LUR 104 | Real Estate Tax

 

Real estate is steadily gaining interest as a potential source of passive income. But what does passive income really mean especially when we talk about its tax impacts? Brandon Hall is the founder and Managing Partner of The Real Estate CPA. He is on a mission to educate as many real estate investors as possible on the tax opportunities available to them. Tune in to get advice on how to navigate through the intricacies and complexities of today’s tax laws.

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Navigating The Tax Impacts Of Investing In Real Estate With Brandon Hall

Welcome back everyone to another episode. Here with me, another amazing guest, Brandon Hall. He’s the Managing Partner of The Real Estate CPA. He leads a team of 25 tax and accounting professionals who service the firms for 700 real estate investor clients. Brandon has gained a significant amount of tax experience over the years and has made it his mission to educate as many real estate investors as possible on tax opportunities available to them. Brandon’s personal real estate portfolio consists of 12 properties, 24 units and he has stakes in real estate syndications across the US. Welcome to the show, Brandon. I’m happy to have you.

Thank you, Lisa. That was a great intro. I appreciate that.

Thank you for providing it. I appreciate that. I’m excited to have you on the show. My show is broken into three parts. We get into a little bit of background, the meat of the episode, and then we close up with the level-up questions. We chatted a little bit before the show started on a couple of things that I want to touch on, which is tax for passive investors in real estate syndications and moving on from there for business owners who are interested in investing in real estate, some of the tax benefits of doing so and how they can manage that. I wanted to finish up with real estate syndicators, who I’ve met along my journey, who are building their businesses and are trying to do it in the most tax-efficient way as well as they build that business. To get things started, can you share with my audience where in the US do you reside?

I am in Raleigh, North Carolina, but our firm is 100% remote. My 25 staff are all over the United States, which is cool. It’s a lot of fun.

What do you and your family like to do for fun?

I have a wife, a son and another little one on the way. On weekends, we like to go on bike rides and hiking. There’s a couple of lakes around Raleigh that we can walk around. We’re big-time bikers, like a cyclist.

Before we get started with everything, can you share with my audience anything on the tax side for real estate that investors, in general, should know about?

LUR 104 | Real Estate Tax

Real Estate Tax: Rental real estate by default is subject to the passive activity rules.

 

There’s a lot. The number one thing in the context of this show, we’re talking about syndicates on the GP side and the LP side. The number one thing to know and understand is that rental real estate by default is subject to the passive activity rules. What that means is every rental activity that you have, large or small, is a passive activity by default, except for short-term rentals.

There’s a carve-out for short-term rentals, which we don’t have to get into. For most rental activities, by default, passive activity. You get around that by default rule if you qualify as a real estate professional and if you materially participate in the activity. If you qualify as a rep and materially participate rep as a real estate professional, then you have a nonpassive activity.

Take it out of the passive bucket. You put it into the nonpassive bucket. Every dollar that you earn is either passive or nonpassive in this context. My W-2 wage, business income, gain on Apple stock are nonpassive. You have either passive income or nonpassive income. Rental real estate because it’s passive, any loss generated by rental real estate is passive. Passive losses can only offset passive income or gain on sale from a passive activity. If I don’t have passive income or a sale of a passive activity that has gain and I have passive losses current year passive losses for my rental real estate portfolio or the syndicates that I’m investing in, then that passive loss is going to be suspended and carry forward.

For the LPs out there, be careful with the sales pitch of the tax benefits because a lot of syndicates like to say, “It’s so great tax benefits. It’s amazing.” In reality, if you can’t use the passive losses that are going to be passed back to you because you’re not a real estate professional, you’re not materially participating. Those are passive. You don’t have your own rental portfolio that you can make special grouping elections and make the entire thing nonpassive.

Those are passive losses being passed back to you by that syndicate. You’re not going to be able to use them unless you have passive income or unless you have gained on sale from another passive activity. Those losses do get suspended. They do get carried forward. You will use them at some point. You’re just not going to be able to use them now.

When we work with clients in any context, all 700 of our clients are real estate investors to some degree. There might be like flipping, developing, running a syndicate or a fund, or just investing in a syndicate, a fund, building their own real estate portfolio or whatever it is. We’re trying to assess whether or not they can qualify as real estate professionals because if you can qualify as a real estate professional and if you materially participate in these rental activities, I can make syndication investments. I can make an election to the group that investment with my rental portfolio where I’m already a real estate professional or materially participating. I group that syndicate investment into that portfolio. Now the entire thing is nonpassive.

