Brandon Hall joined us for a second round on the podcast to discuss some of our top Real Estate Tax questions heading into 2020.
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. He holds degrees in both Accounting and Finance from East Carolina University.
Check out the Real Estate CPA https://www.therealestatecpa.com/
The Real Estate CPA Educational Blog https://www.therealestatecpa.com/blog
Real Crowd - All opinions expressed by Adam, Tyler, and podcast guests are solely their own opinions and do not reflect the opinion of Real Crowd. 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.
Brandon Hall - First off we do recommend investing in different states. We think that it's good from just a general geographic risk mitigation stand point. But also a lot of these states have credits that'll start offsetting each other if you're doing it in a strategic manner.
Adam Hooper - Hey Tyler.
Tyler Stewart - Hey Adam, how are you today?
Adam Hooper - Tyler I say this, I say it a lot, but you know it's another great day in the studio.
Tyler Stewart - It is. It's always a great day and as we close out 2019 here it's a great day to start talking about taxes, huh?
Adam Hooper - It is. So who do we have on the show today?
Tyler Stewart - We have Brandon Hall, founder and CEO of The Real Estate CPA.
Adam Hooper - Sounds like a pretty good guy to talk to.
Tyler Stewart - Absolutely, yeah, we covered a lot of information in this podcast. One of the things we covered was what questions should an investor ask a sponsor before making an investment.
Adam Hooper - Yeah, it's been a while. Brandon's been on the show before. It was a super jam packed episode. Links in the show notes to that one. We referenced another couple episodes in the show today, so kind of some deeper dives on 1031 exchanges, opportunity zones and what not. But good to check back in with Brandon, see what they're kind of forecasting here as we round out 2019. Maybe some kind of year end planning ideas that you can get in order. But overall, just a really good foundational episode on what it takes to look at the tax impacts of investing in commercial real estate.
Tyler Stewart - Yeah, this was a bare bones straightforward podcast, where we just went over everything investors should think about when they're planning for their taxes and whether or not you should hire a CPA and what to discuss with the real estate sponsors as you look at that deals. And are you going to file your taxes state by state if you're in a fund, or is just going to be one tax form. We went over a lot of questions that our listeners have.
Adam Hooper - Yeah a lot of the tough questions again around kind of multi-state investing, about K1s, who's responsibility, timing of those. Talked about depreciation, we talked about cost segregation, 1031s, opportunity zones, kind of of a smorgasbord of tax related questions here in the real estate space. So really good episode. Definitely some opportunities to take some notes, some actions items. Again, very happy and grateful to Brandon who was able to join us on the show today as a new father. He was able to carve out some time to come talk with us, so we're very appreciative of that. As always, again let us know your feedback. Do you like the topics? Do you want to do a deeper dive on any of these issues? Let us know. Send us an email to email@example.com and with that, let's get to it. Brandon, thank you so much for joining us again here on the show. It's been a while we've had you on and we're glad to have you back.
Brandon Hall - Yeah absolutely, thanks for having me on again.
Adam Hooper - So we talked a lot last time kind of about basics or real estate and tax, what that means for investors. 2019, have we see any updates to the tax climate. Has anything really changed in that perspective since we connected about this time last year.
Brandon Hall - Yeah so, there's really not, not like crazy changes, especially compared to the 2018 Tax Cuts and Jobs Act. There have been a number of clarifications, one of which as just to, like the rental property qualifying for section 199A. So there was a few. There was a little bit of that kind of going on, but other that, it's just been a lot of small tweaks and clarifications due to the 2018 Tax Cut Jobs Act.
Adam Hooper - And why don't we take a minute to talk about that then, the 199A.
Brandon Hall - Sure, so the 199A deduction is a 20% pass-through deduction on basically qualified business income. So if you have qualified business income, then you can take a 20% deduction on that net business income. It has to be positive obviously, so a lot of our real-estate clients, they don't really qualify for something like this, because they're generating passive losses. But assuming that we do have passive income, then we can potentially qualify for the 20% deduction. So the question was though, in 2018, they basically said qualified business income, you have to be a real, sorry you don't have to be a real property trader business you just have to be a trader business. So your activities have to the ride to the level of a trader business. The big question was, do my rental activities rise to the level of a trader business. Right, 'cause if I'm investing in property and I'm collecting rents, that might not rise to the level of a trader business, and this is all in section 162 of the Internal Revenue Code. But instead, it might just be a passive activity. So the IRS came out with Rev. Proc. 2019-7. They basically just said that your rentals will rise to trader business if you keep separate books and records per rental real estate enterprise, if you have 250 hours or more or rental services per year, but you're managing property managers and all that stuff, that counts towards the 250 hours. And then you have to maintain time logs as you go. So as long as you hit those three things, then you can use at least the safe harbor
Brandon Hall - described in Rev. Proc. 2019-7 to automatically qualify your rentals for that 20% pass-through deduction. But there was a big caveat that triple net lease properties do not qualify for the safe harbor. Doesn't necessarily mean that they can't qualify as a trader business and the qualify for that 199A deduction, but at least not going to be able to qualify for that safe harbor.
