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The Insider's Guide to Real Estate Investing Loopholes

John Wiley & Sons

Chapter One

If you had a choice of paying tax now or later, which one would you choose? How about if the government asked you whether you would like to pay tax equal to half of your income, or tax at a rate of 10 percent or less? The amazing thing is though, that this is exactly what the government asks us, each and every day. And we choose what tax we will pay, by the actions that we take.

If you choose to continue working at a job or in a profession where all of your income is earned by the work that you do, you will pay the highest rate. If you choose to work a little harder by taking another job or working overtime hours, your tax goes up along with the income you make. But, if instead you choose to invest in real estate and do that investing in conjunction with a tax plan, you will pay less tax.

First, though, let's look at how the tax system actually works.

WHY CAN'T I EVER GET A STRAIGHT ANSWER ON A TAX QUESTION?

Have you ever wondered why you can't get a straight answer to your tax question? Or worse, have you asked numerous people and gotten numerous answers? Why does this happen? The answer is quite simple. As we said earlier, tax law is complex.

Did you know that there are more than 500,000 pages of written tax law? (That makes it roughly 5,000 times as long as the Constitution!) And, what's more,tax law is constantly changing and being modified. Every day is a new day when it comes to taxes! Consider that there were more than 400 IRS Code changes for 2001. And for every code change, there are also one to five accompanying Treasury Regulations, Revenue Rulings, Revenue Procedures, and eventually multiple tax court cases. So more than 400 Code changes-and 2001 was considered a pretty uneventful year in the tax world! Now contrast that with years like 2002 when a new tax act came into play. In a busy year, you can have several thousand changes to the tax laws.

Now let's add another layer of complexity. There are three different key players in determining tax law: Congress, the IRS, and multiple district tax courts. Sometimes these different players don't agree. There are numerous instances of conflicting tax court opinions. And sometimes the code isn't even consistent within itself.

To make it even more complicated, tax law is comprised of "facts" and "opinions." A fact is something that can be proven to exist through physical evidence, while an opinion is something that may or may not be true. A tax fact is something that is so simple and clear-cut that there is only one answer. An example would be the instructions that tell us what line of our tax return form our income should go on. A tax opinion is much less clear. It is based on an interpretation of facts, and it may or may not be true. An example of a tax opinion would be how much income needs to go on that line of our tax return form.

Most tax decisions are made based on opinion, which may or may not be true. Fortunately, there is a lot of guidance in tax law that helps informed and educated tax strategists make good decisions. The problem occurs when partially informed people try to make tax decisions. Tracking all of the tax law changes is a full-time job, and it is not something that a casual advisor can do well.

Believe it or not though, the worst answers of all can come directly from the IRS. Its agents are given only three days training before they are let loose on the Service Center telephones as "experts." IRS agents frequently don't even have accounting degrees. And if you get bad advice, the IRS is not liable for giving you that bad advice. In the late 1990s, the IRS did a much-publicized internal study of its own ability to answer questions. It discovered, to its chagrin, that the telephone questions were answered wrong almost 33 percent of the time. A recent internal study was done, a little more quietly this time, and it was discovered that questions are now answered wrong more than 40 percent of the time! And if you get the wrong answer, follow that advice, and are then later audited-you will pay tax, interest, and penalties.

To make matters worse, there are few CPAs who really understand real estate investment tax issues. The American Institute of Certified Public Accountants (AICPA) recently estimated that more than 80 percent of CPAs do not understand the basics of real estate tax issues.

So the bottom line is that we have a complicated set of tax laws, influenced by individual circumstances and understood by few. The Insider's Guide to Real Estate Investing Loopholes can help de-mystify tax law.

DO I REALLY NEED TO KNOW ALL THIS?

Well, yes and no. A major frustration for taxpayers is asking a question and being told that the answer is, "It depends." Accountants are famous for answering "it depends" to just about any question, but the fact is, the right plan really does depend on your own circumstances.

This is where you need to rely on your tax experts to further interpret the entire body of tax law based on what you want and need. It's not your job to be the tax expert (unless, of course, that really is your job). It is, however, your role to understand what they are talking about. Accountants, just like most other professionals, really do have their own language sometimes. If you want the best results, learn to speak their language.

