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FLIP 03: Key Tax Strategies and Tips to Minimize Tax on Your Property Flips & Developments

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In this episode, Brandon Hall & Thomas Castelli discuss key strategies and tips property flippers and developers can consider to minimize taxes on their profits!

This episode is sponsored by our free Tax Smart Investors Facebook Group.

Full Transcript:
This podcast has been transcribed using AI, please excuse spelling, grammatical, and other errors.

Thomas Castelli 0:00
You're now listening to the real estate CPA podcast.

Brandon Hall 0:04
Your source for all things real estate, accounting and tax. Here we reveal our secrets that can save you 1000s in taxes, streamline your accounting process and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors and current clients on what strategies they use to grow their business, and how they steer clear of Uncle Sam.

Thomas Castelli 0:30
Hi, everyone, thanks for tuning into the third and final episode in the flipping series of how to avoid dealer status. And today we're going to be discussing how to mitigate your exposure to the self employment tax as well as how to reduce your exposure to the ordinary income tax, using some of the strategies that you've may have heard on the podcast here before. But primarily, it can be the real estate professional status, and using S corporations that's going to use to mitigate the self employment tax.

Brandon Hall 0:57
Yeah, so the assumption in this episode, if you're listening is that you are a dealer. So we're talking about folks that are real estate dealers, they are flippers, builders, developers, they are engaged in a trade or business where they are holding property out primarily for sale. So you are a dealer. So now the question is, how do you avoid the various taxes that come with being tagged as a dealer? Now, there's two myths that I want to tackle right off the bat. The first one is that you cannot 1031 exchange any property that is held primarily for sale, and not primarily for investment. So if I buy a single family home, and I rehab it, and then I turn right around, I'm trying to advertise it for sale, I cannot 1031 exchange that property. So don't fall into that trap of thinking that you can roll your gains forward. When you are flipping property or developing property, you cannot do that in order to change that status, per se, to being held primarily for investment, I would need to rent the property out post rehab post development for a period of time, typically 12 months. At that point, I may have successfully demonstrated that I'm holding the property primarily for investment. And at that point, I could 1031 exchange the property. But don't just be really careful, don't go into this planning and thinking that you're gonna be able to avoid taxes by rolling your gains forward via a 1031 exchange, it's not going to happen if you're primarily holding property out for sale, and you're not renting it out for a long period of time. The second key myth that I want to tackle because I've seen this online written by financial advisors and some other tax advisers, unfortunately, is that you cannot avoid dealer status simply by not reporting your flips on Schedule C. So I've seen that content online where people advocate for advisors, I should say advocate for simply reporting your flips on Schedule E, or unscheduled D. And just reporting them on Schedule E or Schedule D is not going to help you if you get pulled for an audit, they're going to audit everything, they're going to look at all your facts and circumstances, they're going to be trying to determine was your property primarily held for sale, they're going to look at the nine factors we discussed in episode one of this series. So don't think that you can skirt the rules or get cute with it, simply by not reporting it on Schedule C, which is where it should go. You have to structure all of your facts and circumstances to point to the fact that you're a real estate investor, not a real estate dealer. We have helped clients in the past correct this mistake from their prior CPAs and tax accountants where the CPAs will say, Well, you're flipping property. But if we reported on Schedule D, you're an investor, not a dealer, that's just not gonna fly. Think about an IRS auditor pulling your file and asking you a bunch of questions. They're gonna get to the fact real quick, that you're a flipper, and you just incorrectly reported your flips on Schedule D versus Schedule C, they're not going to say Oh, because you reported on Schedule D, you must not be a flipper. That's not how it's going to work. So be real careful with this. There is bad advice online, we've seen it and that's why I wanted to point this myth out. Just don't fall into that trap. You got to work with people that are going to tell you what you need to hear to win IRS audits, not what you want to hear. We talked about this a little bit with real estate professional status because everybody loves to hear that that education and research hours are gonna count but guess what they don't count. Investor hours don't count unless you're managing the day to day operations will Same thing here. It just reporting a schedule deep or Schedule II does not save you. So make sure that you work with advisors who are going to set you up for success, not failure. Work with people that are To tell you what you need to hear to win audits, not what you want to hear at that given time.

