4 Key Tax Strategies to Implement Before the Year End

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Don’t you just love this time of year? Pumpkins, turkeys, Christmas trees, and family gatherings. Nothing but good times.

Unless, of course, you have taxes on your mind. Yikes!

Today, I’m going to provide a few suggestions to help you relax and enjoy the holidays. While these strategies are primarily for flippers, developers, and agents, anyone can apply the principles to their business or real estate holdings.

1. Get your books in order and document everything.

I hate to break it to you, but without proper documentation, a tax strategy is pointless. It’s a tough conversation when a client tells me they have no system for organizing receipts. I have to be the one to explain that I’m not going to show expenses on their tax returns that can’t be substantiated under audit.

When my firm is hired to help implement or improve an accounting system, we utilize technology to improve efficiency and train the business owner on new, better processes. Here’s a snapshot of the main recommendations.

Make sure you have a W9 from all contractors before work begins. Keyword here is before.

Look, I know contractors have this thing against payments other than in cash. It’s not our place to question them as long as the job is done well and to our standards. But it is absolutely in our best interest to protect our business.

In order to protect our business, we need to have a W9, among other documents, in hand prior to work commencing. Let me explain why.

Contractors can cost a lot of money. We want to deduct those monies paid as a business expense. However, in most cases, in order to do so we must issue a 1099-MISC (if over $600) to contractors at the end of the year. And where do we get the information for the 1099-MISC? That’s right, Form W9.

If we don’t have a W9 — and as a result can’t issue a 1099 — we’re sitting ducks in regard to an IRS audit. Good luck substantiating those cash payments where you did not have a 1099-MISC.

Once we have a W9, where do we put it? Hopefully not in a filing cabinet. Get yourself online and in the cloud! There are many cloud-based documentation systems that are excellent and available with smart phone apps. Talk about easily storing receipts — take a picture and upload it on your phone then throw the physical receipt out. The IRS is perfectly fine with digital documents.

If you want to get a tad fancier, you can try out various expense recording and mileage tracking apps. I highly recommend that any sort of documentation or tracking you do is performed on a smart phone app. It’s efficient, you are more likely to use it, and it ensures that you don’t lose information along the way.

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Related: What Will Happen to Real Estate Tax Loopholes Now That the Election is Over?

2. Review your entity structure.

If you are running an active business (we’re excluding rental property owners here) then you need to have an entity structure in place. It’s always a good idea to do so from a legal and liability perspective, but for our active business owners, it’s critical from a tax perspective as well.

Set up an LLC at the very least. It’s easy and cost effective unless you’re in that giant West coast state that loves to squeeze every penny out of its business owners.

Consider this scenario — you had a killer year and netted $100k. Unfortunately, you don’t have an entity structure in place, meaning that your entire profit is subject to self-employment taxes, about $15k in our example. So you’re paying $15k in taxes before we even consider your marginal federal and state tax rates. You’ll probably end up paying around 50% of your profit to federal and state governments.

Don’t do that!

Instead, set up an LLC and transact all business or pass profits through that LLC. The reason for this is that we can retroactively elect the S-Corporation tax status. If you set up an LLC at the beginning of the year, we can wait until the end of the year to decide if you should actually be an S-Corporation. In our example above, this simple step saves you about $7,500. Worth it!

If you are a real estate agent, you need to check state laws before setting up an entity. Most states allow agents to set up a personal LLC to take their sales commissions in; however, some states do not allow for this. So double check before you go through the process.

The S-Corporation election is a huge tax planning strategy, but you don’t have the option to use it if you don’t already have an LLC set up.

Another key to entity structuring is setting up partnerships for future growth. Many of you are partnering with others, and it’s highly encouraged. What’s not highly encouraged is to take your stake in the partnership entity in your own name.

When I’m reviewing your operating agreement, I don’t want to see “Brandon owns a 50% stake in Partnership LLC.” Instead, I was to see “Brandon LLC owns a 50% stake in Partnership LLC, and Brandon owns 100% of Brandon LLC.”

Basically, I’m advocating that you establish a holding company that then takes the partnership stake rather than you doing so in your personal name. The reason relates to how profits are passed through entities. If the partnership entity is owned 50% by you personally, then the profits get passed straight through to you personally. On the other hand, if you own an LLC that owns a 50% stake in the partnership, the partnership profits flow through your LLC.

This is important because we can elect to have your personal LLC taxed however we’d like without affecting your partner’s tax position.

Imagine that you and your partner take a 50/50 stake in an LLC. The stakes are in your personal names. Due to your tax situation, you need an S-Corporation, while your partner needs a C-Corporation. Unfortunately, the partnership LLC can only elect one tax status, so either you or your partner are going to be out of luck.

