Epic Real Estate Investing - Sneaky "IRS Audit" Protection - Joel Jensen | 952

Episode Date: March 9, 2020

This Monday, Matt, and Joel discuss differences between a real estate investor and a dealer from the tax point of view and how to protect yourself from the new and sneaky IRS audit, especially when you are starting in real estate! Learn more about your ad choices. Visit megaphone.fm/adchoices

This is Terio Media. Success in real estate has nothing to do with shiny objects. It has everything to do with mastering the basics. The three pillars of real estate investing. Attract, convert, exit. Matt Terrio has been helping real estate investors do just that for more than a decade now. If you want to make money in real estate, keep listening. If you want it faster, visit R-E-I-A's.

Here's Matt. Okay, welcome to the epic real estate investing show. Glad you found us if this is your first time. If it's not, welcome back. We're here each and every day of the week, seven days a week, talking everything about real estate, how to make money and how to keep it. And we've been doing this for about 10 years now, a little over 10 years. We just passed our 10 year anniversary and we just would not be here if it weren't

for you. So thank you. Thank you for listening. Thank you for sharing this with your friends and family because of you is the reason I still do this. And thank you for all the feedback that you give and sharing with me all the help that you get from this show. It just fuels me and it keeps me going. All right. So I've got a guest for you today.

Actually, a repeat guest. We're going to talk more taxes because it's that season. And you heard a great interview with him last Monday. And here he is again. A week later, Mr. Joel Jensen from Tax Sentry. Joel, welcome back to the show. Hey, thanks, Matt. Appreciate it.

Glad to be here. Yes, glad to have you back. So today we're going to talk about something that, you know, a lot of people ask about their entities, like which entities show you? Should I use an LLC, an S corp, a C corp? And so we're going to go into that. But one thing that we were talking about before we started recording was like the big difference between what a real estate investor is and what a real estate dealer is and how

they are treated differently by the tax code, by the IRS. So let's kind of go through, let's start with definitions. What's a real estate investor? What's a real estate dealer? Okay, great. Yeah, let's go through it. So I like to think of real estate taxation as kind of a coin. You know, if you look at a quarter, it has a heads and a tail side.

Real estate kind of works the same way. And now we have an investor side and we have a dealer side. And they are treated very differently by the IRS. And I like to tell people, you have to have a really good. understanding about which path you're walking down. So am I walking down the investor path and we're walking down the dealer path? Because when you mention real estate to most people, I guess, if I say, hey, I'm in real estate, they automatically go straight to, oh, you own a bunch of rental properties, right?

That's kind of the... Or they think you're a real estate agent. Yeah. Yeah. But realistically, there's another side, which is that dealer side, and people kind of have to understand the differences of both. So let's talk about the real estate investors. So the real estate investor, like I said, is what people think about when it comes to real estate investing.

And that is the rental side. Let's say I own a couple rental properties. When I buy them, maybe I have some fixing up to do. So I'm going to put a little bit of money into it. I'm going to put it out on the market, try to find some rentors to come in, make me some money. That rental income that comes to me as I own that property is what we consider passive income. Passive income, the real difference is that it does not come with that dreaded self-employment tax associated with it. So I'm not paying Social Security on that income.

So I like to think of it as cheap income. That's why we do it. In fact, that's why I do it. So I have commercial properties on the investor side that I rent out and make that passive income because it's cheap income. And over time, as the markets increase, we look for the appreciation in those assets. that we buy and we're renting out. And so when we sell those properties, we have capital gains that we have to deal with. Capital gains rates can vary depending on how long I held the property.

And also now with the new tax code, how much other money I make. So we can be at a 15% or 20% capital gains rate, and that's largely due to my other sources of income. I also have the ability on the investor side to 1031 exchange. And as we all know, 1031s are awesome because it deferred. income. It allows me to exchange taxes. Properties. Yeah. Defer. Sorry, defer my taxes. Yes. And so I can buy something, 1031 exchange it into a bigger or maybe a better cash flowing property and not have to pay taxes. So it allows me to invest more money. That's a really great tool. Maybe one day we can

get into the details of that. So that's kind of the investor side of things. If we flip the coin over, we have the dealer side of things. And it's funny that when I talk to people about being a dealer, realistically, you're no different than a retail business. So if you think about a retail business, for example, I'm going to maybe go out and buy, I don't know, we always like to use widgets in the accounting world because it's like a doesn't really mean anything. So if I go buy 100 widgets and I'm going to resell those, I buy the inventory, I expense off the inventory. When I sell it, I earn revenue. I go through and revenue less my expenses. I get to my my income, and that's what we call ordinary income.

