How to Pay (Much) Less in Taxes as a Real Estate Investor (Rookie Reply)

0:00What if one tax strategy you think is reserved for big investors only could wipe out a huge chunk of your W-2 tax bill on your very first rental rental. Or maybe you're about to hand a stranger the keys to a property you just spent every last dollar on and you have no idea what to actually put on your tenant application. And finally, what happens if you fall in love with the idea of flipping houses, but you want to roll every dollar of profit into the next deal without losing a chunk to capital gains? We're answering all three of those questions and helping you keep more of every deal you do.

0:39This is the Real Estate Rookie Podcast. I'm Tony J. Robinson. And I'm Ashley Kerr. And with that, let's get into today's first question. So today's first question comes from Arenze in the BiggerPockets forums. And this question says, I need help making a decision on whether to use a cost segregation or not. I'm still a new investor, but I bought a six unit residential property this year in central Massachusetts and plan to, and I do plan on holding the property for a long time. I have a high W-2 plus another side business with six figures. My question is whether using a cost segregation will help in dropping down my taxes, what are the pros and cons, and then what are some referral companies that can do this cost segregation study?

1:21I think first, let's talk about what a cost segregation study is. It's basically like an engineering study where instead of taking standard depreciation on a piece of real estate, and I believe for a single family home, it's 27.5 years. I think for commercial property, it's 39.5. Don't quote me on those, right? Somewhere in that ballpark. But instead of taking the depreciation across that standard schedule, you reclassify different components of the property, the roof, the appliances, flooring, whatever it is, and you accelerate that depreciation. Some get bunched into the first year. Some get spread out over five years, but there's like a scale there.

2:03So it allows you to basically accelerate a lot of that depreciation. So instead of waiting, you know, almost three decades, you can get a big portion of that depreciation in year one. Okay. Now the cost segregation study can be combined with something called bonus depreciation, which again is where you get like all of that. You can take 100 % of that in year one. Um, now the, the, I think the trap here where a lot of folks get confused is that if you generate this massive paper lost from, from your cost sex study, it typically does not offset your W2 income or your other forms of active income, unless you qualify for what's called real estate professional status, or you use the short-term rental tax loophole.

2:48Um, now, again, we should have said this from the beginning, Ash and I are not CPA. So go talk to a qualified tax professional for your specific situation. But typically, reps, real estate professional status, or the short-term rental tax loophole are the easiest ways to kind of unlock the benefits of the cost segregation study. If you don't qualify for either of those, well, then all of that paper loss can only be applied against your other forms of passive income from your real estate. So basically, the income produced of cash flow from your property, that can be offset by the cost segregation study.

3:22Now, it is incredibly difficult to qualify for real estate professional status if you're working a full-time job because you have to prove that you spent more hours in real estate than you did in your full-time job, right? So if you're spending 40 hours a week working full-time, well, then you have to prove and show that you've spent more than 40 hours per week every single week working in real estate. And for most people, that's just unreasonable and not possible. That's part of the reason why the short-term rental tax loophole is so popular today because it is significantly easier to apply the short-term rental tax loophole than it is rep status.

4:06For the short-term rental tax loophole, there are a few different kind of tests you can meet. One test is the 100-hour rule where you spend at least 100 hours working on your short-term rental. And if you add up all of the other time that other folks have spent, your cleaners, your maintenance folks, whoever it may be, they haven't exceeded the 100 hours. The other approach is the 500-hour rule where regardless of how many other hours other folks have spent, if you spend at least$500 for the whole year, you can qualify for material participation through the short-term rental tax loophole. So that was a lot, but I just wanted to make sure I kind of lay the foundation there for the differences and when you can and can't apply the benefits of the cost segregation study.

4:52We actually have a couple resources and I was just trying to look for the links of them, but I'm going to put them in the YouTube description if you're watching this. We do have a sponsor and I'm going to link their blog post, but you can get discounts on some cost segregations too if you guys are interested in doing that. I did a cost segregation on a property and it was my when it was my first time going through and doing this process. I invested for so long without ever doing it doing one and it was such a huge regret of mine that I didn't know about this sooner. I literally found out about this several years ago.

