Article Courtesy Of David Warrick
Helping You Keep More of What You Earn
David M. Warrick CFP, EA firstname.lastname@example.org
Admitted to Practice Before the Internal Revenue Service
(610) 945-1954 1109 West Main Street, Norristown, PA 19401 www.thetaxreductionnetwork.com
Ten Tax Reduction Mistakes Real Estate Investors
Make That Are Costing You Thousands (or what congress and the IRS hope you never learn!)
Are you satisfied with the taxes you pay? Are you confident you’re taking advantage of every available break? Is your tax advisor giving you proactive advice for saving on your taxes I’ve got bad news and I’ve got good news. The bad news is, you’re right. You do pay too much tax. You’re probably not taking advantage of every tax break you can. And most advisors do a poor job of actually saving their clients money.
The good news is, you don’t have to feel that way. You just need a better plan. Today, we’re going to talk about some of the biggest mistakes that real estate investors make. Then we’ll talk about how to solve them.
My name is David Warrick, I am a CFP and an Enrolled Agent, (admitted to practice before the IRS) I have over 30 years experience in tax planning, tax reduction, accounting, bookkeeping and tax preparation for business owners, individuals, and real estate investors.
My firm The Tax Reduction Network was founded to provide cutting tax reduction and financial advice to help business owners & individuals so that they keep more of what they earn. I also teach tax planning and tax reduction to CPA’s at a major university. You can view my website at www.thetaxreductionnetwork.com
What’s the secret to beating the IRS? It’s really no secret at all. It’s planning. I don’t care how good you and your tax preparer are with a stack of receipts on April 15. If you didn’t know you could write off your kid’s braces as a business expense, there’s nothing we can do. Tax planning is about giving you a plan for minimizing your taxes. What should you do? When should you do it? How should you do it? And tax coaching offers two more powerful advantages.
First, it’s the key to your financial defenses. As an investor, you have two ways to put cash in your pocket. Financial offense is making more. Financial defense is spending less. For most of us in this room, taxes are our biggest expense. So it makes sense to focus our financial defense where we spend the most. Sure, you can save 15% on car insurance by switching to GEICO. But how much will that really save in the long run.
And second, tax coaching guarantees results. You can spend all sorts of time, effort, and money advertising your properties. But that can’t guarantee results. Or you can set up a medical expense reimbursement plan, deduct your daughter’s braces, and guarantee savings. Let’s start by taking a quick look at how the tax system works. This will “lay a foundation” for understanding the specific strategies we’ll be talking about soon. The process starts with income. And this includes most of what you’d think the IRS is interested in:
• Earned income from wages, salaries, bonuses, commissions, and businesses. • Interest and dividends from bank accounts, stocks, bonds, and mutual funds. • Capital gains from property sales.
• Pensions, IRAs, and annuity income.• Rental income and losses
• Alimony and gambling winning.
• Even illegal income is taxable. The IRS doesn’t care how you make it; they just want their share! (The good news is, if you’re operating an illegal business, you can deduct the same expenses as if you were running a legitimate business. If you’re a bookie, you can deduct the cost of a cell phone you use to take bets.
Once you’ve added up total income, it’s time to start subtracting “adjustments to income.” These are a group of special deductions, listed on the first page of Form 1040, that you can take whether you itemize deductions or not. Total income minus adjustments to income equals “adjusted gross income” or “AGI.” Adjustments to income are also called “above the line” deductions, because you take them “above” AGI. Adjustments include IRA contributions, moving expenses, half of your self-employment tax, self- employed health insurance, Keogh and SEP contributions, alimony you pay, and student loan interest.
Once you’ve determined adjusted gross income, you can take a standard deduction or itemized deductions, whichever is greater. The standard deduction for 2014 is $6,200 for single taxpayers, $9,100 for heads of households, $12,400 for joint filers, and $6,200 each for married couples filing separately. Tax deductions reduce your taxable income. If you’re in the 15% bracket, an extra dollar of deductions cuts your tax by 15 cents. If you’re in the 35% bracket, that same extra dollar of deductions cuts your tax by 35 cents. You can also deduct a personal exemption of $3,950 for yourself, your spouse, and any dependents. Once you’ve subtracted deductions and personal exemptions, you’ll have taxable income. At that point, the table of tax brackets tells you how much to pay.
