Tax Strategies for Small Business and Real Estate

Speaker - Paul Hodge CPA

I.     Introduction: My name is Paul Hodge

A.  Qualifications: I am a Certified Public Account with degrees in Accounting and Finance from the University of Texas A&M.

B.  Experience: I have worked as a Controller and CFO for twelve years at a variety of companies.  I have had a small sideline CPA practice for four years and have for the past year devoted all my attention to the practice.

C.  Subject Matter – Tax Strategies for Small Business and Real Estate

II.   Why do we need a tax strategy?

A.  You keep more of what you make

1.    You reduce your taxes which increases your cash position

2.    It provides you more capital to grow your business and invest in real estate

B.  You understand your business better

1.    Analysis of your business from a tax perspective will help you understand where and how you make your money

2.    How your business is classified with the IRS will help you understand how to reduce your tax burden and increase your profit

C.  You make your business more valuable

1.    By reducing your taxes you increase your profit which increases the value of your business and the amount you can borrow or sell your business.

2.    Decreasing taxes increase cash flow which allows for more rapid growth of your business.  Cash, not profit is the life blood of business.

D.  Avoid issues with the IRS because you have a plan


III. Strategy 1: Converting Passive Losses into Active Losses

A.  Why do we do this?

1.    There is a $25,000 loss limitation on passive income from rental real estate.  As a real estate investor you have a limitation of taking up to $25,000 in losses if you or your spouse do not qualify as a real estate professional.

2.    Investors with high adjusted gross income (AGI) $100,000 to $150,000+ start to phase out of the $25,000 loss limitation.  As your AGI increases from $100K to $150K you will lose $1,000 of real estate rental loss that you can take on your tax return for every $2,000 increase in AGI.  Eventually at $150K you lose all your ability to take a loss from your rental activities.

3.    Those who need the deductions the most cannot use them.  If you do make an AGI of more than $150,000 then the tax advantage is even more advantageous.  You are at a 28% tax bracket going to a 35% tax bracket at $336,550 AGI.

B.  What are the real benefits?

1.    Investor in the 28% tax bracket without tax strategy will have a loss that will carry forward for at least three to five years until the real estate investment actually start to show a taxable profit.  This loss carry forward will benefit them in no way for the 3-5 year time period.

2.    Using this tax strategy will enable them to take advantage of some of the losses normally associated with rental real estate

Example:  John is a successful engineer and makes $85,000 a year and his wife Mary is a para-legal making $65,000.  John and Mary just invested in 3 rent houses and are looking forward to the tax benefits and cash flow they provide.  The only problem is that their combined AGI is $150,000 and since they both have full time jobs neither can qualify as a real estate professional.  They cannot take advantage of any of the book losses on their real estate investment to reduce their tax liability on the W-2 income.  John gets smart and contacts a CPA from the Lifestyles Unlimited vendor list.  The CPA then helps John create a strategy to separate his investment from his investment activity.

C.  You must separate the investment from the activity

1.    Create separate entities

a)    Asset holding entity (LLC or LTD)

(1)  This entity with own the assets of the business

(2)   It will only pay for  the direct cost of the assets

b)    Management entity (LLC or LTD)

(1)  This company will maintain the assets

(2)   It will pay for the business activities associated with your real estate business

(3)  There will be a management agreement between the two entities

2.    Separate books with different chart of accounts

a)    Rental real estate chart of accounts

(1)  This is specific for an asset holding company

(2)   It will not have accounts related to management

b)    Management company chart of accounts

(1)  This is specific for a management company

(2)   It will not have accounts related to real estate assets

3.    Separate bank accounts

a)    Very important item

b)    Helps establish separation in the two companies

4.    Expenses

a)    Management expenses

(1)  Repairs (as defined by management agreement)

(2)  Meals and entertainment

(3)   Consulting fees

(4)  Professional fees

(5)  Travel expenses

(6)  Office supplies and equipment

(7)  Vehicle expenses

(8)   Dues and subscriptions

(9)  Telephone and internet

(10)         Advertising

(11)         Credit Card Interest and Bank fees

Example:  Since John separated his investment from his investment activity John is able to capture expenses normally lost in the $25,000 loss limitation.

