Bruce Norris is joined this week by Matt MacFarland and Amanda Han with 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 4 and regional CPA firms. Amanda has over 18 years of experience as a CPA with a special emphasis in real estate, self-directing investing, and individual tax-planning. Amanda has extensive Big 4 public accounting experience, and you can catch her book on BiggerPockets Tax Strategies for Savvy Real Estate Investors.
- Is there anything taxpayers are most surprised by this tax season?
- How easy is it to file your taxes?
- What percentage of their clients filed with a standard deduction last year, and how many plan to this year?
- How do they handle property taxes on second residences?
- What is the alternative minimum tax, and how has this been affected?
- What types of businesses qualify for the 20% tax break this year?
- What are the Safe Harbor rules?
Bruce began by asking if tax payers are being surprised by anything in particular. Matt said they are a couple weeks into the tax season, and it’s hard to say right now. From their end, some things are surprising. You see some taxpayers who have more taxable income but are paying less taxes since they lower the rates. You are seeing some people with less taxable income and paying more taxes since they took away deductions. This seems to be running the gamut.
Amanda said the definition of surprise will differ from taxpayer to taxpayer. A lot of their clients were very proactive last year who were prepared for the result, whether it was more or less taxes. She thinks they may come across more people this year who weren’t more proactive, and they might be surprised by a larger refund or tax bill.
Bruce thought everything was so simple since he sees the ads on television saying you can just file your tax returns for free. Bruce asked how easy it is. Amanda and Matt went to a tax update seminar a couple weeks ago, and over 800 CPAs were in the room. If you stood at the front of the room and looked at everyone’s facial expressions, it would give you an idea of the simplification. The tax return has been simplified for certain taxpayers, such as individuals who really did not have too much besides the W2 and a primary home. For those who have investments, whether stocks, bonds, or real estate, it has gotten a lot more complicated, especially for business owners. With the tax reform, there are a lot of benefits that came through with lower tax rates and better deductions. However, they do make it very hard. There are a lot more calculations and thresholds you have worry about in order to maximize those new benefits.
Bruce asked them what percentage of their clients filed using a standard deduction last year and what percentage would do that this year. Matt said last year, for the individuals it was less than 10%. They are seeing it more already, although it is early in tax season. Because they are tapping that state income, both the state, local, and property taxes, by $10,000, married couples are falling under the $24,000 even with all their itemized deductions. Of the individuals he has looked at, it has likely been 40-50%, which is a huge change.
Bruce asked if getting rid of exemptions is a surprise to people. At the end of the day, it depends on how huge of a swing it is. Amanda said for taxpayers in higher tax states like California and New York, one of the most surprising things is the cap on state income tax and property tax deductions. Unfortunately, this is one that hurt people the most when looking at the year-to-year comparison. Bruce asked if the cap is $10,000 total or in each category. Matt said it is $10,000 combined for state and local taxes plus property taxes on your primary residence. Amanda said if you make a decent amount of W2, your state income tax deduction might be $20-$30,000. On top of that, you have to add on the primary home property tax. Now, 2/3 of that goes away because the total is limited to $10,000. Even though the brackets are rates are theoretically lower, the removal of the deduction is hard to gauge from person to person when it comes to whether someone ends up owing a little bit more or getting a higher refund.
Bruce asked what they do with property taxes on second residences. Amanda said for the second home, it is all part of the same limitation. What is not part of it is for the rich people who have too many homes. The good thing about this is the property tax limitation or the limitations on mortgage interest. None of those apply to investment property. This is good news since the majority of their clients invest in real estate. For real estate investors, it does not hurt them at all. For people who have rental income, you are still able to write off all the property taxes and mortgage.
Since real estate values have gone up in the last couple years, they have seen a lot of people refinancing their primary home and taking the loan out to buy more investment properties. For people who have done this, it is very important to make sure they work with their tax advisor. You can trace the interest expense to potentially be the deductible against rental income instead of deducting it and having all the new regulations.
