1. AVOID PASSIVE LOSS LIMITATIONS: Deduct Unlimited Property Tax Losses Even if Over $25,000 or Your Income is Over $150,000 by Being a Real Estate Professional.
With the aforementioned non-cash componentizing deductions piling up, your properties are going to be throwing off paper tax losses which you want to fully deduct against your other income.
Except for $25,000 of losses, rental property losses are subject to passive loss limitations. This means real estate investors cannot deduct property tax losses against non-passive income such as salaries, business income, gains, IRA distributions, etc. If the investor’s adjusted gross income (AGI) is above $150,000 they will not even be allowed the $25,000 exception for deducting such losses. Moreover, even if the investor is eligible for the above exception, but has over $25,000 in property losses, the excess over the $25,000 is still subject to the limitations. Being subject to these limitations means the investor cannot currently deduct the losses in the year incurred. The losses are “suspended” and must be carried forward until the property is sold at a gain. The savings from the losses are also delayed as well as the investment use of such savings.
What to do: To avoid being subject to these limitations, the investor must document at least 751 hours (or an average of about 14-1/2 hours a week) with the majority of their time in the real property business. A “real property trade or business” is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. This includes real estate investors who do rentals, management, rehabbing, wholesaling, retailing, foreclosures, short sales, self-storage and other type’s real estate activities. With the right planning and documentation even those with full time jobs can meet these requirements.
Do this and fully deduct your property tax loses without limit, save a ton of taxes, and increase your cash flow every year!
2. AVOID IRS: Employ “Audit-Proofing” Techniques To Be Free of The Worry & Costs of IRS Intervention.
There are over 30 ways to audit proof your return against the IRS. Here are two powerful ways:
(a) File an extension for your tax return. File as late as legally possible, with typically is October 15 following the tax year. Because of the IRS computer’s “first come, first serve” system, returns filed early are more prone to audit. To file extensions, use IRS Forms 4868 for individuals and 7004 for entities such as LLC’s and partnerships. Understand, that filing an extension does not postpone the payment of any taxes you owe. This is not its purpose. The purpose is to reduce your chances of an audit, stop the April 15th mad rush and numerous other advantages.
(b) Attach written explanations to your return, for items that you believe unusual or audit prone. Include the appropriate tax law citations with these explanations. For example for high travel and entertainment deductions you can attach this audit-proofing statement: Auto, entertainment and travel deductions are necessary for my business and are done in strict accordance with the substantiation requirements of IRS regulation 1.274-5T(c), including maintaining written account books with date, place, persons, amounts and business purpose. Also on file are related bills and receipts as well as notarized statements explaining and attesting to the business use and purpose of these items.
Sign and notarize the statement. This will help keep you out of the audit pile.
3. UNDERSTAND THAT SAVING TAXES ACCELERATES WEALTH: Know why saving taxes makes you wealthy and is well worth the effort.
In my tax presentations one of the first things I cover is why and how saving taxes can make you richer, faster. Well, here it is…
If you take $1.00 and double it tax-free for 20 days it’s worth $1,048,576 (over a million dollars). Take that that same $1.00, taxed every year at 30%, it will be worth only about $40,640 — A LOSS of a MILLION DOLLARS! Why is this so? Because with tax-free compounding, earnings accumulate not only on the principal amount of money but also accumulate on the tax-free earnings as well. (“Earnings on Earnings”). Thus compounding combines earning power on principal and earning power on interest. Compounding has been called the “8th wonder of the world”, a “miracle”. Compounding money at high rates of tax-free return is a definite advantage of real estate, especially with a great tax plan.
The wealthy know that taxes are a primary factor in determining whether you get rich or stay poor. Let’s say, for example, you’re able to save just $2,000 annually on your tax bill. (With a good tax plan it will be much higher). You invest the $2,000 annually in an IRA which earns a tax-free annual return of 10%. After 20 years, you’ll have over $114,000! If you can save $10,000 annually on your tax bill and invest it in a Simple IRA for 20 years, you’ll end up with almost $573,000!
$5,000 in tax savings (which is found money) as a 10% down payment can allow you to buy an additional $50,000 in real estate! Assuming a 20% yearly return you would earn $10,000 which in 5 years would accumulate t to $50,000!
