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  • Tax Tips and Tricks | By: John Hyre

SMALL TAX FIRM SPECIALIZES IN LEGAL & ETHICAL TAX REDUCTION FOR LANDLORDS & REAL ESTATE INVESTORS

 

  • Tired of conservative CPA's who refuse to use the law in your favor?
  • Tired of CPA's who “don't get” real estate?
  • Tired of educating your CPA – and then paying him for the time spent learning from you?
  • Tired of CPA's who only do returns, but won't help you plan ahead?
  • Tired of CPA's who are afraid of the IRS, and won't fight?

 

At Real Estate Tax Accounting, LP, all we do is figure out and implement ways for landlords and other real estate entrepreneurs to legally pay less to the IRS.  We have over 250 clients nationwide (and increasingly, overseas), all real estate investors, of all sizes - brand newbie, commercial property portfolio holders, and everything in between.  The firm's founder, attorney & accountant John Hyre, is a local, active real estate investor (mobile home parks, single-family rentals, and small multi-unit rentals).  Our staff is trained with John’s experience in mind.  We get real estate.  We get taxation, both from an attorney's viewpoint and from an accountant’s viewpoint.  And we most certainly get taxation of real estate, and how to save you the most money in a legal and ethical manner.

 

CONTACT DATAWe can be reached at (800) 762-3290 or www.realestatetaxlaw.comWe are located at 2737 Sawbury Boulevard, Columbus, Ohio 43235.  We are presently accepting clients for tax returns, planning, audit & IRS collections work.

 

 

INFORMATION PACKED ARTICLES IN THIS NEWSLETTER:  READ ON TO LEARN HOW LANDLORDS AND REAL ESTATE INVESTORS  (“REI”) CAN:

 

  •   Increase depreciation deductions by 90%+ (we can help you amend if your existing CPA took the way-too-conservative “Joe Blow” approach);
  •   Use your IRA or 401(k) to safely invest directly in real estate;
  •   Three Key Tax Tricks with Lease Options that will save you Thousands of Dollars;
  •   Use Tax Court to get three bites at the apple when the IRS isn't playing nice;
  •   And much, much more.

 

DEPRECIATION:  MORE IS USUALLY BETTER

Most CPA's segregate rental real estate into two categories:  Non-depreciable dirt, and building, which is depreciated at 3.6% per year (residential) or 2.6% per (non-residential commercial).  By breaking out various categories of assets that depreciate more or faster (e.g. sidewalks, driveways, appliances, “loan assets”, etc), the average rate of depreciation can often be increased to 6%+, essentially doubling the annual depreciation deduction.  Very few return preparers take this approach.  We have amended a number of returns to maximize depreciation deductions and generate refunds.

Example:  Taxpayer purchases a rental for $100,000.  Joe Blow CPA allocates $20,000 to land and $80,000 to residential rental property (the building).  Total average annual depreciation = $2,880 ($80,000 x .036). 

 

Tax Lawyer/Real Estate CPA does it differently:  First, approximately $9,000 of the $20,000 in land gets reclassified as Land Improvements (sidewalks, driveways, etc) which depreciate at @ 7.5%/year, for $750 in “extra” depreciation.  Then $12,000 of the $80,000 of “building” gets reclassified as personal property (carpets, window treatments, appliances, etc).  Instead depreciating at the 3.6% building rate, the $12,000 of personal property depreciates at 20% per year.[1]  So instead of depreciating at $432/year, the $12,000 depreciates at $2,400/year, and the remaining $68,000 of building depreciates at $2,448/year.  Adding up the depreciation, we arrive at a total of $5,598 per year, a $2,718 (94%!) improvement over the Joe Blow method.