You may also owe self-employment tax, which replaces Social Security and Medicare for sole proprietors, partnerships, and LLCs. You’ll also owe state and local income and earnings taxes. Some types of income aren’t taxed at the regular rate. For example, tax on “qualified corporate dividends” and long-term capital gains is capped at 20%.
There’s also a 3.8% “unearned income Medicare contribution” on investment income for single taxpayers earning more than $200,000 and joint filers earning more than $250,000. For purposes of this new rule, “investment income” includes interest, dividends, capital gains, rental income, royalties, and annuity distributions.
Oh, and don’t forget that your itemized deductions and personal exemptions start phasing out once your income hits certain levels. For 2014, those are $254,200 for singles and $305,050 for joint filers. The bottom line here is that “tax brackets” aren’t as simple as they might appear. Your actual tax rate can be quite a bit higher than your supposed “tax bracket.”
Finally, you’ll subtract any tax credits. These are dollar-for-dollar tax reductions, regardless of your tax bracket. So if you’re in the 15% bracket, a dollar’s worth of tax credit cuts your tax by a full dollar. If you’re in the 35% bracket, an extra dollar’s worth of tax credit cuts your tax by the same dollar. There’s no secret to tax credits, other than knowing what’s out there.
Ultimately, there are two kinds of dollars in this world: pre-tax dollars, and after-tax dollars. Pre-tax dollars are great. And after-tax dollars aren’t bad. But they’re not as good as pre-tax dollars.
So here’s the bottom line:
You lose . . . every time you spend after-tax dollars . . . That could have been pre-tax dollars.
Let me repeat that. You lose . . . every time you spend after-tax dollars . . . That could have been pre-tax dollars. We’re going to spend the rest of this presentation talking about how to turn after-tax dollars into pre-tax dollars. We’re going to use three primary strategies. First, earn as much nontaxable income as possible.
Second, make the most of adjustments to income, deductions, and credits. There’s really no magic to it, other than knowing what’s available. Finally, shift income to later tax years and lower-bracket taxpayers. This includes making the most of tax-deferred retirement plans and shifting income to lower- bracket children, grandchildren and other family members.
The second big mistake is nearly as important as the first, and that’s fearing, rather than respecting the IRS.
What does the kind of tax planning we’re talking about do to your odds of being audited? The truth is, most experts say it pays to be aggressive. That’s because overall audit odds are so low, that most legitimate deductions aren’t likely to wave “red flags.” Audit rates are actually at historic lows. For 2012, the overall audit rate was just one in every 100 returns. The IRS primarily targets small businesses, especially sole proprietorships, and cash industries like pizza parlors and coin-operated laundro-mats with opportunities to hide income and skim profits.
In fact, they publish a series of audit guides that you can download from their web site that tell
you exactly what they’re looking for when they audit you! The IRS audits just one-half of one percent of S corporations and partnerships. If you’re really worried about being audited, you might consider reorganizing your business to help fly “under the radar.”
When it comes to filing taxes on your rental properties, you’ll start with your total rental income. Then you’ll subtract your obvious operating expenses, like advertising, insurance, interest, maintenance and repairs, professional fees, and the like. But then you get to take depreciation deductions. Depreciation is the process of writing off a capital asset, such as a rental property, over a period of time intended to approximate its useful life. For residential properties, this is 27.5 years; for nonresidential properties, it’s 39 years.
Depreciation is especially valuable because it’s not an actual out-of-pocket-expense. But lots of investors miss valuable depreciation deductions because they don’t know how to make the most of them.
Raw land is non-depreciable. But what about land improvements? Driveways and sidewalks crack, landscaping needs replacing, and pipes from the house to the street deteriorate over time. So you can depreciate land improvements over 15 years. If you miss those assets, you lose money!
