What does effective tax planning look like?

What Does Effective Tax Planning for Real Estate Investors Look Like?

A lot of Investors on BP recognize that they need something more than a trip to H&R Block at the last minute.

1] At the very basic we want to use losses in the current tax year, and we want to postpone or defer capital gains. In TaxSpeak we want any losses to be Non-Passive, and capital gains deferred with an IRC §1031 exchange. (Sometimes we may not defer the gain.)

2] We recognize current losses as either an Active Participant, or as a Qualified Real Estate Professional who is a Material Participant.

3] Those are the basics. Much planning consists of meeting the tests for Material Participant, and grouping multiple properties.

A few definitions and explanations. Active Participant – such Taxpayers can recognize losses from rental real estate up to $25,000 if their Modified Adjusted Gross Income is below $100,000 [Married Filing Joint]. As your MAGI reaches $150,000, that $25,000 gets reduced to zero. But, hey, it makes life simple for those with modest incomes who rent property. Not much planning here.

The real benefits for those with larger losses and larger incomes belong to Qualified Real Estate Professionals. QREP. Think of this as a Badge. A QREP Badge. If you can wear that Badge, then we measure how many hours you materially participate in real estate. So, the sequence is (A) get the Badge, and then (B) measure your involvement.

Both (A) and (B) are fraught with hurdles. This is where planning is needed.

4] A big hurdle for investors is understanding just how real estate income/losses flow through the tax return. Further the Taxpayer should understand in broad terms how the tax return will look in December of the current year. No one wants their CPA to surprise them in April. Get acquainted with “Schedule E”. If you plan, there are no surprises.

5] OK. So, how is this accomplished?

Right after Thanksgiving we prepare a Pro-Forma tax return. We begin with the prior year numbers and update with estimates. For example, that Salary can be projected with the 11/30 paystub. If there are brokerage accounts, we can plug in the 11/30 numbers. And interpolate as best we can.

As for real estate which is currently owned from the prior year, we update rent and expenses. Depreciation will remain the same, unless there are improvements.

In December is the time to educate the Taxpayer about how all this will flow. Perform alternative projections etc. Decide upon making estimated tax payments by Jan 15.

Thus by the time the return is prepared there are few surprises. That is the hallmark of planning. NO SURPRISES!

What does no planning look like? On April 1 the CPA presents a draft of the tax return which shows a balance due. No explanation. No discussion. Taxpayer may volunteer some additional information such as “Didn’t I tell you about X” or “I spent X dollars on such and such” and so forth. No one is happy.

6] During the year, there will be discussions about asset grouping, maintaining records to establish material participation, and so forth. Even getting a Qualified Intermediary to help with a §1031 deferral. Maybe a Delaware Statutory Trust.

And maintaining status as a Qualified Real Estate Professional, perhaps doing something creative. How so? Let’s say a Taxpayer works for a company involved in real estate. But the Taxpayer does not own > 5% of the his Employer. In that case, he is not going to get the Badge. Well, depending upon his relationship with his Employer, perhaps some of his compensation can be paid to him as an Independent Contractor. Now, that counts towards getting the Badge. That’s just an example of effective planning – ahead of the following April. That scratches the surface on planning for that Badge

There are certain traps in getting the badge for married taxpayers, some of whom may or may not work in real estate. Filing Separate or Joint can have a big impact. This is really where CPA’s add value.

7] So, planning is a continuous dialogue between CPA and taxpayer. Some professionals will bill each month for their time, others will let those hours accumulate as part of the final invoice when the return is filed. It depends. Effective planning will cost more, no question. Maybe an additional ten tankfuls of gasoline. That's one way to think about it.

8] Certified Public Accountants, Enrolled Agents, and Attorneys are all licensed professionals. Be cautious when dealing with anyone without a license.

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