It’s the time of the year when we talk about our tax situation, significantly if we passively invest in real estate. In this episode, let’s listen to Lisa Hylton with her guest, Amanda Han, a tax strategist and real estate investor. Amanda discusses the tax impact of investing passively in real estate. She explains some strategies to help us deal with our taxes through investing passively and what we should look out for. Join them as they deliver excellent help in our tax situation today!
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Amanda Han On Investing Passively In Real Estate And Its Impact On Our Tax
I have on the show Amanda Han. She is both a tax strategist and a real estate investor. She helps investors with strategies designed to supercharge their wealth-building using entity structuring, self-directed investing and income offset opportunities to keep more of what they make. She is also the author of the highly-rated book-tax strategies for the savvy real estate investor on Amazon and has been featured in prominent publications from money magazine, talks at Google, CNBC, and Smart Money Talk Radio, as well as BiggerPockets podcast. Amanda, welcome to the show.
Thank you so much for having me. I’m excited to be here and chat with you.
This episode is about taxes as we stand in the middle of 2022. One of the times that people should start thinking about their tax situation as they approach the last six months of the year is because if they plan to do anything, it’s going to take some time to get those wheels moving. Hopefully, this episode delivers a lot of good help and strategy for people who are in that situation.
Most of the time, people don’t think about taxes until January. January through April is when taxes are on people’s minds. The middle of the year is the best time to be planning because if you’re going to implement any strategies, it’s going to be now. It’s not going to be after the year’s over.
Jumping right in because a lot of people who read the show invest passively in real estate syndications. I wanted to start with the tax impact of passive investing. Can you talk a bit about the income coming from those investments during the whole period, when those investments sell at the end, and some of the tax implications they can run into?
In addition to being a real estate investor and having my own single-family and small multi-families that we have, I myself am also a passive investor as well. I invest passively in other people’s deals. We also have a lot of clients who either invest passively in other people’s deals, or we have clients who are on the syndication side as well, those people who are sponsoring those deals. One of the things I love about being a passive investor from the tax perspective is that a lot of the strategies that you hear people talk about with respect to the benefits of owning real estate, specifically writing off deductions against the rental income, being able to take depreciation where we can write off the purchase price of the building over several years and all those strategies on how to use accelerated depreciation and all that.
Those are all available to passive investors like they’re available to someone who had their own single-family, small duplex or condo. When you’re investing passively through syndication, what’s awesome is that you don’t have to do the work. You’re not the one who has to hire a CPA to do all that analysis. You don’t have to hire a cost segregation company to accelerate the depreciation. All of that stuff is done at the syndication level for you. The syndicators are the ones who are doing all that work, dealing with maybe some of the headaches of getting that done.
What happens early in the year, hopefully, you can get a K-1 from that passive investment. That K-1 oftentimes will show a good amount of tax loss. Effectively what that means for investors is that if you’re investing correctly, you’re getting good cash flow and appreciation, but on the tax side, you’re not having to pay taxes on the income generated currently because of depreciation and other write-offs.
This jumps nicely into depreciation. Can you start a little bit about the big topic of 2022, which is bonus depreciation and the fact that I believe it ends at the end of 2022?
Depreciation means that the government allows us to take a write-off for a portion of the building over time. Their understanding is that you have this building. It’s got a lot of components within it, and as time goes on, there’s going to be erosion deterioration. If you have a $100,000 building, we’re writing it off slowly over the next 27.5 years if it’s residential. One of the strategies surrounding depreciation is that you can have accelerated depreciation. Typically, it works by having a cost segregation firm look at an analysis of the building. Instead of saying, “Here is a $100,000 building that I bought. It’s made up of a lot of components.” Maybe $20,000 in flooring, $30,000 in appliances or specialty plumbing.
Once they break out those different components, then your CPA can calculate faster depreciation. Instead of waiting 27.5 years, you might be able to write something off over 5, 7 or 15 years. Traditionally, these are the strategies that investors use when we talk about maximizing or accelerating our deductions. What’s great about 2022 is we have what’s also considered bonus depreciation. Bonus depreciation, as an example, means that, let’s say, I had this property I purchased and I did cost segregation.
