Business Innovators Radio - Real Estate Investing for W2 High – Income Earners

Episode Date: February 14, 2024

Jaimie Klawitter CPA, CVA, and Kenny Schmidt CPA join us from Strategic NavigatorsAccounting, PLLC to discuss the pros and cons of real estate investing for high-income W2 earners. We cover types of RE investments, the tax implications of RE, what it means to be designated as a “RE professional” in the eyes of the IRS, and much more.Learn more about Kenny and Jaimie’s accounting practices:https://insightcpafinancial.com/about-us/https://www.stratnavacct.com/aboutReach out to Strategic Navigators, Inc.https://www.stratnavinc.com/NAVIGATEhttps://businessinnovatorsradio.com/navigateSource: https://businessinnovatorsradio.com/real-estate-investing-for-w2-high-income-earners

It is a long-term investment. The cash flow is going to come in. You'll get the cash out of it, but it's not a quick tax savings thing. It's not something that's there to save you on taxes every single year. What's up, guys? Welcome back to the Navigate podcast. I'm your co-host, Mitch Salanti. We're here with Strategic Navigators, where we save entrepreneurs 40 to 60% on their income taxes.

And I'm co-host Adam Ders. And today's episode, we have Jamie Clawwitter and Kenny Schmidt. Well, welcome to the podcast. guys. Thank you, Jamie and Kenny, for joining us here and for those listening. Kenny and Jamie are CPAs with our Strategic Navigators accounting team. They're a wealth of knowledge and thank you for coming on. No problem. Thanks for having us. Would you guys mind telling us a little bit about your credentials before we get going?

Jamie, you want to start for us? Sure. So I am a CPA. I've had that longer than I'm willing to admit. But I recently got my CBA. So I just did. do some business valuations, do a lot of tax work, and I'm working to get my CFE, so I can start doing some forensic fraud work. Very good. So like Jamie, I'm a CPA as well. I don't have the CVA or CFE yet, but those are in the future. I mostly work with tax, tax planning, any and all aspects of accounting that anyone needs help with. Very good. Before we jump into all these questions here and I guess the main topic of our podcast. Can you tell us a little bit about

what a CVA is and CFA is? So CVA is a certified valuation analysis. It's pretty much I took a class learned more about business valuation and calculations and values and how to do those and what it actually takes to value a business because to value of business is not what most of us think about. you know, it's not just one number out of an error. You actually have to look at stuff. And then the CFE is certified valuation examiner or certified fraud examiner. And that's just being able to go through someone's records if they think someone's committed fraud, maybe stole money from them, maybe someone's hiding money.

It kind of teaches you those techniques and things to do to look for those types of things. Out of my own curiosity, do you get those calls often? The valuation stuff, I think, has come more frequently than the fraud stuff. The fraud is starting to pick up a little, but the valuation, unfortunately, divorces on the uprising, I feel like, and a lot of people need their businesses valued for that reason, or they're trying to buy out family members. And that's where they're calling in to get help with that type of stuff. So we have seen an uprising some of that.

Interesting. All right. Well, thank you for that. Now, we're going to get into the topic here about high income earners and W2 employees with real estate interest. And the reason we wanted to get this on an entire podcast, not just touch on it, we briefly touched on it in a previous podcast. But I want to go into a lot more depth here is because we get a lot of questions coming in, inquiries on our website or through our marketing team of high W2 earners. They have a lot of real estate interest. And they ask us a lot of questions about that and what they're able to do, what they're not able to do, how that goes against their income for tax savings and things like that. So I thought this just would be a really educational, beneficial podcast for that. So Mitch, you want to start us off

with some questions? Yeah. My first question, Jamie and Kenny would be, why is it that high income earners, high W-2 earners? Why do they consider getting into real estate in the first place? So from my perspective, a lot of the times the reason they get into real estate is it's a good investment. So it's property. It has a lot of investment value there. It's always going to appreciate. But there are certain things that as high W2 earners that being able to get into real estate and things like that, it kind of gives them that outlet for maybe some more expenses, more deductions, things to maybe help lower their income at some point in time. And my favorite answer to everyone is it depends what's happening in your life.

It always depends what's going on, what's going to happen. That depends on your tax situation. But for me, it's a great investment, long term or short term. So let me, let's expound on that a little bit, Kenny and Jamie. One, I guess, twofold with the questions that that we get with our inquiries, our clients are wondering, it doesn't make sense when they buy the real estate property to do cost segregation right away. Does it make sense to do that right away? Or is that more of a conversation piece where you find out, you know, what are your goals?