But if each of you sets up personal LLCs that then take 50/50 stakes in the partnership LLC, the partnership profits will flow through each of your personal LLCs. At this point, your personal LLC can be taxed as an S-Corp and your partner’s can be taxed as a C-Corp. Best of both worlds!

Bottom line: Make sure your entity structure is properly formed and can set you up for future success.

3. Make smart investments before year end.

Hopefully 2016 was a good year for your business. Ideally, your business will grow even more in 2017. I encourage you to think about products or services you can buy before year end that will help you in the future.

I’m not talking about buying a TV or other wasteful items. What I’m advocating for are the essential items that will play a key part in your future growth.

For instance, you may wish to buy a new computer for your or your employees. Perhaps a new truck is going to be needed to haul materials around in the future. Or maybe you can pre-pay for a 12 month subscription to your software or advertising services (or a BiggerPockets Pro membership!).

If you can make these purchases before year end, you’ll be able to write the cost off in 2016. A word of caution here: If you think you are going to crush it in 2017, you may actually want to hold these purchases until next year.

A couple of key rules to consider are the De Minimis Safe Harbor and the Section 179 rules.

The De Minimis Safe Harbor Rule allows you to make an annual election to write off all items that cost less than $2,500 each. Contrary to popular belief, in most cases we want to minimize our exposure to depreciation for two reasons:

  1. A current year full-cost write-off provides us with working capital from the tax savings.
  2. Depreciation will eventually result in depreciation recapture unless you sell the asset at a loss or hold it until it is worthless.

Knowing this rule means that you can strategically plan your purchases to be less than $2,500. Items that are less than $2,500 that will help your business in the future include scanners, printers, computers, handheld tools, small construction equipment, and many more. Just make sure to make the De Minimis election annually on your tax returns (or make sure your CPA does so) and keep your purchases below $2,500 per item.

The other major rule to know is the Section 179 deduction. This will kick in when you make purchases above $2,500.

The Section 179 deduction can be used to write off new and used business equipment costing less than $500,000. Used equipment qualifies, but it must be new to you.

Examples of property that qualify for the Section 179 deduction: business vehicles and equipment, computers, office furniture, and office equipment. Tangible personal property also qualifies for the deduction.

Related: The Most Flexible & Tax Efficient Way to Structure a Partnership

Heads up: The Section 179 deduction can change each year without notice. It has never been “permanently” implemented by Congress. Because of this, it’s important to analyze whether you can take advantage of the Section 179 deduction each year.

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4. Establish and use retirement accounts.

If you are a reader of my articles, you know that I’m not a fan of using retirement accounts. I think too many people contribute blindly to their 401(k)s simply because a company matches a certain percentage and “it’s what you’re supposed to do.”

However, when you are running an active business, like flipping, developing, or selling homes, retirement accounts become a powerful tax planning tool. Instead of being limited to small contributions each year, business owners can contribute up to $53,000 per year, which will increase to $54,000 in 2017. When you can contribute this kind of serious cash to your retirement accounts, I’m all for maximizing the use of retirement vehicles.

The big question is: Should you use an SDIRA or Solo 401(k)?

SDIRAs are generally cheaper to set up and manage. However, I tend to recommend the Solo 401(k) due to the fact that you can take a loan on 50% of the balance. So, if we contribute $53,000 to our Solo 401(k), we can turn right around and loan ourselves $26,500. Our tax savings, in the 25% tax bracket on a $53,000 contribution will be $13,250. So we’ve contributed $53,000 to the Solo 401(k), saved $13,250 in taxes, and have the ability to loan ourselves back $26,500. How sweet is that?

An added benefit of the SDIRA or Solo 401(k) is that you can self-direct the accounts. Because of this, you have access to many more options compared to your standard mutual fund choices found in a regular 401(k) or IRA. As a result, your ability to build a massive retirement account increases exponentially.

Mitt Romney has an IRA valued between $20M and $100M. It’s highly likely that he undervalued (legally) partnership interest that he placed into his IRA initially. Basically, he would buy partnership interests in businesses, contribute his interest into his IRA when the partnership’s current value was worthless (and therefore getting around the $5,500 annual limit), and then direct the partnership to buy various assets. As a result, his partnership stakes grew to be worth from $20M to $100M!

The other side of the story is that Mr. Romney likely uses an SDIRA for a portion or all of his IRA funds. In addition to contributing worthless partnership interests, he also has the capability to self-direct the account. This allows him to buy more partnership interests within his SDIRA, improve the business, and then sell the partnership interest without paying taxes. He is effectively flipping businesses within his SDIRA.

When you can utilize a retirement account to massively increase your returns, I’m all for it. When you are contributing a portion of each paycheck to your retirement account and you’re not sure why or can’t adequately tell me what those funds are invested in, I’m not a fan.

