Streamed: Tuesday August 23, 2022
Duration: 54 minutes
Language: English
About This Webinar:
Join Steve and Liz for a conversation on tax planning for real estate investors with veteran realtor Donna Marie Baldwin.
Webinar Transcript:
Liz Prehn:
Welcome everyone. Welcome to “Tax Planning for Real Estate” with Steve Moskowitz and Donna Marie Baldwin. We’re gonna go through our presentation. Feel free to chat us questions in the chat box, and we will try to get to everybody. Steve, take it away.
Steve Moskowitz:
Welcome to everyone. Thanks for attending our webinar.
And I’m really excited to be talking about tax planning for real estate. I’ll begin with the Congress so favors real estate with tax planning. There’s so much we can do in real estate. It’s really exciting. And we have a little disclaimer here. As you can clearly see and easily read, this presentation is for educational purposes only. It doesn’t form the attorney-client relationship. Although, if you would like to form the attorney-client relationship, we can chat about that and sign the appropriate documents.
Now, we’re gonna be talking about a number of topics tonight, and some of them overlap. For example, I’m gonna begin with opportunity zones, and we’re also gonna mention opportunity zones near the end of our webinar. We’ll see how some of these things fit together, or at least that’s the goal. Now, the other thing is I realize this is not a highly technical webinar. So, basically, what I wanna do is make you aware that these things exist. As the technicalities, the slides you’re gonna see are gonna be more technical than what I’m gonna be talking about. And if you’re interested in the technicalities, we’re happy to talk to you about them, but the most important thing that you can do is understand these things are available ’cause most people don’t even know. And the important part, if you invest in real estate, you can go ahead and have such incredible tax benefits. If you sell real estate, you have something far more to offer than someone that never heard of these things.
Okay. So, we’re gonna begin with opportunity zones. Well, what is an opportunity zone? This is something that the federal government created under the Tax Cuts and Jobs Act, which, essentially, is helping out certain disadvantaged areas in the United States. So, what happens is we say, “Okay, somebody sells appreciated assets.” Now, what’s important here is we’re gonna find out later with 1031s that we can only go ahead and do that for real estate anymore. But there’s some workarounds here too.
So for example, we have the situation of selling appreciated assets. Now, if you have a debt, if you don’t have to pay interest on the debt, it’s always better to pay the debt tomorrow rather than today. Why? Because the money that you otherwise would’ve given to the IRS, instead, you can go ahead and invest that money and earn on it. Otherwise, it would be a canceled check to the IRS. So, that’s really important. And a little technicalities, what happens is if you’re gonna go into an opportunity zone, you have to do it within 180 days of making the sale. So, just keep that in mind. And another thing that we say, “Well, okay, now there’s two things we’re taking a look at.” The first thing is if we go ahead and we sell something, anything, your Van Gogh painting, your real property, anything, you have in most cases a capital gain or a loss. But this is primarily for gains. We only tax on that. What we start off with with real estate, we’re in a favored position, ’cause even if we did have to pay the taxes, and that’s what this webinar’s all about, avoiding them. But even if we did have to pay the taxes, capital gains taxes are less than ordinary income taxes. We don’t wanna pay those taxes.
So, the first thing we can do is go ahead and defer these gains until 2026. All right. In addition to that, with the opportunity zone investment, if we hold it for the requisite period, 10 years, our gain is free of capital gains tax, free of tax. So, suppose you invested $1 million in here, and 10 years from now, you sell the property for $100 million. You’ve had a $99-million gain. The tax on that, let me calculate it in my head. Oh, it’s zero. So, that’s a big deal. And there’s a bunch of technicalities. Don’t worry about ’em. But the idea is this is something that is very, very valuable to real estate investors.
Now, what is an opportunity zone? It’s something, challenged properties all throughout the United States and Puerto Rico. There are publications, and if you sell real estate, you should know what they are, listing all the properties. And you say, “Well, okay, you know, that’s good. But one thing I’m a little bit worried about is, you know, Steve, you said they were in challenged neighborhoods. Now, it’s great I’m deferring my capital gains till ’26, and it’s wonderful when I sell this thing 10 years or more later, I don’t pay any capital gains. But suppose there’s a problem with the property. Suppose the property doesn’t go up in value?” Ah, there’s a hedge. So, I’m not gonna give you the math here with the 90% and 70%. I’ll just give you the bottom line. What you can do is you can limit your investment in the challenged properties to just 63% of the investment. The technical stuff is here if you’re interested in it. But the bottom line is you can go ahead and limit your property investment in the opportunity zone to 63%.
So, what’s that mean? So, okay, we go ahead, and of our investment, we put 63% in the opportunity zone, and the rest of it we put into Rodeo Drive, Beverly Hills, Park Avenue, the poshest places around. It counts as one investment. So, suppose my investment in Beverly Hills goes up and up and up and up in value. It’s wonderful if the challenged area goes up, but whether it does or not, you’ve escaped the tax on the Beverly Hills property, the Park Avenue property. And also sometimes people call this, and you know, this term, sometimes people say this is great. Sometimes people aren’t happy with the term, but something we’ve heard about called gentrification. There’s a very high probability that some properties that are challenged today are very, very worthwhile. I remember there were properties in New York that they were so bad, the police were afraid to go there. Now, they are trendy neighborhoods and they cost almost as much as Manhattan to live there.