They said, “There’s about $30,000 worth of appliances and equipment, furniture or dishwasher, microwave bag,” all the other stuff that’s coming in with the property. If there’s a $30,000 worth of those, normally, you write those off over five years, but with bonus appreciation in 2022, that means you can write off 100% of that immediately in 2022. We have depreciation and then we accelerate that with cost segregation. The next step is now we also can take a bonus as well. We’re supercharging that benefit significantly.
There is a little bit of a change coming up that you are referencing. We can do 100% bonus depreciation, which means we write off 100% of that five-year asset, in my example, immediately. The tax law is scheduled to start reducing that. If you put an asset in place in 2023, you still get bonus depreciation, but it starts to trend down to 80%. Instead of having 100% immediate write-off, like we do in 2022, in 2023, it’s 80% immediate, then the remaining 20%, you’re depreciating it over whatever the life of the asset is, 5, 7 or 15 years.
We do have a lot of clients and investors who are aggressively looking for real estate or syndications. For your real estate, you want to make sure it’s placed in service in 2022 to get that 100%. If you buy something in 2022, but you’re still rehabbing it or, for some reason or not, it’s not placed in service until 2023, then it will go under 2023’s law, even though it was acquired in 2022. The key thing is to buy it and also place it into service.
Someone reading is thinking, “How does this relate to me?” They might be a W-2 employee and they aren’t real estate professionals which you can get into what a real estate professional is. They’re curious, “Does this bonus depreciation, this depreciation, any of this depreciation impact my investment in any material way?”
That’s an interesting question and one that we hear a lot about. I hear that from a lot of CPAs as well. As the most common thing that I hear is, “You’re just a passive investor, so you don’t get any tax savings at all.” People will say, “If I’m passive, then I shouldn’t do cost segregation or I can’t write off certain things.” That’s not true at all. It depends on how you’re looking at the situation. If you’re a passive investor, in our scenario, we’re assuming that means you’re not a real estate professional and you’re someone with of higher income. All that means is that any losses you generally cannot offset your W-2 and non-real estate income, but it absolutely can offset your other passive income and passive income from gains, for example, the sale of a rental property.
In the worst-case scenario, let’s say you don’t even have any passive income. You have tax losses only and then you don’t lose on those benefits. It carries forward into a future year. You do get to utilize that to offset future income from passive activities. What we’re talking about here is a timing difference. When you hear some CPAs might tell you, “You get no benefit when you’re a passive investor,” that’s a very limited way of looking at it.
What they’re trying to tell you is you’re not going to see a huge benefit today against your W-2 income, but you absolutely will get a benefit at some point in the future because, as investors, our goal is to get income and generate income and gains. It’s just a matter of the timing of when you’ll get the benefit, but we do have clients.
Let’s say you’re a physician, you have a lot of W-2 income and you nor your spouse can be a real estate professional, then sure, you’re not going to reduce your taxes immediately. What if you also have other passive income? What if you invested in a surgery center, a dialysis center or something that’s kicking off passive income? Your rental losses can offset other passive income or passive income from other businesses you might’ve invested in.
We have the 1031 exchange. They might have a situation where they have invested passively in a deal. The deal is selling and either they don’t want to 1031 into the opportunity that’s available or the operator isn’t doing 1031 at all. Is that a situation where if they’re investing in another syndication that same year, they could generate losses to offset some of the gains from the sale?
We rarely see syndication do a 1031 exchange because most of the time there are hundreds of investors in the fund and some people want to exit, some people want to stay. For simplicity, a lot of syndications choose not to 1031 exchange, in which case then yes, the investor will get a K-1 showing taxable income.
First and foremost, if I’m someone who was a passive investor, not a real estate professional in that profile we described, here’s our opportunity. In previous years, I had all these losses from cost segregation, write-offs and things that my CPA I didn’t get a benefit from, here’s my chance to get that benefit. If I had a $100,000 gain, but I had $80,000 of losses that have been accumulating, now my taxable gain is only $20,000 cause I can use it to offset all of that gain immediately.