What do you want to do with it? Are there different? It's a loaded question. It's a loaded question. It comes back. It does depend. It depends their situation. So it's always when you're thinking about getting into that, it's talking with your tax professionals,

talking with Strategic Navigators, Counter, strategic Navigators, Inc. And figure out what is your goal? What are you trying to achieve by getting into real estate? Is it just for investment purposes? Is it because you're looking to reduce your income and pay less taxes, whichever one's trying to do that? But what is the end goal?

What are you trying to do? And that's going to help dictate, you know, getting you off on the right foot as far as whether you do the cost segregation right away. A lot of people jump into that, but it may not be the best option depending on what your end goal is. Something that also depends on the property itself as well as your financial position. You know, cost aggregation studies can vary anywhere between, you know, $3,000 to $10,000. So depending on your tax bracket, that may not be, the cost savings may not be there for what you're spending.

And as Jamie said, too, you know, depending on. the value of the building, value of the land. It may not make sense for you to spend that, have that capital expenditure for the cost segregation study based off the value of the building itself. Okay. And going along with that, is cost segregation and accelerated depreciation the same thing? Or are they two different things, two separate things? So a cost segregation study is the study of going through a building and breaking it down into its individual components. So by itself, a building, a residential building is 27 and a half years. A commercial building is 39 years.

What a cost segregation study does is instead of saying, here's the building, it takes it and breaks it down into its more individual parts, interior doors, moldwork, flooring, windows, faucets, let's while, things like that, breaking it down into small individual pieces. And that's why it costs three to two. $10,000 because you have to hire someone to go and evaluate every like door knob and every really this is not something we typically do um you know this is normally a there's firms out there that specialize in this you know where they have engineers and accountants and lawyers and all different people who are this is what they specialize in is doing just these cost segregation studies and knowing

what the IRS looks for, things like that. So the purpose of getting down to those smaller components is the smaller components have a different depreciable life than what the building components does itself. Why it's important is those smaller, any assets that have five, seven, 15-year lives are eligible for what's called bonus depreciation, which right now is that, which allows you to take under current law, I guess for 2020 and 2020 and it reduces going forward

is 80% of the cost in the first year. Interesting. Okay. One thing I will say with cost segregation is very expensive to do it. But if you are building a building, if you're going from scratch, we do try to tell clients work with the person building, like whoever you have helping you.

And they can kind of do the cost segregation as they go because as they're invoicing, if they break it out on the invoice, they're doing it for you. So there is a strategy there too where you're not using, you're not spending a ton of that money because you can kind of,

if you're building it, have them help you do it as you go. And is that true for residential and commercial? Yeah. You're doing it along the way if you're building. Yeah. Just talk with the person who's building it with your subcontractors,

your electricians, plumbers, things, have them break it down by costs, what they're doing. Okay. That is essentially what a cost segregation is. right and it makes sense to do that along the way so someone doesn't have to kind of redo all their work coming afterwards and do it all yeah another question I had was because we were talking about the value of things like that the fair market rent and why is that important that's a new concept to me can you talk a little bit about fair market rent and why it's important for depreciation yeah fair market rent is not something that a lot of people think about when they get a rental property they're like oh you know here's

what my costs are. So here's my, here's my rent price. But fair market rent is essentially, it's looking around in your area and seeing what are the rental prices for buildings like yours. So if you own a commercial property on a street that has 20 commercial properties, you're going to look to see what the values are and what they're renting them are and what is that possibility out there. And one reason to do this is, you know, A, you want to be competitive with your prices. You don't want to rent a building and be the cheapest one because then you're not making money. And then B, that's what the IRS is looking for. So if you are undervaluing your rental property and you're not running for the full rental value, the IRS could come in and say,

you know, especially if you're renting it to yourself or to a family member or someone you know, they could come in and say that's wrong. And then you could get in trouble with them. So you do want to make sure that you are essentially being fair in what you're renting, don't under rent because you're trying to be cheap with family members. So fair and reasonable. That's a term that I've heard is kind of a great area with the IRS, fair and reasonable. It's up to anyone. They never define them, but they love those words.

Oh, but it's only fair what they say. Yep. Yeah. And they better like it. Oh, fun. And it may change from time to time. And it depends the auditor you get, what they consider fair and, what they consider reasonable.