Revenue                      $  4,800 ($400 a month to manage properties)


Advertising                 $     225

Repairs                        $  9,800

Meals                           $  1,750

Consulting Fees          $10,500

Professional Fees        $  2,500

Travel Expenses          $  3,800

Office Supplies           $     375

Office Equipment       $  4,200

Vehicle                        $  7,800

Dues and Subs                        $     255

Telephone                    $  1,325

Internet                       $  1,080

Interest                                    $     785


Total Loss                   $39,595

True Savings           $11,086

b)    Asset Holding Expenses

(1)  Mortgage Interest

(2)   Insurance

(3)  Depreciation

(4)   Management fees (This is the revenue source for the Management Company)

IV.Strategy 2: Converting Active Income into Passive Income

A.  Why do we want to do this?

1.    Eliminate Self-employment tax of 15%

2.    Protect assets from liability of the business

B.  What are the real benefits

1.     Reduction of a tax rate on portion of income by 15%

a)    With out tax strategy - Income tax 28% and self employment 15%, total tax rate of 43%

b)    With tax strategy- Income tax 28% and self employment 0%, total tax rate of 28%.

Example:  A person with a pass through company making $128,000 a year will pay approximately $55,000 in taxes with out a strategy.  If that same person converts $100,000 of the $128,000 to passive income they will only pay approximately $40,000 in taxes.  That is a savings of $15,000.

2.    If sued for the activity of the business then the assets used for the activity are protected.

Example: A HVAC Mechanical company installs an air conditioning unit that causes an electrical fire.  The owners of the house sue the air conditioning company for more than the general liability insurance will cover.  Since the assets the HVAC Mechanical company uses are owned by another entity they are protected from the lawsuit.  The lawsuit ends with the insurance because there is nothing of value to sue in the HVAC Mechanical company.

C.  Separate the Assets from the Business

1.    Create two different entities

a)    One entity provides the service or product and is contracted to do the work

b)    The other entity owns title to all of the assets and leases them to the other company.

2.    You create a leasing agreement between the business entity and the asset entity

a)    The intent is for the business entity to rent the building, office, equipment and other assets from the asset entity.

b)    This creates a business expenses for the business entity and passive income for the asset entity.

3.    Make sure that the rent is reasonable, but high and that the asset entity always makes a profit.

V.  Strategy 3: Deferring Capital Gains through 1031 Exchanges

A.  Why do we want to this?

1.    Deferral of capital gains indefinitely and as many times as you want

2.    Building wealth by reinvesting the capital gains you would have spent on an exchange

3.    Trading up for higher quality and more secure property

4.    Relocating investments to a better market

B.  What are the requirement for 1031 Exchanges

1.    The properties exchanged must be for business uses or held for investment.

a)    Excluded are residences, vacation homes, and second homes

b)    Foreign replacement property is not considered like-kind exchange

2.    The price of the replacement property must be equal or higher.

a)    The property does not have to be a single property of equal or higher value

b)    As long as the total value of the exchange properties is an equal or higher

3.    The mortgage on the replacement property must be equal or higher.

4.    The taxpayer must not get actual or constructive receipts of proceeds.

5.    The taxpayer must use qualified intermediaries to qualify for safe harbor.

6.    The taxpayer must meet the identification and closing time requirements.

a)    The replacement property must be identified within 45 days of the closing of the relinquished property.  A replacement property is identified only if it is designed as replacement property in a written document signed by the taxpayer and sent to the person obligated to transfer the replacement property.

b)    The replacement property must be received within 180 days of the closing/transfer of the relinquished property.

c)     Both time periods begin on the closing of the sale of the relinquished property.

7.    Holding Period Requirements

a)    Reasonable period is one year but is not defined by the IRS

b)    To be absolutely sure you should hold for two years

C.  Exchanges between Related Parties

1.    Related Parties are defined as you and a member of your family.  It also includes any corporate entity that you own 50% or more.

