As a real estate investor, there are plenty of tax strategies at your disposal. Many times, an investor is able to position themselves in such a way that they don’t pay tax at all on their current year earnings.
Time and time again, real estate investors come through our virtual CPA firm’s doors requesting help. That means I get to see a lot of tax returns. And while almost everyone can improve, the number one issue I see across the board that significantly limits an investor’s ability to reduce their tax bill is lack of flexibility.
I know you may be thinking that “flexibility” does not sound like a tax strategy. Most certainly not a sexy one.
But if your tax strategy foundation is solid, then tax planning will be easier for you. And easier = less money spent.
General Rule for Implementing Flexibility
The general rule for implementing flexibility into your business or portfolio is this: the more data the better, and that data should be up-to-date.
If you have a scope of work from a contractor that says the kitchen rehab will cost $10,000, that data is pretty much useless from an analytical standpoint. Obviously, you need a scope of work, and having one up front can help set expectations. But itemizing that scope of work can lead to a better tax result when you prepare your tax returns. Itemizing the scope of work will also allow you to analyze material and labor costs, sometimes down to the penny, which can be quite powerful when building a business. The more data you have, the better the results.
However, more data can be meaningless if that data isn’t up-to-date. Many investors don’t keep up-to-date records. They then find themselves analyzing months old data or not analyzing anything at all. That’s also why our accounting practice has taken off – once we realized investors need up-to-date data, we created a solution to give it to them.
How can you get up-to-date data? It starts with your accounting system. You need to use software that allows you to log transactions as they occur, record the supporting data for that transaction, and itemize the data as much as possible so that you can analyze it later. Ideally, your accounting system automates almost all of the grunt work that you would otherwise do if you were just using spreadsheets (don’t use spreadsheets!).
Related: 4 Different Types of LLCs and the Ways They Pay Taxes
How Landlords Can Be More Flexible
The number one thing landlords can do to create flexibility in their tax position is to simply itemize all invoices and scopes of work related to their rentals. By doing so, you will be able to easily analyze cost data for the De Minimis Safe Harbor election or for 100% bonus depreciation.
The De Minimis Safe Harbor election allows us to deduct any item on the invoice that is less than $2,500 as long as we avoid the anti-abuse rule. So by itemizing a $10,000 scope of work, you automatically have a higher chance of qualifying for the De Minimis Safe Harbor.
But even when you can’t qualify for the De Minimis Safe Habor some costs may qualify for 100% bonus depreciation, which allows you to write off the cost of the component in the current year.
For example, let’s say you had a $10,000 scope of work to rehab a kitchen in your rental. If you hand me a $10,000 invoice, I’m booking that as 27.5 year property on your tax returns. That means you won’t get any special tax treatment and you’ll recover your costs over 27.5 years.
But if you show me that $3,000 is applied to appliances, $3,000 is applied to floating laminate flooring, and the remaining $4,000 is applied to fixtures, we have flexibility! Assuming we can’t use the De Minimis Safe Harbor, we’d book the $3,000 of appliances and the $3,000 of floating laminate flooring as 5-year personal property. The aggregate $6,000 would then qualify for 100% bonus depreciation meaning you get a current year deduction of $6,000. The remaining $4,000 would be booked as 27.5 year property and written off over that time frame.
There are many more things landlords can do to add flexibility to their tax position but itemizing invoices and scopes of work is top of the list.
How Flippers & Developer Can Be More Flexible
The number one thing people who are flipping and developing property can do to create flexibility is to launch each project under an LLC.
Do not launch a project in your personal name. Ever. Do not launch a project under an S/C-Corporation unless you have been specifically advised to do so.
Related: How Debt & Taxes Make the Rich Richer and the Poor Poorer
By launching all projects under LLCs, you create tax flexibility in terms of how we elect to tax your entity. When your flipping business hits net profits of around $40k-$50k per year we likely want to have those profits run through an S-Corporation to save on FICA taxes. If you had previously been running your flipping business through an LLC, we can retroactively elect to be taxed as an S-Corporation.
But if you don’t run your business through an LLC and you hit the profit thresholds, we can certainly set up a new entity and tax it as an S-Corporation, but all of your prior profits will not be counted toward the S-Corporation status. This is because those profits occurred before you had an entity in place that could be taxed as an S-Corporation.
For example, let’s say you set up an LLC on January 1. Throughout the year, you flip properties, and in November, you cross the $40K profit threshold. At that time, we would make an S-Corporation election retroactive as of January 1. On the flip side, if you never set up an LLC, we can’t make a retroactive election as of January 1 because there’s no entity in place on January 1.
Why not just elect S-Corporation right out of the gate? Because you’re going to pay a CPA $1,200-$2,000 to prepare your S-Corporation’s tax returns. You’re also going to pay $300-$500 per year in payroll costs. I don’t want you to incur those costs unless your tax savings exceed the costs. Your tax savings will break even around $40K-$50K in net profits. So run an LLC until you hit that profit point, and then we can make a retroactive S-Corporation election to capture all current year profits.
How General Partners in Syndicates Can Be More Flexible
The number one thing that anyone buying larger properties, especially when they are raising investor capital, can do to create flexibility is to not sign any financial document without allowing your CPA to look it over first.
Way too often, banks will slip weird clauses into their debt contract with you. For example, they may require “certified financial statements” and you may automatically think “of course that seems natural.” But your CPA would ask “what is a certified financial statement?” because in the CPA world, there is no such thing. There are only audited, reviewed, and compiled financial statements.
I’d rather figure this out with you before you ink the deal. We’ve had clients that have had to pay $10K+ for financial audits because the terms were not clearly defined and hashed out prior to inking the contracts.
Don’t put your investors at risk because you don’t want to invest properly in your due diligence.
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
How do you use flexibility to reduce your tax bill?
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.