Brian Borawski CPA, PC

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These are definitely unusual times. Most people should not be leaving their homes unless it’s absolutely necessary yet there are still things you have to get done. Grocery shopping is the biggest thing at the moment but at some point in time, especially if you expect a refund, you’ll need to get your 2020 tax return finished some time soon. The good news is the IRS and most states (I’m in Michigan and they’ve extended their deadline) have moved both their filing and payment deadline to July 15, 2020.

People might struggle if they’re used to going to a “big box” tax preparation store like H&R Block. Some of these places might still be open, but if you want to minimize your interaction with people and practice social distancing you might be looking for a better way. The good news is there are ways to get your taxes done without even leaving your house.

More then half of my clients send me their information without a face to face meeting. There are a variety of methods people get me their information to do their taxes and when combined with email for questions, we’re able to knock out their return with little difficulty. The great thing about this is you can be in a different state or even a different country and you’re still able to get your tax return finished.

People send me their information in a few different ways so if you want to discuss a plan that meets your needs, then click on this link and we can figure it out. I’ll give you a price quote before we move forward so there’s no surprises and there’s no obligation until the work is done.

While I continue to fret over my “about me” page, one of the things people ask me is, “What is your specialty?”  Over the course of my 18+ year career in tax, to a certain extent, I’ve done it all.  I’ve worked on billion dollar bank and insurance companies and large multinational manufacturing companies all the way to the businesses that bring their receipts in a shoe box.  Still, for most of the past ten years I’ve been immersed in real estate.  They’re not the only clients I work on but it’s become a niche I’ve embraced.  This includes big real estate (I spent over five years in the tax department of a publicly traded REIT) to local real estate working with investors mostly in the Detroit-metro area.  You’ll also find that a lot of the content on this site is real estate related.

One of the things I haven’t touched on in a post is the taxation basics of rental real estate.  If done right, rental real estate can be a great investment but when you take into consideration some of the favorable tax rules that surround it, it can definitely be something you want to look at to add to your portfolio of investments.

First off is the disclaimer. I’m going to making a lot of general statements but as always, everyone’s tax situation is unique so be sure to consult with a professional before you put any of this advice in place.

The first question I usually get asked is about entities.  I’m going to focus on just the tax implications and leave the entity protection discussion for your attorney.  If you want to buy and hold real estate, most of the time you’re going to hold it in a non-corporate entity.  If you want to read about why you probably don’t want to hold real estate in a corporation, I discussed that specific issue in a separate post.  Most of the time you’ll be dealing with a limited liability company (LLC).  If it’s a single member LLC, you’ll be reporting your rental real estate activity on Schedule E of your 1040.  If its a multi-member LLC, then the default tax form is the Partnership Return, which is Form 1065 with the specific rental activity being reported on Form 8825.

The next question I’m usually asked is “What can I deduct?”  The IRS’s general rule is an expense has to be ordinary and necessary expense in carrying on the  trade or business.    As usual they like to keep things vague but the first bucket of expenses are what I call the Big Three.  This is your interest, insurance and taxes.  Rental real estate will almost always have insurance and taxes and if there is leverage involved, you will have interest as well.  In dollar terms, those three expenses usually make up the bulk of you cash outflows.  If you hire a property manager, that is also a deductible expense.  Repairs (not to be confused with capital improvements) can also be deducted as can utilities if that’s a cost you incur on behalf of your tenants.  Costs to advertise the property are also deductible and you can also deduct your mileage if you’re making trips out to the property (within reason). You can also deduct legal and other professional fees (accounting and tax as an example) as well.

I mentioned repairs and you have to distinguish between a deductible repair and a capitalized capital improvement.  Lets use a roof as an example.  If you have someone come and patch up your roof, it’s probably something you can deduct. If you’re replacing the entire roof, that would probably fall more into the improvement category and you should capitalize it and depreciate it over its useful life.

