Tax reform Q&A Thread 4 - New creative tax strategies

33 Replies

Colleagues and friends,

The original GOP reform thread started by @Brandon Hall is well over 200 posts by now. This is one of the follow-up threads specifically for discussion of new creative tax planning strategies, in view of the reform. 

PLEASE POST QUESTIONS IN THE OTHER TAX REFORM THREADS. THIS ONE IS FOR THE DEBATE OF NEW IDEAS.

Specifically, Brandon suggested 2 ideas already:

#1: Allocate more basis to land, to increase room for the 20% deduction and decrease depreciation recapture at sale.

#2: Switch from W2 to 1099, to benefit from the 20% deduction.

Both are subject to debate, and feel free to add your ideas. I will add mine for sure. 

Together, we will conquer this monster legislation and figure out how to benefit from it.

It looks like the creative strategy of prepaying the 2017 property tax this year, instead of next year, won't work for many people, due to the fact that you need to have the property assessed prior to 2018, and my guess is that's not the case for many people :-( 

IRS News

Originally posted by @Soh Tanaka :

It looks like the creative strategy of prepaying the 2017 property tax this year, instead of next year, won't work for many people, due to the fact that you need to have the property assessed prior to 2018, and my guess is that's not the case for many people :-( 

IRS News

 I would still prepay. See discussion on this thread.

Can someone please explain why you would allocate more income to land.  It seems it would only get more of the new 20% deduction but lose the better deprecation deduction for the building--(the applicable tax bracket for most owners will be above 20%).  Am I thinking about this wrong?  If you aren't in a higher tax bracket in the early years then the depreciation recapture won't apply to you upon sale.  

@John Akolt

Below I copy/pasted from another thread a hard-to-find description of this "allocate more to land" strategy provided by its author @Brandon Hall (For the record, I think this strategy is debatable, which is exactly what I will do shortly.)

------

Here's one that we've come up with.

For new acquisitions, if the rental will likely generate passive losses, allocate more basis to land and take less depreciation.

The new pass-through deduction is a freebie. But the deduction is only available if you have net taxable income after all expenses, including depreciation and amortization.

So when you buy the next property, allocate more basis to land. This will reduce your depreciation expense. But if you have a smart tax advisor, you can likely net out the lost depreciation expense with this new freebie deduction.

The tax benefit is realized on the sell-side. When you liquidate a rental, you pay depreciation recapture taxes on the depreciation you've taken over the life of the rental.

So if you report less depreciation over the hold period, you pay less recapture taxes in the end. But best of all, it didn't hurt you during the hold period because you utilized this new freebie deduction each year to bring your taxable income down to $0.

Note: this is not a relevant strategy if you purchase property that is likely to produce high amounts of net income after depreciation every year (NNN, Commerical, Large Apartments, Short-Term Rentals).

Second Note: more planning will be required for folks that want to utilize cost segregation. You don't want to crush it on the cost seg side and not be able to utilize this freebie deduction because you no longer have net income to report. 

And now, my reservations about the "allocate more to land" strategy suggested originally by @Brandon Hall and replicated in my post right above.

Say, my property rents at $10,000 annually, and my holding/operational costs are $7,000. My depreciation is $3,000, for $0 net income. Since there is no net income, there is no 20% deduction. 

If I understand what Brandon suggested, we re-allocate the property basis more to the land (using one of the alternative valuation methods, legally). Now, depreciation is only $1,000 instead of $3,000. So we have $2,000 net income. Great! We created a "freebie" 20% deduction of $400. But - we now have $1,600 taxable net profit!

We cannot squash this net profit with more deductions. More deductions would mean that we have to collapse the remaining income and, with it, the 20% deduction - defeating the purpose!

In other words, the only way to create room for 20% deduction is to create taxable income - where there was none previously! So we will be increasing our taxes just to make room for the 20% deduction. You lost me here, Brandon. Please tell me what am I missing. (Yes, I sometimes can't see the obvious, sorry.)

Now, you mentioned that by taking less depreciation we will reduce depreciation recapture at sale. Sure, I get it. But it seems that the price for this eventual "break" at sale is paying more taxes every year that we own the property. That is a bad trade-off, even considering the 20% discount. We are essentially PRE-paying the future capital gain! The capital gain that could be deferred into 1031 or stepped-up at death. Something does not add up for me.

Apology in advance if my analysis is missing your point. Thanks, Brandon!

