402: Special Guest Interview with Bo Travis—Tax Advice (Part 1)
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Episode Transcript
Welcome to Episode Two of Season Four of the Growing Empires show. Today my guest is Bo Travis and this is part one on our tax advice segment to make sure that you get the most out of your investment properties. So stay tuned.
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Welcome to Growing Empire hosted by real estate entrepreneur and trusted investment advisor, Jennifer de Jesus. Growing Empires provides insight to building wealth through passive income producing real estate investments for those who want to build and manage a more profitable real estate portfolio.
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I'd like to welcome you to today's show. My guest for today is Bo Travis. Bo Travis is a certified public accountant and its managing partner of Gorman and Associates, which is a public accounting firm located in Northampton, Pennsylvania. He's been in the public practice since 2006. He studied at East Stroudsburg University, where he graduated summa cum laude from earning a Bachelor's of Arts in Economics as well as a Bachelor of Science in Business Management, specializing in Accounting and Finance. So Bo, welcome to the show. Thanks for having me. Absolutely. So, very excited about today's topics — we will be discussing the tax consequences of selling your personal residence, we will be discussing ordinary investment and passive activity. We will also be selecting which real estate entity is best for different types of investing strategies. We will talk a little bit about the 1031 exchange, and probably the most exciting is the recent tax law that allows for extra deduction on qualified business income tax. So, Bo, is there is any particular topic you want to start with today? Why don't we start with your selling your personal residence, since it's a kind of not related, so we'll get that one out of there. Most people know that when you sell your primary residence, you can exclude most of the gain. And the rules following that — it's probably one of the most common questions I get, everybody's selling their house, like how much tax it's gonna cost me? Well, the IRS, it's probably, I would say the number two best tax break you get in the in the code. But if you lived in your property, if it was your primary residence for two out of the last five years, you don't have to pay a single tax on any gains that you've attributed when you sell that residence. Now those two out of five years don't have to be consecutive, you could live in the property for one year, you could have moved somewhere else and had to do temporary work and then come back and live there another year. You're still excluded up to half a million dollars for married filing joint and $250,000 for single individual. You know, that's standard here. One of the other things that you want to know, which some people don't know is you can actually if you don't meet those two year requirements, there are reduced maximum exclusions. So if you've only lived in the property for a year and a half is your primary residence, it doesn't mean that you're going to have to pay tax on the gains that you have on that property, if you qualify for some special exclusions. Now there's a bunch of different ones. One of them could be if you had to move for your job, and you had to travel more than 50 miles away, and you had to sell your house early because of that, you can actually get a reduced exclusion amount, and maybe not have to pay any capital gains tax. So a lot of people don't know that. But there's a lot of those. There's other things for health reasons, if you had to move, and it could be any qualified member in your family that was their primary residence, if you had to move closer to a hospital or something like that, you can get a reduced exclusion amount. And unforeseen circumstances — there's a bunch of them that's listed, I do recommend that you talk to your tax advisor about those exclusions, if you know if you qualify for any of those if you sell your house and you and you're thinking about a gain, and maybe you don't make the two of the five years. Great information. I was curious as you're talking about primary residence, your personal residence, how do they look at maybe not investment properties? But how would they look at the difference between maybe your primary residence and you know, some people have a secondary residence that they live in for half of the year because whether you know, how would they make a determination on which one is considered the primary residence? That's a good question. So like say you were Snowbird and you lived in Pennsylvania for you know, half the year and then you lived in Florida for half the year. Your primary residence is where you were for those days in that house. So I might have to live in if I had a Pennsylvania home for four years, but I only lived here six months. Well, you got to that's why it doesn't have to be consecutive. It's only two of the last five years. So if it's only six months, one year, it's three months, the next year, as long as you get up to two years out of five years than you then you can be at that exclusion. Great information. Yeah. So is it if you have own these two houses, let's just say I would assume that you can't take that deduction really on both? Correct. So after you use that exclusion, you have a two year waiting period before you can use it again. Okay, good to know. Alright. Um, since we were talking a little bit about personal residence, I think we should now maybe venture into the category of investments.
