[00:00:00] Hi, everyone. This is the how to lower your tax bill [00:00:10] podcast. I'm your host, Terrence Hutchins. I'm, a financial and tax advisor in the Dallas Fort worth area. And the goal of this podcast is to help you listeners get [00:00:20] educated on different tax strategies. That you can implement to improve your tax situation immediately? Each episode, we'll break down useful tax tips you can use to save [00:00:30] money no matter what your personal or business income situation. Because our motto is keep more of what you earn. So let's get into today's [00:00:40] episode. Okay. Welcome back to another episode of how to lower your tax [00:00:50] bill. We are going to be starting a series about real estate investing and the impact it has on different types of taxpayers. And I'm going to [00:01:00] be giving you a lens at which I think you would process out how you want to, create the right environment in order to leverage the tax benefits. And then to also see if you think [00:01:10] it's actually worth it, depending on the work that's going to be required to do it. And so today I'm going to be focusing on the taxation of real estate as it [00:01:20] relates to wage earners. Before I get into that, I want to think about the lenses at which I introduced how you make the income that you make [00:01:30] and how that impacts how you earn taxes. So we talked about the cash flow quadrant. So you have your. wage earners You have your self employed, you have your business owners, and then you have your [00:01:40] investors. We talked about the idea that wage earners pay the highest amount of taxes. Those who are investors generally on the opposite spectrum can have the option to pay the [00:01:50] lowest amount of taxes. Now, when it comes to that, you also have to think what is it about these individuals and how they make their money? Well, there's three buckets of income or types of [00:02:00] income that I want to focus on. So you have active income, passive income, and then you have portfolio income. And so active income is generally going to be income that was [00:02:10] earned for performing some type of service. normally that's going to be your job or if you're self-employed. You also have passive income, which is income that you get when you [00:02:20] don't quote unquote materially participate in the activity. And so that's generally something where you are involved, or maybe just from a monetary standpoint, but you're not really [00:02:30] making any decisions or you don't really spend any time doing the activity, then you have portfolio income. So this is income that you get from your investments. So this could be [00:02:40] interest dividends, royalties, capital gains. So you have those three types of income and for the most part, the type of income you make can only be offset [00:02:50] by that same type of income. So if I have a passive investment, I can only offset income from that passive investment with a loss from another passive [00:03:00] investment. There are a few exceptions, which as it relates to real estate, we'll get into, but I want you to think about this as, how do I make my money? And then what bucket does it fit in when I actually [00:03:10] make it? That'll give you a good foundation around how you wanna think about what your options are in relation to your taxes. Now, as it goes into real [00:03:20] estate, real estate is defined, even though you might be actively participating in it, you know, your, your, Maybe going to fix the toilet. you're actually doing all the [00:03:30] work to get the renovations done. You can be doing all that yourself.And, you could be considered an active participant, but generally real estate is considered a passive [00:03:40] activity. So that means that other passive activities that you're involved in can only be used to offsetpassive income that you generate. Now, normally what happens is [00:03:50] I get a high income earner who has heard that, Hey, I can get benefits from investing in real estate. And so they believe that when they go and invest in real estate, that they're going to lower [00:04:00] their tax bill. And that usually is not the case. And the reason is whenever you invest in real estate, normally that's a passive activity by definition. When you go to your job and you [00:04:10] go make your two, three, four, $500,000 a year, that's active income. So even if you have a loss in your passive bucket, you can't use that loss to offset the active bucket. I have to [00:04:20] educate people on the fact that art, when you invest in real estate, there are ways to do it in an active fashion, which we'll get into. But normally if you're not looking to give up your day job, then [00:04:30] you are going to be investing in a passive way. And if you're a passive investor, then there's only going to be a few ways that you can actually utilize the losses that you accumulate in your real [00:04:40] estate. On a previous episode, we talked about depreciation and the fact that you can actually deduct based on the value of whatever you purchased, the wear and [00:04:50] tear that accumulates on a property or an item over with the IRS's defined useful life. So when it comes to real estate, they have two different useful lives [00:05:00] for most any property. You have residential and then you have commercial. So residential property, you can deduct that over 27 and a half years or 3. 63 percent a [00:05:10] year. And then you have commercial, which is over 39 years or about 2. 