“Real Estate – Be A Professional” – by Lee Phillips

Somehow you know that people who do real estate investing get rich.  I didn’t fully realize that until I was in my forties, even though I spoke at thousands of real estate events.  I didn’t want to deal with the “hassles” of real estate investing, so I invested in the stock market.  After 20 years of stock market investing, I almost broke even.  There’s a statistic that says 95% of people who invest in the market, as individual direct investors, lose money.  I was better than most, but certainly didn’t get rich. 

As I matured (at least got older), my focus on asset protection expanded and my vision of real estate started to open up.  Plus, Kristy said forget the market, I am going out and buying real estate.  (She was always smarter with money than I was.)  I am conservative and didn’t want the debt real estate brings, but she charged ahead.  That was the best thing that happened to us financially. 

She didn’t know if the real estate market was up or down.  She didn’t really get deals.  She didn’t even make a cash flow, but I was making enough money that I could subsidize her real estate investing.  Twenty-five years later, the properties she bought are still bringing in rent, and the mortgages are gone.  I have a friend that says, “Don’t wait to buy real estate.  Buy real estate and wait.”  I can better understand what he is saying now.

I didn’t fully appreciate the concept of having the renters paying your mortgage.  Yes, all of the rent went to the mortgage.  I had to throw in a thousand or two each year to fully cover the mortgage and expenses on each unit, but most of the mortgage was paid by the renters.  Ultimately, the rents increased as inflation did its thing, and the renters were paying all of the mortgage and expenses.  Now the properties are paid off, the rent is ours.  Plus, we have the properties. 

We’re not rich like some of my students who have dozens or hundreds of properties, but we have a nice income that just flows in.  There was a sacrifice, but it wasn’t bad, and now there is a reward. 

Real estate investing and my changing focus on asset protection has caused me to see things in a different light.  It’s funny how getting older changes your vision – beyond needing stronger prescriptions for your glasses.  Real estate investing adds value to your net worth, it can give you a cash flow, and it does something many people miss or just plain miss out on.  It is or can be a great tax shelter.

My asset protection view has changed from a focus on lawsuits and related standard “asset protection stuff” to a focus on the ever threatening drain of taxes.  When Kristy started to buy our real estate, the last thing I wanted to do was participate in the upkeep.  I would get upset every time she sent me to unclog a drain.  I’m not helpless.  I can basically build a house from the ground up, and have done so with our current house, but I hated to “spend the time” playing with our real estate.

I have mellowed over the years, as I have realized that our real estate forms a major portion of our wealth, and the amount of time I have spent developing that part of our estate is nothing compared to what I have spent accumulating the other portion of our estate.  Maybe I should have concentrated on becoming a real estate professional.  Your knee jerk reaction may be, “Oh, don’t become a real estate professional.” 

Over the years I have attended the real estate conventions and the gurus have always warned against being classified as a real estate dealer.  Note that that is very different, under the IRS Code, from being a real estate professional.  They are right.  You don’t want to be classified as a real estate dealer, but you do want to be a real estate professional, if possible.  If you are a real estate professional, your rental losses can be used to offset your real estate income and all your other active income (income from your day job).  For example, if you are a real estate professional and your spouse has a day job, your real estate losses may make it so you don’t pay any taxes, even on your spouse’s day job.  

A Real Estate Professional

What is a Real Estate Professional and why does it matter to you?  It’s a tax issue.

When you have rental real estate, the income generated by the rent is generally treated as a “passive income.”  When you earn income through the sale of goods or services, it is “active income.”  Even though I work a lot to keep my rental units up and running, the IRS does not consider my participation in the generation of the income as enough activity to make the rental income active income.  Active income and passive income are taxed very differently. 

Obviously, the advantage to passive income is that it comes to you without the IRS imposing self-employment taxes on it.  Active income is subject to the 16% self-employment tax.  (You’ve got to fund your Social Security and Medicare, which you may never see.)  If you don’t have to pay the “social taxes” on passive income, that’s great, but the IRS has a “got ya” that they attach to passive income. 

Not only does real estate generate passive income, it also generates passive losses.  The losses come from all your expenses, including mortgages, expenses, taxes, etc., and depreciation on the property.  The losses generated by your real estate help on your overall taxes, but your ability to “use” passive losses is severely limited.

Section 469 of the Internal Revenue Code imposes limits on deductions for losses from any passive activity. Under this section, an individual cannot deduct a “passive activity loss.”  The IRS defines a “passive activity loss” as the amount of total passive losses left over after you offset your passive losses against your passive income.  Your passive losses can eat up your passive income, but if there are any passive losses left over after your passive income is offset (your passive activity loss), those left over passive losses cannot be used against your active income and must be carried forward until you have passive income or dispose of the property. 

As a general rule, any rental activity is a passive activity. A rental activity is defined by the IRS as “any activity where payments are principally for the use of tangible property,” aka real estate. There are certain exceptions to this rule, which we will discuss later. Rental activity (including rental real estate activity) is per se passive, unless you can qualify as a “real-estate professional.” If you can qualify as a real-estate professional, your rental real estate activity escapes automatically being classified as a passive activity. 

In order to qualify as a real estate professional, you have to meet both of the following two criteria. Notice it doesn’t require you to be a “Realtor.”