Thomas Castelli 5:06
Absolutely 100%. And you know, kind of one of the things you're talking about about the myth, the first myth, but a 1031 exchange, how you can't defer properties, because it's pretty much inventory and not a capital asset or not real property at this point, after the tax cuts and Jobs Act, you're similar, you can't use passive losses, generally speaking to offset profits, we'll call it profits, the ordinary income generated from your flips, because it's not a rental activity, right, this is not considered an investment property, it's not considered passive, this is an active business. And therefore, you can't use the passive losses from your rentals against ordinary income unless you're a real estate professional, which kind of brings us into the first way to actually mitigate your exposure to that ordinary income tax. And that is, if you're in real estate full time, maybe you're a flipper, you have a flipping business, then you also have rental properties, there's a good chance you can qualify as a real estate professional. Now, we're not going to go through all the details on how to do that we have an entire series that we did on the real estate professional status. But in short, by being a real estate professional, basically, the losses from your rental properties become non passive. And again, the income from your flips is non passive income, it's ordinary income, but it's non passive in nature. And what happens is you can take, you basically buy some rental properties, you can do some cost segregation studies to them, and it's gonna generate non passive losses that can offset your flips. So there's some strategic timing issues that you can get into here and how to best utilize that this strategy. But kind of the one comment I do want to make on reps about this is this kind of the intent of the real estate professional status, right, you're in the business full time, you're a real estate dealer, you're buying properties you're developing, you're subdividing them, you're improving land, you're maybe in a development business. And now you have rentals that you also have. And now you can use the losses from your rental properties against the ordinary income that you're generating from this other real estate business that you're also in, in this case, it's flipping properties.

Brandon Hall 7:04
Yeah, that's a great point and use the word full time you're full time in, in this business, and to qualify as a real estate professional. Again, we have a whole series on it highly recommend that you go check that out. But to qualify as a real estate professional, you have to spend 750 hours and more time than then anywhere else in a real property trader business. So if you're flipping property, or if you're developing property, you are in the real property development or redevelopment business, which are two of the 11 real property businesses that you can qualify as a real estate professional status for. So you can be a real estate professional as a flipper or a builder. Even if you don't have rental properties. If you're doing it full time, if you're flipping full time building full time developing full time, you're a real estate professional for sure, then it doesn't help you don't have rental properties, but you are a real estate professional. So go listen to those those episodes. If this is the first that you're hearing about it, because it's a really, really powerful way for our clients who are full time in a real property trader business to offset their business income, with losses from their rental activities. Because as Tom said, when you're a real estate professional, and you materially participate in your rentals, they become non passive, you can cost segregate them to increase the tax losses. And those tax losses can then offset the business income. But if you are not a real estate professional, let's say that I earn $200,000 From my flipping, developing activities or whatever, $200,000 net profit, and then I go and buy like a million dollar apartment complex, and I get a $200,000 tax loss. If I'm not a real estate professional, or if I don't materially participate in that apartment complex, then that $200,000 tax loss from that apartment complex is passive. And it cannot offset my active business income, my non passive $200,000 business income coming from my flips. And also for the purposes of the 20% pasture deduction, I still have to net out all of my income anyway. So my business income subject to that 20% passive deduction in this case would be $0. Even though I can't use the $200,000 tax loss today on my taxes, for the purposes of that 20% pass through deduction, section 199 cap A, I do have to net it all out. So my business income that I can take that 20% deduction on in this case is $0 really painful place to be. So if you're going to be flipping property, developing property, go listen to the real estate professional status series. It's the reps series Our EPS, because it's going to be it's going to be eye opening for you. It's going to really help you understand how to structure your facts and circumstances and understand how buying rental property can help accelerate wealth building for you by mitigating your ordinary income from tax. But, and this is a big, but like I like big and I cannot lie, you know, that's a big butt. Alright, this is a big but. But if I if I have non passive losses coming from my rental activities because I'm a real estate professional, I materially participate in my rentals. So in this apartment complex example, I've got $200,000 of non passive tax loss coming from my apartment complex. And I also have $200,000 of flipping net income coming from my flipping business, they net out to $0 Woohoo, I avoid the marginal tax rate, I'm good to go. But guess what I don't avoid, I don't avoid that 15.3% self employment tax that is factored on that $200,000 of net business income before factoring in tax losses from my rental real estate activities. So what we do is we set you up in an S corp. I'll let Tom explain that.