So, the bottom line is we want to take a look at the opportunity zones because we have a tremendous opportunity here, and we’re gonna see some things about these later.
Now, the next thing we want to take a look at is entities for real estate. And here’s a mistake that a lot of people make. Suppose you’re buying rental properties and you say, “Okay, I bought it my own name.” That’s what most people do. That’s a terrible mistake because if something happens. Suppose that your tenant gets rip-roaring drunk, falls down, breaks his or her spine. What are they gonna do? They’re gonna sue you. Now, the jury looks at you and says, “Hmm, you know, you’re a landlord. So therefore, you’re inherently evil.” And they award an amount in excess of your insurance. Do you know, one lawsuit can wipe out a lifetime of investing, saving, working. You could be ruined. And this almost happened to the wrestler, Hulk Hogan. You can read about it in his book where he was sued like that, And if he had lost, he would’ve lost everything that he worked for. These things really happen.
So, what’s the secret? The secret is setting up an entity. And let’s talk about an LLC first, limited liability company. You set up an entity, and then what happens is, suppose the same thing happens. The tenant falls down, breaks his or her back, and they say, “Okay, you’re gonna pay me.” You’re not personally liable. That’s the big deal. You are not personally liable. The most they can take is the net equity of the property. And if you’re making money with OPM, other people’s money, what happens is if there’s not much equity in the property, you say, “Here you go.” For example, some taxi companies will set up an LLC for every taxi cab. So, if you have a fleet of 50 cabs, and somebody has an accident, they say to the victim, “Okay, here’s your one cab.” That’s your settlement, that’s it. So, that’s one of the things that we do with limited liability companies. Very, very important.
Now, also we’re gonna take a look at your jurisdiction because the LLCs are set up under state law. And there’s some differences going from state to state. Let’s tell you one of the little tax tricks here in California. The state of California charges $800 a year for the privilege of being an LLC. Suppose you have 10 rental properties. How many LLCs should you have? 10. Why? Because what happens is we’re protecting it. If that tenant falls down in property number three, that’s it. That’s all you lose, property three. All the other properties are safe. Your personal assets are safe. Everything is safe. But somebody says, “Well, wait a minute. You know, 800 bucks a year, that’s 10 properties. That’s 8,000. I don’t know that I wanna spend 8,000.”
Well, here’s the trick. We set up one LLC and pay the $800 a year. We set up nine limited partnerships. There’s no annual fee with those. So, now we have our 10 entities protecting us. We have everything we want, but we’re only paying a fee of $800. And this is basically almost like the lowest-cost insurance you could ever imagine having. You say, “Well, all right, what’s the difference between an LLC and an S corporation and sole proprietorship and limited liability partnerships. What’s the differences here. And we’re gonna see there’s overlap here because later on in another section, we’re gonna be talking about how these properties will help us. So we say, “Well, alright, we have pass-through entities.” So, what that means is with these entities, the entity itself, unlike a regular corporation, a C corporation, doesn’t pay any taxes. We don’t want a C because then you’d pay taxes twice.
Now, with an S corporation, there’s, I don’t wanna call it a trick, but there’s a device where you can save on social security taxes. Suppose for example, you said, “Okay, my total, before I take anything from myself, my total profit for the year is 100.” Suppose you’re a sole proprietorship. We know our first problem here is, “Uh oh, we have unlimited liability. We don’t want that tenant suing us.” But another problem we have with our taxes is not only will we pay income taxes on that 100, we pay social security taxes on the 100. With an S corp, you can divide reasonable compensation and dividends. Dividends are not subject to social security taxes. So, we start off, you know, when social security taxes being 15.3%, for a lot of people, that can be a substantial savings every year. Now, you have to make sure that you have reasonable compensation on the wages, not take it all as a dividend. But as long as you do that, you can save a lot of social security taxes. Now, there’s more formalities in having a corporation than there is in an LLC.
For example, with a corporation, suppose you have three people that are equal owners. They have to split the profits in the same relation as the ownership. So that means that A, B and C own the corporation, A gets a third of the profit, B gets a third, and C gets a third. “But I don’t wanna do that.” You know, the way it’s working out, where, because of other arrangements that we’ve made, we want A to get 90% of the profits, and B to get 5% and C to get 5%. Can’t do that with an S corp, but we can do it with an LLC. “But wait a minute. With the LLC, I have all my earnings taxed, and I like the S corp where I could save the social security taxes.” So, we want the best of all worlds. What we do is we go ahead, and we can form an LLC. And then we make an election to be taxed as an S corporation.
