Short Summary
If you're feeling overwhelmed by the complex tax strategies and loopholes in real estate, then you are not alone! Trying to navigate the STR loophole, cost segregation, vehicles, and recapture avoidance can feel like an impossible puzzle to solve. And if you're not sure how to optimize these strategies for maximum tax efficiency, it can lead to missed opportunities for substantial tax savings and informed financial decisions. But fear not, because we’re joined by Tony Hoong to demystify these tax-saving opportunities and kick the IRS out of your pocket. Let's unravel the mystery together and reveal the secrets to optimizing tax efficiency for real estate professionals.
Our special guest is Tony Hoong
Tony Hoong, a respected expert in real estate tax strategies, brings a wealth of knowledge and experience to the table. With a sharp focus on helping real estate professionals optimize tax efficiency, Tony has a proven track record of guiding individuals towards substantial tax savings and informed financial decisions. His in-depth understanding of the STR loophole, cost segregation, and other tax optimization techniques has made him a go-to resource in the industry. Tony's personable approach and ability to demystify complex tax concepts make him a valuable asset for anyone looking to navigate the intricacies of tax strategies in real estate.
In this episode, you will be able to:
Discover how to leverage the short-term rental tax loophole for significant tax benefits
Uncover the potential tax advantages of a cost segregation study for real estate investments
Learn effective strategies to avoid tax recapture when selling your property
Maximize tax savings with a Section 179 vehicle deduction strategy tailored for real estate professionals
Explore the benefits and requirements of achieving real estate professional status for tax optimization
Short Term Rental Tax Loophole
The Short-Term Rental Tax Loophole is an efficient strategy for real estate professionals to optimize their tax savings. Through active participation in managing properties, and aided by specific limitations, investors can convert passive losses into active ones. This essential loophole in tax codes can significantly reduce taxable income, unveiling a considerable saving strategy for owners of short-term rentals.
Avoiding Tax Recapture
Another significant strategy is avoiding tax recapture when selling a property. Investors who've capitalized on depreciation may face tax liabilities upon property sale, but smart planning can help prevent this. Among the effective techniques is using mechanisms such as charitable remainder trusts and 1031 exchanges that facilitate the movement of assets and limit recapture, enabling the preservation and even growth of wealth.
Cost Segregation Study Benefits
Cost Segregation Studies play a valuable part in the world of real estate tax planning. By separating different parts of a property into diverse depreciation categories, these studies enable you to make the most of bonus and accelerated depreciation. The resulting tax savings can be substantial, particularly for properties with low land values and those whose cost justifies the expense of the study.
Link and Resources
Subscribe for free episode bonus materials: https://www.thestrinsiders.com/
Join the conversation with Tracie on Facebook: https://www.fb.com/groups/strcentral
Follow Jacquie on Instagram: https://www.instagram.com/5starbnb/
Connect with Tony: https://thecpadude.com/
Follow Tony on Instagram: https://www.instagram.com/thecpadude_/
Transcription
00:04
Tracie Fowler
Welcome to the STR Insiders podcast. We share tips for achieving your STR goals. Aha moments, funny stories, and all the latest gossip of this STR life. Listen in as we keep it real and maybe a little sassy, celebrate successes, and own all the mistakes we've made along the way. Whether you're new to real estate investing, new to short term rentals, or a seasoned pro, there's something here for you. Jacquie is an STR property manager who consults with individuals looking to grow their own property management firm. Tracie owns STR Consulting and media firms that provide education to investors who want to learn all about STR investing. For more information, please visit www.thestrinsiders.com. Welcome back for round two of March tax Madness. Now that you know how to choose an STR CPA, let's demystify the big savings opportunities that are available to you.
01:04
Tracie Fowler
We're talking about the STR loophole, cost segregation, vehicles, avoiding recapture, and other ways to kick the IRS out of your pocket.
01:15
Tracie Fowler
Clarify what exactly the STR loophole is so that any of the listeners understand, because I think it's a buzzword that gets tossed around a lot and people don't really understand.
01:26
Tony Hoong
Oh yeah, for sure. So the short term rental loophole is essentially a quirk in the tax code. So I think it comes from a section in 1986, I think when the tax code got reformed. And essentially this was originally made for bed and breakfasts. So like real places where you stay and the people are serving you either through food, accommodations, tours, there's always those smart folks that are like, wait a second, this seems gray. How can it's open for interpretation. And through that there was actually the material participation test. So in order to meet it, there's hoops you jump through. So your first one is your average stay of seven days or less throughout the whole year. So simply put, it is your total days divided by your total stays.