5:36And at that point, I'd already been investing for like eight years. So I think this is a really beneficial tool. I recently went to Florida and go ahead, put your hate comments on about investing in Florida. But I wanted to look at property while I'm there. So when I looked at this market, it's a buyer's market. There's not a ton of cash flow. Your biggest opportunity there renting to a snowbird for six months out of the year. But the real benefit, if you were to purchase a property there, would be doing a cost seg on the property and getting tax savings. It wouldn't be cash flow right now. It definitely wouldn't be appreciation in that market either.

6:23So I think that was something that took me a long time to realize are the tax benefits of actually owning a property besides just your regular depreciation that you're getting off of standard amortization of depreciation. Now, one last piece that I'll comment on is that even when we do something like a cost segregation study, we get this bonus depreciation, we qualify for material participation or rep status. It's not like the taxes that are due that they just disappear, right? We're basically just kind of getting a loan from the IRS to say, hey, we're not paying this today, but the IRS is still keeping track of what you owe them, right?

7:00Like it never just kind of goes away. And then if you do sell that property in the future, there's a recapture of those taxes that'll be applied. But in order to, again, continue to delay those taxes due, you can do what's called the 1031 exchange, where you're able to defer both the recapture and the capital gains on that sale. So a lot of folks, you know, they'll use the 1031, it's called swap to drop, where you basically never actually sell or you're just recycling that capital into the next deal. Or you can just hold the property forever, like just never sell the property. And you can do things like a refinance to try and get some of that equity back.

7:40But I just want to highlight that because people think that, okay, hey, if I do this and it's just like free money from the government, when that's not quite the case, it's just deferring that tax liability to some point down the road. You know, I've heard several people that have retired and they said the second best day of their life was when they bought their rental property and the best day of their life was when they sold it. But if you're going to hold it forever, you're going to keep that, not have to recapture that depreciation. That's not going to work. But you'd also put it into a trust for a family member, your kids or whatever, so that when you pass, they get the benefit of the trust or the beneficiaries, and they will only pay taxes on what the value of the property is when they inherit it.

8:30So instead of paying taxes on what you bought it for 20 years ago compared to what they could sell it today, that could be a huge difference. So you can even continue on the tax benefits until after you have passed away. Okay, we're going to take a short break, but coming up, we've got one shot to pick the right tenant. So what criteria should you actually set the before you list? We'll break it down right after this quick word from our sponsors. People love to call real estate passive income, which is interesting because most of the investors I know are very busy. Busy finding deals, busy managing teams, busy worrying they picked the wrong market.

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10:59Good morning, all. I am set to close on my first investment property tomorrow. This is a two-unit multifamily with one unit occupied and the other has been turned over and is ready for rent. What criteria does everyone here set for tenants? Minimum credit score, criminal history, income amount, and so on. I have a good idea of what I want, but would love to hear input from some more seasoned investors and anything to look for or to avoid at all costs. Okay, so to recap, set to close, two-unit, multifamily. They don't need to start screening tenants to look for them. So it is very important to set your criteria.

11:43Easiest thing to do, go into AI, ChatGPT, go into Claude, and have them give you a checklist, create a checklist of what is the screening criteria I should have, okay? Now, I don't want you to use what it actually says for your screening criteria, but I want you to look at these different things and see if it maybe even gave you more. But you want to set a minimum credit score. You want to set criminal history. And you want to set, you know, if they have violent criminal past, you're not going to accept them, what the income amount is. And by this, I usually do it as to how much more income they need than what the rental is.

12:24So common is three times what the rent is or three and a half times what the rent is. This also depends on your class and your neighborhood too that you're investing in. So these are different criteria that you want to set. And I would put it right into your listing so it's very clear what it is. When someone fills out the application, I would put it in there. So they're not wasting their time and you're not wasting your time. But also you don't want to violate any fair housing laws. So this criteria cannot be no kids allowed or anything like that. And you want to check your state laws as to how specific you can get on what you can deny for criminal history too.

