327: Real Estate and Taxes: What You Need to Know!
Buck: Welcome back to show everyone. Today. My guest on Wealth Formula Podcast is Brandon Hall. Brandon is a Certified Public Accountant, national speaker, and is a founding managing partner of Hall CPA. He works with real estate investors indicators private equity funds and helps them to optimize tax positions to streamline accounting and business functions. Brandon believes that real estate investing is critical to building sustainable and generational wealth. He’s worked at some big firms like PricewaterhouseCoopers Young prior to launching his own CPA firm Hall CPA PLLC. He is a guy with his own podcast as well, I believe it’s called the Real Estate CPA and we’ll talk about that in a minute. Brandon, welcome to Wealth Formula Podcast.
Brandon: Thank you. Thank you for having me on. I’m really excited to be here. It sounds like you have an awesome group behind you.
Buck: Oh, yeah. The Wealth Formula Nation is one of a kind. It truly is. We talked a little bit offline. This is a real group with a lot of interests, smart people, and lots of questions. So you obviously are CPA and you’re at Pricewaterhouse. And with these big four type places, why did you focus on real estate is sort of your specialty?
Brandon: Yeah, great question. So when I was at PricewaterhouseCoopers, I was probably three months into my corporate career, realized I wasn’t going to last. I didn’t see that for myself. So I immediately started looking for a way out. And at the time and I believe that the movement is still strong, the financial independence retire early movement I kind of found that, fell into that, found real estate and realized, hey, I can buy a bunch of rentals and I can replace my day job. So I bought a rental, bought a three unit rental, and it cash flows, $700 a month. I still have it today. It’s beautiful. But I started looking at my Excel sheet and realizing, okay, I would have to buy like 20 of these to really get to where I want to be. And that’s going to take me 15 years at this CPA salary rate. So this isn’t going to work. So I started looking for entrepreneurship opportunities and around the same time got involved in the Bigger Pockets forum. So a lot of people asking tax questions just decided to start answering them and just sort of snowballed into the firm that I have today. So I’ve got 40 people now. We are national. We work with clients in every single state. We are solely focused on real estate, have about 700 clients, and we go all the way to the private equity firms. We’ve got one that’s got a billion and a half under management and where they’re CFO. So we do everything for them, all the way down to the mom and pops that just bought their first short term rental out in the smokies or at the beach or something.
Buck: How many CPAs? Is it 40 CPAs?
Brandon: No, I think we have like 20 or so CPAs. Yeah, about half the group.
Buck: Well, this is a group that’s very familiar with real estate, but just to set the stage, remind us some of the major primary tax benefits of real estate, investing in this type of investing as opposed to other things.
Brandon: Yeah. So I think where I’d like to start with this is just in general, what are the benefits of real estate? Because I think what happens in high income groups, they all get together either online or in person, and they start talking about the tax benefits of investing in real estate. And typically the conversation terms turns to tax losses and then 90% of the group is going, well, my CPA didn’t allow me to claim my tax losses. So that must mean that I’m not getting any tax benefits. So I want to start there. I want to address that. Sure. When you buy a rental, let’s say you buy a rental for $100,000 or you could buy a fractional rental, right? Like if you’re investing in syndication, same concept, I buy a rental for 100K. Let’s say that I have $6,000 of cash flow throughout the year and I have $8,000 of depreciation expense for whatever reason. Maybe I’m accelerating some depreciation. So my $6,000 in cash flow, that’s cold, hard cash that hit my pocket, but I have enough depreciation to create a tax loss. So what’s important to understand is that the cash flow is tax deferred. Now, I’m not paying tax on it today thanks to that depreciation. Now, if I have a tax loss, once I factor in that depreciation, I may not be able to claim that tax loss. So let’s just call it $2,000. Let’s say I have a $2,000 tax loss. I work full time in my CPA firm, so I would not be able to claim that tax loss unless I meet one of the exceptions to the past activity loss rules, which we can talk about here in a few minutes. But the point is that I still receive $6,000 of cash flow and I didn’t pay tax on the $6,000 of cash flow today. And that’s what I want people to not lose sight of, is the fact that if you invest in real estate, the cash flow coming back to you. You’re not paying tax on that. So even if you can’t use the tax loss, you are still benefiting. But that depreciation is really the main benefit to investing in real estate because it just defers the recognition of the tax that we have to pay on that cash flow and just owning that asset.
Buck: And this goes back to just, again, just as some basic 101 stuff on this, the idea of different baskets of income. Do you want to kind of outline that a little bit?
