By Jason Watson, CPA

Posted Sunday, January 21, 2024 after a painful Packer loss

WCG CPAs & Advisors receives about 2-3 emails or phone calls (and the occasional text) per week from people saying, “I am jumping into real estate investing and need some guidance.” Cool! But there are several paths to the coveted real estate investor name tag, and this article walks you through the common ones plus some other tidbits. Here is our loose real estate investor agenda-

1. Buy and Hold (the classic)
2. Fix and Flips
3. Fix and Hold (with optional BRRRR of course!)
4. Short-Term Rentals (the STR loophole, and the Vacation Rules)
5. Subleasing Vacation Rentals (aka rent arbitrage)
6. NNN Leases (good, but has risk!)
7. 1031 Like-Kind Exchanges
8. Cost Segregation
9. Real Estate Professional (REP status)
10. Holding Company Structures
11. Lending Options

Here we go!

This is your common strategy of buying a single-family home or something similar, and renting it out long-term. Easy, right? Well, the acquisition is the toughest part for two reasons. First, you understand the objective and easily detach yourself from falling in love with the kitchen or the yard or the neighborhood. However, you are competing with the nutty couple who just has to have the house for the kids or for some other heart string. In other words, your competition is not necessarily playing the same game as you.

Second, financing. Lending has gotten all loosey-goosey lately, but it still might be challenging. In the “old days” lenders wanted 30% down and would charge up to 1.0 to 1.5 points above the normal lending rates. So, a 3.5% interest rate might be 5.0% Yuck. Those days are largely behind us, but you might still see a small uptick on interest rate for non-owner occupied acquisitions.

As such, a lot of people tell the lender “heck yeah we intend to move in and make it our primary residence, and then rent out our current place.” Right, wrong or indifferent it is a frequent path into expanding your real estate investments without paying too much in borrowing costs.

Buying a fixer upper is another path to your real estate investment portfolio. You can pay $3,000 for a silly real estate investor seminar or you can google yourself ad nauseam for free. It reminds of you of that scene in Good Will Hunting where Will crushes the pony-tailed wizard at the bar about paying $150,000 for an education that he could have received with $1.50 in late fees at the public library. We digress…

Everyone will tell that the money made on a fix and flip is done on the buy side. In other words, the effort to find the right buy… the right price… is where the money is made. Sure, but in our experience the fix is also where the money is made. Do you know which people make the best fix and flippers? Realtors? No. Contractors? Maybe. The answer is interior designers… huh? Interior designers take a house, spritz it up with new paint and floor coverings on the cheap, and make it into a lovely home. And they don’t have to remind themselves that they are doing it for others… that is already a part of their DNA.

Said differently- fix and and flippers make one mistake with real estate investments; they fall in love with the property as if they were moving in and raising a family. They compete with the heart strings above on the buy, and then project their tastes onto the property when they fix it up. Detach. Be practical. Be smart. Don’t fall in love. Maybe saying be smart and don’t fall in love is saying the same thing but you get the idea.

Also, fix and flip activities are usually reported on Schedule C of your Form 1040 tax return are subject to self-employment taxes. What makes things worse is that the houses you are flipping are considered inventory, and all the fixes… all the improvements and dollars spent… are capitalized into inventory and are only recognized when the property is sold (as cost of goods sold). This is where an S Corp election might be handy in reducing the self-employment taxes.

There are some exceptions when you buy something as an investment, and then later determine that you need to fix it up. For example, you buy a house. Try renting it. Decide that you need to renovate to get a better rent. You do that, and then decide that selling the moneypit it is preferred. This is not a fix and flip situation… this is an investment activity, and is not reported on Schedule C nor does it pick up self-employment taxes.

Nothing really special here in terms of real estate investing. You buy, you fix and you turn it into a rental, either short-term or long-term. The improvements are going to be capitalized which is a fancy way of saying added to your fixed asset listing and depreciated over time. There might be a cost segregation benefit (see below), but generally that big kitchen renovation or basement finish will be depreciated over 27.5 years. There is an acronym called BAR; if the cash outlay makes the property better (new kitchen), adapts it to new use (basement finish) or restores it to the original condition (new roof) it is an improvement and not an expense, and as such is depreciated over time.

