There are new amendments to the tax laws. If you haven’t of them, you’ve come to the right place. Richard Welling is a CPA and Founder of Welling and Associates, a tax firm with offices in California. In this episode, Richard joins Athena Paquette Cormier to discuss the new tax laws that affect people involved in real estate. He gives clarity of the definition of what a real estate professional is, the process of becoming one, and the benefits of being one. He also touches briefly on the advantages of doing a 1031 Exchange. Lastly, he discusses what the tax law changes mean for non-real estate professionals and gives some tips for putting oneself in a better position tax-wise.
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The New Tax Laws And How They Affect You With Richard Welling
I have Richard Welling. He’s a CPA and the Founder of Welling and Associates, a tax firm with offices here in Torrance, California and Newport Beach, California. Welcome, Richard.
It’s good to be here.
Thank you for joining us. Why don’t we start by finding out a little bit about you, your background, professional educational background and what led you into accounting?
I’m originally from this area. I went to West High in Torrance and went to Long Beach State. I got a degree in accounting and finance. I worked for Arthur Andersen in downtown LA for seven years. I was a tax manager there. When I was at Arthur Andersen, I worked a lot of real estates. I decided to go into business for myself and started a practice. We have a firm that focuses on tax services for real estate, investment management, and private clients. Private finance typically has a lot of real estate and investment holdings. That’s what we focus on.
I remember you telling me once that you had a heavy base in builder developer-type people.
Yeah, all types of real estate people that are in construction people. Every type of real estate transaction, public funds and private funds. We’ve done work all the way from companies like Westfield, KB Homes, and CB Richard Ellis. We also have small investors that have a couple of apartment buildings or a couple of rental homes and things like that. We’ve done a lot of different work in real estate over the years.
You are focused on the investor and how the new tax laws will affect investors going forward. Lots of people are excited.
We’re talking about real estate investors now, but I think generally, the tax laws are beneficial for real estate investors. There’s the new 20% deduction that applies to owners of S-corporations, partnerships, owners of rental properties. Any flow-through businesses that have qualified income, you can get up to 20% deduction of the income. The new top bracket for individuals is 37%. You can shave that by 20%, getting it down to 29.6%. That’s one of the most beneficial things. The other thing is there are much more generous depreciation expense deductions. It gets pretty complicated, but there are a lot more opportunities to take what they call cost recovery deductions or depreciation deductions. For example, under the new law, if you buy a new $4 million building and you do a cost segregation study.
You find out that 25% or $1 million of that relates to shorter life property, 5, 7, 15-year property. You can take bonus depreciation and deduct that whole $1 million in the first year. I started to do that for some clients. Some of my clients are looking to buy some property before year-end, so they may get $500,000 to $1 million of depreciation deduction as long as they close escrow before the end of the year. They can use that to shelter other income. Also, for certain types of property, owners make improvements that like redoing the roof, add HVAC, make certain tenant improvements for commercial property. There are a lot more beneficial ways to deduct that. It gets pretty complicated but, in general, you can accelerate the deductions a lot faster now.
The third thing is on 1031 Exchanges. They used to apply to all like kinds of property. Now, it only applies to real estate. You can’t exchange cattle, horses, trees, or equipment anymore but you can still exchange real estate, which is good for real estate investors. All investment or business real estate is considered like-kind. You could exchange raw land for a factory or an apartment building for an office building. That’s considered like-kind. The only caveat now is that if you own a property that has some identified tangible personal property that may not be considered like-kind. If you have a related business or if you’ve done a study and you’ve got a lot of short life property, when you do an exchange, you have to make sure you get good advice that all the property you’re exchanging is real property. Every structure, every building, may have some components that are personal property. That’s something that people need to watch out for. Those are the main areas that affect real estate investors.Any flow-through businesses that have qualified income can get up to 20% deduction of the income. Click To Tweet
Are you saying that you couldn’t do that before or they sped it up even more?