If I put $100,000 into syndication, they gave me a $90,000 loss back. It’s a nonpassive loss because I’m already a real estate professional. I have already materially participated in my portfolio. That $90,000 loss can be currently used to offset any of the other income that I have. It’s important to understand the passive activity rules. We talk a lot about this on our podcast. We’ve got all sorts of resources out there for people to learn about the passive activity rules. That is the foundation for tax when it comes to investing in rental real estate.

It’s really important to understand the passive activity rules. That is the foundation for tax when it comes to investing in rental real estate. Click To Tweet

Continuing on that vein, one of the things that comes up a lot for a lot of passive investors is during the whole period of the asset, by and large, most of these large syndications are doing cost segregation studies to accelerate depreciation expense. During the whole period, many investors aren’t necessarily paying any taxes because of this situation, but can we talk about when we get ready to sell and everything from depreciation recapture to the potential disappearing of the 1031 exchange and how investors should go about managing their tax risks at the sale?

That is very difficult for limited partners to do because you don’t have any control. My suggestion is for a limited partner not to skip those quarterly investor meetings, read any updates that the sponsors give you because you want to know the timing of the potential sale. They might tell you, “We’re expecting to sell 5 to 7 years,” but then in year four, they get an amazing offer and they decide to sell.

You want to be plugged in because when they sell, you’re going to have a large gain. The gain is going to consist of capital gain, subject to long-term capital gain rates. It’s also going to consist of depreciation recapture. Depreciation recapture is broken down into three different categories. Whenever somebody says depreciation recapture, it’s technically not a term.

There are three different categories. There’s something called Section 1245 Recapture, Section 1250 Recapture and the third one called Unrecaptured 1250 Gain. Unrecaptured 1250 Gain is that 25% one. It’s maximum. That’s what most people refer to when they say depreciation recapture. What they forget to talk about is Section 1245 and 1250 Gain. In very simple terms, that’s gained from bonus depreciation.

That is taxed at my ordinary tax rate. I saved money at 37%, but then I got to pay it back at 37%. That’s taxed to my ordinary tax rates. You’ve got three buckets of depreciation recapture. It’s important to understand that 5- and 7-year property that we wrote off is going to be recaptured at my ordinary tax rates. When I cost segregate a property, depreciation is a hedge. It’s an arbitrage strategy.

I’m going to get tax savings now. I need to be able to reinvest those tax savings. Ideally, at a 10% rate of return over seven years, I’ll almost double my money. I’m going to take the tax savings off the table, but I’m going to pay that initial tax savings back. Whatever benefit that I received, I’m going to pay it back. The mistake that we see LPs make is they get the tax benefit, then go and buy a boat, a Ferrari or something crazy. Five years later, they had a massive tax bill that they couldn’t fund effectively or they were not planning on paying. That’s a big issue. You can offset that big tax bill because all that’s coming from is just the gain on sale. We’ve got the depreciation recapture and the tax on the appreciation.

If my gain is $100,000 between those two pieces of gain, I can go and put $100,000 into new syndication and maybe they pass me a $90,000 loss back. Thanks to a cost segregation study. That $90,000 loss, whether it’s passive or nonpassive, it’s going to offset the other syndication’s gain. I can make a roundabout way and do my own 1031 exchange without doing a 1031 exchange. I just have to be up to date on the timing. That’s why I tell people, “Make sure that you’re plugged in with the sponsors. You need to understand what their plan is to liquidate.”

LUR 104 | Real Estate Tax

Real Estate Tax: Any loss generated by rental real estate is passive and passive losses can only offset passive income or gain on sale form a passive activity.

 

That strategy is going to go away as bonus depreciation starts phasing out over the coming years. That’s also something that we’re going to have to be thinking about. If you invest in something now, by 2026, this strategy is not going to be nearly as effective because bonus depreciation at that point will only be 40%, not 100%. That $90,000 loss is going to turn into a $20,000 loss.

That’s important to know because a lot of people are going to need to start thinking about other ways in which to manage the tax bills accordingly, which in my opinion always comes from having those early conversations with tax professionals like yourself and your team to be able to manage the risks, to look into your own personal because everyone has their own personal financial situation that might complicate things or provide opportunities not to pay as much taxes.

