All Forum Posts by: Brian Schmelzlen

Originally posted by @Dave Toelkes:

According to the little that I have read on this subject, the 20% pass-through deduction only applies if the taxpayer has a taxable net rental income.  

In my case, with multiple rental properties, I usually have an aggregate net passive loss and take the net passive loss allowance on my 1040.  I have not been too concerned with the details of the pass-through deduction, because I assumed I don't qualify for it.

However, this thread has raised a couple of questions for me.  

• Is eligibility for the pass-through deduction determined on a property-by-property basis?  
• If yes, then would I be able to use the pass-through deduction on those properties with net taxable income, even though (in the aggregate) I have a net passive loss on my rental activity?  If the answer to this question is yes, then the pass-though deduction on my taxable income properties would effectively increase my aggregate net passive loss allowance.  

No, you cannot have your cake and eat it too.

My reading is that in general your eligibility for the Section 199A deduction is determined on a property by property basis, although there are some aggregation rules.  You would not be able to pick and choose which properties it applies to.  As part of the calculation, all of your qualifying business income from all properties/businesses (income or loss) are aggregated together to determine your deduction.

Originally posted by @Alex Bacon:

Hello BRers, 

Quick question for ya'll and especially the CPAs. I'm located in Southern California and newly investing in Ohio at the moment. My question is just would you suggest a CPA that knows Ohio and it's REI taxes and laws or should they be more focused on CA tax laws? I've spoke with a CPA located in Ohio but should should they know more about CA tax laws? Just wondering your suggestions and opinions.

Thanks, 

Alex 

I think that is a good question, but in general you would want to focus on the CPAs knowledge of real estate related tax rules at the federal level because even in high tax states like California the federal tax rates dwarf our state rates.  Only once you are comfortable that the person has a solid understanding of the real-estate tax rules at the federal level would I consider their state-specific knowledge.

If looking at their state knowledge, I would start with someone who knows your resident state (CA).  Your resident state will, at a minimum, look at all of your income from all sources, so it is important to go with someone who can help you with that.

Its helpful of course if you can also find someone with experience preparing tax returns for the state you are investing in.  More experience means more likely to catch state-specific issues that other competent CPAs might miss.  However I still say that federal knowledge and resident state knowledge is more important.

Most of us on BP work with clients throughout the country remotely, so you will likely find a number of people who meet these qualifications.  After that, it simply comes down to how comfortable you are with your tax preparer.  This person will come to know your finances very well, so it is important that you are comfortable working with that person.  If you can find someone good locally that you can get to know in person that is ideal, but I wouldn't pass up someone who you meets all of the above requirements and you are more comfortable with just because it means working remotely.

Originally posted by @Eric C.:

Originally posted by @Nicholas Aiola:

Originally posted by @Eric C.:

@David T. Good luck with your search. I've done my fair share of research on CPAs and it's VERY difficult to find one where the pricing could be justified. I'm not sure how anyone can justify a return cost for $1000-$2000 with a W2 + a few rental properties. I would love to have one of "expert REI" CPAs have a look at my return to see if they can add any value. I've already gone through 3 CPAs and found mistakes in all of them. Some more serious than others. I got 2 of them as referrals on BP! I always worry that if I can find a mistake in my return, what other mistakes are there that I'm not aware of.

It’s tough to justify the cost of your CPA if the value is not correctly perceived. A run of the mill tax preparer could prepare the same return for cheaper but it could wind up costing you 5x more in tax liability. The same could be said if you prepare your own returns.

If a real estate savvy CPA saves you $10k in taxes, would you pay $3k for that? Or would you rather pay $500 to the general tax practiotioner who cost you $10k in taxes?

This is a classic FUD statement from CPAs that try to justify their high price for preparation. I would say 90% of people don't fall in a category where these numbers would even be possible. Most people seem to be stuck on the thought that they will get a better "product" by paying more.  Most of the time when someone says my new CPA saved me X, it's usually due to an egregious error from the previous CPA (ie. not taking depreciation).  It's pretty rare that the new CPA has some magic strategy that saves a person thousands of dollars.

My rule is thumb is not to go with the cheapest CPA, but also not to go with the most expensive.  In the end, a return that takes 2-3 hours max (ie. W2 + say 3 rentals with organized documentation + few 1099s) should cost no more than $600 ($200/hr is more than a fair rate).  This assumes that the CPA doesn't spend time "thinking and researching" about how to do certain things.  If I'm paying a professional, I'm assuming they should be able to fill in numbers in a spreadsheet then transfer to Schedule X without much thought.  I've had a CPA tell me they had to spend a few hours figure out how to do a 1031 exchange which boggled my mind.  I specifically asked if they had experience in a 1031 before hiring them.

If you are only paying $600 for a tax return that has brokerage accounts and rental properties, then you are probably going to a tax-preparer who works on volume (a similar model to H&R Block).  You may have your tax return prepared correctly, but it is unlikely that your tax preparer is doing anything to better position you to minimize taxes in the future.