 

If anything, we have understated the possibilities for write-offs from rental property assets.  To keep things simple for the sake of illustration, we have dug only partway into our bag of tricks.  Ask us how recording carpeting in a different way on your tax return can result in thousands of dollars in extra write-offs.  Ask us how we amended one client's return (@ 30 leveraged Section 8 properties) to get an extra write-off of over $100,000.[2]

 

But to be Honest, “More” Is Not Always Better:  We have also seen a few instances where CPA's use this “break out” method when it is not appropriate or outright harmful to the taxpayer.  For example, upping depreciation deductions for taxpayers who cannot use the extra losses on their returns (e.g. due to passive loss rules) results in no savings, but can increase the taxpayer's bracket if they sell the property down the road (e.g. depreciation recapture).  Details & honesty matter.

 

 

A TALE OF TWO AUDITS (Both in 2011)

I am a real estate investor who owns approximately 100 rental properties. When I was audited by the I.R.S., I thought I was in for a world of hurt.  I have only heard horror stories of unreasonable demands, I figured they would put me out of business. I even contemplated offering the I.R.S. a lump sum of cash just to make them go away, so I could get back to running my business. After talking to Nate at Real Estate Tax Law and Rob at Hyre Legal Group, I was informed that I had little to worry about. Although I still worried, Nate and Rob were there every step of the way to make sure I gave the I.R.S. everything that was requested and to make sure there would be no reason for me to owe any more money. Rob and John attended the audit with me and it could not have gone better. After I found out I wasn't going to owe any more money to the I.R.S. I was very relieved and extremely happy that Nate, Rob, and John were on my side. As a real estate investor, I would recommend them to anyone.

 

- A.F. from Dayton, Ohio

 

I was recently audited by the I.R.S. and facing a potential increase in my taxes of tens of thousands of dollars.  As a result, I engaged the help of Nate at Real Estate Tax Law and Rob at Hyre Legal Group and I could not be happier with the result. I went in worried about how much trouble I could be in and came out with the I.R.S. actually owing me a refund. Nate and Rob were there every step of the way and they took on the I.R.S. head-on to make sure I didn't pay the U.S. Government any more of my hard-earned money. In the event that any real estate investor is audited, I would strongly recommend Nate and Rob.

 

-Robert from Chicago, Illinois

 

 

USING IRA's & 401(K)'s to ACQUIRE REAL ESTATE:

Many REI do not know that IRA's and 401(k)'s can invest in real estate (and many other assets, including gold & silver).  The law permits such investment.  Your specific custodian (e.g. Fidelity, etc.) may not permit such investment....in which case, you can often transfer IRA/401(k) funds to a new custodian who will permit you to invest to the extent permitted by law.  We personally invest our 401(k) money in local rental properties – and you can too.  We also partner with others' IRA's & 401(k)'s to fund personal investments in local property – and you can too.  There are two major rules that need to be followed:

 

1)  Avoid “Prohibited Transactions” at All Costs

A Prohibited Transaction, no matter how small, results in an IRA being forced to distribute all of its assets.  That distribution is treated as taxable income and is also normally subject to a 10% penalty.  Additional penalties, some of them quite large, can apply depending on the facts.  Example:  REI owns a rental in his IRA.  Including the rental and cash, the IRA has a $100,000 balance.  He receives a $700 rental check.  Instead of depositing the check into the IRA, he deposits it into his personal bank account by mistake.  He discovers the mistake and transfers the $700 to the IRA account.  A prohibited transaction has occurred.  The IRS can force distribution of the $100,000, which creates $100,000 in taxable income to investor.  A 10% ($10,000) early-distribution penalty may apply (e.g. investor is less than 59 years old and no distribution exception applies).  The $700 will probably be penalized for 20% - 60%, or $140 - $420.