Brandon: Yeah, absolutely. So we got that $2,000 tax loss and the question then becomes, can I use the tax loss? And to answer that question, we have to look at Section 469 of the Internal Revenue Code that came into effect in when it came into effect, it created two buckets of income. So there’s a passive bucket of income and there’s a non passive bucket of income. But before 1986, I could be a physician earning a million dollars a year, go buy a rental property cost segregated, accelerate the depreciation, and take a big tax loss against my position salary. So the Section 469 rules that were implemented in 1986 were implemented to stop people working full time in non real estate businesses from using rental tax losses against their non real estate income. So after 1986, the same position that could use the rental losses last year, they can’t use it this year unless they qualify for an exception. So these rules created the passive bucket and the non passive bucket. And what they say is all rental activities are passive unless you qualify as a real estate professional. And any trader business that you do not materially participate in is passive. So any rental activity that I buy is automatically going to flow into that passive bucket. And any trader business that I invest in that I’m not materially participating in. Like, let’s say I go put $100,000 in my local hair salon to help them with expansion opportunities. They give me $10,000 a year back and net profits. But I’m not participating. I’m not making decisions, I’m not voting. That is passive income. So that also goes into the passive bucket. Passive losses and passive income can offset each other, but passive losses cannot offset non passive income. So that’s the other bucket. So non passive income is my W2 income, my CPA firm income, since I materially participate in the CPA firm, right? So that’s all non passive income. What happens is the $2,000 of net loss that I was talking about in my prior example flows into my passive bucket and it’s going to be stuck there if I don’t have any passive income. Or I can qualify for an exception to the passive activity loss rules. One of those is real estate professional status, which I’m sure everybody has heard of. So if I can qualify for that exception, then I can effectively jump the $2,000 tax loss out of the passive bucket and put it into that non passive bucket. And that’s ideal because that’s where my W2 income is. That’s where my business income is, and then I can use it to offset that type of income.
Buck: So this is just a lot to unpack here. But just for the audience sake, there are a number of physicians out there and this is a very interesting thing. A lot of you are not old enough. And I wasn’t old enough to have the good old days being a physician back in the early 80s where you were making ridiculous amounts of money and reimbursement was great and you would be able to buy these apartment buildings and basically depreciate all of that millions of dollars against those were like the seriously good old days for doctors. And so now we’ve got this other since 1986, we’ve had these other rules in the basket. Anyway, that’s where we’re at. Now, you mentioned and I want to get into rep status in a bit, but some other potential exceptions, what other kinds of exceptions are there for using passive depreciation against potentially other types of income?
Brandon: Yes, the exceptions allow you to move the rental losses out of the passive bucket and into the non passive bucket. And again, that’s ideal from a tax optimization standpoint. I’d rather do that than have my losses be suspended. And if my losses are suspended, you don’t lose them, they just carry forward. So we get that question every once in awhile, but they are suspended passive losses. Now, the three exceptions. The first one is real Estate Professional status. So if I qualify as a real estate professional and we can go over these rules in a second, then I can jump my if I qualify as real estate professional and materially participate in my rental activities, then I jump my rental losses out of the passive bucket into the non passive bucket. So that’s ideal. Two other exceptions are if I sell my rental so I can sell a passive activity at a gain, and my passive losses can offset the passive activity gain. So Rental B can offset Rental A, right? My syndication losses can offset my rental gains. And then the third exception is if I earn less than $150,000, I can claim up to a $25,000 passive activity loss allowance. And there’s some rules in there that you need to be aware of. Like you got to own 10% of the activity, you’ve got to be actively participating, and you only get the full 25K if you’re below $100,000 in earnings. Once you get above 100, between 100 and 150, that $25,000 starts to phase out. It’s actually kind of interesting because every once in a while we’ll get clients that are like one hundred and fifty five k and they’re like, oh, I’ll put $6,000 in my four hundred and one K and then I get $25,000 loss allowance. That’s not how it works because you’ll be at 149 out of 150, and that means you get like $500 of that passive activity loss allowance. So you really got to get down into earnings to qualify for that. But that’s nice. If you can qualify for that passive activity loss allowance, it’s nice because it’s a very low threshold of work that you have to do to actually qualify. You don’t have to be a real estate professional. You don’t have to materially participate. So that’s a nice one. There is a fourth exception and kind of like not an official exception, but it is the short term rental loophole.