So, we can split up the profits any way we want. There’s a lot less in the way of legal formalities with an LLC. Yet we can still make an election to be taxed as the S corp and have that benefit with the social security taxes. And limited liability partnerships, I won’t go into very much. Again, this depends by state, but for example, here in California, it’s very limited to a few of the professions like attorneys, accountants, architects. So, basically, what we say is, “Okay, limited liability partnerships,” probably not for most of this audience. “Sole proprietorship has multiple problems. We don’t want to do that.” So, most of the time we’re gonna choose between an LLC and an S corporation, but we really might want to consider doing the LLC and electing as an S corporation. Not to mention the fact that if you’re in a state like California where you can make the election to have a limited partnership, not a limited liability partnership, but a limited partnership, we have all the benefits, and we save on the fees. Now we have Senate Bill 113, and AB150. This is for California. But if you’re outside of California, don’t touch that dial. About half the states have something similar.
So here’s what happened. In the Tax Cuts and Jobs Act, there was a major change. I’ll call it a hacking of our ability to deduct state income taxes on the federal return. Before the Tax Cuts and Jobs Act, you could deduct in unlimited amount your state taxes from your federal return. For a lot of people, that was their biggest deduction, especially in a high-income tax state like California or New York. So, under the Tax Cuts and Jobs Act, suppose you paid $1 million in California taxes, you could deduct the $1 million. Under the new law and the current law you could only deduct $10,000. Another $990,000, tough. So effectively, it really increases your federal taxes. Or another way to think of it, makes your state taxes more expensive. So, what about half the states did is pass something like this. And here’s the deal. If you have a flow-through entity, like we just talked about, say, an S Corp, an LLC, and other entities as well, you can make an election at the entity level to pay the state taxes at the entity level.
So, I don’t wanna get too technical, but what happens is we, remember with an entity, the entity does not pay its own taxes. It’s not like a regular corporation. It’s a flow-through entity. But we say, “Okay, I choose to pay the state taxes at the entity level,” essentially cutting through the smoke. You effectively get around the limitation on the federal because what happens is if, those of you are familiar with K1 showing the amount that flows through from your entity to your return, we deduct the state income taxes paid. A lower amount goes on your K1. A lower federal tax is due. So effectively, you’re deducting state taxes. Now, there’s some rules. And again, this depends on your state, but the bottom line is with entities, this is a workaround.
How’s the IRS feel about this? They actually agreed to it under the current administration. This law was passed under the previous administration, but under the current administration, the IRS said this is fine. So if you have an entity, you wanna take a look at that. And entities can be used for all types of things, businesses, rental properties, and investments, and a lot of other things. And asset protection is all part of what we just talked about. One of the reasons you wanna be an entity. Now, I have a tough mathematical question for the viewers. Go ahead, get your calculators out. And let’s see if you can solve this. Are you ready?
If you had a choice, would you prefer to legally pay tax on, A, 100% of your income, or B, 80% of your income? Let me know when you’re ready for the answer, and in question and answer period, you can tell me. But I’m gonna make the wild guess that most of you say, “Hey, I’d be happy to pay taxes on only 80% of my income instead of 100%.”
So, what do we have to do here? Well, again, in the Tax Cuts and Jobs Act, certain taxpayers, not all taxpayers, can avail themselves to this. Essentially, what happened with the Tax Cuts and Jobs Act, it gave more to business owners, investors, and took away from wage earners. This is the first time in American history that what you do makes a difference in paying your taxes.
Suppose we have this situation. John lives next to Mary. They’re identical in all respects. John has a job where he makes $1 million a year in wages. Mary has a business where she makes a profit of $1 million. Everything else, they’re identical. And 199A, that refers to Internal Revenue Code Section 199A. What happens under this section, Mary gets to pay tax on $800,000 and John has to pay tax on the $1 million. Why? ‘Cause all that law is what those in power say it is, and that’s what they say it is. For the first time in American history, it makes a difference how you earn that same amount of money. So, next to our neighbors, Mary’s only paying tax on $800,000 and John, the full $1 million. Now, what happens here? Well, we say, “Okay, I’m interested in real estate. Can I do this for real estate?” ‘Cause remember, not everybody qualifies. So, there’s some limitations that I’m gonna go over a little bit later. There’s gonna be some numbers, but I’ll be very general. I promise. And what I’ll say with real estate is real estate businesses qualify, but real estate investments don’t. You say, “Okay, Steve, wise guy, what’s the difference between a real estate business and a real estate investment?”
Now again, most of the things, you know, the lawyer, our answers are, it depends on facts and circumstances. But as way of an example, suppose you have an investment in one real property and it’s a triple net lease. Basically, the only thing you do is receive a check from time to time. It’s probably an investment. On the other hand, suppose you manage 1,000 real properties. That’s clearly a business. Well, what about if it’s 999? Well, that that’s a business. So, the bottom line is we wanna do everything we can to try to qualify that as a business because, again, we’re paying tax on only 80% of our profits instead of 100%. And when I get to the number crunching section, I’m gonna show you where it makes a difference, whether you’re sole proprietor or an entity for this calculation. So, here’s the numbers, and I hope nobody’s eyes are glazing over.
