Business Management

Story From a CPA: The Time an Investor Paid a $96k Tax Bill He Shouldn’t Have

Expertise: Business Management, Real Estate Investing Basics, Personal Finance, Personal Development, Real Estate News & Commentary, Mortgages & Creative Financing
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This article is an excerpt from The Book on Tax Strategies for the Savvy Real Estate Investor by Amanda Han and Matthew MacFarland. Pick up a copy from the BiggerPockets Bookstore!

There is no such thing as a “tax guru.” In other words, no one single person in the United States can claim to know everything about the U.S. tax code. That would be impossible. Have you ever met a healthcare guru? Someone who can clean your teeth, deliver your baby, and do heart and brain surgery on you at the same time? Of course not! The heart surgeon went to school for years and years and worked thousands of hours to fine-tune their skills in heart surgery. He is probably not the best person to choose when you need your teeth cleaned or a baby delivered.

Meet Jack (of All Trades)

One of the biggest issues we see in our accounting profession is that, unfortunately for many taxpayers, a lot of advisors fall into the jack-of-all-trades category. You see, setting up an accounting business is actually pretty easy. In fact, tax preparers don’t even need a college degree; a large percentage of the people who prepare tax returns at the franchise-type locations have neither a degree nor any advanced tax or accounting knowledge.

You may wonder, “What about someone who has gone through the most extensive training and obtained their CPA license and met all the education and work experience requirements? Does that make them an expert in all tax matters?” Of course not! The tax code and its complexities are simply too much for one individual to know completely.

However, we often see individuals, whether licensed or not, open an accounting and tax office and just start advertising for clients. After all, there’s a very low barrier of entry for this business. Your biggest expense in opening an accounting and tax business is probably rent—which you can avoid if you work from home. You probably also need a laptop and some office supplies such as paper and paper clips, right? Oh, we forgot a calculator! Yes, you do need a calculator.

Assuming the person has great marketing skills, potential clients will come knocking as soon as the business is open. It is generally hard to turn away clients, and this goes for accounting and tax businesses as well. National statistics show that the average one-person tax company has approximately 700 clients, if not more. Those clients can represent many different types of tax profiles, such as W-2 employees, consultants, owners of restaurants or manufacturing companies, and of course, real estate investors.

This means that to provide the best service, the tax advisor should keep up-to-date on all the changes for these areas within the tax code. Not only do they need to know how to take advantage of the latest manufacturing tax credits, but they also need to know about tax credits for physicians who work in remote, rural locations, as well as the latest depreciation rules for improvements made to a rental property.

Each of these tax benefits is buried within its own set of complex rules, exceptions, and loopholes. On top of that, the average preparer works about 18 hours a day during tax season, so it is no wonder that a lot of tax deductions and loopholes are missed.

Let’s be honest, have you ever met a CPA or tax person who told you they couldn’t help you because they didn’t understand real estate taxes? If you did, that would be an exception and extremely rare. In fact, you should count your lucky stars if someone has told you they couldn’t help you with your taxes because they didn’t understand or specialize in real estate. This honest and trustworthy person may have saved you thousands of dollars in taxes by telling you the truth.

In the real word, most tax advisors will likely tell you that they understand real estate. Not only can they help you with your real estate taxes, but they can also help with your brother’s restaurant business, if your brother is looking for a CPA, too.

It would be nice to have a jack-of-all trades tax advisor, right? At the very least, that person could be a kind of one-stop shop where you and your brother could both go to get your taxes done at the same time.

How specialized does your CPA really need to be? After all, taxes are taxes, right?


Something Doesn’t Add Up

Real Life: Our client Darren is a Bostonian who raised seven sons by working in the welding business for more than 25 years. After hearing us speak on an educational podcast, he sent us an email to ask if we could help him. Now, let me warn you, this story is not a happy one—definitely not one of those feel good, chicken-soup-for-the-soul types of stories. If you are brave enough to read a real story about how a real estate investor could lose a ton of money because of a small mistake, keep reading.

We received the following email from Darren:

My name is Darren, and I retired early from welding a year ago to sit in the sun, or so I thought. My wife and I moved away from the harsh New England winters to work on our tan in sunny Florida.