Matt said he would encourage people with their tax offer is there is a summary sheet that will print with your tax return showing a comparison calm between 2017 and 2018 and the different line items. This is a quick and good way for someone to evaluate their taxes, work with their advisor, and see if anything has changed. Bruce asked if the Obama tax is gone, which Matt said it technically is not. The penalty is still around for 2018 and 2019. Amanda said unearned income, Medicare, contribution tax, and hospital insurance tax is sticking around to be assessed on the higher income tax payers. There is no word of that going away anytime soon.
Bruce asked what the percentage is and what income it is over. Matt said the unearned investment income tax is 3.8%, and it kicks in when people have AGI above 250 for a married couple. The hospital insurance taxes is .9% on your earned income. This kicks in at $250 of earned income for a married couple on your 1099. It’s too bad they’re not taxing people who make a lot of money.
Bruce asked about alternative minimum tax and how this has been affected. Matt said it will affect far less people going forward. Before, people living in California and taking a large state income tax deduction was an AMT adjustment. People who tended to have that tended to be an AMT. However, people will have far less of the state income tax going forward, so the flipside is it will push less people into AMT. They have also raised the ceilings before the AMT kicks in. He was not sure what percentage of their clients last year had AMT; but if it was 50%, it will be down to 20% or less this year.
The biggest topic this year will be the new 20% tax break for small businesses. Bruce asked what types of businesses qualify. Amanda said the majority of active businesses fall within the definition for qualification. Those include manufacturing companies, sales companies, physicians, and accountants. On the real estate side, most real estate types of income would qualify. This includes real estate commission, brokerage income, fix and flips, wholesale, and rentals are in the gray area. The only thing that does not qualify in the real estate realm is interest income. With respect to interest, if someone is a passive note investor, they are not in the business where it would show up as interest from the bank. Those are actually considered investments and not eligible. Most types of active income falls within the definition. Beyond that, there are a lot of different rules and thresholds, and certain types of income are better for the deduction. If you happen to fall within the definition of a service business, it is a little bit harder to get the qualification. Service providers include medical professionals, attorneys, and your local friendly CPA.
When this first came out, everyone was under the assumption that rental income would qualify for the 20% tax break. Then they came out with some weird wording and people thought rental income was more of an investment than active income. Most recently, the IRS came out with some more guidance. What they released were the Safe Harbor rules. These mean if you meet certain criteria, your rental income falls within the eligible definition for the 20% flow-through calculations. It does not mean if you do not meet Safe Harbor you are not automatically eligible. It was great they provided guidance to see if there is something to rely on to see what is eligible for the tax break when preparing the 2018 tax returns.
Bruce asked what the rules are and how you know what qualifies and what does not. Matt said one thing the knows does not qualify is triple income from triple net leases. For some reason, the IRS or Congress said that does not qualify as a trader business. Amanda said the other is a property that was also used as your home during any part of the year, which could include turning a primary home into a rental or renting out a part of the room. In terms of safe harbor, they have a couple bullet points. First, you have to show at least 250 hours of rental service activities for your real estate business. You are supposed to be keeping records and documents of these hours and have separate books and records for the rental activities. You also have to attach a signed statement to the tax return indicating you meet all these safe harbor requirements. The signature is supposed to be under Penalties and Perjury. It is kind of an overkill since everyone signs their tax return already to indicate everything on there is accurate.
Bruce’s understanding is that the 250 hours do not have to be your time, but a property manager can be included in the 250. That is another area of confusion. When they talked about real estate professionals in the past, it had to be your time. They wanted to see that the taxpayer was actively involved. One of the great things about Safe Harbor Rules is the 250 does not have to be just your time, it can be people you hire. This includes property managers and contractors. But, practically speaking the question is whether this means you now have to request time logs from your property managers or people doing rehab. That part is going to be confusing, so he is not sure how they are going to enforce that type of requirement.
Bruce next asked about a partnership that derives its income by having rentals. By the end of the year, the partnership has engaged all the players and the limited partner gets a check for their share. Bruce wondered if this is considered a small business. Matt said regardless of what happens at the partnership level, this is all decided at the partner level when you file your 1040 return. One of the cool things about the Safe Harbor is you can group your rental activities so you don’t have spend 250 hours on each property. It can be 250 hours combined for all your groupings. You can be grouping your three rentals you own personally and the hours you spent on this partnership. It can count, but you have to meet these requirements.