Buck: Yes, I keep hearing about that. Something I don’t know a lot about, but what is that little loophole we’re talking about?
Brandon: Yeah, I have to start by explaining the rules to real Estate Professional status. Sure. Again, I’m going to keep repeating myself because I know that this is a lot to take in. So just bear with me. The passive activity loss rules say that they create two buckets of income, passive and non passive. All my W2 income, my business income, where I would be able to participate that’s in the non passive bucket. Ideally, I can move my rentals into the non passive bucket, but they are default in the passive bucket. So all rental activities where I am not a real estate professional, that is in that passive bucket. Right. So the question becomes for a well, let me back up. Qualifying as a real estate professional means spending 750 hours and more time in real property trades or businesses than anywhere else. So what happens with physicians, for example, is you’re working full time at your hospital or private practice and you can’t spend more time in real estate than you can at your w two job or at your business. And as a result you can’t qualify as a real estate professional. So when the passive activity loss will say all rentals are passive unless you qualify as a real estate professional, well you lose because you can’t qualify as a real estate professional. So all your rentals are going to be passive and that’s it, game over. And that’s where short term rentals come in because the definitions, the words that we use are very important. So the passive activity loss rules say again, all rental activities are passive unless you qualify as a real estate professional. So the question becomes what is the definition of a rental activity? And so we go to the treasury regulations and the treasury regulations define what a rental activity is not. And they say a rental activity is not a rental where you have an average period of customer use of seven days or less, which is most short term rentals. So if I have an Airbnb or a VRBO property and I have an average period of customer use of seven days or less, then I don’t have a rental activity under section 469. So if I go back to those passive activity loss rules and it says all rental activities are passive unless you qualify as a real estate professional, I get to axe that line because I don’t have rental activities. So I don’t have to worry about real estate professional status. I do have to go down to the next piece of this, which is if you don’t materially participate, it’s still passive. So if I have a short term rental where the average period of customer use is seven days or less, and if I materially participate in that short term rental activity, then that will be a non passive activity. Meaning that I can cost segregate, it bonus depreciate, it create a large tax loss and I can use that tax loss to offset my w to income, my CPA firm income, even if I’m working full time at those jobs. That’s the beauty of this is I can still be a full time employee running a full time business and still use short term rentals to offset my income and my tax.
Buck: Well, let’s talk about reps as a real estate professional status because this is obviously a big thing for people if they can qualify. There’s tremendous opportunity here, but I think let’s talk about what exactly the rep status is. How do you qualify and then we’ll kind of move on from there.
Brandon: So to qualify as a real estate professional, you need to spend 750 hours in a real property trader business, and you need to spend more time in those real property trades or businesses than you do anywhere else. So if I’m a full time position, I cannot qualify as a real estate professional. And I think that that’s typically a shock to high income earners because they’re very ambitious. I know I am myself, and I don’t like to be told no. But that is the way that it works with real estate professional status. If you are a full time employee or you are working in a business full time, you cannot qualify because you cannot work more in real estate than you can at your full time job or your full time business. So you got to spend 750 hours and more time in real estate than anywhere else. Typically, the conversations divulge into, like, what hours count, what hours don’t count. We got to remind ourselves that the IRS does audit this. It’s one of the most litigated pieces of the entire tax code. So you got to be really careful. Cross all your T’s, dot all your I’s, anybody that tells you it’s easy to get, they don’t know what they’re talking about or they haven’t been through the audit, so you’ve got to be really careful. But typically, the people that lose IRS audits with real estate professional status or people that book research time, education time, travel time as qualifying hours, none of that time is going to count as material participation hours or real estate professional status hours. And it’s not going to count because that’s the easy stuff, right? I could sit on realtor.com all day long and counted as research time, so they’re never going to count that stuff. You got to be down at the property, swinging the hammer, moving things around. You got to be dealing with tenants, leases, evictions, that type of stuff. That time is going to count. And if you think about it, all that time is like property manager type time, right? So if you have a property manager look at what they’re doing, that’s your real estate professional status times. It’s a really simple way to think about it.