Adam Hooper - Got it and have you seen that play, how have you seen that play out I guess in our space where most of the investors are making passive investments as LPs in these deals versus actually purchasing their whole properties in more active management?
Brandon Hall - Yeah, well so the 199A deduction is determined at the entity level. So if you're investing in a syndication, the syndicate's typically going to be able to qualify for that passive deduction. But a lot of our clients that are investing passively, like maybe they're buying turnkey properties and things like that, out of state properties, they're not going to qualify. Nine times out of 10. So the Rev. Proc. was a nice surprise, because it at least gave us a target. And the question is, can we hit that target.
Adam Hooper - And so in the case of a syndicated deal you said that that determination is made at the actual investment entity level.
Brandon Hall - Yes.
Adam Hooper - Which obviously very active management going on there, so it should in most circumstances, be able to qualify for that.
Brandon Hall - Yes, yep.
Adam Hooper - Cool. Generally tax climate 2019 and heading into 2020, do you foresee any big changes coming up? I mean obviously heading into an election cycle could have some impacts. How do things look for the rest of kind of this current environment and maybe what's up on the future do you think for tax environment? And again it's obviously a large crystal ball there.
Brandon Hall - Yeah, yeah, yeah.
Adam Hooper - We're not going to put ya, hold you to task on record here or anything.
Brandon Hall - Yeah, so we're kind of eddy steady right not. Not expecting a whole lot of changes, at least for the next few months. Conservation easements are kind of on the chopping block right now, and it doesn't appear that they will be cut out or anything like that. There might be some tweaks to investing in land conservation easements and what those benefits might be and we're kind of expecting those by the end of the year. We were expecting them to hit last month, but just kind of got delayed there. So we're taking a look at that. But definitely any sort of political change or any sort of election year where you replace, you know if we get Democrats into office, there will most, I would say most definitely be tax changes. I don't know how soon afterwards, typically a year or two after they change office there so.
Adam Hooper - So for next, you know next short while nothing major on your radar at least that you guys are keeping an eye on that might impactful to investors out there?
Brandon Hall - Yeah, nothing crazy right now, but we try to stay on top of all the bills that are going through the House and Senate, but yeah nothing majorly impactful. All that was kind of hashed out in 2018, which is nice.
Adam Hooper - Yeah, okay. So we're kind of at the end of the year here, 2019. Any kind of quick tips or any and obviously consult your own tax advisors and this is not tax or investment advice, but any kind of general quick tips that you guys are seeing or anything as people are trying to get their house in order as we close out the year? Any that you see that's kind of low hanging fruit that can be fairly impactful for investors, real estate investors out there?
Brandon Hall - Yeah, so the biggest thing is to really just understand if you were to build out a P&L, a profit and loss statement for 2019, what are your passive activity, what does that passive income look like at the end of the day? Do you have passive income or do you have a passive loss? If you have passive income, then let's explore investing in syndicates that are going to cost seg and 100% bonus depreciation and let's place those investments by the end of the year. That's pretty much what we look at with a lot of our clients, especially the clients that are on the limited partnership side or the accredited investor side. It's a lot of that sort of planning. So we're looking across all the syndications that they're investing in. Are any of the syndicates liquidating? What do we expect the K1s to show? Is it going to be positive, negative? If we've got a lot of positive income, if you have your own rental portfolio and you've got a lot of positive passive income, then how do we offset that? One way to easily do that is to invest in a syndication that's going to run a cost seg study, it's going to run a cost seg study and then produce 100% bonus depreciation for you. And we can kind of like, we can invest a certain amount to get the result that we're looking for which is really nice. We can gear it up or gear it down, depending on how much we're trying to offset by the end of the year. So that's what a lot of our clients are doing right now before the end of the year. But other than that, it's really just kind of gettin' financial house in order. If you're running a business,
Brandon Hall - do you have solo 401Ks set up? You have to set those up by December 31. If you're qualifying as a real estate professional, is you're time log up to date and accurate? If you want any sort of year tax planning from us, do you have up to date financial statements? So we can't do any sort of tax planning if the last time you did your books was January 2019.
Adam Hooper - Got it. And so you mentioned cost segregation. We've talked about that a few times on the show before but for maybe some of the newer listeners out there, can you run us really quickly through what a cost segregation study is and what those impacts are to the investors?
Brandon Hall - Sure so a cost segregation study is the exercise of taking a building's purchase price and allocating that purchase price between five, seven, 15 and 27 1/2 year property or 39 year property. So basically what we're trying to do is we're basically saying, when I buy a 200 unit apartment building, the entire building and all the components inside of it are not actually going to be depreciated over 27 1/2 years, right? I have appliances, I have countertops, I have carpeting, I've got land improvements. I've got components that have a smaller or a shorter useful life, and a cost segregation study the whole point there is to just recognize that. So when I go and buy a $1 million building, typically we can allocate 20 to 30% of that purchase price to five, seven, and 15 year property. So we're looking at 200 to $300,000 and basically what we're doing it we're reclassifying it from 27 1/2 year property, that's what you depreciate residential property over normally, 27 1/2 years. We're basically saying, $1 million should not be depreciated over 27 1/2 years. 700K should be depreciated over 27 1/2 years and then 300K should be depreciated over five, seven, or 15 years. So we're basically just saying we've got components with a shorter useful life and a cost segregation study recognizes that. And of course in that example I didn't account for land, but land is also a factor here.
