Bruce Norris is joined this week by Matt MacFarland and Amanda Han with Keystone CPA. They are the owners of Keystone CPA. Matt has over 20 years of experience in public accounting as a CPA and tax strategist. He has worked for both the Big Four and Regional CPA firms. Matt has served as a tax manager in the private client advisor group, where he focuses his expertise in tax planning and compliance for high worth individuals, business owners, commercial real estate investors, and professional athletes. The man has over 18 years of experience as a CPA with special emphasis in real estate, self-directed investing, and individual tax-planning. Amanda has extensive Big Four public accounting experience in the lead tax groups serving clients in the real estate industry.
Amanda and Matt have been in this industry for two decades. Bruce also started at an early age and spoke in front of an audience in his early 30s. Bruce wondered if people have ever mentioned to them that they look to young to know what they do. Amanda said people generally say that to her, but not to Matt. Matt jokingly said he is the one who looks older, so it is okay with him. Bruce said this is probably true during mid-tax season. Bruce asked if their business is more structured to where their type of client needs them all year, then naturally there is a rush during tax season. Bruce asked if this is more of their clientele and for whom they do more of the strategic planning. Amanda said it is; and what is interesting is that they meet with clients throughout the year.
A lot of CPAs are usually very busy from January through April, then they close up, go on vacation for a few months, then come back again for the second tax time. Their busy time is pretty consistent all year round. The good thing about this is in the busy season when they are doing tax returns, there are not a lot of surprises because they have already been talking to clients throughout the year and would already be aware of what is occurring. Therefore, there is not a lot of last-minute scrambling, which is a good thing.
Something interesting happens when people do their taxes. Sometimes they act like you are their counselor. When Amanda and Han were sitting across from people involved in real estate back in 2008 and 2009 or even 2002 for the stock crash, they would have dealt with people who were pretty sad. Matt said in their business, like a lot of other ones, you see real life. A lot of times it is numbers on paper, but also a lot of times it is real true stuff where somebody lost $50-$100 grand, but they also get to see the upside as well. The good thing is that it has been happier more recently. Sometimes they do take on the role of a counselor in an unexpected way. Since they work heavily with real estate investors, a lot of times they do find there are moments when they will meet with a husband and wife and one of them will be really gung ho about real estate and put their money into it. The other is not quite sure, and sometimes Amanda and Matt will come in as the intermediary to try to get them to agree.
Bruce asked if the majority of the clients are very diversified, or are they more inclined to be just in the pile of investments where they have expertise. Amanda said at least for them they are not representative of most CPAs and because they have chosen for their firm to specialize in the real estate industry. The vast majority of their clients have a significant amount of their wealth in real estate. The dispute is over whether diversification is good or not, but for Amanda she comes from the belief that if you have a special or unique insight into a particular industry or business, it makes sense to have more of your eggs in that basket than spread it out evenly over other classes about which you may not know as much. Bruce said he would definitely land in that category because he has dabbled in some of these other things and realized he did not have a clue what he was doing. He would have to take a lot of time to become an expert in this and pass on the category. He always hears that for some people who are not in the real estate world that it is important to diversify. Usually they are diversifying in something in which they have no idea what they are doing. They have a part of their money in a hedge fund that is invested in one thing, and you are not sure this will work.
Bruce said the tax rate in California bothered him last year because they managed to reach the upper limits of what was possible, and he did not like this. Bruce asked about the tax rate progression and if it is causing people to contemplate not being here. Matt said from their experience California is one of the highest if not the highest tax rate states along with New York and Illinois. You get to about 9-10% of California rates, are single, and are making $50,000 or married and making $100,000, you see how this can come up pretty quickly when you are living in Southern California. You have two people working W2 jobs, and you just see it all the time. When you are talking about federal tax rates and see that it is 25-35%, you almost automatically have to add 10% for California since most of the clients are in the range where they are making over $50-$100,000. It is a real life problem, and people are definitely moving out.
Matt said he knows people who have moved out of the states or relocated their business to get out of California so they are not looking at a 10-13% tax rate every year. Bruce asked if there is another tax rate and how high you can get since Bruce did not remember paying this tax rate. Matt said in the state of California you can get up to 13.3%, and this would apply to anybody making $1 million a year. What is interesting is if you get to $100,000 as a married couple, it kicks in to 9% but then goes up slowly from here. It is pretty huge when you think about how you are already paying anywhere from 25-44% to the IRS.