Buck: So that’s an interesting topic you bring up because obviously you’re representing some big players in real estate too. And Donald Trump is a real estate professional. He’s not swinging hammers, right? Talk about this distinction there, because obviously there’s underwriting there’s making decisions on properties and leases and due diligence and all that. But when you look at sort of higher end real estate syndicators, are we talking about the same type of criteria here? Is Donald Trump walking around filling out his diary? I’m curious about this. It’s always like, for somebody like me, I’m really a full time real estate guy, right? And I do keep a diary and stuff, but sometimes I sit there and I’m wondering, what the I mean, seriously, we’ve got a couple of billion dollars in real estate under management. Am I really keeping a diary, but I am. So talk a little bit about that or is this come down to listen, the litigation is in the cases that are not that obvious, right? Yeah. So talk a little bit about that because there’s the law and the technicalities and then there’s reality of what’s obvious and what’s not obvious.
Brandon: Yeah, great points and great questions. So first, I just want to disclose I’m not Donald Trump’s, CPA.
Buck: You don’t know about the diary.
Brandon: But you do bring up a good point. So if I’m syndicating real estate full time, but I’m not necessarily one swing of the hammer, what’s the deal? Now we kind of swing on the side of you’re probably safe because you’re in the real estate game full time. We would probably peg you under the real property operations trader business. There’s eleven real property trades or businesses that the IRS or the Internal Revenue Code lists out as qualifying real property trades of businesses. Real property operations is one of those and that’s all the things that you would do as the owner of a business as a property. So I would say you’re probably fine. One of my partners, Tom, would probably say that you’re fine as well. If you’re a syndicator that raises a ton of money and hand it to somebody else that’s sponsoring the deal, like the actual sponsor and they’re the ones that’s on the phone with the property management company all day long. Maybe you have some risk there. But typically the people that are doing this full time are fine. They’ve got enough going on.
Buck: You’re general partner on billion dollar real estate.
Brandon: Yeah, but that said, I would still highly encourage you to keep the time log only because there is a tax score case and it’s slipping my mind right now, but I’ve got it in my dock somewhere. Tax score case where a real estate agent didn’t produce a time log and was thrown out. And a real estate agent like brokerage is a real property trader business. So keep the time log regardless because you asked the question of are they only kind of litigating these edge cases and they’re litigating cases. The IRS is going to litigate cases where they think that there’s a return on their time, right, a return on their investment. So if they audit you and you’ve got everything in order, they’re probably going to leave you alone. If they audit you and you’re booking like thousands of hours of research and education time, you book the listening to this podcast as reps hours and stuff like that, you are going to be audited pretty hardcore. You’re probably going to lose that audit and then you’re going to have to go battle it out in tax part where you’re probably also going to lose. So you just got to like if you keep great documentation, you do it legit. You generally have nothing to worry about. I don’t know if that.
Buck: No, that makes a lot of sense. I think that’s the point I was trying to get at though, is there’s different skills of this being owning a Duplex versus being Kenny McElroy or any of these other guys out there who are doing tons of real estate. I know you’ve talked about defending audits before and you’ve had these situations where you’ve defended people for rep status yourself. What is your sense about the actual auditors and their level of knowledge in this space? And the reason I ask you that is because I’ve been audited a few times and for various reasons, I think anybody who generally makes a lot of money can do or what will have happened. But I’ve never found them to be particularly sophisticated. I always feel like they’re kind of because the stuff that you’re talking about, some of it gets pretty nuanced. And I’m just curious, in your experience, are these auditors coming at you with stuff that a lot of real estate CPAs aren’t even bringing up?
Brandon: Yes and no. So I would say auditors are relatively sophisticated. They understand real estate professional status, the nuances, they understand all the TaxPORT cases. I have found ourselves. Not really. I mean, we do a little bit of kind of hey, here’s our position, here’s why. A little bit of that sort of explanation, education type of stuff. But typically they already know. Now I will say that we have not had any of our clients. I shouldn’t say we have one right now that is getting audited. But the audits that we’ve helped in, we get pulled in mid audit because people listen to our podcast. They get audited for real estate professional status. So then they go and listen to our podcast, they read our big guide and they call us up and say, please help me with this audit. So we get pulled in and we’ll review the records. I would say 95% of the time are delivering bad news right from the get go. It’s like, yeah, you have 1000 hours of research, it’s not going to fly. And they always lose every single time. We won a few where it’s just kind of like I should say we won because we’re just kind of like edge consulting. We’re not really in the thick of it with them and their tax pros, but we have helped guide conversations and guide audits and help people win those audits. So it just kind of depends. I mean, most of the people that are losing are the ones that are booking all the education time and the research time and they think that, again, it’s just the easy time to book that. You think that qualifies you, but it just doesn’t. And the IRS will tell you it doesn’t. And then they’ll just back the entire thing out and tell you to battle it out in tax court. And then the recommendation is going to be don’t do that because that’s going to cost you ten grand and you’re going to lose.