If I didn’t have other losses, as this deal has been such a sweetheart deal the whole time, then one of the strategies to reduce that $100,000 gain is to simply take the distributions from the first fund and shop around for additional passive investments to invest in. Ideally, my second investment will kick off some losses for me and I can use that loss to offset the gain from that first asset that has exited.
Can we touch a little bit about depreciation recapture? What is it and how does that work when an asset sells?As investors, our goal is to generate income and gains. Click To Tweet
Depreciation recapture simply refers to the fact that once you have written off a part of the asset, you don’t get to claim that again. Let’s say if I buy a $100,000 property and in the same year if I sold it for $150,000, I’ll just have a $50,000. Let’s take a more practical example, which is if I have a $100,000 property, I’m taking depreciation. Over the years, if I have already depreciated $20,000, then that means my cost basis is $80,000 because I already wrote it off. That’s what they’re talking about. I’m not going to consider that as an expense again. In that scenario, if I sell my property for $180,000, then my gain is going to be $100,000.
$180,000 minus my $80,000 cost basis. $100,000 is my capital gains on that. That’s what it refers to. Sometimes, clients will say, “My CPA told me not to claim depreciation because I’m not getting a benefit. I don’t want to recapture it.” That’s bad advice because depreciation is not a choice. You are required to take depreciation. If someone’s telling you to choose not to take it, you have to be aware.
If you’re audited, the IRS does not say, “You chose not to do with, therefore there is no recapture.” There is still recapture. Do it correctly. Take depreciation because it is a benefit, but even if it doesn’t benefit you immediately, it will benefit you in the future and it is required. Do that, so you don’t put yourself in a bad situation of losing out on a particular benefit.
Can we talk a little bit about state income taxes? When some of these syndications, the property maybe is in Atlanta, for instance, and it’s sold, there might be income taxes at the state level. That might trickle down to the investor. Can you talk a little bit about that? I believe that ties in with composite returns.
In terms of when you are possibly investing in the syndication or this work the same exact way with a single-family home that you own in Georgia is, with the exception of a handful, most states have state income taxes. The way it works is in the first couple of years, when you’re owning a property, if it’s kicking off losses because of the strategies and depreciation, then there’s no income tax that you’re paying for those particular states. It’s a good practice to file tax returns in that state. Whether you do it yourself or composite returns simply mean that the entity is falling the tax on your behalf. In any case, the goal is to file the return, so you can capture those losses in the year when you have losses.
In a couple of years down the road, when the property sells, the expectation is there’s going to be gains. The states want taxes on the part of that gain as well. If you had filed taxes in those states before, oftentimes, you can carry over those losses. The losses from the previous years can help to offset the taxes in the year of the game. Sometimes, investors are a little bit surprised that they have to pay state taxes. Unfortunately, it is one of the roles. It depends on what state you’re operating in. If you’re one of the handful of states that don’t have state taxes, then you don’t have to wait too much.
The other part too that people sometimes forget is that you might also have to pay state taxes in your home state. For example, if you live in California, you invested in the property in Georgia, you might have to pay state taxes to Georgia, but also California wants a piece of that because you are a resident of California. Things to be aware of, there are a lot of credits that the states give so that you’re not paying double or triple the tax, but nonetheless, it is something that you want to be on the lookout for.
That’s a reason why it’s important when you’re working with a CPA to file your tax returns. You want to work with someone who is well-versed in multi-state because if you’re like most investors, we’re not just investing in our home state. You’re investing out of state, especially if you’re part of syndication investments. Most of the time, the syndications aren’t going to be out outside of your home state.
I also think that there isn’t one specific practice with syndications when it comes to executing composite returns because you said the composite returns are where this indication entity files the return in that state and essentially pays the taxes. They’ll do that by taking money out of the distribution that would’ve gone to the investor to then pay the taxes. This is typically happening when the investment is sold. If they don’t file that composite return, the investors will need to file a return in that particular state.
Even if a composite return is filed, sometimes we find it is beneficial for the investor to file a return because you never know, the investor might be able to get a refund. Maybe there are other things going on from the investor’s perspective and then we get a refund to get some of that withholdings back. The practice differs from syndication to syndication. Lisa might decide to do composite and another syndication might decide they don’t want to. It also differs across states too. Not all states allow for composite returns. You might have something that’s in a state where it doesn’t have the option of doing composite. In this case, the only decision is to come through a regular K-1 and then the investors will decide with their CPA what they’re going to do.
