experience a temporary hissy fit. Dividends for the whole market rarely decline, but periodically do before resuming their upward march.

Index fund investing is also highly diversified. A total market or S&P 500 index fund spreads your investment over a vast range of industries. Index investing gives you exposure to large and small companies, including growth and value stocks.

The value of the broad market follows the growth of the economy, plus increases in productivity. Interest rates play a large role in determining the discounted value of future earnings.

The automatic advantages of index investing are absent in real estate unless you invest via a real estate investment trust (REIT).

Real estate struggles to keep up with the stock market. The more time that elapses the greater advantage equities have. Source: Russell Investments

 Real Estate Investing

Dividends tend to be smaller than the cash flow from a real estate investment if it is an income property.

Your personal residence will not produce a rental income stream, but you avoid paying rent so there is an implied value.

Real estate values tend to track personal income. If prices get ahead of themselves buyers don’t have the income to support the payments, thus containing real estate gains.

Unlike index funds, real estate is local. Prices accelerating on the coast have nothing to do with prices of homes in the Midwest. Even the section of town a property is located in has an effect on the value and potential for future gains.

Buying a stock or mutual fund is the end of the work. Periodic review of the investment is the maximum extent of effort required to maintain the investment. Real estate holdings require continuous management.

Real estate has serious holding costs! Property taxes, insurance and maintenance are the obvious costs. If the property is used as a rental you have the cost of finding a tenant. If the tenant damages the property legal costs will be added to the mix.

Investment properties are considered passive income for tax purposes, but as any seasoned landlord can attest, it takes work to turn a profit on a real estate investment. Even with a property manager you need to remain active with your investment or serious losses can occur.

Real estate has one major advantage: rents. Rent income can spike the investment’s return.

Real estate also has a double edged sword: leverage. For a real estate investment to achieve close to stock market returns leverage must be used. And with leverage comes risk. The longer you maintain a high level of leverage (borrowed money compared to the value of the asset) the greater your investment return as long as prices are increasing. If prices stagnate or decline the real risk of bankruptcy rears its ugly head.

Comparisons

I’ve included two charts in this post. The first chart comes from Siegel’s work and shows the relatively stable rate of return of the stock market over long periods of time. Inflation affects results, but the market returns about 7% per year after inflation (real return). The inflation of the 70s smacked the stock market around while rallying smartly in the 80s when inflation and interest rates declined.

The second chart compares real estate to the S&P 500 from 1977 to 2014. This chart unfairly gives real estate an advantage. Real estate prices were moving higher fast in the late 1970s and early 1980s while the stock market was getting crushed until August of 1982.

Real estate was given a head start and still lost the race by a massive margin! In the 34 years covered the broad stock market returned nearly 2 ½ times what real estate did without the risk of leverage or the work real estate investments require. Even if you used no leverage, you needed to fund the property from other investments (lost opportunity cost) and if a roof or furnace died you would also need to use leverage or cash from other investments to cover the cost.

What the second chart doesn’t show is individual markets. Averages work wonderful for index funds, but are terrible for real estate. Real estate has more opportunities to find a hidden gem than individual stocks.

Taxes

Tax laws have changed radically over the years as it applies to real estate.

Until a few years ago, dividends were taxed as ordinary income, but now are treated as long-term capital gains in most cases.

Tax laws favored real estate holdings in the 1970s and early 1980s. The 1981 and 1987 tax overhaul changed all that.

Recent changes to the tangible property rules and the repair regs have made real estate more desirable than a decade ago.

Real estate sometimes has other serious tax issues such as depreciation recapture.

Both real estate and index funds tax income currently (unless held inside a retirement account (easier for an index fund than real estate)). Both investments enjoy long-term capital gains treatment if held for a year or longer.

Rent profits are treated as ordinary income and taxed higher than most index fund profits/dividends. Losses are limited to each: real estate is limited to $25,000 under passive activity rules if you are not a real estate professional and capital losses on index funds are limited to $3,000 per year against other income.

REITs are taxed as ordinary income and are required to distribute 90% of gains each year. The REIT itself does not pay taxes; they pass the bill on to investors.

The Best Investment

It might sound strange coming from a man who owned millions in real estate over the years, but real estate is frequently a poor performing asset compared to equities (stocks; business ownership). That said I still own my home and farm, office building and paper on some real estate.