So, let me just explain it. Anybody, even a sole proprietor, can use this up to a certain amount. But the problem is that unless you’re an entity, once you go over a certain amount, these rules no longer apply to you. So, we have multiple reasons why we wanna be an entity. Why? Well, first of all, what do we want? We want asset protection. That’s a reason to be an entity. But the entity can deduct this in unlimited amount. Whereas the individual is severely limited. So, how’s this work? Suppose for example, we go ahead and we have $1 million worth of profit. QBI just means qualified business income. Don’t worry about the technical terms. Think of it as profit.
So, okay, we have a profit of a million bucks. We get to deduct the lesser of 20% of that. And that’s the deduction here, $200,000, or 50% of the W2 wages. As a sole proprietor, you can’t pay yourself W2 wages. So, that means if you made this $1 million as a sole proprietor, you pay tax on the $1 million. If you set up an entity, then you just make sure that you pay yourself a sufficient wage, and you only pay tax on $800,000 instead of a $1 million. I mean, to me, that’s just fascinating. But just knowing, think of the difference between paying taxes on a million bucks and $800,000. Just because you set up an entity, which you wanna do anyway for asset protection.
So, you’re beginning to start to see how these things overlap with each other. Now, we have another example. Oh, more numbers. Besides wages, depreciation counts. So, don’t stress over the numbers. Let’s just say that we understand the first example, the lesser of the 20% or 50% of the wages. Here, we have the same thing with the wages or 25% of the wages and 2.5% of depreciation. So, the bottom line is, again, if we have a rental property, we can make that $1 million worth of profit. And instead of paying tax on the $1 million, we only pay tax on $800,000.
And one of the reasons that I got into tax law was when I was a student a while ago, my first day in law school, I already had a bachelor’s and master’s degree in accounting. I was already a practicing CPA, doing taxes. But it absolutely fascinated me when I saw the Fortune 500 making billions of dollars and legally not paying taxes. How could that be? I wanna learn how to do that. I don’t wanna be a guy that just moves the numbers from one place to another and say, “Here, pay this.” I wanna be the guy that can do this for much smaller business. And that’s why I became a tax attorney. It really does fascinate me. Now, the next thing we take a look as deducting passive losses. Well, what is a passive loss? The Congress said, “Well, certain types of income are considered passive, like rental income.” But what does that mean? That means can I deduct a rental loss against most of my other income, wages, dividends, interest, profits from a business? And that IRC, Internal Revenue Code, 469, in most cases, no. So, most of the accountants will say, “Uh, you know, rental loss, too bad. With some limited exceptions, no deduction for you.” But there’s an exception. The exception is real estate professional.
So, let’s say we have this situation. We have Peggy who is a brain surgeon, and Peggy owns a building, and Peggy makes a cash profit of $1 million a year. And the sweetest thing in the English language is positive cash flow with a tax loss. So, what we have is, let’s say, and I’m gonna tell you how to do this more. I’ll show you a little bit later. But let’s say with our depreciation, we have a loss. And let’s assume that we have a $1.5 million additional depreciation. So, we say, “All right, we have a cash profit.” Peggy has $1 million more at the end of the year because the rent she received were $1 million greater than the checks she wrote. But we have a depreciation of $1.5 million. So, we have a tax loss of half a million bucks You don’t write a check to depreciation. It’s just a paper entry. Whoever prepares your return says, “Okay, here’s the number.” Now, she also makes $500,000 from her medical practice. And if we don’t do some tax planning, Peggy doesn’t want to pay tax on $1 million of rental income and $500,000 in medical income.
Now, her husband Al is a house husband. And, basically, one day says to him, “Al, you’re gonna have to tape Oprah. And instead of sitting home, I want you to manage the real property.” And we qualify Al to be a real estate professional. Now 469 does not apply because one of the spouses, it only takes one spouse, remember, he was a house husband before, is a real estate professional. That means that what we do is we say, “Okay, even though you made that $1 million worth of profit on the building, with depreciation, you pay zero income tax on your $1 million of rental income. And Peggy, you know, that $500,000 you made from your medical practice? I can offset the remaining $500,000 from the paper loss on the real property. So Peggy, you made $1.5 million, but legally you don’t pay any income taxes on it.” So, the bottom line is this is something where you can get around the passive activity loss rules.
And this works really well for a lot of people. Now, we say, “Okay.” That’s what we’ve been talking about. So, you say, “All right, Steve, you know, depreciation,” and I know, I hear it. Somebody started yawning. “Oh, he’s gonna slip back into numbers. I know it. I know it.” I promise I’ll go light.
So what is depreciation? Suppose you bought a building for cash, and your cash base is taxable. Unlike most expenses, you can’t write off the building that you paid in cash. You have to write it off over a period of years. So, if it’s commercial real estate, it’s 39 years. Residential’s 27 1/2. But you say, “You know, that’s an awful long time. So what can I do?” Well, there’s accelerated methods of depreciation that you can elect that’ll increase your depreciation. But also there’s something else that’s very good. It’s called cost segregation analysis. So, what happens is we hire an engineer who goes and visits the property, and he or she pokes around and says, “Well, okay, you know, this portion of the building really is 39 or 27 1/2-year property. But this portion is 15 year property. This portion is 10 year property. This portion is five year property. And this portion, you can write off all of it in the year you buy it. That is how we can greatly increase our depreciation.