QUICK-START GUIDE TO TAXES

So how do you become an expert on more than 500,000 pages of constantly changing tax law? Good news! There is actually a simple formula that explains how tax in the United States is calculated. It is called the Three Stage Tax Formula.

To do a Three Stage Tax Formula calculation, you:

* Report gross income.

* From gross income, you subtract deductible expenses to come to the amount of taxable income.

* Multiply the taxable income by the tax rate to determine the amount of tax.

It actually sounds quite simple, and a good tax strategy will encompass each of these stages. The key is to learn how you can manipulate each of these stages to your advantage, using IRS-approved loopholes.

* Income: What is income? What are the different types of income? How can you change from one type of income to another and why does it matter? How can you turn taxable income into tax-deferred income or tax-free income?

* Expense: What expenses are deductible? How can you make use of multiple business structures to create expenses on one side that are not income on the other? What personal expenses do you have now that are really hidden business deductions?

* Rate: One of the best provisions that we have in the United States, and that many other countries do not have, is the ability to make use of a graduated tax rate. This means that there is not a flat tax rate applied to your taxable income. Instead, a portion of your income is taxed at one rate and then the next layer of income is taxed at a higher rate, and so on. If, for example, you have a tax rate of 28 percent for your personal return, this actually means that you have already filled up the income portions allowed at 10 percent and 15 percent, and for every additional dollar you make over these two amounts, you will pay 28 percent. So you aren't paying 28 percent on all of your income, only the amount that exceeds the 10 percent and 15 percent portions. We call 28 percent your marginal tax rate. Now how can you move income from your higher tax rate to a lower (or zero) tax rate?

A financial and tax strategy that incorporates real estate is the easiest way to impact ALL levels of the three stages-income, expenses, and tax rate. Real estate also allows an employee to deduct many business expenses that normally would not be deducted against their wages. Finally, real estate, more than any other type of investment, has the widest range of tax law available to reduce, and even eliminate tax.

THREE BASKETS OF INCOME

Since the 1986 Tax Reform Act, the IRS has defined three different "baskets" of income. They are:

* Earned income-you work for the money.

* Passive income-your business or real estate works for you. * Portfolio income-your money works for you.

Earned income is taxed at the ordinary tax rate. If you are self-employed but have the wrong business structure in place, you will also pay self-employment tax of 15.3 percent. If you were paid at the highest tax rate in 2004, that would mean a tax rate of more than 40 percent, for federal tax alone!

Portfolio income is usually in the form of long-term capital gains (assets sold after owning for more than one year) or dividends, and has a maximum rate of 15 percent.

Passive income such as that earned from real estate, if set up correctly, can receive cash flow with no tax whatsoever.

So based just on tax rates, it makes sense to move from earned income to portfolio or passive income. Real estate investing can help you do that!

There is one important thing to note about the three baskets of income, and that is there are many restrictions on losses and expenses that are incurred within these three categories. For example, you are limited in the amount of passive loss that you can take against earned income. You are similarly limited in the amount of portfolio loss (such as investment expenses or loss on sale of stock) that you can take against earned income.

REAL ESTATE LOSSES

Since 1986, U.S. tax laws have stated that losses can be claimed only against income in the same category. For example, passive losses can be used only against other passive income. You cannot take passive losses against earned income. Investment expenses, such as expenses for margin interest or investment education, can go only against portfolio income.

In the case of real estate the rules regarding passive losses are more complicated. If your income is less than $100,000, you are allowed to deduct up to $25,000 in losses from your real estate against other income. If you have more than $25,000 in losses, the excess amount is held as an unallowed loss until a future date when you sell the property. You don't forfeit the loss, but it's not very good tax planning to put off that loss to the future.

If your income is $100,000 or more, the amount of loss you can currently deduct is phased out. The unallowed loss is "suspended" against a future date when you sell the property. So the loss isn't "lost," but it is deferred. That's not great planning, either!

But, here's our first loophole, which will help you with this: Qualify as a real estate professional. If you are a real estate professional, you can take an unlimited amount of real estate losses against your other income.