For business owners, the SDIRA or Solo 401(k) needs to be set up by Dec 31 of the current year. You then have until April 15th of the following year to make a contribution that counts for the current year. Make sure to loop in a series of professionals for their advice before going this route.

Conclusion

This year is quickly coming to a close, and you need to make sure you are taking the appropriate steps now to minimize your tax liability. The strategies I have highlighted in this article are a handful of awesome tax strategies that you can be utilizing in your business. Connect with a solid CPA, attorney, and finance professional today to minimize your tax burden. Now go spend some quality time with your family!

Which of these steps will you be taking before the year’s end? Anything you’d add to the list?

Let me know with a comment!

About Author

Brandon Hall

Brandon Hall, owner of The Real Estate CPA, is an entrepreneur at heart who happens to be good at taxes. Brandon is a real estate investor and CPA specializing in providing business advice and creative tax strategies for real estate investors. Brandon's Big 4 and personal investing experiences allow him to provide unique advice to each of his clients. Sign up for my FREE NEWSLETTER to receive tips and updates related to business and taxes.

19 Comments

  1. Justin R.

    The Solo 401k loan limit is capped at 50% of the value OR $50k, whichever is lower, right? If someone has a balance >>$100k, would that change your recommendation to use an SDIRA or not putting additional funds in a retirement account?

  2. Andrew Angelo

    I’m just getting started, I’m going to sell my principal residence after 18 months for $60K profit, and am closing on a duplex in January. Do I have to act fast to prevent tax liability? I can’t get duplex in LLC because I’m going to owner occupy for a bit to be able to use a 3% down loan from Wells.

  3. Dmitriy Fomichenko

    Brandon, thank you for the article and great tax savings tips that you have shared here!
    Since I deal with self-directed retirement accounts daily please allow me to add my observations:

    You mentioned that SD IRAs are generally cheaper to setup and manager than Solo 401k. In my experience the initial setup fee might be lower for SD IRA, however as years go by the cost of maintaining such account is generally higher compared with truly self-directed Solo 401k. The reason for that is because with custodial self-directed IRA in addition to basic custodial fees the account holder is paying bunch of other fees such as sale or purchase of an investment, transaction fee when investment related expenses are paid, etc. Some custodians charge a fee based on the total value of the account, which pretty much ensures higher fees year after year. Of course the total fee depends the size of the account and number of transactions in a given year. I have assisted some clients who were paying over $1,000 each year with SD IRA and where able to save over 80% by switching. With truly self-directed Solo 401k there is no custodian, which means there are no transactions, investment sale/purchase or other fees which come with custodial account.

    I totally agree with you that Solo 401k is awesome tax-sheltering vehicle. Some of my clients are husband and wife team working in the same business which means that those number can double. Imagine sheltering over $100,000 of earned income from taxes in a year and then being able to self-direct those funds!

    It was a great read Brandon, thanks again!

  4. Audrey Ezeh

    You are absolutely right Dmitriy, SDIRA typically cost about 1% the value of the account per year so it is something that requires careful thought if you want to go that route.

    So Brandon, you mention borrowing from your retirement funds. So many reasons not to but i view double taxation as probably the worst disadvantage. You set aside money you have not paid taxes on, then you borrow some of it and pay your self back monthly. Sure you are earning interest but you are paying it back with money you have already paid taxes on. Then when you retire and start drawing down on your account, you pay taxes again. There is nothing sweet about volunteering to pay taxes twice!

  5. Brandon, is there any strategy to pull money out of an IRA with low to no taxes? In the Romney case above, what good is having such a large IRA if you are going to have to pay some serious taxes on the distributions?

  6. Steve B.

    Hi Brandon,

    thanks for the great insight. I just listened to your podcast then came across this article and you seem to be the guy to ask. So if it’s not to much of an inconvenience. From a tax point of view, would it be wiser to create a promissory note or loan from myself to my LLC to purchase a single family rental and pay myself back or to just make a member contribution? As I pay myself back will I have to pay taxes on that money? I am taking the money out of a personal HELOC to purchase within my LLC. I will probably refinance down the road and pay back personal. BRRRR! I am on my first investment and already have new LLC. When I asked my CPA she told me it didn’t matter, but I’m confused. Anyway, if you could shed some light on the subject that would be awesome for my wife and I. And obviously legal disclaimer is understood.

    Thanks,

    Steve

    Thanks,

    Steve

  7. Jason Stratman

    I am currently in a partnership that we have an LLC set up, but the operating agreement lists our personal names as stake holders, just as you described. Would we be able to set up a holding company for each of our controlling interests like you recommended, or not in this instance because the operating agreement for the LLC was already created using our personal names… can that be changed after the fact?

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