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While managing my investments over the past year, it has become crystal clear to me that I need to invest in real estate to build wealth, so as of early December, I have begun taking steps to abandon the stock market. I have purchased a few properties and plan on buying more before the year is over. I really need someone to help me on this journey.

Let me know if this is something you can help me with. I’m not sure if it is too late, but we paid Uncle Sam $30,000 in taxes this year and still owe him $66,000. I did not have a business last year, and we are both retired, so I didn’t have any money to use to start my real estate investing aside from my work 401(k) money.

I look forward to hearing from you.

As soon as we read this email, we knew we needed to speak with Darren immediately. It didn’t make sense that someone with his profile—who had recently retired, did not own a business, and had no other income—would owe more than $96,000 in taxes. It just didn’t add up. Owing this much in taxes would mean that Darren, this self-proclaimed retired (and tanned) gentleman, had somehow made more than $300,000 in income that he had to pay taxes on.

Related: 4 Helpful Tax Tips for Overwhelmed Landlords

Did he get some sort of large severance check like big corporate executives do? That’s not something you commonly see in the welding industry. Also, Darren didn’t mention anything about severance pay. Could he have received a large vacation payout when he left his employer? This was also not likely, unless his company had paid him for years and years of accrued vacation. None of the numbers really made sense to us. The only other thing he mentioned in his email was his 401(k), which was the only source of cash he could use for real estate investing. We had some theories about why his tax bill was so high, and unfortunately, when we spoke with Darren, he confirmed exactly what we had feared.

About a month into his retirement, Darren felt like he was losing control of his finances. Watching the stock market rise and fall every day made him uneasy, so he decided to take matters into his own hands when he heard about a real estate investment conference just a few miles from his house. At the conference, Darren met all sorts of real estate investors from across the United States. It was an eye-opening experience, and he quickly learned that if he wanted to have more control over his money and build a legacy to pass on to his kids and grandkids, he should consider adding some real estate to his investment portfolio.

According to the expert who taught a breakout class during the conference, one of the emerging markets that would likely show a large appreciation in the next five years was none other than sunny Florida.

"Not a bad idea," Darren thought. What better way to start than to invest in his own backyard? A few of the teachers taught some creative financing techniques, which really piqued Darren's interest, given that he didn't have a pile of cash with which to jump-start his investing at that time. This was why he was so excited to learn at the conference that using retirement money for real estate investments could be a good idea.

Traditionally, people put the retirement money in their 401(k)s and IRAs into the stock market or mutual funds. However, the experts at the real estate conference apparently thought that real estate was a great place to invest retirement money as well.

Early the next morning, Darren contacted his retirement custodian and told them he wanted to use his money to purchase some rental properties. To his surprise, the investment custodian told him he was not allowed to do this. Shocked and disappointed by this response, Darren didn’t understand why he couldn’t. He was pretty sure one of the instructors at the conference had told him he could use retirement money to buy rental properties and that there was some benefit to doing so, though Darren couldn’t exactly remember what.

To get to the bottom of the issue, Darren contacted his CPA in Boston, who was an old family friend who had helped Darren and his parents file taxes for over a decade. In fact, Darren seemed to remember that his CPA also owned a few rental properties. He felt that he was the best person to ask.

Unfortunately, the CPA did not have good news for Darren. He agreed with the investment firm’s conclusion that there was no way for Darren to use his 401(k) money to purchase rental real estate. It simply was impossible with his existing account. The CPA suggested a work-around in which Darren would take his retirement money out of the 401(k) and simply pay the taxes on it. Then, Darren could invest in whatever he wanted to.

Although this was not the best news, Darren took his CPA and investment advisor’s advice and called the retirement custodian to liquidate his account. Darren believed this was the only way he could get a large sum of cash to jump-start his real estate venture, so at the time, it seemed like a great move. Over the next several months, he did fairly well for himself and bought a few single-family homes, which he fixed up and rented out.