TAXABLE INCOME

The three baskets of income are considered "taxable income." The IRS defines taxable income as "gross income" and says that "Except as otherwise provided ... gross income means all income from whatever source derived." The best tax planning is in finding the loopholes that are defined within "except as otherwise provided."

For example, here's another great loophole available through real estate: Take money out of a property by refinancing. The cash you receive would not be taxable. Of course if you refinance, the payments on the property would go up. However, if you have been a responsible landlord, you will have been increasing the rents to offset the increased payments that would become due under a refinance.

On the other hand, what if you hadn't increased rents and couldn't get any additional rent from the property?

Say you refinanced a property and took out $100,000, intending to use that money for another investment. Your refinanced property now has additional mortgage costs of $7,500 per year. You used the $100,000 from the refinance to buy another building for $500,000. This building created a 15 percent cash-on-cash return in an area that had a conservative appreciation rate of 6 percent. After five years, using the refinancing loophole, here's what could happen:

Cash flow in new building = $7,500 ($15,000 minus mortgage payment of $7,500).

Cash flow total for five years: $37,500.

Appreciation = $169,000 (after five years).

Total Increase: $206,500.

Wow! Debt can make you rich!

TAX-ADVANTAGED INCOME

The IRS has provided ways to take what would otherwise be taxable income and turn it into tax-deferred or tax-free income.

Tax-deferred income means that you put off having to pay tax until a later date. The benefit is that your money grows at a faster pace. For example, assume you pay tax at a 28 percent marginal tax rate and you earn $1,000 per year. After taking out money for taxes, you actually have only $720 available for future investment. On the other hand, if all of the amount can continue to grow, there is more available to grow. For example, if you invest that $1,000 per year at 12 percent for 20 years, the difference between paying tax each year and being able to defer that tax to a future date would mean an additional $6,456 in wealth. If you invested the $1,000 for 10 years, the difference is only $1,179. The unknown factors, of course, include the amount of interest you will earn and the future tax rate.

Tax-free income, on the other hand, means that not only does the investment grow without tax, but you can also liquidate that investment and take the value without paying tax on it. Obviously, tax-free income is the best way, wherever possible.

DEFERRED TAX

There are three ways to hold or transact real estate in a way that tax can be deferred. Sometimes you can even defer that tax forever!

1. Installment Sale: If you sell a property over time, that is called an installment sale. In other words, you will receive installments of payments over time. Each payment you receive is composed of at least two parts: (1) principal and (2) interest. The interest received will always be taxable just like any other portfolio income. However, in the case of the principal, it will actually be only partially taxable, depending on how it is apportioned between gain and return of capital.

The calculation is important for two reasons. First, you are required to report the mortgage interest that you receive on a Form 1098 on an annual basis to the person paying you. Second, you will need that calculation to complete your year-end tax return. In both cases, I strongly recommend that you use a qualified accountant to prepare and calculate the forms, or at least use them to check your math!

A word of warning regarding installment sales. If the IRS considers you a real estate dealer (involved in the trade or business of real estate trading), you cannot qualify for installment sale treatment on payments. If you are a dealer, you must take all of the gain as taxable immediately. That means you could be in the position of paying tax on income you have not yet received! More on this in Chapter 2 "Tax Traps to Avoid."

2. Buy real estate through your pension plan. Some pension plans allow the purchase of real estate through your pension plan. There are some rules to follow about how you do it and some restrictions as to how the mortgages are handled, but there are a lot of benefits to doing your investing this way. For example, with a regular pension plan, the gain is deferred until you withdraw it from your pension plan. With a ROTH plan, you never pay tax. For more on this, see Chapter 2 "Tax Traps to Avoid."

3. Section 1031-Like-Kind Exchange. Currently, under U.S. tax law you can exchange real estate with someone else, in certain circumstances, and defer the gain that you would otherwise have to declare. The most common way to do this is through a "like kind," "Starker," or Section 1031 Exchange. These are all different ways of saying the same thing.

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Excerpted from The Insider's Guide to Real Estate Investing Loopholes by Diane Kennedy Excerpted by permission.
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