[RWS #605] How Trump’s Tax Reform Benefits Real Estate Investors

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picture of man with briefcase for Real Estate News for Investors Podcast Episode #605

Now President Trump has signed the new Tax Bill into law, accountants have their work cut out for them!

The new tax code went into effect on January 1st, so it’s crucial to know how the changes will affect you, your finances, and your investment portfolio. On this episode of The Real Wealth Show Kathy interviews a CPA with 12 years of experience at two of the world’s biggest accounting firms, and several large U.S. companies with international connections. He’s now the founder and “Chief Problem Fixer” at Indigo Spire in San Jose, which he calls, “a creative accounting firm for small business.”

He also says on his website, he loves to “sort through his friend’s IRS problems.” Now everyone needs a friend like this — especially right now! I am delighted to “talk taxes” today with someone I’m happy to call my friend, Ryan Shellhous.

How Trump’s Tax Reform Benefits Real Estate Investors – Transcript

Kathy Fettke Interviews CPA Ryan Schellhous on The Real Wealth Show

Kathy: Tax accountants certainly have their work cut out for them. The new tax reform law goes into effect January 1st – and it’s crucial to know how the code will affect you, your finances, and your investments. Today I have with me a CPA with 12 years’ experience at two of the world’s biggest accounting firms, and several large US companies with international connections. He’s now the founder and chief problem fixer at an accounting firm in San Jose, which he calls a “creative accounting firm” for small business. He also says on his website that he loves to sort through his friends’ IRS problems. Wow, everybody needs a friend like this, that’s for sure. I’m delighted to talk taxes today with someone I’d better start calling my friend, Ryan Shellhouse. Welcome, welcome back Ryan.

Ryan: Thanks, Kathy. Thanks so much for having me. And this is a great time to be alive for tax guys. These are the biggest changes in 21 years to the tax codes, so there’s lots going on here and happy to talk about it today.

Kathy: Oh my gosh, yeah. I mean some of it is really great for real estate investors, I think. So let’s talk about some of the things that were kind of on the table and it was a little worrisome, but didn’t get changed. I know they were possibly on the cutting board during the Obama days – and even in the past few weeks, but what did not change that are normal benefits to real estate investors?

Existing Tax Benefits for Investors that Didn’t Change

Ryan: So some of the key things that people may have heard about were up for changing that didn’t actually make it to the final bill, and then President Trump actually signed the bill into law this morning. Some of the things like tax credit for electric vehicles is still there. There’s still all the credits for higher education that people were worried about. Student loan interest still is deductible.

And maybe most importantly for some of the folks listening is the home gain exclusionso the rule that allowed you to exclude some of the gain from the sale of the home you live in – that remains intact and under all the new law provisions. So I mean, there’s a bunch of other things that kind of came up. And were in a house bill or in a senate bill, that didn’t end up making it into law. But we’ll just kind of cover some of those other items as we go through what did change, and what people should be thinking about going into 2018.

Kathy: Yeah, so hopefully you all heard that. Because there’s a lot of confusion out there among regular folks who don’t obsess with this kind of stuff, and that is that you can literally cash out right now. You can sell your home. I know you’ve made a lot of equity if you own a home, and if you don’t plan to live there forever – you could sell it now. And walk away with $500,000 tax free if you’re married, and $250,000 if you’re not – if you’ve lived there for 2 out of the last 5 years, right? That’s still around.

Ryan: Yeah. Everything you just said is still the law.

Kathy: So that’s incredible. And then you still have the opportunity – again, if you’re in a high priced market – and I know so many of you are because you’re California listeners. If you have investment property that you’ve made a bunch of money on, have a lot of equity but not much cash flow – you could do the 1031 exchange, and just sell those properties. Exchange them for high cash flow properties, and just postpone that gain until later in life – and maybe never have to pay it, if you die and pass that property onto your children. So this 1031 exchange is an incredible benefit to real estate investors, something you definitely should consider or learn more about.

