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Rich Dad’s CPA Shares 5 Steps to Eliminate Income Taxes through Real Estate w/Tom Wheelwright

Rich Dad’s CPA Shares 5 Steps to Eliminate Income Taxes through Real Estate w/Tom Wheelwright

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If you’re asking your CPA how to not pay taxes, this may be the perfect episode for you. In fact, this episode is geared towards anyone making money in real estate, and listening could save you a massive amount in taxes over your lifetime. But isn’t tax reduction only for the ultra-rich? How can the average, everyday investor who has one, two, or a dozen rentals keep more of their capital so they can invest in more deals?

Tom Wheelwright is the exact man to ask this question to. He’s so good at what he does, that he’s been advising Rich Dad Poor Dad’s Robert Kiyosaki for decades. Tom is dedicated to minimizing the tax burden that he and other investors suffer from. If you’ve read Rich Dad Poor Dad, a lot of Tom’s strategy will sound familiar, but in reality, it’s what all intelligent investors are doing.

In today’s episode, Tom walks through the biggest areas where real estate investors can cut their tax bills, how to generate losses through depreciation, building an investment system, and the five steps to eliminating income tax from your real estate deals. If you make money in real estate, no matter how, this is information you can NOT live without.

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Listen to the Podcast Here

Read the Transcript Here

David:
This is the BiggerPockets Podcast, show 569.

Tom:
So, they’re saying, “Look, if you invest in real estate, we’ll give you a better deal than if you’ve invest in the stock market.” Literally, that is built into the law. And so, once we understand it, now we have a choice. And the goal here is, the more education we have, and this why I love BiggerPockets, the more education we have, the better our choices.

David:
What’s going on, everyone? It’s David Greene, your host of the BiggerPockets Podcast, where we arm you with the information that you need to start building long-term wealth through real estate today. If you’re new here and you like today’s show, check out biggerpockets.com. It’s the website that hosts the podcast. It’s a free one-stop-shop for all things real estate investing. It’ll help you save time and money, avoid mistakes, and tap into the wisdom of two million fellow members. Now, on today’s show, we are joined by an awesome guest. You are going to love this show if you’ve ever wondered, how do the wealthy not pay taxes?
Today, we have Tom Wheelwright. Now, on episode 500, Brandon Turner and I interviewed Robert Kiyosaki, the author of Rich Dad, Poor Dad. And Tom is Robert’s CPA and owns a CPA firm. He’s also a speaker and investor himself, an author of several books, one of them, Tax-Free Wealth, has sold very, very well and is very well respected within the real estate investing community. And Tom comes on to tackle the question of, how do people, particularly wealthy people, avoid paying taxes? How can real estate help you, the listener, to do the same thing? And what is actually happening behind the scenes that make this possible?
Now, I remember at one point when I heard people talk about Elon Musk doesn’t pay taxes, Donald Trump doesn’t pay taxes, I assumed it must be such a complicated concept that you need lawyers that graduated from Harvard working on it. That’s not the case at all. It’s actually a handful of things that we talk about that will work for most people in most situations that will save you massive, massive amounts of taxes and allow you to reinvest that capital into more real estate. And even more important, it forces you to develop healthy habits when it comes to managing your money so that you can take advantage of this.
That’s personally why I love it because no one likes paying taxes, but you can’t just avoid paying them, you have to actually do something different to do that. And the steps you have to take to avoid paying taxes will make you a better investor, a more disciplined person, and an overall more prudent and safe investor and steward of your money. Now, Tom’s awesome. And I’d like you to make sure that you listen all the way to the end of the show. We went a little bit longer than we normally do, specific because he was dropping fire. And I thought, “Hey, if this takes two listens to get through, that’s better than not getting information from Tom Wheelwright that can save everybody a lot of money.”
Even if it’s something that isn’t going to save you money today, as you grow in your investing journey, this stuff will become very important. If you can make it to the end, Tom actually breaks apart my businesses, my tax situation, how I’m structured, and gives me some advice on how I could be doing things better, safer, and more prudently. I’d love for you to be able to hear that. I also want to make sure you guys learn the concepts we talk about today, because they are not nearly as complicated as I originally thought, probably not as scary as you. There’s a really good section where we talk about, should I do an LLC? Should I invest in my own name? And what is the difference? Does an LLC even help me? And if so, how?
And then Tom shares some of his five steps for how you can get started, also at the end. I love today’s show, I really think you’re going to also. Please consider sharing this with anyone you know who’s interested in, saving in taxes. Make sure you follow us on BiggerPockets YouTube page so you can watch the interaction between us, and then comment, like, and share with anyone that you care about. All right, today’s quick tip is, our podcast has a new landing page, it’s biggerpockets.com/podcast. This is where you can see all the shows that we’re putting out across the entire BiggerPockets network.
So make sure that you save that one in your browser or you save it in your phone. So whenever you want a podcast to listen to or you feel like you want to be able to make some money and build some wealth, you know exactly where to go. After you listen to this one, if you’re curious for a little more background on this topic, please check out episode 500 of the BiggerPockets Real Estate Podcast where Brandon and I interview Robert Kiyosaki, which is how we ended up getting here with Tom himself. Hope you enjoy it.
Mr. Tom Wheelwright, welcome to the BiggerPockets Podcast. It’s great to have you.

Tom:
It’s great to be here. Thanks for having me.

David:
Now, Tom, you’ve written a very impressive book that many real estate investors have read and loved, and that was Tax-Free Wealth, which is just a great name for a book. Who doesn’t want tax free wealth? And my understanding is you have another book coming out. Can you tell me a little bit about this up and coming book?

Tom:
I do. Very excited. It’s called, Incentives: 7 Investments the Government Will Pay You To Make. I’m very excited about talking about the role of taxes in getting done what the government wants done.

David:
So much of life is perspective that we take and looking at it like you did, these are things the government will pay you to do to grow your wealth, is a great way of looking at it, especially because so many other people benefit if you do it, as opposed to looking at it as a way that greedy, shady people can hide from their responsibility to pay their own fair share. Now, we recently interviewed one of your partners, Robert Kiyosaki, and he mentioned you on the show. We’re going to talk about that in a minute. But before we get into that, I want to play a clip from our interview with Robert, and then we’re going to get your feedback on that. So let’s go ahead and start with that.

Robert Kiyosaki:
Ray Kroc, founder of McDonald’s and my friend who was at the University of Texas, he was talking to Ray Kroc and he said something about, “Ray, what business are you in?” Ray says, “What business is McDonald’s in?” And everybody says hamburgers. And Ray said, “No, McDonald’s is a real estate company.” And today I think they own more real estate than the Catholic church. Back in the ’70s, when I was trying to figure my life out, my rich dad said the same thing. He says, “The purpose of a business is to buy real estate.” Now, if you understand that, your brain will shift. But it’s not about starting a business to make money, the purpose of a business is to acquire real estate so you can use massive amounts of debt and pay no taxes. That’s why I do it.

David:
All right. So as you saw, Robert talked about that the purpose of a business is to buy real estate and then you can use massive amounts of debt and not pay taxes. And that’s why he actually does it. This is obviously a hot button topic, because the minute that some multi-millionaire says, “I don’t pay taxes,” it upsets people. I’d love it. If you could give your perspective on what that actually means and how it plays out in real life.

Tom:
Yeah. So let’s do this. Let me share my screen here. Let’s actually look at Robert’s cashflow quadrant here. And if you look at his cashflow quadrant, you see, well, really there’s four ways that people make money. They make it as an employee, we’ve all been employees at some point, self-employed, as a big business, or as a professional investor. What’s interesting is that how much tax you pay depends largely on how you make your money. So if you make your money as an employee, you’re typically going to pay a tax at around 40% if you make a good income.
If you get more education, you become a doctor, lawyer, etc, now you get to pay 60%. If you’re a big business owner, you tend to pay around 20%, which is, by the way, why Warren Buffett said that he pays less tax than his secretary because he’s paying at a 20% rate, she’s paying at a 40% rate. And then if you’re a professional investor, you can pay zero. So what Robert does is, and this is what everybody who knows how the tax law works does, is he takes his money, let’s say, he goes out and speaks and makes money speaking. He puts it into investing. He combines it with debt, buys an investment. Or if he makes money in his business, combines it with debt and puts it into an investment.
And the investment he likes is real estate. Now, it doesn’t have to be real estate, it could be agriculture, it could be energy, it could be a business. But this is how the tax law, by the way, in every country, it’s not just the US, every country works this way. And the reason is, because, look, what does the government want? They want tax dollars, but they also want certain things to happen. They want energy, they want housing, and up here, they want jobs and then they want food. So the government is saying, “Look, if you take the risk, you’re the entrepreneur. And you put your money where we want it, we’ll encourage you to do that by giving you the tax incentives.” And it’s really that simple.