So this ordinary income has all those dreaded social security or SEC tax components associated with it. So I need to pay those on that type of income. I can't 1031 exchange those properties. I'm not using capital gains relative to those properties. So you really have to think of it as what I would call an ordinary retail business. In fact, the IRS considers those investment properties that we purchase as inventory, They actually call it inventory.

So really it's like a retail business versus a rental business. And they are very different, taxed very differently. So you always have to kind of understand which path you're going on. Because what you want to do is be able to define what it is that you do to the IRS rather than having the IRS define it back to you. And what I mean by that is I've actually seen this. And this is kind of a little bit of a horror story. But I've actually seen the IRS reclassify someone's,

rental properties into what we would term a real estate professional, thereby making that everything ordinary income and applying social security taxes and different things to them that really hurt them from a tax perspective. And part of their issue was simply that they really weren't defining their path. So I always say if you're going to do real estate investing, great, make sure it's in its own company. And if you're going to go out there and start flipping a bunch of properties and become a dealer, make sure that's in a separate company. Always defined to the IRS, what you do, don't let them define it back to you. Got it. Yeah, I was, two things real quickly. When it comes to dealer, I remember reading an article, and this was a while back, and I

didn't really know what it meant, and I never dug any deeper because I really didn't care. I didn't think it applied to me. But there was some sort of article, and I think it kind of ties right into what you just said about when you're out there and you're making money in real estate, there are different ways to avoid being tagged as a dealer by the IRS. I think that's what you just kind of said. Like, you want to make sure that you control what you're classified as and don't want the IRS to do it for you. Right.

And, you know, people who get into real estate often like to do both. Like I said, I have rental properties. I also like to flip, and I do the occasional flip. And really, I guess, becomes important to look at is, can I sell off a rental property or go in and buy a property, sell it, and still be considered an investor and not a dealer? And the way that the IRS would look at that is they look at fact patterns. Often people think that, hey, it's a rule that would define it. It's not necessarily a rule, but they do look at the fact patterns. You know, when I went in and I bought the property, after I was done with it, immediately listed with an agent for sale.

because that would kind of define that, you know what, really you bought it for a, to flip it like a dealer, not so much as an investment. But so I just always tell people, hey, if you're, if you want to do both, you can do both, maybe one doesn't necessarily make you a dealer. But if I'm the type of person that is going to start doing it two, three times a year, then you've got to really segregate those two operations and not have them even listed personally. This is my viewpoint, within the same company. me. You've really got to separate them. Got it. Okay. So the big distinction, what I'm gathering now, and I remember why that article intrigued me is that if you do both, which I think most people do to some degree, and you're classified as an investor with passive income, and you get tagged by the IRS as being a dealer, because

you flipped a few properties that year, they could treat your rental properties as dealer status as well as what you were saying. Correct. Yep. That would suck. That would be. That is not a good thing. Okay, got it. And so that's the reason we separate them into two different entities. Right. And the other thing, I mean, the other thing I like is if I'm going to flip some properties and I'm going to make active income, there's also things I can do with that active income.

Like now I can contribute to my self-directed 401K plans and, you know, how I deduct health insurance and all these kinds of things that roll into an active business, which allows me kind of different opportunities than if I just had passive rental income. Right. Got it. Okay. And then one other word you dropped and we'll move on. You said real estate professional. Right. Is that synonymous with dealer? Typically, they would fall underneath the same category. Yes. Okay. To me being a real estate professional for my situation and probably for a lot of people's situations, it's actually a good thing for me because I'm able to take revenue I generate from other sources and take my real estate deductions and apply it to that. revenue as well. Yes, that's where we would take a step back and look at tax planning and why tax

planning becomes such an important thing for people to do. And oftentimes it's maybe something they don't do, don't do as much as they should. So in your case, for example, we'd want to look at, okay, what are your various sources of income? What are your various sources of expenses? What is the best way to optimize your kind of real estate portfolio and business? And that's one of the things we would do in tax planning, but you're accurate. Yeah. Right. So the really cool scenario there is, you know, we'll just take middle of the road,