Buck: Yeah, right, sure. Going back to talking about the baskets a little bit, you have people who in our group, I’ve come across this a few times and have been asked, and I’m not a CPA, obviously, I know a little enough to be dangerous, but I try not to be dangerous. What happens, for example, in my group, in our investor group, people invest in tons of real estate, and they’ve got they may have like a half million dollars of losses that they’re just that they’re not able to use against ordinary income. Maybe they saw the practice in the next year, they’re like, you know what, I’ve got a bunch of money. I’m just going to become a real estate professional. I’m going to do all this. So they make the move, right? They do that. What happens to the passive losses that were suspended? They can’t get active evaded in the rears or can they?
Brandon: You mean when you qualify as a real estate professional?
Buck: Yeah. If you’ve got a bunch of passive losses that you’ve accrued over time, then one year you make the leap, and now you’re legitimate rep. What happens to those passive losses?
Brandon: You have the right understanding. So if you have prior suspended passive losses, qualifying as a real estate professional will not unlock those losses. The only way that you can tap into those prior suspended losses is to generate current year passive income or sell a passive activity at a gain that those suspended losses would then offset. So that’s the only way to tap into those prior suspended losses.
Buck: Brandon, tell us a little bit more about your practice. And if people want to engage in various ways how they could potentially do that. I mean, it sounds like you work sometimes in advisory role. Sometimes you have actual clients. Tell us a little bit about that.
Brandon: Yeah, so there’s generally two options to come on board with us. So option number one is the very low cost option. It’s more of a course education platform that we’ve built out. We run tax boot camps. The whole idea there is for you to just come get educated on this type of stuff so that you can take it back to your own CPA. Like, we don’t want to blow up relationships with your best friend CPA guy that you’ve been using for a long time, or gal. But we do want to make sure that landlords are educated because we see a lot of bad, low quality tax advice and tax returns. So we’ve got a boot camp. We’ve got some courses you can check. We’ve got a free community group on Facebook called Taxmartrealestateinvestors. I think it’s just Facebook. Comtaxmartinvestors. Check that out and you’ll see, like, our boot camps and stuff there. If you want to come on board as an actual client, we have two options. The first option is to come on board with tax advisory. So you’ll have an advisor, they’ll sit down with you. It’s a whole year thing, but the first 45 to 60 days are more intensive. It’s a planning process and we’ll map out everything that you need to be focused on over the coming years so people walk out of that. Our average NPS score, net Promoter Score is like a 9.7, which is ridiculous. I think in the CPA industry, the average is like a six. Net Promoter Score. It basically just asks, like, how likely are you to refer us to a friend or family member? Okay. And the idea is, if you get like above a nine, you’ve got promoters of your business, and if you’re below a six, you’ve got the tractors. The CPA industry in general kind of stinks. A client service.
Buck: That’s very true.
Brandon: Yeah, for sure. We’ve dropped the ball a lot too, but our advisors, they crush it. So if you’re interested in that, you can go to the real estatecpa.com and there’s a big become a client button that you can click. But if you’re running like a syndication or a fund, or if you’re a larger operator, if you’ve got a larger portfolio, we do a whole lot of outsourced. Accounting, controller services, CFO services, and we’re really growing that practice out right now. And if you’re interested in something like that, you can also go to the real estatecpa.com and click that become a Client button and we’ll take care of you there too.
Buck: And then you obviously have a podcast. Tell us a little bit about the podcast.
Brandon: Yes. So the podcast is called Tax Smart Real Estate Investors podcast. We actually just switched it from the real estate CPA Podcast to Little Rebrand. Yes, we have a few hundred episodes, 100,000 downloads a month on average. It’s a pretty big one, but yeah, we do deep dives into these types of topics, but we try to break it down into layman’s terms. Like that whole short term rental thing that I just explained. I think we have like seven episodes on that Real Estate Professional status. We have like six or seven episodes on. We label them so it’s easy to go find them. But yeah, definitely check that out. A lot of people give us really great feedback about it.
Buck: Good stuff, Brandon. I appreciate you being on, and I’m sure Wealth Formula people will be contacting you in short order, so good luck and I hopefully will not overwhelm you guys with too many people, but this is the kind of stuff we talk about on this show. So I want to thank you again for being on Wealth Formula Podcast and love to have you on again in the future sometime.
Brandon: Thanks, Buck. Really appreciate it.
Buck: We’ll be right back.