Remember, you never wrote a check for depreciation, but with Peggy, what we did is, remember, before we did the extra depreciation, she would’ve paid tax on $1.5 million of income. We increased, in my example, doing this method, we got an extra $1.5 million worth of depreciation, and we didn’t pay the taxes. That’s what we wanna do. And you say, “Well, Steve, you know, eventually won’t this go away, you know?” Yes, but then he can do other tax planning. For example, one of the things that Peggy and Al can do, they say, “Well, you know what? I’m gonna make,” when the property is depreciated, they say, “You know, I wanna throw in a little estate planning here. So, I’m gonna gift the building to my kids, Kelly, and she has the building, and Bud.” Well, okay, so with the exemption from gift taxes, we don’t have to worry about paying any gift taxes. And that was very nice of them, but what happens now? Well, Peggy and Al want to go ahead and transfer some money to the kids. So, what can they do? They can rent the property back from the kids, pay them fair rental value, get a tax deduction for it.
Essentially, they’re depreciating the building twice. And the kids are in a much lower tax bracket, and they can do things, too, that would offset taxes. So, there’s just, there’s a world of things. I know that I was told I’m limited to 10 hours tonight, but there’s just so much I have to cut out ’cause there’s so many things that we could talk about here. And now we’re gonna talk about deferring taxes. So again, that goes back to it’s better to pay, if you don’t have to pay interest, it’s better to pay something tomorrow than today.
So, we have a 1031 exchange. Well, what is that, like-kind exchange? Under the Tax Cuts and Jobs Act, there were changes made, and this only applies to real property now. So, you can have some challenges because suppose you say, “Well, okay, it’s wide-ranging, the property.” We could switch a hotel in San Francisco for raw land in Georgia. But wait a minute, the hotel has personal property in it. It has furniture, or an apartment building may have appliances, and that’s not covered as part of this. But through bonus depreciation, which is an advanced form of depreciation, we can wipe that out. So, it’s still okay. And what we also have to watch out for if you’re gonna do a 1031 exchange, there’s a couple of periods you really have to watch out for because they really cause people problem.
One of ’em is a 45-day rule where you have to identify the property in 45 days. And the other one’s 180-day exchange period. And these rules are really strict. For example, with most things in tax, if the due date lands on a Saturday, Sunday, or legal holiday, you get ’til the next business day. Not here. If the last day for your 45 or your 180 days is Christmas, too bad. If you don’t do the transaction by Christmas, you don’t get ’til the next day. So we say, all right, is there some way around that?
Yes. And the way around it, although those dates are very strong, in the contract that you’re right for the real estate, you can have extension periods, so you don’t lose the sale. But then if you extend it, the holding periods don’t start. So, that’s a way around it. So, basically, if you’re thinking about doing a 1031 exchange, you want to make sure in the contract you have a few extension periods in there to give you more time. Also, I’m gonna mention Delaware statutory trust soon. And that’s another thing that we would do because during that 45-day period, you have to identify the properties, and you can identify multiple properties. As a practicing tax attorney, I can’t tell you the number of times that people have come into my office, wavin’ a piece of paper at me saying, “But it was a done deal, but it was a done deal.” And generally when a lawyer hears it was a done deal, you know, something went wrong. The deal fell through. And all of a sudden they owe a very large tax, but they have a property. They don’t have the cash, and they have a problem. You can avoid that by naming multiple properties, including a Delaware statutory trust. And I’m gonna explain those a little bit later. They’re very, very powerful. And also with the Delaware statutory trust, I was quoted in the “Wall Street Journal” about them. They really can do a lot of good for you. So we say, “Okay, what is it?” Well, first of all, it has nothing to do with Delaware. It’s a financial instrument that you can purchase from the financial institution of your choice. Essentially, what it does, it enables you to get 1031 treatment, but now you don’t have real property anymore. Instead, you have an interest in a real estate portfolio.
Basically, you’re holding stock like a mutual fund in real estate. This works really well for a lot of people in different ways. First, you always wanna put in a DST in your 1031, just as insurance in case that deal you were so sure was going to work falls through, so you don’t get taxed because you can always get the DST. That’s one thing, Another thing that you wanna watch out for, sometimes this happens. Somebody says, “You know, I’m sick of being a landlord. I don’t wanna be a landlord anymore. And my building is worth an awful lot more now, and I wanna sell it, but I don’t wanna pay the taxes either.” This is the way out because when you do the swap, you don’t pay the taxes ’cause the DST qualifies for 1031, but you’re not a landlord anymore. You’re an investor in some stock. Also, this is very, very, very beneficial for people that are selling houses. Suppose we have this situation. We have a nice couple that 50 years ago, they bought this big house ’cause they planned on having a big family, and they bought it for a $100,000, and they had a whole bunch of kids.