One other thing I want to pivot onto is the intersection of real estate and cryptocurrencies and the impact also on taxes. It’s my understanding that when people invest in cryptocurrencies, there are no real tax benefits to be had when they sell and have all these gains, whereas on the real estate side, you do have the ability to have these tax benefits. What are you seeing from your practice when it comes to cryptocurrencies, the intersection of real estate and maybe how they could complement each other or maybe they don’t?

I’m not sure about how they would complement each other. That’s something that we’re still trying to figure out as well. One thing with crypto that not a lot of people realize is that it is treated as a capital asset. What that means is when you buy something with crypto, you have to treat it as a sale of your crypto holdings. It’s not like money. If people think that crypto is money, “I could just buy things with my crypto coin and I’m good to go.”

What you’re doing is you’re selling a capital asset, probably at a gain and you have to pay tax on that gain. With that capital asset, you’re exchanging for whatever goods or services you’re purchasing. If I spend one coin on a Tesla or something, it’s not like spending $50,000 on a Tesla. It’s like selling a capital asset at $50,000 or paying tax on the $50,000 and then getting a Tesla. That’s what crypto is.

That’s the one thing that we’re seeing. We’re also seeing a big ramp-up in the IRS audit division for cryptocurrency. If you have not been reporting your crypto transactions or you think that it’s all safe and everything, the problem is that blockchain literally creates the audit trail. The IRS is going to be ramping up enforcement over the coming years on crypto acquisitions and liquidations. If you’re not reporting them, you should start coming into compliance as quickly as you can.

Moving on from there to talk about business owners who are interested in investing in real estate. Some of the things that they should think about as they might be running a very successful business and may have personally invested passively in other businesses and then are now in a position where they want to also invest in real estate assets. Can you talk about maybe some of the considerations or things that they need to think about as they proceed?

One of the rules to qualify as a real estate professional is you have to spend more time in a real property trade or business than you do anywhere else. Click To Tweet

From a tax perspective, it’s those passive activity rules. I run a CPA firm. The net income that I receive from the CPA firm is subject to self-employment taxes and my marginal tax rate. I can’t go buy a ten-unit apartment complex, cost segregate it and expect the $200,000 loss that comes back from bonus depreciation to offset my self-employment income. That $200,000 loss is passive by default. My self-employment income is nonpassive. It’s in two separate buckets.

I’ve got to get that $200,000 loss out of the passive bucket and into the nonpassive bucket. I’ve got to do that by my spouse qualifying as a real estate professional. I can’t qualify as a real estate professional because I run my business full-time. It’s not a real property trader business. One of the rules to qualify as a real estate professional is you got to spend more time in a real property trade or business than you do anywhere else.

I’m not going to go spend an additional 2,000 hours running a real estate business. I’ve got to get my spouse to qualify, and then we’ve got material to participate in our rental portfolio. That $200,000 loss from that ten-unit apartment complex will be deducted against my self-employment income. It starts with understanding the passive activity rules from a tax perspective. That’s the basis of understanding how to maximize tax deductions if you’re investing in real estate.

Moving on from there for syndicators. One of the things I brought up to you was that as I’ve met syndicators on my journey, a lot of them are building and creating syndication businesses. When it comes to tax time, they’re hair on fire trying to figure out everything that they need to do to get their stuff sorted out. Can you share some misconceptions or things that people beginning in their real estate syndication journey aren’t thinking about when setting up their business?

When you are setting up a syndication business, you need to work with an attorney and a CPA on your operating agreement. That’s step one. The attorney is going to draft everything. Most of the times, the attorneys are drafting the tax provisions inside of your operating agreement from templates. We know this because we see hundreds of operating agreements and lots of them look the same. The problem is that people mess tax attributes up almost more than half the time. As our team comes in, we review the tax attributes and we say, “Here are the changes that you need to make in order to drive whatever economic situation you’re trying to create. You have to change the wording in these ways.”