A few examples: 1) When a client sells a business, I know their personal interests and amount of time that they have available and I help them by coming up with multiple strategies to reduce or defer the income taxes on the sale.  Often one of the strategies does involve real estate.  2) With the change in tax law, at the end of 2017 I worked with my clients by looking at their individual situations to determine how best to take advantage of the changes to minimize their tax liability.  3) I have come up with new business/investing structures for my clients to minimize or defer their income taxes while working with their estate plans.

I agree that paying more does not mean that you are getting more quality of work (you should pay attention to the everything your tax preparer does to evaluate that), but if you are paying less it is an indicator that your tax preparer isn't devoting much time to you.

@John Hyre I think that your analysis is in line with what the presumed Congressional intent was, and it is very taxpayer friendly so I hope it ultimately is proven to be correct. My hope is still that the IRS will announce its position on the issue soon, and that it will be a taxpayer friendly position. Even winning in tax court (or through a settlement) is expensive for the taxpayer.

Originally posted by @Bryan Devitt:

Is it possible to over-pay the management company of the properties, which you also own and is a trade business with a schedule C? Hypothetically speaking of course

Technically is it possible? Yes.  In an audit would you get your *** handed to you?  Yes.

I suspect that the IRS will (eventually) have their systems attempt to detect actions like that and flag it for an audit.  That could be giving too much credit to the IRS though.

When you are conducting business with an entity that you control, you have to be sure to have a business (non-tax) reason for the transaction.  If you are doing something purely for the tax benefit, unless it is specifically allowed in the Code the IRS will invalidate it and hit you with penalties.

I really want to know what a stage two bubble is.

I think that in my area (San Diego) the real estate market is getting near the end of the cycle because reports have come out showing slowing sales/price increases.  However, I don't think there a bubble popping like 2008.

My realtor friends are predicting that in my market rents are going to go down (because that is what they are starting to see), but that any decrease in home prices will largely be contained to condos.  The reasoning was that while some bad lending practices may have crept back into the system, by and large most loans are now backed by solid fundamentals and most single family home owners have significant equity.

Originally posted by @Josane Cumandala:

Interesting. Following this thread to further my knowledge and plan my investing strategy. Thanks so much everyone for sharing! 

I can see how this hurts small landlords and turnkey investors. Does this apply for commercial real estate? By that I mean larger apartment buildings with 5+ units that have to get commercial mortgages? Or even things like self-storage, mobile home parks, etc.? Generally commercial buy and hold real estate is much more complex and often involves syndicating with many passive investors fronting the money. 

The same Section 162 standard applies to commercial real estate, but in my opinion it will be easier for commercial real estate to qualify as a trade or business.  It depends on the trade or business though since not all commercial is the same.

Self storage, for example, is pretty clearly a trade or business.

Owning a property that you rent through a triple net lease though seems to pretty clearly be an investment and not a business.

Larger apartment complexes and mobile homes parks would also have a fairly easy time qualifying as a trade or business because of the amount of continuous, systematic activity that is required to keep them operating.

However, the smaller you go the more questionable it becomes.  For a single family home, it is possible that your only activity would be to collect rent (and you might outsource that to a property manager).  Therefore, it looks like an investment and not a business.  However, the more units you have the more likely it is that there is continuous, systematic activity (and that indicates that it is a business).

Originally posted by @Michael Plaks:

As @Brian Schmelzlen and @Natalie Kolodij said - we're basically in the same muddy waters as we were before the Temporary Regs, as far as qualifying as a "trade or business."

We assumed back in December (see earlier threads like this one) that Section 199A would defer to Section 162 for this definition, but we hoped for more clarity. Alas, more clarity was not provided. We're back to Sec. 162 court cases, which offered some flimsy guidance but no certainty.

I disagree with Brian that the number of properties does not matter. Existing Sec. 162 precedents indicate that it does. Having a lot of properties does not automatically makes you a "trade or business," but it helps your case. 

Michael, I agree that Section 162 precedents would allow for aggregation.  However, the language in Section 199A itself seems to disallow that; my interpretation is that it requires each activity to be evaluated independently unless the activities can qualify for aggregation under a new scheme in Section 199A.  You are right that I may have been a bit too pessimistic in my initial reading.

I like the Forbes article that Natalie posted (https://www.forbes.com/sites/anthonynitti/2018/08/...), so are the requirements as listed in the article:

"Aggregation under Section 199A can only be done when the following requirements are met:

• The same person or group of persons, directly or indirectly, own 50% or more of each business to be aggregated. For S corporations, the ownership is measured by reference to the outstanding stock; for partnerships, it is measured by reference to the interest in capital or profits in the partnership. There are obviously attribution rules for these purposes.
• The "control test" is met for the "majority" of the tax year.
• The businesses share the same tax year.
• None of the businesses may be SSTBs [Specified Service Trade or Business].
• The businesses to be aggregated much satisfy two of the following three factors:
  • They must provide products or services that are the same or customarily offered together;
  • They must share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; or
  • The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group."