It makes the cost segregation study more beneficial. Before you would do a cost segregation study and you identify the property. Instead of depreciating it over 27.5 years for residential or 39 years for commercial, if you identify this shorter life property, under the old rules, you could depreciate under 5, 7 or 15 years span. You can get more depreciation for the first several years. Under the new law, you can get 100% bonus depreciation on anything you identify as the 5, 7 or 15 years. It accelerates it all into one year. You get this big deduction in the first year when you place the property in service. You have to make sure that you can take advantage of it. You have to consider the passive loss rules, whether or not you’re a real estate professional and if you have other income, you can offset it against.
The caveat for all this stuff is complicated. The new laws are the most exhaustive tax reform since 1986. The old law was still complicated. There are a lot of interesting things in the new law, but it requires somebody. There are a lot of special provisions and caveats that you have to be aware of. You need a good tax advisor to come in, understand your facts, where you want to go, and what you should do. In the 20% deduction for qualified business income, for some of my clients looked at that when the law passed. We changed some things early in the year because they were in a position where they could take full benefit of the new law. We had to rearrange certain things in the way their business was structured in order to maximize the benefit of the new law. You can’t wait until November or December. You can’t wait until you’re pulling your information together in February. You have to start looking at it now.
Can you explain that a little bit better? I’m having trouble understanding. If I have a pass-through, are you saying that even if I make income, I’m deducting the 20% off my taxes owed?
Let’s say you own a 100% rental property and your taxable income on your Schedule E is $100,000 net after expenses. That’s eligible for this 20% deduction. You report the hundred thousand on your return and then you get a $20,000 deduction in addition to that. Your net income from the property would effectively be $80,000. You get a $20,000 paper deduction. That’s the simple way of looking at it. There are rules that say that it’s the lesser of 20% of qualified business income or 50% of wages. Alternatively, it’s less of 20% of qualified business income or 25% of wages plus 2.5% of qualified property. This code section is ten pages long with all these parts and subparts. You have to see where you’re going to be impacted by it. Not everybody’s going to get a full 20% deduction. Some people won’t get anything and some people will get a portion of it. Real estate investors were given a bone on it because it’s less of 20% of that income or 2.5% of your depreciable property, which includes real estate. That could help you with the production
That would be a big number, potentially.
Yes. Also, since payroll is involved, too, you have to consider that. If you have a business with employees, consider what your payroll is going to be because that’ll impact the deduction. In some cases, by adding $100,000 of payroll, it’ll increase your deductions by $150,000, depending upon your tax situation. It may impact your decision as far as whether you want to do something with employees, do it by outsourcing, or have an independent contractor that you want to make an employee. From the taxpayer’s side, the new law makes it better to be not an employee. The law probably hurts employees that live and work in high-income tax states the most. High-income employees in California, New York, New Jersey and etc., are generally paying more tax because they can no longer deduct their property taxes, state income taxes, and miscellaneous itemized deductions. What the new law did was take away some deductions, decrease the tax rates and gave some benefits to businesses and some benefits to investors. The other thing is that writs are treated favorably in the new law. If you have an investment in a writ, you can get that 20% deduction. If you could have a $50,000 of dividends from a REIT, then you would get a $10,000 deduction off of that.
Since we do have a lot of real estate people, can you help us understand who is considered a real estate professional? That’s not like, “I get in my car and I show homes to potential homebuyers.” That’s an IRS definition of a real estate professional.
A real estate professional could include real estate brokers and agents. It’s somebody that spends over a certain amount of time on real estate service businesses. It includes brokers, agents and people that own rental properties. The time limit is to be a real estate professional. You have to spend over half your time or at least 750 hours on real estate service businesses. The rules get technical. There are details in there like whether you’re an employee of a business, how much percentage of this company you own and things like that. I’ve been through IRS audits on this. If somebody is semi-retired and owns three rental properties, they spend all their time paying the property bills, property visiting, collecting rent and barely spend 751 hours, IRS is going to knock you out of being a real estate professional.
