Taxes Taxes Taxes & How to Avoid Them

Dan Austin: [0:02] Welcome to the Collecting Keys Friday Focus. Hey there. Welcome back to another episode of the Collecting Keys Friday Focus. If you're new here, these are the episodes where Mike or I just spent a few minutes taking a deep dive on a specific topic, something that's relevant to the industry or going what's going on out there in the market, or something top of mind for us in our business throughout the week. And today, I will be your host, Dan Austin. And today is about two weeks before the infamous tax day, where all of us real estate investors rejoice because we're so excited to tell everybody that we have broken the tax code and we are efficiently investing our money at the most tax advantage way possible. Or at least we think we do. Honestly, 99% of us think we know what we're talking about when it comes to taxes, but the tax code is so big and robust, you really do need an accountant, a CPA that understands this stuff, which I am not, and I will put that up front. Should definitely talk to a tax advisor before taking anything from this podcast, as I always say. And you hear me quite a bit on on the podcast actually bringing up taxes, because that's something that really, as I've dove into becoming a real estate investor, have talked about.

Dan Austin: [1:09] And so today, I actually wanna talk about that, some of the some of the top things you hear about, and maybe break some myths for you, or explain into detail how you can utilize some of these tax benefits as a real estate investor, as a real estate business owner. And first, we're gonna talk about expenses versus capital and write offs, and this is where I wanna queue up. If anybody watches Schitt's Creek or has watched it in the past, where David has explained to his dad what write offs are.

Speaker 2: [1:34] Is that a new lamp? Yeah. I'm thinking of bringing homeware into the store, so that's a write off. That's a write off? Yeah. Do you even know what a write off is? Yeah. It's when you buy something for your business and the government pays you back for it. Oh, and who pays for it? Nobody. You write it off. Who writes it off? I don't know. The govern the write off people. What why are we having this conversation?

Dan Austin: [2:00] I think it's funny, and it's kind of what most people have the challenge and the misconceptions of understanding taxes. Write offs are one of them. But anyhow, we're talking about write offs, we'll talk about depreciation, ten thirty one exchange deferral, being a real estate business, and some of the advantages of that. And then lastly, I'll just highlight real estate professional, which I know you all have heard me talk about on the podcast, and the great advantages of that, so I'll lightly touch on that again. Anyhow, let's dive into write offs. People say that is a tax advantage, yeah, but it's also an expense, Right? So when you report your taxes from say a single rental property, you're going to have what's called a Schedule E on your ten forty form, which is the form you submit for your federal income taxes. And the schedule e outlines how much money did you make on that property. So your rents, how many rents and fees did you collect associated with your rental property, and say that's $10,000. And then it provides categories for qualified expenses, which are like mortgage interest, insurance, property taxes, utilities, your maintenance, lawn care, all the things that cost you to run that or operate that rental property fit into that expenses bucket.

Dan Austin: [3:10] Right? And so then you have say you have $9,000 in expenses, so you profited, or your gross revenue is 10,000, not profit, 10,000, and you had $9,000 in expenses, you made $1,000 off that rental property, and you're going to get taxed on that $1,000 based on your income tax bracket. Sounds like pretty simple there. Where people get caught up on that piece of it is a capital expenditure versus a actual write off, and a write off is not a tax benefit, technically, I guess it is, but it's money you didn't use saw and you spent anyway, so it wasn't profit to you, right? But with expenses, what I just listed are all expenses, but where they get challenged is like the maintenance versus capital improvements. And so when you hear about Mike and I talking about analyzing a property, we put set asides, which are opex and capex, operating expenses and capital expenditures. Capital expenditures are big things like roofs, furnaces, windows, carpet, all that sort of stuff. So you technically can't write some of those things off as an expense. Now, there's some tax laws that say you can write off anything below $2,500, and those sorts of things, and you should dive into those, and talk to your CPA about what that means. There's also depreciation rules for everything, and we will talk about depreciation next.

Dan Austin: [4:27] And the pre capital expenditures get depreciated, where operating expenses are like maintenance and utilities and stuff, those get expensed in that year. So that was at $9,000 in expenses, got expensed totally. Now if you had a new roof that cost you $9,000, now that's going to get capitalized, that's going to add to the asset value. And that comes in to play right here, where I wanna talk about depreciation, which is a huge tax benefit to real estate. Depreciation is essentially the government giving you a write off every year for your property depreciating. It kinda needs it gets wear and tear, it falls apart a little bit every year, it ends up being like 3.8% or something like that. I I can't remember exactly what it is. But essentially, if you go and buy a house, say it was a $100,000, then the government says a $100,000 minus the land value. So the purchase price minus the land value, actually gives you the structure value. You divide that by twenty seven point five years, which I said, like I said, it's like 3.8% or whatever per year, and that's what you get to write off as an expense every year for your income. So hypothetically, in our example, where you collected $10,000 in rents, you had $9,000 in expenses, so you profited $1,000. Well, say your depreciation is exactly $1,000, boom. Now, you pocketed, you actually put $1,000 in your pocket, but the government's saying you don't have to pay taxes on that, because depreciation is an expense. Awesome. One of the best benefits about real estate, I love it, it's it's fantastic.