David:
I want to jump in briefly to highlight what you said because that’s the part that doesn’t come up when we talk about, “I pay no taxes.” When we look at this quadrant that you’ve drawn out for us, and where in the E area, the employee, their taxes are high, but their risk is low. Employees don’t contribute capital to their own company. When you become self-employed, your taxes are high, but your risk is lower. There is absolutely a relationship between the risk you take and the tax benefits that you get. It isn’t free.

Tom:
It’s true.

David:
And that’s what I wanted to hire light, is the government is incentivizing you to do this because no one likes risk, risk is inherently expensive. You have to put that on a sheet somewhere to account for the risk you’re taking and how you could lose something. And what we’re actually talking about is investing is a way of sort of like riding this wave of risk and reward, and there’s some skill that like just every surfer needs to understand. Is that similar to how you see it or do you think that there’s a more nuanced perspective?

Tom:
Oh no, for sure. And it’s actually even simpler than that. The government actually makes money on it. It’s not just that the government wants housing and they want energy and they want food, they want jobs, obviously, but the government actually makes more money when you have entrepreneurs… For example, let’s take an entrepreneur who starts a business. Well, literally you can start a business and the government will pay you for all of the costs of starting that business, and I actually show you that in my new book. Okay, well, what does the government get out of it?
Well, they get a share of the income for the rest of your life, and you can never get out of that partnership. So the reality is, we’re all partners with the government. The question is, are we active partners? Are we silent partners? And employees are silent partners, most small business owners are silent partners. But the big business owners, the professional investors are active partners. We’re actively saying, “Look, we’ll do what you want done, and you’ll share basically in the capital it takes to start it, and then we’ll share in the profits once we get them.”
And frankly, they make so much money, and I show this in my new book, but they make so much money in this, that you go, “Why would they not do this?” It’s kind of like take Amazon. When Amazon was going to set up shop in New York, politicians that would shout, “We don’t want you because we don’t want to give you the tax benefits.” I’m going, “But they weren’t giving tax benefits.” They weren’t giving the Amazon money, they were just saying, “Amazon, you won’t have to pay as much tax as you would otherwise have to pay.” So the government still would’ve gotten from that.
When Amazon moved and chose another location, that other location said, “We’ll take it because we’d rather have half the money we were going to get than have none of the money we were going to get.” And that’s essentially what they’re saying,” We’d rather make an investment,” the government is saying this, “We would rather make an investment and we’ll take the risk. You may not make a profit and then we’ll see nothing, but we’ll take that risk, because we know that we’ll actually make more money if you’re successful, and if we can contribute to that success, great.”

David:
I think part of the problem is when we focus on Amazon as a corporation and we say, “Well, they’re getting tax benefits. Why are they getting all these loopholes so they don’t have to pay?” And we don’t think about all the employees that Amazon is bringing along that are paying taxes. We don’t think about all the houses they’re going to have to be built for all these people to live in, where property taxes. We don’t think about all the times they’re going to go eat at restaurants or buy things and all of the sales taxes. There’s more than just income tax that should be accounted for. Right?

Tom:
Well, and actually, when you look at it, the incentives Amazon was going to get in their New York, for example, it’s not income tax incentives. These are property tax and lower property taxes than they would otherwise pay. These are sales taxes that without Amazon there, they’re not going to pay, but with Amazon there they’ll pay, they just pay less or they defer the taxes. It’s not like, “We’re taking money that we already have,” it’s not New York saying, “We’re going to take government money we already have and give it to Amazon.” No, no, this is, “We’re going to share in the profits down the road. So if Amazon would normally pay a billion dollars in taxes down the road, we’re going to split that, we say, ‘Amazon, you pay 600 million in taxes. And we won’t collect the other 400 million because 600 million is better than zero.”

David:
Which is not uncommon for everyone else in life to do the same thing. If someone comes to me and says, “David, I want you to sell my house.” And I say, “Okay, here’s our commission.” You say, “Great.” What if you’re bringing me 10 houses every single month? Wouldn’t you expect to have some form of discount on that commission? And it would be misleading for me to say, “Tom is trying to steal money from me because he doesn’t want to pay the commission I pay.” You’re actually giving me quite a bit of money.

Tom:
Or better yet, let’s say that we go into a business deal together, we’re going to go develop real estate. I say, “David, I’m only going to do this if you’ll do it for free, I want all the profits.” You’re going, “Why would I do that?” Where you say, “Well, look… ” What are we always doing? We’re competing with other partners and saying, “We’ll give you a better deal.” And that’s all the states are doing. The states are just saying, “We’ll give you a better deal,” while the federal government is already built into the law. So they’re saying, “Look, if you invest in real estate, we’ll give you a better deal than if you invest in the stock market.” Literally, that is built into the law.
Once we understand it, now we have a choice. And the goal here is, the more education we have, and this is why I love BiggerPockets, the more education we have, the better our choices.

David:
This will be a bit of a caveat, I won’t put you far down that road, but I see this happening in the opposite sense. What you’re talking about are incentives to bring business to an area. So we see that happening in states like Florida or Texas, where they’re saying, “Bring your business here. We’ll give you a reduction because we want all the revenue that’s going to have.” Well, the state I live in, California, is constantly talking about raising in state income tax. They’re now trying to push it upwards of 18%.

Tom:
That’s called a disincentive.

David:
There you go. And here is what I just want to highlight for the people who hear that and think, “Well, what’s wrong with that? We’re going to get more revenue. We need it. It would be another five or 6%.” You’re not getting an extra five or 6% by raising taxes. If people leave, you are actually losing the 13% that you were getting and it goes somewhere else. And so there is a point of diminishing returns where if you ask for too much from a business owner or a resident and they leave, you hurt yourself, you end up getting nothing.

Tom:
Yeah. To that point, actually I’ve been in this business a long time, and 40% tax rate is the magic number. When you get over 40% federal tax rate, it starts being a disincentive. That’s why 40% is that magic number. And it’s that magic number in most countries.

David:
That’s wonderful. I love that you know that. That’s why I’m so glad that you’re here right now. So when we interviewed Robert at around 16 minutes, he actually gave you a shout out. He referred to your book, Tax-Free Wealth. And he basically explained that taxes are incentives from the government to do what the government wants done, not loopholes. Would you mind sharing your perspective on how we should look at this and then maybe giving some examples of the most common incentives that people can take advantage of?

Tom:
Yeah, sure. Let me give you, first of all, definition of loophole. Loophole is an unintended consequence. So for example, last year there was a loophole in cryptocurrency that if you sold it a loss, you could immediately buy the crypto back and you could recognize that loss, that’s a loophole. They actually closed that loophole in the infrastructure bill. So that would be a loophole. An incentive is something they actually thought about and going, “What do we want to have happen?” And let me give you a simple example that everybody will relate to, your home mortgage interest deduction.
Now, I will tell you that not all countries give a deduction for home mortgage interest. They do for rental properties, but not for your personal residence. Well, what’s the policy there? The policy is simply, we think we have a more stable population if we incentivize home ownership. And so there’s incentives for home ownership. Because if you pay rent, you don’t get a deduction for rent, but if you pay on a mortgage, again, go out of your risk standpoint, no risk with rent, there’s risk with a mortgage, because now you own the asset. If I take that risk, I’m going to get a deduction for that interest. And that’s the most common sense. Nobody would turn that down, nobody would call that a loophole.

David:
Well, you’re also incentivizing people to save money, to invest that money smarter, to buy real estate so that more home builders build more homes. To me, it sounds exactly like what the parent would do, where they say, “If you get all A’s or if you get a grade point average, I will give you a raise in your allowance.” That is a natural way that human beings understand things.

Tom:
Yeah. It’s interesting. This actually really got going under President Kennedy, a Democrat. And he very much looked at tax incentives and that’s where we got the investment tax credit, was under John F. Kennedy. This is something that all countries do. In my new book, we actually look at 15 different countries. And you look at that and you go, “Wow, this can’t be a loophole in every single country.” We didn’t get the same lobbying from the same people in every single country. What we got instead was, what does the government want done? Let’s incentivize it. Let’s take some of the risk off, and then we’ll take some of the rewards.

David:
This is what’s so important about education because if most people will do what they watch everyone around them doing. So if you just see people working 40-hour-a-week W2 jobs and you are accustomed to zero risk, being normal, then any risk seems risky. I’m probably not articulating that well, but it feels wrong, like, why would I want to take risk if normal is to have none. But if you grew up in the world 400 years ago or so, where you didn’t have all these labor laws and you didn’t have a guaranteed job that you could just fall into something like what we have right now, you didn’t have an education that was provided for you subsidized by the government, risk was a normal part of life all the time.
And so you didn’t need to be educated on your options, it was right there in front of you. Well, in today’s episode, I’m so excited that people are going to have a path painted for them, that when you hear us say you cannot pay taxes as a real estate investor or an investor of any type, this is exactly what you’re doing in order to make that happen. It will come alive as if you were living 400 years ago and you’re looking at it everywhere that you turned.