You can also break out “personal property” included in your property and depreciate it separately. This process is called “cost segregation,” and it lets you depreciate that personal property over as little as 5 years – which gives you far more deduction in the early years you own your property. Personal property includes all sorts of assets you can break out to boost depreciation deductions:
The best part is, if you’ve missed out on these deductions in the past, you can still take them. The process is called a “cost segregation study,” and it lets you go as far back as 1987 – calculate what you could have depreciated versus what you actually depreciated –then take the difference as a deduction this year. You won’t even have to amend your old returns – just file Form 3115 with your supporting evidence with the IRS. So please see me if you have real estate you haven’t done this with!
One of the most important decisions you’ll make as you own your properties involves distinguishing between “repairs” and “improvements.” Repairs are deductible immediately as you make them. Improvements are depreciable over time. It usually makes sense to characterize fix-ups as repairs so you can deduct them faster. The definitions seem straightforward enough. Repairs keep your property in good operating condition. They don’t add value, and they don’t prolong the property’s use.
IRS examples include painting, plastering, repairing broken windows, and fixing gutters, floors, and leaks. Improvements adapt your property to new uses, add value, or prolong its use. IRS examples include room additions, upgraded appliances, new landscaping, and replacing components like furnaces, roofs, and windows.
But even the Internal Revenue Manual that tells IRS agents how to audit you admits that distinguishing repairs from improvements is a gray area. You’d think that replacing a roof is pretty clearly an improvement, right? Common sense tells you it adds value and prolongs the property’s life. But a recent tax court case ruled that an investor could deduct a roof as a repair because it just helped keep the property in good operating condition over the course of its existing expected life.
Most investors buy property for long-term investment. Your total return includes current income from rents and long-term capital appreciation. But some investors don’t want to manage tenants or hold long- term. They’d rather buy, maybe rehab or renovate, and flip for quick gain. How does that affect your tax bill? If you buy a property to hold and manage for long-term gain, it’s considered an investment. There’s no self-employment tax on rental income or gains. You can take depreciation deductions.
When you sell, you can take advantage of lower rates for long-term capital gains. You can even use tax- free exchanges to defer tax on your sale. But if you buy a property with the intent to resell it in the ordinary course of your trade or business, it’s not considered an investment. It’s considered a “dealer” property.
It’s essentially treated like inventory, just as if you were selling groceries or car parts. You’ll owe self- employment tax on your earnings. You can’t take depreciation deductions. Your profit when you sell is treated as ordinary income. And you can’t use tax-free exchanges to defer tax on your sales.
For most “dealer” properties, the biggest problem is self-employment tax. If you want to reduce that tax, you might consider operating that part of your business through an S-corporation. If you deal in properties as a sole proprietor, or a single-member LLC taxed as a sole proprietorship, you’ll report your net income on Schedule C. You’ll pay tax at whatever your personal rate is. But you’ll also pay self- employment tax, of 15.3% on your first $117,000 of “net self-employment income” and 2.9% of anything above that. You’ll also owe a 0.9% surtax on earned income over $200,000 if you’re single, $250,000 if you’re married filing jointly, or $125,000 if you’re married filing separately.
Let’s say your profit at the end of the year is $80,000. You’ll pay regular tax at your regular rate, whatever that is. You’ll also pay about $11,000 in self-employment tax. The self-employment tax replaces the Social Security and Medicare tax that your employer would pay and withhold if you weren’t self-employed. How many of you plan to retire on Social Security?
An “S” corporation is a special corporation that’s taxed like a partnership. The corporation pays you a reasonable wage for the work you do. If there’s any profit left over, it passes through to you, and you pay the tax on that income on your own return. So the S corporation splits the owners income into two parts, wages and pass-through distributions.
Here’s why the S corporation is so attractive. You’ll pay the same 15.3% tax on your wages as you would on your self-employment income. BUT – there’s no Social Security or self-employment tax due on the dividend pass-through.
