Taxes and depreciation question

Tax, SDIRAs & Cost Segregation
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Taxes and depreciation question

Matt Lord
Member since 2019 · 23 posts · 10 votes

I’m a newbie here. Been listening to tons of the BP podcasts and I read a bunch of books. But my mind is somewhat simple. I’m having some trouble understanding a few things.

My wife works full time, I recently walked away from my job as a teacher. I’d like to do do fix and rents full time. We file jointly and my rentals are getting transferred into an entity in January.

Could somebody explain, in relativity simple terms, the MAIN tax benefits of owning rentals.

Is building depreciation and component depreciation different things? Can you claim them both or do you have to select one or the other?

How is rental income taxed? Is it taxed the same as earned income?

If I’m personally and physically doing the rehab work, management and maintenance, and everything else, will I be considered self-employed and be subject to SS, Medicare and all the other joyful taxes?

What’s the basic formula or strategy to drastically reduce or eliminate paying income taxes on my rental income?

Should I consider forming an LLC that would be my "construction business" which would be payed by my rental LLC for doing all of the rehab work. Or should I just do the purchasing, rehabs and management all through a single entity?

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Natalie KolodijBusiness Member
Moderator
Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
6y

In a Nutshell: 

Main benefits of rentals are: Depreciation. You get to deduct something you did not have a cash outflow for. 

So ideally, at the end of the year- you can have $5k in the bank that a rental earned but after your $7k depreciation deduction- you actually have a loss of $2k on taxes. 

If your income is under $150k or if you're a real estate professional- you can utilize those losses to offset your other earned income. (Flip income and your wife's w2 income)

If you are now full time in REI, and do not have another 9-5 job talk to your tax pro, as you can potentially qualify as RE pro. This means that you can utilize rental losses- with no limit- against other income.

Rentals are ordinary passive income. Taxed at your ordinary tax rate (if they have income not a loss) but NOT subject to self employment taxes (15.3%)

Your flips will be ordinary income, but active. Meaning no limits on losses, but all income is subject to that 15.3% tax. 

I would keep RENTALS AND FLIPS SEPARATE. 

They are taxed differently and we can't maximize either if they're combined for an assortment of reasons. 

Also however, I would NOT bill your rentals for work your construction/flip company does. This is just moving income from a category with no 15.3% tax, to one where it DOES have the 15.3% tax - and costing you more. 

I would recommend finding a Tax pro who specializes in REI and reaching out for a consultation. If you look through the forums on BP there are several who have been here long term, and you can read through lots of their responses and see who you think would be a good fit to work with.

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  • Adam Rasmussen
    Accountant · Vancouver, WA · Member since 2019 · 100 posts · 71 votes
    6y

    @Matt Lord

    Definitely some good questions here, Matt.

    The "main" benefit is really dependent on what your goals are. From a tax standpoint, people may think that depreciation is the main benefit while others find that 1031 exchanges are the main benefit. 

    Building depreciation is very slow where component depreciation is more accelerated. 

    Rental income is taxed at your ordinary rates, just like earned income. The benefit of rentals is there are no payroll taxes taken out.

    If you are flipping the house, then yes you will be subject to an additional 15% tax (self-employment tax). But if you are renting the houses, then no you will not be subject to that tax. 

    There really is no magic formula for eliminating taxes as everyone's situation is drastically different than their neighbor. However, through depreciation you could be cash flowing on your properties but showing a loss on your income taxes. 

    I would think a single entity would be best. If you do a construction entity you run the risk of showing self employment income subject to the extra 15% tax. 

    1Reply
  • Natalie KolodijBusiness Member
    Moderator
    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    6y

    In a Nutshell: 

    Main benefits of rentals are: Depreciation. You get to deduct something you did not have a cash outflow for. 

    So ideally, at the end of the year- you can have $5k in the bank that a rental earned but after your $7k depreciation deduction- you actually have a loss of $2k on taxes. 

    If your income is under $150k or if you're a real estate professional- you can utilize those losses to offset your other earned income. (Flip income and your wife's w2 income)

    If you are now full time in REI, and do not have another 9-5 job talk to your tax pro, as you can potentially qualify as RE pro. This means that you can utilize rental losses- with no limit- against other income.