Ryan: You’re exactly right. So they did make changes to the 1031 rules, but not for real estate. They actually narrowed the 1031 – you used to be able to exchange lifetime property, and there were kind of wide varieties of opinions on what was actually “lifetime”. But they narrowed all that stuff and said, “The only thing you can 1031 now is real estate.” So obviously congress took a look at 1031 and said, “We still support and endorse the tax free exchange of real estate, so let’s keep it in.

Kathy: Well, this is one of the benefits of having a big time real estate investor in office, right? But even so, it seems that congress likes to protect the tax benefits of real estate. It just seems to happen over and over again.

Ryan: Yeah, that’s right.

Kathy: Okay, so what are some of the big changes that we need to know about? I mean, it got signed today, right? This is actual law – the President signed it into law today, correct?

Ryan: That’s correct. No more legislative hurdles. This is the effective date of the legislation. Many of these provisions have effective dates up for the provisions of the law to actually start, January 1st. So it’s actually nice to have a little bit of certainty at least, what are we at? Just a few days ahead of the New Year. But there is one key provision that has some retroactive effect. It’s going to have an effect on real estate investors and we’ll talk about that as we get to that. But you’re absolutely right, Kathy. This is law, this is how life is now.

Kathy: And today, meaning we are recording on Friday December 22nd. If you’re listening to this at a later date then you’ll know what to look back to. Now, a lot of us have been coming out with what we think was signed into law, but has it changed since Thursday, or Wednesday? What got signed?

Ryan: No, it did not. There were just – a bill came out of conference, which is the house and the senate getting together and agreeing on all the provisions of the law. The bill came out of conference late last Friday, December 15th. And then the house and senate both voted on it this week that passed. The senate voted on something and there were some procedural and parliamentary things that changed. So it went back to the house one more time for final approvals, so both houses of congress have passed – the exact same language, the President signed it, and away we go.

Kathy: Amazing. Okay, so I mean there’s so many things we could talk about – the different tax brackets, and so forth. But I think it’s easier for people just to look that up, because it’s a little complicated don’t you think?

Ryan: Sure. Yeah, yeah. Maybe we could just kinda hit on some of these big ones. And maybe, Kathy, let’s just start with some of the bigger provisions from an individual perspective.

Kathy: Okay.

Ryan: And then we can touch on just a couple of the boring business ones that may apply in certain situations. And then I do want to spend time helping you and your listeners understand – from a real estate perspective, especially as an investor in real estate – how this bill might be fantastic for people.

Kathy: Yeah, let’s talk about that.

Big Tax Changes for Individuals

Ryan: Yeah, so I’ll kind of tease that for the end here. But from an individual perspective, Kathy – obviously the tax brackets got wider and the rates went down. So all things being equal, if that was the only thing that happened, it’s going to be a large benefit for many people.

The personal exemption amount – and some of these are kind of tax geek terms, but your CPA’s going to know what I’m talking about. TurboTax will know when they get around to releasing their version of the software that’s going to accommodate this. The personal exemption is gone, however the standard deduction goes up to accommodate for that.

There’s going to be an enhanced child tax credit, enhanced in 2 ways. 1, the amount per child of tax credit is being doubled. But maybe even more applicable to many folks – is the number of people that are going to be able to take a child tax credit is going to go up, because it used to phase out at such a low level that very few people – households that had 2 jobs, that kind of thing even saw the child tax credit as it used to be around.

Just a couple other things on the individual side – and I’m not going to hit all the things that have changed, just some of these highlights so that you can talk intelligently at the bar. If you’re talking about taxes, go to a different bar. But at least if you’re at that one, you can talk about these things.

The individual mandate, so the penalty that people used to have to pay for not having health insurance, the penalty is still there but the penalty is statutorily set to zero. The charitable deduction for cash that you pay to charities, the limitation on that has gone up a little bit. And then they got rid of a whole bunch of deductions that used to on your Schedule A. They were subject to, like, the 2% floor – again, that’s tax geek language.

But things like union dues, and CPA tax prep fees, those kind of things are no longer deductible at all.