Real estate has a home in many portfolios. I always cringe when I see people overloaded with real estate compared to other more liquid investments. I understand the risks of leverage and the capital requirements real estate frequently demands.

Investing in the stock market can be made automatic. Real estate is less forgiving.

Buying in a down market or distressed properties has its adherents. If the right property shows up I’m always happy to buy it and sometimes do.

My experience also gives me an advantage when it comes to determining which investments are best. As the owner of a tax practice for over 30 years I know who is winning who is and losing. Landlords have the distinction of having more bankruptcies of any client class in my office. They also are among the richest.

Leverage determines the winners. Property investors who pay down and eliminate leverage fast have less risk. Those who manage their properties as a business also do well. Those who buy a program thinking real estate is easy money go broke.

Real estate has one final advantage and it’s a big one: forced saving. The increase in property value is hard to access and it doesn’t always feel like value unless the property is sold. Mortgage payments applied to principle is another form of forced savings. “Good” investment property owners keep a cushion of cash for emergency property expenses which is another form of forced savings.

My successful investors don’t spend every penny of profit from their properties. There is a compounding effect with income properties harder to calculate than with equities (stocks).

A smart person will consider all traditional investments. Index funds should be a part of most portfolios. Real estate, for those who are interested in such investments, is a great way to round out a portfolio with a larger cash flow.

You can retire on real estate faster than index funds due to the extra cash flow investment properties provide. But you don’t want your eggs all in one real estate basket in case we end up back in 2008 again.

In Detroit.

Wealth Building Resources

Personal Finance 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 Finance is free?

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to skyrocket, 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.

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

Amazon good way to control costs and comparison shop. 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.

How a Broke Farmer Became a Millionaire

1978: It was hot and dry the summer of 1978 in northeast Wisconsin and I hated it. My fourteenth birthday was around the corner and I was recently out of the hospital from heart surgery. The doctor said I needed to sit still as I healed over the next six months and my grandmother did her best to enforce the rule. I was having none of it. I wanted to run, bike and play.

It was the best of times as long as you ignored the building storm clouds on the horizon. Inflation was a problem, but interest rates hadn’t risen enough yet to reflect the new reality. The government encouraged borrowing by farmers through Land Banks.

We were dumb farmers and dumb farmers were soon to learn they had no place in the new world order. Yes, farm prices were high due to inflation while interest rates were lower. Unfortunately, these situations don’t last for long.

Ground was broke on the new milking parlor within an hour of the moment I went under the knife. I was young and innocent and full of faith. As I recovered in the hospital those two weeks I decided to fill my time reading the Bible to other patients less fortunate than me. God had plans for the Bible-thumper.

1980: The hot wind from the storm clouds began to blow. Interest rates climbed as the first recession of the 1980s was about to begin. It was only a warning shot.

Healed from heart surgery, it was learned my surgeon was deathly ill from AIDS, except it wasn’t called AIDS back then and blood wasn’t screened either. The surgeon may have nicked his finger from an infected patient or he may have been gay. I never found out. All I know is I survived without infection. A few years later the man who saved my life was dead.

The World’s Luckiest Man went about life as if nothing were wrong. But plenty was wrong. The family farm tilled by our blood for five generations was in deep trouble and we were all in denial. The debt burden had continued growing and rising interest rates coupled with the first crack in agricultural prices brought us to the edge.

Deep down I knew the farm was in trouble. Some family members started gambling in futures looking for the big score to solve the farm’s money problems. Too young to really understand and enjoying my first real girlfriend distracted me from the truth. These were the last good days of my childhood. A nightmare was about to begin that would scar me so deep I would never again forget the fear.

High school wasn’t a high priority for me. I assumed my life would be filled as a farmer, as my father, grandfather and great-grandfather before me. Excluding my senior year, the only thing that stuck with me is a lesson from Social Studies: the 1929 stock market crash. We spent one day only on the event, but I was completely hooked. I had to understand why things happened the way they did back then. The lust to understand the crash follows me to this day. This is the very moment I decided my career if farming didn’t turn out: stock broker.

1982: The winter of 1981/82 was the cruelest. The farm’s coffers were depleted and heavy snow caused the free stall barn roof holding the milk cows to collapse. The insurance was delayed and there was no money to fix the problem. The barn cleaner froze tight and manure piled up. Those animals suffered like nothing I’ve seen before or since. I shiver from the memory now 35 years old. Another scar was created.