05:21
One of the things that we wanted to talk today was about the differences between ordinary investments, passive investments, passive activity, what really is the difference between them and how they are taxed differently. So elaborate on that topic. Okay. So this is a real nuanced area that, you know, investors should have kind of at least a basic understanding of, now the IRS classifies as your income into these three types of categories. Um, ordinary income, you know, is what you can make, let's say you have a W-2 job, you know, that's considered ordinary income. Also, you know, if you're a sole proprietor, that's considered ordinary income, anything that you — even business activity, if you own a business, and you are a material participant in that business, that's considered ordinary income. You also have investment income, which is, you know, stocks and bonds that you hold, and then you sell or dividends, that's all considered investment income, it could even be land, if you hold land, and then you sell it later on, and you have a gain on that land — that's investment income. There's also passive income, which automatically rental real estate is considered passive income, no matter if you're a material participant or not. Others are royalties, you also have, you know, other if you are a business owner, like I own, you know, a majority share, or any kind of share in another company, a small business or whatnot, but you don't materially participate, then that would be considered passive income to you not ordinary income. Now, the material participation rules are really nuanced, and we can get into the weeds on that, we can probably talk all day on it. But the basic rule of thumb is if like you work 500 hours in a business, throughout the year, you're considered a material participant. Now, with all that said, there's a bunch of other ways that you can qualify or not qualify as a material participant. Um, you really need to talk to your, you know, your tax advisor, who knows your situation, who could actually advise you on that, but it is relevant for the information. Now, the reason that they're different is because there's different rules about when you make money and what your losses on other activities that you make, can actually offset each other. Okay? So, for example, if I'm working as a regular W-2 job, as an accountant, and I also own a restaurant on the side, but I'm a passive investor in that restaurant, I don’t actually work it, I don't put the 500 hours into it — that would be passive income to me. If I lost money, if my restaurant lost money, I couldn't use those losses to offset my ordinary income. Okay. Interesting. Right. Okay. Now, I could, there is some limitation, so if I make less than $100,000, for a year for married filing joint or a married couple, or actually you can for a single as well, if you make less than $100,000, you can take up to $25,000 of losses against it. But if you make over 100 grand or $50,000, if you're married filing separate, you don't get to take anything. Those losses get held in perpetuity, well, they get held and carry forward, until you actually sold your shares at the business or the business sold, then you could actually use them to offset against your ordinary income. And that's called the passive activity loss rules or PAL. And those are very, they can be a problem for investor especially because like a lot of your investors probably have regular day jobs or other companies that they run, but they also have rental real estate activity and rental real estate activity generates usually the first couple years, especially the first five years of tax loss, usually. And that's mostly because of depreciation, mortgage interest you're paying. Now, you might actually have not cash flow loss, but you'll be generating a passive tax loss. But if you make over those numbers make over 100 grand, you can actually use them to offset against your ordinary income. Now you can use it to offset your other passive income. So if you have multiple properties that are maybe you don't have a mortgage on the building anymore, and that one's actually generating a lot of income, you can use your other passive losses to offset those passive income. Okay, so that's, you kind of need to know where that goes. So maybe you think, oh, well, I have all these tax write offs and maybe you don't know. It depends on how your your income is classified.
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Now your ordinary income is taxed, you know, at the progressive rates that we all kind of know, you know, everybody knows their tax brackets, they're like, okay, well, I'm in 22% tax bracket or, and it goes all the way up to 37%. Now remember, it's not a flat tax. So if you hit like right now, the tax income bracket for being the highest tax rate for married filing joint returns is $612,000. So $612,000, if you make that you're paying 37%, on any additional dollar, above the $600,000, your money that you made prior to that is taxed at those rates in those brackets. So your first $19,000 is only taxed at 10%. And then it goes up in there. That's why you have marginal rates versus effective tax rates. So it's not like, Oh, I don't want to make any more money, because I'll be in a higher tax bracket. Well, that's kind of a silly argument, when people say that a lot, because they don't really understand it's a progressive tax system, it's only the additional dollars is taxed at the higher tax rate, your earlier dollars are still going to be taxed at that lower rate. Okay. And I assume that that pertains to any tax bracket, no matter where you are, and how it works. That's that's what your ordinary income and your passive income come in, and they'll be taxed in those brackets. Investment income has a different scale, if it's short term investment income, meaning that you've held it the investment for less than a year, it's taxed at ordinary tax rates. But there's what's called a long term capital gains rate, which is a special tax rule for any any investment that you hold over a year. So if you hold, you know, a piece of land, and you hold it over a year, you get some favorable rates now, and that's not always the same. So if you make less than $79,000, in your other income, like say, you're married filing joint couple, and you sold a long term investment, the tax rate is zero, you pay nothing on that gain. Wow. If you make over that up to the highest tax bracket, so if you make anything from $79,000, up to $600,000, your long term capital gains rate is at 12%. So that's a lot favorable than you know, most your marginal tax rates, so it's a better tax rate. And you know, it's good. Um, if you're over that it's at 20%. So if you're over the $600,000, for married joint couples, it would be at a 20% rate for long term capital gains investment, which is better than the 37%, right, at that bracket. So definitely if you hold any even property land, you want to hold it for, even your home, a home that you sold, you don't have an exclusion — you definitely want to hold it for at least a year. Because you get those favorable rates and it can be almost sometimes we pay nothing, it is something to keep considering.
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The episode will continue in just a moment.