Now the kids are all grown. The people are rattling around in the house. “This house is too big. We wanna move.” But now that house they bought so many years ago for 100 grand is worth $5 million. And they say, “Well, you know, I don’t really, sure I have my exemptions, you know, $250,000 each, and that’s half a million bucks, but I still have a capital gain of over $4 million. That’s a lot of money. I don’t wanna pay the taxes on that. Isn’t there something I could do.” How about a 1031 exchange? “Well,” you say, “okay, but, you know, 1031s are for a property held for business or investment.” They’re not for personal residence or vacation residence. The trick is you can convert this into 1031 property. So, what happens? You say, “Well, wait a minute, what do I have to do?” Remember at the beginning of our webinar, I said how the Congress had just so favored real estate to convert a principal residence into a 1031 property. It’s almost ridiculously easy. It is super easy. So, you do that. So, now you have a conversion from what used to be your principal residence into 1031 property. Then you exchange it, not for another property ’cause you don’t wanna be a landlord. You wanna cash out, but you qualify for the DST. And then what happens, so now you’re holding stock. There’s still no tax, and you only pay tax as you sell the shares, but you can sell those shares over a lifetime. Otherwise, where a lot of people get hurt is for a lot of people, basically, their savings is the equity in their real property, their home, principal residence. When you sell it, and maybe they’re gonna live on that money for the rest of their lives.
But when you sell it, you give an enormous check to the IRS and that’s it. You just lose that money. But if you did the DST instead, you don’t pay any taxes when you do it. And as you sell the shares, you will only pay tax on the shares you sold. So all the other shares, you still have them, and they’re earning money for you. Money that would’ve gone in a canceled check to the IRS, instead, you have in your portfolio that’s earning money for you. And let’s assume that your DSTs outlive you, and you say, “Well, whatever I don’t use myself, I want my beneficiaries to have.” Then you get what’s called to step up in basis. So what happens is this.
Suppose grandpa bought something, anything, whether it’s stock, a house, anything, for $10,000 when he was a young man. And when he is an old man, he decides to give that to his favorite granddaughter. And he says, “Here you go.” And it’s worth a million bucks now. She sells it the next day. Essentially, she gets his basis. So, she pays cap gains tax on $990,000. But instead of giving it to her outright, if grandpa gave it to her in his trust or will, then she would get what’s called a step up in basis. That means that fair market value with the date of death of grandpa. So, in my example now, she sells the stock the next day, sales price, $1 million, adjusted basis, not $10,000 what grandpa paid for it, $1 million, tax zero. Nobody ever pays the tax. And you can do that with a DST.
So, the bottom line is there’s so much here. And again, I’m just flying through these and skipping over ’em. But there’s really so much here that people can do. And again, real estate’s such a favored area in tax. And we talked about opportunity zones earlier. And what happens with the opportunity zones, this is still another way to defer our taxes and we know we can do it until 2026. And then if we hold the property for 10 years, there’s no tax.
Imagine that you have a property that’s appreciating in value and you sell it, unlimited tax savings here. So, if you bought something for $1 million, and it’s worth $100 million 10 years later, you get the $99 million tax free. And, you know, a lot of times people complain that wealthy people get all the tax benefits, and everybody else pays too much in taxes. One of the things I would say is all these things that we’re talking about tonight. These are doable probably for almost everybody in the audience. So, rather than lamenting and say, “Oh well, you know, it’s so unfair. The wealthy don’t pay taxes.” There’s so many opportunities for just a regular middle-class person to do these things. And it’s tremendous. Once you do it, you’ll love makin’ money. OPM, other people’s money, and gettin’ all these benefits. And also, you know, some people with their investments, they’re very concerned with the environment and being green and also doing something good in the world. And I’ll just step out of the financial hat for a second.
You really are doing good for people when you’re investing here. So, if that’s something that’s important to you, here’s an opportunity, not to mention all the taxes you save. Now, retirement accounts. Who can have retirement accounts? So, basically this is for businesses. However, suppose you say, “Oh, well, you know, I’m gonna go to sleep now because I’m a wage earner. I don’t own a business.” However, you can set up business up for your investments, your real property. And again, remember I was talking about the interchange between things. Why do we wanna set up an entity for our real property? Well, one reason is because of asset protection. If we get sued, we don’t lose everything. But also there’s a number of other benefits, like setting up a retirement account. There’s four big areas here. One, you reduce taxes. Most people say, “Sign me up with reducing taxes.” And there’s over 20 different types of retirement accounts. Most people are familiar with the simple ones, like IRAs and SAPs and 401Ks, and they’re fine, and you can have them. But you can also have multiple pensions at the same time. And a lot of people have never heard of these.
Some of these pensions, people can put away hundreds of thousands of dollars for themselves every year. The next benefit is the income is not taxed while it’s in the account. Imagine that. All of your retirement account income is not taxed while it’s in the account. So, no-brainer. If you’re not paying tax on the profit like you are with your regular investments, your fund grows faster and larger than if you got taxed. And cash flow. This is something also that’s amazing with the pensions. And again, the Congress is just givin’ the stuff away.