You can use the tax savings to upgrade your rental properties for more monthly cash flow. One of my students, Richard, used $2,000 of tax savings (like found money) to employ the Mr. Landlord technique of adding optional upgrades to his facilities and increased his cash flow by $200 a month or a yearly total of $2400 which divided by $2000 = 120% return! But because the $2,000 in tax savings is found money, the return is really infinite!!
So does Saving Taxes Makes You Wealthy? – What would you say now?
4. CREATE VALUABLE DEPRECIATION DEDUCTIONS: Substantially Increase Depreciation Deductions Via Componentizing (Cost Segregation Analysis).
Depreciation is your most valuable deduction because it does not require you to expend cash to get the deduction, yet it creates cash flow in your pocket from the deduction’s tax savings. For example, a $20,000 depreciation deduction reduces your ordinary income. In a 30% bracket this will save you $6,000 in taxes. This is like found money because you did not have to spend any additional cash to get the deduction. The $6,000 as a 10% down payment can allow you to buy an additional $60,000 worth of real estate, which, at a 20% yearly return, would be $12,000 more income every year. Plus, like money in the bank, you get the deduction and tax savings every year (for the recovery period of the property). Yet, when you sell, you can have no recapture and thus not have to pay any of these tax savings back by selling the property, tax free, via the powerful 1031 exchange (covered later). You still continue to pocket the tax savings from depreciation. Money makes money; but saving taxes (every year) makes a whole lot more money so you can get wealthier, quicker!
So how can you make this already valuable deduction save you even more? Componentize!
Componentizing (or Cost Segregation Analysis) is something that I have been using for over 25 years to dramatically increase my cash flow (and wealth) via tax savings from much larger depreciation deductions. Many of my students also use it with the same money-saving results.
Reason: With componentizing, you break out components, from the property cost, that allow you to use shorter recovery periods with the result of much larger deductions and savings. An overview of these components and strategies follow:
5-Year personal property — Included in the cost of your property are many items of “hidden” personal property that can be written off over 5 years, using a faster accelerated method, instead of 27-1/2 or 39 years, using a slower straight-line method. Typically, the amount of personal property will be at least 10 to 20% of the cost of a rental property. Some Examples: Kitchen cabinets, shelves, storage, carpeting, appliances, movable wall partitions, including “non-weight” bearing interior walls. One of my students, Ron, installed $80,000 of non-weight bearing movable walls in his commercial property. Result: Because the walls can be moved without adversely affecting the building structure, they are considered personal property and can be depreciated over 5 years (accelerated) instead of 39 years (slower) straight-line. This equates to a $16,000 a year deduction vs. $2,000. Tax savings of over $5,000 for five years! (Plus Ron expanded his rental market with the movable walls giving his tenants more options as to office space). There are many other items of such personal property fully supported by tax law citations.
15-year land improvements to the land — Also included in the cost of your property are many items of land improvements that can be written off over 15 years, using a faster accelerated method, instead of not being depreciated at all if they were part of the land. Some examples are landscaping, paved surfaces, and parking lots.
Land improvements to the building — These are depreciated along with the building (27-1/2 or 39years), instead of not being depreciated at all if they were part of the land. Some examples are outside lighting and utility connections to the building.
A low land value maximizes depreciation deductions — The land portion of the cost of the property is not eligible for depreciation deductions. The less of the property cost allocated toward non-depreciation land, the more toward the other depreciable components, the more non-cash deductions, the more savings. Don’t be talked into using a high land value! You can justify a very low (or no) non-depreciable land value if you know the rules. Keep the following in mind – Allocations toward depreciable land improvements reduce the amount allocated to non-depreciable land. Special valuation factors have also worked to the taxpayer’s advantage in lowering the value of land (such as housing shortages).
Fully deduct the remaining basis of components that are replaced (gut out). For example, in doing a rehab, if you replace existing property components with a remaining componentized cost basis of $30,000, you can claim the entire $30,000 as a full ordinary deduction. In a 30% bracket this puts $9,000 of savings in your pocket, yet you did not have to expend cash for the deduction!
So how much extra did you pay in taxes not using componentizing because your tax advisor did not know about this incredible legal strategy? According to the follow quote from one of my students, probably a lot!
“Al, your component depreciation method saved me almost $20,000 dollars in income taxes. It helped me financially having four girls in College at the same time.” …Angelo D. Guerra, Investor, Broker/Owner, ERA Platinum Realtors, Conshohocken, PA.
By the way, that’s $20,000 a year, which if invested at 10% a year for the next 10 years would accumulate to over $318,000! That’s how much you lose!!