I had a client like this that was being audited. IRS asked for a detail of all of his time. He was semi-retired and most of his time was spent on his real estate. He did document that he spent over 750 hours. It took a long time. We had to go through all his time, detail it, put together a spreadsheet and give the IRS a summary. The IRS told us, “This doesn’t count.” They were being picky about his time. There’s been a lot of cases on that and the IRS is one. There is a high chance of being audited if you have a small number of real estate investments and you’re trying to say you’re a real estate professional. The IRS is pretty aggressive on that. You need to be diligent in how you document your time and make sure you qualify. If you have a full-time job doing something unrelated to real estate, it’s going to be difficult to qualify as a real estate professional.
The good thing is that for a married couple, it could be your spouse. If one of the spouses is considered a real estate professional, all of the losses qualify as active real estate losses. The main reason for being a real estate professional is there are two benefits. One is that if you have income from your real estate activities, it’s not subject to the 3.8% Obamacare tax that was added. If you have losses, those losses will be considered active and they can be offset against the active income. For example, wages and interest dividends, if it’s passive, the income is subject to regular taxes plus 3.8%. The losses can only be offset against passive income. It’s beneficial to be a real estate professional, but it’s also difficult.
You can declare losses against all the other income if you’re a real estate professional?
You can deduct your rental activity losses against all other types of income. It doesn’t matter where it comes from.
If you’re not a real estate professional, they cap how much you can deduct?
You can only offset it against past income, like partnership investments, active trader business that you’re not involved with or if you have other rental properties that are generating income. You can’t offset it against interest dividends, capital gains from securities, wage income and retirement income, none of that stuff counts.
Where is it that I heard that you could only deduct up to $25,000 in losses or something like that?
A $25,000 losses are deductible but you have to have under a certain amount of ATI. I’m not 100% sure but they get caps at 150. If you have over 150 ATI, that $25,000 allowance is wiped out. I think it starts to be phased out at 125 or maybe 100.
Is that where they’re calling it suspended losses, like you’re saving the losses for later when you sell the property?
The $25,000 is an allowance for low-income taxpayers that have up to $25,000 of net rental losses. If the losses are suspended, they’re carried forward. Some of my clients have millions of dollars of suspended losses. It gets carried forward for as long as you’re alive. When a person dies, it disappears. As long as the person is alive, those suspended losses get carried forward and can be offset against future passive income. The other thing is that you can offset the losses against the gain of the activity. If you have any losses that are left on the activity that you disposed of, you can take those losses.
In plain English, is that if I sell the property?A real estate professional is somebody that spends a certain amount of time on real estate service businesses. Click To Tweet
Yes. If you had $3 million of suspended passive losses and you sold the property for $1 million gain, you would have a capital gain on the $1 million. You can take that suspended $3 million as an ordinary loss. You would have a net change in taxable income decrease of $2 million. That’s only if it’s a taxable disposition. If it’s a 1031 Exchange, those losses carry over to the new property.
That’s good news because most people are exchanging.
A lot of people are exchanging. It’s interesting that exchanges became rare around 2008, 2009 when the economy went down. I started doing a lot of 1031 Exchanges as the years have passed. Some of my clients do 2, 3, or 4 1031 Exchanges every year. They’re buying property and fixing them up. They’re increasing the rents, increasing the value. 2 or 3 years later, they’re exchanging it for another property and then doing the same thing over again. Some of my clients are taking the money because they’re having trouble finding a property that’s good. They’re selling the property because they feel like it’s overvalued and the cap rates are low. When they go look for a new property, they think all the new properties are overvalued and may not be a good investment. Some of them are just taking the cash.
If you have losses to offset that gain, then you’re just walking away with that money tax-free, right?
Yes. In some cases, if you have enough suspended passive losses, you can sell it and recognize the gain.
Are some of your investors sitting on that cash, waiting for a dip in the market again?
They may be investing in something else.
Do you see a lot of your clients cashing in in California and moving their money to other states? Do you see a trend like that?