We’re looking at the allocation section and distribution section. Those are the two key sections that we look at when we’re reviewing an operating agreement. Some of the big mistakes that we see, the first is paying a preferred return based on unreturned capital contributions. If you’re paying a preferred return based on capital, not based on how the entity performs and you don’t have any blocker there in terms of like, “It’s at the manager discretion. If there’s not enough cash, we’re not going to pay the preferred return,” but even then that preferred return accrues. You’re ultimately going to pay a preferred return based on unreturned capital contributions, not based on the entity’s performance. If that’s how your operating agreement reads, then that preferred return is most likely a guaranteed payment that will hit your investors’ 1040.

It will not be offset by any loss that you pass back to them via their stake or whatever loss allocation you make to them via their stake in the entity. They can very likely have a $10,000 guaranteed payment. It’s essentially treated as interest, guaranteed payment that I have to report taxes on. Even though I have a $90,000 loss from this entity, I still have to pay tax on that $10,000.

LUR 104 | Real Estate Tax

Real Estate Tax: The one thing with crypto that not a lot of people realize is that it is treated as a capital asset.

 

If you’re paying a preferred return based on capital and not based on how the entity performs, you are subjecting your investors to risk. Will your CPA report it that way? Maybe not because it seems in practice that this is not followed. That doesn’t mean that it’s not correct. The IRS can most certainly come through and they have come through, audit the partnership and make adjustments to adjust for that preferred returns.

That’s one of the main mistakes that we see. Another big mistake is not understanding what qualified non-recourse financing means. This is a CPA mistake, but I’m telling you this because you need to be aware that this mistake exists and it can cost you hundreds of thousands of dollars in tax savings. I’m literally working with a client on getting their CPA to understand what the option agreement says and make amendments to the tax returns that they’ve already filed and sent out.

There are hundreds of investors that are all incorrect. It’s costing the client about $200,000 in tax savings. When you’re a GP and you’re a sponsor of syndication and let’s say you contribute $0 to the syndication. Your profit and loss allocation section read something like, “First, losses are allocated based on exhibit A’s proportional shares.”

Let’s say that you own 30%. Exhibit A says that your proportional share is 20%. You should receive 20% of that loss. That’s what the loss allocation says. It says, “We’re going to split losses in X, Y, Z manner. However it reads, we’re going to structure it so that some of it goes to the GP.” Sometimes, what we see is we’re going to allocate all losses first to our limited partners are Class A members, until their capital accounts reach $0. Any additional loss is going to be allocated to the Class B members. That’s fine. There are issues with that too.

In this instance, what we’ve seen is we’re going to allocate losses to Class A and B based on their proportional share of ownership listed in exhibit A. Exhibit A says that you, as the GP owned 20%. That’s your proportional share. You should be allocated 20% of the loss. Where CPAs make a mistake is they say, “You didn’t contribute anything to the partnerships. Your capital account is $0. I know from that one CPA that I took on partnership tax law that capital accounts cannot go below $0.” That is not true.

If you have qualified non-recourse financing allocated to you, I have not seen a case where a GP does not have qualified non-recourse financing allocated to them. What is qualified non-recourse financing? Everybody gets non-recourse financing on the entity or on the property. In the tax world, non-recourse financing that is secured by real property is qualified. You got qualified non-recourse financing. Qualified non-recourse financing gives everybody an additional at-risk basis that they can take deductions against. I can put $0 into the deal.

If I’m allocated $2 million of qualified non-recourse financing, I have a $2 million runway of losses that I can claim currently against my whatever other income because I have an at-risk basis per the tax code. We see mistakes where CPA say, “We’re supposed to allocate 20% of the loss to the GP, but they contributed $0. I know that our capital accounts can’t go below $0, so we can’t allocate losses to them. We’re going to allocate 100% of the loss to the LPs.” That is incorrect treatment.

The correct treatment would be, “You contributed $0, but you’ve also been allocated 20% of the qualified non-recourse financing. You have $1 million of basis that you can take losses against and 20% of the loss for you, Mr. GP is $600,000. We’re going to allocate $600,000 of loss to you.” Now you get to claim a $600,000 deduction on your tax returns. That’s a big mistake.