Related: How the Final GOP Tax Bill Will Affect Real Estate Investors

The Shocking Reality

Not until tax time did Darren realize he had a problem. When his tax returns were done for that year, his CPA told him he owed close to $96,000 in taxes. According to the CPA, Darren’s liquidation of $200,000 of 401(k) money earlier that year had resulted in federal income taxes. In addition, because Darren was under the age of fifty-five when he received the retirement distributions, he was also subject to a 10% penalty fee on the withdrawn money.

This was terrible news for Darren, and he was not prepared for this bill. He had already used every penny of that 401(k) money for his new rental properties. Even though the cash flow he had received from these new rentals over the past few months had been good, it was nowhere near what he needed to send to the IRS. This was the precise reason he had contacted us. He was desperately hoping that we could somehow help him avoid or reduce this tax bill.

Unfortunately for Darren, it was too late for us to help him unring that bell. By the time he contacted us, all the paperwork had been executed, and the money was firmly invested into real estate deals. The only thing he could do at that time was try to maximize all the expenses he had incurred on his rental properties and accelerate the depreciation on the improvements he had made.

Had Darren’s CPA been better informed and more familiar with real estate and investment strategies, he would have advised Darren to simply move his 401(k) money into an IRA with a self-directed custodian and then use the new account for his real estate investments. When the investment firm told Darren he could not invest 401(k) money into rental real estate, that was misleading. The truth was that their specific investment firm did not have a way for Darren to do this. The types of assets—generally stocks, bonds, and mutual funds—the firm provided limited Darren’s investment choices. He did not realize that if he had simply moved his account to a new firm, he might have a much wider variety of investment choices.

A Small Mistake That Cost Big-Time

The IRS has no restriction that requires you to put your 401(k) money into the stock market. As we have explained, it is perfectly legal for someone to use retirement money for real estate deals. You simply need to transfer your money to the right custodians who can help you do so. These special custodians are referred to as “self-directed” retirement custodians. “Self-directed” simply means that you can choose where you invest your retirement money. In a truly self-directed IRA, the custodian does not give you a list of investment choices. Instead, you get to choose whatever you want to invest in, whether that be rental properties, start-up businesses, notes, liens, etc.

Now the IRS does specify a few things you cannot invest your retirement money in, such as life insurance contracts and collectible items. But for the most part, self-directed investing means you have 100% control over where your retirement money is invested. Therefore, you could use your retirement money to buy that new property on the market on Main Street or to invest in your cousin’s new start-up Internet business.

Often we have clients who will call their investment firm and ask to move their money into a self-directed account, only to be told they already have a self-directed IRA. Some financial planners will tell clients that in their IRA, the client can choose whatever they want to invest in, so it is already self directed.

How do you know if you are being misled? Here is a quick tip:

If the firm offers you a list of investment choices, you do not have a self-directed account. Self-directed retirement means you choose what you want to invest in; you do not select an option from a predetermined list of choices.

Again, had Darren simply moved his money from the 401(k) into a self-directed IRA, he would have been able to avoid his tax issue altogether. Not only could he have rolled his 401(k) money into a traditional IRA in a tax-free manner to later purchase his new rental properties, but also, any rental income he would earn over the next several years could grow tax deferred in his retirement account. Thus, the mistake Darren made by simply liquidating his 401(k) cost him more than $96,000 in taxes and penalties. He also missed out on a great opportunity for tax-deferred growth.

Had Darren’s CPA been a tax expert in the self-directed arena, he would have advised Darren to do the following:

  • Step 1: Find a good self-directed custodian and set up a self-directed IRA account.
  • Step 2: Fill out the paperwork for the self-directed custodian to request that 401(k) funds be directly transferred into the new self-directed IRA.
  • Step 3: Use the funds in the self-directed IRA to purchase rental real estate and pay for any necessary property improvements.
  • Step 4: Earn rental income in the self-directed IRA to allow for tax-deferred growth.

Darren’s CPA may have been familiar with real estate–related taxes, but he was not an expert in self-directed IRA-related strategies. Because of this lack of knowledge, his incorrect advice cost Darren a great deal of money that could have otherwise been saved.