Let’s say your S corporation earns the same $80,000 as your proprietorship. If you pay yourself $40,000 in wages, you’ll pay about $6,120 in Social Security. But you’ll avoid employment tax on the income distribution. And that saves you $5,184 in employment tax you would have paid without the S- corporation.
Now let’s talk about the fifth mistake: missing family employment. Hiring your children and grandchildren can be a great way to cut taxes on your income by shifting it to someone who pays less.
•Yes, there’s a minimum age. They have to be at least seven years old. •Their first $6,200 of earned income is taxed at zero. That’s because it’s the standard deduction for a single taxpayer – even if you claim them as your dependent. Their next $9,075 is taxed at just 10%. So you can shift a lot of income downstream.
•You have to pay them a “reasonable” wage for the service they perform. The Tax Court says a “reasonable wage” is what you’d pay a commercial vendor for the same service, with an adjustment made for the child’s age and experience. So, if your 12-year-old son cuts grass for your rental properties, pay him what a landscaping service might charge. If your 15-year-old helps keep your books, pay him a bit less than a bookkeeping service might charge. Does anyone have a teenager who helps with your web site? What would you pay a commercial designer for that service?
•To audit-proof your return, write out a job description and keep a timesheet. •Pay by check, so you can document the payment. •You have to deposit the check into an account in the child’s name. But it doesn’t have to be his pizza-and-Nintendo fund. It can be a Roth IRA for decades of tax-free growth. It can be a Section 529 college savings plan. Or it can be a custodial account that you control until
they turn 21. Now, you can’t use money in a custodial account for your obligations of parental support. But private and parochial school aren’t obligations of parental support. Sleep-away summer camp isn’t an obligation of parental support.
Let’s say your teenage daughter wants to spend two weeks at horse camp. You can earn the fee yourself, pay tax on it, and pay for camp with after-tax dollars. Or you can pay her to work in your business, deposit the check in her custodial account, and then, as custodian stroke the check to the camp. Hiring your daughter effectively lets you deduct her camp as a business expense.
If you hire your child to work in an unincorporated business, you don’t have to withhold for Social Security until they turn 18. So this really is tax-free money. You’ll have to issue them a W-2 at the end of the year. But this is painless compared to the tax you’ll waste if you don’t take advantage of this strategy.
Now let’s talk about health-care costs. Surveys used to show that taxes used to be small business owners’ biggest concern. Now it’s rising health care costs. If you pay for your own health insurance, you can deduct it as an adjustment to income on Page 1 of Form 1040. If you itemize deductions, you can deduct unreimbursed medical and dental expenses on Schedule A, if they total more than 10% of your adjusted gross income. But most of us don’t spend that much.
What if there were a way to write off medical bills as business expenses? There is, and it’s called a Medical Expense Reimbursement Plan, or Section 105 Plan. This is an employee benefit plan, which means it requires an employee. If you operate your business as a sole proprietorship, partnership, LLC, or S corporation, you’re considered self-employed. So, if you’re married, hire your spouse. If you’re not married, you can do this with a C corporation. But you don’t have to be incorporated. You can do it as a sole proprietor or LLC by hiring your spouse. The one exception is the S corporation. If you own more than 2% of the stock, you and your spouse are both considered self-employed for purposes of this rule. You’ll need to use another source of income, not taxed as an S corporation, as the basis for this plan.
Let’s assume you’re a sole proprietor and you’ve hired your husband. The plan lets you reimburse your employee for all medical and dental expenses he incurs for himself – his spouse (which covers you) – and his dependents. This includes all the expenses you see listed here. Major medical insurance, long- term care coverage, Medicare, and Medi-gap insurance. Co-pays, deductibles, and prescriptions. Dental, vision, and chiropractic care. Braces for your kids’ teeth, fertility treatments, and special schools for learning-disabled children. It even covers nonprescription medications (when prescribed by a physician), vitamins and herbal supplements, and medical supplies. The best part is, this is money you’d spend anyway, whether you get a deduction or not. You’re just moving it from a nondeductible place on your return, to a deductible place.
