All Forum Posts by: Michael Plaks

Yes it would change my answer. First, do NOT file 2553 without consulting with a tax expert. S-corps are severely over-hyped. They do not always produce tax deductions that you expect, it depends. What they always do produce is increased complexity of operation. For example, you would need to submit your driving reports to your S-corp and have the S-corp specifically reimburse you for driving. No deduction otherwise.

Important tip: we cannot see your questions unless you tag us. Type "@" and then the name of the person you want to address.

@Adi Bajaj

The article you quoted could be easily misinterpreted since it does not offer an example. You cannot write off your entire mortgage interest, taxes, insurance, and utilities simply because you store inventory in the house. You can only write off a portion of these expenses that corresponds to the area used as storage. 

Keep in mind that merely installing a shelf in your bedroom does not convert that entire bedroom to "storage." And there're some other conditions to watch for. It's a good useful deduction, but not some magical freebie.

You can also use the simplified $5/sq ft method for your storage area.

By the way, equipment such as computers or office furniture have nothing to do with home office deduction. If it is used for business, you can deduct it with or without home office.

Last tip: ask your insurance agent if you need to buy an additional rider to your policy.

@Sergey Kalina

You don't get to choose your family, but at least get better friends, приятель. ;)  "Bad advice" is an understatement.

You don't "write off the money put into the house." For starters - what are you going to do with this house? Live there yourself? Then this money is never tax-deductible.

Rent it out? Then you need to wait until the house is finished, aka placed in service. Probably it was 2020 in your case. Then you can write off some pieces like carpet and appliances, but most of the rehab will be slowly deducted over many years, known as depreciation.

And if you plan to sell it in 2020 - then and only then you get to deduct all construction costs and utility bills against the sale price.

This was just a brief intro, the real picture is more complicated.

My client, let's call him Paul, was not happy to owe the IRS $100k - the tax penalty of having a successful flipping/wholesaling operation. So, based on his buddy's advice (sounds familiar?), he ordered a cost segregation study on his 20 rental SFHs. Paul was pretty upset with me when I informed him that he still owed the IRS. He expected to erase all of his taxes, because, according to the cost segregation firm he hired, they created "$600k in cost seg tax savings" for him!

Indeed, their report shows an average savings of $30k per property. Times 20 properties - yep, $600k protected from the evil Uncle Sam and back in the investor's pocket! Don't know about you, but I would LOVE to save $600k on taxes. 

Now, shall we look a little closer? Here is one page from the cost seg report, for one of Paul's houses.

1. Yes, the number circled in red is $30,740, and it was sold to Paul as his savings. But what that number represents is the lifetime sum of the annual savings - i.e. the total of the last column! This is what Paul would receive over 28 years of depreciation. What can he claim now, on his 2019 tax return? Only the current year savings $2,868, plus we can retroactively claim the two past years, 2017 and 2018. Together, this is less than $9k in savings - a far cry from the $30k.

2. But let's look at this $2,868 "tax savings" for 2019. How was it figured out? I'll tell you how. It's 40% of $7,171. First, what is 40%? I could sort of understand this rate if the property was in CA with its insane state tax. But this property is in FL, with no state income tax! Paul's tax bracket is 24%, reducing his alleged 40% tax savings almost in half!

3. The most troubling part, if you have not noticed it yet, is that the 40% is applied to $7,171. $7,171 is the total depreciation for the year. It is NOT the cost segregation savings - which is $3,317, less than half! Without cost segregation, Paul still had $3,855 in depreciation, per the 3rd column. Cost segregation increased it by $3,317 - and that is the number that should count!

4. The real number of Paul's savings for 2019 for this property is $3,317 x 24% = $796.  Yes, only $796, as opposed to $2,868.

5. I'm afraid you still do not appreciate the extent of deception on this report. Let me show you. Look at the red numbers circled by my blue pen. This is what they mean: starting from year 6, cost segregation creates negative tax effect - i.e. you pay MORE taxes than you would've paid without cost segregation! 

In case you're wondering WTH - it is exactly how cost segregation is supposed to work! They tell you it "creates" more depreciation, right? They lie. All you do is you accelerate depreciation! You do take a whole lot more depreciation in the first 5 years, as the table correctly shows - but you have to rob your future years in order to do so.
Cost segregation does not magically create additional depreciation deductions. It merely lets you take depreciation earlier.

And now look at what the last column of the table shows. It assures you that you continue to generate over $1,000 in "savings" every year! Not at all! This is simply $2,737 of remaining depreciation per year, times the inflated 40% rate. Without cost segregation, the remaining depreciation per year would've been $3,855.

6. This particular property was placed in service in 2017. Some of Paul's 20 properties were placed in service in 2018 and 2019, giving him just 1 or 2 years of savings today. And some properties were not in service until 2020 - meaning no immediate tax impact at all.

To recap, here is the cost segregation sales pitch:

• You will get over $600k in "tax savings" from our report!

