All Forum Posts by: Melanie Baldridge

There are several different types of income in the US tax code.

Two main types are “active income” and “passive income".

Active income is money you earn from working, such as wages from a W-2 job or income from running a business.

Passive income is money you earn from investments like real estate, stocks, or rental income from your RE portfolio where you earn $ without actively working.

Normally, you can't use passive losses (like losses from real estate investments) to offset active income like your salary from a W-2 job.

That is unless you are an RE Pro.

The reality is, that Real Estate Pro status is just a filing status similar to filing married or jointly.

And if you are a real estate professional you CAN use passive real estate losses to offset active income from other sources.

To qualify as an RE Pro you must:

1. Spend more than half of your total working hours in an RE business in which you materially participate.

2. You must work at least 750 hours per year in a qualified RE business.

So most people who have high-earning W-2 jobs outside of real estate wouldn't qualify.

But the unique thing about RE pro status is that even if you don’t qualify but your spouse does, you can both file jointly and claim the losses from your RE investments to offset your other active income together.

It's an incredibly powerful hack if you do meet the criteria.

In other words, marry a real estate agent who's an RE Pro!

We’re being funny because there's still a bit of nuance here.

There are strict guidelines and it's sometimes a blurry line between being an RE pro vs not.

Always talk to your CPA to see if you qualify.

That said, the benefits are definitely worth it if you do.

Bonus depreciation is just a special part of the US tax code.

It allows you to take accelerated depreciation on portions of your property depending on when an asset is put into service.

At the time of this writing, you can write off a huge portion (60% in 2024) of many qualified components that have a useful lifespan of 15 years or less.

That means a certain percentage of things like landscaping, sidewalks, latches, appliances, fences, certain flooring, etc is depreciable in year 1.

The bonus depreciation rate percentage changes yearly depending on the administration and the tax code.

For years 2015 through 2017 first-year depreciation for all the items on a 15-year schedule or less was set to 50%.

It was scheduled to go down to 40% in 2018 and 30% in 2019 and then 0% in 2020.

But then Trump got elected, and he enacted the Tax Cuts and Jobs Act.

That moved the bonus depreciation percentage to 100% from 2017 to 2022.

In 2023 it went down to 80% and it’s currently at 60%.

Depending on who gets elected again, 100% may be back on the table.

Only time will tell.

We know that the US government wants to incentivize more development and ownership of RE.

They want Americans to continue to build and maintain our physical world.

That’s why real estate is one of the most tax-advantaged assets in the US.

Depreciation and bonus depreciation for RE are very positive and will likely continue in the years ahead.

The tax benefits of bonus depreciation can lead to massive savings but losses won’t help one bit if you can’t use them.

Before you buy a cost seg, you need to know the rules:

Tax all starts with the types of income.

1. Active = Income earned from Material Participation.

Whether that's SMB, W-2, contract income, or prof real estate.

This is income where ordinary tax is paid and losses offset other income.

Other sources have certain loss limitations.

2. Portfolio = Income derived from financial instruments like dividends (including REITs), interest, royalties, and capital gains.

Mostly income w/out loss potential, and favorable tax rates.

Cap losses may offset cap gains w up to $3,000 loss. Investment interest can be deductible.

3. Passive income which sec 469 defines as:

1. Income from a trade or business where a taxpayer doesn’t materially participate.

2. Rental activity.

Passive losses may only offset passive income, not active or portfolio.

This is a problem for wage-earning real estate investors.

So HOW DO I GET THOSE DEDUCTIONS?

Become a Material Participant.

We are given a clear framework for determining Material Participation (not passive) in Pub 925.

There are 7 scenarios that will get you there.

Material participation scenarios (Pub 925):

1. 500 hours.

2. Substantially all participation.

3. More than 100 hours and 1/2 of your time.

4. Significant participation.

5. You materially participated in the activity for any 5 of the last 10 tax years.

6. Personal service activity w participation in last 3 years.

7. Continuous participation.

This is great if you are talking about an SMB with effectively connected Real Estate.

Note rental activity is considered passive unless you meet the RE Pro threshold of 750 hours and more than 1/2 your time.

This is the conundrum for passive real estate investors.

If you have a full-time job or a large, time-consuming business it can be difficult or impossible to qualify.

A huge loss from depreciation if you have one LP investment isn’t going to do anything for you.

You won’t be able to deduct it.

So what to do?

A few ideas:

1. Acquire enough RE that it takes you or your spouse more than 750 hours a year and 1/2 of your time to manage.

When you are a material participating RE pro all of your and your spouses’ RE activity becomes active, allowing you to offset RE losses against other active income.