02:14
Tony Hoong
As long as that number comes out to 7.0 or less, you meet prompt one. So you could have 2 30 day stays and then just add in like 20 single day stays. As long as that number comes out to seven or less, you'll be okay. Number two, don't use it personally. Some people are like, oh, nice, I can go vacation here. Don't do that, you're going to lose out a lot of your benefit. And then number three is that you have to show material participation. And that is whether seven prongs and they're more or less making you work on the property. So you just can't buy it and have a PM property manager come in and manage it all. You have to show 100 hours of actually working on the property.
02:56
Tony Hoong
And when you say working on the property, it's like, hey, managing all the guest communications, coordinating with cleaners, going there to clean yourself, adjusting your prices, doing your pictures like real work, not just, hey, I'm browsing for a new STR. Let me count these hours. That does not count. So it has to be real hours that you put in and no one else can work more than you. Or if you're creative and you want some life back, you can do 500 hours and you can also have a property manager. So those are the main two prongs. There is another prong that's very gray that says you substantially perform bell services. So there's no hours tracking, but more or less you have to show, and the burden of proof is always on the taxpayer that you did everything on the property. You had no help.
03:43
Tony Hoong
So once you have all that now, your passive losses that you're generating from your Airbnb short term rental are considered active now because they see you working 100 hours on it. They see you having people come in and out really often, average of seven. And they'll give you that on the tax code. So the beauty of it is that previously your losses would have been suspended to the passive piggy bank. Now they're actually unlocked and the floodgates open to wash away your active income. So I would say it's the ugly duckling of rep status. So real estate professional status, just because it's just one property, right. Versus real estate professional status, you have to show material participation again in. So 500 hours of general managing your rentals. But then you have to have 750 hours.
04:33
Tony Hoong
It can be in your rental space if you make a grouping election, but generally brokers, agents, operations, property management. So it's a little like watered down version of it because it's not as intense, because the one prong that everyone fails on for real estate professional status is that over 50% of your time has to be in trades or business of real estate. But if you're working W2, you automatically fail. However, there is a new wave of the overemployed crowd. So ever since COVID, they work from home. No one actually works 40 hours anymore. Right. Your butt's not in the seat pretending to work 40 hours like you used to be, right. So there's some creative folks where they were like, I think I qualify for reps. I was like, do you actually not work at your job?
05:24
Tony Hoong
Like, yeah, I work like 10 hours. I'm like, oh, okay, I guess this works. So the burn of proof is on them again to show how many hours they work at their day job because it still looks like full time pay. How many hours do you have in real estate professional stat aside? So I've had single people qualify for this. I was pretty picky though. And I was like, dude, is this real or not? Because I'm not putting my name on this.
05:47
Tracie Fowler
I have heard that if you try to get rep status with a full time W2, it definitely sets off some flags for the IRS and maybe increases your chances of getting audited. So it makes sense that you would be highly selective about what you allowed on that return.
06:04
Tony Hoong
Exactly.
06:05
Tracie Fowler
You also mentioned cost seg briefly. Could you clarify what that is for the folks that haven't heard of that before or aren't exactly clear on that?
06:16
Tony Hoong
Oh yeah. So cost segregation study. So what this is essentially a computer or if you can have humans come out to your property. But by definition, single family homes are considered 27.5 year useful lifes for depreciation. So the whole entire thing. So from your windows to your floors to your doors, and then the whole thing is defaulted as that. So it doesn't help you because the whole thing is purchase price minus land divided by 27 half years. It's very slow of how much depreciation you can get. Gets worse when it's commercial. That's 39 years that the IRS says. So what a cost segregation study does, essentially is that a bot or a human comes out to your property and they're like, oh, hey, we got ten doors. This is like five year property. Oh, we got 3000 square foot of flooring.
07:19
Tony Hoong
This is like 15 year property. We got windows, 15 year property. So they start segregating all these pieces of the house into different buckets.
07:29
Tracie Fowler
The actual life of the individual item instead of the house as a whole.
07:35
Tony Hoong
Exactly. So now you're going to separate the whole thing. So the report is super long, right. Because they look at everything from your sink to your cabinet to anything that's affixed the house, your fan, the light back here. I guess. So it's everything. And if your whole goal is to get property that's under 20 years, and the main reason why is because of bonus depreciation. And what bonus depreciation is that it allows you to take a substantial amount of the property as an expense as year one versus generally speaking, taking over the whole useful life. So for example, we have 100 grand and it was considered five year property, you would have to take the 100 divided by five. So you only get $20,000 per year.