Tom:
I think it’s also interesting, as you get more education, you change your mind on what’s risky and what isn’t. For example, I went, years ago, I went to work as the in-house tax advisor for a Fortune 1000 company. And my very first task was to lay off half of my department. We were doing a company wide layoff. And I’m going, “So let me get this straight, if you’re an employee, you have one customer, and you are at risk even if you do a good job.” And then I look at, “Well, what if I start my own firm? Okay. Let’s say I have 200 clients. Well, if one client fires me, okay, but I still have 199 clients and I just go get another client, but if I only had one client… ”
Think about this, if you went to a bank, you’re a business owner, you went to a bank and you had a single client, would they lend to you? Probably not. Probably not. They’ll lend to you if you’re an employee, but not if you have a single customer as a business owner, which is really interesting. It’s just a different assessment of risk.

David:
Yeah. That’s a very good point. I also think about, if you really wanted to decrease your risk in the world in general, you would build as many skills as you could. You don’t know what’s going to happen. What if our power grid goes out? That’s when you’re going to find out who has survival skills and who doesn’t. And the same happens in the workforce in a capitalistic country, the more skills you have, the less you worry about losing that job. And in my mind, the risk I see in the person who just shows up and does the same thing every single freaking day for 30 years is they stop building new skills and they become dependent on that employer, and maybe even that specific company, not just that industry, that they work in.
Versus someone like you that has several different businesses, that is an investor and a business owner. You are forced to build skills all the time. And so you don’t live in fear of change. You’re not worried about if the tax code changes or the economy changes. We frequently say here, if we have a recession that’s horrible for the most of the country, we’re going to be good. We will know how to adapt and take advantage. Another reason I just want to encourage everybody to really listen intently to this show is to understand this will help you build skills, which will ultimately reduce your exposure to risk in life.

Tom:
Right. The more education you have, the less risk you have by definition. And that’s true in the tax world too. The better you understand the tax law… People ask me, “Are you aggressive or conservative?” And I say, “Well, let’s define that.” I think aggressive is somebody who does something that’s outside their education level, that’s aggressive. But if I do something within my education level and I just have a lot more education, I’m conservative. I like to think that I’m the most conservative accountant in the world, or I would like to be, because I just want to understand the tax law so well that there’s nothing I’m going to do that I’m going to feel is outside my comfort zone.

David:
Yeah. That’s the secret to being good at something in life, isn’t it? Is you get so good at doing it that you can be aggressive in that area and you’re not actually increasing your risk. Let’s talk about what you think are some of the biggest areas where somebody can decrease their taxes. The first one to me, and I’ll defer to your expertise here, but it’s probably where you get the most bang for your buck as possible, it’s the full time real estate professional status. If you want to jump off there and then walk us through your list, that’d be great.

Tom:
First of all, I would get even one step backwards, and Robert talks about this all time, it’s debt. So if I invest in real estate, but I put all my own money into it, then my deduction ratio is one to one. But if the bank puts in $4 and I put in $1, my deduction ratio is five to one. So I’m literally in all of the bank’s money, I get tax benefits for all of the bank’s money in addition to my money. And that’s why debt and taxes go together. And Robert’s always saying debt and taxes will make you rich. It is that combination. I know Robert talked about that in his interview. It is that combination of debt and taxes because by itself, frankly, you’re not going to need to be a real estate professional if you’re using your own equity for all your real estate, because you’re never going to have a loss from your real estate, unless it’s an economic loss, you’re never going to have a tax loss that is what we call a phantom loss.
So that’s the first thing I would say, David, is that debt piece is actually a pretty important piece. But then the big issue is, back in 1986, when I was in Washington DC, actually, with a national tax office of Ernst & Young, we had this big Reagan tax bill. And part of that tax bill where these passive loss rules. And basically, all the passive loss rules said, was prior to 1986, if you were a doctor, you were an E or an S, you could invest in any investment. And if it created losses, you’d get those losses whether you didn’t have any active participation in that business or that investment or that real estate, whatever.
That’s what changed in 1986, is, all of a sudden, it became okay if you’re a passive investor, passive losses can only off the passive income.

David:
Can you give us a brief example of what passive losses or passive income would be in practical terms?

Tom:
Sure. It’s actually pretty well defined. The term that the Internal Revenue Service uses is material participation. So the general rule is that if you spend more than 500 hours in a business activity, you’re active. If you spend less than 500, you’re not active. Now, there’s six other rules that we won’t get into, but that’s the primary rule. There are two exceptions to that. The first exception is a negative exception, and that’s real estate rental. And real estate rental is, as a general rule, always passive. Real estate rental is always passive. It doesn’t matter if you work 500 hours, it’s always passive. Oil and gas investment is always active, whether you work in it or not. As long as you structure it right, it’s always active.
So those were the two primary exceptions. Well, active real estate professionals didn’t like this idea, so they started lobbying. And in 1993, the lobbyist, which included fellow by the name of Donald Trump, by the way, just little tax history there, were able to change the law and said, “Well, look, if you’re really a real estate professional, you shouldn’t be subject to these passive loss limitations, even on rental property.” And so they made up these rules, and the rules are really simple. So to be a real estate professional, you have to spend more than 150 hours in real estate. And it defined what real estate is, there’s seven categories. And you have to spend more time in real estate than all your other business activities combined with your day job.
So there was an example where a nurse who was a full-time nurse was actually able to prove that she worked more time in real estate that she did… She actually worked 2300 hours in real estate and 2200 hours as a nurse. And I’m going, “Oh, my heavens, this sounds terrible to me.” Now, what’s interesting is, she lost the case. And the reason is because you really have two rules. The first rule is, remember, real state rental is by definition passive, unless you’re real estate professional. But once you meet that rule, you still have to meet the material participation rule. And that is a by per activity. So she had like 25 different properties. Well, she couldn’t meet 500 hours for each property. She didn’t qualify to be non passive in that real estate, even though she was a real estate professional.
So real estate professional is just first test. So what you have to do is, there’s actually an election you make, and that you combine all of your real estate activities into a single activity. Literally, it’s a section 469(c)(7) election. You probably want to write that down, section 469(c)(7), and you elect to combine all your rental real estate into a single activity. And then, if all your work is on the rental real estate, you’re going to meet that 500 hours because by definition, if you hit 750 hours, you hit 500 hours. So you do have to meet both tests.
And that’s a pretty big distinction that people forget that if you don’t make that election… Or let’s say, for example, you’re a full time real estate agent. Well, that’s a real estate professional. Does that mean you worked 500 hours in your rental properties? Nope. You still have to work 500 hours in your rental properties. So you still have to meet the general rule, even though you met the specific rule for real estate professional.

David:
Now, I want to make sure I understand this concept. So I’m going to give you an example in layman’s terms and you can correct me if I have it wrong. When we talk about passive losses, what that basically means is, I imagine a rental property like its own standalone business, and you can take losses like depreciation and other losses against the income that that one business, makes meaning the rent that property generates. But if you have more depreciation than you can actually use, it doesn’t help you. Now, when you’re talking about being a full-time real estate professional, the lobbying that was done by Donald Trump and others said, “Hey, if you’re taking a loss in this area, you should be able to count it against income that you made in another area because it’s more or less all real estate.” Do I have that right?

Tom:
Yeah. That’s the general rule. And just a couple of fine points on this. First of all, you don’t lose the loss. Just because you’re passive, doesn’t mean you lose the loss. You can use only use the loss against passive income, which means you can use it next year, the year after. It carries forward forever. And then once you sell the property, it frees up and you get to use it all. So it’s a temporary, it’s just a deferral of the loss, basically. It’s just postponing the loss. So that’s the first thing to remember. You’re not losing the deduction, you’re just getting it later in time.
What we want to do, of course, though, everybody that’s in real estate knows that it’s all about having capital and employing that capital. So the less tax we pay, the more capital we have, and the more capital we can deploy and the more debt we can get, it’s a wonderful vicious cycle because we actually buy more real estate, we pay less tax, we buy more real estate, we pay less tax. And literally, you can actually triple your benefit in a single year just because you know you’re going to take all that tax money, redeploy it. So you just have more money and you have more access to debt.

David:
Now, I want to slow you down for one second, have you unpack something. Because the minute that you say taking on more debt means you have less risk, the Dave Ramsey folks, bells are exploding in their head, whistles are going off, sirens are alarming in they’re like, “Heretic!” Can you take a minute to explain how debt is actually reducing your own risk?

Tom:
Yeah, let me walk you through. So I love walking through financial statements. If you’ve read Rich Dad, Poor Dad, Robert’s book, you know the whole book is full of financial statements. It’s really a book on accounting. And if you look at, you have income, expense, assets, and liabilities. So the first question is, what’s the purpose of each of these. So if you have income, what’s the purpose of the income? Well, the purpose of the income is to create cash flow. And so if you have somebody owe you money, that doesn’t do you any good until they pay you. So the purpose of income is to create cash flow. What’s the purpose of an expense? Well, the purpose of an expense is actually to increase your income.
If you’re in a business and you’re spending money and it’s not creating an income, you should stop spending the money. It’s that simple. An asset, what’s the purpose of an asset? Two purposes. One is, it’s either to create income or reduce an expense. That’s what an asset does. What’s the purpose of liability? A purpose of liability is to buy an asset. So here’s what I would say to everyone who has that… when it comes to debt, if you’re afraid of debt, it’s not really the debt that you’re afraid of, it’s the asset. If you’re secure and the asset is going to produce income, why wouldn’t you want to take on the debt? It’s really a function of the asset, not the deb.