Big Tax Changes for Real Estate Investors

Perhaps important for real estate investors is the lifetime estate and gift tax exclusion. Lifetime amount was doubled, raised to $10 million. So now you can give up to $10 million away in your lifetime – or after you’ve passed on, tax free – to friends and family. And then there’s some changes for moving expenses and alimony. Some of the ways you can use your 529 plan changed a little bit. And those are some of our biggest changes from an individual perspective.

Kathy: Fascinating.

Ryan: I kind of hustled through that, Kathy, so if I need to hit any of those a little bit more that’s fine. But we can talk about whatever you want. We can kind of move on to the business stuff too so we’ve got time for real estate.

Kathy: Yeah, I was just going to say I think everybody would hope that they could be friend or family of somebody who–

Ryan: Who’s got 10 million to give away?

Kathy: Yeah, that one. That one sort of stood out.

Ryan: Exactly.

Kathy: Yeah. So let’s talk about how we can increase our cash-flow and make more money as real estate investors.

How To Increase Cash Flow & Make More Money as a Real Estate Investor (Business Tax Changes)

Ryan: Yeah, so a lot of these are going to go hand in hand with some of these business tax changes that came into play. First and foremost, and most celebrated part of this tax law, is that the corporate income tax rate was lowered from 35% to 21%. So this is – for smaller real estate investors, this probably isn’t as big of a deal, but there are a few ways investors can benefit:

We’ve talked about specific tax strategies for people using their self-directed IRA, investing through a corporate form in order to avoid UBIT. This will make this particular strategy far more attractive. There’s going to be a new limit for businesses on how much interest they can pay. Now it’s going to be capped at 30%, which sounds terrible for real estate companies – except there’s a special carve out for people in the real estate business. You can continue to be as levered as you are now with no limitation.

Kathy: Interesting. Can you explain that a little bit further? What do you mean? Let’s go back to – I know you have mentioned the C-corp before, for avoiding UBIT, but can you explain that a little further?

Ryan: Yeah. So lots of times when people invest into real estate with their self-directed IRA – depending on the form of that investment, that investment will give off income that’s subject to unrelated business income tax to self-directed IRA’s. Investing through a corporation kind of turns that off, but with the cost that that corporation that you’ve invested into the real estate through has to pay its own taxes.

Well, now we’ve significantly reduced the rate of tax that that corporation’s going to pay. So now it makes this particular strategy for self-directed IRA investors to invest into real estate through that. Kind of combine that with – there was one small change to the UBIT calculation included in this law – which is not great. So now you actually have to calculate UBIT on a business by business basis. It used to be if you had some UBIT winners and some UBIT losers in your self-directed IRA, you could just pool it all together and whatever the net number was–

Kathy: Yeah.

Ryan: Is what you would pay in UBIT. Now you have to go piece by piece.

Kathy: Per deal?

Ryan: So if you’ve got a winner you pay – yeah, you have to pay UBIT on that. And if you’ve got a loser, that loser just carries forward until that loser becomes a winner. And then you can offset that loss amount with the winners going forward. So those kind of little tweaks, that was rated as like a $5 billion revenue raiser, which is pennies in the spill. It gets forgotten about by most people, but for some self-directed IRA investors, that’s a huge change for UBIT.

Kathy: That’s a huge change, but it begins next year? 2018?

Ryan: It begins in 2018. That’s right.

Kathy: Okay, so people would want to take their losses to offset gains in their self-directed IRAs in 2017.

Ryan: If they have losses to take, that’s right. Pool that stuff together and then even consider this more corporate investment strategy. One of the other celebrated parts of this tax bill is a 20% deduction for flow-through income. So whether it’s a schedule-c, schedule-e partnership that you’re in with other LLC – an LLC with other members, or an S-corporation. If you earn any money through one of these pass-through entities, you get a 20% deduction off of the net ordinary business income of that entity.