It starts with understanding the passive activity rules from a tax perspective. That’s the basis of understanding how to maximize tax deductions if you’re investing in real estate. Click To Tweet

In the other instance where we have Class A versus B, we allocate 100% of the loss of Class A first. Any excess loss goes to Class B. If I raised $3 million total from my limited partners, my aggregate Class A membership is worth $3 million. If I create a $3.5 million tax loss, thanks to a cost segregation study, I’m going to have a $500,000 loss. That’s going to be allocated to me as the general partnership or as the general partner got it. Mistakes are made again where it’s like, “You contributed $0. Even though you’ve got $500,000 of loss allocated to you, you can’t claim it.” That’s not true.

I’ve got that qualified non-recourse financing that allows me that additional basis to claim that loss. The big takeaways here, make sure that you have a CPA review of that operating agreement. They got to review those loss allocations, the distributions and make sure that you are understanding or that your CPA understands what qualified non-recourse financing is. You probably want to get that tax return at the end of the year. You want to double-check that tax return against those loss allocations in the operating agreement. We see mistakes all the time. If you’re a limited partner reading this, you need to be doing the same thing.

In those scenarios, it would almost seem as though the limited partners are getting allocated more losses than they should. This was so much good information. Anything else that I didn’t ask you about like real estate taxes, helping passive investors, active investors, syndicators before we move to the last round?

I can’t emphasize enough that even though we just talked in the context of the operating agreement about the general partnership, limited partners or investors in these deals, you guys need to also understand what those loss allocations look like because you don’t want to be in a situation where like everybody says, “We’re going to allocate loss to the investors and that’s how we’re going to do it in this percentage or in this amount.” If it’s not in the operating agreement, then that’s not going to happen. You need to review the loss allocations in the operating agreement to make sure that you understand how things will be allocated when they are allocated.

This then brings me to my final round of questions, my level-up questions that I ask all my guests. The first one is, what are you grateful for in your life?

I am grateful for a very healthy son who keeps me on my toes. He teaches me new people management styles every day.

What has attributed to your success and continuous growth?

LUR 104 | Real Estate Tax

Real Estate Tax: You want to double-check that tax return against those loss allocations in the operating agreement.

 

Continuous learning and striving for excellence, I try to understand the ins and outs of various regulations, legal language, but then also I try to understand how to break that down for other people. Our firm is known for the content that we put out, the education that we provide and not many CPAs are. In my experience, a lot of people are very good and technical, but it’s difficult for them to break it down for other people in a way that they’re going to hear and understand. I feel like that’s one of my special talents that has contributed a lot to our growth.

What do you now know that you wish you knew at the beginning of your journey?

That it’s going to be okay, just relax. I have paid for many Harvard MBAs and it’s going to be okay. If you can’t see this, life is like a simple, very calm wave. It goes up and down a little bit. Business is like scaling Mount Everest and then being thrown off the top. It goes way up real fast. You’re on a high as the highest you’ve ever been, then it tanks the next day.

If I could go back and tell myself something, it would be, “Crap’s going to hit the fan. Take a deep breath. Find something that you enjoy, that you can step away from and get your mind off of things, whether it’s exercise, video games, hanging out with your spouse or whatever it is. It doesn’t matter. Know that it will ultimately be okay. If you’re a good person and have integrity, you’re not going to get it all right.” We get 60% of it. Any of our old clients that are reading this, they’re like, “You guys didn’t get it right. I’m right there with you. We didn’t get it right. We get 60% of it right.” We try to learn and improve continuously. As long as you’re a good person and you’re trying to get better, it will be okay.

If my readers want to learn more about you, your firm and get help, there’s so much all this knowledge that you gave on this episode, where are the best places they can go to get help?

Two good places. One is our actual website, TheRealEstateCPA.com. The other one is a membership site that we’ve launched. You can get a trial to it. It’s a weekly tax strategy newsletter, then all the prior articles that we’ve released. That’s at TaxSmartInvestors.com. Either one of those resources will be good for you.

Thank you so much for coming to the show. I appreciate it.

Thank you, Lisa.

 

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About Brandon Hall

LUR 104 | Real Estate TaxAs a real estate investor, I recognize the benefits that real estate will bring to my overall portfolio. As an entrepreneur, I know what it takes to create wealth and want to protect it. And, as an accountant, I understand what it takes to minimize taxes while maximizing compliance.
I started The Real Estate CPA to merge my interests and skills. Little did I know that the need for an advocate to help investors navigate through the intricacies and complexities of today’s tax laws would be in such high demand. To date, my team has significantly reduced tax bills for real estate investors across the globe.

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