All Forum Posts by: Melanie Baldridge

The tax benefits of bonus depreciation can lead to massive savings but losses won’t help one bit if you can’t use them.

Before you buy a cost seg, you need to know the rules:

Tax all starts with the types of income.

1. Active = Income earned from Material Participation.

Whether that's SMB, W-2, contract income, or prof real estate.

This is income where ordinary tax is paid and losses offset other income.

Other sources have certain loss limitations.

2. Portfolio = Income derived from financial instruments like dividends (including REITs), interest, royalties, and capital gains.

Mostly income w/out loss potential, and favorable tax rates.

Cap losses may offset cap gains w up to $3,000 loss. Investment interest can be deductible.

3. Passive income which sec 469 defines as:

1. Income from a trade or business where a taxpayer doesn’t materially participate.

2. Rental activity.

Passive losses may only offset passive income, not active or portfolio.

This is a problem for wage-earning real estate investors.

So HOW DO I GET THOSE DEDUCTIONS?

Become a Material Participant.

We are given a clear framework for determining Material Participation (not passive) in Pub 925.

There are 7 scenarios that will get you there.

Material participation scenarios (Pub 925):

1. 500 hours.

2. Substantially all participation.

3. More than 100 hours and 1/2 of your time.

4. Significant participation.

5. You materially participated in the activity for any 5 of the last 10 tax years.

6. Personal service activity w participation in last 3 years.

7. Continuous participation.

This is great if you are talking about an SMB with effectively connected Real Estate.

Note rental activity is considered passive unless you meet the RE Pro threshold of 750 hours and more than 1/2 your time.

This is the conundrum for passive real estate investors.

If you have a full-time job or a large, time-consuming business it can be difficult or impossible to qualify.

A huge loss from depreciation if you have one LP investment isn’t going to do anything for you.

You won’t be able to deduct it.

So what to do?

A few ideas:

1. Acquire enough RE that it takes you or your spouse more than 750 hours a year and 1/2 of your time to manage.

When you are a material participating RE pro all of your and your spouses’ RE activity becomes active, allowing you to offset RE losses against other active income.

One pitfall of a RE Pro spouse if you are full-time W-2.

Mind Excess Business Loss Rules.

You can only offset W-2 income with $610K in 2024.

For single filers, the limit is $305K.

2. Run an Opco/Propco model.

If your business utilizes real estate as part of ongoing operations you can get all the tax benefits of active RE by having the building purchase and hold the RE.

3. Build an SMB on top of your real estate (the reverse of #2)

Short-term rentals and high owner-participation real estate businesses can have great returns.

Obviously not for you if you just want passive RE.

We are in the deep end here, where each case should be judged on its own facts and merits by your CPA.

You should hire a professional to review your particular situation before you make an investment. It is worth it to know where you stand.

Why I like investing in real estate more than 401(k)s.

Both offer tax deferrals, but here's the difference:

If you're making pre-tax contributions to your 401(k), then withdrawals = ordinary income tax.

With real estate gains, you're paying capital gains tax (which is typically lower).

Plus, RE investors get:

1. Cash flow from their properties

2. The ability to do cost segregation and bonus depreciation

3. The ability to use leverage to acquire more attractive assets and amplify their potential gains

4. A physical property that has real-world use and value vs. holding stocks and bonds

5. The ability for 1031 exchanges

6. Access to Opportunity Zones

7. Step up in basis to reduce your heirs' taxes and more

Too many entrepreneurs make good money each year but pay Uncle Sam 35-50% of it.

It takes a long time to build a massive wealth snowball when 1/3 to 1/2 of your snow gets chopped off each year.

Real estate can help with this.

The best model I've seen is:

1. Earn cashflow from entrepreneurship.

2. Buy real estate as a "real estate professional."

3. Book losses through bonus depreciation.

4. End up with all cash and little to no tax.

Your wealth snowball ends up a lot larger 10 years down the road when you make and keep your money in a more tax efficient way.

Did you know that Limited partners or real estate investors can absolutely benefit from depreciation?

RE Pro Status supercharges this.

If you or your spouse are an RE Pro, your LP investments can lead to depreciation offsetting both passive and active income.

If you are not an RE Pro, the losses due to depreciation can only be used to offset passive income—such as income from other rental properties or other passive investments.

Someone I know bought a ranch to use as a short term rental property in 2021 for $1.7 million.

Engineers did a virtual site visit, they were able to assign a value of $347,000 to either 5-7-15 year assets that were eligible for depreciation.

In 2021, the bonus depreciation amount that you could take was 100%.

This means that the owner could immediately deduct the full amount of eligible property in the year it was placed in service, rather than depreciating it over time.

With that in mind, he took the full $347K deduction in his FIRST YEAR of ownership to offset taxable income from rentals.

This was roughly ~20% of his purchase price.

It was a big win for him.

In 2024, the bonus depreciation rate is 60% so the calculation would be different.

That said, you can still save and defer a ton.

Quote from @Sean Graham:

Quote from @Melanie Baldridge:

A question that we get:

"Does the IRS require site visits for cost segregation studies?"