David:
When we’re afraid of debt, what we’re actually afraid of is the asset not covering the debt service.

Tom:
That’s correct. We’re afraid that the asset won’t actually produce the income we think it’s going to produce. I would go a step further, why are you willing to risk your money and not the bank’s money?

David:
So that was a point you made when you said the bank’s putting in $4, you’re putting in one, versus if you put in all five of your own money, that’s an 80% reduction of your own risk because you’re not putting your capital into this investment, you’re putting money in from somebody else.

Tom:
Right. Now, obviously, if it’s a recourse liability, so you’re on the hook for it, you’re going, “Okay, well, eventually I’m going to be on the hook for that.” But here’s the reality, do you cover your capital first, do you cover the debt first? You cover your debt first. So as long as your rent can cover your debt, you are not making the income on your capital, but you’re still covering the debt payments, so you’re covering the debt service. But it really is a function of, do you trust the asset? And that’s why education like BiggerPockets is so important because the more education we get, the more comfortable we get with the asset. And the more comfortable we are with the asset, then we can leverage that asset and we can actually go after the bank’s money and not just risk ours.

David:
And that’s why we say that not all debt is good debt or bad debt. When we talk about good debt, what we’re generally referring to is buying something, an asset with that money, that will produce income to pay back your debt service and hopefully some extra, and hopefully will appreciate. Bad debt is using that money to buy something that will not pay you back, that’s the motorcycle, the RV, the home that doesn’t generate income, the time share. Whatever it is that you’re spending that money on, it’s not an asset in the sense that it’s not actually creating income.
It is an asset on a balance sheet as in it has value and it can be sold. But according to Robert’s definition of what’s an asset, is it’s something that pays you to own it. Is that accurate?

Tom:
Absolutely. And so if you want more assets, the easiest way to do that is to borrow, but you only want to do that if the asset actually does put money in your pocket.

David:
There we go. And that’s why people that are becoming financially educated listening to something like this shouldn’t be afraid of the word debt. People who are not, who are just out there like, “Ah, let me just buy something and see what happens.” Those are the ones that need to be listening to Dave Ramsey very, very seriously and not taking on some of that. So what about the seven-day rule?

Tom:
Real estate professional, remember, it applies to real estate rental. We only care about it when it comes to real estate rental. If you have a property that rents for seven days or less, it’s not under the tax law definition, it’s not a rental, it’s a business. You don’t have the real estate rental issue, you don’t have to be a real estate professional. Now, it’s still real estate, don’t get me wrong. And so you can become a real estate professional for purposes of your rental property, with your short-term rentals, but the short-term rental itself is not subject to the real estate rental rules because it’s by definition, not rental, it’s just a business.
What that means is that now it’s the 500 hour test, it’s not the 750 hour test. And you’re just looking at, “Okay, do I materially participate in my short-term rental or not?” Well, you have to do that in your long term rental too. Now, one thing we can’t do, you can’t aggregate, in other words, you can’t combine your short-term rentals with your long-term rentals. Because again, short-term rentals are not rentals for tax purposes, long-term rentals are. So we can’t combine unlike properties or unlike businesses. The great thing about short-term rentals, and a lot of people do this and they’re total professionals, I’ve stayed in Airbnbs, I’m sure you have to. And there’s some great properties out there, and they do a great service.
Guess what, they just have to meet the regular rules. They don’t have to meet the real estate professional rules. They still get the depreciation, but they don’t have to worry about the passive loss rules as long as they’re active in their business.

David:
Now, I’m curious, I never asked this earlier. What if you use a property manager to manage your rental, does that actually hurt you from making that 500-hour rule?

Tom:
Sure, absolutely. It will only reduce the number of hours you have. So it’s very important that if you’re going to take the real estate professional, if you’re going to go down that route, which is not the only route to using the losses right now, but it is the easiest route, then what you have to make sure of is that combined of all of your rental properties, you’re going to have to work 500 hours realistically in those properties that you have, on a combined basis.

David:
Okay. Thank you.

Tom:
Let’s talk about how we generate losses, shall we, in real estate?

David:
Yeah.

Tom:
This is what I call in chapter seven of Tax-Free Wealth, I call the magic of depreciation. So when I met Robert back in 2001 and the first time he put me on stage, I was at one of his three-day events, and it was November of 2003. I remember very clearly. We didn’t know each other very well, we’d just gotten to know each other a little bit. And he pulled me up on stage. That is one brave guy, Robert, because he had no idea if I even knew how to speak English and he pulls me up on stage, he says, “So, tell us about depreciation.” I said, “Well, it’s magic.” He looks at me, he goes, “What?” I said, “Well, here’s what it is, you get a deduction for an asset that’s going up in value. You get a deduction for an asset that’s going up in value. Where else do you get that?”
You get a deduction for oil and gas. The minute you drill, it’s going down in value because you’re depleting that asset. You spend money on your business, that expense is gone. Now, hopefully, it’s going to create income, but that expense is gone. So this is the one place, real estate’s really the one place where you get this deduction for an appreciating asset, so it’s pretty cool. But here’s what makes it even better, a lot of people have heard that we have what’s called bonus depreciation. And bonus depreciation means that rather than taking it over the whole, let’s say useful life of the building, we actually get to take it faster than that.
And certainly, there are some things when we buy a property. Think about this, when you buy a property, typically you’re buying four things. You’re buying the land, you’re buying the building, you’re buying the land improvements, which includes all of the sidewalks, the driveway, the landscaping, all that kind of stuff, and you’re buying the contents of the building, like the window coverings and the floor coverings and all of that kind of stuff, cabinets, etc. We all know that carpets wear out faster than buildings. Landscaping actually wears out. It wears out faster for some of us who are brown thumbs than others who are green thumbs, but it wears out.
And so what we do is we appreciate those at a faster rate. So where a building, for example, a residential property, we might depreciate the building over 27 and a half years, which is about three and a half percent a year, depreciating the carpet will probably depreciate at 20% a year. Except when it comes to bonus depreciation, which we have this year and for the next couple of years in a decreasing amount. The land improvements and the contents, which typically amount to 20 to 30% of your purchase price if you do a cost segregation, those are deductible the year you buy the property and put it into service.
So you might have, say, a million dollar building, you buy a million dollar building and you might get a 200 to $300,000 deduction in year one on that million dollar building.

David:
Okay. Let’s break this down to make sure that I understand it. When you talk about depreciation is magic in real estate. There’s a few things I want to highlight for our listeners that are inexperienced with the tax code. When you hear depreciation, that does not mean the value of the going down. It’s not the opposite of appreciation, which is what it sounds like. It’s an accounting term that is used to describe the fact that when you buy something, an asset for your business, it will fall apart over time. So if you understand that owning real estate is owning a business, you can compare it to a different business.
So let’s say you have a landscaping company that cuts grass. Well, you’re going to have to buy a truck to drive all your stuff around. You need that as an expense to create income. Because like you said earlier, Tom, that’s the purpose of an expense. That truck, the minute you start using it, depreciates in value, or maybe not in value, but it falls apart. The tires start to get worn out, it needs to have the oil changed, the windshield wipers are going to go bad. The truck gets worn down. And we all understand, if you own a restaurant, you buy a dishwasher, it’s not going to last forever. So they let you take off of your income this concept of depreciation to pay you back for the fact that when you buy these assets to run your business, they fall apart.
Now, the reason it’s magic in real estate is because even though the buildings are falling apart and the stuff inside them is falling apart, the value of the thing is going up, real estate goes up over time, trucks typically don’t. During the last couple years of supply chain issues, we’ve seen that’s a little different, but in general, nobody’s paying more for a dishwasher that’s 30 years old than they’re going to pay for the one that’s right now. This counting concept of depreciation is fair. The business owner should be compensated for the fact that the things they’re buying or falling apart.
It just so happens to work in our favor in a massive way when you’re buying real estate, because the value of the asset is going up. Now, ideally, they would’ve let us just write off the full value of the property in year one, so if you buy it $400,000 house, you’re covered for $400,000 of income, but they realized no one would ever pay a tax. So instead, like you mentioned, they write it off over 27 and a half years for residential. I believe it’s 38 years for commercial property, if I’m not mistaken, and you get that three and a half percent every year.
So if you buy a property, do you have a number in mind? Like $400,000 house, probably get you around, what, like 12,000 a year something? Am I off there?

Tom:
Well, remember, we are buying land also.

David:
Okay. That’s a good point.

Tom:
So land does not wear out, even the IRS knows that. So you don’t get a deduction for the land. And land typically is going to be anywhere from 10% to 40% of the value. So if you buy a $500,000 property, for example, you may have $400,000 that is not land. So 100,000 land and then the 400,000 that’s not land.