 

In short, Prohibited Transactions are B-A-D.  We are talking “my child is engaged to one the cretins from Jersey Shore” bad, which is very bad indeed.  Fortunately, Prohibited Transactions are not hard to avoid.  Here are the basic rules[3]:

  •   No Incestuous Business:  The IRA cannot do any sort of business with you, your spouse, either of your children, grandchildren, parents or grandparents.  No buying or selling, no loans to or from[4], no provision of services (even for free) to or from such people.  None, nada, nichts, nichevo, no matter how indirect (e.g. - via entities or trusts) or well disguised (e.g. in someone else's name)
  •   Even better:  Just don't have your IRA do business with relatives at all. Can your IRA do business with your brother?  Technically, yes.  But that opens the door for some subtle IRS traps.  Given how harshly Prohibited Transactions are treated, one had best take a conservative approach to avoiding them.
  •   No Services, Even for Free:  Remember, you cannot provide services to the IRA, even for free.  There are some very limited exceptions, such as certain rental property management activities.  For example:  You help rehab a property owned by the IRA with or without charging the IRA a fee.  You have provided services to the IRA and entered into a Prohibited Transaction.  Better to have Justin Bieber crawl into your daughter's window at night and, God forbid, sing[5] her a nighty-night song.
  •  IRA Must Invest for Its Sole Benefit:  The IRA cannot benefit its owner, even indirectly.  It must invest for its own, sole benefit.  For example:
  •  An ambulance chasing lawyer[6] has an IRA.  The IRA lends money to his clients, none of whom are family.  The lawyer does no business of any sort with the IRA, nor does he provide it with any services.  He has entered into a Prohibited Transaction because the IRA's money benefits the lawyer's practice by enabling clients to pay court costs, or just live, while his contingency-based lawsuits move forward.  In short, the IRA loan makes his clients more able to sue, and therefore the IRA's funds are being used to benefit the lawyer and not the IRA.
  •   REI buys a vacation condo in his IRA.  He rents the condo to his boss for full market rent.  There would certainly be a Prohibited Transaction if the rent were below market, or if the REI or his family used the condo.  In this case, the IRS could still argue that REI is “currying favor” with his boss by allowing him access to the condo, even at a full FMV rent.  Solution: Just rent the condo to third parties, and not to people you know.  Mildly irritating, but also very simple.  Why risk the whole IRA?

 

Avoiding Prohibited Transactions is not difficult.  Basically, the IRA should do business with third parties.  For example, the IRA can buy a rental from a third party and rent it to a third party.  Simple.  But I'm always amazed by the number of REI who simply must have their IRA do business with themselves or Cousin Bob.  Go figure.

 

2)  Be Aware of and Avoid UBIT

UBIT stand for Unrelated Business Income Tax.  In plain English, UBIT is a tax on your otherwise tax-free IRA.  UBIT tax rates tend to be high, around 35% in most cases.  Unlike Prohibited Transactions, incurring UBIT is not fatal to your IRA.  At 35% tax rates, UBIT is unpleasant and best avoided.  There are two ways to create UBIT:

  •   Debt:  If an IRA borrows money, any income or profits on the underlying assets are taxable in the same ratio as the loan bears to the cost of the asset.  For example, a property that is 70% debt-financed in an IRA would be subject to UBIT on 70% of its profits or gain on sale.  If the debt is paid off, and the property is held free & clear for at least a year, any sale would be free of UBIT.[7]
  •   Trade or Business:  If the IRA is engaged in the conduct of a regular trade or business, the income from that trade or business is subject to UBIT.  Whether an “activity” is a “regular trade or business” is a very gray and mushy concept. Generally, ownership of rental properties will not be viewed as a regular trade or business.  Buying and selling more than a property or two per year (i.e. flipping), especially if the properties are rehabbed, can easily be viewed as a regular trade or business.  The difference between “not a trade or business” and “regular trade or business” is very similar to the infamous “Dealer” issue – see our article at for more information.  Bottom line:  If your IRA is engaged in an active trade or business, as opposed to investment activity, it will pay UBIT.