Adam Hooper - And now even a higher level up that an a cost segregation study, concept of depreciation. You know again, a lot of investors that maybe are looking at real estate, investing for the first time, maybe aren't that familiar with how the depreciation rules work. Take us kind of high level 101, what is depreciation, how does that work? What are the benefits and what does that offset?
Brandon Hall - Sure, so depreciation is the IRS's way of one incentivizing investment in real estate. But the idea of depreciation is to essentially track the deterioration of your asset over time. So the idea is, I buy a $100,000 property it's not going to be in great shape 20 years from now if I don't do anything to fix it, so I get a small write-off every year for 27 1/2 years. The IRS came up with 27 1/2 years or Congress came up with 27 1/2 years, so that's the code. But basically what you do is, it's just a, we call a phantom expense, because it's something that you get to claim, it's an expense that you get claim every single year, but you don't have to shell out more cash for. You purchase the property at the beginning and then the depreciation expense is an expense line item on your schedule E or on your 1065 if you're filing a partnership. Basically, it's an expense line item that reduces your net operating income and allows you to essentially report a smaller net taxable income, or even a net taxable loss to the IRS.
Adam Hooper - And that's one of the biggest benefits of, at least from a tax perspective of investing in real estate, right? I mean that is one of the main drivers, a lot of of the motivations of investing in real estate is that benefit of depreciation and how that can offset that cash flow.
Brandon Hall - Exactly, yeah, because I can have cash flow of like $10,000 but I can tell the IRS that I actually lost $2,000. So cash hit my pocket in the amount of 10K, but then I'm going to go tell the IRS that actually lost two. And that's largely due to depreciation and amortization of loan costs and things like that. So when we tie this back to cost seg studies, what a cost seg study is doing is it's saying, instead of depreciating over 27 1/2 half years, which is a very long time, let's accelerate the amount that we get to write off over five, seven, and 15 years. We get to take higher depreciation in the first five years there because we're writing off a lot of that over five years rather than 27 1/2 years. But then on top of that we all have 100% bonus depreciation now thanks to the 2018 Tax Cut and Jobs Act. It used to be 50, not it's 100%. And we can take that, we can take 100% bonus depreciation on any component with a useful life of less than 20 years. So if I do a cost segregation study and I'm able to allocate my purchase price to five, seven, and 15 year property, let's say I allocated 300K of that one million, five, seven, and 15 year property all have useful lives of less than 20 years, so the year that I do that cost seg study I get to take a $300,000 deduction. I get to write it all off immediately, and that provides a really big benefit to any investor in real estate, but definitely the limited partners who are investing in syndication deals.
Adam Hooper - And assuming, again in this case if you buy an asset for a million dollars, maybe cash flow is going to be 10, 12% levered, right so you're getting 120 grand in cash flow. If you have a $300,000 expense, all that cash flow is basically no tax impact, no tax on that cash flow that you received as cash in your pocket.
Brandon Hall - Yeah, yeah, so if you took that first year bonus depreciation but you received a ton a cash flow, well really what it comes down to is what is your net operating income and then what's that depreciation on top of it? Do you have a net taxable loss or net taxable income? Typically in the year that we take 100% bonus depreciation we're going to have a pretty big net loss for tax purposes, but not for operating purposes.
Tyler Stewart - And then how are LP investors, in a syndicated deal tracking depreciation? Is that on the investors or is that something the real estate sponsor handles?
Brandon Hall - Yeah so that's going to be at that partnership level. They're going to be tracking that depreciation recapture. But each investor has basis in the entity and it gets intertwined into that basis if that makes sense. So whenever the deal's liquidated, the investor's going to get a K1 that's going to say here's your total gain and of that, here's what that section 1250, that depreciation recapture looks like.
Adam Hooper - And now depreciation recapture, it sounds like there's a catch there. What is depreciation recapture again for some newer investors in the space?
Brandon Hall - Yeah, so when you liquidate a piece a real estate, you've been taking depreciation. It's this freebie expense so to speak that you've been able to write off every single year. You haven't paid tax on your cash flow, because you've got enough depreciation to totally offset that. At some point it is going to catch up to you and that's what that depreciation recapture is. It's technically called section 1250, unrecaptured gain and you just have to watch out for it and you have to plan for it. So if I've got a $100,000 home and I've depreciated $20,000 over the past, I don't know, I don't know how long that would be. Well just call it five years. So we've got $100,000 home and I've depreciated it straight line over five years, the accumulated depreciation's 20K. By basis on this home now is $80,000. So if I go sell it for $100,000, a lot of people think, oh I broke even, right, 'cause I bought it for 100K and then I sold it for 100K. But really you bought it for 100K, you depreciated it to where the basis is now 80K, and now you're selling it for 100K, so you actually have a $20,000 gain. That trips people up a lot. And when ever you're running a cost seg study, obviously we're really writing down the basis really quickly. So if we're selling it a short amount of time after that cost seg study, the depreciation recapture piece can be pretty painful. And really what this comes down to then is a time value of money calculation. So is the tax savings today going to be worthwhile whenever that depreciation recaptures comes around. At least that's what we look at with the cost seg study.