The key there is the investor talking to their CPA and being on the same page with them in all the different investments and states. Working with someone, a CPA that is knowledgeable in all these different states as well. That way, they can help guide them along the way.
One of the things that you and I were chatting about a little bit beforehand was the fact that there have been losses outside of the real estate, in the crypto space, and in stocks. This is a very interesting dynamic because we are seeing a lot of money being made in real estate, whether it’s selling your own single-family, duplex, a fourplex or if you’re a passive investor, syndications, exiting deals, apartments being sold, commercial or mobile home parks being sold with lots of gains.
One of the benefits is that, generally speaking, if you have stock losses or crypto losses, harvesting those losses can potentially help reduce some of that gained from the sale of real estate. If you’re someone who’s sitting on or expecting a significant amount of gain, it definitely makes sense to meet with your tax person and try to plan on what are all the different ways, or we talked about reinvesting in other syndications. Now their stocks or crypto losses. Planning way ahead because, by January 2023, it’s going to be a little bit too late to look at how can I reduce my gain from the year before
This moves me right along to the things that passive investors investing in these deals, they will typically get a K-1. When they get that, can you talk a little bit about some of the things that they should be looking at when they receive that?
It’s difficult. I never know what the investors are looking for. First, if you have a CPA doing your tax returns, send a copy of that K-1 to your CPA sooner rather than later. They’ll take a look at it. They’re the first set of eyes to say, “This makes sense. Is it an issue to your name or your LLC’s name? Which one is correct, or is it to your retirement accounts name?” There are all these different options. Sending it to them earlier allows them to look at it, oftentimes that you have the opportunity, if it’s, “This was supposed to be in my LLC name, but it came through my personal name, YOUR CPA will know that, and then be able to help guide you and see if there are ways to fix it.”
If your tax advisors do not see your K-1 for six months later, the syndication return might’ve already been filed. That becomes more costly or impossible for them to make that correction. For me, I’m always looking at reasonableness. Is this the loss or profit that I’m expecting? I know that it is a little bit harder to gauge for investors because you don’t necessarily know what is creating that number. Sometimes we have someone who invested $50,000 and a $70,000 loss. It’s like, “What happened?” Those are the tax strategies being done.
One area that the investor for sure knows and should be tracking is the distribution. Your K-1 one will always show your distribution for the year. That’s pure money. Match that up to your records. Double-check is. The K-1 one says, “I received a distribution of cash of $10,000. Is that what came in?” if it’s not, then earlier rather than later, send a question to the sponsor and hopefully, they will be able to get to the answer for you.
One quick question on that. Is it best practice? Do you find some syndications that might have closed in June or early fall, and they send their first distribution check? Maybe January, they include that distribution as a part of the 2021 period. You bought the asset in 2021, and then you get the K-1. They didn’t send out that distribution until January of 2022. Do you find that it’s incorrect to essentially accelerate the depreciation on the distribution on the K-1 by showing it as a part of 2021?
I don’t see that as a standard practice. Typically, the K-1 will match when the money has been given out. There are always anomalies and differences in what might cause something like that. I’ll give you an example. We had a syndication client who exited a deal in 2021, but the entity still had some wrap-up stuff in terms of trying to payout small utility vendors here and there. They gave out most of the distributions, but there was a little bit left because they don’t have an exact number of the windup expenses.
That might be a situation where, if the syndication is decided, “We’re pretty much done to have some small things here and there. We want 2021 to be the final year, so the next year investor doesn’t have to wait another year for a K-1 that’s final with $10 or $20 here and there.” Those are examples where could you might see someone that already included that on a year before it was closed to wind it up and make things simpler. I have seen that, but it’s not the norm for regular operational stuff to report something beforehand.
Leading to my final question here. Are retirement accounts to invest in real estate? Passive investors who choose to use their retirement account vehicles, everything from solo 401(k)s to self-directed IRAs, to invest in syndications, are there tax implications for doing so?