2.    You must hold onto the property for at least a year or the exchange can be disqualified.

D.  Recharacterizing A Disqualified Property

1.    The character of the property is determined by how it is treated.

2.    Reporting the property as an investment property on your tax return is a good start

3.    Treatment for a year as an investment property will reclassify the property for 1031 purposes.

E.  Converting an Investment Property to a Primary Residence

1.     You must live in a property for at least two years as your primary residence within the five year period prior to the sale to take advantage of the Primary Residence exemption.

2.    1031 Exchange of investment property and for other investment property that you hold for at least a year as an investment.  Then live in that property for two years converting it to your primary residence.  Sell that property with your $500,000 exemption and pay no taxes.

VI.Strategy 4: Installment sales

A.  Why do we want to do this?

1.    Creates a stream of income

a)    The interest charged on the self financed note can be more than the return from operating the property

b)    Frees up time from having to operate and maintain the property

2.    Defers capital gains tax

a)    Depreciation recapture is also deferred

b)    Depending on the structure of the note it can be indefinitely  (Interest Only)

3.    Investment Leverage

a)    Leverage provided by the capital gains portion of the note will increase investment return

b)    Capital gains tax-deferred dollars earns approximately 20 to 30 percent more than interest on after tax dollars

Example:                     After Tax                                Installment Sale

Sale Amount               $500,000                                 $500,000

Adjusted basis                        $100,000                                 $100,000

Capital Gain                $400,000                                 $400,000

Net Proceeds               $500,000                                 $500,000

Taxes                           $100,000                                 $           0

Amount Invested        $400,000                                 $500,000

Yearly Income 10%    $  40,000                                 $  50,000

Net Advantage           $           0                                 $  10,000

4.    Increase value of property

a)    Seller financing is preferred by buyers

b)    Lower cost and less hassle translates into higher sales value

c)     Limited commercial financing for certain properties lends itself to seller financing

B.  Why we do not want installment sales

1.    Risk of foreclosure

2.    Risk of Early Pay-off

3.    Risk of Property Deterioration

4.    Lack of Liquidity of Note

C.  How do we set up an installment sale

1.    Determine loan to value (down payment)

2.    Determine note period

3.    Drafting the Note (not a complete list)

a)    Interest Rate

b)    Late fees

c)     Attorney’s fees

d)    Due-on-sale clause

e)     Due-on-transfer clause

f)      Due-on-encumbrance clause

g)    Tax service

h)    Insurance requirements

i)       Assignment of rent provisions

j)      Inspection and maintenance provisions

k)    Prepayment penalties

l)       Assumption clause

D.  When are taxes paid?

1.    Payment received (Down payment or regular note payment)

a)    Interest Income (taxed)

b)    Return of adjusted basis (no tax)

c)     Portion of Gain on Sale (taxed)

2.    Reported on form 6252

VII.       Avoiding the Hobby Loss Classification

A.  Make sure that you have a business in the eyes of the IRS

1.    Profit Test

a)    Show a profit three out of five consecutive years

b)    You do not need to show a profit in total for the five years

2.    Behavior test

a)    Treat your activity as a business

b)    Show that your intent is to make a profit

(1)  Act like a business

(a)   Separate entity

(b)   Separate bank accounts

(c)    Create a business plan

(2)  Your expertise

(3)  Time and effort on the business

(4)  The nature of your activity

(5)  Keep good records

(6)  Have a separate phone line

(7)  Join professional organizations

VIII.     Avoiding Trouble with the IRS

A.  Create a separate entity – businesses have a separate indentity

B.  Get separate bank accounts – businesses have their own bank account

C.  Get an accounting system (Quickbooks)

D.  Keep good documentation

E.  Make sure everything you do passes the LAUGH TEST. The rules is this; if you can claim an expense for business without LAUGHING about putting one over on the IRS then you are probably OK.

F.   Get a good CPA that knows your business and they will pay for themselves many times over.

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