Which leads me into depreciation.  When you buy a piece of real estate, you buy several different things.  You get a building, you get land and unless the house is gutted, you also get a lot of fixtures, pipes and wires.  You have a couple of choices when it comes to depreciating your property.  One option, although it’s usually not cost effective for single family homes, is a cost segregation study.  When you do a cost seg. study, you really break down the cost of what you’re buying and the end result is, you usually get property that you can depreciate over a shorter useful life (i.e. more depreciation expense now) versus property you can depreciate over a longer life (less depreciation expense now).  The other option is to just go with an estimate like an 80/20 split between property and land with the 80% being depreciated over 27.5 years.  You don’t get to take advantage of the quicker depreciation tables but you also have to spend less administrative time and money to break everything down.

When you prepare your taxes, the calculation isn’t that challenging but you have to make sure you fill out the form completely and accurately.  You take your rental income and subtract your cash expenses and your depreciation to come up with a net number.  If it’s a positive number, it’s either reported on your 1040 or it will flow through from your Form 1065 via a Schedule K-1.  If it’s a loss, then it gets a little trickier because the passive activity loss rules can get complicated.  I will save how and when you can take these losses for a post of its own.

Hopefully this is enough to get you started or if your already renting property, it validates what you’re doing. There are some other strategies I’d like to talk about, including ways to set things up if you own multiple properties, but this is getting a bit long and I will save those as well for a future piece.  As always, if you have questions, you can find a few different ways to contact me on my contact page or if you have a comment, feel free to leave one here.

Selling an asset can be taxing and sometime you run into problems when you sell an asset and you don’t collect all of the money at once.  Let’s look at an extreme example.  You have a building that’s worth $1 million but you’ve owned it for so long that it’s fully depreciated so if you sell if for $1 million, you’re going to have quite the gain.  Since it’s a long term capital asset and you sell it by the end of this year, your gain would be 15%, or $150,000.  You had a hard time finding a buyer and the one you finally found is cash strapped and they put 10% down and you seller-finance the rest.  The problem here is, your tax ($150,000) is actually more then the cash you received ($100,000) so you’re left with a shortfall.

That’s where the installment sale rules come in.  You can elect to report your gain on an installment basis if you expect payments in a tax year after the year of sale.  This is done on Form 6252 and the first thing you need to do is compute the gross profit percentage. In our example, since there’s no longer any depreciable basis, the gross profit percentage is easy because it’s 100%.  That means whenever you collect principal payments, you pay tax on 100% of the amount received.  In our example, the down payment would result in a $100,000 or $15,000 in tax (assuming this year).  If you collected $50,000 in principal next year, that would be your gain in that year and so on until the note is paid off.

One interesting quirk this year is capital gains are expected to go up in 2013 so you might want to actually pay the tax on the entire amount rather than wait and potentially pay a higher tax rate in the future.  The good news is, you elect the installment method when you file your return so you could potentially put off the decision until you have a better handle on what tax rates will be.

Many people feel that the two absolutes in life are death and taxes.  In my experience, if there’s something that comes to close to a third absolute it’s that you should never hold real estate within a structure that’s taxed as a corporation.  I can give you some examples of where it works out okay but still not as well as under a structure taxed as a partnership but I can give you a few different examples of where you can have some disastrous tax circumstances when holding real estate in a corporation.  The primary pair of reasons are basis rules and distribution rules.  As always, I’m keeping this simple so if you have a specific situation that applies to you, be sure to contact a professional.

Let’s say you get a great deal on a property.  You’re able to buy a $1 million piece of property for $500,000 and because of the great purchase price, you’re able to finance the entire $500,000 with  a bank loan.  Let’s take a look at what happens in two years when you try to distribute this piece of property out of your legal entity.

If you bought the property under an LLC that’s taxed as a partnership, you’d be in pretty good shape.  You’d probably (it would depend on the bank note) be able to pass through any losses from the partnership because your debt has given you basis.  In two years, if you distribute the property out of the LLC, it’s a tax free transaction and the property would come through with its basis and carrying period intact.