08:24
Tony Hoong
However, if you take bonus depreciation on it, then you're able to get, as of right now, January 22, because the tax laws are actually pending right now. From a signature wise, you'll get 60% of that. So if you had 100K property, you can actually take $60,000 of that in year one. So now you triple the amount that you can take. And the big thing is that it used to be 100% and it's been phasing down 20% each year. So right now they passed, not passed. It's proposed to bring it back to 100%. So hopefully the signs next week, really kind of looking out for that. It'd be a massive change for real estate investors if this passes and goes back to 100%, because the tax planning for not and losing 40% is pretty substantial. So that's bonus depreciation.
09:13
Tony Hoong
And you only get that by doing cost segregation study, because bonus depreciation only applies to useful life of 20 years or less. And then lastly, there's the part from where cost segregation study can still work, is that you don't have to take bonus depreciation, and you can take accelerated depreciation and accelerated depreciation, simply put, is that instead of everything being divided by 27.5, now you're just dividing it out by five, by seven and 15. So you're not going to take the full benefit year one, and you're just going to smooth it out over five years, seven years and 15 years. So it's another strategy that you can be doing if you don't need all that depreciation in year one. But yeah, you need this study to do it.
09:56
Tony Hoong
And essentially all it is just a report that breaks out your whole house into different components for your CPA to put onto your tax return. And you can always do this. I always recommend doing it the year that you buy the. You know, if you listen in, you're like, oh, shoot, bought a property a few years ago, you can still do the study, you just have to do a change of accounting method, and you don't have to mend your prior year's return. You just take everything and front load it to this current year. So it's never too late if you want to still do a cost tech study. It's just a lot of work for your CPA to go back and refix all your depreciation schedules, but could very.
10:36
Tracie Fowler
Well be worth it with the tax savings versus whatever you're paying the CPA to do that work.
10:42
Tony Hoong
Yeah, easily, like thousands if you have an STR and you actively participate in it. Oh, it's almost nine times out of ten a no brainer to do it. And then if your reps, generally no brainer to do it. Sometimes, though, if you don't even have reps or you don't qualify for the STR loophole that year, you may want it just because, say, if your STR is so profitable and you want to front load some of your depreciation just so you don't pay income taxes on it. That's another strategy, too. So it's like a great tool in the toolbox is just when do you use it? Because depending on your property, at least 600 is the minimum for a bot study versus 2.53 4K plus for an engineered study.
11:27
Tony Hoong
It depends on the savings, but generally it's pretty substantial because they'll produce 50, 80 plus k of depreciation depending on your purchase price, of course.
11:35
Tracie Fowler
So let's talk about that a little bit in general, again, every situation is going to be an individual, but what properties are good candidates or not good candidates for a cost seg? Because I think there are some kind of baseline standards for someone who's listening to just say, okay, this property really probably isn't going to get me very much appreciation versus this one. That's cash cow in tax savings.
12:00
Tony Hoong
Depends on your risk tolerance level. So are you a Vegas person or not? So it starts there. And I'd say if we kind of just take the textbook answer. And the approach is that you generally want to buy where your land values are lower per the county assessor's record. So whatever the county assessor says, generally the IRS may lean on that and use that as a place to pin you towards your land value. So if you're on the coast, of course it's not as great because land values are so high on the coast. Think about that. Condos, depending on how the condo is set up, generally don't have land value. So another better area. So that's if you're more textbook. Now, if you have some appetite of risk, and it's not the textbook answer. And this is one of the weird things it was.
12:51
Tony Hoong
Generally speaking, a lot of tax professionals, I think this is just like passed on information. I don't think it's in a tax code anywhere, but everyone just takes like an 80 20 approach. So understanding, like, hey, 80% is building, 20% is land. And seeing how much do you want to take against it? So a lot of people do that style. But do note that the IRS can attack that because it's like, where's your burden of proof on it? And you don't really have it. So understand the risk behind that. But it's one of those unspoken rules in the accounting world where you just take 80 20 because everyone else takes 80 20. It's weird.
13:30
Tracie Fowler
Got it. So condos where you don't own the land are going to be like the cleanest approach because there's no arguing the value of the condo is the condo.
13:42
Tony Hoong
Yeah. So I think I've seen mostly most condos who you don't own land, some rarely you actually do.
13:48
Tracie Fowler
And then from a valuation perspective, I have a townhouse that I only paid like 150 for and I own the land. When we talked last year, you were like, I don't think you're really going to get a whole lot of benefit from paying someone to do a study to have me filing because the property value itself is so low, even regardless of the land. And so wondering if there's kind of a general threshold for what the property value minus the land, where do you feel like that line kind of starts to tip over to where paying for a cost seg may make sense.
