April 18th, 2016. Tax day. A day that brought many investors tears — and others, sweet happiness.
Now that it’s over and your tax returns are submitted or extended, it’s time to look back on 2015 and ask yourself how you can improve your financial and tax position for 2016.
Being real estate investors or business owners adds significant complexity to one’s tax situation. It’s important to remember that reducing your tax liability is one key to investing and business success. Decreasing taxes translates to more money in your pocket, a higher return on investment, and a faster accumulation of wealth.
I’m going to discuss common topics to bring up and review with your CPA. Even if these topics are not applicable to you, I encourage you to think about how they may eventually impact you.
For Those With a Day Job
Having a day job is tough from a tax perspective, mainly because few tax strategies will result in savings significant enough for me to want to call a tax planning engagement successful.
The number one strategy those with a day job can implement is to review how much money you owed or were refunded and determine how you should adjust your W-4 so that you owe or are refunded less in 2016.
There is a tax rule that says as long as you pay in 90% of your tax liability, you won’t be penalized come April 15th. If you extend your returns and you’ve paid at least 90% of your tax liability, you will have an additional six months to come up with the remaining 10%, penalty-free.
At my firm, we work with clients to adjust their W-4s so that they owe around 5-8% of their total tax liability on April 15th. This means that throughout the year they have paid in 92-95% of their total tax liability.
The key reason for this strategy is that you will have more working capital in your pocket throughout the year, rather than getting a large refund or owing a small amount at year-end. Having working capital throughout the year allows you to maintain a more flexible investment strategy and take advantage of opportunities when they present themselves.
Many CPAs will be delighted to tell you that you are receiving a large refund. Others will tell you that they want you to be as close to $0 owe/refunded as possible.
Both of these strategies are classic CPA strategies, meaning the client will be super happy, but in the end, the client will lose out. This is due to the fact that time value of money creates significant opportunity costs when the IRS is holding your funds hostage. Find a CPA who will have this talk with you, as it means they have your best interest in mind and are more interested in seeing you create wealth than being elated by a large refund.
For Those Owning Rental Property
Take a look at your 2015 returns and determine whether your rentals generated taxable income or loss. Then consider your plans for 2016 and how many rentals you’ll be adding to your portfolio.
If your rentals generated taxable income, consider having a cost segregation study performed on one or all of your rentals to boost depreciation. You will want to understand your current tax bracket, how your tax bracket may change in the future, and whether a cost segregation study makes sense at the given time.
You may also wish to focus on repairing and replacing worn out components in 2016. Doing so will reduce your taxable rental income through writing off currently deductible expenses. Remember, due to the Tangible Property Regulations, the key here is to “mend and patch” rather than replace. This is because any expense over $2,500 most likely needs to be capitalized.
The $2,500 threshold is a result of the De Minimis Safe Harbor. It’s important to note that this is a book conformity rule, meaning that your accounting records must reflect the writing off of the component under $2,500 rather the than capitalization of the component.
If 2015 generated a passive loss, first determine if — and how much of — the passive loss was deductible on your returns. The Passive Activity Loss rules dictate how much of a passive loss you can actually write off on your returns. High earners may find that they cannot write any of their passive losses, and instead those losses are continuously carried forward year over year.
If you have suspended passive losses (meaning, those carried forward), then this year may be a good year to consider selling property with large built-in gains. The passive losses will be used to offset some, or all, of the capital gains. Considering how well the real estate market is trending, 2016 will likely be a good year to off load some of your property and re-allocate your capital.
If you have a decently sized rental portfolio built out that always produces a taxable loss, consider quitting your day job if you haven’t already. I know, that’s an extreme measure, but it could produce significant tax savings, especially if you are married and now able to write off the passive losses against your spouse’s income.
You should also consider how you may be able to qualify for the real estate professional tax designation. Becoming a real estate professional allows you to write off all of your passive losses against your earned income without regard to the passive activity loss limitations. The result is significant tax savings.
To qualify, you must work 750 hours in a real estate trade or business, and more than half of all working hours must be in that real estate trade or business. This means that people with full-time jobs must work an additional 2,081 hours on top of their day jobs or they won’t qualify.
There’s another step after qualifying as a real estate professional to write off your losses. You must then materially participate in your rental activities. More on that another time.
Lastly, consider your entity strategy. Does it make sense? Should you make any changes? Now is the time to do so.
For Real Estate Agents, Flippers, Wholesalers, and Developers
Entities and accounting. That’s what it’s about for self-employed individuals.
Entity structuring is one of the best ways business owners can save money. If you are expecting to earn more than $40k net profit, it may be a good idea to consider establishing an S-Corporation. However, you should never do this without the guidance of professionals. Many folks come to me after establishing an entity, and I hate when I have to tell them it was a poor choice.
Review 2015 and determine if entity structuring could have helped you save money. Then plan for 2016 and determine if you are on the right path.
Why did I mention accounting? The secret to saving significant amounts of money on taxes is documenting all of your expenses. Without an accounting system in place, you’re missing out on hundreds, potentially thousands of dollars in savings.
You will need to review your current accounting system and determine whether or not it meets your needs. A good CPA should be able to help you establish a streamlined accounting system and coach you through accounting processes.
Consider cloud based accounting systems and documentation management for best results. This will make collaboration with your CPA easy and seamless.
A trend I’ve noticed among my clients who are flipping homes over the past year and a half is that margins are decreasing. This means to generate the same profit, flippers will need to scale their businesses. Ask your CPA how he/she can help, as there may be tax consequences to scaling. For instance, hiring full or part-time employees is significantly costlier than hiring a contractor.
For Those Lending Personal Funds
Lending money is a great way to produce significant income and returns. In fact, I’d wager that most of the smart money is currently in lending. This is based on my own observations of my clients and the real estate market.
The problem with lending your funds is that the returns generally come back as interest income. That’s bad because there are very few ways to develop tax plans around interest income without getting really creative (and also expensive).
So for the average small time lender, consider whether lending still makes sense for you or if there are alternative routes to take. To figure your real return, multiply your interest income by your tax rate. The net result will not likely be as high as you originally thought.
For Everyone Performing Their Own Accounting
Accounting is a critical function for every business and should not be taken on haphazardly, yet so many investors and business owners do just that.
If you do not have an accounting function in place, start with MS Excel and see if that continuously meets your needs. As you scale, you will likely want to move to cloud accounting systems and have CPA oversight. You may even wish to fully outsource your accounting.
The key is to ensure that your accounting function captures all of your business expenses. Handing a box of receipts to your CPA at year-end may be sufficient for you; however, I guarantee you are missing out on plenty of tax savings. Not only that, the cost for a CPA to wade through your pile of receipts will be significantly more than adopting an online accounting solution.
Ask a CPA what software they prefer to work with and if they offer any sort of setup or training. Many CPAs will love to help you, as it will make their life much easier during tax season.
Get Started Today, Don’t Wait!
Start your review and plan a meeting with your CPA today. Don’t wait until the end of 2016 or the beginning of 2017, as it will already be too late.
There are plenty of strategies your can discuss with your CPAs to save money on taxes. One of the best strategies is to simply document everything. This means implementing an accounting solution that works for you and meets your needs. Ask your CPA how he/she can help you streamline your business.
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.