Dan Austin: [6:00] But when it comes to those capital items that I was telling you about earlier, some of them have to get added to that basis of the property. So if you do install a new furnace, and it costs you $10,000, you don't generally expense that in a year, that gets depreciated over a specific time, which I think, but don't don't quote me, it's like twenty seven point five years. There's some intricacies like carpet is five years, but if it's glued down, it's twenty seven point five years. And so there's some differences, and I don't understand exactly all of them to explain to you, but just know that when you're doing big large projects, those actually get added to the basis of the property, and get depreciated at a different rate, depending on what it is. It's not always twenty seven and a half years. So, you hear about something called cost segregation, typically on larger multi families, but you can They are low cost solutions now on like single family residentials, if you own a portfolio, it becomes a little bit more valuable, like say you have 10 properties to do this on. And that's essentially a cost segregation service or engineer you pay, comes in, they look at all the different items in your home, from the outlets, to the carpet, to the windows, to the roof, to the furnace, and they apply a value to that, and a depreciation schedule. So you're gonna instead of just flat depreciating the whole property at 27.5, like right when you buy it, they're going to have a bucket of a five year depreciation. So maybe you have, you know, $25,000 of five year depreciation, so you take 25 divided by five, and now you get $5,000 every year for the next five years in depreciation, as opposed to having to divide that whole bucket by 27.5. Right?

Dan Austin: [7:31] So it allows you to accelerate a ton of the depreciation, and so now, instead of getting a thousand dollar write off, maybe you got a $5,000 write off, and showing you as a $4,000 loss, our our fictitious example of 10,000 in revenue, 9,000 expenses, which leaves you with $1,000 profit. Boom, 5,000 in depreciation, now drops that profit to a $4,000 loss. Although you still put that $1,000 in your pocket, keep that in mind. That is a next level technique a lot of people are starting to use and focus on, that become a little bit more seasoned in real estate investing. But just recognize depreciation, as I explained it to you, as a really good benefit to real estate that you get no matter what when you buy properties. So while we're on the topic of depreciation, let's talk about a ten thirty one exchange tax deferral. So when you buy a property, say you buy a property and you own it, and you pay it off, and during that time, you own it for twenty seven point five years, the house is paid off, and all of it's depreciated. You can no longer depreciate it, because you've now depreciated the entire value of that $100,000 home. There's something called depreciation recapture. Meaning, if you sold that house for a $100,000, you would have to pay long term capital gains on that entire $100,000, because it's completely depreciated.

Dan Austin: [8:53] And they're basically saying there's no value to it, so when you sell it, anything above that is a profit to you. Well, in order to avoid paying long term capital gains on that, you can do what's called a ten thirty one exchange tax deferral. So, say you sell that property, it's sold, just closed, you now have forty five days to identify up to three different properties that you're going to roll that $100,000 profit into. And and you have to close on one of those within a hundred and eighty days, so you you can pick up to three, but you have to close on one, and you have to, within forty five days, and you have to report that to the government, and then you have to find the or close on the next property a 180,000, or a 180,000, a hundred and eighty days. And that property has to be like for like, so if it's real estate, it needs to go to a real estate property, you can't go and sell it and buy some other asset, like a tractor for a farm or something like that. And it must be of equal or higher value. Those are the rules. The great thing about this is, now you just avoided paying capital gains on any profit above selling that property. So say, in this example, you bought the house for 100,000, you sold it for 200,000, and you had depreciated it all the way to zero, so now you're gonna pay long term capital gains on 200,000. This avoids capital gains on the entire thing.

Dan Austin: [10:12] And then the cool thing about this is is you just keep ten thirty one ing as you please, and then if you don't actually ever pay taxes on that, you always just keep rolling it into another ten thirty one when you die. Your heirs or your children, they get that property tax free. They do not have to pay any of the taxes, which could be a massive tax bill over, say, a thirty, forty year career of investing. They it automatically steps up to the current value. So say, you started out at a 100,000 and now you've got a $2,000,000 property, they don't have to pay any taxes on that recapture of any of those, the depreciation or ten thirty one exchanges or anything like that. So that's the huge, really cool benefit, you just completely defer taxes for an entire generation. Okay. So we've talked about write offs, the expenses, versus capital, we've talked about depreciation, we've talked about how to avoid paying taxes on that depreciation recapture via the ten thirty one exchange tax deferral. Now quickly, I wanna talk about if you're a business owner in real estate, it could be any business, but a lot of our listeners are running wholesale businesses, or flipping businesses, or off market real estate businesses. One of the great thing about being a small business owner, is that you can actually avoid paying a lot of the income tax, or sorry, rather, payroll tax that you would normally have to pay as a company, right, that you would pay for an employee.