Brandon Hall - But depreciation is required, it's not optional. So you do have to take it on your schedule E's or on your tax returns. Sometimes we'll run into new clients who don't think they have to take depreciation and they don't want to take it, because they don't want to have to pay that depreciation recapture tax at the end of the day, but the IRS is going to assess you that tax, whether you've taken the depreciation or not.
Adam Hooper - And we'll talk about, a little bit on depreciation recapture when we dig into 1031s. But I think taking again kind of a step back, doing a little deep dive there, just generally when investors are looking at investing in real estate, again whether it's buying whole properties on their own as investments or investing in syndicated deals, high level, again for listeners that maybe haven't heard some of the other podcasts or they're just fresh into the space, what are some of the biggest tax implications or just tax ramifications that they should be thinking about when they invest in this asset class maybe for the first time?
Brandon Hall - Yeah so, so if I'm investing as an LP first time into a syndicated deal, I definitely want to understand the tax impacts. More so I probably want to understand the sponsor team and just make sure that my money's protected. But understanding the after tax benefit or the after tax gain is going to be important as well. So I'd be asking the sponsor some things like are you going to be running a cost segregation study and can you project how that might impact me? Because if I can invest in a syndicated deal, let's say that I have 50K of passive income and let's say that I'm investing in a mobile home park fund or something and I put 50K into it, if they run cost seg studies, I'm probably going to get my 50K back in terms of passive losses. So if I've got 50K of passive income on the left hand and I'm investing 50K into a mobile home park fund, I'm going to get a $50,000 passive loss, boom I've offset my passive income on the left hand over there. So it's really just kind of understanding your entire tax impact or your entire tax situation. But you're just kind of like, if this is your very first syndication deal ever, you don't have any other real estate, all you've got is a W2 job or you're running a business or something like that, then really it's going to be a question of when I get allocated losses or income how is that going to look? When I'm allocated distributions how is that going to look? Do I pay tax on those things? But it's going to be a simplified conversation because you don't have that puzzle piece of, cool I've got this big passive loss
Brandon Hall - that the syndication's going to provide me with, what can I use that passive loss against? You won't have that aspect to worry about at that point.
Adam Hooper - Okay, and then to follow on Tyler's earlier question, where does the responsibility lie in a syndicated deal of who's doing what in terms of tax responsibilities? Who's doing the tax prep, who's doing the K1s? And then once that flows to the investor, what is their responsibility to take whatever information they're getting from that manager and what do they do with that?
Brandon Hall - Yeah so the sponsor team is going to have an accounting firm on their team, ideally a CPA firm. And that CPA firm is going to be responsible for getting the final financials together for the deal and then getting those translated into that form 1065 or whatever form their filing, but that partnership level tax return. The CPA team through that preparation process, so through preparing the sponsor's, like the deal's tax return, that property entity's tax return, the CPA firm is going to generate K1's for all the investors. And then sometimes the CPA firm itself will send out K1s. Other times the CPA firm will tell the sponsors, hey the K1s are ready for you guys to send out. Just kind of depends on their own operating procedure. But if you're investing in a deal, you should just be expecting to get a form K1. Now if it's a partnership tax return, which most of these are, you've got a March 15 filing deadline. Sometimes they file extensions and they get an extension to September 15. So if you are an LP in the deal, just understand that you might also have to file an extension on April 15, because you do that K1 in order to finalize and send in your tax return. So you might be waiting until September 15 to get all that done. Now we understand that that's a huge pain point for limited partners, 'cause we work with a lot of limited partners so anytime that we're working with a sponsor or syndication or fund, we're always trying to get 'em early March. Our data shows that the faster that sponsors can get the tax returns out,
Brandon Hall - the more capital they end up raising over time, because investors are going to keep coming back to them. But yeah as an investor, you're going to receive that K1 and then it's just your responsibility to get that into your tax return. It's relatively simple to get that stuff into your tax return. If that's the only other thing outside of your W2 job that you have going on, I would say you could probably use Turbo Tax, something like that. But if you've got a lot of other things going on, it's definitely a good idea to get a CPA on so that they can handle all that for you.
Tyler Stewart - Speaking of using a CPA and as a CPA yourself, if you have a client that's in a syndicated deal, what do you need from that sponsor in order to do the taxes and make sure you're taking care of all the advantages? Do you just need the K1 from the sponsor or are you looking to connect with the sponsor's CPA? What kind of is the best opportunity for you as a CPA?
Brandon Hall - Yeah so if I'm a CPA and I'm representing the limited partner in the deal, I'm pretty much just going to take the K1 at face value. I can reasonably rely on information without having to ask questions. Now if I notice that there's some pretty significant basis issues, I might ask the CPA firm what they're tracking our client's capital account to be. We had a partnership earlier this year, we had a client earlier this year who was invested in a partnership and they liquidated and we realized that they had underpaid the client some $30,000 or something because they had miscalculated his basis in his capital account. So we try to pay attention to those types of things. We'll track our clients basis as the deal goes along so that we make sure that at the end of the day they are going to be paid back what they're owed. But we typically during the deal operation, we're not going to ask a ton a questions, unless we just see something that's really whacked out.