Just as you would not want your dentist to diagnose your chest pain, you would not want to work with a tax advisor who does not specialize in the areas where you need assistance the most. If you ever receive advice that doesn’t make sense to you, it doesn’t hurt to get a second or third opinion, just to make sure your bases are covered. Learning something too late can often be a costly, but avoidable, mistake.

How to Know if You Are Working With the Right Tax Advisor

Here are a few tips to help you easily and quickly determine whether you are working with the right tax advisor for your particular situation:

  1. Avoid the glazed look: If your CPA gets a glazed look on their face when you start talking about real estate or you find yourself having to explain your real estate transactions year after year, you may be working with the wrong person. Yes, we all do creative real estate transactions from time to time, but your CPA should know the basic transactions within your industry.
  2. Who’s the CPA: It is okay for you to tell your CPA from time to time about a new tax loophole you’ve heard about. Maybe you just attended a seminar and learned of a new, cutting-edge idea that your tax advisors weren’t yet aware of. But if you are bringing ideas to your CPA more often than they brings ideas to you (i.e., you feel like you are the CPA), you may not be working with the right person.
  3. Giving you leverage: Your tax advisor should be someone who can help you with more than just taxes. They should also be able to share what they see in the market, what other investors have been doing that has been successful, and how other people have been able to raise money. You should be able to leverage your CPA's knowledge and experience to supercharge your investing plans.

Has a non-real-estate-informed CPA ever cost you money?

