Brandon Hall, Founder and CEO at The Real Estate CPA, joined us on the podcast to discuss tax strategies that real estate investors can use.
Brandon is the Founder/CEO of The Real Estate CPA. Brandon works with real estate investors, syndicates, and private equity funds to optimize tax positions and streamline accounting and business functions.
He believes that real estate investing is critical to building sustainable and generational wealth.
Brandon worked at PricewaterhouseCoopers and Ernst & Young prior to launching his own CPA firm, Hall CPA PLLC (The Real Estate CPA). Through the knowledge gain by working with real estate investors, Brandon invests in multi-family properties personally and through his capital group, Naked Capital.
Brandon is a Certified Public Accountant and national speaker. Brandon holds degrees in both Accounting and Finance from East Carolina University.
Learn more about The Real Estate CPA and check out their Virtual Workshops for real estate investors.
Connect with Brandon on LinkedIn.
Tyler Stewart - All opinions expressed by Adam, Tyler, and podcast guests are solely their own opinions, and do not reflect the opinion of RealCrowd. This podcast is for informational purposes only, and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing, please consult your advisors. Hey listeners, Tyler here. Before we start today's episode, I wanted to quickly remind you to head to www.realcrowduniversity.com to enroll into our free, six week course on the fundamentals behind commercial real estate investing. That's www.realcrowduniversity.com. Thanks.
Adam Hooper - Hey listeners, Adam here. Since tax season is upon us, we thought we'd do a quick episode with Brandon Hall of www.therealestatecpa.com. They were gracious enough to have me on their podcast, so check a link in the show notes for that. And this will hopefully answer a lot of the questions that we've been receiving from our users and listeners about taxing, so we talked about K1s. We talked about opportunity zones. We talked about some cost segregation analyses. A lot of really good tax information, as we prepare for that April 15 deadline, so as always we appreciate your reviews, feedback. If you have any comments, please send us a note to email@example.com, and with that let's get to it.
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Adam Hooper - Brandon, well thank you for joining us today. We're excited to jump onto some tax related issues. Hope all is well back east. You're in the Carolinas, right?
Brandon Hall - Yeah, it's getting a little colder. Not a lot of fun for me. I like warmer weather, but other than that, yeah. We're good.
Adam Hooper - Good. Well why don't we start and give us a little bit of the background on kind of how you got to where you are. I know you were at some bigger firms before you split off to do the Real Estate CPA, and tell us a little bit about your background.
Brandon Hall - Yeah, yeah, so I started at PricewaterhouseCoopers, and did a stint there for a little over a year. I was in their advisory practice, and then moved over to Ernst and Young after that, and pretty much during that time frame I was at the big four for maybe three years total before I broke off on my own, and started my firm, but the idea kind of generated during my time at PwC and Ernst and Young. I kind of recognized really early on that corporate life wasn't really for me, so I started looking for a way out pretty soon into my corporate career. I found rental real estate to be one of those potential ways out, and then also found that as a CPA I could service a lot of the people that had rental real estate, so was kind of able to mesh the two together and build a business off of it.
Adam Hooper - And so what was it that drew you to real estate as an asset class? Was it anything in your experience at PwC or Ernst and Young, or just something you were just attracted to generally and started to explore?
Brandon Hall - I think it was the cash flow at the end of the day, like I would sit in my cube at PwC and trade stocks, and I think I was trading volatility funds at the time, and while it's fun, you have to get in and out, and it's a lot of stress, and I don't know. I bought my first three unit property toward the end of my PwC stint, and it started cash flowing about 700 bucks a month, and I was like, all right, this is the way to do it. The problem was is that 700 bucks a month, while great, if I continue investing in real estate, it's going to take me a decade to get out of my corporate job. I was like, that's way to long for me, so then I started looking for other ways out, which is where the idea for the business came along.
Adam Hooper - Good. Well, and tell us a little bit about what you do now, since you left corporate and went out on your own. Tell us a little bit about what you do at Real Estate CPA.
Brandon Hall - Yeah, so it all kind of started accidentally. I invested in that first property. I was an active participant on a forum called www.biggerpockets.com. Kind of became their tax person. People started tagging me in posts. I would just try to answer the questions to the best of my ability, and that snowballed into actually landing clients, and building a small tax practice, and that was cool because I could see all the real estate investors, and if real estate actually makes sense for wealth building, and pro tip, it does. So kind of just doubled down and decided, you know what? I'm going to niche in real estate. I'm going to create a virtual CPA firm, 'cause I hate coming into the office. I don't understand why you have to wear a suit and tie every day. I don't even see the clients, so what's the deal? So I was like all right, virtual CPA firm. Going to niche in real estate, 'cause real estate's awesome, a big, awesome wealth building tool. There's a ton of tax benefits with real estate, so I'll probably always have a job, or I'll always have a business that somebody needs me. I mean that's kind of how it all started, and now we have about 320 clients across the United States.
Adam Hooper - Nice.
Brandon Hall - Our smallest client has one rental property. Our biggest client's a over 100 million dollar real estate fund.
Adam Hooper - Good, so you run the gamut from, again, starting with your personal investing, all the way up to professional investors and mangers, so you've seen it from all sides.
Brandon Hall - Yeah, yeah, absolutely. We have a team of 12 people made up of CPAs, EAs, just generally smart people. About half of them also invest in real estate, which is really cool, so we definitely have a neat edge that we bring to the table when we work with clients.