Adam Hooper - Got it. Now back to the delivery of the K1s. You know I wish I could say that every manager that's ever done a deal on Real Crowd has got their K1s done in a timely fashion, but unfortunately that's not necessarily how it always comes together. What would be the cause for a manager to not get their K1s out by that March 15 date?
Brandon Hall - So the main cause is just not being organized, at the end of the day. That's like the number one issue. And that comes in a couple of forms. So right now, like literally right now, we're recording this in November, we have already sent out a ton of tax preparation engagement letters for next year. So we get a really early start on it and we prioritize all of our deal sponsors. So we put it in their hands to get an engagement letter signed back to us, but we do work on a first come first serve basis, because we don't have unlimited capacity. So when we have to file extensions, it's typically because either the deal sponsor waited until January to sign their engagement letter or they waited until February and they thought that that was realistic. Or they signed their engagement letter now, but they're waiting until like mid-February to finalize those financial statements. And a lot of times deal sponsors, we give everybody, so our cutoff for uploading financial statements, 100% complete is January 31, every single year. And sometimes we get new sponsors that are like there's no way I can get this out before like mid-February. And to me that just tells me that you have a very poor accounting process in place. There's really no reasons that you can't get financial statements for the entire year wrapped up and done by January 15, every single year, without having to do a bunch of adjustments after that January 15 date. If you can't do that, then you probably need to re-look at your accounting procedures. You might need to re-look at
Brandon Hall - that property management company that you're using, maybe they're not organized. But there's definitely something going on there.
Adam Hooper - So it should be theoretically doable without too terribly much fanfare to get those things done on time and get those K1s out?
Brandon Hall - Yes, yes. I will say there is another thing though. I mean, so you could have the most organized sponsor, perfect financials, signs the engagement letter early, and then you could just have the CPA firm flop too. So there is definitely that aspect as well.
Adam Hooper - Right. Now another question that we get a lot from investors, this again might be the first time that they're looking at deals, they're not buying themselves in their backyards or their neighborhood markets, maybe looking at deals out of state. How does that play into an individual's tax perspective if they're investing in multiple states? Is that something that's handled by the manager? Do they have to do anything different on their tax returns? Are they going to have to go file in those states? I know it's kind of a broad questions, different circumstances, but kind of generally, how should an investor think about investing in multi-state, building a multi-state portfolio?
Brandon Hall - Yeah, so first off, we do recommend investing in different states. We think that it's good from just a general geographic risk mitigation standpoint. But also, a lot of these states have credits that'll start offsetting each other if you're doing it in a strategic manner. So you could actually enhance you overall IRR, by picking and choosing states wisely. But the way that it works is if you're going to invest anywhere you definitely need to understand what the tax implications are going to be. Every state is very different and you need to know if I get a K1 from a sponsor in Michigan, do I need to file a Michigan tax return? So there's a couple factors that go into this. The first major factor is, is the syndication going to file a composite return for the partnership? What that means is that the syndication at the syndicate level files the state return and none of the partners have to file the state return. Typically that's not very advantageous. The individual limited partners or just individual people in the deal, they tend to lose out more on composite returns then not, because there's a lot of limitations to the deductions that they could have otherwise taken. So we will typically say is no, let's not file the composite return. You got a K1, or if we're working with the sponsor we'll say in general, let's not file composite return, let's just issue the K1s and then each partner needs to go and figure out on their own, whether or not they need to file that state return. And obviously if we're working with them,
Brandon Hall - then we can help them with that determination. But yeah it's definitely something that you should be aware of. Your preparation cost if you're working with a CPA, they will go up. The way that CPA software is structured is they will charge you for each additional state return that you file, so we have to bill that back to the client and it does require a little bit of extra compliance on our end to get that done for you. So your tax return fees are definitely going to go up, but it's typically not, it's typically marginal. It's typically not something that should be a major deciding factor.
Adam Hooper - So I guess the overall answer as with a lot in real estate, is it depends.
Brandon Hall - Yeah, yeah right, that's the classic. That's the one everybody hates.
Adam Hooper - It depends.
Brandon Hall - It depends.
Adam Hooper - So with a composite return, is that an all or nothing for that partnership, for that entity, or if an investors does find out that the manager is planning on filing a composite can they say no, no I don't want to be a part of that and then just peel off my individual K1? Or that's an all or nothing thing?
Brandon Hall - Yeah, it's an all or nothing thing. So the partnership filing the composite return, basically alleviates all partners of having to file their own individual returns.
Adam Hooper - Got it. And what percentage of managers are you seeing out there file composite versus just flowing through individuals K1s.
Brandon Hall - Oh gosh, it's pretty low. Well generally see it at the fund level, like the bigger funds. But the syndications, it's pretty slim.