    Rentals are ordinary passive income. Taxed at your ordinary tax rate (if they have income not a loss) but NOT subject to self employment taxes (15.3%)

    Your flips will be ordinary income, but active. Meaning no limits on losses, but all income is subject to that 15.3% tax. 

    I would keep RENTALS AND FLIPS SEPARATE. 

    They are taxed differently and we can't maximize either if they're combined for an assortment of reasons. 

    Also however, I would NOT bill your rentals for work your construction/flip company does. This is just moving income from a category with no 15.3% tax, to one where it DOES have the 15.3% tax - and costing you more. 

    I would recommend finding a Tax pro who specializes in REI and reaching out for a consultation. If you look through the forums on BP there are several who have been here long term, and you can read through lots of their responses and see who you think would be a good fit to work with.

    Podcast Guest on Show Pay Less Tax to the IRS This Year With THESE Real Estate Tax Strategies
    Kolodij Tax & Consulting
    WebsiteView Page
    5Reply
  • Anthony Wick
    Rental Property Investor · Ankeny, IA · Member since 2017 · 2k+ posts · 3k+ votes
    6y

    This is definitely why I hired a CPA when I started investing in real estate. Many complicated scenarios that just reading a book or using Turbo Tax will not explain well.

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  • Ronan DonnellyPro Member
    Investor · New York City, NY · Member since 2012 · 332 posts · 385 votes
    6y

    @Matt Lord, the main benefits are depreciation, long term capital gains, tax free cast out refi's and 1031 exchanges. I leave it to tax professionals to go into the specifics of each but you can learn a lot yourself by searching the forums. Good luck!

    [email protected]
    0Reply
  • Matt Lord
    OP
    Member since 2019 · 23 posts · 10 votes
    6y

    Thanks everyone. I’m planning to meet with my CPA after the holidays and get things set up correctly from day 1.

    One of my main questions I forgot to originally ask is about the rehab costs.

    If I do a substantial rehab on a BRRR property, say 50% (or whatever it costs) of the value of the property I paid cash for, do I add in the improvements to the sales price and count the whole thing as a package/acquisition costs then depreciation the total over the 27.5 years? Or do I count the rehab costs as a line item expense for that particular year?

    What about capital improvements as the years go by? Say a furnace craps out and needs replaced. Is that an individual expense for a fiscal year or does that get depreciated over time?

    Is there a way to depreciate the building AND do a segregation to double dip so to speak? In other words, depreciate the structure over the 27.5 years, but then segregate each individual system of the house and take that in conjunction with the structure? Or is it an either/or scenario?

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  • Natalie KolodijBusiness Member
    Moderator
    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    6y
    Originally posted by @Matt Lord:

    Thanks everyone. I’m planning to meet with my CPA after the holidays and get things set up correctly from day 1.

    One of my main questions I forgot to originally ask is about the rehab costs.

    If I do a substantial rehab on a BRRR property, say 50% (or whatever it costs) of the value of the property I paid cash for, do I add in the improvements to the sales price and count the whole thing as a package/acquisition costs then depreciation the total over the 27.5 years? Or do I count the rehab costs as a line item expense for that particular year?

    What about capital improvements as the years go by? Say a furnace craps out and needs replaced. Is that an individual expense for a fiscal year or does that get depreciated over time?

    Is there a way to depreciate the building AND do a segregation to double dip so to speak? In other words, depreciate the structure over the 27.5 years, but then segregate each individual system of the house and take that in conjunction with the structure? Or is it an either/or scenario?

     You definitely can't double dip. This isn't the salad bar at Sizzler. 

    If your CPA is good they will know which element of your major renovation they can break out onto a shorter timeline. There are a handful of items on a rental outside that can be 15 year assets, and some inside that can be 5 years. Those can then qualify for bonus depreciation which allows for 100% expensing in 1 year. 

    If a major component like a furnace craps out down the link you fall under the tangible prop regs. If it's under $2,500 you can expense it, there's another safe harbor that may allow expensing too, but likely- it will be capitalized. 