There are two issues with California. One is because California is a high tech state, you can only deduct up to $10,000 of income taxes and property taxes as an itemized deduction. Some of my clients are thinking about leaving California as a residence and are going to Florida, Washington State, Texas and these states that have no income tax. The other thing is that sometimes people are buying properties outside the state. I had one client that sold an apartment building in LA County. He did a 1031 Exchange and he acquired a half a dozen rental homes back in the southeast. Some people are buying outside the state. I had one client that when he first became a client, he only bought in LA County. Now, he’s buying in other states like Oregon, Washington and other parts of California.
It used to be that you could live in a house two out of the last five years and then take whatever profit from that home and it’s tax-free, right? Did they change that rule?
I think there were some minor changes to it, but in general, the rule stays the same. If it’s your main residence in two out of five years before you sell it, if you’re single, you can exclude up to $250,000. If you’re married, you can exclude up to $500,000. It’s not tax-free. Let’s say somebody has a gain that’s greatly in excess of $500,000, another idea is to turn it into a rental property and do a 1031 Exchange. There are people that bought homes maybe twenty years ago for $1 million that are now worth $5 million. What they could do is turn that home into a rental property and take the $5 million after they’ve rented it out for a year or so.
Then they could dispose of the property, take the $5 million and buy some investment property or something like that. There are ways to benefit from both the 1031 Exchange and the $250,000 or $500,000 exclusion if you do it right. Let’s say a person lives in it as their main home for two years and then rent it out for two years. At the end of four years, they do a 1031 Exchange and take out $500,000 cash. I’d have to look into this further and work it out with somebody. It’s possible that they could both defer the gain over $500,000 and get the $500,000 cash tax-free. It was both a rental property and a former principal residence of theirs.
I recommended that to a few people that have a pretty sizable gain on their hands. I was curious if they had changed that or not. What are the main changes for a regular taxpayer that doesn’t own property, maybe just has some securities or something? You said that in California, we didn’t get a lot out of this deal. What would be the main things you think we did get out of this deal if you’re just a W-2 employee and make under $100,000? What would you say the benefits were in the tax law?
Off the top of my head, the tax brackets went down so the tax rates are lower. The standard deduction was increased, basically doubled to $12,000 for single and $24,000 for married. If people were barely itemizing or they weren’t able to itemize, they could have benefited from it. The childcare credits increased. For a low-income taxpayer that wasn’t itemizing, generally, they should be better off. They may save $500, $1,000, $2,000 in taxes. The downside is that if somebody itemized, a lot of the itemized deductions are now limited or went away.
Do you have any tips or strategies for investors? Knowing what you know about the changes in the tax law, what would you suggest people do to put themselves in a better position tax-wise?
The first thing would be to talk to their tax advisor because it’s complicated. Clients and people I meet come to me and say, “I heard so and so on this seminar. I heard from somebody that you could do this.” It’s hard to do this based on hearsay. Find, get or have a good tax advisor and sit down with them. If your audience doesn’t do this on a normal basis, it’d be good to sit down with a tax advisor. Take an hour of their time to go over everything, ask them and pick their brain and say, “What should I do to get ready for taking full advantage of the tax law?” This new tax law changes maybe 20% of the things. It’s not just the new tax law but how it integrates with the law that was unchanged. The tax law is about 1,000 pages of amendments to various code sections. We’re still waiting for guidance from the IRS on some things. Some people criticize the law that some things were done last minute, not well-written and not completely unambiguous. We’re waiting for the IRS to tell us what their interpretation is. In the meantime, we’re trying to take our best understanding of it.
What are the changes in capital gains?
It’s unchanged. It’s still a maximum of 20%. The only thing that changed for capital gains that I could think of is the carried interest. If somebody is a real estate syndicator or promoter and they get a carried interest, instead of a one-year holding period to get capital gains, there’s a three year holding period. Some of my clients are in that situation. That’s the main thing I could think of the impact of capital gains.
I think most of us don’t understand what that even means. What is carried interest? Who usually benefits from that? As you’re saying, it went from one year to three years. What does that mean?