And here is the reality:

• $600k is the total depreciation over the 28-yr lifetime of Paul's properties, times the inflated 40% tax rate
• this total depreciation would've been taken over 28 years either way, with or without cost segregation; cost segregation only shifts more of it towards the first 5 years
• the actual tax savings for Paul were $35k for this year, with another $55k coming over the next 3 years (your mileage will vary)
• if he sells his properties, as opposed to 1031 exchange, he will have to return all these savings to the IRS at the time of sale

So, am I just anti-cost-segregation, you would ask? Absolutely not. Cost segregation is an excellent tax strategy when applied correctly. For Paul it was still pretty helpful, since he qualified as a real estate professional. For other investors, it could've been a waste of money and effort. Consult your tax accountant before doing it.

My problem is not with cost segregation. My problem is with selling Paul on $600k "tax savings" when in reality he only received $35k.

Two comments to @Mike S. suggestions. Again, a disclaimer: I'm not a lawyer and therefore could be wrong.

1. Having a WY LLC own a local LLC for charging order protection may not be necessary in some states. For example, a TX LLC has its own charging order protection.

2. Using a local property management company probably does not solve the problem. The LLC owning the property is still conducting business in that state and still needs to be registered as a foreign company.

@Damon Wong

Not an attorney, so my opinion is not worth much. 

If you own a property in Texas, your out-of-state LLC must register with the state. The fee is $750, as opposed to $300 for forming a native TX LLC.

@Adi Bajaj

I don't know how your LLC is set up and why you even needed it. A single-owner LLC is usually ignored for tax purposes, known in technical terms as "disregarded entity." If this is your case, you don't need anything more than carefully tracking your business-related miles with an app such as MileIQ. There're tons of mileage tracking apps - google them.

Here is a short article:
https://www.nolo.com/legal-encyclopedia/how-deduct-your-local-business-driving-expenses.html

If your business setup is more complicated, then it's best to consult an accountant.

@Thomas Harpole

You're mixing two things together, which is completely understandable, but it has to be pulled apart for the calculations.

1. Taxable profit
2. Distributing money

It is very hard to get used to thinking this way, but it is necessary if you're to understand it. 

For distributing money, you can do your own spreadsheet and equalize it any way that makes sense to you guys. But it does not mean a squat for figuring out taxable income.

Here is a sample calculation for taxable income, with many details omitted:

• sales price of $495,000
• minus purchase price of  $340,000 
• minus closing costs at sale per closing statement (commissions, seller concessions, title charges etc)
• minus closing costs at purchase per closing statement (legal, title, origination etc)
• minus all construction costs: labor, materials, delivery, taxes etc
• minus all interest paid on borrowed money, for all lenders including yourselves
• minus all holding costs (taxes, insurance, utilities etc) but make sure to not double-dip since they are often paid at closings
• minus all other costs for the deal not mentioned above

Here is what you have to ignore: 

• all loan principal amounts received and paid back, because they end up a wash: whatever you received you ultimately returned
• earnest money, because you paid it but then it was credited back to you at closing, resulting in a wash again. You already included it in the purchase price.
• amounts brought to closings and received from closings because they are simply a combination of numbers already accounted for elsewhere. Or, to put it differently, they are a result of you borrowing money for the deal, and it is accounted for already.
• settlements with lenders, because they are simply a sum of the principal which is a wash and interest which was accounted for as an expense
• money deposited to and pulled from your business account, because it's nothing other than moving money from one pocket (personal account) to another (business account) which ultimately is a wash and has no tax consequence

This probably does not make any sense, because as an investor you think about cash movement, and this calculation does not match it. For cash movement you use the first of the two calculation: your spreadsheet figuring out who gets what.

Here's a bit of good news. If, after the deal is done, you distribute out every penny from the business account, then the total increase in your personal accounts should match your taxable profit + the interest you paid yourselves.

And if it does not, and things still don't make sense - then you will need an accountant. You probably do anyway.

This is also true, and I give you thumbs up for understanding the rate difference.  The analysis gets more complicated, because some of the capital gains will be depreciation recapture that could be at or close to your ordinary rate anyway. And then there's investment income tax of 3.8% that can hit you at higher income levels.

Either way, a much more important concern I have is your focus on taxes and on finding a way to use suspended losses in particular. Taxes are important, but business comes first. If you have a great opportunity, say in syndications or land development or oil, and it does not give you passive income - would you pass on it just because it does not have the specific tax benefit you're looking for? This could be a trap.

@Paul Kersey

You have two conflicting considerations here, and it's up to you to decide which one is more important.

1. Taxes. If you buy it for $40,000 and 5 years from now sell at $140,000 - you will have capital gain taxes on $100,000. If you receive it as inheritance, you are considered to have acquired it for its market value of $100k, and you will only have capital gain tax on $40k.

If you lived there all the time, then you don't care, because it will be tax-free either way. But if you start using it as a rental at some point, then this difference might become a factor.

2. Qualifications for Medicaid and state programs. For Medicaid, there is a 5-yr lookback. If you buy it today, and next year your Dad faces huge medical expenses, this house will count against him. State programs are likely to have similar lookback periods. 

Keep in mind that this is an issue for all 3 of his houses, plus his own house. And these issues are for attorneys knowledgeable in senior planning and specifically in benefits eligibility. 
https://www.payingforseniorcare.com/medicaid/look-back-period