So normally, in order to take a tax deduction, you have to write the check by December 31st year one, to deduct it in year one. Not so with most of the pensions. With most of the pensions, you get up to the time of filing your return plus extension. So in English, what that means is for most people, you get about three quarters of the way into year two, and then you can set up the pension, fund the pension, put the money in and still deduct it for year one. Also there’s such flexibility. Suppose you have just a beaucoup year. You know, you sold a property and you say, “Steve, I don’t wanna do any of that stuff. I wanna cash out.” And you cash out and you have beaucoup income in that year, an unusually large amount of income. With the flexibility of some of these pensions, what you can do is you can make multiple plan year contributions in one calendar year.
In English, that means in the year that you had the especially high income, you make contributions that’ll cover several years of your pension, but you get to deduct it all against that high income. That’s still another trick. And if you have a bad year, you can do that in reverse. And fourth is asset protection. Retirement accounts have special protections under the law. So, what that means is if you get sued, remember, you’re a landlord or you’re driving a car, or somebody says, “You looked at me the wrong way,” and you get sued, and the jury awards an amount in excess of your insurance, they can’t touch your pension. And the poster boy for this, although I hate to mention his name, is OJ Simpson. OJ has had a multimillion dollar judgment against him for many years. OJ has not lost one penny of his pension. And if everything goes badly for you, and you have to do a bankruptcy, even the bankruptcy court can’t take away your retirement account.
So, it’s so incredibly powerful. And we’re gonna end up with home mortgage interest. And we all owe a debt to Mr. Voss. So, what happens is we know that now we can only deduct the interest on $750,000 of principle on the mortgage, on the first or second home. Mr. Voss purchased a home with his girlfriend, not his wife, his girlfriend, and Mr. Voss said, “Well, you know, I should be able to take interest on $750,000, and my beloved should also be able to take interest on $750,000. So, really together we’re taking interest on $1.5 million. IRS said, “No, no, no, no, no, the limitation is per house.” And Mr. Voss said, “No, no, no, no, no, the limitation is per person.” They went to tax court and the tax court said, “Mr. Voss, you’re correct.” And this is very powerful because, and this was decided right here in California, Ninth Circuit Court of Appeals, a lot of people, boyfriends and girlfriends buy houses together. They’re not married. If they were married, this wouldn’t apply. It doesn’t matter whether they’re doing married filing jointly or married filing separately. This only applies to unmarried people.
So, boyfriend and girlfriend go ahead and buy a house together. They’ve effectively doubled the amount of interest they can deduct. Suppose three friends buy a house together, and so on and so forth. On that happy note, I’d like to thank everybody for listening to us today. And if you have any questions, you’re more than welcome to contact us.
Liz Prehn:
Hi, Steve. I think we do have some questions.
Steve Moskowitz:
Okay, let’s see if we have some answers.
Liz Prehn:
I was gonna let Donna Marie go ahead and tee these up because I think a lot of her contacts are the ones that were relaying the questions to her. Does that sound like a good plan?
Steve Moskowitz:
Sure.
Liz Prehn:
Great. Oh, I think you’re on mute.
Steve Moskowitz:
I sure hope not ’cause then I get the whole speech to myself.
Donna Marie Baldwin:
With inviting people over the weeks to your fabulous seminar, I’ll tell you I’m blown away. I have to take this about 10 times. There were questions that I found from them that they asked me to ask you. And one of them was a young couple owned a house in Redwood Shores, five years, bought a home in San Carlos, have lived there over two years, rented out the Redwood Shores home for two years. They’re going to sell it. So, they’re entitled, and I always have a question mark because you’re the pro, they’re entitled to the Section 121, $250,000 each, which gives them the $500,000 tax free on the Redwood Shores home. Now, they’ve been in the San Carlos home two out of five years, and they appear to be entitled to take the Section 121 on the San Carlos home also. Can they do that, number one-
Steve Moskowitz:
So again, with the questions, basically, because of liability purposes, and this is an educational seminar, we’re happy to answer general type questions, but the minute somebody says, “What should I do?” I have to defer that they should talk to their tax advisor because there’s a lot of things that have nuances, and if you do this, you can do that. And also a lot of times, the courts are split on the cases. So, the real specific stuff like that, they have to ask their tax advisor because if I just give it an answer, there’s a lot of facts that I may not know about that could move this one way or the other. So, we need sort of like more general type of question, not specific what should this John and Mary do.
Donna Marie Baldwin:
Oh, okay. And then how about taxes on the estate when they, I think it’s $11 million-ish before the big tax kicks in.
Steve Moskowitz:
So that’s per person. So, basically you’re talking about an awful lot of money before there’s any gift or estate taxes. And at that level they probably have an advisor. But the other thing you wanna watch out for, people should know about something called portability. So, suppose for example, John and Mary are married, and one of them dies. And let’s assume they don’t have a taxable estate and they don’t file a return. Their exemption dies with them. Under the portability, all as you have to do is file the estate return, check off a box, do you want this? And then what happens is the deceased spouse’s exemption goes over to the living spouse. So, essentially in the example we’ve used here, the living spouse would double his or her exemption.