Adam Hooper - Okay and now I think that's another interesting segue there with funds. If you're investing in individual properties, multi-states we just covered that, right? So you'll either get your individual K1 or it'll be a partner with composite return, which is less likely. When you're investing in a fund that's investing across multiple states, how does that change? Does it simplify things for the investor? Does it make it more complex for the investor?
Brandon Hall - Well yeah again, it just depends on if the fund's going to file a composite return in all those states or not. If the fund's not going to file a composite return of they pick and choose, wherever they don't file a composite return, the investor will have to make that determination on whether or not they have to file a state tax return.
Adam Hooper - Okay, so in a fund, if that fund holds multiple properties, generating income in different states, that investor if they get the K1 for that fund they might still have to attribute that income to each state that that fund has property in?
Brandon Hall - Yes, yeah.
Adam Hooper - And where would an investor find that out going into an investment? Is that something that would be in the PPM? Is that something they would ask the manager about? Where would they find that information going into to the deal, so they could be prepared for what's likely to happen at the end of the year?
Brandon Hall - Yeah, it's typically going to be, at least the fund strategy or the syndication strategy should be highlighted in the offering documents. So somebody should be able to understand what markets are being targeted and all of that. You might not understand to what degree. I mean funds do want some flexibility to move cash around when needed. But definitely just ask questions to the sponsor. When are we expected to target these different markets? Maybe there's a plan that we're only targeting one or two markets this year and we're target five more next year. It really just depends on what the fund is doing. But yeah, and you can even ask for the CPA firm too and just shoot them a quick email. We'll handle investors all the time for our fund clients and they're always asking things such as, where do we need to, what potential state filing liabilities am I going to incur by investing?
Adam Hooper - Okay, and we don't see a ton of debt investments on Real Crowd, but for investors out there that are investing in debt either on their own in hard money loans, or senior notes or mezzanine, is there any different tax treatment or do they need to be looking at those debt investments different from their equity investments?
Brandon Hall - Yeah, yeah absolutely. So debt investments are going to generate interest income and interest income is very difficult to shelter. You're not going to get, if you're investing on the debt side, I'm not going to benefit from the bonus depreciation or anything like that, 'cause I've just got a loan and I'm getting interest income from that loan. So it really just depends on what your tax situation looks like and what makes the most sense. But there's also that wealth building piece to it as well. Like I'm a big fan of people having debt exposure in general. I think it de-risks your over portfolio a little bit. You get that consistent cash flow and ideally, hopefully, you've collateralized the asset with that loan. So again, just kind of going back to that de-risking aspect to it.
Adam Hooper - Another thing that we've again been, varying levels of interest that kind of seems to ebb and flow a little bit throughout the year, self-directed investing. I know we talked about that before. Is there anything new in that space, whether it's through a solo 401K or a self-directed IRA, have you seen anything interesting in that space coming along, or is that's still also been kind of very steady eddy?
Brandon Hall - Yeah still pretty steady eddy. Nothing crazy going on there. It's really just people not understanding when UDFI kicks in, when UBIT kicks in and all that fun stuff, so.
Adam Hooper - Okay so those are a couple acronyms there. So UDFI?
Brandon Hall - Yeah, so UDFI is unrelated debt financed income. So that's going to occur if in invest on the equity side. This is not a factor if I'm investing on the debt side. But if I invest on the equity side and the sponsor has obtained financing then I'm going to have UDFI, unrelated debt financed income. And then UBIT's unrelated business taxable income. Rental income is excluded from UBIT. Not a lot of people realize that. But what triggers the rental income being subject to UBIT is that UDFI income. So what we do typically, is we'll say all right, if you're going to invest with a self-direct IRA into a syndication, is the syndication going to be leveraged? If yes, great, we've got UDFI income and now we need to make sure that we're just staying on top of the UBIT piece as well as the K1s come back in.
Adam Hooper - Now when would an investor want to invest through a self-directed IRA versus using taxable investments?
Brandon Hall - Yeah, we typically see a lot of our clients use their SD IRAs and even solo 401Ks to take debt stakes. So that interest income that we were just talking about, interest income's really hard to shelter unless you're in the business of notes. But it's a good exposure to have the debt exposure to have that consistent cash flow and to de-risk your entire portfolio. So we'll see a lot of our clients take those debt stakes in their self-directed IRAs to basically just avoid paying tax on the interest income today.
Adam Hooper - Right, because again like you said, you can't necessarily offset that interest income, so when you put that into a qualified, a non-taxable account, no tax to pay on it anyhow, so really no adverse effect of making those debt investments through that.
Brandon Hall - Exactly. Yep.
Adam Hooper - Let's talk a little bit about 1031 exchange. We talked about that before on the show. Generally what is the process of a 1031 exchange? Let's maybe talk about some of the complications in an exchange if you're investing as an LP or unit an LLC and how that relates to a 1031 exchange.