Regarding the Federal rate, there are some new additions to the tax. If we had this conversation in 2013, you could have been told a top tax rate and this was it. Now there are more pieces that can be added, and Bruce wondered what these new pieces are. Amanda said for the Federal rate the highest is now 39.6%. You add this to another 13% for California, and more than half your money is going to various governmental agencies. To reach the 39.6%, for married couples you have to make over $450,000 and $400,000 for a single person. There is a huge marriage penalty there because you would envision that since it is $400,000 for a single person then you should have up to $800,000 for a married couple. However, this is not the case and you get $50,000 incrementally before you get to that top rate.
Something that is somewhat new that has been around for over a year is two brand new taxes. One is the Unearned Medicare Contribution tax. Essentially a lot of people call this the Obamacare tax, and this is an additional 3.8% on top of federal and state income taxes. The part that impacts real estate investors the most will be with respect to net rental income or capital gains. For people doing lending activities, interest income is potentially subject to the 3.8% as well. This kicks in at $200 for a single and $250 for a married couple after adjusted income, so it sneaks in there before the 39.6% rate does. There is a marriage penalty here too since it kicks in at $200 for a single person, so you would think a married couple would kick in at $400. After a certain amount of income, the Federal rate is actually 43 in change. It’s really a good idea to avoid some of these things.
Amanda said what is interesting is you hear about the marriage penalty, but people don’t really think about it. She spoke with a client yesterday who was a very successful real estate broker, and they were talking about a strategy. He was unmarried but had a girlfriend, so one of Amanda’s strategies was to shift some of his income over to his girlfriend since she was helping him in the business. He told Amanda he might potentially propose soon, and Amanda told him that might be bad for tax season. It is interesting how people generally do not think about things like this, but when you look at the numbers and how the tax rates work, you can see a huge difference that you might suffer for somebody who is potentially getting married in the near future.
Bruce asked about social security tax and where it cuts off. Matt said he does not know the exact number, but it is in the range of about $117,000. Medicare never cuts off, so as an employer you are always paying the 1.4-1.5% on any earned income. It used to stop, but it doesn’t anymore. For the social security, they keep ramping up the limit a little bit each year. Five to six years ago it was around $100,000, now it is at $117,000. This is a bigger chunk of it and could stop at least at some point, but it still adds up to a big dollar people get taken out of their paycheck. Bruce asked how people can protect against this and what choices they can make to say they don’t want to end up in this high of a tax bracket. They may want to have the revenue but take it in such a way that it is not fully burdened.
Bruce asked what choices some of their clients have made to help it go down. Amanda said one thing to keep in mind in terms of minimizing taxes is to really start with understanding what items can be tax deductible. This is one thing about which people are really confused and don’t really understand what they can deduct. This could mean if they are spending money traveling or if they went to a class. A lot of times it is the fact that we don’t know what counts as a legitimate write-off. Understanding what legitimate write-offs are can really help to reduce taxes. The IRS is pretty clear about what is deductible and what is not, and they are really looking at two key terms. These terms are ordinary and necessary.
If you are incurring an expense, whether it is an expense for a laptop, a cell phone, or marketing expenses. For example, if you are a real estate investor with these expenses the ordinary and necessary would carry on your business. If the answer is yes, then generally that means it is tax-deductible. There is a lot of myth or misinformation out there about the fact you have to have an LLC or corporation in order to save taxes and write off their expenses. This is not 100% true. Amanda said they actually like legal entities because they help us to minimize taxes, especially with respect to certain employment taxes on Medicare and payroll. If we take a step back and look at general expenses and see what we can write off, then you can see that you can write off these expenses as long as they are ordinary and necessary in the course of regular activities. You don’t have to have an LLC or a corporation; these are deductible regardless.
Regarding a small business owner who does not have a commercial space and who is using residence, Bruce wondered if this is one of the things they have available to them as a home office deduction. The IRS is actually making this easier now as they realized before it was taking people a long time to calculate things. They actually let people take a simplified method now of a flat $5 per square foot up to a maximum of a $1500 deduction. They realized a lot more people were working from home. Matt said the last article he read a couple years ago said 50% of the people in America had a home base of some kind. This is definitely something the people should be taking advantage of and should not be afraid to take. It is not really an audit red flag like some people think.