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To keep your real estate investments working hard at growing passive income, you need to have the right resources to help reduce risk and exposure to over taxation. Having the right attorney and tax advisor and insurance protection is critical to ensuring your investments are safeguarded and set up for success. Knowing tax laws and legal regulations while securing experts who care and understand your goals will allow you to prosper. If you need help finding the right resources to mitigate risk and maximize your tax advantages, let's talk. I can help you know what to look for and how to scrutinize new or existing resources so that you have the right fit and get the best protection. Schedule a call with me today and I'll listen to your goals and make recommendations. To get even more information that will make you a smarter real estate investor, be sure to sign up for the Growing Empires Advisor Guide at GrowingEmpires.com, that's GrowingEmpires.com, and I'll help you get the right resources to protect your investments and your future.
14:04
Now, how does the investment activity that you're referring to like stocks and bonds and stuff like that, how are they taxed differently, you know, in comparison to like ordinary income, or again, are they not taxed until you actually sell them? When you own, we can talk some about this, like a regular C corporation. So that's a large corporation, an entity that has stocks and shares most of the stuff that you would buy on the stock exchange, let's not talk about, we can get into mutual funds if you want, but let's just talk about regular shares. So if I own shares of Apple, okay, I go and buy this share of Apple, and let's just say the market price at the time is, I don't even know what it is. But let's just say it's 500 bucks, I buy a share, and next year, it's worth $600, I don't actually have to pay tax on any of that gain until I actually sell the stock. Okay. But would Apple also does in any kind of C corporations, and I own a piece of that company, when I buy a share is they give out dividends. So and whenever a C corporation is going to pay out money to their owners, they do it in the form of a dividend. So C corporations, they pay tax themselves, they're entities that pay tax, they have a tax rate now with the new the tax cuts and JOBS Act, which is the Trump taxes, we can just call it that they reduced a lot of the corporate rates, but they still have to pay a tax on the income they generate. Then if they want to get money to the people who own the company, they have to issue a dividend. Now that dividend is taxed at the individual level when they receive it. And that's taxed at the long term capital gains rates or in the investment income rates. Okay. Okay. So then that's taxed at the either the 12%, zero or 20%, depending on where you fall in the spectrum of the tax brackets. And since you started to lead into maybe our next topic, I think it would be prudent to talk now about entity selection, why somebody would choose their real estate activity to be in a corporation, a partnership, an LLC, an S Corp. I know you get in your business, you get a lot of questions about, you know, people selling their personal residence and how things are taxed differently. In real estate, I get a lot of questions regarding you know, should I form an LLC? Should it be an S Corp? Should it be a partnership? Should it be a corporation? What should I do? Or should I just own real estate in my personal name? Right. First, we just talked about corporations and how they're taxed. Now, any person can form a corporation or any one of these entities that we'll talk about. So there's not restrictions on who can start one of these. A corporation is not ideal, you know, a corporation, for purposes is great for liability protection. It's actually got the strongest liability protection that you can have, but there's that double taxation, which I was talking about, because not only does the corporation have to pay tax, and you know, a lot of the state taxes are really high in corporations, but then when they pass money to the actual individual, they have to pay tax again. So that if you calculate it up, you're talking, you know, 30, 40, 50% of the income that was generated is all taxed. So that's not usually ideal on anybody. Especially if you're going to be an investor on real estate, don't recommend a C Corp, even with the liability protections, because you can get that from some of these other organizations. The S Corp is a small corporation, that's what it stands for — “S Corp”. And it's, you can either register it, you can do a charter of incorporation, or you could be an LLC, and then ask to be treated as an S Corp. So either one, an S Corp is a flow through entity is what they call, it's a pass through entity. So any that the earnings that the company makes is so when you do your tax return at the end of the year, that income that that that company makes is passed through and shown on the individuals 1040 as income, and then they're only taxed at their personal rates, not double taxed, so it just automatically flows through so you earn money, your hit on it, it comes through on a K-1 form, and then it's taxed at the individual’s rate.