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Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 ye...
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    Kristina Jensen from El Paso, TX
    Replied over 2 years ago
    If a W2 wage earner is not eligible to retire (age 42) and contributes to a 401k through their employer, can they initiate a transfer to a Self Directed IRA while working, or do they need to wait until they are eligible to retire? Thanks for the article Amanda, and maybe you could do a follow up on some questions BP members might ask a CPA to ensure they focus on Real Estate matters rather than the multitude of other disciplines within a CPA’s toolbox.
    Derek Dame Investor from Bismarck, ND
    Replied over 2 years ago
    It really depends on your plan. Some may allow you to roll funds over while others may not. Typically you can roll it over to an IRA after you leave employment with the company. You can still work, but for a different company. This might not be the way your plan works, but only what I have seen.
    Camilla S. Rental Property Investor from Indiana
    Replied over 2 years ago
    I’d be interested in your thoughts on converting from a regular IRA to Roth. Is there an article anywhere on how to do this based on income to pay the least amount of taxes? Have you heard of a Roth conversion ladder? Kristina, I know that I have checked into the very question you asked above for my husband at his work. Their rule is that you can take out a percentage while you are still working. I think it depends on the company and the 401K company that they use, my husband’s being Fidelity. He could transfer about 1/6th of his balance to another retirement vehicle. He’s not retired and still contributing to it.
    Replied over 2 years ago
    In this example, wouldn’t the real estate investment within a self-directed IRA be disallowed if the welder used his personal labor to fix-up the rentals? I have read that would be considered a non qualified contribution. Unless that is untrue, it severely limits the investments that many of us would otherwise choose such as fixer uppers.
    Dan Herman
    Replied over 2 years ago
    Yes, that is true. If he were to use a self-directed IRA he would have to hire contractors for any and all work on the property.
    Gordon Visfeldt Investor
    Replied about 2 years ago
    That depends on the ” format “. I have an 401a IRA with a K-rider, and with that my brother or sister or I can contribute hours of work. I can however not pay myself for work contributed, and can not use the labor of mother/farther or children. In a Roth IRA I also control, I am not allowed to contribute ANY labor of my own. I am not sure if there is a way around this, but if anybody knows about this, please let me know.
    Peter Kraft Flipper from Cedar Grove, New Jersey
    Replied over 2 years ago
    Good question, I’m curious about this as well.
    Laura Tokgozoglu Rental Property Investor from Catonsville MD
    Replied over 2 years ago
    Thanks for the articel. We have quite a bit in our 401K and it would be great if we could use some of it for Real Estate investment. Are there income limits with IRAs? Do you have to be under a certain amount of income in order to do this kind of transaction? Laura T
    John Murray from Portland, Oregon
    Replied over 2 years ago
    I have a great wealth building CPA that advises me. My CPA is very knowledgeable in Real Estate as well as equities investments. I study tax codes constantly as well as investment vehicles. I have a friend that went to federal prison, an actuary scientist. Now comes the words of wisdom. Never mix investments that are highly liquid with investments that are not. To dummy down never take uncomplicated IRA, 457, 403b, 401k and make them complex. When you add Real Estate complexities, short sales, flips, BRRRR, passive activities, material activities and the like to mix the IRS does not like this not to mention the DoJ. I think Amanda is smart enough not to give specific advise on what is not prudent.
    Marina Spor Investor from Buena Park, California
    Replied over 2 years ago
    Another option would have been to borrow againt the 401k. I believe the limit is $50k, and you just pay interest to your own 401k account. Or, get a home equity line of credit on your primary residence. It does get complex to use a self-directed IRA for rental real-estate investments since there are restrictions such as you cannot manage the property yourself nor fix it up yourself.
    Peter Grexa
    Replied over 2 years ago
    With all due respect this is a Fake News article from someone looking for business. The details of this story iare not credible. An average non Real Estate oriented CPA would know about the liquidation rules and tell them before they liquidate that they’ll have to pay a large tax penalty regardless if they do not know about Self Direct plans and moving the funds from the 401K to the Self-Direct IRA. There is no mention of this in the article. Any CPA is at serious risk of a lawsuit and extremely negligent by NOT having that large amount of money set aside from the liquidation to pay that tax bill. Not having that discussion is unrealistic. Even a Non-CPA can research the simple rule that after you liquidate a 401K or IRA that you have to pay a withdrawal penalty of 10% plus the % of what tax bracket you’re in. Bigger Pockets please stop allowing fake articles to be published. Thank you.
    Stephen Shelton from Debary, Florida
    Replied over 2 years ago
    The article says: “The CPA suggested a work-around in which Darren would take his retirement money out of the 401(k) and simply pay the taxes on it. Then, Darren could invest in whatever he wanted to.” Doesn’t this mean that the individual was aware that taxes would need to be paid on the very process he ultimately used to obtain the funds? Was he unclear on the amount it would be? Best case on realizing profits would be the capital gains rate (15%? 20%? I forget) but it’s widely known that the taxes for pulling money early from a retirement account are incredibly high so… I don’t want to knock the guy but it just doesn’t seem plausible that he wouldn’t have been aware that he would owe a massive amount of taxes.
    Kennith Osborne from Spring Hill, Tennessee
    Replied over 2 years ago
    After moving to a new area I searched for a new accountant and ran into one extremely inept CPA. I questioned him about his experience with customers who own real estate investments. He flat out told me that it would be foolish to put so much money in one investment. When asked about tax planning for next year he suggested we talk about it then. All he wanted was for me to drop off all my paperwork, hand it to someone below him and write him a check. Research a CPA like you do your investments.
    Robert Church from Waterford, Michigan
    Replied over 2 years ago
    I’m going to ignore the main point of the article that all CPAs are not created equal (ok, sure) and the impossibly ignorant behavior of both the CPA and their client (wow!). It made a very attract-tive headline. (smile). Hopefully readers of this forum are a little brighter than to liquidate an IRA without first considering the tax consequences. All that said, let me say I really like SDIRAs invested in real estate. But I learned that if you plan to purchase in the name of a multi-member LLC (or single-member LLC for that matter) and manage the real estate yourself, you cannot use your own SDIRA funds. Neither can you use anyone else’s SDIRA funds as equity in conjunction with recourse funding for a property. Stated another way: The multi-member LLC that I manage, can buy properties that I manage using SDIRA funds of the other members only if the loan is a non-recourse type, and can never use my own SDIRA funds. Right? Please reply and confirm or refute this post. Thanks!
    Anthony Wilks
    Replied over 2 years ago
    IF he wasn’t told the simple rules on paying taxes on his withdrawals, plus the well known 10% penalty, this is almost bordering on incompetence and negligence by his CPA and/or retirement investment firm. I say IF. It kind of sounds like perhaps he only heard what he wanted to hear in order to withdraw his money.