403: Special Guest Interview with Bo Travis—Tax Advice (Part 2)
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Episode Transcript
Welcome to Episode Three of Season Four of the Growing Empires show. Today I'm back with my guest, Bo Travis, and this is part two of our tax advice segment. So stay tuned.
00:13
Welcome to Growing Empires 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.
00:32
Welcome back to part two with Bo Travis. So let's go into 1031. exchanges, what they are, and why is it beneficial to do a 1031 exchange? So if you'd like to start with that, sure. I mean, 1031 exchange is probably the greatest thing for loopholes in the tax code that there is, it's an awesome way to generate a lot of wealth and not pay any taxes. It's not really an exchange. I mean, it's kind of weird in the terminologies, exchange is more really like a purchase upgrade - is what you can really think of it as. There's some rules in 1031 exchanges, but when you own a property and this only qualifies for real property now in in the past prior to the 2008 tax code changes you could do on equipment, or you know, like tractor trailers or stuff like that different types of equipment people can do 1031 exchanges on with the new tax law, they got rid of all of it, the only thing that they qualify now is real property. So real property they call it but you know, like residential or commercial property, a lot of people use this as a great wealth builder because what you do is say you bought a property, you know, for 100 grand and then you held it for 10 years and now it’s worth, let's just say $200,000, well, if I sold that property and I bought a new property, for the $200,000, that I had, I would have to pay $100,000 would be subject to capital gains tax for an investment property. What the 1031 exchange lets you do is that lets you say that I'm going to buy a similar type or like kind property, and that I'm going to roll that basis into the new property that I purchased. So you get to defer that gain and to push it way down the road and never have to pay tax on it until, at some point, when you finally do sell, and you don't upgrade or buy another one, or if it goes into a trust, or however you're going to pass that wealth on. So it can be a pretty awesome tool. Um, there are requirements for it, and you, you have to be strict about it. I mean, I definitely you need to get an intermediary, um, to help you with this transaction. Yeah, there's two really basic numbers that are important in an exchange, and one, it's the purchase price, right. So if you're selling a property that's worth $200,000, you need to plan to invest $200,000 or better into your next property. And then the other piece of the puzzle, like he had mentioned before, was that taxable capital gains, right, you want to reinvest at a minimum, that capital gain amount into your next property to get the full benefits of the exchange. Yeah, the other requirements of it is like, if you sold the property, you have 45 days to identify another property, you have 180 days to close. So there's time requirements. Um, if you receive any boot and boot means cash, any cash, part of the thing is that boot, no matter what if it was less, it will be subject to tax. So you got to be careful about if they're going to give you cash because you know, the property you're exchanging for has more value than what you're getting, that any kind of boot or cash settlement is going to be taxable. Just one note too, you can't do foreign property, it’s not considered like kind. So if your investor is, you know, trying to sell something here in the states and buy, maybe a condo in Canada, doesn't count can't do it. Very good point. It only counts for business activity, too. So you can't have like your vacation home, and you had a gain in your vacation home wasn't your primary residence, something that you visit, but you still consider you know, your other primary house, and then you want to buy a bigger vacation home? Well, you can't use a 1031 exchange that has to be business activity.
04:22
Last but not least, I want to just touch on the Qualified Business Income tax deduction, which is, which is the newest tax allowing for an extra deduction on real estate activity. Would you like talk about that? Okay. All right. This is the hot topic that I tell you people are fighting about. That's true. And mostly, the qualified business income tax deduction came into play last year with the new tax cuts. Now it wasn't just for real estate activities, it was mostly for - what happened was the corporate tax return, the C Corps we're talking about got a big tax break. Well, they wanted that to pass through because most businesses in America are small businesses, either S Corps or LLC, or partnerships. So they wanted to make sure that they got a tax break. Now, the details of if you qualify, have qualified business income and how much threshold you have is your personal to if you actually qualify for the deduction that's quite nuanced. And I'm not going to get into here because we're going to talk we're primarily talking about investment income. But in essence, they pretty much like it is whatever income you have to first make it generate income, you know, so whatever your business, your flow through entity, either be your S Corp, or your 1065. If you're a sole proprietor, or if you have real estate activity, if it has income, then you can take what that income is, and pretty much multiply it by 20% and take it as a deduction off that income for what you have to pay tax on. So it's sweet. It's like, just a deduction flew out of the air and hit on to you. Now, like I said, it's more nuanced than that. Because depending on how much income you had, what your other W-2 income is, what type of business it is, if it qualifies, that changes, and you should talk to your tax advisor about that. But for the most part, you have this qualified business income tax deduction. With that said, when it comes to rental real estate, there's a lot of confusion because it was taking over a qualified trader business because that's what has to qualify under Code Section 162. Do you qualify as a trader business? There's a bunch of court cases that say that rental real estate activity, being a passive investor like that does qualify as a trader business. And it's still confusing, because there's been court cases for are you material participant or not a material participant? And that gets completely nuanced. So what the IRS did was they decided to make a Safe Harbor provision, okay to see if your passive activity qualifies for the QBI deduction. The Safe Harbor changed in January of 2019, they came out with a Safe Harbor and now they've modified it again, just in September of what these procedures are supposed to be. Now, again, with this said, you don't have to follow Safe Harbor. Safe Harbor is if you want to make this election, you make it because you don't want the question the IRS to question you about is, is your passive income, is your rental real estate activities actually a qualified trader business? Or is it a hobby or something else? If you follow the Safe Harbor provisions, then you're lock stepped and they can't question you in court and try to say, well, you didn't qualify for it. But you can still have the argument that you do qualify as a trader business. And then you have to go through the whole material participation rules, it depends on how much activity you've been involved with, the burden of proof then becomes on you that you do not have to fight it in tax court if the IRS ever questions you. So you can follow the Safe Harbor rules, if you want to know if they do that.