median income in the United States. I think is what, 45,000 bucks is a median household income. With a few investment properties and being classified as a real estate professional if they met all the qualifications, they could virtually, you know, almost eliminate their W-2 taxes, right? It is possible. Yes, exactly. On the real, yeah, because on the real, the, on the,

dealer side of the professional side it allows us more width to go negative on the real estate investment side we have caps right so my real estate investment side i can i can record a 25 000 loss per year but if i make too much money then that starts to get suspended and pushed into the next year whereas my losses for real estate professionals do not they go in they don't have a bottom cap at 25 grand um i can use it against any other source of income that i have so it really allows some flexibility on that standpoint, yes. Right, right. And so when I heard that, I was like,

wow, it makes sense for everyone to own a few rentals, you know, the middle of the road person, to own a few rentals, even if rentals don't even cash flow. Oh, yeah. I mean, that's the beauty of, that's the beauty of real estate is the, typically the losses that they can kick off

to help offset other income and reduce your overall tax burden. Absolutely. So, I mean, if you're in a 30% tax bracket or 30% of your money, your W-2 income is going to Uncle Sam with a few income properties, all of a sudden, can structure it in a way that you get to keep all of that. Correct. Even if you made no money on the real estate itself, but you know, you will.

Right? Real estate. I love it. Okay, good. I always understood, or my context for real estate professional was a really good thing if you had additional income outside of the real estate arena. Yeah, so I would always, exactly. So I always say, or tell people, listen, take what you're doing, look at your

real estate, sit down with someone that understands real estate and is qualified and can consult with you appropriately and start to organize things that are going to really help reduce your tax burden as close to zero as we can get it. Perfect. I love it. Okay, moving on. Now, we've got real estate investor and real estate dealer and which entity should each use. So we'll start with an investor.

Yeah, I have some strong opinions about this. Yeah. Most attorneys do. Yeah. So I'm, okay, so let's start on the investor side. On the investor side, I would almost always use an LLC. It's, I mean, LLCs haven't been around as long as some of the other types of corporations, but the flexibility that is built into them is just too high to not to want to use them. I mean, LLCs act is, they're kind of a tax chameleon, as I would put it, because I actually get you, pick the tax code that the LLC will follow. That's relatively new, right?

That's relatively new, yeah. So I can change it. You can create an LLC and I can tax you as a corporation or an S corporation or use the partnership taxation rules or even the sole proprietorship rules depending on how many owners we have. So that we call it a tax chameleon because I get to select what's best for you. And when we're dealing with the investment side or the investor side of real estate, some of the flexibility issues that comes with the LLC is my ability.

to move properties into and take them out of the LLC without triggering really any kind of tax consequence. So the transfer of property becomes a really, really big deal with specific to rentals. Because oftentimes what's happening is that I go out, I buy a rental property and maybe my LLC hasn't been established long enough or doesn't have enough money to qualify for loans and so forth by itself. So I'm going out, I'm buying the property in my own name, and then I'm going to quick claim deed that thing into the LLC to create some liability protection. And if I ever need to refi that property, for example, I can quick claim it back out, not trigger any tax, refy it, throw it back in, and then let it sit there for my liability protection again.

So I really like that flexibility because when it comes to real estate, I want to be able to move them wherever I want to place them within my entity structuring. So that becomes a big one. The one I would not use when it comes to investment properties is an S-Corp. And I know that sometimes I've seen other people, I guess, promote those when it comes to rental properties. In fact, just two days ago I was dealing with someone that came to our firm who has an S-Corp and has rental properties inside them and some of the problems that he was going to run into

based on using S-corporation for rental income. Now, rental income, as we said, is passive. And there are passive income limitations when it comes to S corporations, and a lot of people aren't aware of those. And it's this 25% rule. So if 25% of my income comes from a passive nature, then I get hit with this penalty tax on anything that's above that 25% threshold. So really what you're doing is creating a structure that's going to promote tax penalties. And then the other issue with S corporations is what we call built-in gains tax, where if I have an appreciable asset inside of an S-corps,

which is the purpose for buying rental properties or at least part of it, and I ever have to move that property out to refi it because I was click-claiming deed it into the S-Corp. If that property went up in value, I created what's called built-in gains tax, and all of a sudden I owe tax just because I was trying to refy the property. So from an investment standpoint, just, just be aware of that kind of stuff. And I would just simply say, avoid S-Corps for my rentals, use LLC, simpler, easier.