3 percent a year. So even if the value of your property goes up, so let's say I buy $100,000 residential [00:05:20] property, there's no land, I'm going to get a $3,600 tax deduction. So if I go buy a rental property, I'm thinking, all right, I got income coming in from this rental, but I get to deduct any [00:05:30] interest that is applied against my mortgage. I get to deduct the taxes. I get to deduct any repairs, any utilities that I've maintained while the property maybe wasn't rented or is [00:05:40] rented. I get to deduct the insurance for the property, and then I get to deduct the depreciation. And so. Whenever I file tax returns, those are always the things I check for [00:05:50] first. and many times people overlook those things because either they don't know they can deduct them or they didn't do their proper due diligence and review and to make sure they were able to take all the [00:06:00] deductions that they were eligible for. So a tip to lower your tax bill, if you have a rental property, make sure you're deducting all six of those things if you have them. Now, as it relates [00:06:10] to the property, once you've added all those deductions together and the depreciation, many times you're actually going to create a loss on paper. So even though you might be [00:06:20] able to cashflow your property and you're making a little bit money every month, then on paper though, once you factor in the depreciation, you actually create a loss. So let's just say you brought in $20,000 of [00:06:30] rental income and you have a 25, 000 of deductions that qualify you have a $5,000 loss. That loss can only be used in a specific situation. [00:06:40] So that loss can be used to offset any other passive income that you have. So if you have, another rental property that you invested in, then [00:06:50] you could use that $5,000 loss to offset any positive income from that activity. So you can use them to offset each other. That $5,000 loss could be used to offset. If [00:07:00] you sold another property and you have a capital gain, I can use that $5,000 loss to offset the capital gain that I got on a sale of another asset that's passive. So [00:07:10] that could be my stocks. That could be other real estate I can use that $5,000 loss against. If my income is below $150,000, then I could use that $5,000 loss [00:07:20] up to $25,000 per year against my active income. So if I make $100,000 and I have a $5,000 real estate loss, I can claim that 5, [00:07:30] 000 loss against my income because I'm married and I make just $100,000. Now, once my income goes above $100,000 then the [00:07:40] amount starts getting phased out. So for example, if I make $125,000, I can't deduct the full $25,000. I can only deduct $12,500. So I'm kind of be right in the [00:07:50] middle. if I'm a lower earner, at least as the IRS defines it, I can potentially use that $5,000 loss to offset my active income. One of the planning points there would be [00:08:00] if your income is right around that threshold then it would behoove you to try to get below it. So it would actually kind of feel like a double deduction in a sense. So let's just say, for example, [00:08:10] my income is $155,000. And I have the opportunity to do an IRA. And I can deduct it or I can do something else that would get my income below [00:08:20] $150,000. Well, if I contribute to get my income below the $150,000, then that automatically introduces the real estate losses that I have in addition to that. And so when you think about if your [00:08:30] income is right around that threshold, then you want to be very aware of your above the line deductions, which we talked about on previous episodes, as well as like your 401k to see can I [00:08:40] contribute to something over there that will bring my income down that will now allow me to use these real estate losses so that my overall tax bill will come down? And like I said, it's kind of a double deduction. So that [00:08:50] $5,000 loss, just to recap, I could use it to offset a positive passive income source that I had. Like another rental property that made money. I can use that 5, 000 loss to offset a capital gain [00:09:00] that I received from another passive income activity. I can use that $5,000 loss to offset my income if I make less than $150,000. Or I can use that [00:09:10] $5,000 loss if I'm considered a real estate professional. So we're going to have an episode strictly devoted to this, but if real estate is your full time job, which means that you work more [00:09:20] than 750 hours in real estate. And you do more hours than any other job that you have, then you could be considered a real estate professional then I have [00:09:30] to now materially participate in my real estate, then I can deduct my losses. So material participation is a little bit different than active participation, [00:09:40] which is what the IRS does. dictates you need to have to be able to claim that $5,000 loss to start with. So active participant in my real estate just means I make managerial [00:09:50] decisions. I don't have to swing a hammer. I don't have to go change a light bulb I just have to make managerial decisions and IRS pretty much says, okay, you actively participate in your real estate. That's [00:10:00] different than me materially participating, which we'll get into with a real estate professional episode. But generally, I have to spend at least a hundred hours doing that activity. Plus [00:10:10] more than any other person, or I could spend 500 hours. Those are probably your two most popular tests for material participation . So if I meet the criteria for that, and I'm a real estate [00:10:20] professional, then I could deduct that $5,000 loss against my other income that I generated. Let's say I'm a realtor and I have some rental properties and, I make $300,000 as a realtor, I can use that [00:10:30] $5,000 loss to offset my $300,000 realtor income. So when it comes to your real estate, the first thing I encourage people that are high income earners is, okay, how do you make your [00:10:40] money? What bucket of income is the money that you make going to fall into? So when you get into real estate, you're going to know to see how your losses are treated. Unless you meet one of those [00:10:50] exceptions. Then you're not going to use your losses. if your income is above the $150,000, those losses don't go away. They will actually just get suspended and they will carry forward to a future [00:11:00] year. if I have a 5, 000 loss, I can't use this year. Next year, I'm going to look at my income sources for that year and my time and determine, okay, how is my income going to be [00:11:10] taxed that year? So tax planning is a year by year decision. And that's why you have control as a taxpayer to change the facts of your circumstance to put yourself in a better position to where you [00:11:20] might have more tax favorable treatment on the money that you