If you bought the property under a C-Corporation, you’d have a mess.  When you distribute property, it’s the same as if you sold it then distributed the proceeds so you’d have about a $500,000 gain that the C-Corporation would have to pay (plus any depreciation that you took in those two years).  On top of that, the distribution would be taxable to the shareholder at the value of the property or in this case, $1,000,000.  Those two layers of tax that will chew into that $500,000 in savings you picked up when you bought the property pretty quickly.

While not as bad as the C-Corporation example, if you had put it under a corporation that had made a Subchapter S election, you’d still have some tax to pay.  You wouldn’t have any basis in the corporation because the debt from the bank note isn’t eligible as basis.  You’d have the capital gains hit that would occur at the S-Corporation level (which would ultimately flow through to the owner’s personal return) but not the second layer of tax because the dividend would come through half tax free and half as a taxable S-Corp distribution because you’ve established some basis when the capital gain was taxed but not enough to cover the entire $1 million.

In short, putting into an LLC is pretty much a no lose situation.  Putting into a corporate structure, you could have a tax mess on your hands.  Be sure to discuss your personal situation with you tax adviser.

Cancellation of indebtedness (COD) income has become a bigger issue in the past few years then I ever remember it being.  At its core, if you take on debt and that debt is subsequently forgiven, you should be taking the amount of debt into your tax return as income.  It seems harsh because usually debt is cancelled because of a hardship but the good news is, there a couple of different exclusions that mean when you get a 1099-A (Acquisition or Abandonment of Secured Property) or a 1099-C (Cancellation of Debt) you should be talking to a tax professional.  If you ignore it, the IRS will come back at you (I know because I’ve helped people fix this when they’ve gotten a notice) but you also don’t want to just take the full amount reported as income and pay the tax either.

The first major exclusion addresses the foreclosure crisis and was part of the Mortgage Debt Relief Act of 2007.  The provision basically says that if debt was forgiven on your purchase of a principal residence, you can exclude up to $2 million of COD income if the debt was forgiven between 2007 and 2016 (expiring soon).  In order to qualify as your personal residence you have to had lived there for two or more years out of the last five.  Also be careful because this usually includes just the amount on the original note.  If you refinanced at some point and pulled cash out, then that debt might not qualify (again, be sure to talk to a tax professional) so it’s not as easy as just ignoring anything related to your home.

The next major exclusion is a four parter detailed in Code Section 108.  The four exclusions are for

1)  a debt discharge in a bankruptcy action under Title 11 of the U.S. Code in which the taxpayer is under the jurisdiction of the court and the discharge is either granted by or is under a plan approved by the court.
2)  a discharge when the taxpayer is insolvent outside of bankruptcy
3)  a discharge of qualified farm indebtedness
4)  a discharge of qualified real property business indebtedness

Okay, take a breath.  The exclusion most people will fall under is number two.  The short explanation is, if you have a debt that’s cancelled and you’re insolvent (liabilities are less then assets and you get to take into account the debt that was forgiven), you can exclude the debt. It get’s tricky when you have multiple COD events (i.e., you have three credit cards and their forgiven at certain times) and in that event, as your liabilities come down, you might find yourself paying tax on some of the COD income.  And I’ll say it for a third time, but when you’re working in this arena, be sure to talk to a tax professional.

Yesterday I gave the ins and outs of cost segregation studies.  Today, I’m giving you some of the research resources attached to it.  One good place to start, if you don’t mind the investment is CCH’s U.S. Master Depreciation Guide (2011). This guide book will give you the ins and outs of the depreciation rules like nothing else will and it comes with CCH’s top notch explanations.

If you don’t want to spend the money, then I’d recommend Publication 535 which has a section on capitalizing assets in it.  I’d also highly recommend the Audit Technique Guide on Cost Segregation. Between those two things, you should have the tools to at least get started.