Vacation rentals add a lot of variety to your real estate investing activities. A lot of people rent out their ski condo or beach house to help offset some of the costs; that was the primary reason. Today, with the help of VRBO and AirBNB, people are not just offsetting some costs, they are running a business. Additionally, these activities are routinely mishandled on tax returns even by the most seasoned tax professional.

H&R Block has a wonderful 2-page PDF titled AirBNB Host Reporting Guide, and it contains all kinds of flowcharts and rules for how to report your vacation rental activities. There are two big determinations, and then some other minor ones.

Tax Return Schedule

The first is where to report the activity on your tax return.

Did you use the property personally? If Yes, and you rented it for 14 days or fewer, then it is non-taxable and not reported on your tax return (this is the Master’s Rule as they say with a loose connection to The Masters Tournament in Augusta). This is outlined in Section 280(A) of the Internal Revenue Code if you can’t get enough.

• If you did not use the property personally or if the rental time exceeds 14 days, then the rental activities will be reported on Schedule E unless you provide substantial services.
• If you provide substantial services such as cleaning the property while occupied (housekeeping), concierge services, guest tours and outings (think hunting lodge), and other hotel-like services, then your rental activities are reported on Schedule C and might be subjected to self-employment taxes.

Vacation Home Rules

The second is to determine if vacation home rules apply. The graph to the right helps highlight this test (thank H&R Block). If vacation home rules apply, your real estate investment expenses (tax deductions) will be limited.

There are a zillion little nuances and other things to consider for vacation rentals. One of the nuances is the definition of a personal use day; if you occupy your ski condo or beach house while installing new flooring, painting the interior or some other maintenance, that might not be considered personal use. It is always a bit of a chuckle when ski condo landlords seem to perform most of their maintenance the day after a nice snowfall hits the Colorado mountains. Yes, of course, it’s purely coincidental.

Short-Term Rental (STR) Loophole

If your rental property is considered a short-term rental where the average stay is 7 days or less, and you materially participate in the activity, then your activity will be considered non-passive. Why is this a big deal? Typical rental activities are considered passive; passive losses are limited and your rental losses might not be deductible. However, an STR that is considered non-passive generally does not have a limit on rental losses. This is especially helpful when a cost segregation study is used to accelerate depreciation.

This is an interesting real estate investing strategy, and it requires relatively low cash. It goes like this- you find a house or something similar in or next to a vacation hotspot, or a least something with a ton of activity. You enter into a 5-year lease with a sublet clause allowing you to sublease to others. Don’t be surprised if your landlord adds a premium to the rent; then again, you are also committing to a multi-year arrangement so it might cancel out.

Next, you spend $25,000 to $40,000 furnishing the property complete with dishes, artwork, linens, etc. There might be accelerated depreciation such as Section 179 or bonus depreciation available on some of these expenditures depending on your situation.

Next, you stage the place and hire a professional photographer for your VRBO or AirBNB listing. You collect short-term rent, you pay long-term rent, and pocket the difference. WCG has a client who clears over $400,000 with this type of arrangement. However, the walls are closing in in certain cities and counties. For example, Summit County in Colorado (which holds Breckenridge, Keystone and Copper ski resorts) is creating havoc with restrictive rules and whatnot making it onerous for the the do-it-yourself short-term rental investor (and not just the sublandlord situation). One of the things they are doing is contacting property owners with multiple properties, and assigning commercial property tax rates to all but one property, and saying, “hey, you are running a business and as such your property taxes just went up.” Lovely.