So it's a fun game that gets played. Guys, can you explain how profit from real estate investments are taxed and how this might differ depending on the type of investment? So from a rental real estate, if you're kind of just doing on the side, so you're not considered what's a real estate professional or material participation in it, it's actually considered passive income, which means that you're taxed on the income no matter what. However, if you end up with losses or anything like that, from a passive loss standpoint, you can only offset your passive income. So if you have a ton of rental properties, some have profit and some have losses, you can offset those.

But as a W2 earner, you can't offset your losses with your W2 income. So that's the one caveat with if you're trying to lower your income as a high W-2 earner, it doesn't work that way necessarily if you're just doing real estate on the side because it's considered that passive income passive losses. But I will say you don't lose your losses. So any remaining loss gets carried forward to next year to continue to apply to all of that income. And then what eventually happens is, you know, one day if you go to sell,

that property, it releases all those losses at that point. And then that's when you can take them against your other income. So it's a long-term game is what I would say for people trying to get into it, that it's not their profession. It's not what they want to do. It's something they do on the side that they maybe hire a management company to help them worth or something. It is a long-term investment. The cash flow is going to come in. You'll get the cash out of it, but it's not a quick tax savings thing. It's not something that's there to say. gave you on taxes every single year. And you mentioned that's something if you're doing real estate on the side.

Is that very different from quote unquote being a real estate professional according to the IRS? So being a real estate professional means that you derive more than 50% of your working hours per year are in real estate. That doesn't necessarily have to mean that you are doing all rentals. That can be, you can be a construction, you know, you can be a carpenter. any sort of tradesman, realtor, it just has to be something in real estate. Once you reach the real estate professional status,

if you have rental losses, those are considered, you can offset your, those are considered to be non-passive and can offset your, path, your, can offset your other income, so your W-2 income,

income from K-1s. It's not all locked up. It has to be, against other rental properties at that point. And how is that tracked? The 50% hours to a real estate being a real estate professional. How's that tracked? And is that taken advantage of?

I can see that. Yes, that's up to you. With most things, the burden of proof obviously falls to the taxpayer, like everything else at the IRS. You know, that would be keeping track of, you know, how many, you know, you went to property A to check the water. meter. You did this for property B. You worked with the bank to do this. You are approving new tenants. You're looking for new properties. You know, now if you're a realtor by trade or carpenter or home builder, any of those things, obviously the burden of proofs a little easier. You have your, you have your W2 from these jobs. You have time carts. You have meeting logs.

All those things proving that, hey, I derived more than 750 hours. I was working in real estate of some sort. I think one way this gets abused, and I don't know if people just aren't thinking, is for real estate professional, it is solely on you. So if you're married, your spouse's hours, you know, if they're helping with their rental properties or anything like that, your spouse's time, your spouse's hours do not qualify you as a real estate professional. It is purely looking at each one of you individually. And usually with high W2 earners, if you think about, all the work they're doing at their regular job that's getting them to be a high W2 earner, they're not going to meet that real estate professional because they're never really going to hit

that goal. So is that a red flag to the IRS if they see that you're a high W2 earner and then you're trying to do the real estate professional thing? It can be depending on the business you're in. Like Kenny said, if you're already in the construction business plumbing and electrical, you're already in that type of business. And that's what you do. and that's where your W2 incomes coming from, you know, it could be, but still at the same point,

most high W2 earners are not in those fields. Most of them are coming from, you know, they're doctors, lawyers, accountants, you know, whatever, they're in those fields that it's not usually in the construction world. But where it comes in is you don't necessarily have to be a real estate professional. you could also do material participation. So there are two different types of things you can have here. There's real estate professional, which gives you a whole lot of benefits. But most people can't hit that unless they're in that world.