 

Well, there you have it:  The bare-bones rules of IRA investing.  Bottom line:  An IRA can own rentals if it does not do business with, or for the benefit of, third parties.  You should generally not provide the IRA with services, even if at no cost.  And the IRA might get away with a few carefully structured buy-sell transactions without paying UBIT.  One last note:  We do assist with IRA-related LLC's, sometimes referred to as “Checkbook LLC's”.  Google the term, there's lots of information out there....though much of said information is dangerously incomplete.

 

 

LEASE OPTION TAX TRICKS

For those of you who rent/sell properties on lease option:[8]

 

1)  Income taxes are not due on the “option” portion of a lease option until the option:

  •   is exercised;
  •   expires; or
  •   defaults.

In short:  Option cash received now is taxed later.

 

2)  Draft Options Correctly to Get the Option Taxed at 15% or Less:  Any capital asset held for more than one year is normally taxed at long-term capital gains (“LTCG”)rates, which are presently 15%, or less in some cases.  An option on a rental property is treated as a capital asset, just like the underlying rental property.  Therefore, if the option is held for at least one year before it expires or defaults, the resulting income will be treated as LTCG.  In our experience, many investors grant successive one-year options (e.g. 5 one-year options, instead of 1 five-year option).  This approach ensures that LTCG rates can never apply, because the option term never exceeds one year.  A simple change in drafting will allow for the option to “age”, and qualify for LTCG treatment if the triggering event occurs after 12 months.

 

3)  Lease Options Must Be Lease Options in Substance:  The IRS has the ability to reclassify any transaction to reflect reality if the reality conflicts with what's “on paper”.  This is commonly known as the “Substance Over Form” doctrine.  The leading case, which went all the way to the US Supreme Court[9], involved a lease option that the IRS successfully treated as a financed purchase.  In this case, a bank officer wished to borrow from the bank, purchase a building, and rent it to the bank.  Federal law prohibited an officer from borrowing the amount Lyons wished to borrow.  To get around the law, Lyons had the bank buy the building, lease it to him with an option to buy, and in turn lease it back from him with no option to buy.  The lease payments on the lease option equaled what the interest payments would have been on the forbidden loan.  The option payments equaled what the principal payments would have been on the forbidden loan, with a $1 buyout at the end of what would have been the loan's term.  For federal income tax purposes, the Supreme Court rules that the “lease option” looked and acted like a purchase & loan, and would therefore be treated as a purchase and loan, and not as a lease with an option to buy.  In short, if you call it a dog, but quacks like a duck and flies like a duck, the IRS can treat it like a dog or a duck, whichever results in the most tax.[10]

 

 

THE POWER OF TAX COURT

I was recently reading a internet post about Real Estate Professional status and fighting the IRS in Tax Court.  It dawned upon me that REI are unfamiliar with the Tax Court, greatly underestimate the benefits of filing a case, and often overestimate the costs of fighting the IRS.  We have had some nice successes in Tax Court with REI from all over the country.  I thought I'd share how it works:

 

TIMING:  You have ninety days after being assessed by the IRS to file a petition in Tax Court. The IRS sends LOTS of different types of letters looking for money.  A lot of those letters are simply “requests” and not formal “assessments”.  With a “request”, you do not necessarily owe the money (though people often pay it anyway because they fear the IRS, and the “requests” sure so sound like demands), but the IRS would sure like you to pay it and not fight them.  Better than 50% of those “requests” are wrong, so I would not simply jump and pay the IRS because they “asked” you to. 

 

An IRS Notice of Deficiency is quite different.  The IRS is no longer asking for money, they are formally saying that you owe it, and that if you disagree, you must speak now or forever hold your peace.  A Notice of Deficiency basically says “We the IRS have gone through the legal process to determine how much you owe.  We opine that you owe $xx,xxx.  If you do not fight us within a certain time frame, then the law says you SHALL owe $xx,xxx”, period, stop, end of sentence.  A Notice of Deficiency is easy to recognize.  The three things to look for:

 

a)  Such a letter is almost always sent via certified mail;

b)  First page, upper right side of the letter says “Last Day to Petition With the United States Tax Court” followed by a stamped date; and

c)  First page, about a third of the way down, look for the bolded and capped words “NOTICE OF DEFICIENCY”. 