Thomas Castelli 10:50
Yeah, so one of the reasons why you want to use an S Corp is because if you do have a rental business, you do want to break up those two businesses, because you don't really want to put rentals into an S corporation, because it can cause a myriad of problems when you're trying to restructure a business. So you want to keep your two business separate. But the S corporation really what it does, is it allows you to pay yourself a reasonable salary. And on that reasonable salary, you're going to be subject to that 15.3% On that salary only. So for example, if you had $100,000 worth of profit from your flipping business that's held an S corporation, and you pay yourself a $40,000 salary, you're only going to pay the self employment tax at 15.3%. On that $40,000 of salary pay yourself, the remaining $60,000 of profit can come out of the S corporation as a distribution. And that is not subject to self employment tax is not subject to that 15.3% amount. And it's important to note that 15.3% is up to the first $142,800 of income in 2021, that increases each year, but in 2021, it's 142,800. And then above that threshold, there is a 2.9% Medicare tax beyond that. So you can have an exposure, a pretty large exposure, I'm sure we'll get into some numbers in a little bit, which is why the S corp helps. But it's also important to note that with the buy in tax changes that are coming up, they are talking about potentially adding a 3.8% tax on to those distributions. So just something to keep in mind as you kind of go on about your trucking business.

Brandon Hall 12:25
And a quick note on the S corp piece too. Whenever you run an S corp, you have to pay yourself a reasonable salary, the IRS wants you to pay yourself a salary equal to your net profit, that's a perfect world for the IRS, you want to pay yourself a salary of $0. Now you can't because that's not reasonable. But in a perfect world, you'd be able to do that. And the reason for that is the SAT like Tom was saying the salary portion is the portion of your net profits from an S corporation subject to that 15.3% tax. So if you pay yourself a salary of $0, and then take a $200,000 distribution of profits, you avoid that 15.3% tax on that $200,000 a distribution of profits. And by the way, you also have that apartment complex over there on the back end that you're materially participating in, that's creating that $200,000 of tax loss, you have $0 in tax, right. So the IRS wants you to pay a $200,000 salary so that you pay the entire 15.3% Then once that's phased out the Medicare taxes, you pay the entire FICA tax on that $200,000. So what you have to do is you have to determine a reasonable salary. And the way to think about it is meeting in the middle to some degree. Now you can come up with random reasonable salaries. Like we see a lot of advisors that just pull numbers out of the air, they say, Oh, well, you need to pay yourself 60% of net profits, or you need to pay yourself 30% of net profits or 90% of net profits, then you ask them, How did you come up with that number? And they go well, that's based on my experience. Well, in my personally for me, your experience is hogwash. I don't care about your experience. I care about actual facts and actual data. So what we do is we go to the Bureau of Labor Statistics, and we start doing actual research on the activities that you're performing in your geographic location to come up with a weighted hourly rate, right? Because if you're running a flipping business, what are you doing, you're scheduling calls and contractors, well, that's an admin job, maybe you're paying $10 an hour for something like that. You're also doing the technical work, the GC work, maybe that's $50 an hour, you're also doing the CEO strategy, Vision level work that might be $300 an hour. So we have to look at how much time you spend in these various buckets in your geographic region, then we have to come up with a weighted hourly rate. So we take all those hours and we multiply it basically by the ratio of time that you spend in all those buckets. We've got a weighted hourly rate, then we multiply that weighted hourly rate by how much time you spend in your business every year, and that's going to give us a salary that if you're ever audited is easy to substantiate and defend Because what's the worst thing? The worst thing is an auditor comes in and says, Tom, you reported $10,000 of wages on $100,000 in net income. How'd you come up with that? And you go all my CPA came up with that and think, Oh, well, let's go ask the CPA. How did you come up with all 10%? In my experience is what you should know, full bullcrap this BS hogwash, it's never gonna fly, they're gonna say, well, the iris can come out? Well, I think do you just pay yourself 95%. And now you're gonna battle it out. But instead, if you go and you say, Hey, Tom, you're paying yourself $10,000 on $100,000 profit. We don't think that's reasonable. Why? And Tom is able to produce a memo that documents the analysis with actual third party statistics. How does an auditor argue that that's very difficult at that point, you've put yourself in a way better position. And now you're not subject to whatever the auditor is feeling that day, right, you're challenging them to step up to the plate, and talk facts. And that's the difference between winning an audit and losing an audit. So don't just jump into this stuff, thinking that you can just come up with any random salary, it's not going to work. If you ever get pulled for an audit, you will lose, we have seen people lose. And it's painful, you get penalties, you get interest back taxes, it's painful. And sometimes those those penalties can be substantial, depending on how far off you are. So you don't want to mess around with this type of stuff. Make sure that you do the actual analysis or hire somebody that will