The family farm was gone. The collapsed barn roof hastened the inevitable. Maybe God was merciful to me after all. But those beautiful animals paid a dear price.

Spring came and the clean-up began. Lawsuits flew as a last desperate hope was cast to cling to a past no longer possible for our future.

It was only four years ago I left the hospital excited to see our new milking parlor. Gone were the grand emotions of seeing our farm grow with cutting edge modern technology. The cows were now gone. My uncle and I were the last to clean up the mess. My dad started an agricultural repair business he runs to this day and is very successful. You can’t keep a good man down. My mother sold Tupperware to pay the bills as my dad’s business struggled for traction during those early days. My mother sold a lot of burping bowls; so many in fact she earned a company car.

The second recession of the early 1980s was biting deep as I graduated from high school with the barest of margins between passing and failing. I still held hope I would be a farmer as illogical as that looks in hindsight.

Some young stock remained and the fields still required planting and later harvesting. Still, most days that summer I spent playing a card game called Rummy  with my uncle and throwing darts at a dartboard with a picture of the Ayatollah Khomeini.  (Remember the American hostages in Iran?) The summer went on forever.

I discovered a love for reading my senior year in high school. The summer of 1982 was my first opportunity to dig deep into the knowledge books had to offer.

Back then they had something called Value Line in the library. They’re still around, but nothing like it was back then. Value Line was a treasure trove of information on publicly listed companies. I reached the age of majority in June with no real future before me while I invested heavily into myself without even knowing it.

The family was broke, the farm damaged beyond repair. I was broke, too, in a manner of speaking. The first 18 years of life I spent as close to nothing as you can without saying nothing. Money from my birth went into a passbook savings account. Money from birthdays, confirmation (church) and high school graduation added to the stack.

Passbooks actually had a reasonable return back then and I loved watching that puppy grow. The passbook wasn’t computerized. They stamped the numbers in a real, honest-to-God, passbook! I was thrilled each quarter when I could hitch a ride to town to the State Bank and have them stamp the accumulated interest since the recording of last quarter’s interest.

Added to my passbook was income from working on the farm. My wage for seven day work weeks of fourteen hour days was $40. Yup, ten bucks a week. I didn’t complain much; I now realized how bad things were. I was more concerned what I would do when the bankruptcy of the farm was finalized.

In November the farm was gone. The homesteads were preserved, but most of the land and all the cattle and machinery were part of history. It was cold that winter. We had no money to heat the rickety farmhouse. At least we had a place to stay.

1983: I went to work for my dad’s agricultural repair business once the farm was wrapped up. The pay wasn’t any better, though I was earning $400 a month by the time I quit. We struggled to survive.

My passbook was a beacon of hope for me. Nearly $10,000 had accumulated over my years of youth.

I hated every moment working for my dad. The work was hard and did not thrill me. I wanted a different life. There were no other options in the deep recession of 1982. There were no jobs available in my community. None. It was work for dad or starve. I worked.

My investing research brought me to my stock first purchases. Philip Morris was one of my first buys and has clung to me like smoke in a bar. I played with other ideas to learn more about investing. Most of my passbook money was cashed in shortly after my 18th birthday and placed in growth and income mutual funds. The timing couldn’t have been better. August of 1982 was the launch of one of the biggest bull markets in history.

I still own my FFA jacket. Those were fond days.

By the time the farm was gone and I was turning a wrench in my dad’s company I knew I needed another source of income. In high school I was in the Future Farmers of America (FFA). To raise money for our group we sold light bulbs. This is when I learned I could sell an Eskimo an ice cube.

Every year I was in FFA I sold more light bulbs than anyone else by a large margin. When the group decided to sell seeds, I topped that list as well. I could sell anything!

By the time 1983 arrived I found a company called Specialty Merchandising Corporation (SMC). I think they’re still around, but they have a lot of complaints online.

SMC was different in 1982-85. I was able to buy junk, ah, I mean stuff through them mostly made in China (yes, it’s my fault China ever got a foothold in our economy (sorry)) at wholesale. My selling skills from high school did not work as well as an adult. People will waste money on stuff sold by the school without question. (Did I say that?) When an adult goober like me showed up they questioned.

My advantage was persistence. Okay, stubbornness. I didn’t give up not because I was smart or energetic; I was desperate. The profits were thin, but added up as time went by.