5. GENERATE REPAIR DEDUCTIONS: Employ Strategies To Reclassify Rehab Improvements Into Fully Deductible Repairs.
There are three major tax-saving benefits of classifying expenditures as repairs rather than capital improvements. One of them is immediate tax savings. For example, the owner of a rental property is in a 31% tax bracket and pays $20,000 as a repair is an immediate deduction which is worth $6,200 in tax savings. But if the $20,000 is capital “punishment” it must be written off over 27-1/2 years = an annual deduction of about $720 year = tax savings of only about $200 in the first year. A difference in immediate tax savings of $6,000! These tax savings could be used as an immediate source of down payment monies for other income-producing real estate.
There are over 20 tax saving ideas to convert capital improvements into fully deductible repairs! Let me share some of them with you.
Componentize improvements – Just as a big forest is made of many smaller separate trees, so is an extensive plan of improvements made up of a series of smaller, separate repairs. That is, much work resulting in the “permanent improvement” to a property, in essence, consists of a series of “separate repairs”. Such repairs could be immediately deductible if documented separately. Otherwise they will lose their nature as repairs if they are part of a general plan of improvement or reconditioning. You therefore need to componentize or fractionalize the large expenditures into a larger number of smaller repair categories. Do this with separate invoices for each repair job.
Documents (such as bills & contracts) should be worded as “repairs” – Use such words as: “repairs”, “prevent damage”, “patch”, “temporary”, “incidental”, “minor”, “fix”, “piece meal”, “annual”, “less than a year”, “decorating”, “painting”, “small”, etc. Also, the prefix “re” is effective. For example, “repaint”, “rematch”, “repaper”, “recoat”, “resurface”, “redo”, etc. These have been in the taxpayer’s favor in deciding that expenditures were repairs. Do the above and put more tax-saving dollars in your pocket!
6. Buy Your First Multi-Family Investment Property & Live Rent Free
Use an FHA loan to purchase a multifamily property that generates enough income to allow you to live for free while you occupy the property, and healthy cash flow when you eventually move out.
A Real World Example of a FHA Financed Multifamily Investment
A recent example of executing this strategy is a duplex that an investor client recently purchased in Manayunk, a small section of Philadelphia comprised largely of college students and young professionals. This investor purchased a duplex that had two identical units that each had two bedrooms, one bath and one parking space. I’ve rented several apartments on that street so I knew that a 2-bed apartment with parking rented for $1100/month plus utilities.
The investor paid $250,000, which included a seller’s assist that covered all of his closing costs and his monthly payment for principal; interest and PMI came to about $1,250/month. All in, his monthly total with taxes and insurance came to approximately $1,550/month. The investor was able to rent the first floor apartment for $1,100/month plus utilities and then occupied the top floor apartment with a roommate who pays $550/month plus utilities.
So the investor is currently getting $1,650/month plus utilities in rent and spends only $1,550 per month for principal, interest, taxes and insurance. The additional $100/month surplus goes into a reserve account to cover repairs or future capital improvements and the investor currently has virtually no monthly housing expense!
When this investor inevitably moves out, he will generate $2,300/month plus utilities and will still have the same $1,550 per month payment for principal, interest, PMI, taxes and insurance. His monthly surplus will be $750 per month which will easily cover his operating expenses and still allow for a healthy cash flow.
So to recap, it’s possible to use an FHA loan to purchase your first investment property for very little cash, allowing you to live virtually rent free while you occupy the property, and to make generous cash flows after you move out. This scenario is low risk because as long as the property is 50% occupied the majority of the debt and expenses are covered and the second unit is largely profit. The ROI on an investment like this is can be quite good and there are significant tax deductions that the investor can take advantage of. Hopefully now you can see how using an FHA loan to purchase a multifamily property is a smart way to buy your first investment property with very little money down
7. New Strategies in Leveraging Your Money in Today’s Market.
Buying properties already up and profiting on DAY 1! (And use the banks 4.5% money for your 1st mortgage)
Get your down payment from a 401K (borrow form yourself not others)
Get your down payment from a whole life insurance policy (Put it’s cash value to use instead of earning an embarrassingly low rate of return)
Get your down payment from a commercial line of credit against your other rentals (yes, banks want to lend money now!)