That's what they do. So then there's material participation. And that is where most of your high W2 earners are going to come in because they're going to spend enough hours to actually meet that goal. So that's 750 hours during the. year. But that can come from you and your spouse. So it doesn't just have to be you. If you file the return together, it can come from both of you. That's where they're going to meet it. And that material participation is what's going to give them some more of those benefits, especially when you start talking about short-term versus long-term rentals. So for short-term rentals, those have

really taken off. I don't know about anyone else, but, you know, Airbnb, verbote, those have really taken off. And if you're qualified under material participation, those short-term rentals are now just like you're a real estate professional. They qualify any loss that you have for them can qualify and be taken against other income. And so some people are taking advantage of that. You know, they have a ski, you know, they have some place up where, you know, ski lodge. Short-term rental, vacationers, places like that, you know, you can still go use it. you know, most high W2 earners, they will use their houses, vacation homes, you know, two,

three times a year, do short-term rentals on the other side to get your, be able to still deduct expenses of carrying that vacation home. So is there an increased tax benefit in the short-term rentals like Airbnb and VRBO then for those W-2 earners that isn't there for other rental properties? Potentially, actually the opposite. With short-term rental, depending on your level of participation, it may rise to the level of being considered self-employment tax or, I guess, non-passive income, which would be subject to self-employment tax of Social Security and Medicare. If rentals by nature are passive, you know, you're not really having to do a whole lot. I say that very broadly, you know, you're not having to really be there working every single day to earn that income, so it's passive. So it's not subject to self-employment tax.

With short-term rentals, if you are going there every single day and giving them fresh towel regardless of, you know, what they're doing, if you're providing other amenities besides just the place to stay, the IRS has issued more guidance on, well, if you're really doing a whole lot for these rentals, it's not really passive anymore. You are actually actively participating. You are there every single day. This is like your job, a normal job. and therefore you're subject to Social Security Medicare tax on those earnings. So one thing I will point out there is if you're a high W2 earner, most likely you've already capped out your Social Security. So now you're just talking Medicare and that's 1.45% tax.

So still additional tax, but it's not as bad as if that's all your income. Okay. Does Social Security kind of tap out at, is it like $150,000? Is that right? Yeah. And most high W2 earners have already hit that. Right. Yeah.

Is that differ throughout state or is it 150,000 across the board? Across the board. That's a federal thing. Okay. Can you guys give a little guidance then as far as what you both personally recommend for W2 earners considering real estate, whether or not you'd recommend Airbnb or multifamily or commercial or just what, you know, explain a little bit of the different options and why someone may or may not want to choose that. So obviously, everyone's individual situation is going to be different.

You know, what they have to be able to put in for capital, what they want to deal with time-wise, what's available to them in their area. You know, certain areas may not really have availability to Airbnb or BRBO just based off of the geographical location. So it's really depend on each client, and that's where strategic navigators and strategic navigators accounting can really help you look at your options based off of, you know, like I said, lifestyle, income, long-term goals, and guide you on which one of those options is best for you. So I'll give an example. If your goal is that you're snowbird, you don't want to be, I don't know about anyone else, but it has been cold this week. here in central Illinois. I would have loved to have been in Florida. You're someone that wants to go to Florida, but you know you're only going to use that home maybe in January, February, and you're working the other times, but you don't want it sitting there idle, but you do want to buy a property.

You want to do the investment. That might be something for a short-term rental. If that is your goal, is personal and nature, you may do short-term rental. You may go and you get something, but then you hire management company that then does a lot of the stuff for you while you're gone. You may go help and do some things that get you the material participation and you're going to do that. That'll come naturally for most of them. But if that is your goal, you might go to short-term rental. If you're looking for, it's more long-term goal. You're looking for an investment. You're looking for something that is there to help with taxes somewhat, but it's more of an end goal and you're playing that long-term game. Then you might want to go more of the long-term rentals. I would stay away from trying

to qualify as real estate professional. You're probably not going to hit that. But the idea is that even if you have losses in this long-term game, they're going to keep building up. And when you go and sell that property, everything will start to kind of offset each other. And you're going to have that windfall in that year. You're going to get capital gains. You're going to make profit off of it. you're going to get cash out of it. It's your long-term investment game. So those are just a few examples of what you can do. And like Kenny says, it all comes down to what is your goal and it's a personal situation.

And that's why you want to talk with your advisors to figure out what is your best option. And that may change throughout your life. You could have a short-term rental and turn it into a long-term rental. There are things you can do. Jimmy, I'm glad you touched on capital gains. That was going to be my next question. Can you give us just, I guess, paint with broad strokes here, definition of capital gains and the pros and cons and what it is limited to and not limited to? So when it comes to capital gains, it's mainly when you go to sell the property is when you're going to recognize those capital gains.