Bruce made a good point that if you have a partnership, which in turn hires these people to do the hours, then theoretically this limited partner will be allocating these hours. It would be too easy for them to say rental properties qualify for the 20% deduction. This will ensure they have a 1,500 person audience next year at the tax-law change seminar. If you have out-of-state properties, then you for sure will not be spending your own time. It is still ok as long as you hire people to spend that time with respect to the Safe Harbor Rule. This is very different and has nothing to do with real estate professional time, which is another time log that is that is only based on a tax payer. If it is a husband and wife, if the wife is claiming real estate professional it is only on the amount of time the wife spends. However, the Safe Harbor Rule is different in that it says it is people you have hired as well.
Bruce asked if the business can be in an entity or if it has to be sole proprietor. Amanda said for all these various things, including rental real estate, it is actually irrelevant whether it is a legal entity or held in a personal name. For the most part, LLCs, partnership, S-Corps, or sole proprietor really makes no difference. The one not eligible for the flow-through benefits are C-Corporations. Matt thinks this is actually a surprise to a lot since most people think they have to have some legal entity to take advantage of this. However, they have been beating this drum for a year and still seems a lot of people do not necessarily know or understand it can be property you own personally or an LLC.
Bruce asked how many opinions he gets on what this means and how different they are. You have to have someone you trust and knows the field since there are so many different opinions. Bruce had just read one this morning that talked about how you have to have an entity, and he did not think this was true. In a lot of tax situations, tax law is open to interpretation. If you pose the same scenario to three CPAs or attorneys, it is possible you might have three completely different answers in a regular world. Today, on a weekly basis we are seeing new details from the IRS to further define every term they have used. It is natural to see a lot of different opinions, even the question of whether rental income qualifies for the 20% tax break. There were people who had the strong opinion that it did not. Amanda and Matt were of the opinion that it definitely did. Neither were technically credit as it could be or it could not be.
It is interesting how trust deed income does not qualify since there are now people with money who do it themselves and it is not passive at all. It depends on how you are reporting the income. Amanda said they have points for note investors since that is their active business. They reported it as active income or scheduled fee income. They pay self-employment taxes on it, and it allows them to lower the tax to fund the retirement account. This would qualify. If you just have a few notes here and there you try to treat as a passive investment, then it would not qualify.
Bruce asked what the maximum allowable income level is for the 20%. Matt said for a married couple, for anyone under $315,000 of taxable income there is no limitations or separate calculations. Your 20% will be of your business or taxable income, whichever is lower. Once you get past $315,000 as a married couple, there is more calculations involved when looking at the types of businesses you have. Once they get to $415,000 for service type businesses, that break completely goes away. Accountants who make $415,000 will not be able to take advantage of this at all whereas they would get some of it if they fall between $315,000 $415,000. If you are not in the service business and are married with a combined income of over $415,000, you will still get a reduced benefit. It does not all go away because your income exceeds a certain level if you are not in the service business.
It is possible for someone to have different types of business. Keystone CPA has real estate income and the CPA firm, which is service-based income. You can already see the complication of there being two different defined incomes and calculations. This is why Bruce is glad they simplify things and people can file their tax returns for free. As long as you understand it, that is a good thing.
Bruce ended by asking if there is anything they would warn people to look out for when doing 1031 exchanges. Matt said they are still eligible, and the big change is you can only do it with real property. Before, you could do it with personal property like a car or apartment. The current market is a seller’s market, so a lot of clients are pushed down for the deadline in terms of identifying replacement properties. The earlier you start shopping for replacement, maybe even before selling, the better it is. This way you are not under the gun. The nice thing about construction exchanges is you have already earmarked what it is you will get. These times can come around pretty quickly.
The Norris Group originates and services loans in California and Florida under California DRE License 01219911, Florida Mortgage Lender License 1577, and NMLS License 1623669. For more information on hard money lending, go www.thenorrisgroup.com and click the Hard Money tab.
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