David:
There we go. Good point. So then that’s what’s depreciated over 27 and a half years. And whatever that number is, you can write off against the income that that actual property or business made. Fair?

Tom:
Correct.

David:
And what you’re explaining in this concept is that with certain things like carpet, like plumbing, the infrastructure of the home, the cabinets, they’re not going to last for a full 27 and a half years, so the tax code allows you to accelerate how quickly you take the depreciation on those specific assets, right?

Tom:
Correct. And the normal rule is somewhere between five to seven years for those, and about 15 years for the land improvements. The true magic comes from the 2017 Tax Cuts and Jobs Act, what we like to call the Trump Tax Act, where we now get those two items, land improvements, and the content we get to deduct 100% the first year. We don’t have to wait five years, seven years, 15 years to take the deduction. We can take it all in the first year.

David:
Wonderful. And that is typically done through cost segregation studies. Is that right?

Tom:
Right. So that means you hire an engineer, an accountant and they go out and they actually do a study on what are the different cost elements of the property.

David:
And that does cost money. So this isn’t free. I think I paid for two-

Tom:
Of course, yeah. You have to pay for the services.

David:
Yeah. It was like six grand per property, and then I had a big one that I did, that one was one, much more expensive. So it typically isn’t something you want to do if it’s a really small property and it’ll be a very small tax benefit.

Tom:
Again, what I would suggest always though, David, is you run the numbers. So I’ve seen cost segregations for small properties be as little as $2,000 and say $15,000 and that’s on a less than $200,000 property. So it also depends on what you’re going to do with the money. So if you can deploy that tax savings, you can use the tax savings. So either real estate professional or you have other techniques like we use to use that tax loss against other income, and you can take that tax money you would’ve sent to the government and combine that with that and buy more property.

David:
That’s the magic formula.

Tom:
Then that’s the magic.

David:
Okay. What are some of the drawbacks of using accelerated depreciation?

Tom:
I hear a lot of people talk about drawbacks, I don’t think there are drawbacks. And here’s why, because people say, “Well, what about recapture?” Let’s talk briefly about this concept of recapture, which is a hugely misconstrued concept. Basically what happens is that when you sell an asset like real estate, the amount of gain or loss that you recognize for tax purposes is the difference between your basis and your sales price. Well, your basis is your original cost, less depreciation. So effectively when you sell it, you’re bringing that depreciation back into income.
Now, here’s where the misconception happens. People go, “Well, wait a minute, if I got a 40% deduction today and three years from now I have to pick up 40% in income. Is it really worth the three years?” Well, for those of us who are heavy real estate investors, yes. But let’s say you’re not, is it still worth it? Well, here’s why it is, because you’re going to save money at that 40%, but you’re going to pay tax at the most to 25%. So there’s a differential, we call that a conversion. So we’re actually converting ordinary income to capital gain income. And so even though yes, there is technically recapture, really the highest it should be is 25%.
Now, the part that’s the contents of the building if you sell it within five year years, you’re going to have some actual 40% recapture, but I don’t look at three-year deals, I’m typically looking at five years or more. And so the question is, A, do I need the capital? Can I deploy the capital? And B, if I can’t deploy the capital immediately, do I have a rate differential in that capital gain versus ordinary income?

David:
Now, what about the fact that if you normally were going to get depreciation over 27 and a half years and you took a lot of it up front, that would mean that the period of time you can take that depreciation is shortened.

Tom:
Right. Could be shortened in one year. And what that means is that it creates a positive addiction. So it means that we actually literally have to become addicted to buying more property and building more wealth. So I call it a positive addiction because I think an addiction of building more wealth is not such a bad idea.

David:
That’s a great point. So that’s what I wanted to highlight is because you’re taking it in year one, or maybe in the first couple of years, you have to buy more real estate in order to be able to offset the additional income, which forces you to make prudent decisions, to save your money, to invest it in something, to delay gratification, not to say, “Ah, I just made a bunch of money. I’m going to go be frivolous and spend it everywhere.” If you want to save in taxes, you have to be disciplined and prudent. And that’s why I believe you’re calling it, what was the word you used for it?

Tom:
A positive addiction.

David:
Positive addiction, right.

Tom:
Correct.

David:
I think I have another question I was asking you, one of the main questions we get here on BiggerPockets, this is probably very similar to you with your CPA firm, is, should I start an LLC to buy a property or should I buy it in my own name? And it’s very hard to get people to take any form of action until they get the answer. Can we try to lay that to rest once and for all now, what is the difference between owning an LLC? Why would you want to do it? And when would you not?

Tom:
First of all, let me tell you, there’s something that’s not a difference and that is your tax treatment. Whether the property is in LLC or whether it’s in your own name, you get the same tax treatment. This is a big issue that I hear because I’ll actually hear advisors say, “Well, you need to be in a corporation.” First of all, please don’t ever put rental real estate into a corporation, that’s a no-no. Every good real estate tax professional like myself knows that you don’t do that. There’s lots of bad things that can happen and nothing good happens. So instead, what we do is, do we use an LLC? Maybe.
The reason for an LLC is simply asset protection. Now, here’s what we might call the fallacy of the LLC, and that is that if you have an LLC nobody’s ever going to sue you. That’s not true. Or if you have an LLC, they can never get your assets, also not true. Here’s the way I look at it, David, if you and I go out camping in the woods and we come across a mama bear and she’s starts chasing us, do I need to outrun the bear or do I need to outrun you? I need to outrun you. And that’s the idea of the LLC. The LLC is you’re going to outrun your neighbor who doesn’t have an LLC. So is it better than not having LLC? Absolutely. Do we always do it? Pretty much, pretty much always do it.
There are some states where it’s a little more challenging like Tennessee, but we pretty much always want to have some kind of either an LLC or a limited partnership that we use for our real estate, because we do want to protect our assets and we want to make it more difficult, like putting a lock on your door. Will it keep the thief out of your house? No, but will it make it harder for them to get in? Might they go to the house next to you doesn’t have their door locked? Yes. And that’s the idea, we’re just trying to reduce the liability. But the reality is that, let’s say you buy the house and a month later you put it into an LLC. Well, what that means is that you have that risk for one month, that’s it. After that, you don’t have the risk.

David:
My understanding of LLCs was this idea, and I think most people probably share it, that it’s a corporation, that if you put something in there and you get sued and lose, they can only take what is inside of that LLC, and they can’t get after any of your personal assets and therefore, an LLC is way safer, and the trade off is the convenience, it’s a pain to get financing. Can you clear up some of the fallacies behind the fact that they can’t get into anything that’s outside of the LLC as well as what an LLC even really is?

Tom:
Yeah, first of all, it’s not a corporation. It is a limited liability company and it’s actually more like a limited partnership than it is like a corporation. Really, the only difference between an LLC and a limited partnership is that you don’t have to have a general partner. It’s really like a limited partnership where everybody’s limited partner. And so that’s really what it’s like. The real key to the LLC is that it’s not that they can’t get the asset, let’s say you have a tenant that slips and falls, are they going to still be able to get the asset in there? Yes. Is it harder for them to get through that LLC and get your personal assets? Yeah, it is.
If you treat it right, if you set it up right, particularly if you have multiple owners, it’s going to be way more difficult to get you to your personal assets. But let me tell you the other thing, I’ve got clients who have been through lawsuits, I’ve been through lawsuits, the attorneys are always going to sue you too. So they’re not just going to sue the LLC, they all see they’re going to sue you too. So will it help you? No question. I think LLCs are extraordinarily valuable. Is it impenetrable? No. Do you have to absolutely maintain every single detailed and do it right all the time? Yes. So they’re a bit of a trap sometimes because people think, “Oh, well, if I have an LLC, I just have to have the LLC and then I’m done.”
No, you have to maintain books and records. You have to have annual meeting minutes, you have to file the tax return. You have to do all those things. So there are expenses to the LLC and there are requirements of the LLC. And if you don’t follow those, the judge is just going to look at that and say, and so will the IRS, by the way, they’ll look at it and they’ll say, “Well, you didn’t respect the form of the LLC, so I’m not going to.”

David:
I want to get your perspective on this thought that I’ve often had, from a practical standpoint, it seems like if you had six paid off properties in an LLC and they were worth 2 million, that would be way riskier from the perspective of being sued than if you had six properties in there and you had leverage on 80% of it and there was way less actual equity in the deal.

Tom:
Yeah, for sure. That’s the other thing that it gives. You talk about risk, now, instead of having $2 million in that LLC, you have 20%, you have 400,000 in that LLC. The other thing you can do of course, is you can form multiple LLCs, you can have holding company structures, all of these things. When we do a tax strategy with a client, we look at all of that and we set it all up.