Dan Austin: [11:30] So for you, if you want to be avoid paying as much employment tax as possible, because you do have to pay self employment tax, even if you're the boss, and you're the owner of the company, you have to pay that. You can identify as a s corp, and within that, you can designate a reasonable salary to yourself, whatever that is, a reasonable salary to yourself, and you're gonna end up paying about 15% of payroll tax on that, and that's what typically your employer pays part of that, and you as an employee, it comes out of your paycheck typically, so that roughly is about 15%, and then you have to pay income tax on the rest of that. So when we talk about that, we're talking about unemployment, Medicare, Social Security, all that sort of stuff that comes out, that's about 15% of your paycheck. So you designate a reasonable salary, and then as the owner, you can take owner draws throughout the year, above and beyond that, as long as it's reasonable, and that avoids that 15% payroll tax, and you just pay regular income tax on it. So that's a quick way to save 15% on your income. So that's just a side note benefit. When you're running a business, like I said, wholesaling, flipping, or anything like that, you should look into that, making sure that you're being the most efficient you can with your income tax. And then lastly, the last point I wanna talk about was the real estate professional, and that's when you are actively working in real estate, and are considered a real estate professional, which means you actually do real estate work, which is work that the IRS tells you is considered real estate work, and you work at least 750 a year in that profession, and it's your main profession, meaning if you have a w two job, you'd probably Like a full time w two job working two thousand eighty hours a week, you would need to prove that you're working two thousand eighty one hours a year, rather, in real estate, and you'd have to track all that to prove that out, but what that allows you to do, is take those passive losses, and apply them to your active income. So for example, if you're pulling a w two off of your real estate business, and you're depreciating your portfolio, like in our earlier example, where we actually had more depreciation than we did profit, you can now take that additional, and our example was $4,000 in losses, and you can apply that to your w two income.

Dan Austin: [13:41] So say, maybe you gave yourself a $100,000 of your w two income, well, now that w two is, instead of 100,000, the government only taxed you on 96. And you can see how this scales to the point where many, many real estate investors actually don't pay any income tax, because they are able to write off through depreciation and real estate professional status, all of their active income, as well as all their passive income. So I've blabbed on for a little bit longer than I usually do, but there's just a lot of detail with these taxes and the nuances, And again, we're coming up on tax day, and so if some of this is new to you and you own rental property, or you run a business in real estate, and you're like, oh my gosh, I did not know this existed, definitely talk to your CPA, and make sure you're getting the best bang for your buck on all these sorts of things. I've had people tell me like, well, I just delayed my depreciation. Sorry, you can't do that. I figured that out the hard way, and so making sure that you're getting your depreciation put on your 10:40 and through your schedule, you know, all that sort of stuff is important. Talk to your CPA, check anything I said, fact check anything I said. I don't know how accurate it is, I'm not gonna claim anything, but I do know these are things that I have looked into research and talked to my CPA about, so you should definitely take a look at them. If you haven't started investing and these this tax benefit discussion did not motivate you, I don't know what will motivate you, but literally, you can get to a point in real estate, and it's not that hard where you're not paying any taxes, which, you know what, another wrong with paying taxes, we need people to pay taxes, but if there's loopholes, and there's ways for you not to, that means the IRS and the government is actually incentivizing you to go to those loopholes, because that takes out a huge chunk of money you would otherwise have to pay the government. Right?

Dan Austin: [15:19] So say maybe it's $30. Maybe you were in your old w two job, you're paying $30. Well, you go into real estate, and the way if you can use these tax benefits, and you can write off all that $30 from your taxes, you're not having to have it, not literally write off, but you're not having to have to pay that 30,000, you can leave your w two job and make $30,000 less if you want, or you can make $30,000 more, however you wanna look at it in that mentality. It's that's a huge chunk of money, and it goes up in scales to millions of dollars for a lot of people that are really big time in real estate. So that's all. If you liked this, or you wanna know more details about it, hit me up on Instagram, investor man dan. I'm not the tax expert, but I definitely can point you in the right direction, and at least explain to you some of the things that we've been able to leverage. If you wanna know what know how to do what Mike and I do, you wanna get into the off market real estate game, go to Instant Investor, I always screw that up, go to collectthekeyspodcast.com, and click the Instant Investor button, the little blue button at the top, and you can see the tiers of the instant investor program we have. If you really like what we're putting out here, please give us a five star review. Send me a picture in the DMs of the five star review, and I will send you a Collective Keys podcast shirt and or a BDE shirt if you so choose.

Dan Austin: [16:33] Just let me know. Thanks for listening. Catch y'all next week. Thanks for listening to this collecting keys Friday focus. Be sure to subscribe wherever you listen to your podcasts.