There’s a lot of complications to this provision. It’s a huge boom for some folks, and it’s not going to matter that much for others, but that’s the headline. Now, that only applies for people who are married up to $315,000 of taxable income. And above that it starts to scale back, or you have to take a limitation with respect to wages or an investment. And it’s a pretty complex provision in the law. So it’s something you definitely want to talk about. If you’ve got flow through income, and you make less than $315,000 as a married couple, you’re going to see a benefit here. If you make more than $315,000, talk to your CPA because you can still get a benefit of this, you’re just going to have to do a little extra work.

Kathy: As in, yes, creative structuring I’m guessing?

Ryan: Creating – that’s right. That’s right?

Kathy: Okay. Which is why good CPA’s are going to be real busy.

Ryan: Yeah. This change always brings about uncertainty, and people like to get certainty, and they pay for it. So it’s definitely the accountant’s full employment act of 2017. Let’s hit the big thing for real estate investors.

Kathy: Yeah, let’s do it.

Big Tax Reform Changes That Affect Real Estate Investors

Ryan: Is this accelerated depreciation, okay? And this has been around for a while in certain types of assets. So the old rules used to be if you bought a piece of property and it was brand new, you could take accelerated depreciation – in some years it was 50%, some years it was 100%. Like you could write off the entire investment in that piece of property. They would kick these things in when they wanted to give the economy a little bit of a boost, and it was widely regarded. Businesses loved being able to depreciate their assets faster.

The main kicker for real estate guys, and why they never got as much benefit out of these prior accelerated depreciation or bonus depreciation methods – was that it had to be brand new. It had to be the first time anybody was using that. So sometimes it only applied if you like, bought a new kitchen for a piece of rental property. Well this law – the one that President Trump just signed – makes it so that it just has to be new to you, in order for you to get a full 100% deduction for depreciation for property that’s less than a 15 year life.

Okay, so what that means for real estate investors – because normally when you buy real estate. If it’s rental real estate you have to depreciate over 27 and 1/2 years. But what it really means is you have to take a close look – and this is something our firm’s going to be, we’re going to be in this with online tools and all kinds of stuff because I think this is going to be huge. When you buy a piece of rental real estate now, you obviously, and you should be taking a look at what you actually paid for that property and dividing it out into all the different types of assets that you really bought, okay?

So when you buy a piece of rental real estate, you buy the kitchen cabinets, and you buy the HVAC, and you bought a roof, and you bought landscaping as well as the land and the actual house. So with this bill, there’s going to be an incentive for us to be very thorough in that – in saying that anything that’s not the land or the actual house, we’re going to get to write off that entire amount now. And it could be huge for single family investors.

Kathy: Man. What do you think will be the ramifications? Do you think more people will be buying, and selling, and trying to take advantage of these things? Or do they just stay put? I mean, what do you see?

Ryan: I actually see that as being a positive. Now, that depreciation deduction is not available to people who aren’t using that property in a business. So real estate investors get this huge depreciation benefit. Home buyers – the people that are going to live in those homes – do not, right?

Kathy: Right.

Ryan: So this kind of slightly skews a home purchase – if I want to live in a home that costs $200,000, and you want to buy it to rent it out, your after tax cost is going to be much lower than mine because maybe 30% of the house is stuff that you can depreciate right away. So you’re going to take a $60,000 tax deduction on the very first year you buy the property, whereas I don’t get any deductions, right?

Kathy: Wow. I mean, it’s so great for us. It’s just amazing that at a time when we’re seeing home ownership at their lowest rates that there wouldn’t be more incentive for the individual when they need it the most. Again, I’ll be out there trying to teach the average person to go buy an investment property, maybe even instead of that primary residence, because you’re going to get so many more benefits. I mean, would you say that’s one of the things we might see more of?

Ryan: Yeah, we might see more of that. I mean, leaving the home gain exclusion intact kind of makes up for it a little bit. Because when a real estate investor sells their property with appreciation, they get to recapture all that depreciation and then pay capital gains, whereas the homeowner does not up to $500,000.