    This is one of the most intricate and no "black and white" answer areas of tax- make sure your CPA is up on strategy for REI so that you don't lose out.

    Podcast Guest on Show Pay Less Tax to the IRS This Year With THESE Real Estate Tax Strategies
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    0Reply
  • Matt Lord
    OP
    Member since 2019 · 23 posts · 10 votes
    6y

    @Natalie Kolodij

    Wonderful. Thanks for the information! I’ll see you at the Sizzler!

    1Reply
  • Brian Poppleton
    Accountant · Vista California · Member since 2017 · 30 posts · 7 votes
    6y

    The great tax magic of real estate is depreciation.  

    If you paid all cash for a $100,000 property, you may see a $3,000 depreciation tax deduction each year. Good, but not super magical.  

    Lets say you take $100,000 cash as down payment and buy $500,000 property.  You could then possibly see depreciation deduction each year of $14,000.  A little more magical.  

    Do a cost segregation on your $500,000 property and apply "bonus depreciation"  you could see a tax deduction of $100,000 to $150,000 in the first year.  Then invest the tax savings into another property.  Super magic.  

    If you combine real estate, leverage and taxes  you will find yourself wealthy.   

    1Reply
  • Daniel Chun
    Gilbert, AZ · Member since 2019 · 31 posts · 3 votes
    6y

    @Brian Poppleton what is depreciation and what types of things make up for it.

    Curious how you can end up with a loss

    0Reply
  • Natalie KolodijBusiness Member
    Moderator
    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    6y
    Originally posted by @Daniel Chun:

    @Brian Poppleton what is depreciation and what types of things make up for it.

    Curious how you can end up with a loss

     On assets that have an extended life the IRS says okay this should go down in value and be used for multiple years so you get to deduct a portion of it's value each year

    So for residential real estate that's 27.5

    So you get to take a deduction every year for 1/27.5th of your building's value 

    You didn't write a check for this deduction, no cash out. So you can have cash profit from a rental- but after depreciation have a loss on paper. 

    Podcast Guest on Show Pay Less Tax to the IRS This Year With THESE Real Estate Tax Strategies
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  • Matt Lord
    OP
    Member since 2019 · 23 posts · 10 votes
    6y

    I have a new question to add to this:

    If I take a loan from a friend or family member, may I treat it as a mortgage and deduct the interest?

    I have access to a 7 year loan at 4%. After which I’d have to refi into something longer term. If I use this I’d have enough cash available to purchase about 8 rentals in my target area. It’s a decent amount of $ available. So it’s basically a very cheap hard money loan that’ll get me started building my portfolio quickly.

    I worry that I’ll miss out on some tax benefits without using a normal mortgage. I also have concerns about asset protection and how to structure this. Finally, rates are pretty cheap right now on conventional 30 yr notes. They may go up drastically in 7 years when I need to refinance.

    Thoughts?

    0Reply
  • Natalie KolodijBusiness Member
    Moderator
    Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
    6y
    Originally posted by @Matt Lord:

    I have a new question to add to this:

    If I take a loan from a friend or family member, may I treat it as a mortgage and deduct the interest?

    I have access to a 7 year loan at 4%. After which I’d have to refi into something longer term. If I use this I’d have enough cash available to purchase about 8 rentals in my target area. It’s a decent amount of $ available. So it’s basically a very cheap hard money loan that’ll get me started building my portfolio quickly.

    I worry that I’ll miss out on some tax benefits without using a normal mortgage. I also have concerns about asset protection and how to structure this. Finally, rates are pretty cheap right now on conventional 30 yr notes. They may go up drastically in 7 years when I need to refinance.

    Thoughts?

    Yes still deductible interest. 

    I'd provide your friend with a 1099-int each year for the interest you pay him since they won't likely send you a 1098 since they're not in the business of being loans. 

    Podcast Guest on Show Pay Less Tax to the IRS This Year With THESE Real Estate Tax Strategies
    Kolodij Tax & Consulting
    WebsiteView Page
    1Reply
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