make. So let's say in the future year, I now. am a real estate professional, I can't use a loss that I had in the past, but I [00:11:30] can use a current year loss to offset my income, or if my income is below the $150,000, I can now use the loss that I had, and I can add it to my current year loss. So let's just [00:11:40] say, if you're looking at your plan and you had an opportunity to make some income adjustments to where you got below the $150,000, you could use the losses from prior years to [00:11:50] offset your current year income up to that $25,000 mark. So each year, it's something that you're going to want to assess. on your situation to see how your losses are handled. If you are a [00:12:00] high income earner, and you're going to maintain that way, then the losses you have are just going to accumulate and accumulate and accumulate, which can be positive because that gives you some flexibility on future years. [00:12:10] Remember, whenever you sell a property, you can use those losses. At that time to offset any capital gain that you have. And the thing that you're going to want to pay attention to is a form 8582. [00:12:20] A 8582 form is going to show how many passive losses do you have and how many of those are going to get carried forward to future years? So that you could probably [00:12:30] track and maintain the fact that, hey, if I've had five, 10, 15 years of losses, I don't want to lose those losses. And that's why if you change tax preparers, or, something [00:12:40] happens if you're a self preparer, you're going to make sure that you look at that form every year and you make sure you carry it forward. And then you also use that when it comes to the tax impact of selling a future [00:12:50] property. I've had people that have losses, but then they'll do something like a 1031 exchange, which is a strategy to help defer your taxes When they wouldn't even be [00:13:00] able to use it or it wouldn't have made sense for the situation. We'll get into what a 1031 exchange is and why that's applicable but this is why it's important to assess your current tax [00:13:10] situation Your current tax facts for that year, and then how you're gonna handle if you do have real estate losses for the current year or for future years. And then if you had any past losses, [00:13:20] making sure that you carry those forward so those get captured properly. So just to recap, if you're high income earner, then you're probably gonna be limited on using your real estate losses until you [00:13:30] have a capital gain, until you have positive income from another passive income source or you for some reason got below $150,000 or you became a real estate professional. All [00:13:40] right. And so what I tell people is if you're a high earner, the amount of money that you make in real estate, isn't going to necessarily lower your tax bill, but it can reduce the percentage of taxes that you [00:13:50] pay. So if you could build up a real estate portfolio and now you're making 30, 40, $50,000 a year in real estate cashflow, many times that cashflow can be shielded from taxes. So if I make [00:14:00] $300,000 and I'm in a 32 percent tax bracket, if I go make another $50,000 in my job, I'm going to pay 32 percent tax on it. But if I go make it in real estate, I [00:14:10] might not pay any tax on that. So my effective tax rate will actually come down. So if, my tax bill stays the same, but my income goes up, then [00:14:20] ultimately I'm still winning. And that's generally what a lot of people will do is say, okay, let me focus on the percentage of taxes that I'm paying versus just the amount solely. that way [00:14:30] I can actually increase my income without increasing my tax bill. And effectively I've lowered the amount of taxes that I pay. Few takeaways is number one, [00:14:40] understanding how do you make your money? Number two, what bucket of income does that money fall in? So now you can determine what are your options in relation to lowering your tax [00:14:50] bill or how do you need to change the facts of your circumstance in order to where the income you make can be treated more tax favorably. And so next week we're actually going to be our [00:15:00] next episode. I should say we're going to be talking about selling of your principal residence. And so if you're a wage earner, we're going to have a series of episodes that are kind of devoted to you on how do you lower your [00:15:10] tax bill, even when you own real estate as a high income earner. So we're going to be diving into selling your principal residence and some of the nuance around that. And this week, we also [00:15:20] have a interesting tax court case that happened back in 1981 relating to real estate. So there was a Dr. Arthur Pervsner versus commissioner [00:15:30] and in that case he owned a Beverly Hills mansion and he thought he could write the whole thing off. In his mind, his house was a business [00:15:40] expense all the way around. He had a deal making space. He said that his pool and his tennis courts were for client entertainment and that the guest bedrooms were available because his [00:15:50] clients might want to stay overnight. Why he thought that he was going to get away with this, I don't know, but the IRS first objected and he decided he wanted to go to tax court. [00:16:00] The tax court also determined that because he did not use his home exclusively for business, that he could not write off all of it willy nilly. He could only [00:16:10] write off the spaces that were dedicated exclusively for business to the business that he was operating. And so when you are taking a tax position, understand that you might be able [00:16:20] to, write it off that first year, or maybe even following years. And you may get away with it. However, if you do get audited, you're going to have to back up your claims. So that's why it's important to know. [00:16:30] Yes, we're all about lowering your tax bill, but we got to do it within the confines of the law. It changes our. If you have a Beverly Hills mansion , the whole house is not for [00:16:40] business purposes. All right. So remember to keep more of what you earn and we will look forward to talking with you next time.