13:07But also evictions. In New York State, you cannot deny someone a rental because they have been evicted in the past. It has to be for some other reason. So you can't say no past evictions if you're in New York state. So I would start with that as to kind of setting your criteria for what you want and then set up some property management software that has the screening process. There are companies out there that are just the tenant screening. I really like it integrated with the property management software because you can go ahead and do the full process from start to finish of renting out your unit.

13:47So you're going to set the listing inside. You're going to hit one button and the property management software is going to push it out to multiple websites. Every time you get a lead, someone clicking that they're interested, it will go right into the property management software. So even though you're listed on apartments.com, Facebook marketplace, or, you know, realtor.com, Zillow.com, whatever it is, it all comes into one place for you. Craigslist demon. And so then from there, you could send a prescreen. you could send the application. You can send them a link to schedule a showing for the apartment.

14:22And then from there, when they fill out the application, you can select the screening to be done. So a background check and a credit check. I like to verify their income. Some property management software has that integrated where it will do that for you based on their pay subs. It will verify that. If not, you're going to want to call and verify any documents they give you. So they're pay stubs. I've had people before submit to me fake pay stubs. I would literally just Google that the address they put on there didn't even match the company. And then I would call the company and ask, and they would have no record of this person at all.

15:00So sometimes it's that easy to catch them, but I would verify as much as you can. References, ask them for personal references, ask them for past landlord references. I also like to, the character references, I don't take much weight in because they can literally put down anybody and they're usually going to put down people, give them a good recommendation. But the previous landlord, I tried to do a little research and make sure like, okay, this is where they said their last address was. I look up who actually owns that property, see if I can find any correlation to the name they actually gave me.

15:39the phone number to coordinate with the address or whatever. And then when I am doing the phone call, verifying, you know, with the landlord, I try to ask some questions that don't make me accuse the landlord of being an imposter, but like maybe something they, you know, would only know about the property if they were the landlord or something like that. You know, you can look up the tax record history or, you know, something like that. But I'm more just trying to compare that they actually own it. It's not just their friend's phone number they're giving me to pretend to be their landlord. Ash, have you ever actually experienced that where you like caught someone red-handed in that kind of situation?

16:18Not for a landlord, but for an employer reference. I thought I did. I thought I did because it was so sketchy and it was so weird. And I'm just like, and it was like, the email was like a Gmail account, not for like a company or anything. and I actually called where the it was up for a bakery that they said they were starting employment at they just moved to the area or whatever but like any interaction with the landlord was like through a gmail or like a text like it was very very weird and I'm I thought I was catching them lying because like they didn't even have a first pay stub yet they just had like a letter written up and then they went and then I called the bakery and they actually like I asked to speak to that person and so I got to talk to them there but the fake pay stubs like I found that I got the fake pay stubs before and I just I didn't even you know take it a step further because they were fake I wonder if you could run them through AI like some of this verification and like ask Do you see anything that stands out that this is fraudulent, I wonder?

17:26I was going to say the inverse. I feel like it might be even harder now to catch those things because of AI, where someone can make an incredibly easy-looking, not only a pay stub, but someone can build out an entire fake website with a few prompts to say, hey, I was the VP of finance at this company. There's a whole digital presence behind it now. So, yeah, I was just curious if you've ever kind of caught someone red-handed. I mean, look at the people that there's like documentaries on where they've like inserted themselves into the wealthy of New York City or whatever and like pretend that they are, you know, part of that society and everything.

18:06People believe it. It goes along with it and all this stuff. And it's like someone can do that. Someone can easily rent an apartment on fraudulent information. Fake it till you make it at the highest level. Unless you're renting from me, don't do that. All right, guys, we're gonna take a quick break before our last question, but while we're gone, be sure that you are subscribed to the Real Estate Ricky YouTube channel. You can find us at Real Estate Ricky and we'll be back with more right after this. When you're just getting started in real estate, it feels like every dollar has a job, down payment, reserves, repairs.

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19:55Eligible students get a year of Microsoft 365 Premium and a year of Xbox Game Pass Ultimate with a custom color Xbox wireless controller. Learn more at windows.com slash student offer. While supplies last, ends June 30th. Terms at aka.ms slash college PC. All right, so let's jump back in. Our last question today is one that could save you maybe a lot of money in your taxes as well, or cost you if you get it wrong. So the question says, I purchased an off-market fix and flip property in New Jersey using hard money, and I plan to list it within about two months or a month, eight weeks, give or take, after closing.