Adam Hooper - And now as an investor getting involved in the real estate space, they probably have maybe our investors do their taxes on their own, and maybe they have a tax consultant, but what is the biggest benefit from working with a CPA when you're looking at investing in real estate, either wholly owned properties or investing in syndications?
Brandon Hall - Yeah, we often get clients that come in and they're like, I just don't know what I don't know. I don't know what questions to ask, and what that's going to lead to is not structuring your investments correctly, and it could be simple things like throwing the property into an LLC versus a corporation versus your personal name. How do you understand which route to take there? But from not only a tax perspective, but also a liability perspective, so it's like little things like that that end up adding a lot of value. We've had people come in, they go to an attorney and they get all these crazy entity plans drawn up and we come in and we're like, whoa, that's going to cost you an arm and a leg every single year. Why don't you just do something like this? So we also save money that's really not even related to taxes. It's just the experience that we have of helping build real estate businesses, helping people place investments in syndications or buy their own rental properties. A lot on the structuring side, and then a lot of it is too is on the tax strategy side, there's all sorts of strategies that you can use. You can go all the way down to simply use a home office, right? Set your home office up, make it business purpose, and you're good. All the way up to big land conservation easements, and so our job kind of comes in, we come in and we analyze the situation, and we look for the hardest hitting things that we can do, and then there's always the timing aspect of it, so anybody can tell you to go be a real estate professional,
Brandon Hall - but is it going to be relevant to you at all? So why waste time explaining something to somebody and having them get their head around a relatively complex topic if they can't even use it now or even in the near future? So that's really where we come in on the tax strategy side.
Adam Hooper - And then on timing, you said the example you mentioned where maybe someone has met with attorneys and they've got a strategy that's blessed by legal but maybe not thought through from a tax perspective, when is the best time to engage with a CPA, whether you're looking again either at crowd funding or platforms like ours or out buying assets individually?
Brandon Hall - Yeah, so it really depends on a couple things. One, it depends on the deal size, and two, it depends on your analytical ability, so we've had some people come through that have a portfolio of 10, 20 units, or 10, 20 properties, and they're super analytical. We take a look at their tax returns and we're like, honestly, you're already doing everything that we would recommend, so don't pay us. You're fine. And then we have other people that have one property, and they're just totally overwhelmed. So it depends on your analytical ability first, but in general if we're talking to like the syndicators. We work with a lot of these general partners in the big syndications, we do not want them to sign mortgage documents without us taking a look, so we want to be involved in the due diligence of the property from a very early stage.
Adam Hooper - And then in that case you're working, again, like you said, with the general partner, the manager of whatever the asset is. Do you guys do much work with individual passive LP investors in these deals, or is your practice primarily focused on the actual manager side of the equation?
Brandon Hall - Both, both, so by working with managers, we typically get a lot of the LPs as well, and something that makes our practice a little bit unique is that all of our accredited investors that are clients are always looking for deals to invest in, so we can actually make those connections and it becomes this big Petri dish of activity, which is a lot of fun. Yeah, so when working with the accredited investors, it's a little bit different, because you have to, one you're looking at the actual person's tax and financial position, not necessarily the company's, so we'll help with personal tax strategies, and especially if we're getting to the higher net worth folks, we've got a lot of really hard hitting strategies that can eliminate taxation, but one of the key things that we do with our accredited investors who are investing into these syndications is we help them understand what questions to ask. So we will tell, we'll give a list of questions and we'll go over it with these guys on the phone and like, okay, ask this general partner in the syndication about how they're going to handle the business interest limitations, and if that general partner turns back to you and says, what are business interest limitations? Then it's not necessarily, we don't expect the general partners to know what that is off the bat, but we do expect them to be able to say, I have an awesome team in place, which includes a CPA, so let me get you connected there, but if they can't say that, then that's an issue. Then they might not have an awesome team in place, so we kind of work with our accredited investors
Brandon Hall - from that aspect of helping them do due diligence on the sponsors of the deals.
Adam Hooper - Yeah, and I guess to kind of expand on that, general partner's going to set the overall tax strategy at the asset level, right? So what is the ability for an accredited investor or a limited partner investing in these deals, what is their responsibility from a tax perspective? They obviously can't drive the overall structure at the asset level, but how much can they control their own cash flow that comes down into their accounts?
Brandon Hall - Yeah, so it's really important to understand capitalization policies. So if I'm a sponsor, if I'm a general partner, I can set my capitalization policy to be whatever I want, and a capitalization policy means that if there's an expense that comes in, if it's over whatever threshold I set, then I automatically book it to the balance sheet, instead of writing it off as a current year expense, and what that does is it inflates profits, right? So it could theoretically make the deal look a little bit better, but at the same time it doesn't necessarily affect the cash flow, so that's something to understand. Most syndicators will use a $2,500 capitalization policy, or if they have more strenuous financial reporting, they'll use a $5,000 capitalization policy, so that's one thing to understand. The other thing to understand is just what is the actual strategy with the deal? Are we doing a value add deal? Is it not a value add deal? Are we just investing for cash flow, or are we investing on the debt side? Am I investing in a debt syndicate? Am I earning interest income? If I'm investing in value add opportunities, and that capitalization policy is $5,000 bucks, then I can expect a lot of write offs in that first year, as we're rehabbing the property, because most of that rehab or the individual items will be less than that $5,000, which obviously helps pass through bigger losses to me, but to really kind of make a good point here about just kind of circling back to the timing thing that I was talking about, that's really where I think the accredited investors
Brandon Hall - have the biggest responsibility is understanding the timing of the various deals that they're invested in. Let's say that you've invested in a deal five years ago and it was a five to seven year hold, and this year it's liquidating, and let's say that it liquidates in November 2018. Your responsibility there would be to understand what that capital gain looks like and if you can invest in another deal before the end of the year that might be doing some sort of cost segregation study, or something that's going to give you a big first year write off for investing in that deal. That cost seg study will produce a passive loss on the new deal that could offset the gain on the deal that just liquidated, so it's a lot of the timing stuff. It's making sure that you're asking questions related to timing. So I don't want to go into any syndication without understanding if they're doing a cost segregation study, and if they understand business interest limitations, 'cause that's going to tell me a whole lot about how much they've thought through their tax strategy.
