what is your tax strategy during buy-and-hold growth phase?

Question

As the subject questions; what is the most effective tax strategy during the buy and hold growth phase? While working to grow and add additional properties, would it be a good idea not to report any expenses to your CPA, versus reporting all/as many expenses as possible in order to reduce your tax burden? All of the topics I've researched here cover how to reduce the amount of tax you pay in regards to your RE business, but that can hinder ones ability to obtain financing. Of course lenders want to review two years' returns, and the more profit showing on your returns the better when calculating DTI.

I am working to find the proper balance in order to continue growing my portfolio.

I am working to find the proper balance in order to continue growing my portfolio.

Brandon Hall · Answer

@Albert Bui All good points. The point I was trying to make is that for an incompetent lender, EBITDA will be a better explanation of your investment decisions prior to any tax strategies you employ.

Also, to your point about depreciation recapture - you can always report accumulated depreciation once you dispose of a property. You file Form 3115 (application for change in accounting method) to claim the depreciation, then report the adjustment of accumulated depreciation on Schedule E as an "Other Expense." So you would still get the benefit of depreciation.

*I should note, that's obviously not ideal.

Albert Bui · Answer

@Steve Vaughan  That is correct as I've run through that scenario with multiple tax advisors as well and its better to depreciate based on your claimed terms then to have the IRS back track and use their Land/Improvement value allocation to calculate your recapture on what you should have paid since they are probably going to calculate it to their favor rather than yours.

A lot of accountants will use county tax records to allocate value to land or the actual improvement/building so determining this upfront can be of huge importance since residential is depreciated over 27.5 years or about 3.63% of Improvement value per year (1/27.5 = 3.63%).

Sometimes using an actual appraisal may be better or worst. The third option is to ask your insurance broker to check the marshal and swift database for the cost of replacement of your building so you can use that value and between the 3 options you and your tax advisor can determine which is most beneficial for your particular scenario.

It would suck to be responsible for deprec. recap. if you never took any benefit =(. Last I heard federal taxes are only amendable up to 3 years behind but imagine if you loss 10 years of depreciation benefit but were responsible for the recapture.

Albert Bui · Answer

@Amanda Han I attribute a lot of my tax strategy info from my past work with Amanda if you guys have specific questions amanda is a great resource on real estate investing taxation.

I mainly help balance between the tax side of things and the banker side of things focusing on the bigger picture of the finances.

Steve Vaughan · Answer

@Brandon Hall  Great tip on Form 3115 to claim depreciation after the fact.  Now if I can only figure out where to store that info where I can remember where to retrieve it in 20 years or so...    Thanks!

Albert Bui · Answer

@Brandon Hall  that's pretty advanced Brandon and definitely a loop whole to include all prior losses via change of accounting method. I've seen it being utilized before but that is some high level stuff!

Steve Vaughan · Answer

@Albert Bui  Wow, I didn't know there were so many ways to calculate the value of the depreciable improvements.  I just took my purchase price minus what the county assessor had for land value and divided by 27.5.  The insurance replacement cost is much higher than FMV on most of my policies and that doesn't include the land.  When market prices rise up to equal insurance replacement cost, that's my trigger to sell sell sell!

Steve Vaughan · Answer

I didn't need losses, so I went without depreciating my real property for a long time.  Then I realized  you will recapture all allowed or allowable depreciation at the time of sale anyway.   I depreciate now.  I used to think it made my income look low on my tax returns, too, but my lender said she is smart enough to add back the depreciation to calculate my actual income!  Good discussion.

Albert Bui · Answer

@Brandon Hall

From an accounting perspective yes that would be the "operations view," but from a lending and banking point of view the cash flow statement is the most important aside from the profit and loss statement since the earnings could be stored in current assets or accounts receivables and the turn time on converting that AR/asset into "cash," may be many days out.

I guess if you're doing your P&L on a cash basis and this is only rental real estate then that could be used, however there are other deductions we add back that aren't typical that affect qualifying income such as .23 cents per business mileage (IRS rate for depreciation for bus. miles) claimed on line 44A of schedule C, home office use, we give the borrower back half of the SE tax since a normal wage earner would only have to pay half we try to put the SE borrower on the same playing field and more.

Elizabeth Colegrove · Answer

Personally I do everything I can to keep expenses low as that helps me on my 1) tax returns 2) cash flow for buying future rentals. At the same time if I have an expense I report it. I don't not report it because I am trying to grow. My goal is for all my properties to wash out on my taxes. We can support new growth with our w2's as long as old growth is support themself. Also due to new laws many of the repairs are depreciated over years because they are now considered improvements. So a single expense is not as damaging as you may believe.

Again always speak to a tax provider!

Brandon Hall · Answer

Throw in "EBITDA" on your financial statements, then show them to loan officers. EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) will show the result of your business's operations. Then you apply your tax strategies to arrive at a Net Income/Loss.

Regardless, you absolutely need to report your expenses, especially on big ticket items that need to be capitalized and depreciated, as that is the law.

what is your tax strategy during buy-and-hold growth phase?

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