NNN or triple net leases is one of the next-level steps in your real estate investment activities. First, what are the three nets in triple net? 1. Property Taxes, 2. Insurance and 3. Maintenance. This means that in addition to the rent, the tenant is also responsible for reimbursing the landlord for these expenses. From a landlord’s perspective, NNN leases are wonderful since a lot of the risk associated with increasing costs and variability are shifted to the tenant. On the flip side, triple net leases are not eligible for the Section 199A qualified business income deduction (QBID) since it fails to rise to the level of a Section 162 business. This makes sense since the landlord is shifting direct expenses to the “customer” which is contrarian to normal business operations… in other words, Apple doesn’t send you a supplemental cell phone bill for your incremental portion of its insurance costs. Oh but there would be the Apple faithful who would be happy to pay it.

For the tenant, NNN leases blow. Property taxes and insurance are one thing, but the maintenance can get out of control quickly. Since the landlord is not incentivized to minimize expenses, they tend to overpay for services. Instead of finding a more economic and reasonable solution for the clogged toilet, they call the most responsive (ie, expensive) plumber at 4:00AM. Another way of saying this is that landlords find it easy to spend other people’s money. Heck, everyone does.

There are brokers who specialize in triple net commercial leases. Alan Fruitman of 1031tax.com is one of the more prolific people in this space. Here is a quick sample of some listings as of this writing-

Walgreens for $9,162,547
CVS for $8,689,714
Chase Bank for $4,687,786
Wells Fargo Bank for $5,089,548
Advance Auto for $1,537,141
AutoZone for $2,771,387
McDonald’s for $2,209,471
Starbuck’s for $1,464,074
Taco Bell for $1,449,336
Dollar General for $1,302,393

Check out CVS and Walgreens. That is scary stuff right there in our opinion; one of those have to give and with the pressures of online retailing, this could be a mess.

What is also interesting is that there are certain lenders who provide favorable financing for certain franchises like Starbuck’s. The lender is decreasing the risk of the loan based on the long-term tenant, and as such provides a better rate to you, the real estate investor.

If you dig into the life of Ray Kroc, founder of McDonald’s franchise, they made most of their money in real estate. On one hand, McDonald’s did not want to be in business with their franchisees and rather than supply product, they would help the franchisee source the product (potatoes, buns, meat, etc.) locally. Grinding It Out is an excellent and quick read by Ray Kroc.

However, when it came to the building itself, McDonald’s would buy the land, build the restaurant and then lease it back to the operator. So, they were certainly in business with the franchisee, just at a different level. Today, McDonald’s owns over $30 billion in real estate with annual profits in excess of $5 billion. As said in the movie, The Founder, “You don’t build an empire off a 1.4% cut of a 15 cent hamburger, you build it by owning the land on which that burger is cooked.” 1.4% franchise fees? Those were the days…

What are we getting at? Well, some franchises shy away from owning real estate. They would rather pair up the franchisee (the operator) with the landlord (the real estate investor). Check it out!

When you sell a property, you can invoke Section 1031 of the Internal Revenue Code to fully defer your capital gains tax including taxes associated with depreciation recapture, as long as you buy another similar property within 6 months. This is also called a like-kind exchange. Do this right, and you can daisy-chain transactions to avoid capital gains on real estate through your entire life, while enjoying the benefits of larger and larger incomes (the assumption is that you “1031” into larger investments with better cash flow, etc.).

How does leveraging work?

You buy a house for $250,000 which required a $50,000 down payment. You sell it for $350,000, take your $150,000, flip it into a down payment and buy a $750,000 8-unit apartment building. You sell that for $1,000,000 and use your $400,000 as the down stroke on a $2M commercial property. Lather. Rinse. Repeat. Eventually you too can have a tower on the north end of the Las Vegas strip.

To top it off, your heirs still get a full step up in basis under current tax law (although they are tinkering with it as of this writing).

Cost segregation, or “costseg” at the cocktail party, is a process of breaking down a real estate building into virtual piles of stuff, and assigning different asset classes to the piles. This allows you to accelerate depreciation on a portion of the overall structure. Without a cost segregation study, a commercial building is depreciated over 39 years as a whole. Done. With cost segregation, you will still have a large chunk of the purchase price being depreciated over 39 years, but you’ll have other chunks that depreciate quicker and even some chunks that are eligible for bonus (instant) depreciation. Yay!