Adam Hooper - Okay, let's do a little bit of a detour here for listeners that might not have heard about a cost segregation study. Can you just kind of overview on that real quick?
Brandon Hall - Yeah, so a cost segregation study is the practice of identifying components of the property and assigning a different useful life to that component, so every property has a roof, and a roof is a 27 and a half year property. Without a cost segregation study, though, we're just going to book the entire building as whatever the purchase price is. Let's call it a million bucks. With a cost seg study, we're going to go through and we're going to say, well, the roof is $20,000. We're going to assign a value to the roof, but we're also going to do that for all of the components. We're going to do it for the carpeting. We're going to do it for the appliances, the windows, the countertops, the bathrooms, everything is going to have a value, and what happens with cost seg studies is you can generally allocate anywhere between 20 to 30% of the value of the purchase price of a multi family property, you can allocate 20 to 30% to components with a useful life of less than 20 years, so we're talking about five, seven, and 15 year property. Five year property, seven year property, generally personal property, so like the appliances, things that you can easily move around. 15 year property is a land improvement, so I don't know, you get a driveway installed or a parking pad installed. That's all land improvement. You cut down trees. You plant new trees. All land improvements. A cost seg study is going to identify those five, seven, 15 year components. It's also going to identify all of the 27 and a half year components, but the key now with 2018 tax law changes
Brandon Hall - is that if you do a cost segregation study in the first year that you own the asset, before you file that first tax return, then you could take 100% bonus depreciation on any component with a useful life of less than 20 years. So I just said that a cost seg study will generally break out anywhere between 20 to 30% of the purchase price or the basis, will be able to allocate that to components with a useful life of less than 20 years, so if I buy a million dollar property, I might get a $300,000 allocation to these components with a useful life of less than 20 years, and then with bonus depreciation, I can immediately write off that 300K and pass that back to my investors.
Adam Hooper - That's huge.
Brandon Hall - Oh it's massive, yeah, yeah. So think about it, right? You go and you buy, you put 50K in some deal, and it's liquidating this year. You're getting 100K total return, 50K principal plus a 50K cap gain, and you're like okay, well what do I do for this $50,000 capital gain? And there's some other things that we can talk about too, but one thing that you can definitely do is you can say can I invest 50,000 bucks in a new syndication if that syndication is going to do a cost seg study? And the answer is yes, but we want to make sure that we ask about the cost seg study and what the expected results are. These guys already have it all planned out. Like there should be no surprises, so I invest $50,000, in a new property doing a cost seg study, I could probably get a $50,000 write off, or a $75,000 write off, the first year, which could eliminate my gain from my other paths of investment.
Adam Hooper - And so where does that depreciation flow down to in the investor's mindset, right? If I'm an investor in this case and I've put that 50K in, and I get a $75,000 allocation for this deduction, what does that allow me to do?
Brandon Hall - Yeah, so that would, it depends on your allocated profit and loss, so if you, I don't know, let's just say that the net profits were 10,000 bucks. They do the cost seg study, and they're able to allocate 75K to you, so you would have a $65,000 loss, and it's just a passive loss that passes all the way through and offsets passive income or capital gain from rental real estate sales.
Adam Hooper - So that's, I mean again, if you're in a situation where you have other income, you have other capital gains, this could be huge in reducing that tax burden for your other business activities, your other income, the other gains that you're seeing as well.
Brandon Hall - Absolutely, and again it's all about timing, right? So that's a same year type of thing, like okay, we have this big liquidation. We want to make sure that we can offset it, so let's aim for syndications that are doing cost seg studies, but there's also another aspect too. Let's say that you're investing in your very first syndication ever, and they're going to do a cost seg study. Let's say that you earn over 150K. The passive losses coming back to you, they're going to be big in that first year, 'cause that's the point of a cost seg study, with the 100% bonus depreciation and everything, but because you earned over 150K, you can't take the passive losses, so instead they become suspended. That's not necessarily bad. You can basically protect yourself from future passive income by taking a current year big passive loss that becomes suspended, so there's a future aspect to it as well, like if you invest today.
Adam Hooper - Like you said, it kind of carries forward for future passive income.
Brandon Hall - Absolutely, yep.
Adam Hooper - Yeah, and who's job is it to make sure this all happens appropriately? Is it solely on the manager? Is it, as an LP, do they have any say in this, or control over how these either cost segregation or how this tax treatment is actually handled?