One more side gig appeared at this time in my life. In 1982 I prepared my first tax return. (Later, a client with several unfiled tax returns, would give me the chance to prepare tax returns back to tax year 1978.) Let me be clear; I prepared a tax return. I consider it my start date. (Laugh all you want; it’s my story.)

1984: The economy was improving in the Rust Belt, but it did a certain neophyte accountant no good.

The good news was my mutual funds and individual stocks were tucked in for the ride to the moon with the stock market. Profits from tax returns and SMC added to my meager wages working for the family business. In 1984 I was a poor farmer with no debt, no bills (living at home with my folks) and over $50,000 invested.

The spring of 1984 I made more money preparing tax returns than I did working all year, 90 hours a week, swinging a hammer. Thank God, business in the ag repair industry was slow during tax season. Thank God the repair business was slow over the holidays so I could sell like a Wildman for the Christmas holiday. It made a difference.

1986: My investments reached $200,000; it was time for vacation. I quit working for dad (it was a minor family crisis), bought a mobile home in Forest Junction and read books all day and drank coffee. The amount of information I consumed during this gap year was immense.

I was starting to grow up, but there was a bit more to go.

1987: The most fantastic thing to ever happen to me happened in 1987; I met Mrs. Accountant! (You thought I was going to say I made a pile of money in the stock market crash of ’87, didn’t you?)

A respectable man I am, but finding an awesome woman like Mrs. Accountant only made me consider getting a “real” job.

That would all change one year and six days from the day I met her.. Mrs. Accountant forced me to marry her and she wasn’t even knocked up!

1988: One year and six days from the day we met we were married. While going through orientation with the minister it was brought up I do not work. Good husbands work and the church had an open position for a janitor.

I took the job. It paid $7.65 an hour. Not much even in 1988, but honest labor.

1989: I hated swilling toilets for a living about as much as I enjoyed turning a wrench and swinging a hammer for dad. A year and bit later I quit. Good for nothing husband!

SMC was history by now, too. Tax work paid the real bills. And I found another profit engine: real estate. We bought our first home (mobile homes don’t count) and investment property.

My net worth was climbing slowly now. I estimate my net worth hovered around $300,000. The ’87 crash had recovered and I was still adding to the stack. However, a woman entered my life and for the first time did some spending as part of my mating ritual. Thank the powers that be it worked or I’d still be single!

We tend to remember the good times of our youth and forget the rest. As long as we learned the lessons we’ll be fine.

1996: The first years as a full-time tax practice were difficult. I made money when my costs were zero and I did returns by hand. As a “real” business I automated and computers and printers were ungodly expensive. It took three years before I turned a profit. My buffer of investments was my only comfort (and a friendly snuggle from a certain young lady nursing our first child).

To keep the finances in the black, Mrs. Accountant and I took in foster kids until our daughter was born. They paid $1,000 per month to take foster children back then because we took high schoolers. It was a challenge to say the least.

Real estate’s best days were in the 1970s. High inflation meant leverage amplified gains by several magnitudes of order. Tax law changes in 1981 and 1987 reduced some of the benefits of investment property ownership and real estate inflation was back to normal levels while interest rates remained historically high.

Real estate was still profitable for collecting rents in our locality. My dad, brother and I formed a partnership so we could by more properties. Without going into details, all I can say is we owed a lot. I mean a real lot!

Around this time the bank demanded a personal financial statement because we had a modest loan on our investment properties. When I added all the numbers and subtracted the small loan on our primary residence and my portion of the loan for the rentals, it tallied to $1.2 million. I was stunned.

The mutual funds and stocks were worth close to $850,000. Our personal residence had maybe $30,000 of equity (it was a small home worth maybe $70,000). LuK Enterprises, the family partnership for the rentals, was worth approximately $350,000 for my pro rata share of ownership; the original investment was $105,000. The business was still in the home so I valued it at zero. In reality, the tax practice was worth $200,000 to $250,000, I estimate.

The next year I bought the office building my tax practice currently runs out of and the farm I currently live at. We sold our home in town for a $40,000 profit.

 

And that is how a broke farmer became a millionaire He never quit trying; he never gave up.

As Dickens said: It was the best of times; it was the worst of times.

And I wouldn’t trade them for all the money in the world.

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.

Organize Your Life to Maximize Net Worth and Minimize Taxes

JD Roth

I had the awesome opportunity of meeting JD Roth! While not fast buddies, I look forward to meeting JD in the future. He is even better in real life than I imagined.