 

In some cases, you may receive a very similar letter called a “Notice of Determination”.  It should be treated as a Notice of Deficiency, and most certainly not ignored.

 

Such letters are very important and should not be ignored.  The date stamped in the letter is set in stone.  Miss it by 30 seconds, you can only file in District Court, which is much more expensive than Tax Court, and you must pay all of the taxes that the IRS says you owe first.  On the other hand, to go to Tax Court, you do not need to pay the tax demanded in the Notice of Deficiency.  Furthermore, litigating in Tax Court is normally much cheaper than doing the same in District Court.  In short:  Tax Court is normally a much better option than District Court for small REI, and the Letter of Deficiency sets your deadline to file your case.

 

COST OF FILING, SETTLING AND FIGHTING  To sue the IRS in Tax Court, you must file a petition.  There are two types of petition:

Small Tax Case:  A small tax case normally involves tax owed of less than $50,000.  The procedures in a Small Tax Case are simpler than with a Regular Tax Case, which helps keep the costs low. The major downside when compared to a Regular Tax Case:  The case cannot be appealed by the taxpayer or the IRS.  The Tax Court's decision is final.  For most REI, the cost and low chances of winning mean that an appeal was never a very realistic option.  As such, giving up the right to an appeal is a small sacrifice to make in exchange for a simpler & cheaper day in Tax Court.  90% of our clients who litigate in Tax Court choose this option.

 

Regular Tax Case:  More complex rules apply than in a Small Tax Case.  Such rules increase our fees.  Such cases can be appealed, but such appeals rarely occur in fact.  Very few clients select this option, most of those who do are over the $50,000 threshold. 

 

THE REAL REASON TO FILE:  THREE BITES AT THE APPLE  Once the case is filed, the IRS Appeals Office will contact you.  Often, this is the real reason we file.  Here's why:

 

IRS Appeals Officers are much better trained than regular IRS agents.  This higher level of training is especially important when dealing with complex or exotic topics, such as sandwich lease-options or subject-to deals, to name two examples.  It is quite common for normal agents to say “that's illegal” or “you cannot do that”.  It is also quite common for Appeals Agents to quickly recognize and favorably settle such items.  We have often had such settlements result in everything the taxpayer was looking for.  In addition to superior knowledge and experience, IRS Appeals Agents are generally looking to avoid litigation if reasonably possible.  Lawyers are expensive and the IRS does not have unlimited resources with which to pay them.  Sound familiar?

 

Technically, there are other ways to get to the Appeals Office, but none of those methods tend to get  results comparable to filing in Tax Court.  For example, our experience has been that when we file a formal petition for Appeals Office review (which is cheaper than filing in Tax Court), there is no pressure on the Appeals Office to act intelligently or promptly.  In those cases, the Appeals Office takes its time (often 12 or more months) to act.  The bureaucratic shuffle often results in lost paperwork, slow action, transfers from one agent to another, etc.  Further, we also find that the lack of a pending court case tends to make for less favorable settlements when they finally do occur.  In contrast, when a Tax Court petition is filed,the Appeals Office normally follows up in a comparatively timely manner, and negotiates with a much more open attitude.  As a result, most Tax Court cases end up being settled with the Appeals Office on pretty reasonable terms.

 

The second bite at the apple is with the IRS lawyer assigned to try the case.  These lawyers are generally very civilized and reasonable.  They are also tough, quite knowledgeable, and tend to drive a much harder bargain than the Appeals Office.  Most of the time they will settle, but they will squeeze for everything they can get.  Only a minority of cases get this far, because the Appeals Office will normally offer a “good enough” deal to avoid having to talk to the IRS' lawyers.  The third bite at the apple occurs in court.  Very few cases make it this far, and those that do end with mixed results.  It is very hard to predict what will happen in most cases once they are in court.  There is usually enough “gray” that the taxpayer and the IRS attorney each think they can win, which is why they are both willing to take a case “all the way” instead of settling.  The vast, vast majority of “slam dunk” cases get settled, the ones that have a lot of gray also tend to get settled, and a few of the gray ones end up in front of a judge.  In conclusion, filing in Tax Court gets you three things:

 

  •   The best chance for a relatively fast and favorable settlement with the Appeals Office;
  •   A chance at an “OK” settlement with an IRS lawyer; or
  •   Your day in court.