Brandon Hall - Yeah, so technically there is a tax matters partner in every partnership, and that will generally be one of the general partners or the one that's calling all the shots. The LP is technically legally have no say, and that'll all be in your subscription documents. It'll tell you that you have no say, but the way that we've seen it are there will be LPs that will bring it up and the general partners will be like, oh, I don't know what a cost seg study is, and they go talk to their CPA and they get one done, so just because you know that a cost seg study exists, or you know that these things exist, and you have no say doesn't mean that you shouldn't actually bring it up. We've been really surprised at how many of these sponsors don't really know these tax strategies exist.
Adam Hooper - And maybe, 'cause we do have a number of real estate managers that listen to the show, why wouldn't somebody do that?
Brandon Hall - A lot of people will say, so a lot of the limited partners could give you push back and say well I can't use my losses. They're going to become suspended, right? So just the example we were just talking about. To that degree, we just tell 'em hey, you tell your investors that it's not that bad. You build up your suspended passive losses, and then at some point you'll be able to utilize them in the future. Another one would be well I have to recapture the depreciation at some point, which is true. You do have to recapture the depreciation, but the idea is that the current year write offs, if you reinvest those tax savings, that you're receiving, you're going to far outweigh the depreciation recapture in the future, so those are two things that we commonly hear as push back, but other than that, I mean there's really no reason to not do this.
Adam Hooper - Yep, and are there specialized firms that do the cost segregation, or is that something that you guys do, or other CPAs do? Who does the actual cost seg analysis?
Brandon Hall - Yeah, so we do not do cost seg analysis. We kind of do the back end work, so we'll take the actual analysis, and then make sure that it's reported correctly to the IRS. There are specialized firms that do this, and we just kind of, I almost said partner. We don't partner with anybody officially, but we have our vendors that we refer clients to, so yeah, we have a couple cost seg firms. You have to be really careful with cost segregation. There's no compliance requirement. There's no licensing requirement, so theoretically your neighbor who, I don't know, has had a job at Walmart for 50 years could turn around and become a cost seg professional overnight.
Adam Hooper - So that's, again, as investors are out there picking managers, make sure you pick your cost segregation firm appropriately as well.
Brandon Hall - Right.
Adam Hooper - Yep, so I think one of the interesting parts that you mentioned there, this is a tax strategy to potentially mitigate some capital gains treatment on other income or other assets. We would be remiss if we didn't touch on opportunity zones. We're about a week and a half I guess from when we got the first tranche of proposed regulations from Treasury. How did you feel about that release as it relates to investors looking at participating in opportunity funds?
Brandon Hall - Yeah, it was relatively clarifying. Still waiting on some further technical details, but for the most part relatively clarifying. Opportunity funds are easily one of the best tax vehicles that I'm aware of. I'm a young guy, so I didn't want to say, since I've been in practice because it's only been like five years, but that I'm aware of in all the previous tax laws, yeah, I don't know of one better than what we are currently facing with opportunity funds.
Adam Hooper - Yeah, I mean you look at each of the components, and on their own, they would be pretty impactful, but then you get this combination of, and we talked about it on another show, but maybe we can just kind of rehash really quickly, you get the 10 or 15% step up in basis, on what those capital gains actually are. You get the deferral to the end of 2026, and then if you hold that investment for more than 10 years, you get basically an exclusion on tax for when you sell that asset, right? Each one of those.
Brandon Hall - Yes.
Adam Hooper - Independent of another would be a pretty big impact, but combining all those together is just, it's almost hard to believe that they're not going to change it, right? I mean, I think we were, we were kind of waiting to see in this first round of proposals, are they going to throttle any of this back, but it doesn't seem like there's any plans to, right?
Brandon Hall - Yeah, no, it seems like we're locked in, and we're good. The 10 year hold that's additional appreciation, so additional gains, but the one thing, the one kind of key thing that I like to point out to people is that the investment horizon for this is really by the end of 2019. If you can't invest by the end of 2019, then it's probably not that great of a deal for you anymore. There's two reasons for it. In 2026, everybody across the United States, you have to recognize your gain that you've deferred. You only have to recognize 85% of it, but you have to recognize it, so if you invest in 2020, by the time 2026 rolls around, you only have six years. You don't have the full seven to get that 15% step up. Then additionally, in 2019, that's when the 10 year thing kicks in, so one of the big questions that we still have going forward is, did I say 2019 or 2029? I meant to say 2029.
Adam Hooper - 2029, yeah.
Brandon Hall - Yeah, so 10 years after 2019, that's when you have to sell per the code. One of the big questions, 'cause the opportunity funds are, the definition expires in 2029, so then the question is, if I still hold my opportunity fund investment, and I've got it in 2030, there's no longer a definition surrounding any of this, so do I even have a qualified investment at that point? If I hold for 11 years, do I lose all my tax benefits? That's one of the kind of things that we're looking out for as well.
Adam Hooper - Mm-hmm, and there was guidance in there, or I guess maybe it was a recommendation for further guidance on extending that 10 year horizon out to 2047, right? So providing a window for when you can basically elect to step up that basis without necessarily forcing a sale.
Brandon Hall - Yes, yeah.
Adam Hooper - We're kind of getting into the weeds here, but maybe that's something, once we get another round of clarifications by Treasury, hopefully by end of year, that'll be a little bit more clear, do we think?