The following post is based on a presentation I gave at Camp Mustache SE in Gainesville, Florida on January 15, 2017.

There are several ways to convince someone to speak at your event. Stephen Baughier used the most sure-fire method ever. Stephen noticed I wrote a blog post back in August listing some people I would like to meet someday. He checked two people on the list and found JD Roth open to attending. He then called me and said, “Hey, Keith. I saw on your blog you wanted to meet JD Roth. Well, he is speaking at Camp Mustache SE in January. We would love to have you speak as well and you can meet a man you admire.” How could I say no?

Picking a topic of discussion is something I allow the event organizer to decide. If they have no preference I choose something currently exciting to me. In this instance Stephen thought something about organizing your stuff in preparation for meeting your accountant/tax guy would be a good choice.

I grimaced. My organizational skills are not legend. However, I do keep a tight fist on in financial organization.

Bookkeeping is not a topic which lends to filling an hour presentation. My first thought was to stand in front of the group and yell, “Shut up, and sit down!” while I stabbed my finger at them. “Enter your paperwork once a week and stop bitching about it.” Then I would grab a beer from the fridge and sit down. My first inclination had a slight flaw I thought might turn off the crowd and upset Stephen so I moved to plan B.

After considerable thought (somewhere in the neighborhood of three or four minutes while I was feeding the chickens one day) I decided to expand the idea from organizing your stuff for the accountant to organizing your life in a manner that reduces the workload, stress, and procrastination inducing part of record keeping to include maximizing net worth while reducing taxes. Who doesn’t like saving on taxes? I surmised. And who would argue with growing their net worth at the fastest clip possible? Since no one threw anything during or after the presentation I assume the audience was either kind or mildly receptive. My ego demands I tell you it was the later.

The Ugly

After a brief attempt as humor I discovered I was no George Carlin reincarnated so I moved on to the topic at hand. The best place to start is the ugly.

The worst thing you can do is drop a crate (happens more often than you think)/shoe box/envelope stuffed full of receipts on your accountant’s desk. From your viewpoint you watch a box disappear from your home/office and magically reappear as a neat tax return and a box of papers neatly stapled together in a few weeks. Here is what really happens.

We are so excited to have the extra work we take that box of papers and dump it on the conference table so the room is unavailable for normal use for a day or so. We bring a temp with a bad attitude to the room and, under threat, demand she take the mound of papers and separate it into piles: office expense, cost of goods sold, utilities, et cetera. When she is done she takes an adding machine and creates a z-tape of each pile. The z-tape is stapled to the top of the pile with an industrial strength stapler. The remaining pile of receipts she doesn’t know how to classify is neatly tucked on the bottom of the box and those deductions, if legitimate, are missed. The remaining piles stapled together are used to prepare the tax return.

I suspect most accounting firms around the world use a similar practice in such extreme instances. Time is tight and after a 687 hour workweek during tax season, we are in no mood for bullshit. If you want all your deductions, might I suggest bringing your books into my office in proper order? My job is not to guess what a receipt means; only you can answer that.

The Proper Way to Keep Records with Almost no Effort

The process of organizing your business and personal life should be simple and with modern technology it is fast, simple, effective and low cost.

Small business, a few income properties and personal life: When organizing only requires the documenting of a few items there is no need to go crazy buying software to manage the 17 items needing a place in the data fields. Old fashioned guys can use the old columnar pad or Excel. (Yes, I have a few clients with beautiful records brought in on a columnar pad.) Excel is an awesome tool for managing small amounts of data for personal finances, up to five or so income properties or a very small business without any employees. Fast and simple are the key words here.

The time required to keep your life in order is about one hour per month. In most cases once a month is enough to enter your data.

Medium sized company and more than five income properties: A medium sized company is defined as a business with bookkeeping requirements of between three and ten hours per month.

IMG_20170116_161903

After the conference I stayed in Gainesville to finish some business and writing. While taking a break I saw this sign, fell to my knees and wept. I knew I was coming home.

Once you have more than a token amount of data to manage it is time to open your wallet and invest in some form of accounting/recordkeeping software. QuickBooks is the largest. QB has a robust program with enough features to handle most businesses. The downside is that the payroll module is expensive and limited. (In a few weeks I will publish a post on how to get your payroll done fast and easy with low cost and no additional paperwork headaches for you.)

QB is not the only game in town. You might want to consider other software, including: Freshbooks, Xero, or Sage (the old Peachtree). Each program has its strengths and weaknesses. Space (and my time) requires I move on without reviewing each software package.