David:
That’s wonderful. That’s another where I had several paid off properties and I’m a victim of a fraud where people are basically stealing them. They’ve taken title from those properties through fraudulent activity, through a title company and they were paid off. Had they not been paid off, if there was a ton of equity, the person would not have been able to get them and then try to sell them to someone else. And so it’s just another thing you don’t hear when you hear people say the paths of freedom is to pay off all you’re debt and own it free and clear, and you’re good to go. I was literally this big fat target sitting there with these paid off properties that drew somebody in.

Tom:
Yeah, for sure. Let’s take an Airbnb, our short-term rental. You got 150 people going through your house every year, 150 potential lawsuits going through your house every year. So if you own that free and clear, that’s all at risk.

David:
That’s a great point. Now, one of the ways that you can reduce that risk is instead of just thinking of an LLC is actually taking out insurance in your name on the property. Is that a more prudent decision if you’re going to hold it in your own name?

Tom:
If I had to choose between insurance, typically an umbrella policy, if I had to choose insurance and LLC, I would choose insurance. And now fortunately, we don’t have to choose, we can do both. The reason the insurance is so important actually, we think about, “Oh, well, if I get sued, then the insurance will pay off.” Maybe. What’s the most important thing is that the insurance company will use their attorney and they will take care of it.

David:
There you go.

Tom:
And I’ve had that situation. I had a rental property up in Utah and the renter lost their job. And next thing I know they’re saying that they slipped and fell. So maybe a coincidence, I don’t know. But what happened was property manager contacted the insurance company. Actually, I spent five minutes on the phone with the insurance adjuster and that’s the last I heard of it. They handled everything. My mother taught all of us a long time ago, she said, “The two most important people in your life are a good CPA and a good insurance agent.”

David:
That’s some good education you had. I’ve always looked at it like having big brother on your side. Their attorneys know what they’re doing, they’re paid to save that company money. You’ve now aligned yourself with this big, powerful expert in that field. It’s very similar to when you’re buying commercial property and you’re getting a loan from a bank, their underwriters are looking at that deal because they’re putting 80% of the money and they’re more exposed than you are. It’s another set of eyes that is an expert in doing that that can verify what you’re doing. And that’s one of the reasons why you just want to have the right people on your team when you’re buying real estate. It’s not about learning it yourself.

Tom:
100% agree.

David:
So tell me about the system that you’ve created. How does one go about starting out on the right foot when they want to get into an investing system that can be repeated?

Tom:
Here’s what I’ve learned over the years, and I’ve had a lot of clients that are very successful real estate investors, that’s really been my specialty for 40 years and a lot of developers, a lot of investors, and here’s what I found is that there’s something in common with all of them. And that is that they do all have a system and they have a set of criteria they use. So we call it the three-minute investment decision. For example, what kind of a cap rate are you looking at? What location are you looking at? What size of property are you looking at? What kind of a loan are you looking at? All of these are criteria for investing.
And what happens is, two things are going to happen. The first of all is you only have to make one decision. You’re just going to apply that decision multiple times. So the professional investor makes a single decision, applies it over and over, and over again. The amateur investor makes a new decision on every single property. So to me, that’s the key because I don’t have a lot of time, I have four different businesses besides all the investments. And so I want to make sure that I’m not looking at a property unless it meets my criteria. And so I’ll take, for example, Ken McElroy, who’s big real estate investor. A lot of people know Ken, good friend of mine. We’ve taught all over the world together.
And I’ve listened to Ken on stage, after stage, after stage. In Moscow, I’ve listened to him in Australia, I’ve listened literally in New Zealand, everywhere. And what I found was is he always does the same thing. He’s in a certain type of market, in a certain type of property, with a certain type of tenant, in a certain cap rate, etc. He’s looking for the same thing. And so what it does, it makes the investment decision much less risky and it makes it much easier. The other thing that’s pretty interesting though is it actually gets you a lot more opportunities. And if I can, I’ll just share why I say this, and it’s what I call the blue Honda rule is.
It’s like, you decide you’re going to buy a car and you do all your research, you go, “Well, I want reliability and I want to resale value, etc, etc, and I want it to be blue.” So you go into the Honda dealer and they say, “Great, we’ve got that coming in three weeks.” So what car do you see on the road for the next three weeks? Blue Honda. That’s how our brains work. Let’s say you’ve got those same criteria for investing, you’ve got the same criteria, what kind of investments do you see? Those are the ones you see.

David:
That’s a great point.

Tom:
And a lot of other people will pass them by because they never see them, but you’ll see them. And so I think it brings you… Deal flow is a big issue for a lot of investors and if you want deal flow, you need to set your criteria and really have a system for investing, but the good news is not only can you create a system for investing, you can also create a system for reducing your taxes, so you can make sure that every single thing you do reduces your taxes as long as you follow the system for reducing taxes.

David:
We call that the crystal clear criteria here at BiggerPockets, that you have to be very clear. An idea popped in my head as you were speaking about, my real estate team spends a lot of time helping people with what we call house hacking. So that’s where we buy a house as a primary residents, we rent out a part of the home to someone else to reduce, eliminate, or even give positive cash flow at some point. One of the trickiest things to accomplish in the Bay Area is to find a floor plan that will work for that because like a track house is very hard to do that with, and then have enough parking. No one ever thinks about the fact that there needs to be enough parking.
I’ve noticed that whenever a deal crosses my path, if it has parking, immediately I start to pay attention to that thing. I’ve been programmed to look for that because to me that’s very valuable. And then when I see it, I know exactly what I’m looking for. What’s the floor plan, how many bathrooms does it have? If those three things are there, I’m digging into it deeper. So that is absolutely true. That’s what I love about when you know what you’re looking for, you make these decisions in three minutes and they’re not risky or they’re not any more risky than they would’ve been the first time you did it.

Tom:
They’re way less risky because again, you trust your asset because you made that decision multiple times and it’s worked for you. And so now you can trust that asset, and now, you can think about bringing on debt because guess what? You know it’s going to work.

David:
Yes. I’m just starting to think about like professional athletes when they’re new in the NBA or the NFL, that player doesn’t really know what shot he can get in the NBA when he is new, he’s trying to figure out how is his game going to work? That quarterback isn’t quite sure if that pass will work or not. And then doing it enough times, they get really clear and recognizing that’s open or that’s not, this is good for me. And then what you see is confidence and quick decisions can be made. It’s such a great point that you’re highlighting that this is what successful people do is they start broad, they narrow down and then they just look for that thing and they do the same thing over and over, and over until it’s boring, but awesome.

Tom:
That’s right.

David:
Okay. Was there anything else that you think that we should cover as far as misconceptions on the tax code or things that people can do to save money on their taxes through real estate?

Tom:
Yeah. One more thing. People focus all the time on this real estate professional and people go, “Well, I can’t be a real estate professional.” Let me give you an example. My wife and I. My wife and I are never going to be a real estate professionals. My wife has her own CPA firm, I have not only a CPA firm, I also have a network of 60 CPA firms that I train. In fact, I’m middle of a training program right now. I have a software company and I have a real estate business. I’m not going to spend more time in real estate than I do everything else and my wife isn’t either. She loves that. So how do we get to use those losses?
Here’s the key. You got to go back to this idea, that passive losses, just because passive doesn’t mean it’s not deductible, passive loss means it’s not deductible except against passive income. So the goal with the real estate professionals is turn a passive loss into an active loss. The other side of that is if you could turn active income into passive income, you could accomplish exactly the same result. Well, what makes something active versus passive? It’s the owner spends 500 hours in that business. Well, what if you have owners that don’t spend 500 hours? For example, the trust for your three-year-old. Three year old’s not going to spend 500 hours.
You’re not going to be the trustee because if you are, you’re not asked protected with that trust. So you have nobody who’s active. If the three-year-old own part of your business and owns part of your real estate, now they have passive income from your business. It’s active to you, passive to them and they have passive losses from the real estate. So we can match these up. We can literally create passive income simply by converting active income to passive income. And we can still maintain control over, we can all have what we want with it.
And the most important thing that any asset protection attorney will tell you, and I’m not an attorney, but I have a lot several buddies who are, they’ll say, “Look, the important thing about asset protection is you want to control everything and own nothing.” Well, listen, if I can control that asset, why do I care? It’s eventually going to go to my kids anyway. Why not have them have it now and reduce my tax liability?

David:
So if I hear what you’re saying correctly, one thing you have to be careful of is you put enough hours into something like real estate rentals, but another way to accomplish the same purpose would be to spend less hours on what used to be active income?

Tom:
Sure. I’ll give you a simple example. I started a brand new CPA firm a couple of years ago. The first year, I was active, second year, I was active, third year, not active. I spent far less than 500 hours in my CPA firm. Well, guess what, that’s passive income.

David:
Which means you can use appreciation for rental properties?

Tom:
Which means I used appreciation for my rental properties.

David:
You know what’s beautiful about this, is that actually creates another positive addiction where you have to leverage yourself out of active income, right?

Tom:
Correct.

David:
So every time you start a new business, it’s a race to how quickly can I get other people running the business for me enjoying the fruits of it, making more money so I can get out of it because then I get the tax benefit.