Brandon Hall - Yeah, yeah. I think that it's going to come, I don't know that by the end of the year, but hopefully, right? But yeah, there's a lot of questions. That one is obviously one that would be great, because the way that it's written right now, it sunsets in 2029, and that doesn't do anybody any good. I imagine that, I don't know if they're going to go all the way to 2047. I do imagine that they will extend that window. That way you can hold that investment. You don't have to liquidate in 2029. It wouldn't make any sense for what they're trying to do. They're trying to bring capital into distressed areas, so if you force a sale in 10 years, is the capital just all the sudden exiting all of those distressed areas? So I think that we'll be safe there, but yeah, that is one thing we're waiting on guidance for.
Adam Hooper - So are there any other kind of main points that you guys specifically are waiting for further guidance on anything that wasn't necessarily clarified in this first pass?
Brandon Hall - So yeah, it's been interesting, and there have been a few CPA firms, relatively reputable, that have said that the depreciation recapture, a section 1250 recapture, is included in the term capital gains, but it hasn't explicitly been included in the term, in Section 1231 capital gains, a different section, so it hasn't been explicitly included. It hasn't been explicitly excluded, so that's one thing that we're waiting on, 'cause obviously if you own rental real estate, and you want to roll your gains in, the question is well, I have two types of gains when I sell. I have my capital gain, and I have my depreciation recapture, my Section 1250 recapture. What qualifies for rolling over into the opportunity fund? So that's something that we're waiting on further guidance for, and then we're kind of looking to state levels too, so a lot of states, they either adhere to the IRS code, or they don't, or they adopt new code called decoupling, so they decouple from whatever the IRS regulations are specifically related to certain aspects of the code, so we're kind of waiting for the states to work all of their stuff out. Most states have, but there are still a few out there that are straggling, so.
Adam Hooper - And one of the things that we've been trying to figure out and formulate an idea around is who will be investing in these, right? I mean there's a lot of people that are announcing 200 million dollar fund, half a billion dollar fund, which is great. You can do that, but if you're not actually raising the capital , then these aren't going to go anywhere, so we've been spending some time and I'm curious to get your thoughts around what is the ideal profile of an investor to put capital to work in an opportunity fund, right? You've got this extended time horizon. You've got this capital gain income requirement. Do you think it's going to skew more towards institutional LPs, when they get their partnership income from their LP investing activity, is it going to be sale of private businesses? Is it stock market gains? Do you have any ideas around kind of what the ideal persona of that capital investing in an opportunity fund is?
Brandon Hall - Yeah, so the ideal person is going to be somebody that does not mind the 10 year hold, and that's the key. There's a lot of people out there that do not want to invest in a deal for 10 years, or even a fund for 10 years, so that's the first one. But it's also going to be somebody that has large built in capital gains, and they're looking to reallocate, so there's six trillion dollars of capital gains that are sitting out there untapped right now, a lot of that in the markets, in the equity markets, so I think that we're going to see a lot of people liquidate equities and move, just rediversify, move that money into opportunity funds, now that they can, and they can defer that capital gain. For us, when we have clients that are looking at this type of stuff, we're looking for what do you really need in terms of liquidation? Like why are you liquidating, and what are you trying to gain? So come people want their basis back, or they want some money at sale, so a 1031 exchange might be off the table at that point, because you have to reinvest all of your proceeds, whereas with the opportunity fund, you get to take your basis back, and just roll over the gains, or even a portion of the gains. Another one that we're taking a hard look at are all of our accredited investors that are LPs in these deals, a lot of people don't realize that my limited partner stake in a syndication counts as property that can be rolled, where the gain can be rolled into an opportunity fund, so I'm kind of making them aware of that too.
Brandon Hall - That one's a little trickier, though, because then you have the question of well, again it goes back to timing, and then you also have the question of could I potentially sell my stake in the syndication back to the fund? Can I redeem my stake or can the fund redeem me out of the fund, and can I roll that in? So just a lot of questions there, but yeah, the typical person, you have to be comfortable with that 10 year hold, and that automatically weeds a lot of people out.
Adam Hooper - Yeah, I think that's a good segue into, a lot of the activity that we see on our platform and in our space generally is investing into LLCs, right? It's investing into a partnership. You're not necessarily owning the asset outright, so 1031s, by an large, are off the table, unless that whole ownership group, that whole entity itself, is doing the 1031 exchange.
Brandon Hall - Right.
Adam Hooper - So we think this could be an interesting opportunity for a lot of people in the crowd funding space, or syndicated space, when you're seeing exits on these deals are going full cycle. We're almost six years into this, so we've had I think almost 30 deals go full cycle now, so when investors get that check back and they can't necessarily 1031 exchange that, the ability to have an avenue where they can maybe defer some of those gains and take advantage, if it's the right profile, I think can be an interesting opportunity.
Brandon Hall - Yeah, absolutely.
Adam Hooper - So switching gears then to talking about investing in a syndicated deal, whether it's an LLC or a limited partnership, let's maybe kind of go really basic in terms of how those different cash flows are treated, how this depreciation is necessarily treated, how proceeds from a capital event are treated, and maybe kind of just walk through the major buckets of cash flow that's going to be coming back to an investor. How is that treated from a tax perspective?
Brandon Hall - Yeah, so there's tons of confusion and misguidance around these various streams of cash flow, so the first question we always get, are distributions taxable to the investor? And the answer is generally no. So if you invest in my deal, you give me 50,000 bucks, I can generally give you up to 50,000 bucks back without you having to pay tax on it at all. A lot of people call that return of capital. I just like to refer to it as a distribution from the fund, so it's just one of my quarterly distributions. It's not taxable, unless the distribution, so the total of distributions exceed your basis in the deal.