And then in the end, it will most likely be cheaper for you to run. Got it. Okay. Real estate dealer now. So dealer. So we take a step back on the dealer because now I'm dealing with, again, like my retail business. So everything's in play for the dealer. Do I want to be an LLC?

Do I want to be an S-Corp? and there may be even times where I want to be a C-Corp. But anything's in play when it comes to the dealer side of things because I don't have those investment property or passive income rules that I've got to deal with. S-corp, for example, can work really well. If I'm a dealer, I can buy properties, sell them. Maybe I pay myself a wage from part of my income,

but the remaining income comes to me passively, which is no SE tax component to that portion of the income. So S-Corps can work really well. LLCs again can work really well for dealers. They're just easy to use, super flexible. I like them a lot just from an E standpoint. But from the dealer standpoint, you want to take a step back, look at everything you have going on,

and then put one of the entities in place that's going to be best for your particular scenario. So on the dealer's side, I like to look and say, hey, most of everything is in play for that, but on the investor side, really you're kind of limited to the LLC. Got it. All right. There was another question here. Imagine that. I was listening to you and forgot what I was thinking about.

Oh, here's what the question is. All right. So if someone is just getting started in their real estate journey, financially, when does it make sense to go and start setting up their entity? Okay. So I would take a step back and I would say, even not necessarily financially, but just let's look at it tax-wise. Okay. Okay. So a few years ago, the IRS did a wonderful thing and they shut themselves down.

Now, I wish they would have stayed shut down, but unfortunately it was a three-month process as all. And what they were doing is they were updating their system. And the IRS found that it was becoming too difficult or too expensive, rather, to audit people face-to-face-futable. face. And they have an 11, I think it's $11.1 billion budget. About half of that is used for enforcement. And they are charged with collecting the same amount of money or more every year. And so they've got to get smarter with this kind of stuff.

And as a result of that shutdown and the IRS updating their software and hardware, letter audits became or are becoming now the new norm for the IRS to send and collect information. Letter audits, you know, I would imagine if there are people listening to this, you get a hundred people together, you know, five, six, seven, maybe ten of them have received these audit letters because they're cheap. The computer is generating them, generating them, the computer is sending them out. Most people, if they get an IRS bill that says, hey, you owe $800 or $900, they're simply

going to pay it, even if they don't actually owe it, because it's much simpler to pay the bill than have to deal with the IRS. And the IRS knows that on their end as well. And that's part of the reason that they use these letters now. And I think the last percentage I looked at was 71%. So about 71% of audits are now done through this kind of letter format of just the computer generating the stuff and sending them out. Now, if I were to look over maybe the last five years of how many audit letters that have come through our firm

were addressed to an individual versus addressed to entities, which would be my partnerships or LLC filers, my 1065 filers, or my S-Corps, those are 1120s, or my corporations, my 1120s. So if I put all of those tax returns into one bundle on one side and personal tax returns on the other side, if you were to look at that ratio, the ratio is 100% of them have been addressed to individuals. 100%.

why because it's easier to audit them because the IRS gets so many third party documents on their behalf right so 100% are going to individual so me as a tax preparer what then I look at is say okay I want to put down a level of audit protection for my client so the very first thing I'm going to do and I don't care what business you're doing I'm going to set up a company for you to do it through because I know that the IRS is going to look at that company at a far, far, lower rate than they are if you're just operating as an individual. So I like to look at the company set up as simple audit protection from the very beginning. If I can get that thing out of my tax return, and then it gives the prepare kind of a pretty far width to go through and how we look at, you know, your expenses and what we

include and what we don't include. But it gives me a lot of freedom on that end because I know that the IRS chances of looking at that have been greatly reduced. So if you're just starting out, I would say get your entity form day one. Do it from the very beginning. They're cheap, Pam. They are not that expensive. I mean, I'm trying to think of all the rates from the Secretary of States across the nation. I think maybe Texas is $300.

Maybe that's the most expensive. But typically you're looking at anywhere between $75 and $125 to set it up with your state or whatever you're going to do. But get that stuff done. Set it up. It's cheap. Go out and do it. And it's going to save you in the long run. I think it will save you a lot of money and create auto protection that we're all looking for.