1. More than half of your services (work) has to be in your real estate “trade or business,” and you have to “materially participate” in your real estate trade or business, and
2. You have to work more than750 hours during the taxable year in your real property trade or business in which you materially participate.

If you are married and filing a joint return, the same spouse must satisfy each requirement. However, if one spouse is deemed a real estate professional, the other spouse is also automatically considered a real estate professional.

Here’s where it gets tricky.  “In establishing whether a taxpayer’s real property activities result in passive activity losses, each interest in rental real estate (each property) is treated as a separate rental real estate activity. This means that you must establish that you meet the two criteria above for each property. That’s nearly impossible. The IRS allows a special election to treat all interests in rental real estate as a single rental real estate activity. This election is made once and is effective indefinitely. The election is made with an attached statement to your tax return by the due date, including extensions, of the return for the year in which (1) two or more activities are first grouped together, (2) a new activity is added to an existing group, or (3) an existing group is regrouped. Your tax advisor should know how to make this election and what language to use in the election.

In order to show that you meet your 750 yours, you can “establish hours of participation in a real property trade or business by any reasonable means.”  You could keep a daily log of your time, but “contemporaneous daily reports are not required if you can establish participation by other reasonable means.”   The IRS has issued a regulation that gives some guidance as to what “other reasonable means” consists of.  The regulations say that the following types of proof can be used in determining the extent of an individual’s participation in an activity.

“Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.”

You need to know that the IRS has a little trap for you.  They make it harder to get your 750 hours, because the following activities are considered investment activities and don’t count towards the 750 hour requirement: (1) Studying and reviewing financial statements or reports on operations of the activity; (2) Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual’s own use; and (3) Monitoring the finances or operations of the activity in a non-managerial capacity.

One More Chance

Even if you can’t qualify as a real estate professional, you might still be eligible to deduct a portion of your real estate losses and offset some of your active income. Section 469 provides a limited exception to the general rule that passive activity losses can only be used against passive income.  If you actively participate in a rental real estate activity, you can deduct a maximum loss of up to $25,000 per year related to the activity.  However, the IRS has a “got ya here” too.  The deduction is phased out as your “modified adjusted gross income,” modified by section 469(i)(3)(E), exceeds $100,000, with a full phaseout occurring when modified adjusted gross income equals $150,000.

You are considered to meet the active participation standard if you participate in a significant and bona fide sense in making management decisions or arranging for others to provide services such as repairs.   Basically, you need to manage the property. 

A common asset protection technique is to establish a management company to “manage” your real estate on your behalf.  If you turn your management of the real estate over to the third-party management company it may be questionable whether or not you have a significant and bona fide management control over the property.  Note that the company you establish to be the management company is not you (the taxpayer).  It is a true third party – or at least it should be.

This is a case where asset protection and taxes cross each other.  There are lots of cases where you can maximize your asset protection or you can maximize your tax benefits, but you can’t have both. 

In any case, your adjusted gross income is a critical component of your life.  Most people never give a second thought to their adjusted gross income.  BUT you need to plan on lowering your adjusted gross income this coming year.  The Advanced Tax Tactics gives you ten ways you can lower your adjusted gross income by big amounts.  The Advanced Tax Tactics has been all updated for the new Trump tax laws.  This coming year we will be working on lowering your adjusted gross income, because it affects so many parts of your tax life.  For example, the $100,000 – $150,000 phase out in the passive loss section described above is dependent upon your adjusted gross income.  If you need one of the Advanced Tax Tactics courses, call Candy in my office and tell her you are a newsletter subscriber and I said you could have the course for 60% off retail.

Although it doesn’t lower your adjusted gross income, the 20% deduction under the new Trump tax laws is something you need to be sure you qualify for this year.  (See the September newsletter, and don’t forget all 10 years of newsletters are searchable online if you are one of our Masters Members.)  The 20% deduction for “pass-through entities” usually includes Schedule E activities.  Don’t let your tax dude convince you that you don’t qualify for the deduction until you have talked to Ben, the former special auditor with the IRS, who we work with.  It could mean a lot of money to you when you pay your taxes in April. 

Thank You

Thank you for being a newsletter subscriber.  I try to write things that will be meaningful to you – things that will give you better asset protection and more money.  If you have a topic you want covered, let me know.  2018 has been a good year for me and Kristy and our office.  I am mostly home with Kristy, as she works her way through her 5^th year of ALS.  Your thoughts and prayers on our behalf are deeply appreciated. 

Kristy is almost totally paralyzed and is totally dependent on a ventilator now.  We have emergency power for her machines that keep her alive.  During the day, she is strapped into a huge motorized wheelchair.  Even her head has to be secured because her neck muscles are gone.  If we go on a walk, I marvel that the wheelchair she is driving the equivalent of a $200,000 car.  She has an eye gaze computer that controls everything.  She can surf the net and talk to us with the computer by just moving her eyes.  She eats through a permanent feeding tube.  We are very blessed to be able to pay for private nursing care on 12-hour shifts.  It takes me and a nurse to meet her needs.  If I am gone, there has to be two nurses at the house.  At night she is in a special bed.  Not that I would ever want to move her, but a care facility, a long-term care hospital, and even a standard hospital wouldn’t even take her.  If she goes in a standard hospital, she has to be placed in intensive care.  So, we have our challenges, but we are happy and feel very blessed. I sincerely hope you feel as blessed.