Adam Hooper - Does it matter whether that's coming from cash flow from rental income or from a refinance, just cash coming out, as long as it doesn't exceed my initial investment in that generally is non taxable?
Brandon Hall - Correct, yeah. And it gets a little tricky too when you are allocated debts, right? So let's say that we're in a smaller partnership, not one of these big syndicates, 'cause they won't allocate any of the LP's debt, obviously, but if you're in these smaller partnerships, like if you and I partner together and we take a one million dollar loan, we each put up 50K, you would think that your basis is 50K, but it's actually 50K plus your share of the debts, so now you can take out a lot more money tax free, without having to worry about tax, 'cause your basis has drastically increased due to that debt allocation, but that's a different story. So the way that these syndications, or if you invest in a fund, or these syndicates, the way that these things are taxed, or the way that taxes are passed through to you, the way that it works is you're going to receive a K1 at the end of the year, and that K1 is going to tell you your allocation of the deal's performance, so the deal might show net taxable income of $2,000 bucks. That's after depreciation, after amortization, interest taxes, all of the expenses. $2,000 bucks income. That means that you have to pay tax on that $2,000 allocated income, so you have to report that $2,000 of allocated income. You pay tax on it. The fund could distribute you zero money, right? You could have zero distributions, but you still have to pay tax on that $2,000. On the flip side, the fund could distribute you $50,000. They could give you your basis back. $50,000 bucks, but you don't have to pay tax on the 50K.
Brandon Hall - You only have to pay tax on that $2,000, so it's a tough concept for a lot of people to kind of, like a lot of people think if I receive cash, I owe taxes on it, but that's not how it works when you've invested money in a deal. You can receive up to your basis back without having to worry about taxes, and then it's just that allocation of the actual deal's performance. So normally when we invest in these real estate deals, that allocation is negative, due to depreciation and amortization, especially due to the cost segregation study with bonus depreciation, that allocation coming back to you is going to be negative, and it's just going to be a passive loss that you can either utilize in the current year or it becomes suspended. So you're not paying any tax on that negative allocated taxable income, but even with that negative allocation, you could still be receiving distributions and not pay tax on those distributions, as long as they haven't exceeded your basis in the deal. So that's always a complicated one to talk about with the accredited investors.
Adam Hooper - And I think it's good to take a quick pause here, that, at the beginning of the episode we always have the disclaimer that this is not investment or tax advice. Always consult your appropriate tax and legal counsel. Brandon is not your attorney, nor are we, so we are just speaking here for informational purposes only. I think that's a good disclaimer to have in here.
Brandon Hall - Yeah, absolutely.
Tyler Stewart - Hey Brandon, could you break down a K1 for our listeners? Just kind of what are the components? What kind of information will they find in a K1?
Brandon Hall - Sure, so on your K1, you're going to have basis information, so you should see your share, or your contributions to the syndication in the first year. You should also see increases or decreases in your basis. Increases are going to be profits, or if I've refinanced and I've allocated debt to you, that'll increase your basis. Decreases are going to be losses or distributions. The biggest thing about K1s, the biggest thing for accredited investors is to make sure that you're tracking your basis, year in, year out. We actually had a partnership close down. We were representing one of the limited partners, and we realized that he had not received about $100,000 bucks because his prior CPAs were not tracking his basis correctly, and so we went back through and did a big basis analysis, and then realized hey, if you didn't receive this 100K, then that's what they owe you, so it's really important to track your basis on an ongoing basis, no pun intended, to make sure that that what you are receiving is actually happening, or it's actually reflected in your basis. The other things on the K1, it's really just going to be, did we have rental income or losses? Ordinary income or losses if I'm investing in a development deal or a flipping syndicate? And that'll be ordinary income. That'll all be reported on there, and then another key factor is if you're investing with like a self directed IRA, or a solo 401K, even, then they'll have a UBIT, I call it a disclaimer. It's not really a disclaimer, but it's just money on the K1
Brandon Hall - that's coded for UBIT, so you would then need to look at that and decide do I have a UBIT tax liability or not?
Adam Hooper - And one of the things you mentioned before was depreciation recapture. Obviously that's a very big issue in the real estate space, especially when you talk about 1031s. Can you simplify that for listeners, how that works, what it is?
Brandon Hall - Yeah, sure, so depreciation is the ongoing deduction, so every year I get to write off some of my asset, and it's supposed to track the deterioration of the asset over time, so I pay for the asset up front, and then every single year I get to write off some small amount of that total asset. The problem is is that whenever I sell the asset at a later point, I basically have to recapture all of that depreciation that I've previously written off. So what I tell my clients to think about is it's basically like a loan from the IRS. I get to write it off today, and I get tax savings today, but at some point you're going to ask for that money back, or a portion of that money back, if you do it correctly. So you do have to recapture any depreciation you've written off, so if I write off $10,000 this year on one of my three unit properties, if I write off $10,000 in depreciation, next year I want to sell it, I have to recapture that $10,000 in depreciation and in my tax rate, I'll be paying 25% on that 10,000 bucks specifically, so depreciation recapture is considered gain on sale, like whenever you liquidate it's considered gain and it's taxed at a maximum rate of 25%, so if you're in a higher tax rate, and you're able to claim depreciation, like if I'm in the 37% tax rate, and I'm claiming depreciation, then that's good, 'cause I'm going to recapture it at 25%. If I'm in a 15% tax bracket, and I don't think that exists anymore. I'm in the 12% tax bracket, and I'm claiming depreciation. Not so good, or potentially not so good depending on how my tax position
Brandon Hall - works out whenever I liquidate.