Another thing it’s called by is a profits interest. It’s not just promoters. It could affect some of your clients if they get a profit interest in the company they work for. Let’s say their boss gives them an interest in the partnership or something like that and says, “You get 10% of the income of the company from now on.” That would be a profit interest. In a real estate syndicator, he gathers money from investors and buys some real estate. In the agreement, he says, “The investor gets their money back. It’s a preferred return of 6%.” After that, the promoter gets a 20% carried interest on the gain. After that, it gets split based on how people invested their money. Let’s say this $1 million property sold for $2 million. It’s a $1 million gain. The promoter has a 20% carried interest. He’d $200,000 of the $1 million. If the property was only held for two years, that $200,000 might be taxed as ordinary income instead of as long-term capital gains. The investors will get long-term capital gains, but the promoter might have ordinary income.To take full advantage of the tax law, find a good tax advisor and sit down with them. Take an hour of their time to go over everything. Click To Tweet
It’s a higher tax bracket. That’s why it’s bad.
Ordinary income is generally taxed at 37% and capital gains at 20%. Those are the general maximum rates.
You want it to be looked at like capital gains so that you can pay the lower taxes.
There’s been some commentary that this carried interest holding period of three years may have a narrow application. We’re looking at that. We’re looking into what the guidance is, what the conclusion is going to be and how broad these new laws can be applied. Right now, some people are taking an aggressive position that it doesn’t apply to real estate syndicators.
If they’re wrong, they owe more tax when the taxman comes. A syndicator means someone who puts a bunch of investors together in some kind of legal format and promises a certain return.
Generally, it’s a partnership. He may collect $100,000 from ten people and he may or may not put his own money in. He’ll take that $1 million, go buy the property and manage the property. He’ll make improvements to the property and try to sell the property somewhere down the road, usually after 5 to 7 years.
We have a guest coming on named Mr. Trowbridge. He has written a lot of books about syndicating real estate. Hopefully, he can give us some clarification on how to do that to make your money move faster.
Maybe I’m familiar with him. Is he an attorney?
He used to be a real estate syndicator and then he became an attorney that specializes in real estate syndications. I was on a panel with him and sometimes I coordinate with him on certain client issues.
He’s going to come on and explain to us how that works because some people want to take their real estate businesses to the next level. You only have so much cash savings to do it. That’s the next step up for a lot of people. That’ll be interesting. Those were all my questions. I just like to clarify certain words that you used. What’s a promoter? Can you explain to people what that is?
The promoter is the real estate syndicator, general partner or managing member of the LLC. It’s the person that puts the deal together, gathers the investor money and buys the property. I’m using those terms interchangeably.
If someone wanted to talk to you personally about their situation or their taxes and want to have a tax planning meeting like you were talking about, how would they get ahold of you?
They can call me. My direct line is (310) 697-1501. You can go to my website and that has the phone number on it. The website is RichardWellingLLP.com. If you google Richard Welling, you’ll find me. You’ll also find an artist named Richard Welling from Connecticut that did renderings of buildings, but that’s not me.
You can have more than one business.
You’ll also find a physician in Juneau, Alaska that’s a cousin of mine. Generally, if you put Richard Welling LLP, you’ll find my website. There’s a section where we try to put out an article every week on different tax planning ideas. Some of those are helpful. They could fill in some of the blanks that we were talking about. There’s an insight section on our website that you can look at.
People can sign up for your newsletter, too. I think I received it. You push it out through an email blast or something like that.
Yes. We can just add them to our CRM, our list and we’ll send them out.
Thanks a lot for joining me, Richard. This has been enlightening. I think people had a lot of misconceptions, so it helped a lot and was plain language. I appreciate that.
About Richard Welling
Richard Welling has over 30 years of experience solving complex tax problems for clients in the investment management and real estate industries.
He focuses on strategic business tax planning, combining deep technical expertise with entrepreneurial thinking. Richard was a Tax Manager at Arthur Andersen, and holds a BS in Accounting and Finance from California State University, Long Beach.