Thomas Castelli 16:26
absolutely and those are the those are the two primary ways to do it. I will add that sometimes people do C corporations for this depends on what your ultimate strategy and goal is. Primarily where we see that C corpse being used, though, is in retirement accounts. So for example, if you do use a self directed IRA, or 401k, you are going to be considered to be in an ordinary course of business here. Because you are flipping properties on a regular basis. And you would be subject to ubit. We're not go through you bit today. But you've it's a tax on your on your retirement accounts, when you're engaged in the ordinary course of business. And what the C corporation allows you to do is allow you to basically pay tax that 21% rate. And because it's a C Corp, and not a partnership, or pass through entity, or a sole proprietorship, if you will, I don't know how that works, what that's called with an IRA. But basically you don't pay that you don't you're not subject to you, but and you could skirt you get away with it by using a C Corp when you're flipping properties within your IRA. So just something else to keep in mind because I know I get a lot of questions out there. Well, what if I use a checkbook IRA? How's that work, you know, and long story short, you would be subject to you. But if you do flip properties continuous because you are going to be considered to be in a business and the tax rates on trust, which is what the IRA is considered can scale up to 37% after just $12,500 worth of income. So by using that C Corp at the 21% rate, you're actually cutting that tax down perhaps significantly, and it's just something you're gonna want to keep in mind if you are considering flipping through an IRA just figured it's something to toss in here because it is a related topic. Hey, everyone, thanks again for tuning in today's episode. Before you go, we do want to remind everybody about the tax smart real estate investor Facebook community with over 2500 members and counting. There are a ton of great conversations taking place right now between real estate investors of all levels. And with the binding tax changes in the pipeline. This is something you're not going to want to miss out on to join go to Warn investors or search for tax smart investors on Facebook to join today, everybody thanks for tuning in. I will catch you on the next series and until then happy investing.

Brandon Hall 18:40
Thanks for listening to today's show. If you enjoyed the show, please find us on iTunes and leave us a review. You can also email us at contact at the real estate CPA comm with any feedback or topic suggestions, we are always taking on new clients and with the new tax laws in play. You really don't want to navigate this alone. Let us help you save money on taxes with your accounting and CFO needs. To become a client navigate to our client page at the real estate CPA calm and fill out a webform with as much detail about your situation as possible. Thanks so much for listening. Have a great rest of your week.

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Hall CPA PLLC, real estate CPAs and advisors, helped me save $37,818 on taxes by recommending and assisting with a cost segregation study. With strategic multifamily rehab and the $2,500 de minimus safe harbor plus cost segregation, taxes on my real estate have been non-existent for a few years (and that includes offsetting large capital gains from the sale of property).

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