How An Investor Missed A $100K+ Tax Deduction

Walking around Costco this week, I realized that Halloween stuff has already come out in the stores. Is it just me or do the holidays seem to come faster and faster each year?

Speaking of Halloween, this week I wanted to share a tax-related horror story that happened to a brand new client of mine. To protect the privacy of this lovely person, we will refer to the client as “Jennifer.”

The Story

In 2013, Jennifer left her high paying job in the technology business. At part of her severance, she cashed out a lot of her stock options and deferred compensation, which resulted in a large tax bill. That year, Jennifer’s normal income of $150k ended up being closer to $400k. Even though it was a great windfall, this created some tax issues for her. For the first time, she realized that she needed to do some tax planning to ensure that she invested wisely and to keep some of her money from Uncle Sam.

That year, she interviewed several investment advisors and was able to find one that she was very comfortable working with. Unlike the other advisors Jennifer had dealt with in the past, these advisors were well versed in the real estate arena, as well as the stock market. This was extremely important to her because she is a long time investor and wanted to allocate a significant portion of her money to real estate deals now that she had retired.

Jennifer was extremely excited when her new investment advisors told her about a strategy where she can use her money to buy real estate and write off close to 80% of the purchase price on her income taxes in 2013. In the past when Jennifer would invest in rental properties, her tax advisor would calculate depreciation of that property over a 27.5 year period. This means that if the building portion of a rental property was purchased for $100k, then the annual depreciation would be $3,636 per year.

With this new strategy, however, Jennifer learned that she could potentially write off up to 80% of that property immediately in the first year. As her investment advisor told her, this strategy involved the use of a charitable trust.

Charitable Lead Trusts are a highly advanced planning area, but here are some of the basics of this strategy that Jennifer implemented thanks to the help of her investment advisor:

Step 1: Form the Trust

Jennifer worked with an attorney to set up a special purpose trust called a Charitable Lead Trust. This trust is in existence for a number of years and will dissolve at the end of the trust term. While it is in existence, the trust pledges to donate a percentage of proceeds to charities and non-profit organizations that Jennifer chooses. At the end of the trust term, the assets held by the trust are returned to Jennifer.

Step 2: Buy Real Estate

Once the trust is formed, Jennifer went shopping to buy some rental properties. She really liked the Memphis area and bought a few turnkey rentals. Those properties were purchased and transferred into the name of her Charitable Lead Trust. The rental income and rental expenses all went through the trust bank accounts. Later on, Jennifer identified a handful of charities that she wanted to support, and portions of her rental income were donated from the trust to the charities of her choosing.

What is wonderful about this particular strategy is that Jennifer was able to deduct close to 80% of the purchase price of her Memphis rentals all in 2013. The Charitable Lead Trust essentially is allowing Jennifer to take a tax deduction up front in 2013 for future charitable donations that she will be giving away for the next 7 to 10+ years. For Jennifer, this strategy was expected to provide her with close to $100k in tax deductions.

Seems perfect right? Well, not exactly.

Even though this was a powerful strategy, Jennifer ended up with little to no tax savings. The reason was that her tax preparer did not report the transaction correctly on Jennifer’s taxes. Jennifer did all the right things on her end:

She used a trust attorney to draft up he trust documents.
She did due diligence and invested in rental real estate that provided good returns.
She transferred the title of the properties into the trust so that the trust officially owned them.
She identified charities she wanted to support and donated a portion of her rental income to the non profits.

The only thing that Jennifer forgot to do was to make sure that her CPA was kept in the loop. Even though Jennifer’s CPA was someone who understood rental real estate, she was not informed of this Charitable Trust strategy.

Jennifer’s CPA knew that she purchased a few more Memphis rentals and reported those on her taxes in 2013. What the CPA did not know was that Jennifer had moved ownership of these properties into the trust, so even though the rental activities were reported to the IRS, the $100k+ of charitable deductions were never claimed on her personal tax return.

Due to the lack of communication between Jennifer and her team members, one of the most important steps of benefiting from this strategy was left out: SHOWING IT AS A DEDUCTION ON THE TAX RETURNS.

How to Avoid Tax Errors

This is an example of how important it is to ensure that your various team members are kept in the loop to ensure that you are getting the best tax, legal, and investment strategies. It is not your job to understand and explain everything. It is your job to make sure that you connect your team members so they understand what is occurring in your world. A simple conference call between the investment advisor, CPA, and attorney could have prevented this disaster from occurring.

Ultimately in the end, there was some good news and some bad news for Jennifer. The good news is that we will now file amended tax returns for her to claim that $100k+ deduction for 2013. The bad news is that with any amended tax return comes a higher IRS audit risk. So before you file your taxes next time, make sure you are communicating with your team so that all the major items are addressed before you sign on your taxes.

Have you ever missed out on deductions related to real estate?

Be sure to leave a comment below, and let’s talk!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.