 

Depending on the amount of taxes at stake, your lawyer's fees may be a small sum to pay for three bites at the apple.

 

MORE ARTICLES

For more excellent content, see our “Articles” section at www.realestatetaxlaw.com:

  •   Are You Dealing?  (IRS Dealer Status)
  •  How to Avoid 1099 Income on Short-Sales, Deeds-in-Lieu and Foreclosures
  •  Your Tax Adviser's Recent RE Deals
  •   Choice of Entity 101
  •   Primary Asset Protection (Beyond Entities)
  •   Top Ten REI Tax Return Mistakes

 

 

[1]               Detail Alert:  If you are paying attention, you will say that the depreciation from the Land Improvements is totally new depreciation – meaning that we converted a zero-depreciation asset into a 7.5%-depreciation asset.  The depreciation from converting the building (3.6% per year) to personal property (20% per year) does not create new depreciation.  Rather, it accelerates depreciation ($12,000 over 5 years instead of 27.5 years).  Same amount of deductions, different  timing.  Would you rather have the deductions sooner or later?  For most of you, the answer will be “now, now, now!”

[2]               Hint:  The costs of obtaining loans on the properties (e.g. commissions, points, appraisals, etc) were treated much too conservatively by her old CPA

[3]               For sake of brevity and ease of reading, I am taking shortcuts.  For a true primer on Prohibited Transactions, you should consult a tax professional (like, say, us).

[4]               NOTE:  Guaranteeing a loan to an IRA is considering “an extension of credit” and therefore can give rise to a Prohibited Transaction.  This is why most loans to an IRA are non-recourse, meaning that the creditor can only seize the asset and is unable to “go after” anyone.  Even so, a non-recourse loan will give rise to UBIT tax (we'll discuss that shortly) on the IRA.

[5]               I use the term quite loosely.  Sort of like using “Rap” and “Music” in the same sentence without an intervening “not”.

[6]               Your truly chases IRS Agents, not ambulances.  As such, I consider myself on the side of Justice & Light, and not on the side of Deadbeats Who Play the Lawsuit Lottery.  Press your representatives to adopt the Loser Pays rule today & put plaintiff's lawyers out of work.  While you are at it, press them to adopt a Flat Tax and put tax lawyers/accountants out of work too!  Bad for me, good for the country.

[7]               There are ways to get the same result as using debt, without using debt.  Hint:  Think of a joint venture between your IRA and a third-party investor, with the investor earning a preferred dividend in conjunction with a very carefully drafted operating agreement. 

[8]               The housing boom killed lease options for years.  Why rent with an option to buy when anyone with a pulse could get a 6% loan?  With the sudden death of conventional financing (especially for blue collar buyers) and liberal-inspired destruction of owner-financing (google SAFE Act and Dodd-Frank, it's not yet clear if those idiotic laws include lease options), lease options are back, with a vengeance (assuming that the present administration doesn't outlaw them , along with everything else under the sun).  There are plenty of people unable to get financing, who are delighted to rent-to-own.

[9]               Frank Lyon Company v. US, 435 US 561 (1978)

[10]             Which is why I would rename the doctrine “Substance OR Form”.  Tellingly, it does not appear that the federal government applied the same analysis to determine whether Lyon violated the banking laws.  In other words:  A tougher standard applies when the federal government is protecting its revenue, as opposed to when it is protecting the public.  Probably helps explain why banks do the things they do....