One pitfall of a RE Pro spouse if you are full-time W-2.

Mind Excess Business Loss Rules.

You can only offset W-2 income with $610K in 2024.

For single filers, the limit is $305K.

2. Run an Opco/Propco model.

If your business utilizes real estate as part of ongoing operations you can get all the tax benefits of active RE by having the building purchase and hold the RE.

3. Build an SMB on top of your real estate (the reverse of #2)

Short-term rentals and high owner-participation real estate businesses can have great returns.

Obviously not for you if you just want passive RE.

We are in the deep end here, where each case should be judged on its own facts and merits by your CPA.

You should hire a professional to review your particular situation before you make an investment. It is worth it to know where you stand.

Why I like investing in real estate more than 401(k)s.

Both offer tax deferrals, but here's the difference:

If you're making pre-tax contributions to your 401(k), then withdrawals = ordinary income tax.

With real estate gains, you're paying capital gains tax (which is typically lower).

Plus, RE investors get:

1. Cash flow from their properties

2. The ability to do cost segregation and bonus depreciation

3. The ability to use leverage to acquire more attractive assets and amplify their potential gains

4. A physical property that has real-world use and value vs. holding stocks and bonds

5. The ability for 1031 exchanges

6. Access to Opportunity Zones

7. Step up in basis to reduce your heirs' taxes and more

Too many entrepreneurs make good money each year but pay Uncle Sam 35-50% of it.

It takes a long time to build a massive wealth snowball when 1/3 to 1/2 of your snow gets chopped off each year.

Real estate can help with this.

The best model I've seen is:

1. Earn cashflow from entrepreneurship.

2. Buy real estate as a "real estate professional."

3. Book losses through bonus depreciation.

4. End up with all cash and little to no tax.

Your wealth snowball ends up a lot larger 10 years down the road when you make and keep your money in a more tax efficient way.

Did you know that Limited partners or real estate investors can absolutely benefit from depreciation?

RE Pro Status supercharges this.

If you or your spouse are an RE Pro, your LP investments can lead to depreciation offsetting both passive and active income.

If you are not an RE Pro, the losses due to depreciation can only be used to offset passive income—such as income from other rental properties or other passive investments.

Someone I know bought a ranch to use as a short term rental property in 2021 for $1.7 million.

Engineers did a virtual site visit, they were able to assign a value of $347,000 to either 5-7-15 year assets that were eligible for depreciation.

In 2021, the bonus depreciation amount that you could take was 100%.

This means that the owner could immediately deduct the full amount of eligible property in the year it was placed in service, rather than depreciating it over time.

With that in mind, he took the full $347K deduction in his FIRST YEAR of ownership to offset taxable income from rentals.

This was roughly ~20% of his purchase price.

It was a big win for him.

In 2024, the bonus depreciation rate is 60% so the calculation would be different.

That said, you can still save and defer a ton.

Quote from @Sean Graham:

Quote from @Melanie Baldridge:

A question that we get:

"Does the IRS require site visits for cost segregation studies?"

While the IRS does not mandate a physical site visit, the IRS cost segregation audit technique guide (ATG) does suggest conducting “field inspections.”

It’s important to note that the ATG is not an official IRS document.

It serves as a guide and cannot be used, cited, or relied upon as an authoritative source.

However, the recommendations in the ATG are worth considering.

According to the guide:

“A field inspection is recommended to document the physical details of the building, type of construction, materials used for construction, the assets contained in the building, the size and types of building systems, and any land improvements that were included in the purchase of the property and the condition of that property at the time of purchase.”

So while the IRS does not require a site visit for cost segregation studies, following the guidance from the cost segregation audit technique guide can be beneficial.

@Melanie Baldridge good post. When/how does your team decide on doing a physical site visit vs. a virtual site visit? 

We offer physical site visits for properties above $2.5/3M or if it's required by the client.

Around 95% of our studies are done virtually but if you need boots on the ground and it makes sense for your property or portfolio, we'd be happy to help.

Quote from @Janet Behm:

Melanie, 

You are being prolific!

I just started following you,

Janet

 Appreciate it! 

I recommend that you learn the tax code and take ownership over your strategy.

Not having some foundational knowledge and an opinion on how to approach taxes as a business owner is a huge mistake.

In my experience, every single business owner who says "I just let my CPA worry about it and I focus on my business" is doing a suboptimal job at tax planning.

They are likely missing out on 10s or hundreds of thousands in saved dollars every year.

Stop making excuses and get to work.

Just a few months of part-time learning about taxes will pay you for the rest of your career.