Donna Marie Baldwin:
Oh, okay. So-
Steve Moskowitz:
The tax law’s just full of little tricks like that.
Donna Marie Baldwin:
Now, is the estate considered the gross value, i.e. of real estate if it was $12 million, and 5 million was owed on it?
Steve Moskowitz:
No, it’s the net assets.
Donna Marie Baldwin:
Oh, that’s, okay.
Steve Moskowitz:
It’s the net assets.
Donna Marie Baldwin:
Okey dokey. All right.
Steve Moskowitz:
Also, if you’re doing an estate, I strongly recommend that you have an appraiser because what happens is an estate tax return is much different than an income tax return. An estate tax return is essentially a balance sheet. An income tax return is essentially an income statement. So, an income tax return, most people are familiar with. I have so much income, minus so much deductions, and I pay tax on the balance. With an estate tax return, you’re having the value of something. So, let’s talk about the house that you live in. What’s that worth? Well, if you look on Zillow, you get a number. If you look on another service, you get a number. If you ask an appraiser, you get a different number. So, before you file that return, you would be well advised to have an appraiser so that we can say to the IRS, “Listen, the reason I said the house was worth X is because we have this appraisal.”
Donna Marie Baldwin:
Okay. I just saw a question come in from James Cowing. I don’t see it now, but you just, I’m surprised about the $750,000 per partner.
Steve Moskowitz:
Oh, the Voss case, yes.
Donna Marie Baldwin:
That was exciting because I did have a question yesterday about a bonafide domestic partner because it was registered with the city of San Francisco. So, I’ll have them check with their tax advisor, i.e. you because that is really exciting.
Steve Moskowitz:
And if you have the copy of the PowerPoint, you’ll see the citation there, yeah. That was a real good one. And that applies to an awful lot of people. An awful lot of people loan things together, and they’re not married.
Donna Marie Baldwin:
And then the $1 million of interest write off, if you’ve owned the house or purchased it before 2017, if you refinance the home after 2017, is it $750,000 or-
Steve Moskowitz:
Well, be careful about the refi because if you are just refiing to improve the property, make repairs, that’s fine. But a lot of people go ahead and they refi to pay off credit cards and do other things. Then that’s not going to be tax deductible. A lot of people will use their houses to guarantee a business loan. In that case, they should deduct it. So before you do that, you just wanna see how that’s gonna affect you.
Donna Marie Baldwin:
Okay.
Liz Prehn:
I think there was a question, Steve, on DSTs. How do you get the, how do you cash out of ’em?
Steve Moskowitz:
You sell the shares.
Liz Prehn:
Okay.
And we will be making this recording available to you. You should receive a copy of it tomorrow via email.
Okay.
Donna Marie Baldwin:
Oh, here it is. There is a question from Millie. Can you ask about 1031 info, REIT?
Steve Moskowitz:
Ah, there’s all kinds of special rules. There’s all kinds of REITs, real estate investment trust. And there’s all kinds of rules, and there’s upward REITs and downward REITs. That gets kind of complex and set of rules specifically for what type of REIT.
Donna Marie Baldwin:
All right. And then another question. Who is a better candidate for our REIT versus traditional 1031?
Steve Moskowitz:
So again, something like that, you would go to your financial advisor. And, like, when we do financial advising, we lay things out, and we give scenarios. And sometimes it’s just on the numbers. “Well, look, if you do this.” Other times, it’s, “Well, what’s your risk tolerance. What are your wishes?” You take a look at the financial plan along with the estate plan. And one of the things, when I did this type of work, I explained I could have twin siblings come in the office that are identical financially but have very different ideas about what they should do with the money. Some people say, “Everything for the kids.” Other people like Warren Buffet and say, “Oh, you ruin kids if you give them money,” and they give it to charity. So again, all of that is very specific to the person.
Donna Marie Baldwin:
Okay. So, we just call your office and get in there or do a Zoom with you.
Steve Moskowitz:
Happy to do that.
Donna Marie Baldwin:
All right. And if anyone wants to buy or sell real estate, I’ll talk to you about taxes, send you to Steve Moskowitz first and see how we can save you.
Steve Moskowitz:
Thanks very much. And remember, the Congress has greatly favored real estate, as far as taxes go. So, there’s so much you can do. And you know, basically, there’s so much wealth in real estate.
Donna Marie Baldwin:
Yeah. My goal is to help my clients keep it. So, I’ll send them right over to you and we’ll work it out.
Steve Moskowitz:
You make the money for ’em and we show ’em how to keep it.
Donna Marie Baldwin:
Yeah. It’s a lot of fun. Okay. Let’s see. I don’t see any other questions, and I apologize to James Cowing because I saw it pop up, but then I didn’t see it again. I’ll get better at this on my second-
Steve Moskowitz:
And I would like to thank everyone for listening to us and look forward to our next time.
Donna Marie Baldwin:
Yes, thank you so much.
Steve Moskowitz:
Thanks so much.
Donna Marie Baldwin:
Bye.
Steve Moskowitz:
Bye-bye.