@Michael Plaks you have the right idea and you’re right in that it doesn’t work for one single property. I think when I was tying that I was erroneously thinking of utilizing the 2.5% of unadjusted basis deduction but that wouldn’t be a factor if the 20% deduction is the lesser.

But.... what if you have multiple properties producing passive losses? The next one you acquire, you reduce building basis (legally) to reduce depreciation. 

In your example, you’d get a free $400 deduction. Assuming you also had properties producing a passive loss of $1600, your now benefiting*.

*too bad numbers never work out that cleanly :)

Another strategy I haven’t seen pop up yet:

Paying your kids more (legally).

Previously we were capped at paying our kids $6,350 as that was the standard deduction. If you earn less than the standard deduction, and you are not self employed, you don’t have to file a tax return which means you don’t have to pay taxes.

Now the standard deduction per person is $12,000 which almost doubles the amount we can pay our children without them needing to file a tax return.

Keep in mind that your children are exempt from FICA until age 18.

@Michael Plaks

@Brandon Hall

Maybe one more situation to address is for those long term Buy and Hold Investors.

I have several long term Investments including one that's already held for 20 years. Only 7 years left for the depreciation expense to end.

Several others are around 15 years, so another 12 years to go.

When the depreciation ends, does that mean it will increase my net business income where I can benefit from the 20% deduction?

It seems to me that the loss of the depreciation is counter acted by the 20% business income deduction somewhat.

Prior to the tax reform, I was thinking it would be best to do a 1031 exchange. But now, does it seem like it's better to just hold on to these fully depreciated investments?

@Llewelyn A. I wouldn’t say “counteracted” as @Michael Plaks pointed out that this won’t work for one property.

But yes once you no longer have depreciation to report, you’d then have net income which would qualify for the 20% deduction.

Keep in mind though that the deduction is for your aggregate net income/loss from your rentals. But it’s applied on a business-by-business basis for other businesses. At least that’s how I’m reading it.

Originally posted by @Brandon Hall :

@Michael Plaks you have the right idea and you’re right in that it doesn’t work for one single property. I think when I was tying that I was erroneously thinking of utilizing the 2.5% of unadjusted basis deduction but that wouldn’t be a factor if the 20% deduction is the lesser.

But.... what if you have multiple properties producing passive losses? The next one you acquire, you reduce building basis (legally) to reduce depreciation. 

In your example, you’d get a free $400 deduction. Assuming you also had properties producing a passive loss of $1600, your now benefiting*.

*too bad numbers never work out that cleanly :)

So what you're suggesting is to "create" income on a new property by reducing depreciation, expecting losses from existing properties to cancel out that income.

Then you still have zero combined income, ONE of your properties benefits from 20% freebie, and nothing lost over the life of the property, because less depreciation results in less depreciation recapture. No immediate tax savings, but less capital gain in the end. Without a 1031 or step-up, it will pay off when sold.

Now THAT is something marvelously creative. Thumbs up.

@Brandon Hall

Speaking of "per business"...   

If I have 10 properties spread between 3 LLCs. Do I have 1 business, 3 businesses, or 10 businesses for the 20% calculation? How do you read it? Admittedly, I did not spend enough time looking, but I did not see a clear answer at a first glance.

@Michael Plaks that is an excellent question and one that I don’t yet have an answer to.

My gut says aggregated the rental activities. But what if you have an LLC generating rental income and active business income? Do you parse our the rental income?

Originally posted by @Brandon Hall :

@Michael Plaks that is an excellent question and one that I don’t yet have an answer to.

My gut says aggregated the rental activities. But what if you have an LLC generating rental income and active business income? Do you parse our the rental income?

 You know we're opening a can of worms here. 

  • Should not separate LLCs be treated as separate entities?
  • What if it's a Series LLC?
  • What if it is one LLC with multiple lines of business?
  • What if one LLC is owned 50/50, and the other 40/60?
  • and so on...

This will be fun for months

@Brandon Hall and @Michael Plaks thanks for the interesting thread. I keep telling clients that we'll know more when the IRS digests the law and issues some temporary regs. The short answer is there will continue to be creative opportunities to benefit our clients.

Originally posted by @Bob Langworthy :

Brandon Hall and Michael Plaks thanks for the interesting thread. I keep telling clients that we'll know more when the IRS digests the law and issues some temporary regs. The short answer is there will continue to be creative opportunities to benefit our clients.

We'll know more from the Temp Regs? That may be an overly optimistic prognosis :)  

This is more related to your primary residence...