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A partnership is roughly the same thing, except the only thing is with a partnership, if it's any activity, other than rental real estate activity, or royalty income, any kind of passive income that's within the partnership would be taxed it’s going to be any profits that have been made is going to be subject to self employment tax. And no matter if you're material participant. Well, unless you're a limited participant, but if you do any material participant, you'd be taxed at self employment rates, too which can be pretty terrible. But with real estate activity, it's not a bad idea to be treated as a partnership. Now, well, I recommend mostly is everybody if you're going to be in real estate, go ahead and file an LLC because an LLC is the best of both worlds, and then talk to your tax advisor find out what the activity is going to be. And then you guys can make the election either to be treated as an S Corp, or as is a default practice, the LLC is treated as a partnership, it goes forms on a 1065 and is treated as a partnership. Now, for rental real estate, the best that I suggest is as an LLC, form as an LLC and be a 1065 partnership. The reason I suggest that is because when you’re a partnership, liabilities, like if you own a mortgage in the qualified property or anything like that, become basis in your ownership, okay. And there's problems with an S Corp that if you are in the negative of equity, you could have taxable amounts to you even if you had no profit. Because if you took distributions, when there was no money, you could end up paying additional taxes. So that can be detrimental in some situations. So it's probably easier to just be taxed as a 1065 for rental real estate activities. Now with that said, if you're going to be an investor who's going to buy homes, and flip them, and do that kind of activity, you're going to want to be as an S Corp, because that type of activity is considered ordinary income, not passive income, like rental real estate. And that income would be subject to self employment tax. And if you're set up as a 1065, all that would be subject to self employment tax on your personal return, which is not on top of your progressive tax rates, what I talked about, but you have to pay an additional 15.3% of self employment tax on top of that, on any of that income. So that could be detrimental. So if you're a flipper of homes, and that's what you do, you primarily buy homes, you remodel them, you fix them up, and then you sell them, you probably gonna want to be organized as an S Corp. Very good information. I'm sure there's been a number of our listeners that maybe didn’t get the advice that they needed ahead of time and probably experienced that double taxation. Yeah, that's the thing, like, you know, the biggest thing your investors should really talk with your tax advisor, because you know, we're giving some general topics here in general information, but depending on your situation, and what else you have going on might change the whole game up. You know, when I talk about passive losses, can I offset them, can I not, maybe I want to be an S Corp, because it might make my income more ordinary, not passive. So depending on what my other business is and what it may generate, I want to make sure that I can get the best tax strategy. So you definitely need to talk to your tax advisor before implementing anything and if you're going to make any changes, you're going to buy business or you're going to buy property, you should really talk to them and see what the tax consequence is, how I should set it up — because there's a lot of nuance that goes into looking and actually knowing all of your information. Yeah, that's a good point.
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So do you ever recommend anybody own real estate other than their personal residence in their name versus the entity or are you pretty firm the fact that you will always suggest that somebody at a minimum owns in LLC, and then again talks to their tax advisor about the other types of taxation? The only thing is it depends. So if you're a big insurance person, and you have big umbrella policies and stuff like that, maybe you don't need an LLC, you know, and a nice thing also about an LLC is when you set it up, if you're a sole owner, so you're not husband and wife, but just a one owner, it's called considered a disregarded entity. So it actually flows just like you would own a personal real estate and you don't have to file other forms, there's no 1065, you don't have to pay your accountant to file a 1065. You don't have to keep minutes, you don't have to do all the legal requirements to have a partnership or corporation. It's a disregarded entity, it flows in and you also get your liability protection. So an LLC is nice to start for those. But with that said, I mean, what are you really worried about? Why are we setting these things up? Not only for tax purposes, but it's not really giving you a lot of difference when the income comes in from a 1065 K-1 form versus on your schedule E. It's not giving you a real big tax advantage, not for rental real estate anyways, there's other things that definitely does, but not for rental real estate, it's all flows through on the same line item and it doesn't matter, you mostly do it for liability protection. Because if somebody gets hurt on your property, or somebody walks down your sidewalk and gets hurt, and has medical bills, and your initial homeowners insurance policy doesn't cover everything, they can sue you personally, for your personal assets. So if you want to make sure you protect your personal assets, or your other business assets away from that, and that's why you set these corporations up, they're pretty much shells so the only thing you can get, this was what it was in the LLC. So if somebody was going to open a business and also buy the real estate that their business is going to be running in, would you suggest two separate entities — one for the business, one thing real estate generally? Yes, I would, I would talk to an attorney about that, and they would better advise you on that. But I, in my experience, I think that would be a better protection on because you can get sued on two fronts, you know, not only if somebody hurts you on, on the property or whatever, but then they can also get your other business assets too. So the more protection you have, the better it is, um, you know, it does cost more. So if this is going to be something small, if you're worried about a couple 100 bucks that you're going to be paying into your tax returns, and you think that's worth the risk and do it but if not, I do think you should set those separate entities and then you can have your business, pay rent, you know, be a tenant of your other entity that you have that holds the property. But I do recommend I you know, most cases, I would think that that would make the most sense. I mean, again, it would depend on the circumstances and and the type of business but in general, yeah. Okay, thank you.
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We will be back with more from Bo Travis in next week's episode. Until next time, take care.
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For more information about how Jennifer can help you plan, develop and manage a strong real estate investment portfolio, visit GrowingEmpires.com.
Contact for Robert (Bo) Travis, CPA, CGMA:
Phone: 610-262-1280
Email: btravis@gaapc.com