Adam Hooper - And that again, that's going to be dictated by what happens at the actual asset level, so as an LP investor, in a syndicated deal, you're just dealing with however that comes down allocated to you.
Brandon Hall - Yes, yeah, most of these syndications will have Class A and Class B shares of their LLC or stakes I guess of their LLCs. The Class A will be for all the limited partners, and they will generally be allocated 100% of the income or losses, and then the Class B shares will be the general partners, and it'll be like a 30% capital stake, but 0% profit and loss stake, so really what happens is if I have 10% of the LP stake then I really am going to get 10% of the deal's performance, because I'm getting the LPs that are allocated 100% of that profit and loss, so I'm going to get 10% of everything, of the revenue, the expenses, the depreciation, but it is something that you want to kind of keep an eye on, because when you do liquidate, or when the fund liquidates later on down the line, it's often a surprise that people were not expecting.
Adam Hooper - And so one of the other questions that we get a lot when people are investing, again on a platform like ours, or elsewhere, if they're investing in multiple states do they have reporting requirements in each state? How does that work? Is it where the income's generated? Is it where the property is? Is it where I live? How does that work if you're investing across state lines?
Brandon Hall - Yeah, so to understand state requirements, you have to look at two things. First you have to look at the state's actual, like a lot of states have income filing requirements, so if you're AGI's above X, or if your gross revenue is Y, then you have to file. You also have to look at what the state deems as doing business in that state. So California for instance is a really bad state to invest in passively, because it doesn't matter. They're probably going to say that you're doing business in the state regardless of how much money you earn or lose, and you have to file with the state. So you have to look at income thresholds and whether or not we're doing business in the state. Now that said, it really does kind of depend on exactly what dollar amount we're talking about. Like if you came to me with a K1, and you had 50 bucks of interest income or a $100 passive loss, we might not file that state K1, or we might not file that state tax return. In general, though, we do like to file as many of the state tax returns as possible. You have that $100 loss. As long as our costs to file that state tax return don't necessarily exceed the potential tax benefits at a later point, we'll file that state tax return, and the reason for that is even if we have losses, so a lot of CPAs will not file state tax returns if their K1 shows losses, and I think that that's a really bad move, because if you have losses and you're filing those state tax returns, the states are recording those losses, so whenever you liquidate that property, the state already has a record.
Brandon Hall - Now some states do look to the IRS for this, so in those states, not a big deal, but some states don't, and so it's still important to make sure that you're filing, even if you have those losses, so our general approach is file all K1s in all states unless it's just so minor that it doesn't matter.
Adam Hooper - So that benchmark again, as long as the loss is greater that what it cost to file in that state, you're probably better off to go ahead and file in that state?
Brandon Hall - Right, right, so if we charge, I don't know, $150 bucks to file a state tax return, and you have $1,000 passive loss, no, that's probably not going to work out . If you have a $10,000 passive loss, we would want to file that passive loss, because we're charging $150 bucks. You might save, I don't know, $500 bucks at some later point, as a result, so we would want to get that thing filed. If you came to us with $100 passive loss, we would probably say, ah well, we'll track it, but we're not going to file it, and whenever we do liquidate, we can have that argument with the state at a later point.
Adam Hooper - And so that's something again if I'm investing in multiple deals across the states, is that something that I'm going to be working out with my personal accountant? Is that something that the sponsor is going to be doing? The manager at the asset level? Or that's a decision that as an investor you would make based off of your tax circumstance with your advisor as to whether or not you're going to file in these individual states?
Brandon Hall - Yeah, yeah, so most of the investors are going to have to figure that out for themselves. They're going to get a K1, and that K1 is going to be allocated to a specific state, or states if you're investing in a fund, and then you're going to have to figure out your own filing requirements. Some states do allow, I think they're called composite returns, where the entity itself can file for you. We don't recommend that. As an accredited investor or limited partner, we don't recommend that you allow that to happen. If you have a choice, or if you have any sort of voice, we want you to have control over your filings. The reason being is that if the entity is filing on your behalf, then you personally are paying tax at that highest rate. You're not able to take any sort of state level deductions, exemptions, anything like that, so we'd rather you have control over your own filing requirements.
Adam Hooper - Okay good. And then one of the things that we've touched on a little bit here as we're kind of maybe rounding out the conversation, one of the biggest benefits of real estate is how that can offset other tax that you owe, right? Other gains, other income, it can offset those other tax consequences? Can you kind of tell us how that works, again, from a very basic level? Why does real estate allow us to do that?