Tom:
Well, even better is, in the early years when you’re active, that business is creating a loss, probably. As sooner that starts turning income, now, you become passive because you’ve got the team in place and the systems in place, you become passive, and now you can offset that income with passive losses from your real estate.

David:
Beautiful. Okay. This is awesome. I’m really glad you brought that up. I don’t think I ever was told that before, which is why I’m glad we have the man himself to explain this. In this next segment of the show, Tom is actually going to break down my personal situation with some of the ways that I have income coming in and businesses I own and give me some advice on what I could do to limit my own tax liability. So this is a little bit of like a consultation that we’re going to be having as I come to you that we’re doing in front of everyone here. So what questions do you need to start with to be able to get the information you need to help me?

Tom:
Yeah. So the first thing I need to know is what you own. What do you have now? I need two things. I want to know, what do you have right now, and what are your plans for the future? So in other words, what do you want to have? Because all taxes are based on your current facts and circumstances. We always say, if you want to change your tax, you have to change your facts. So I need to understand not only what you have now, but I understand how are you investing for the future and what are your plans for the future? Because how you make your money, just like I showed in cash flow quadrant, right at the beginning, how you make your money has an enormous impact on how much tax you pay.
And that includes what asset classes, what types of assets, what type of real estate, whatever it is, what type of business. So we need to understand what you have now and what your plans are for the future.

David:
Very good. So this is actually a great time to bring this up. I haven’t really made it public yet, but one of my huge goals for 2022 is to raise money to buy more real estate with. So I have a website set up, investwithdavidgreene.com where people can go if they want to invest with me. And we have a system set up where we look to see if they’re accredited investor or not. And then my plans are to buy some very expensive residential real estate and likely use it as a short-term rental or possible like corporate housing situations, as well as multifamily real estate.
Those are the two things that I’m going to start off focusing on in the areas that I think the population is moving towards, where we’re expected to see both rent growth and price growth. I have a couple corporations set up where I run a real estate sales team, a mortgage company. There’s an insurance company that will be coming soon. A couple other ways that I create revenue. And then I have money coming in that is currently in my personal name that I’m probably going to changing where I have book royalties from stuff with BiggerPockets and other ways that I get paid, like speaking at different events, stuff like that.

Tom:
Okay. So what I need to know now, now I have to start drilling down a little bit. So when you say I have corporations, explain that, do you have C corporations, S corporations, LLCs taxes, partnerships?

David:
I have C corporation, I have an S corporation. And then I have probably six or seven LLCs where I own somewhere between 45 and 50 residential properties between them.

Tom:
And those are taxes partnerships?

David:
Yes.

Tom:
This is a point I’d like to make here is that LLCs can be taxed any way we want, so we can choose to tax an LLC as a corporation, we can choose to tax an LLC as a partnership, we can actually choose to tax an LLC as a sole proprietorship. So we have all these choices. So that’s why I’m always going to go back to, is it a partnership for tax purposes? Is it an S corporation, C corporation, partnerships and S corporations, that income flows through? So the income from an S corporation theoretically can be offset with the losses from a partnership, because those both flow through to your personal tax return. So what we want to look at is, first question I’m going to ask you is, and we’ve had this discussion, do you qualify real estate professional?

David:
By my understanding, yes.

Tom:
Okay. We’ve got that. So what we’re going to do is we’re going to make sure we make an election to aggregate all your properties, we’re going to do that on your tax return. So you’re going to be able to use those losses. Do you spend more than 500 hours when you take all your properties together, do you spend more than 500 hours?

David:
Absolutely.

Tom:
Okay. We’re good there. We’ve met that passive loss rule, that passive loss test. So now active losses, active income. So now what we have is we have the losses from the real estate can offset the income from the S corporation. What it can’t do is offset the income from the C corporation. So tell me about the C corporation.

David:
That’s where the majority of the money that I make, I would say that’s the biggest bucket. And I use that money, I lend it to other companies to earn additional income. So I would lend myself money from that to flip houses, to buy assets in the other corporations, make investments like that. And then there’s the corporate tax rate that I’m paying on that, but I also can pay myself a salary from that C corporation that would be offset by the deductions that we talked about, just like the escort.

Tom:
So we should probably talk about that for a minute. We have a new rule, beginning of 2021, and the new rule is called the business loss limitation rule. And what it says is that business losses, including real estate losses can only offset business income plus an additional $500,000. So, as long as that salary is not more than 500,000 and you don’t have interest income, dividends, retirement, etc, that would push you over that 500,000, you are absolutely correct, you can offset all of that. Once you get over that 500,000 though, you’re not going to be able to use those losses anymore and that will just carry over. So we have to be able to careful with that and that’s brand new, brand new 2021.

David:
Would there be a downs side to shifting the way that income is taxed from a C-corp into an S-corp and making that a pass-through?

Tom:
We may want to do that. So that is one thing we would want to look at right off the bat is, are you going to invest? So this is where the future matters. Are you going to invest so much in real estate that it will offset all of the income from the C corporation because, C corporation is a great thing, yeah it’s 21% tax rate. That’s the good news about the C corporation, federal tax rate of 21%. But if we can get below that, because we got all these losses from real estate, why would we want to get it stuck at 21%, especially knowing that eventually, that money’s going to out and be taxed as a dividend.

David:
When I made that decision to set up the C-corp, I was not buying real estate, I had other things going on and so I could reduce my taxes. Since then, I’ve started not only buying real estate, but ramping it up significantly. And I’ve learned more about a lot of what you’re talking about, the bonus depreciation, accelerated depreciation, cost segregation studies. So now what I basically do is I have my CPA tell me, “Hey David, you’re on track to make X amount of money, you need to buy X amount of real estate.” And that becomes the minimum goal that I’m going to be shooting for.

Tom:
There you go. And that’s why another part of the whole system here is that you meet with your CPA on a regular basis and you’re constantly looking at what your income is and what your cashflow is and do I have cashflow to buy that? And then we also have to know those criteria because we need to know, okay, so how much debt are you going to get? And how are you going to go about getting that debt? Because we all know that if we go through normal channels, we’re limited that way. So, how are we going to increase the amount of debt we can get? And those are all decisions. That’s actually all part of what I consider to be wealth and tax strategies, you’ve got to look at both sides of it. You can’t just look at the tax side.

David:
I think what I love about what I’ve heard so far, well, first off is your approach to this. Like you said, it’s not just saving in taxes, that’s defense, but you also got to play offense. It’s also how you build wealth. And debt is a huge piece of that as well as education. We’re not saying, just go buy anything out there, it’s buying the right stuff. But I only have to know enough of these concepts to feel comfortable trusting someone like you who’s going to tell me what to go do. I don’t need to be an expert in all of this. Part of the reason that we’re sharing this information is it’s good to understand what your CPA’s doing so that you know that it’s legal and the advice they give you makes sense.
But someone like you, like you just said, is going to say, “We need to switch this up. We need to change that. And this is what I want you to go out there and buy.” And I don’t have to understand it all.

Tom:
You don’t. You do have to understand the concept, which is why I wrote Tax-Free Wealth frankly, so everybody could understand the concepts, because here’s the challenge, I can’t reduce your taxes. You’re the only one who can reduce your taxes. What you need me for is to tell you what you need to do to reduce your taxes, what facts do you have to change to reduce that tax? And so it’s very much a team effort, it’s very much a partnership. That’s how we look all of our relationships with our clients, to the point where we don’t even charge separate fee for a tax return, we charge a basically flat monthly fee to our clients.
And that is how we charge because we want to make sure that nobody’s hesitating picking up the phone calling us, nobody’s hesitating with, “Okay, I need to talk about this. Boy, am I going to get dinged for that 15 minutes like you do with an attorney?”

David:
Oh boy, that’s exactly how it goes too. I should probably highlight, you and I have to understand these concepts because we’re responsible for teaching people, but the person listening doesn’t have to understand them all. I’d like if you don’t mind to wrap this up with you sharing your five steps to eliminate income taxes from real estate deals. I think it’s very practical, I think everybody can get started. And it’s great concept to understand if you want to start to take action on some of the stuff we talked about today.

Tom:
Number one is you’ve got to develop that strategy. You’ve got to develop that plan of action. And typically, we find that’s going to take anywhere from three to six months, just developing the plan. If you’ve ever played Robert’s CASHFLOW game, I would encourage anybody who’s played it to try playing it by developing a strategy first before you start playing the game. And what you’ll find is you’ll make far fewer mistakes, you’ll get out of the rat race a lot faster. So you’ve got to start by developing the plan, but you need a team. So part of developing that plan is, who’s on your team? Who’s your tax advisor? Who’s your legal advisor? Who’s going to find the real estate for you if you’re are not going to do it? Who’s going to manage the real estate if you’re not going to do it?
All of these people are part of that. Then the second part is really long term. So remember that you talked a little bit about flipping properties, that’s great. That’s a business. I want to be really clear, that’s not an investment, that’s a business. You are actively managing flipping properties. You’re are more like a developer than you are like a landlord because you’re not just leasing these out. So I love the long-term rentals, which is what Robert likes because, A, you get the depreciation, which you don’t get when you flip. B, you get lower tax rates because you get capital gain rates when you sell unlike flipping, which is ordinary income rates. And you’ve got an asset that’s producing cashflow for a very long period of time.
So I love that. Fix and flips are great if that’s the business you want to be in, but just treat it more like a business.