The “Merry Christmas” in this bill, with respect to this bonus depreciation, is that is the only provision that is not starting on January 1st. So I just want to be super clear to all the listeners, if you bought a real estate investment property – or any property, tangible property that has a useful life of less than 15 years. So rehabs, that kind of thing – if you did those things after September 27th of this year, you can take a 100% tax deduction for those things in 2017.

So I know there’s not much time left in the year, and we didn’t even know this was going to be law until a week ago Friday when the bill came out and then President Trump signed it today on December 22nd. But the “Merry Christmas” here is if you have purchased something since October 27th and placed it in service – or you will do that before the end of the year, you’re going to get a huge tax deduction in 2017. The rest of us are going to have to wait until 2018 when we actually buy the properties.

Kathy: Oh my goodness. Wow, that’s incredible. Okay, so there’s a couple of specific questions. Let’s say that–

Ryan: Yeah, bring it.

Kathy: I think you’re familiar with one of the deals that we’re doing right now which is in Reno. We’ve structured it 2 ways. We’re raising 12 and a half million. We raised over – I think close to $9 million now on the equity side. And then we set up a second phase of it to be just private lending, so that those investors could avoid UBIT. And so the equity investors who invest in their self-directed IRAs would have had to pay UBIT, but we set up a private lending part of it so that they wouldn’t have to. Now, this is in an LLC – so when the investors on the equity side get paid out their profit, they will get a 20% deduction on that?

Ryan: That is correct. Unless they are phased out for some other reason. Income limits phase out for certain people. And even then, for this type of business – we didn’t get into the 20% deduction all that much – yeah, the ordinary business income, we kind of talked about Reno as being, because it’s more than just an investment it’s like an actual business, we’re going to see those K1’s from that LLC go out to the investors with something in box 1 – which is ordinary business income on their K1’s. And assuming they meet the other criteria for this deduction, which are tested at a personal level, yeah they’ll get a 20% deduction off that amount before the tax rate was applied.

Kathy: Oh my gosh, so their return is even going to be better than we thought. And then for the private lending group, whether they want to just be a lender inside or outside of their IRA, is there much difference for them with the new law?

Ryan: You put me on the spot here. So the self-directed IRA guys – interest that’s flowing through to them would not typically be considered subject to UBIT. So I don’t think their thing’s going to change all that much. But the folks who maybe went into it from outside their IRA, the 20% deduction is for qualified business income – that’s the definition. And qualified business income does not generally include investment income. So things like interest dividends, long-term capital gains, those types of things are typically not considered qualified business income for purposes of this deduction.

Kathy: Okay.

Ryan: That would be my initial thought, but we’ll see. Obviously one of the other things that we’re going to see as a result of this maybe not inside the real estate business per-se for investors, but if you have a small construction company – for example, this flowing through income – you’re under the limits. You’re going to want as much as possible in this ordinary business income. Such that you may decide, “Hey, I’d rather just take my salary from the company in terms as k1.”

Like people like to say instead of w2. If I pay myself a salary, I’ve got to pay payroll tax, I’ve got to pay the highest possible rates, and I don’t get this 20% deduction. I think one of the futures of tax compliance is going to be, “Am I paying myself a reasonable salary?” In these businesses that are more active in that regard. So these are just me trying to think ahead for my industry at what kind of stuff CPA’s should be looking at, and it’s going to be absolutely cost-segs.

Even the cost-segregation on purchases. Especially in real estate, and then also with respect to how much wages people are paying themselves in their pass through entities. Because if I don’t pay myself a wage, then that means my qualified business income is higher, and I get a 20% deduction on that, and I don’t pay payroll taxes if it’s an s-corp. And so now there’s this huge benefit, this shift from wage income to just letting it flow through to you through your s-corp. And I think there’s going to be pressure with the IRS.

Kathy: Well, and also you have to explain why you’ve changed. I would imagine you–

Ryan: Oh yeah. Yeah, yeah, yeah.