14:27
Tony Hoong
Yeah. So in that range, I'd say is very close. Under 200 is a safer place to go. It does depend on your taxable income situation. So how. I'd say it is that one hundred and fifty K, and then you take, let's say 20% out. So we're down to 15. Times two is 30. So we're down to 120 and then 120 and say, let's pretend went back in time and it's 2022, when you had 100%, because 23, you only had 80%. So we go back in 2022, and best case scenario, you may say you get $24,000 of extra depreciation. So I'd generally say about 20% of the taxable base. So then if you get 24,000, and then you multiply that against your effective tax rate on generally the Fed side, unless the state's really low, because it's generally your only property.
15:19
Tony Hoong
So unless you live in that state and say your effective rate, not your marginal rate. So your marginal rates are just your tax bracket, but that's not actually how much you pay and say that's only 20%. Now we're at 24,000 times $2,000. So we're at possibly 48. Yeah. Four point eight k, and then is this like, oh, hey, is this going to be worth it for you in terms of paying a study, say it's like two, three k, and then some extra fees to file $500, it's almost going to be a wash for you. And then versus just spacing this out, not having to pay all those extra fees, then you're going to be okay. And then you can just use that depreciation to carry over into all your other properties. So it really depends on your income tax level.
16:02
Tony Hoong
And then along with the property prices in itself, I always just say, will this be a benefit for you?
16:09
Tracie Fowle
rRight, Jacquie, do you have an example for us today?
16:11
Jacquie
Yeah. So I bought a property at the beginning of this year. I closed on, I think, January 3 for 550,000. It's got a secondary unit, a cottage out back, which is great. I have both on Airbnb, and I put probably, I want to say around 80,000. Probably went into landscaping, putting up fencing, outdoor stone, fireplace, fire pits, hot tubs. Everything inside was very little. It was cosmetic. Maybe some tiles, but that was it. So how would that do?
16:42
Tony Hoong
That one would do pretty well. Yeah, definitely. A cosite study would be great here, just because the landscaping in itself, there are so many various components along with the hot tub. This property would do well, depending on your other factors, if your other properties didn't have as much depreciation offset against already. So it's once again one of those, like, it depends type of items. But generally speaking, if you have the cliche like, hey, bought a property, I also have other active income that I need to offset. Oh, it would do great at that level.
17:11
Jacquie
I have a lot to talk to my accountant about.
17:14
Tony Hoong
There you go.
17:16
Jacquie
I hope they're already planning on all this. I hope they're just like, oh, yeah. But I don't know.
17:22
Tracie Fowler
They're a new accountant for me, all this beautiful depreciation. What happens if we sell the property after we do a cost seg?
17:33
Tony Hoong
Oh, you always have to hold after you do the cost seg, though. So taxes in general is just a Rob Peter, pay Paul type of game. So you are robbing Peter today, and you have to pay Paul one day. And the biggest thing is that you want to either one not sell the property and either refi back out to get your cash to go do another property. If you do unfortunately have to sell just because it's not performing and doesn't have hope. And you did take the cost segment, bonus depreciation, where you wiped away a good chunk of the base, you should highly look into a 1031 exchange just to keep on kicking that can down the road. And if you can't 1031 it, then also think about maybe an opportunity zone.
18:19
Tony Hoong
So that's also another area where you're kicking the can down the road again. And then lastly, if you do sell, do you anticipate possibly seeing how much your capital gain is? And do you have capital losses harvested from your back in the day? So one person, they went bonkers on stocks in a bad way and they lost a lot of money, but then they had all these losses that offset the capital gain. I'm like, your trading losses came back to help you. So you want to harvest some losses also, if you want to that year, think about buying another property, but running a cost seg on that property too. So be very mindful, like at least a year or so or two. If you do plan on selling and working with your tax pro just to anticipate that tax hit.
19:09
Tracie Fowler
I think what you're explaining is how to not have to recapture that deduction if you sell.
19:15
Tony Hoong
Oh, is that right?
19:17
Tracie Fowler
I have a reasonable understanding of this. But just for any of you listening that aren't familiar, if you take a cost and you take this bonus depreciation, and then you sell the property a year later, you're going to have to recapture all that deduction because you no longer have the property. And so Tony just spelled out like four different ways to avoid the recapture. So if you weren't listening, rewind and listen to what he just said, because that's some serious gold. And then one of the things I've heard, and again, correct me if I'm wrong, you can like 1031 into oblivion because it doesn't roll over to your beneficiaries at death.