Got it. All right. So that's a good answer. That's a great answer. Because, you know, financially what I was always shown was like it doesn't really make sense. Like, for example, avoiding the self-employment tax, right? Yeah. So when you set up an S-corpor.

and about 30, 35 grand is kind of where the break-even point is. So I've always advised people don't worry about it yet. Yeah, so I like it for auto protection. So let's say I create an LLC for you. You know, let's say even if I was doing it for you, pay me, I'll go out and I'll deal with everything, get you the operating agreements, everything that you need for your LLC and set it up. And let's say you're not making any money up front,

but I know I am just establishing a baseline auto protection for you. As you start making money, yeah, I would never tell someone to be in, S corporation until they had a minimum of probably $50,000 worth of bottom line taxable income. Because I know you got to deal with W2 and payroll and wages and you have all these extra expenses that you're going to have to deal with. And it just has to make sense. So anywhere maybe 35 to $50,000, then we maybe look at S course. But if I set up an LLC from you from the beginning and then two years from now and now you're

making $50,000, and guess what I do? I say, okay, let's have a conversation. do I want to, you know, chamele in your tax, the code that you're following, and now I'm going to change you into an S corporation. Right? Because I can do that down the road.

So I'm just going to always tell people, just at a minimum, set up your LLC from the get-go, and then based on your business and the trajectory of your business, then we'll react based on what you're doing. Awesome. All right. So definitely I learned something there. So that audit thing,

I did not know of that about the letters and stuff like that. Yeah, it's amazing. I mean, I've seen them send letters that, in fact, probably the worst offender that I've ever seen was a person that came into our office. They called us up. They were really shaken. We just got one of these letters. They weren't our client at the time. They became our client.

And the IRS said, hey, you owe us $62,000. $62,000. Wow. Yeah. And I was like, wow, when I saw that thing. and it turns out that that $62,000 was calculated based off of a math calculation. And what I mean by that is the IRS adjusted their loss. So the IRS from the tax return that was submitted had a $400,000 loss.

The IRS adjusted it to a $200,000 loss. But if you think of simple math, two negatives make a positive. in order for that loss to get down, they calculated $200,000 worth of income and then flowed that income down to a tax that was owed. Right? So that's probably the most egregious thing that I've seen. It got cleared up, but it's just simple math, right?

But the IRS knows if they keep sending out these letters, they're going to start collecting more and more and more. And I think it was, I mean, the last time I checked, it's been a couple years, I think it was roughly $30 billion just from interest in penalties. based on these letters that they've collected. That's not even the additional tax. That's just interest in penalties.

Right. $28 billion. So it's a chunk of money, and the IRS is counting on that money, moving forward. I think it's part of their budget now and what they think they're collect. Yeah, so these letter audits,

we have to be aware of it. I see. Okay, well, yeah, for the audit protection alone, it's worth it. Even if you're in California, which is, what, $800 a year? And I know that's bad, but think of it as $800 a year

worth of a kind of a primary level of insurance. Totally, especially if you get a 62, you can avoid getting that $62,000 letter. Very good. All righty. So, Joel, thank you, man. This was actually, I learned a lot more than I thought I was going to learn. Sure. I appreciate your wisdom. And I know you've got the document from last week is still available over at taxhacker.com. The top deductions for real estate investors. This includes dealers on there? Yeah, so most of it's for investors on the investor side. But at a minimum, you know, get out there, download it, see if we can maybe educate you a little bit, expand your tax knowledge, and give you a hand specifically, you know, now that we're in tax

season. Super. So yeah, that's a free gift from Joel. And then if you would like to talk to him more, that will be clearly defined us on how you can do that. All righty. So, Joel, do we got something to talk about next week since we're just going to run with this tax season thing? Yeah, so maybe next week we can talk a little bit about choosing a CPA. We can talk a little bit about tax deductions and maybe a little bit about certain things that the IRS looks for. Maybe we'll call them red flag issues. Very good. Let's put on the to-do list, the 1031 exchange too.

Let's go over that. Okay, we'll do. Cool. All right, buddy. Thanks, and I'll see you next week. That's it for today. God bless. To your success, I'm Matt Terry O.

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