Since those that have historically itemized deductions have now lost most or all of the tax benefits of owning a home, what are some ideas to recover what we've lost in tax benefits on our primary residences?

Ideas:

1. There have been several threads in the past on self-rental, which doesn't seem like viable option... has anything changed that would make sense to transfer your primary to an entity you have control of and rent it back?

2. Airbnb / short term rentals (not sure how significant the tax benefit is here but the income could make up for the lost tax benefit.)

3. Use more of your home for your home office.

4. Sell your house to someone and rent back to use the equity to buy rental properties. Maybe even exchange ownership of homes with someone that has a similarly valued home and rent back to each other.

I should have noted in my previous post that there is limited appreciation expectation in my area, so Section 121 isn't a significant concern. At least until Illinois can get their property taxes under control and fix our out-migration issue.

But for others I'm sure the Section 121 benefits may still outweigh the loss of property tax / mortgage interest deductions.

Originally posted by @Michael Plaks :
Originally posted by @Brandon Hall:

@Michael Plaks that is an excellent question and one that I don’t yet have an answer to.

My gut says aggregated the rental activities. But what if you have an LLC generating rental income and active business income? Do you parse our the rental income?

 You know we're opening a can of worms here. 

  • Should not separate LLCs be treated as separate entities?
  • What if it's a Series LLC?
  • What if it is one LLC with multiple lines of business?
  • What if one LLC is owned 50/50, and the other 40/60?
  • and so on...

This will be fun for months

Seems to me that since the tax is based on a percentage "with respect to the qualified trade or business", I'm not sure how it matters how (what entity type or how many) assets are held (types of LLC). An individual's ownership, 50/50, 40/60, etc., will ultimately need to be resolved at the partnership level (via, I assume, K-1). If a person has interests in LLCs ranging from 20%-ish to 100%, with most 25% to 50%, then it seems like the opportunity is to... interpret "...the sum of..." based on LLC types/groupings (by trade/business) vs. LLC entities? I presume CPAs will run each ownership of "trade or business" scenario and choose the one with least impact.

@Jerome Hranka can you go further into detail on why renting your home back to yourself might be a good idea? also how would transferring your house to a friend, and renting it from them allow you to access the home's equity?
Originally posted by @Donald S. :
@Jerome Hranka can you go further into detail on why renting your home back to yourself might be a good idea?

also how would transferring your house to a friend, and renting it from them allow you to access the home's equity?

 Just brainstorming here but wondering if it would be possible in an arrangement like this (renting from yourself or a home exchange) to expense property taxes, interest, etc (and depreciation) as we have lost most or all tax benefit of mortgage interest and property tax deductions on a primary residence.

Regarding accessing equity, I'm referring to selling your home to someone and renting it back from them and using your proceeds to invest elsewhere.

@Chris Martin , @Michael Plaks , @Brandon Hall , Just to clarify about the number of LLC's question, it sounds to me like there could possibly be a difference between maintaining a pass through LLC versus a partnership LLC? Is that what you guys are talking about?

So, if all my properties are in pass-through LLC's, then the 20% deduction will more likely apply to the aggregate net income calculated on my Schedule E. If there's a net loss over all the pass-through entities, then no 20%.

However, if I'm in a partnership LLC (50/50, 40/60, or whatever), then the 20% deduction might be applied BEFORE hitting the individual K-1's? That would be a pretty big loophole where it would make sense to have some combination of pass-through LLC's that are taking losses, while putting all profitable properties into separate 99/1 split partnership LLC's in order to get the 20% there. Correct me if I'm wrong, but that could increase the amount of net losses carried over to future years, right?

@Jerome Hranka you need an economic reason other than pure tax avoidance in order to substantiate a strategy. Because of this, many of the self rental strategies don’t work.

@Chris Martin the deduction is figured on your allocated profit, but the problem is that there is verbiage that indicates the deduction is figured on a business-by-business basis. 

So if one business nets $10k while the other loses $10k, it’s critically important to understand how the deduction works because we’re either getting a $2k deduction (on the business generating $10k in income) or a $0 deduction (if we aggregate).

@Brandon Hall That's interesting about doubling how much we can pay our children without needing to file a tax return. I asked our accountant about paying kids legally and he discouraged the idea, saying we would need to declare compensation and sign up for payroll. He said it would cost us 'thousands annually' to do this, and we wouldn't be able to immediately deduct their payroll due to passive activity rules for real estate.  What are your thoughts? 

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