A retirement account is a great source of funding for real estate because, most of the time, people have stuck in the stock market. If you’re one of those people, then you didn’t have a good last couple of weeks, but if you had other real estates, then maybe you’re very happy. Retirement accounts are set up in an ideal way to invest passively in real estate. Why? Because as a passive investor. You can’t do much.
One of the requirements of self-directed investing and retirement accounts is that you cannot provide sweat equity. The design of the vehicle and the product makes sense. A couple of things to watch out for with respect to self-directed retirement accounts, if you’re investing in an asset that does not have debt, then that’s great. There are no issues at all.
In the real world, most real estate deals do have debt. Debt meaning, “I have $100,000 I’m investing in this indication. Syndication takes $100,000 as a down payment and goes on borrowed money to buy this $300,000 apartment building.” The majority of the time, these are how the deals are structured. In the initial years of investing in something like this, it’s typically okay because we have depreciation and expenses to offset the taxable income. One of the things is that although the IRS allows you to use a self-directed IRA to invest in leveraged real estate, only the IRA money is growing tax-deferred or tax-free. That means to the extent that leverage is helping you to generate money in your retirement account that is potentially subject to tax, and that is considered unrelated debt financing tax.Depreciation is not a choice. You are required to take depreciation. Do it correctly so you don't put yourself in a bad situation of losing out on a particular benefit. Click To Tweet
It is assessed on the retirement account, not on you as an individual, only in the retirement account. That is at the trust tax rates. It’s pretty high at the maximum level. It’s about 37%. It’s only on the leverage part. As an example, if I had a taxable rental income of $100 and this deal is 50% leverage, that means $50 of my taxable income might be subject to this tax. Going back in the first couple of years of investing, this type of structure is probably not an issue because typically, we’re expecting losses. If you have a K-1 loss, 50% of the leverage on the loss is still going to be zero. Nobody cares. This starts to become a more noticeable issue as you hold the deal longer.
We’re utilizing a lot of appreciation. Now we have taxable K-1s, or more frequently, upon the sale of real estate. When we sell a property, we have a huge game. Part of that game as it relates to leverage might be something that we have to worry about in terms of UDFI taxes. This is on self-directed IRAs, Roth IRAs, SEP IRAs, SIMPLE IRAs, and anything that ends with an IRA effectively.
We have to worry about these types of taxes. The good news is that if you’re eligible for a self-directed 401(k) or a solo K, individual K, you can avoid all these issues regardless of the leverage. I can invest in apartments indication. That’s 90% leveraged. All of the money grows tax-deferred or tax-free, and the retirement account doesn’t have to worry about this UDFI tax at all.
To be eligible for those, you need to be a business owner and can’t have any employees.
It depends on what you define as a business owner. What we tell people is, “You have to have earned income outside of your regular job.” If you’re working for Toyota, that’s okay. You have to have some earned income on which you pay self-employment or payroll taxes on. You could be a property manager. If you’re getting management fee income, you’re eligible. If you’re a realtor, you make commissions.
If you are a CPA and you’re doing consulting where you’re getting paid as 1099, if you’re a salesperson, if you’re selling stuff on Amazon, then you’re getting that type of income. You are eligible for Solo K. In terms of employees for a Solo 401(k), which is the small business owners, 401(k), the only full-time employees would be you and/or a spouse. You can have other employees and they would need to be part-time employees.
This was so much helpful information. Before I let you go, can you also talk a little bit about the real estate professional status? What is it, and its connection to short-term rentals because I know so many people fought on the short-term rental space?
It’s funny because I feel like all of the various topics that we talked about individually could probably be a long-hour discussion, self-directed and passive real estate professional by itself and short-term rental by itself. Big picture-wise, if we talked earlier about if you’re someone who invests in long-term rentals or syndications, which own apartments and stuff usually long-term.
If you’re a higher income, typically that’s defined as over $150,000 in combined income, then your rental losses can only offset your rental or other passive income. It’s not going to offset your W-2 income. The exception to that rule is if you or your spouse’s a real estate professional. If you’re a real estate professional, now you can use rental losses to offset your other income, even though you have a higher income level.