Kathy: Not everyone is going to be able to say, “No, I’m not an employee. I own my own business.” I know we had to turn all of our – most of our people from contractors into employees because of some new rules. So be careful about just suddenly running out and calling yourself a contractor or starting your own s-corp, if indeed you really are an employee.

Ryan: Yeah, that’s a great point. Do so with good advice, paying yourself a reasonable wage, and don’t get behind on those payroll taxes.

Kathy: Yeah, there you go. Okay, one last question. This depreciation, obviously for commercial buildings and so forth it’s really important. But what about somebody who has bought a single family home? Two scenarios: they either bought it totally renovated, or they buy it and then they do the renovation once they’ve bought it. In either scenario do they get that bonus?

Ryan: Yes. So that would be – I mean yes with caveats, right? What we need to do in either situation is be able to reasonably say what of the money that we’ve put into this property is applicable to the types of assets that we can take bonus depreciation on? The window treatments, the floor coverings, all those things are less than – they’re not long lived assets as part of the building. So I would depreciate those under these new provisions. Things like if I’m going to remodel the house and put on a second story, those types of renovations would go to – you would allocate that to an asset class that is outside the provisions of this bonus depreciation, and you would just depreciate that in conjunction with the rest of the house.

Kathy: Oh.

Ryan: Right, so land – never depreciate. House is a long depreciation. Everything else you want to allocate into specific buckets and see if it fits within these rules. And like I said, our firm is – we’re racing, basically. There’s no Christmas here. We’re going to be racing to put together tools to help people be able to do that. Because generally – Kathy, I don’t know if you’ve ever had a cost segregation study done before, but they’re like $30,000. To have an engineer go out.

I mean, if it’s a huge commercial space or a 500 unit apartment building, it makes a ton of sense. But we’ve got to find a way that the IRS will accept it as being reasonable for people to do something for single family homes that’s affordable, right? No one’s going to spend $30,000 on a cost seg study for a $100,000 home. So we’ve got to find some way to do that in a reasonable fashion. And the IRS does not like the, “Hey, I pulled the property tax statements and I just used the same ratios.” Right? All you end up with is some land and a 27 and a 1/2 year depreciable single family home. And we want to think about it better so that more stuff can be depreciated in the first year.

Kathy: Okay, well I can’t wait to learn what you’ve sorted out there.

Ryan: 2017, people are going to – their heads are going to be spinning thinking about if there’s anything I need to do before the end of the year. Let me just hit on a couple of things. If you’ve got estimated tax payments from a state perspective, you can’t prepay taxes but you can certainly make sure that all the taxes that you think you might owe for 2017 get paid in 2017, so that you can get a deduction.

That’s one thing we didn’t talk about, but the amount of deductible taxes that people pay as an individual – whether it be income taxes or property taxes – is being limited to $10,000. So for a lot of people here in California, that’s just their Q1 property tax bill. So it’s not going to be great for some folks, but if you can pay any of that stuff now, go ahead and do it.

If you’ve got properties or any other type of business assets that you’ve purchased after September 27th, give somebody a call and talk about how you can depreciate those things. And keep an eye out for – since the rates got smaller and the brackets got bigger, we want to accelerate any expenses that we can into this year and push income into next year. That’s generally a good strategy just to get one year of deferral, but now we get one year of deferral and we’re going to pay less tax on that income when we push it into next year. So those are just a few things – and I know I’m talking about 1000 miles a minute. But this is good stuff for guys like me, we love this stuff.

Kathy: It’s great for us too. Alright Ryan Shellhouse, thank you so much for joining us again here on the Real Wealth Show. It’s just always a pleasure, even when we’re talking taxes.

Ryan: Thank you Kathy.

Kathy: Alright.

Ryan: Even when we’re talking taxes right before Christmas.

Kathy: Yeah, and thank you all for taking the time to listen to this right before or during Christmas. But yeah, we only have a little bit of time left to implement some things we might need to this year. Alright, thank you all for joining me here on the Real Wealth Show. Have a wonderful holiday and we’ll talk to you soon. Bye bye.

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