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The episode will continue in just a moment.
08:03
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 overtaxation. Having the right attorney, 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.
08:58
Now, the Safe Harbor rules, there's a few things you have to do —- you have to keep separate books and records maintained to reflect income expenses for each rental real estate enterprise. Now, what does that mean? Enterprise. Now, what they consider rental real estate enterprises is residential versus commercial versus mixed property use. Okay? So you need it in those buckets, you have to you have to segregate your you can either group them together in one bucket, all your residential activity, or all your commercial activity in one bucket, or your mixed property use in one bucket. Or you can do each one individually. So each property I'm going to make this test for I'm going to do a Safe Harbor election for each property, or you can do a combined, okay, it's better recommended to do a combined and just your residential and just your commercial, and then you have to meet these certain rules. So you have to do 250 hours of rental service are performed per year with respect to the enterprise. And that 250 hours can be your property management company, you know, it can be you personally as the investor. Um, but anybody you hire to do stuff for your real estate, you need to have contemporaries records of that, meaning you have to have a log and that log has to have the hours of all services performed, the description of all services performed the dates, and you need who did the service. Um, what's included in those logs, you have advertising to rent or lease the real estate, you can negotiating or, or executing leases, verifying tenant applications, collecting rent, any daily operations, maintenance repairs to the property, including purchases of materials, supplies, management of the real estate, supervision of employees, or independent contractors. The main thing that's not included is any kind of financial activity. So any type of reading the profit and loss statement, or going over your numbers with your accountant, that doesn't count towards the hours that you need on that real estate enterprise, or hours traveling to and from on the rental property that's not included in your 250 hour minimum rule, but it's kind of it's kind of crazy, because you got to do it, you know, residential versus commercial, and you got to look at each entity that you have. So maybe you have an LLC that owns five real estate, residential real estate, you know, and then you got to make the 250 within that entity. All right, so that that matters to an entity level. So maybe if you have an LLC that only has one property, well, maybe you won’t hit the 250 hours. Okay, so maybe you can't make the Safe Harbor election. So, you know, any if because, you know, some investors like to make a separate LLC for each one, well, they might have a real hard time doing the Safe Harbor election. Now, that doesn't mean they don't qualify for the QBI deduction, because they can still make an argument that they do, if they are a qualified trader business under Code Section 162. It gets nuanced like, but now the burden of proof is on you if the IRS challenges it, then you have to fight them in court saying that yes, we are qualified trader business and then it gets into a whole other issue. Okay, so it's not really clear cut and dry. The IRS is kind of cheaping out on it. Yeah. Well, you know, that's kind of every IRS thing, right? There's a gray area.
12:32
So just so I understand what the Safe Harbor rules, you do have to submit that documentation with your return, is that correct? No, you don't submit it. When contemporaries tracking means you need to have it, you have the log. You can't like, post date all the information can't like come up with a log after the fact like, oh, now I'm getting audited, now I got to come up with a log, you have to have it on file. Right. Okay. To be honest, some of the rules, you can do that. So like, well, I won't get into it there, because we'll be talking about it forever. But, you know, so you have to have a log, and you should give it to your accountant, you have to sign a pledge that you do have these records. Now, the records saying that you have them all, actually with a new revenue procedure that just came out in September says, you have to say that you at least did the 250 hours, but the records don't have to be maintained until January 1 of 2020. Okay, so only so this tax year, you're still good. If you know that we've done 250 hours, you don't have to have all the records. But starting in 2020, you have to have those records now. They extended it for a year, because of the previous revenue procedure they said you had to have it for all 2019. But now they pushed it back to one more year. And that's just because there has been some rule changes in the course of 2019. Yes, and everybody's fighting like all the everybody's fighting about if this qualifies or not. But you know, if rental real estate is a trader business, and, you know, in my opinion, I think every rental real estate activity, even if you look at some of the old court cases, I think I had some pulled, look back at the hazard case, this was back in the 30s, where they only had one property that was inherited, and they had the same tenant living there for over 14 years, and they were considered a trader business — under Code Section 162. So you know, they're gonna fight about this for a while, it'll probably get changed again, there'll be a new revenue procedure out, but it's it's complicated, but the IRS put the Safe Harbor in to say, hey, if you give this and you're going to testify to this, and you have these documentations, and we won't fight you about it, got it. Okay, so other thing I should mention about that is — what is the actual deduction, is it 20%, 25%? 20% — well it's 20% of what you own in the property, or what the income generated. So it's net profit that you actually got, it's not like gross rents, it's right after your deductions, all your expenses. So whatever your income was, times that by 20%. Now, that's assuming you have enough basis or in the building, which for rental real estate, you're gonna anyway, so I actually can't think of a situation where you wouldn't follow the other rules that you may not qualify for the Qualified Business Income tax deduction. The only thing would be AGI limitation. So if you're real higher, you might not get it. But other than that, you'll be fine. I was just going to ask you that I know that there's a couple of things that do not qualify — triple net leases was one that I remember reading. I also thought that I read somewhere and you can correct me if I'm wrong, but I read that any time that you take to acquire new properties, analyze them, you know, do the actual negotiations, none of that is considered. Correct, that would be considered financial management of the activity, that's doesn't count as time for the 250 hour rule. It's legitimately just the day to day operations of the rental property.
16:08
Thank you for listening to the two part segment with Bo Travis on tax advice. I truly hope that you enjoyed his wealth of knowledge and find it to be useful in your real estate endeavors. 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