Whether buy and hold investors meet these requirements will depend upon their own facts and circumstances.  I certainly hope that some of these requirements (especially the factor about sharing significant centralized business elements) are interpreted broadly as that would be helpful.  I would love to be able to aggregate the basis in various properties because some of my clients have held some of their properties for decades.

Originally posted by @Natalie Kolodij:

I just wrote a whole article on this. 

https://www.biggerpockets.com/blogs/10021/76845-th...

@Brain Schmelzel I think you're off base on this. 

So although the new regs offered basically no guidance @Asnish They read that it WOULD be allowed as an exclusion only if rented to a trade/business that qualified for the 199a deduction owed by the SAME controlling power. So basically if you rent a warehouse to your business. 

While the regs offered some guidance with regard to rentals, it only clarified that you can aggregate rental activities to that of an active trade or business. And rental income would qualify only if the property was rented to a a business owned by the same controlling entity which did qualify for the 199A deduction.

In short what this comes down to is something that the IRS has basically refused to issue clear guidance on historically: At what point does real estate activity raise to the level of a trade or business to comply with IRS Code section 162.

There have been tax cases which rule both directions and the Tax courts have repeatedly said that they will review the specific actions of that investor and determine if it's raised to the level of a trade or business.

What does this mean? If someone is a RE Professional will they qualify? It's much more likely- but definitely not a guarantee.

Additionally, someone who isn't a RE pro CAN operate at the level of a trade or business.

Example: Someone owns 5 rentals that they report on their schedule E. They are all managed by a property manager. 4 are out of state. ....He won't qualify for this deduction. Definitely not a trade or business.

Someone owns 5 rentals that are reported on their schedule E. He self manages them. Does all repairs. Interviews and selects tenants himself. Has a written formal business plan. A growth plan. Assesses his profit and business health regularly. Ect. To me...This is a trade or business. If it walks like a ducks, quacks like a duck...its a duck. Or maybe an-undersized goose.

But you get what I'm getting at.

Additionally, the initial draft of the section 199a did NOT include the second limitation calculation. It only related to the 50% of W2 Income. It was later added to incorporate a limit based on asset basis as well. Many tax attorneys are interpreting this to be indicate of the allowance of rental income as well.

Ultimately: It's a gray area. There was no definitive guidance given. However we do know that it applies to trade or business income. Now the name of the game is prove you're a business.

Andddd to end here is a pretty good tax authority who holds my same viewpoint on this:  

https://www.forbes.com/sites/anthonynitti/2018/08/09/irs-provides-guidance-on-20-pass-through-deduction-but-questions-remain/#2e680a272ff8

I read the same article; he presents a lot of the problems.

Here is a key section of what he said under the "What is a Qualified Trade or Business?"

"3. What do the Regulations say? This ain't good. They are sticking it to us. The regulations require that every business be able to separately establish that it rises to the level of a Section 162 trade or business, and that means big problems for landlords. There's not even a carve-out for real estate professionals under Section 469(c)(7), meaning even those who truly ply their trade in the rental real estate world will have to establish that the rentals satisfy the nebulous Section 162 standard.

The regulations provide only one exception, found at Reg. Section 1.199A-1(b)(13), which provides that if a taxpayer rents or leases tangible or intangible property to a commonly controlled trade or business (a self-rental), the self-rental activity is treated as a Section 162 trade or business. A commonly controlled business is defined in the same manner as in the aggregation rules discussed above. The purpose of this rule is to allow the owners of the two activities to aggregate the businesses together under the rules described above, though the taxpayer is not REQUIRED to aggregate them.

4. Takeaway The only solace one can take from the Section 162 trade or business requirement found in the proposed regulations is that the same standard was demanded in the proposed regulations to Section 1411. By the time final regulations were published, however, the IRS had come to its senses and provided the aforementioned safe harbor. Perhaps a similar form of relief will be found in the final Section 199A regulations. But if not, it's time to learn your Section 162 case history, and perhaps prepare your clients for the need to redo leases to strengthen the case that their rental activity is a trade or business."

I think there was widespread agreement that the Congressional intent was to allow rental properties to claim this deduction.  However, as stated in the Forbes article, it was unstated intent.  It is hard to use something unstated as authority; although it will be helpful when eventually litigated in court.  Therefore, we have to rely upon the Regulations which, instead of clearly stating that rentals qualify (as many speculated that they would), makes it clear that the properties have to qualify under the Section 162 definition.

To qualify as a trade or business, you must do it to earn a profit, and you must "work at it regularly, systematically, and continuously".  Buy and hold investors can meet this standard, but given that the each rental must be considered individually (different aggregation rules than under Section 469, and in my opinion it would be difficult for buy and hold investors to meet all of the requirements) it will be a difficult threshold to pass with confidence.

My hope is that, similar to the situation with Section 1411, the IRS does offer a safe harbor for rentals.  However, in my opinion, the Regulations issued yesterday are not good for real estate investors.  I think silence on the issue would have been much better.

Some friends of mine starting looking at properties in New Mexico.  They definitely are not counting on appreciation there, but it cash flows well.