Brandon Hall - Yeah sure, so the way that a 1031 exchange works, so first off, we talked a little bit earlier about unrecaptured depreciation, right, so section 1250 unrecaptured gain. It's a real pain whenever I sell a property and I have to pay not only the capital gain, but also the depreciation recapture tax as well. So a way to defer recognition of all those taxes is to engage in a 1031 exchange. And kind of think of it like Monopoly, right, I got four house on my card and I'm going to trade those in for a hotel. That's exactly what you're doing here. You're kind of buying up to the next asset. So the way that a 1031 exchange works is I'm going to sell an asset, I have to buy an asset at that replacement value, at equal or greater replacement value. And then I've got two periods that I have to watch out for. I've got a 45 day identification period and then I've got a 180 day close period. And both of those periods start at the date of sale. There's a lot of misinformation out there. A lot of people think, okay I've got 45 days plus 180 days, but it's really 45 days and a 180 days and they're layered. So that's just something to keep in mind too. When we look into syndication space, it gets a little more complicated, because an LP, like if I've invested into a syndication as a limited partner I cannot 1031 exchange my investment in that syndication. Technically I own paper. I can't 1031 exchange paper for real estate. So the syndication itself will have to do the 1031 exchange, or you're going to have to run into some sort of
Brandon Hall - like drop and swap scenario or some sort of tick structure or something like that, which is probably way too complicated to talk with the remaining time that we have here today. But those are two alternative options that we've seen take place. Or if I'm an LP and let's say that I definitely do not want to pay tax on the gain coming out from this liquidation. The syndication's not going to do a 1031 exchange, they're just closing down the entity and calling it a day. I can take my gain and invest that into opportunity fund, but you really have until the end of this year to maximize those tax benefits there. But that is an option as well.
Adam Hooper - Yeah and so we've done a couple episodes, deep dives on 1031 exchanges, so we'll put some links in the show notes for investors out there to take a look at that. And you brought up the, what was once the overwhelming topic dejour, opportunity zones. I think it was then those first launched a ton of interest, ton of excitement, a lot of people out there saying they were announcing 100 million, 200 million, billion dollar funds. You know I don't know that we've seen the capital flood into that space as quickly as we had anticipated. What have you seen in the opportunity zone space as far as attraction from the investor side and maybe what you guys are counseling or how you guys are looking at those as a CPA for investors that you're working with?
Brandon Hall - Yeah, so kind of the same thing that you've seen. We've seen a lot of hesitancy from the sponsor side because there's still a lot of uncertainty around how these things are actually going to play out. But on the accredited investor, the limited partnership side, it was actually really interesting, 'cause we were one of those folks that got super excited. We were like, we are the Real Estate CPA, we are perfectly positioned to crush this space right? And we kind of rode the wave at the beginning a little bit, but it really fizzled out really fast. And one common piece of feedback that we got from every single one of our accredited investor clients was they don't want to place their funds in an investment for 10 years. And it was really as simple as that. Now interestingly we have a few clients that have started syndicates and small funds in opportunity zones, but they're not an opportunity fund. So their whole strategy is to just get in early and then potentially liquidate to the opportunity funds which I thought was very fascinating as well. But yeah, we haven't really seen, we've helped a few funds get up and running. We've done a lot of consulting, but they typically don't, we haven't seen the big push that we were originally expecting.
Adam Hooper - Yeah I think that's been similar. The Venn diagram of overlap there of people that have gains, do they have eligible gains to invest, that are comfortable with real estate as an asset class and are looking at deals that are, inherently have an elevated level of risk, just the opportunity zones are in underserved markets, so there's, in development, the value add strategy's a little higher risk, and people that are willing to lock their money up for that long of time frame, you know that's a pretty narrow slice of all three of those overlapping, right, pretty unique scenario.
Brandon Hall - We've seen, the people that we've seen jump into this space typically have large equity holdings and they just want to diversify into real estate. So they'll liquidate the equity holdings and then roll that into opportunity funds. Or they're selling, we've had a few folks who have sold businesses for a large amount of money and they're taking some of that gain and they're rolling it into opportunity funds as well.
Adam Hooper - I know you mentioned we have this year end 2019 as the first deadline if will, to get the full benefit of that. There's still a lot of benefit beyond that, but explain the benefit by investing by year end here.
Brandon Hall - Yeah so with opportunity funds, there's really three layers of benefits here and it's all related to the time that you invest and how long you hold your investment. So if you invest and you hold for five years you get a 10% step up in your basis. If you invest and you hold for a total of seven years you get an extra 5% step up in basis. The problem is that 2026, everybody has to recognize whatever that remaining basis is and pay gain and that gives you seven years if you invest by the end of this year. If you invest January 1, 2020, you're only going to have six years before that time horizon elapses, meaning that when it does come around you're going to miss that seven year window, so you're just going to have that five year window, which is still a good benefit. It's just not, you lose that extra five.
Adam Hooper - Not the full benefit, yeah. And we'd heard there were rumblings of potentially extending some of those timelines, maybe some further clarifications. Have you guys heard anything lately on what further clarifications or maybe modifications to some of those timelines might coming out of policy?
Brandon Hall - I believe that there was something released a couple months ago. I'm not actually the one that follows the opportunity funds and zones as closely as another one of our CPAs in our firm does, so I would have to follow up with him and double check. But I believe that he mentioned something had come out a couple of months ago just kind of clarifying. I don't know if it was clarifying the timelines but I think it was clarifying an aspect of it. But I do know that in just in my conversations with him, his name is Thomas Cestelli. I think you guys are aware of him, but yeah. Just in my conversations with him too, he's still like yeah, there's just a lot of confusion in the space, so.