While the IRS does not mandate a physical site visit, the IRS cost segregation audit technique guide (ATG) does suggest conducting “field inspections.”

It’s important to note that the ATG is not an official IRS document.

It serves as a guide and cannot be used, cited, or relied upon as an authoritative source.

However, the recommendations in the ATG are worth considering.

According to the guide:

“A field inspection is recommended to document the physical details of the building, type of construction, materials used for construction, the assets contained in the building, the size and types of building systems, and any land improvements that were included in the purchase of the property and the condition of that property at the time of purchase.”

So while the IRS does not require a site visit for cost segregation studies, following the guidance from the cost segregation audit technique guide can be beneficial.

@Melanie Baldridge good post. When/how does your team decide on doing a physical site visit vs. a virtual site visit? 

We offer physical site visits for properties above $2.5/3M or if it's required by the client.

Around 95% of our studies are done virtually but if you need boots on the ground and it makes sense for your property or portfolio, we'd be happy to help.

Quote from @Janet Behm:

Melanie, 

You are being prolific!

I just started following you,

Janet

 Appreciate it! 

I recommend that you learn the tax code and take ownership over your strategy.

Not having some foundational knowledge and an opinion on how to approach taxes as a business owner is a huge mistake.

In my experience, every single business owner who says "I just let my CPA worry about it and I focus on my business" is doing a suboptimal job at tax planning.

They are likely missing out on 10s or hundreds of thousands in saved dollars every year.

Stop making excuses and get to work.

Just a few months of part-time learning about taxes will pay you for the rest of your career.

Quote from @Kevin S.:

@Melanie Baldridge

What is the tax implication if I swap one property for another that is valued at lesser amount.  Say sell property for 2M and buy another (within the required time frame) for 1.5M?

Does the swap has to be one for one property?  Can I sell one property for 2M and buy 2 properties for 1M each?

In a 1031 exchange, if you sell a property for $2 million and purchase a replacement property for $1.5 million, the $500,000 difference is considered "boot" and is subject to capital gains tax.

To fully defer capital gains taxes, the replacement property must be of equal or greater value than the relinquished property, and all proceeds from the sale must be reinvested.

Cost segs unlock these savings, but the losses won't offset your ordinary income from your job unless you are an RE Pro.

Here's how to think about RE Pro status to make the best case with your CPA and the IRS:

RE Pro Status starts with the IRS definition of a Real Estate Professional (IRS Pub 925).

It is not as simple as getting a real estate license or working for a firm that provides real estate services.

Ask yourself these questions to see if you qualify:

Q1: Are you in the right business? A real estate pro is spending their time in real property business. Builders, house flippers, brokers, etc.

Unfortunately, banking and finance services and certain architect and engineering services don't qualify. This includes cost seg pros.

Q2: Are you an equity owner? This trips a lot of people up. You must own at least 5% equity in the qualifying business.

Working a W-2 job at construction company =/= RE PRO
Owning a construction company == possibly an RE Pro

Q3: Are you meeting time thresholds? This is a bright line issue, and unfortunately this is where people lose.

RE Pros spend each of the following:

More than 750 hours of service during the year
AND
More than 50 percent of his/her time working in real property businesses

Additionally, I talk a lot about the benefits of the RE Pro spouse. If you are pursing that path then one spouse alone must meet both tests.

Qualifying hours for the 750 include time spent working on the business activities mentioned above.

Again, more than 50% of your time means this is way more than a hobby. It is typically your primary job.

The 40 hr/week W-2 worker is going to have a hard time convincing an IRS agent they are meeting this threshold.

STR loophole is a better path for my friends in this category.

Once you finally cross the pro hurdle, you're not done! You must also materially participate in your RE activities.

If you materially participate in each RE activity, losses are fully deductible. If not, even though you are a re pro, losses are passive & deductions are limited.

There are 7 scenarios that will qualify as material, and you only need to meet one:

*500 hours
*Substantially all participation
*> 100 hrs and at least 1/2
*Significant participation
*5/10 years
*Personal service activity w participation in last 3 years
*Continuous participation

To materially participate, you must be involved in the operations of the activity on a regular, continuous, and substantial basis.

Once you pass the pro test, the material participation often comes along for the ride.

You can elect to aggregate all rental real estate for purposes of measuring material participation under Sec. 1.469-9(g).

Your time spent on all your rental properties (STRs don't qualify) counts as one activity, making it easier to materially participate.

In order to make a strong case with your CPA and the IRS you need to document your hours.

Best practice is an hours log where you are as specific as possible. If you are audited the IRS will want to see supporting docs (e.g. calendar, CC statements, etc).

If you've reached the end of this thread and your NGMI on RE pro there are a few more options:

1. Buy RE for your business to operate out of
2. Generate lots of passive income that you need to offset
3. STR Loophole

If RE Pro status is in your future, congrats!

As always:

1. Talk with your CPA before making any decisions
2. Be mindful of Excess Business Loss rules
3. Taking bonus depreciation early is a tax deferral, not a tax savings.

Recapture is real and debt must be repaid!