Brandon Hall - Yeah, so why does real estate allow us to do that? I think back in the day they wanted to incentivize long term investments, in communities and neighborhoods. So I think that's ultimately why real estate is such a great tax vehicle, or has all these incentives, but real estate's beneficial from a number of reasons. One, it produces passive losses, in most cases, and if you structure your tax position correctly, you can generally take those passive losses. If you're phased out of your passive losses, they become suspended, but those suspended passive losses could be used to offset future passive income or future capital gains on sale of my rental real estate. So just really great because I can be earning income today but show a passive loss. I could have positive cash flow but actually have a passive loss for tax purposes. I get cash flow that I'm not paying tax on, and that's where it really helps your effective tax rate, because I can increase my cash flow, I can increase my income, but not actually pay tax on it, meaning my income is increased, but my tax bill stays the exact same, because I have these passive losses. So thus since my income increases, and my tax bill stays the same, my effect tax rate goes down. That's how Warren Buffet does it. It's the famous example where he pays way less of an effective tax rate than his secretary does. He pays way more in total actual tax dollars, but total dollars compared to his total earnings are way less because he's structured his income to be coming through these tax shelter vehicles like real estate.
Adam Hooper - Got it. And so again a lot of it is looking at these returns on an after tax basis, right? Most of the presentations and everything that's put out there is on a pre tax basis. Are there any shortcuts or any kind of quick ways to look at things if I know a gross return for something on a pre tax basis, how that would affect my effective tax rate, or how to look at that, on an after tax basis?
Brandon Hall - Yeah, so most of the syndicates will give you a pro forma, so you just want to take that pro forma, look at the projected passive income or losses, and then you just want to allocate that to your tax return. You would allocate it first to your stake in the deal, and then to your tax returns, so if I've got a 10% stake and we're expected 100K, or the deal's expected to show 100K net positive income after depreciation, amortization, and all that, if I would take $10,000 of that 100K, since I have a 10% stake, I would throw it into my tax return and that would be how my taxable income increases, but I might be allocated like $50,000 of distributions throughout the year, and the $50,000 of distributions when I do these calculations, that's when I would say well, I've increased my income by $50K, even though I've only reported an increase of $10K, so there's not really a short and fast way to do this, but you want to understand that cash flow is income to you, so it increases your total income, but doesn't necessarily increase your taxable income, because that passive loss, or that passive income passing through to you might not necessarily be the exact same as the distributions.
Adam Hooper - Got it. Basically give you a call, and you'll help figure it out.
Brandon Hall - Yeah. Yeah, absolutely. It's funny, we get these emails every once in awhile that are like one liners like hey, I've got this really big thing. What do you think? And it's like, I think this would be like a three hour call, you know? Yeah, so it's kind of like that.
Adam Hooper - Yeah, and I think part of what we wanted to try to get to today with this conversation is it can be daunting, right? I mean this can be a pretty complex thing to try to wrap your head around if you're not a professional real estate investor, you're not a career investor. For some of our listeners out there, this might be the first time that they're looking at investing in a private deal in this asset class, so I think what we talked about earlier, making sure that you're aligning yourselves with a professional that knows the ins and outs and will kind of walk you through this, and make sure that you're getting everything set up and structured correctly from the beginning can mitigate a lot of this kind of confusion and challenge and intimidating issues down the road, right? Making sure you're getting a set up structured correctly from the beginning to kind of set yourself up for success as you start down this path of becoming a more active real estate investor.
Brandon Hall - Mm-hmm, absolutely.
Adam Hooper - Perfect, well is there anything that we didn't touch on that you think we should include here at the end, or do you think we got there?
Brandon Hall - I think that we're pretty much good. Well, there's one thing that a lot of our accredited investors that are clients they kind of have a hard time wrapping their mind around is just I'm investing in real estate. I've been told that it's a great tax vehicle, but I'm not getting any of the benefits, because they earn too much income. The passive losses coming back are just being suspended so they feel like they can't fully benefit, and what I encourage people to think about is again what is the cash flow that you're receiving? If you've received cash flow and you're not paying tax on it today, that's a pretty good darn benefit. Even if you do have suspended passive losses, you'll be able to utilize those at some point, so just don't worry. Keep building the real estate portfolio, and eventually you'll get to the point where you don't need the day job.
Adam Hooper - That's the goal, right? That's what we're all in this for.
Brandon Hall - That is the goal.
Adam Hooper - Brandon, we really appreciate it. How can our listeners and investors get in touch with you? What's the best way to contact you guys?
Brandon Hall - Yeah, absolutely. You can contact me or my team at www.therealestatecpa.com, fill out a web form. You can email us at firstname.lastname@example.org, and then you can connect with me on LinkedIn. Feel free to. I love to make posts about how the corporate world stinks, and how real estate's awesome, and taxes rock. So we'd love to have your connections.
Adam Hooper - Yeah, well good. I think that's all we've got for today, so listeners out there, as a reminder, after you're done listening to this podcast, be sure to hop over to Brandon's podcast, because we're going to be doing a little back to back episode swap, and we're going to switch seats. I'm going to be in the hot seat. Brandon, you're going to ask me some questions.
Brandon Hall - It's going to be fun.
Adam Hooper - Yeah, all right, well that's all we got for this one, Brandon. Thank you so much for your time. Listeners, as always, comments, feedback, reviews, we love 'em. Send us an email to email@example.com, and with that, we'll catch you on the next one.
Tyler Stewart - Hey listeners, if you enjoyed this episode, be sure to enroll in our free, six week course on the fundamentals of commercial real estate investing. Head to www.realcrowduniversity.com to enroll for free today. In RealCrowd University, real estate experts will teach you the important fundamentals like the start with risk approach, how to reevaluate real estate sponsors, what to look for in the legal documents, and much more. Head to www.realcrowduniversity.com to enroll for free today. Hope to see you there.
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