Use cash for a down payment (Did I say cash? Yes, I said cash. When coming out of a recession and prices will go up and rents will go up and interest rates will go up, use cash. Trust me, you will get the best deal using cash
8. AVOID INEPT CPA’S: Fire-Up, or Fire Your Tax Advisor.
One of the biggest reasons why real estate investors (and others) pay too many taxes is bad advice from inept or overly conservative tax advisors. An article in Money Magazine revealed that 50 different tax preparers were given the same family’s financial records. The Result: 50 different answers as to what the family’s taxes should be. And we are talking about significant differences as high as 54%, plus the amount of taxes due varied by thousands of dollars. Most erred in favor of the IRS! Money Magazine also did an article titled, “Whose Side Is Your Tax Preparer On?” In many cases, it’s not your side! Unlike doctors, accountants are not formally categorized into various specialties, such as a “Tax Specialist” or a “Real Estate Tax Specialist.”
Here are some suggested questions of a prospective tax advisor:
How much is 2 + 2? If they say “4”, don’t hire them. However if they say, “What would you like it to be!”…Then this may be the one to hire. That is, you do not want someone who is overly conservative. A conservative tax advisor is like a slow race horse — worthless! On the other hand, you do not want the tax advisor to be reckless, blundering, and imprudent. Remember the overall objective is to both maximize tax savings and minimize IRS problems.
Could you tell me about a recent tax change about real estate that may interest me? This will tell you how sharp and updated the person is about taxes affecting real estate.
Will you help me plan my taxes to ensure the best possible outcome under different scenarios? You do not just want a “bean counter” or “glorified bookkeeper” to simply put numbers on a form. You want someone not only to prepare your return, but also to plan it. Expect to pay more for this. However, the additional investment could save you significantly.
What steps do you take to reduce the chances of my return being audited? This is an excellent test of their knowledge and willingness to be diligent and concerned about your tax situation.
Can you provide references from real estate investor clients as to your quality of service? When you are checking with the reference ask specifically, why they like the tax advisor. For example, Did they come up with tax-saving ideas that others did not think of? Were they very thorough by explaining your tax situation? Did they call you during the year to make tax-reduction suggestions?” Would you recommend them to your mother?” If the reason why they like them is too general or more personal than business, this may not be a good referral source.
You want a tax advisor who can: (1) Assist you in rethinking your tax situation under current laws, especially those affecting real estate, (2) Apprise you of tax-reduction opportunities (old & new), (3) Alert you to IRS “tax traps”, (4) Give you prompt, courteous service and (5) Be ethical. If you believe that your tax advisor basically has what it takes, have a candid discussion with them and see if you can help provide any missing links. If after your discussion, the tax advisor is not open to new ideas, then stop the bleeding and immediately get rid of them!
One thing is for sure, like a bad tenant… having NO tax advisor is a heavenly dream next to having a bad one.
Also, do not limit yourself to just someone “local”. With today’s technology we are closer to each other than ever before, despite being many miles way. Don’t let physical distance get in the way of money-saving advice.
9. DO NOT OVERTAX RENT INCOME: While it is Ordinary Income, Rent Income is Not Subject to Social Security taxes.
That is, rents for the use of property are not subject to self-employment (social security) taxes. IRC 1402 (a)(1). This is so regardless of the number of rentals that are owned.
ALERT: I have seen numerous times – CPA’s erroneously classify rent income for the use of property as self employment (social security) income – causing the investor to pay about another 15% of the income in taxes. Ouch! For seven years this happened to one of my students with their self-storage facilities. When they realized the CPA’s blunder, they could only go back three years to amend the return to recoup the past paid taxes. It was too late for the prior four years of $10,000 in taxes!
NOTE: There are many deductions that can substantially lower rent income and even create a “paper” tax loss; see next.
10. WHEN PURCHASING YOUR NEXT RENTAL PROPERTY ALTER WHO PAYS FOR VARIOUS EXPENSES ON THE HUD-1 TO SAVE YOU TAX DOLLARS!
While it is customary for the seller to pay for all real estate commissions out of the proceeds her or she receives, there is no reason why you can’t alter the sales price so that the net proceeds to the seller is the same ye the buyer can take the expense of paying the commissions and therefore the tax benefit. The result is the same to the seller including the effect on their taxes. Furthermore, you can alter who pays the transfer tax and accomplish the same the same thing, which is the seller gets the same net proceeds and has no negative impact on the capital gains tax or income tax they pay and yet the buyer gets the full tax right off.