Before you get all excited, there are some things to consider. First, the costseg report could easily cost you $5,000 (having said that, certain properties especially single-family homes can use a DIY service such as CostSegEZ for $500ish). So, you need a tax benefit combined with time-value of money benefit that makes sense. Second, the tax benefit might be restricted; generally, you need one of the following-

• net rental income that can be reduced by the accelerated depreciation, or
• qualify as a real estate professional (see below), or
• have a short-term rental activity where you materially participate.

There might be some other beneficial avenues, but those are the common ones. As such, a cost segregation study and eventual report is wonderful, but it only works in certain situations.

Why designate myself as a real estate professional? Ok- let’s presume that you have a rental loss. How does it affect your tax return? Rental income is typically considered passive, meaning that you are not directly earning the income as you would with a W-2 job. Passive losses may be deducted from non-passive income such as wages, but there are limits (of course there are!). Passive loss limits for married taxpayers max out at $25,000, and that number decreases as your gross income increases.

Specifically, passive loss reduces $1 for every $2 over $100,000 adjusted gross income and by $150,000 (for married couples) the passive loss deduction is $0. Bummer. Not all is lost however. If your rental losses are capped or disallowed because of passive loss limits, the portion exceeding the passive loss limit is carried forward, aggregated for each year and may be deducted in the year of disposal (sale). They may also offset future net rental income… you had losses, they were carried forward, you now have rental profits and the suspended losses can be used to offset.

There is another angle to all this- if you are a real estate professional as defined by the IRS and you materially participate in your rental activities, you can claim 100% of your losses and you are not capped by passive loss limits. But wait! There’s more. When the Net Investment Income Tax (NIIT) was introduced along with the Affordable Care Act, the real estate professional designation became an important tax planning tool all over again. Huh? The NIIT is charged on all portfolio (interest, dividends, capital gains) and passive activity income (rentals). However, if you are a real estate professional your rental income is no longer deemed strictly passive and as such is not being taxed by the net investment income tax of 3.8%. That could be huge!

So, how do you become a real estate professional? It is not enough to simply own rentals or have a real estate license. There is a two part test… hours spent and material participation. Click on the button below to read our real estate professional article.

WCG recommends a limited liability company (LLC) for each rental, and then a holding company that owns all the LLCs. The LLC at each “subsidiary” or rental property allows for banking and titling segregation, plus some very limited protection between assets (read our LLC liability protection fallacy section from our LLC and S Corp book).

The holding company LLC then owns all the subsidiary LLCs, and you own the holding company. If you rush out and add your spouse to your LLC, and you live in a common law state (opposite of community property state such as WA, ID, CA, NV, AZ, NM, TX, LA and WI), you are suddenly a partnership according to IRS regulations, and you now need to file a separate tax return on Form 1065. Check out our business entity tax preparation page for more information on how this works.

With the holding company LLC owning a gaggle of other LLCs, your estate planning might also become a bit more efficient since the operating agreement of the holding company can dictate transfer of ownership and other things. Even if you and another partner want to go in on a side project, your interest in the partnership can be owned by your holding company.

One massive downside to this arrangement is possible business taxes and filing fees. In California, for example, each LLC is charged a minimum of $800 franchise tax (as of the 2021 tax year). Therefore, having four rentals plus a holding company could cost $4,000 just in franchise taxes. As such, LLC segregation must be met with cost efficiency for an optimal plan.

Lot’s to talk about here, and we are happy to help.

Should you put real estate investment properties into an S Corp? No. The primary if not the only objective of an S corporation is to reduce the amount of Social Security and Medicare taxes on earned income. With the exception of fix and flips, and some vacation rental situations where you provide substantial services, your real estate investment income is not considered earned income, and is naturally shielded from Social Security and Medicare taxes. There is also an issue with S Corp election revocation where the assets have appreciated in value, but we’ll save that for a rainy day. Just don’t do it.

Did you want to chat about your real estate investor opportunities? Unclear about how to structure things? Let’s discuss your objectives and formulate a plan together.

WCG CPAs & Advisors is a full service consultation and tax preparation firm, and we look forward to working with you!