20:30I'm wondering if I can utilize a 1031 exchange when I sell it to defer capital gains taxes. From my understanding, 1031 exchanges are typically for investment properties held for rental or business use, but I'm curious if there's any way my flip could qualify, especially since I haven't sold it yet. Would holding it for a short-term period automatically disqualify me, or are there strategies to structure the sale to make it eligible? Has anyone ever done a 1031 exchange with a flip? Okay, so we talked a little bit about 1031 exchanges in the first question. So this is kind of like a good kind of part B to that.

21:08The short answer is no. You cannot leverage a 1031 exchange on a flip property, right? Flips are inventory, right? They're commodities. They're not true investment properties. And because of that, they don't qualify for a 1031 exchange. So again, just to clarify, going back to question one, the benefit of a 1031 exchange is that you can defer any capital gains taxes on the sale of a rental property if you use those proceeds to buy another rental property. When you're flipping, that's not quite the case because it was never truly a rental. And the IRS looks at intent, not just timing. So even if you hold it for, say, 14 months, if your plan was always to sell that property, well, then you could still very quickly get disqualified.

22:00We've actually done a 1031 before on a property that we held for, I believe it was nine months. But we bought that property with the intention of renting it out and we did rent it out. But the market shifted in our favor where we had a lot of equity during that nine month period. There was another larger kind of set of properties we wanted to purchase. And we were able to 1031 the proceeds from that property that we held for nine months into another rental. But we had a lot of proof. This is a short-term rental for us. It was on a bunch of platforms. We had a lot of guests coming in and out, but Like if anyone ever questioned our intent, it was very clear from the beginning that as soon as we bought it, we immediately put guests into it.

22:35It was never listed for sale. We didn't even do any renovations on it. So it was very clear what our intent was. So for a flip, there's basically no way to, I think, to avoid that. Now, if you want to do like a delayed flip, that could be an option where say you buy a property, you renovate it, you immediately place a tenant in there, and then maybe you hold it for 24 months. then maybe there's an opportunity for you to sell that on the back end and still be eligible for 1031. But again, you want to talk that over with your qualified tax professional to make sure that you're setting yourself up appropriately.

23:11But flipping and 1031 typically don't go together. One thing that I've been thinking about doing is, so I'm doing a live-in flip right now, and I've already got my next property set up, but it hasn't been two years yet. So it's been over a year, so I've fulfilled my mortgage requirements by living here for a year. But if I move out right now, I will have to pay capital gains tax when I end up selling the property because it hasn't hit that two-year mark. So what I think I'm going to do is move out to my new house when it's done, but rent this property for several years. and then I'm going to go ahead and sell it into a 1031 exchange.

23:53So I'm still avoiding taxes and then investing into another property. So it's not, you know, I'm not getting just cash for free. I still have to do the 1031 exchange to put the money into another property. But honestly, I'd probably do that with the proceeds anyways of this property. So there are different ways that you can, work to make something work out if you do have to pivot or change your strategy. But I would definitely not risk it with a flip of just doing the rehab, listing it, and selling it, and then saying I'm doing a 1031 exchange that if you're audited, it will definitely be called out.

24:34Okay. Well, thank you guys so much for joining us today on this episode of Rookie Reply. If you have questions, make sure to check out the BiggerPockets forums. I'm Ashley, he's Tony, and we'll see you guys on the next episode. Hey, rookies, if you're watching this, we want you to apply to be a guest on the Real Estate Rookie Podcast. That's right. Ashley and I are looking for amazing stories just like yours to be a part of our Real Estate Rookie Podcast. Now look, you don't need to be an expert. You don't need to have done thousands of deals. Even if you've done one deal, your story could help inspire the next listener.

25:06As a rookie investor, especially if you just got your first deal, it is all fresh in your minds and you are the best person to tell your story, give your experience on how you got it done to help someone else get their first deal. So head over to biggerpockets.com slash guest. If you want to be a part of our show again, that's biggerpockets.com slash guest. And we'd love to have you on.