In real estate professionals, there are a couple of different roles. First is that you have to spend more time in real estate than in your job. If you’re working full-time at 2,000 hours, it’s going to be very difficult to have more than 2,000 hours in real estate. If you’re working part-time, let’s say, 1,000 hours, you have to spend more than $1,000 in real estate to meet that first rule.
The second rule is you have to have at least 750 hours in real estate. This will apply to more if you’re someone who is working, but your spouse maybe doesn’t work, or you are that non-working spouse, then you don’t have a job to worry about, you still have to have at least 750 hours. The third rule is that you have to meet material participation with respect to long-term rentals.
There are seven different ways to do it, but the most common way to do it is to spend at least $500 on the long-term rental. There are variations within each of those that take a while for us to explain. If you can meet all three of those, then that means rental losses can off seal, offset W-2, and other non-rental income. These are all for long-term rental properties.
What I love about real estate professionals is that if you are a real estate professional with respect to your own rentals, then you meet that 5500-hour requirement. The losses from the passive syndication investments can be grouped together with your rentals. You can use all of that as one bucket to offset W-2 and other types of income.
We have a lot of clients who will say, “I want to be a real estate professional, but I don’t want to have that be my full-time job. I want to have a lot of passive investments too.” That’s a great way for you to use some of those losses from the passive investments to reduce your overall taxes. Short-term rentals are super popular. We have so many clients investing in short-term rentals.
The tax benefit of it is you get all the things we talked about, depreciation bonus, cost segregation, and all that good stuff. The edge that short-term rentals have over long-term rentals is that you don’t have to be a real estate professional to use the losses, to offset your W-2 and other income. In other words, we don’t care about how many hours you’re spending at your job.
To use short-term rental losses, you simply have to meet the material participation, which is one of the three that we talked about earlier. Someone wants to meet it, but the two most common, the first one is once you’ve spent $500 on your short-term rentals, then you’ve met that requirement. You can use short-term rental losses to offset W-2 and other income. The other one is that you spend at least $100, but no one else spends more time than you.
You can meet that as an alternative and then you can use rental losses from the short terms to offset your W-2 and other income as well. It’s a very powerful strategy for a lot of our plans who maybe have a full-time job, or both spouses have a full-time job but want to reduce taxes. I was working with someone who is two working spouses. I was working on their tax return before our show. They’re getting about under $300,000 of losses to wipe out their W-2 income. It’s very significant. They’re looking at probably over close to $130,000 in actual cash refunds.
That $500 that you mentioned earlier, you just need to qualify for at one time. You don’t need to do $500 each year.
It is a year-by-year distinction. This means that if I’m buying my rental property in 2022 and I meet those requirements, the losses I generate in 2022 can offset my income in 2022. 2023 is a whole new year. The question is, “Do I have losses? Do I have the hours? What’s my other income?” Every year is on its own. During COVID, we had a lot of people who qualified because people stopped working by choice or not by choice and then focused their time on real estate. After COVID, maybe they decided, “I want to go back to work.” It’s a year-by-year distinction. You don’t have to meet it every single year.
This was so good and helpful. Thank you so much. If my readers want to learn more about you to get your services for tax work, etc., where’s the best place they can go to learn more?
The best place for people to find me is on the website, www.KeystoneCpa.com. We didn’t have enough time to go over all these strategies, but I do have a free eBook that you can download. It’s called Tax Strategies For Real Estate. In there, we talk a lot more in-depth about real estate professional status, ways to maximize your deductions like how do you shift income by paying your kids and take a tax write-off or what type of legal entity is best for my real estate? We talk about a lot of those things. We always try to provide tax updates webinars as well. You can check those out and participate in one of those there as well.
Thank you so much. I appreciate it.
Thank you so much. That was fun.
About Amanda Han
As both a tax strategist and real estate investor, Amanda helps investors with strategies designed to supercharge their wealth building using entity structuring, self-directed investing, and income offset opportunities to keep more of what they make.
Amanda has a highly rated book Tax Strategies for the Savvy Real Estate Investor on Amazon and she has been featured in prominent publications including Money Magazine, Talks at Google, CNBC’s Smart Money Talk Radio as well as BiggerPockets podcasts.
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