Adam Hooper - Any other tax advantage strategies out there? Any other methods or approaches that investors should be thinking about or looking at outside of the kind of main ones that we've discussed thus far?
Brandon Hall - Yeah, I mean there's tons depending on exactly what you're going for there. I think the biggest one for people that are investing in syndications is to just really clearly understand what the sponsor's going to do to optimize the tax investment for you. And sometimes we'll have sponsors come to us and they'll ask, should a do a cost seg study? Should I have 100% bonus depreciation? Should I elect out of business interest limitations? And what we always tell 'em is look, you might sell the asset in two years which would render the cost seg study totally pointless, just 'cause your savings don't have enough time to kind of what I call season, if that makes sense, like build up. But at the end of the day, that's not really your concern. Your concern is to optimize the investment at all times for your investors from a tax perspective. So yes you should do the cost seg. Yes you should do 100% bonus depreciation. Yes you should elect to have a business interest limitation nine times out of 10. Of course there's always an analysis that goes into that. Should caveat that. Don't just go and take all of that for granted. But as a limited partner, understanding what the syndication's tax plan is going to be is going to be critical for you to understand how you can grown your syndication investing. You can really build out a portfolio as a limited partner where you don't pay tax on the gain coming back from the liquidation of all these assets of you don't pay tax from the ongoing cash flow that you're receiving
Brandon Hall - from participating in these investments. So just kind of approaching it in a strategic manner is going to make a lot of sense for the long run.
Adam Hooper - And I know we asked you on the last one, what are some of the top maybe three, top five questions that an investor should ask a sponsor to get to some of those answers, right? What is the tax plan? How are you maximizing this? Maybe quick run through, top three to five questions an investor should ask every manager about those strategies on the tax side.
Brandon Hall - Yeah well I always start with, what happens if you die? I think that that's a key one that not a lot of people ask. But definitely, what happens if you die?
Adam Hooper - So manager or investor?
Brandon Hall - Yeah so if I'm an investor and I'm going to invest in a deal I want to know what the sponsor's plan is if they end up dying.
Adam Hooper - So business continuity.
Brandon Hall - What's that?
Adam Hooper - Business continuity.
Brandon Hall - Exactly.
Adam Hooper - What happens if it all goes not...
Brandon Hall - Yep, 100%. But then I always suggest that people ask what is your capitalization policy? That's key if you're doing any sort of big value add work. And what that will tell you is how you can expect to see the P&L in the balance sheet before it actually ever is sent to you. Like we ran into an investor, or sorry sponsor that had a $500 capitalization policy. So what that meant is they were doing a ton of value add work, but it was only ever going on the balance sheet it was never showing up on the profit and loss statement because everything was over 500 bucks. That's definitely not tax optimized and it's showing the investors a much higher profit and loss statement than the cash flow story actually tells. So asking what the capitalization policy is always key. And then of course, are you performing a cost seg study? When are you performing the cost seg study? Are you going to take 100% bonus depreciation and what is your plan to deal with the business interest limitations? I would always recommend asking those as well.
Adam Hooper - Perfect and we can maybe summarize those in the show notes or listeners by now, you should know we tell you to bring a pad and paper and a pen for some note taking, 'cause a lot of good nuggets on here, so that's really good. Anything that we haven't covered Brandon that you think would be important for investors to be looking out for? Again I mean it's, obviously yes there's things that people should be look out for, but just kind of high level looking at a deal, getting an understanding of the tax? You know anything else that we think would be super important for investors to be aware of.
Brandon Hall - Yeah so as an investor, just track your basis year to year. So you invested 50K. What'd you get back in distributions? Just track that year to year, because what you don't want to do is run into a situation where you're paying a CPA like us thousands of dollars to help you try to calculate how much a syndication might owe you. So just track that basis on an ongoing basis. Hold the sponsor accountable. If you suspect anything weird going on, call 'em up and ask questions.
Adam Hooper - You know I think that's a very simple thing that a lot of people forget they can still do in this environment of email and internet communications, it's okay to pick up a phone and call someone.
Brandon Hall - 100%.
Adam Hooper - You get a lot done that way. Alright Brandon, why don't you let the listeners know how can they learn more about what you guys are up to, what's going on with your firm and how they can learn more about what you guys do.
Brandon Hall - Yeah so you guys can visit us at the therealestatecpa.com. You can check me out on LinkedIn. I've been posting a lot recently and trying to get back into the swing of that. And I don't remember what my tagline is, but you can just Google Brandon Hall CPA LinkedIn and that'll take you right to me. But either one of those places will be great.
Adam Hooper - Perfect, well listeners there you have another episode on real estate and tax. Brandon we appreciate you coming back on the show. Thank you so much for spending some time with us today.
Brandon Hall - Absolutely, thanks for having me on.
Adam Hooper - Alright, listeners as always, any comments or questions send us a note to firstname.lastname@example.org. And with that, we'll catch you on the next one.