Amanda said what is interesting is when they first came out with this new standard or deduction version of the home office, before they had to keep their receipts and calculate how much of the home is business used. Although this is required, no one really liked to do it. They were all really excited about this thing that came about with the standard deductions, but Amanda said out of all the tax returns they have done they have yet to see one where the standard deduction produced a better answer than the actual expense calculations. It could be because a lot of their clients are in California and the cost of living here and mortgage interest and property taxes are so high that it far outweighs the standard that the IRS gives.
Bruce said this was very true. If you had a home that was 20%, you could say it would be necessary for your business, and it would be way beyond $1500 a year. Now you sell your residence if you are in California or lived in it for the last five years, and it would not be taxable except for the portion you deducted. Matt said this is partially correct, and the only part you have to recapture is any depreciation you would have claimed as part of your home office. The other expenses do not have to be recaptured, including your portion of insurance, property taxes, utilities. He said they sometimes see it where a client will sell their house and have less than $500,000 to gain, so theoretically it is tax-free to a married couple. However, they may have depreciated their home office for a couple years and gotten some depreciation income to pick up.
Amanda said something she hears about a lot in terms of people telling her they don’t want to take a home office is because they are so afraid of depreciation recapture. She said it is important for people to understand that you only have depreciation recapture because you benefited from it via home office write-off. If we are talking about someone who pays 25% for federal and 10% for California plus self-employment tax, then what is happening is they are getting that write-off saving 50% of taxes, then later when they recapture it will be at a lower rate. Generally, it is still going to make sense. You are paying later and paying less than what they took the deduction for, so it is not all that bad that a lot of people think it is a terrible thing.
Bruce asked them if they see any changes coming about in the tax rate structure for next year, either state or federal or capital gains. Amanda said there have not been talks of any rate changes so far. What you could potentially see happening next year might be removals of certain credits or more credits which are expired and not renewed. With respect to tax rates for income taxes and capital gains, they have not seen anything being discussed. Bruce asked if they have an audit flag that would say it would raise the hair on the back of the IRS. Amanda said one audit flag they have been told about that is coming down from the IRS is with respect to self-directed retirement accounts. This is very important for them and something on which they are keeping a close eye. What they specifically indicated is they are doing more audits on the checkbook control retirement accounts where you have an IRA investments LLC, and you as the account holder have access to cut checks or receive money in that particular LLC account.
The reason this will be more of an audit flag is due to the likelihood of a taxpayer making a mistake inadvertently or someone intentionally using retirement money for personal uses. There is also not a lot of oversight or flexibility on the taxpayer’s end. This is one focus area that the IRS had indicated they will potentially spend more of their resources on since they think they can be rewarded the highest. There is a lot of money in retirement, and they are seeing this being moved into the self-directed arena. The rules are complex in that what they feel about the average taxpayer would not necessarily know what they can or cannot do.
What Matt and Amanda usually talk to clients about is people using checkbook control with a self-directed retirement account. However, for Matt and Amanda they always look at it client by client. If it is someone who is very sophisticated and understands the rules, that might be okay. If it is someone who is brand new to real estate who took a 30 minute class, then this is somebody who they highly advise against since there are so many things that could go wrong.
We are already in August, but Bruce wondered if people have already started planning taxes and tax moves now before the end of the year. He wondered if they are what would be some of the things you could do to make a difference in what you ended up paying. Amanda said in the office right now they are touching bases with all the planning clients just to do a check-in. Right now when she talks to people she is trying to get an idea of what has been their activities to date. This could mean people doing fix-and-flip, the profit they are looking at, how many more we are looking at filing before the end of the year. If it is somebody doing rentals, they want to know if they have sold anything, if there are 1031 exchanges, or if they purchased anything.
Typically when they look at year-end planning, it is usually towards the middle or end of October. By then, most people have a really good idea what net profit will look like for 2014. What she encourages people to start doing today in August is to make sure you take some time to get all your financial items up to date. Whether you are using QuickBooks or QuickEnd, you want to make sure all your income and expenses are caught up through today, and for whatever adjustments or questions you may have you have to work with your tax advisor on getting those resolved now. This way by the time October rolls around you have pretty good numbers to work with in terms of projecting what the income and expenses are. With year-end planning, what you want to do is be able to say what you think will happen for the rest of the year. This is what you know already happened this year, and based on those numbers you can figure out what to do. This could mean setting up a retirement account and figuring out how much to put in from each company.
For more information, you can call the Keystone CPA office at 877-975-0975 or email email@example.com.