At this level you have some additional considerations. Doing your own recordkeeping is an unproductive expenditure of time. Hiring a bookkeeping/accounting firm is a low cost way of getting the rote process of bookkeeping done. Bookkeeping firms know how to optimize the process. What takes you a day takes the bookkeeper an hour or two. While the bookkeeper may charge $60 an hour, the time you take to get the same work done translates into your time valued at $20 or less per hour. And the bookkeeper will get it right.

Large businesses and large numbers of income properties: At this level hiring an accountant to handle your workflow no longer is efficient. You need an in-house bookkeeper/accountant to handle all the paperwork daily. Payroll can be handled internally if you have qualified staff or outsourced.

The Good

There is an animal in the tax world called the non-cash deduction. Things like mileage, per diems and depreciation fall into this category. Depreciation is a phantom non-cash deduction since it is related to actual expense. Mileage and per diems are either a hybrid or true non-cash deduction.

Mileage logs: If there is one area that drives accountants mad it is in the area of mileage logs for business owners and landlords. These people are notorious at keeping accurate records. The IRS requires a mileage log be contemporaneous, which means it needs to be recorded reasonably close to the time of the event. The day you get the IRS letter for an audit is not a contemporaneous record.

Contemporaneous records can be easy to keep if you follow my advice. Miles can add to a large deduction fast. The mileage rate for businesses and landlords is 53.5 cents per mile in 2017, down from 54 cents in 2016. Keeping an accurate record assures you take advantage of the entire deduction. You deduct the entire 53.5 cents per mile even if your actual cost is less! Using a low-cost vehicle is the perfect way to legally stick it to the IRS. I can see you are feeling better already.

The reason so many flub on the mileage log is the requirement you write it down. There are apps available to simplify the process. MilesIQ is a paid app which meets all the IRS requirements for your deduction. A free app from Google Play that provides the same service is TRIPLOG.

Let me clear up the requirement. Your records need to contain the beginning and ending odometer reading for each vehicle for the year. Each day you have business miles you need to record the business miles traveled, the date, where you went and the purpose of the trip. The above apps allow you to enter this data. The printout/record produced by the app is adequate substantiation for tax purposes. You simply enter the deduction into your accounting software and the tax return. No additional horsing around necessary.

Per diems: The per diem is an awesome tool in reducing taxes without a real world expense. Under the hi-low method the IRS allows you to deduct a per diem for meals and incidentals (M&IE) without any additional substantiation. You must record the number of overnights, the business purpose and the location only to qualify.

The hi-low method is easy to use. Most locations within the U.S. have a M&IE allowance of $52 for meals and $5 for incidentals. High-cost locals get $63 for the meal per diem. There is also a chart where you can pick the per diem rate per location instead of the hi-low rate. Rather than muddy this post with long charts you can use this link to determine the hi-low rate localities and the per location rates.

The hi-low rate is simplest and only a limited number of taxpayers will benefit enough to justify the additional time of breaking out all the travel locations separately. Only half the expense is allowed as a deduction and DOT (ie. truck drivers) get special rates and can include 80% as a deduction.

Let’s keep it super-simple. Keep track of how many overnights you have for business purposes and where you went and turn it in to your tax preparer. She will take care of the rest.

Note: business owners and landlords need actual expenses (receipts) for lodging.

New World Order

Modern technology has made it easier than ever to track your expenses/deductions. Your time is precious. So is your money!

Whether you do your own recordkeeping or hire it out, you can use apps to get the maximum deductions with almost no effort. These apps allow you to photograph your receipt and forget it. The receipt is automatically downloaded to your software and saved in the cloud should you need to review the expense later or for proof during an audit. No more lost receipts or sleepless nights over an audit. Your books are so clean it will bring a tear to the eye of your accountant. I’m getting misty just talking about it.

Apps in this category to consider are: Expensify, NeatReceipts and Wave.

Clean, accurate records have two significant advantages. First, accurate records allow for an accurate tax return bulletproof in an audit. Second, accurate records allow you to manage your investments and company by visualizing progress or area of concern. Bookkeeping isn’t a crazy idea thought up by geeks to create gainful employment. Records show where you were, where you are and help project where you are going. You can’t fix what you are unaware of. Keeping accurate records is like driving with your eyes open. Or you might take a chance on the alternative.

Yeah, I thought so.