David:
Understand that you’re not in the I segment of the cash quadrant.

Tom:
You’re an S. You’re an S, you’re not an I. Thank you. That’s a good way to put it. Make sure that you’re doing cost segregation and bonus appreciation on your properties. That is just critical. I hear a lot of naysayers about cost segregation, “Oh, it’s too expensive.” Seriously? I’ve seen cost segregation save people millions of dollars. And there’s even some online tools that you can do it for pretty inexpensively, cost segregation on a single family home. So there are some tools that you can use that are kind of quasi-do-it yourself. Next is you either need to look at becoming a real estate professional or your spouse becoming real estate professional.
It doesn’t have to be both of you, just one of you. Or you’ve got to look at the alternatives, which is how do I create passive income? So I either need to take the passive loss, make it active, or I need to take my active income and make it passive. So that would be number four. And then finally, it’s part of number one, and it’s part of number five, which is the team. Investing is a team sport. That’s one of the very first things I learned from Robert Kiyosaki is investing is a team sport, and business is a team sport. Right now, literally I’m right now teaching a class of 60 tax professionals. Well, my team is.
The reason I can do this podcast is because I have a team that I trust and they can do that while I’ve stepped out to do this podcast and teach you guys. So I just can’t emphasize that enough. The Rich advisors actually wrote a book called More Important Than Money, and it’s all about developing that team. So I definitely, I recommend that book as well.

David:
That’s awesome. Now, here’s what’s even more awesome is people like you and I can help with step five. That’s literally what we’re here to do is to help people build wealth through real estate so that they don’t have to figure it all out themselves. That’s where most of the businesses I have were built for that purpose, is you’re going to need a loan to get property, commercial and residential. You’re going to need loans for certain properties that you won’t be able to qualify for based on your own income. You’re going to need a representative to help you buy it. You’re going to need someone to manage it.
You’re going to need a way to keep the books of the income coming in and you’re going to need a way to make sure you’re getting a tax deduction there. So, would you agree, we’ve both committed our life to helping people to do this?

Tom:
For sure. The reason we have a network, it’s called the Wealth Building Network is actually because we had a CPA firm and we could really only handle the high-end clients and we couldn’t handle the beginners. We couldn’t handle people just starting out because you can’t pay somebody differently, you can’t pay a tax professional differently for handling a beginner than you do on an hourly rate, than you do for somebody who makes millions of dollars a year. So what we did was create a network and now we have 60 CPA firms across the country, and now we can handle people at all stages.
And that’s really just like you, David, we are here to serve the entrepreneur and we certainly include real estate investors as a key part of that entrepreneurship group.

David:
Man, it feels good to have big brother having your back when it comes to that. So Tom, for the people that want to reach out, find out more about what you could do to help them or just follow up with you, where’s a good place for them to go?

Tom:
Best way is just go to wealthability.com. It’s exactly spelled exactly how it sounds, wealthability, all one word.com, and just contact us. For example, we’ll do a pre-look at your tax return, we’ll look at say, “Is there some way we can help?” If there isn’t, we will tell you. If there is, we will tell you. If you have a CPA that you go, “Boy, I love my CPA, they just don’t understand this stuff,” have your CPA go to wealthability.com, suggest they become a member. Almost all of our members have come from their clients. And that’s because entrepreneurs hear what we have to say, entrepreneurs want to know what their choices are and they might like their CPA, but their CPA needs to learn this.
If alternatively you go, “I hate my CPA.” First of all, sorry to hear that. And second of all, just go to wealthability to.com and will help find you a CPA.

David:
There are certain pieces of this puzzle that you rarely ever find a human being that says, “I love this person.” Like property management’s one of them. You just don’t hear people say, “I love my property manager.” CPA is another one of those things. And it’s just because it’s so hard. There’s so many questions. A lot of the people who have the most questions are able to pay the least. And so it’s hard to pay a professional to be able to answer those questions if there’s not enough revenue coming in. And frankly, most CPAs will just tell you just like most lawyers, “Just don’t do it.” Because that will get them in trouble.
What you’re looking for as a person who says, “If you’re going to do it, here is the way to do it.” And that’s invaluable.

Tom:
Yeah. Let me give you the question to ask. Instead of asking, is this market deductible? The better question is, how do I make it deductible?

David:
Yes. In life, that is the right way to think.

Tom:
How do I do what I want to do? That’s what entrepreneurs want to know. I would also share, I do have the Wealth Ability Show, which is my podcast. And David, I’d love to have you on some time, by the way.

David:
You got it, man. Absolutely.

Tom:
And we talk to a lot of very interesting people about all aspects of finance and tax.

David:
I’d love to do that. I believe it was in Rich Dad, Poor Dad, where Robert said the rich don’t ask, can I afford it? They ask, how can I afford it? Does that sound familiar?

Tom:
It does actually. Robert and Kim had a rule throughout their marriage, which is, they never say, you can’t buy this, you just have to say, “Okay, tell me where the cash flow is coming from, what asset are you buying in order to pay for that expense?”

David:
Oh, that’s such a great point. I miss Brandon Turner, my former co-host because he would come up with these cool names for everything that we talk about. But there’s this concept that I live by where I basically have all my income coming in from the different businesses, then that’s all invested into real estate, and then amount is set aside in reserves and whatever is left over from that cash flow is what I consider the money that I actually make. I don’t even look at the money that businesses make. And if I want to buy anything, like you said, it comes from that.
And if you live that way, you never run out of money. You can buy anything you want as long as you invested before, which is why these positive addictions are so important because they keep you buying real estate, they keep you saving and investing your money. What was the other example that we brought up about a positive addiction? Oh, getting out of your business. Don’t just follow the temptation to do all the work yourself because it’s easier, train, hire, delegate, grow, become a leader, create opportunity for others. And then you get to take advantage of all the… It makes you a better person when you’re trying to save in taxes. I think that’s what I really like about it.

Tom:
Oh, for sure. And look to your team. I have heard people say, “Well, I’m going to do my own taxes.” I’m going, “Really? That’s how little you value your time. You can’t do something that’s more productive than learning what has taken me 40 years to learn?” I just think it’s crazy. Why wouldn’t you always hire somebody who knows it better than you do and really can do it for a much better rate than for you to have to go in and learn it all and then go do it yourself? I think do it yourself, three most expensive words in the English language.

David:
And I’ve learned that lesson the hard way, I started off just like people, and now that I’m a real estate agent, I see it too. People say, “I’m just going to sell the house myself, save the commission.” You have no idea.

Tom:
Are you crazy?

David:
You have no idea how much money you’re losing, especially in a market like this. And unfortunately, I want you guys to listen and not make that same mistake. You could do anything yourself. You need surgery, you could learn how to do surgery and then you could do it on yourself. You’re in court, you could represent yourself as a lawyer. Anything can be learned, it doesn’t mean it’s smart use of your time to do that way. You let the professionals handle the stuff that they’re better at handling and then you focus on the vision that you have and executing that.

Tom:
Absolutely. 100% agree.

David:
Well, I want to thank you, Tom. This has been fantastic. I really appreciate your time. We’ve been wanting to get a tax professional on here because this is one of those things that nobody values it until they need it. And then all of a sudden, it’s an emergency, “I need to talk to someone right now.” They’ve already made the decision and they go to you and they say, “How do you fix what I did? How do you bill me out of this?” Instead of like you said, step number one was, come up with a plan to work it. Is there anything that you want to say before we get out of here?

Tom:
No, I just wanted to say thank you because I think when you talk about education and how important, if you want to invest money at a really high rate of return, then invest in yourself and invest in your education. That’s what I would say. That’s going to be way more productive frankly, than investing in any singular piece of real estate.

David:
Wonderful. Well, thank you very much for your time, your expertise, your knowledge and your heart, Tom, really appreciate you. And I’ll go to your podcast. I was also on Ken McElroy if anyone wants to listen to that, just Google.

Tom:
Oh cool. Yep.

David:
What was it? Your Nine-to-Five Just Isn’t Worth It Anymore with Ken McElroy and David Greene. And we talk about some of the same stuff.

Tom:
That’s awesome. Great. Thank you, David.

David:
You got it.

 

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In This Episode We Cover:

  • Why rich investors pay fewer taxes than those who are employed or self-employed
  • Tax incentives vs. loopholes and why one is risky and the other is celebrated
  • Where investors can look to greatly reduce their taxable income 
  • How real estate debt gives investors far less risk in their deals
  • Deprecation, recapture, and how real estate gives you a leg up on income tax reduction
  • Whether or not you should hold a real estate investment in an LLC
  • And So Much More!

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