You’ll need a written plan document, which we can provide you. You’ll need to track your expenses under the plan, which we can also help with. But there’s no special reporting required. You’ll report reimbursements as “employee benefits” onyour business or real estate return. You’ll save income tax and any self-employment tax you would otherwise owe on that income.
There’s no pre-funding required. You don’t have to open a special account, like with Health Savings Accounts or flex-spending plans. You don’t have to decide how much to contribute, and there’s no “use it or lose it” rule. It’s just an accounting device that lets you characterize your family medical bills as business expenses. You can reimburse your employee or pay health-care providers directly. Let’s say your husband needs to pick up a prescription. He can use his own money, and you can reimburse him. Or he can use a business credit card and charge it to the business directly.
If you have non-family employees, you have to include them too. You can exclude employees under age 25, who work less than 35 hours per week, less than nine months per year, or who have worked for you less than three years. Non-family employees may make it too expensive to reimburse everyone as generously as you’d cover your own family. But, if you’re offering health insurance, you can still use a Section 105 plan to cut your employee benefit cost. You can do it by switching to a high-deductible health plan, and using a Section 105 plan to replace those lost benefits.
If a medical expense reimbursement plan isn’t appropriate, consider the new Health Savings Accounts. These arrangements combine a high-deductible health plan with a tax-free savings account to cover unreimbursed costs. To qualify, you’ll need a “high deductible health plan” with a deductible of at least $1,250 for single coverage or $2,500 for family coverage. Neither you nor your spouse can be covered by a “non-high deductible health plan” or Medicare. The plan can’t provide any benefit, other than certain preventive care benefits, until the deductible for that year is satisfied. You’re not eligible if you’re covered by a separate plan or rider offering prescription drug benefits before the minimum annual deductible is satisfied.
Once you’ve established your eligibility, you can open a deductible savings account. You can contribute up to $3,300 for singles or $6,600 for families. You can use it for most kinds of health insurance, including COBRA continuation and long-term care premiums. You can also use it for the same sort of expenses as a Section 105 plan. The Health Savings Account isn’t as powerful as the Section 105 Plan. You’ve got specific dollar contribution limits, and there’s no self-employment tax advantage. But Health Savings Accounts can still cut your overall health-care costs.
Now let’s talk about car and truck expenses. I don’t want to take too much time here, but I do want to point out the most common mistake clients make with these expenses. Remember it’s 56 cents/mile, regardless of what you drive . Are you detecting a pattern here? That deduction is the same for everyone, no matter what we drive. Do you think we all spend the same to operate our cars?
It might surprise you to see how much it really costs to operate your car. And it’s not exactly 56 cents per mile!
Every year, AAA publishes a vehicle operating cost survey. Costs vary according to how much you drive – but if you’re taking the standard deduction for a car that costs more than 56 cents/mile, you’re losing money every time you turn the key.
If you’re taking the standard deduction now, you can switch to the “actual expense” method if you own your car, but not if you lease. You can’t switch from actual expenses to the mileage allowance if you’ve taken accelerated depreciation.
Now that you see how business owners miss out on tax breaks, let’s talk about the biggest mistake of all. What mistake is that? The biggest mistake of all is failing to plan. Have you all heard the saying “if you fail to plan, you plan to fail”? It’s a cliché because it’s true. Fortunately, our tax planning service
avoids the problem.
We offer true tax planning. We’ll tell you what to do, when to do it, and how to do it. We start with a three-page “check the box” questionnaire that takes 5 minutes to fill out. Then we prepare a written tax plan that addresses your family, home, and job, your business, and your investments. We’ll even review your last three years’ tax returns to see if we can find savings you overlooked.
“Call the Tax Reduction Network now for your free consultation, but only if you can afford to pay less income tax”
David M. Warrick CFP,EA
“Admitted to Practice Before The IRS” 610-945-1954