19:58
Tony Hoong
Oh, yeah, one of the worst, best tax strategies, dying. So nothing's guaranteed but death and taxes, says Ben Franklin. So, yeah, when you pass, the whole thing gets stepped up. So that's literally generational wealth, is that you had the one person in the family, grandma, grandpa, who started, bought something for 50,000 passes. It's worth half a million. The whole Delta 450K is all tax free now because you get the step up in basis. So if you 1031 and you deferred forever and you kept and held it, then you passes to your heirs, they get all the step them basis, even if you took all the depreciation back in the day. So it really rewinds the whole clock for you.
20:44
Tony Hoong
So that's ironically one of the best ways to keep the real estate going is just to hold it, and a lot of it goes back to policy.
20:52
Tracie Fowler
But I just want to say for any of you parents listening, you're welcome for just clarifying the one way that you can never give the IRS all their tax money and your kids don't have to pay it either. So just keep 1031 forever and keep your money in your pocket.
21:10
Tony Hoong
Exactly.
21:11
Tracie Fowler
That's what we're here for today.
21:12
Tony Hoong
Yeah, it kills and it hits. So that's always big. There's some more like, crazy more advanced stuff out there outside 1031. So there's charitable remainder trusts that folks can look into if you have a very big charitable side to you there. So you essentially donate the property to an irrevocable trust and you get a donation value. So you get to show a contribution. Write that off against your taxes. Then also you'll get kind of like a kickback each year until you pass. And then when you do pass, it goes to the charity of your choice. So that's another way. How you can wipe away capital gains is that you have 100K property. It's worth a million. Now. What can you do? And you're like, oh, well, actually I love this charity that I work for or associated with.
21:55
Tony Hoong
And you're like, hey, at the end of life, you all can just have it. But generally speaking, it's the rich get richer because the charity tends to be their foundation or their nonprofit.
22:05
Jacquie
Sure.
22:05
Tony Hoong
Just how the rich play the game.
22:08
Jacquie
Yeah. Another opportunity that we've heard of is section 179. I think it's the oversized vehicle bonus depreciation.
22:19
Jacquie
Do you want to tell us a little bit about that?
22:22
Tony Hoong
Oh, yeah. So, yeah. Section 179 originally spun up for business equipment. Right. So heavy machinery. And it would allow you to write off the full value of the year that you bought it if it met the biggest requirements, which was the weight, usage. So trucks, vans was the original use. But as there are always creative people out there, it's, hey, g wagons, Hummers. So what you can do with, if it's business property, business vehicles is that one, keep a mileage log, of course, or two, just buy it in the company's name. And then that way if it's more than 6000 pounds, you don't have to depreciate it over five years. Kind of like how rental properties, single family homes are 27 and a half years. Cars are defined as five year property.
23:07
Tony Hoong
So then you're able to take the whole entire thing in year one and then take the benefit. So say if you bought a $250,000 car. You did $1,000 down payment and you're making payments of two k a month. So out of pocket it's at 25 grand. But then you write off quarter million off against your taxes and then just say if you take 30% as your effective tax rate, you're talking about $75,000 in tax savings that you paid 25K for. So Rob Peter paid Paul again, you're actually up 50 grand, and your $250,000 g wagon is only, what, 175K out of pocket after taxes. So very effective a strategy that you can use. A couple of years ago, my attorney's buddy passed in a car accident and the guy was only 29. I was like, oh shit, this could be me.
23:57
Tony Hoong
And then I was just like, I need a car. So then I went out and bought a Tesla and then I did the same. And it helped on the fed side, but state side states generally don't recognize bonus depreciation. So then you still have a massive state tax bill though. But hey, it's an effective, great strategy to use. Tried and true myself.
24:16
Jacquie
Yeah, and I actually needed a big tax break at the end of 2022. Found this out, went out with a few days left of the year and purchased a vehicle that my employees nicknamed as Big Lexi. It's a big Lexus.
24:32
Jacquie
And I actually, I usually drive it myself, but I mean, it's great. Know, my employees need to borrow it, know, load it up with a bunch of stuff for our management company. And now I have a third car. So it was fantastic. I highly recommend.
24:48
Tony Hoong
Oh yeah, it's great.
24:50
Jacquie
Yeah, people exactly.
24:53
Tony Hoong
Stamp in. Yeah, go buy cars now. Go buy cars.
24:59
Jacquie
Well, I'm going to be listening to this episode on repeat until April 15, so I'll be an expert by then.
25:09
Tracie Fowler
And if you're listening to this episode, you have the specifics to be an expert too. But if you want more help on your tax journey, reach out Tony, the CPA dude.
25:22
Jacquie
If you enjoyed this episode, we'd be so grateful if you rated and reviewed it. Also subscribe for more Insider Knowledge. We can help you get the edge in the STr world. You can find additional resources for your STR journey as well as our social media handles at thestrinsiders.com.