You've sold an investment unless it's like, Kenny said, the short-term rental that you've turned into SE income. Because that's more of, that's a different type. But if we're just looking at an investment property, capital gains, the benefit of them is they're not taxed at your ordinary income tax brackets. So you go from zero to 15 to 20. So what happens is for most high W-2-owners, they're in the highest bracket. So for capital gains, you're most likely in that 20% range. So instead of being taxed at 30%, 30, 36, whatever you are, instead of being taxed at that when you go to sell and you sell at a gain, you're only taxed at the 20%. But if you have a ton of losses held up in that passive property, you can offset those gains and get them down as low as possible.

Whether or not that's short term or long term? Well, and it depends. If you turn it into that SE property, that's a whole different thing, probably a whole different podcast to go over with the income and how does that affect you and what you do when you do things. And one thing I will say, no way to touch on it, but a person who flips houses, this does not qualify for any of them. So if you're someone who buys a house thinking that's short term, that is not short term, flipping a house is something completely different. And that's a big thing right now too. I guess one of the question here, we kind of covered it, but let's go over it a little bit more. What happens when you sell a rental property? Let's say for long term, long term property.

What happens when you sell that? What are the next steps to have tax advantages for that and to mitigate your tax situation. So if you are holding the property long term and you go to sell, a couple of things are going to happen. Let's assume you're selling it a gain. Real estate's always going up. Most people are selling it a gain unless you've destroyed your property and then you're going to sell at a loss, obviously. But if you're selling it a gain. A couple of things happen. You have, you've depreciated that property for some of it. If you've held it the entire life of the property. So say it's a long-term rental, residential rental, that's 27-half years. Say you held it for 30 years. Your issue there is

you have depreciation recapture. So any depreciation you've taken, that's going to get, you essentially expense that. So now that becomes ordinary income. So that is outside of capital gains. Once you've exceeded your depreciation on your gain, so say your gains 30,000 and depreciation you took was 20,000, you'd have recapture of 20 and then 10,000 of capital gains. And this is where you really want to talk to your financial advisor before you go and sell stuff so they can help you with these types of things. Because the problem is now you're creating more taxes for yourself. And there are things you can do to get it down. There are tricks of their trade that some people have.

But again, it comes down to your personal situations. So employing someone like strategic navigators, having strategic navigators accounting, look at the books before you go to sell. That is the biggest key, before you go to sell, when you first start thinking about it, have someone help you,

have someone look at it to see what's going to happen. I think that's the biggest plug I can give there and say that's your only option if you're trying to mitigate taxes. is. Go ahead, Kenny. I don't say the other big thing to consider is Jamie touched on earlier is you could have potential losses that become released at that point. If you only have a single run on property, you don't qualify as a real estate professional

and you've generated losses over the years that you have essentially have built up because you've never had income to offset them. As soon as you dispose of that activity, those losses get released. So in a game example, let's say you have a game, but all of a sudden, let's say you had a $15,000 suspended rental loss there. That loss gets released immediately and it can go against any income. It doesn't have to be passive at that point. So to wrap that up, one of the biggest takeaways that I have from this is consult your tax professional. Ask them questions before you go and do something because you could really mess it up and then it costs money to undo.

the issue and look at the different costs that would that you'd incur, especially with cost segregation. I had no idea that it would cost between $3,000 and $10,000. I'm sure there's, you know, outliers there as well, but I had no idea it would cost that much. Yeah, they can be quite expensive. Now, I will say one thing, if you're not going to do cost segregation, you can still do land versus building. And we as tax professionals, we can do that, do an estimate. We usually go, you know, it'll tell you, your county assessor will break it down by land and building at least. So you can at least do that. But if you want any more detail, you've got to go to someone who does cost segregation. So if somebody wanted to get a hold of a tax professional, maybe they like their CPA or they

maybe they're looking for a new CPA, how would they go about finding you guys in our team? So you can reach out to Strategic Navigators, Inc. or Strategic Navigators Accounting. So our phone numbers 309663-1353. And then you can always email Kenny or me. And we'd be happy to ask your questions. You can go to our website. It'll have both of our contact information on there. I'd spell out my name, but I've got a weird name. Yeah, we'll leave the contact in the description for everybody. Any other questions? Mitch, did we capture everything you wanted to? Yeah, I'm all set. We covered it a lot. So thank you, Jamie.

Thank you, Kenny. No problem. Cool. Great. Thanks, guys. Thanks for listening to Navigate. If you're interested in learning more about strategic navigators, feel free to click on the link in the description.