Whether you call them quickturns or flips, real estate investors who primarily rehab a property and then sell those properties rather quickly may fall into a trap.  If the IRS considers you a “dealer” then they basically consider you to be no different then a retailer.  Your houses are you inventory and the sales are your proceeds and more importantly, the gross margin is subject to self employment tax.

One easy way to get out some of the self-employment tax is to incorporate.  Whether it’s an S-Corporation or a C-Corporation, there is no self employment tax.  Of course then you have the complications that surround corporations including payroll and corporate entity maintenance.

There are some other factors the IRS may look at to determine whether you’re a dealer or not.  Here’s a good piece on some of the things the IRS considers.

I was recently on the Just Start Real Estate podcast sharing tax and business tips for new and prospective real estate investors.  You can check out the show notes here and you can download the podcast here. It was a lot of fun and if you have further questions (or you’re making your way here after listening to the podcast), feel free to leave a comment here.

Over the weekend, Instant Tax Service, the fourth largest tax preparation firm, was shut down by the federal government.  If you want the long story, Tax Girl does an excellent job of running through the details.  The short story is, Instant Tax Service was run largely by people who didn’t know what they were doing and who also made up stuff for people on their tax returns as well as lied about their fees.  It’s a sad story and I feel for those who were taken advantage of by this unscrupulous company.

People often ask me what I think of the franchised tax preparation firms.  My answer is pretty standard.  I tell people it’s a little bit like playing the lottery.  I know people who work for these companies and are outstanding tax professionals and there’s a chance if you go into one of these places, that you’ll get someone like them.  You’re more likely to get someone who just took their training and has only filed a a few weeks worth of tax returns.  I’ve also seen what these places charge and it’s pretty high.  The last person who’s return I saw was filed by H&R Block.  They got charged $320 and it’s something I would have charged $150 for during normal circumstances.  I don’t offer the instant cash like these places offer but if you e-file and opt for direct deposit, you usually get your money in around 10 days.  Last year I know people were getting their money within a week.

Ironically I recently did a video on how to find a good CPA (which translates into finding a good tax preparer) and you can check it out below.  In short, if it sounds too good to be true, it might be.  If someone suggests you make up numbers, you probably want to get out there.  One of the easiest ways to get audited is to manipulate your income so you qualify for the earned income credit.  Another easy way to get audited is to fabricate a business that creates a big loss.  If someone suggests either of those things, you’re best finding someone else to help you with your taxes.

S-Corporations are fairly popular and they can be a powerful tool in your tax strategy.  In order to qualify as an S-Corporation there are some requirements you have to meet and then you have to make the election.  The requirements include

1)  Being a domestic corporation
2)  Having shareholders that are only individuals, estates or trusts (or a disregarded entity like a single member LLC)
3) Having only citizens or US residents as shareholders?
4)  Having only one class of stock
5)  You can’t have more than 100 shareholders

From there, you have to make an S-Corporation election.  This must be made on or before the 15th day of the third month of its tax year in order to be timely.  So if you form a corporation and want it to immediately be treated as an S-Corporation, you have two and a half months after it’s formed for a timely election.  If you have an existing C-Corporation and you want it to now be treated as an S-Corporation, then you have two and a half months after its year end to get the election filed timely.

If you don’t make the election in time, you can “try” to make a late election.  I’ve done this before and I’ve never had a late election turned down, which makes the whole deadline thing seem moot but it requires a few attachments to your return and there would always be the chance that you’d get turned down.

Last week, the IRS issued Revenue Procedure 13-30 which now simplifies this late election process somewhat.  What you have to do doesn’t change but it includes the rules for late S-Corporation elections as well as late QSub elections and entity change classifications.  The revenue procedure is long but at the end of the procedure are some really handy flowcharts to help you navigate the waters.  The Revenue Procedure also combines a few different revenue procedures so it’s one stop shopping from here on out.  As always, I’d suggest you talk to a professional and preferably one who’s done a late S-Corporation election in the past.  If you’re interested in seeing how an S-Corporation might benefit you, I recommend this blog post I wrote earlier in the year on the subject.