Today we have two guests with us today to discuss real estate taxes. Stessa is our sponsor and also our guest today, along with Thomas Castelli, an investor, CPA, and tax strategist. So hit play to hear the easiest way to handle your taxes and hear about the new laws. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
- Since the introduction of the Tax Cuts & Jobs Act in 2017 many real estate investors have wondered how these new rules and incentives will affect their taxes this year. Things were so confusing in fact that the IRS recently released clarification on the 20% pass-through deduction, and specifically singled-out real estate investments as needing more clarity.
- Devin Redmond, Head of Customer Success at Stessa and Thomas Castelli, CPA & Tax Strategist at the Real Estate CPA teamed up to help provide clarification on taxes for real estate investors by creating a series of resources that investors can reference.
Best Ever Tweet:
“You really want to be taking a proactive approach throughout the year”
Devin Redmond & Thomas Castelli Real Estate Backgrounds:
- Devin Redmond:
- Head of customer success with Stessa
- Former commercial real estate pro and investor
- Say hi to him at https://www.stessa.com/
- Based in San Francisco, CA
- Thomas Castelli:
- CPA & Tax Strategist at The Real Estate CPA
- Real estate investor, invested passively before being active in an 82 unit apartment community
- Say hi to him at www.therealestatecpa.com
- Based in NYC
Sponsored by Stessa – Maximize tax deductions on your rental properties. Get your free tax guide from Stessa, the essential tool for rental property owners.
Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast, where we only talk about the best advice ever; we don’t get into any of that fluffy stuff.
First off, I hope you’re having a best ever weekend. Because today is Saturday, we’ve got a special segment for you called Situation Saturday, and here is the situation – it’s tax time, and you’ve got to put together your tax returns, or your CPA has to put together your tax returns. Well, you’ve got to figure out what is it with these new tax cuts and Job Act law that you can do, or what is it about that that you can use to benefit you as a real estate investor. Let’s get some clarity on that.
This will be a one-stop-shop conversation for you, Best Ever listeners, as you navigate that… And even if you don’t do your own taxes, it’s important to be educated on this topic, so that you can look for your CPA or make sure your CPA is maximizing the deductions and the benefits that you have as a real estate investor. With us today we’ve got a dynamic duo – we’ve got Devin Redmond, head of customer success at Stessa, who is, as you probably know, Best Ever listeners, the sponsor of this podcast… And also Thomas Castelli, who’s a CPA and tax strategist at the Real Estate CPA. First off, welcome, Devin and Thomas. How are you two doing?
Devin Redmond: Great! Thanks for having us.
Thomas Castelli: Great, same here.
Joe Fairless: You all good, glad to hear that, and it’s my pleasure. A little bit about Devin and Thomas – first, Devin Redmond, head of customer success at Stessa, former commercial real estate pro and investor; their company, Stessa.com – you can go check that out, and you know all about Stessa, because you’re a loyal Best Ever listener; based in San Francisco, California.
Then Thomas Castelli, CPA and tax strategist at the Real Estate CPA. He’s a real estate investor who passively invests, and then most recently is an active investor on an 82-unit apartment community, so learning from someone who is an expert in tax strategy and who also invests actively in deals, which is very helpful, because he’s gonna come at it from a different perspective than someone who’s just an academic person in this field. He’s based in New York City.
Before we get into it, can you both tell us a little bit more about your backgrounds and how you got into real estate investing?
Devin Redmond: Sure. This is Devin, I’ll get started. As Joe mentioned, I’m currently head of customer success at Stessa; we’re a free software platform for rental property investors, to track income and expenses and run key reports. I got started in real estate actually as a tenant rep broker in L.A, so on the commercial side; I spent my days driving around L.A. with clients, helping them find office space and negotiate deals. I then worked for a big owner-developer in the Bay Area; that was mostly office and R&D deals. I did acquisitions and asset management for them. This was kind of 2007 through the downturn, so it was a huge learning experience for me.
Very quickly I learned that the proforma goes out the window when cap rates are going up and the national economy is hurting… And I spent most days renegotiating leases with tenants, trying to cut operating expenses, and trying to run our portfolio as lean as possible.
Another thing I learned there was that institutional investors have a pretty sophisticated way of running the numbers, and we’ve built a lot of very complicated financial models, and that’s something I try to bring to my job at Stessa every day – we want to make it easy for rental property investors, but we also want people with larger portfolios to be able to run sophisticated types of reports that they need to understand what’s going on with their investments.
Joe Fairless: Real quick question on that, in terms of the sophisticated way of running the numbers – what’s an example of that compared to what a beginning investor might use or do when they’re running the numbers?
Devin Redmond: One example – a beginning investor gets set up on QuickBucks, or a quick rental property manager, right? And that’s fine for running a general income statement; it shows you how much money you’re making at the end of the year. Our reporting with Stessa – you can run both an income statement and a net cashflow report, and the net cashflow report breaks down principal versus interest versus your escrow accounts, and it will even show you what your debt service coverage ratio is… So you can get a sense for how you’re doing compared to what your debt service is every month. That’s just one example.
Joe Fairless: And do you all have ways to interpret a net cashflow statement for investors who come into your platform and are like, “Oh, well this looks like something I should do”, and then they see it and they’re like “Well, how do I actually read this and how do I interpret these numbers?”
Devin Redmond: We have a pretty good support center, with a lot of help articles that help you figure out what you’re looking at. One of the things I spend a lot of time thinking about is as newer investors come into our platform, how do I make it simple enough for them to get started, and then sort of guide them through and show them, “Okay, these are the reports you should be running, these are the numbers that really matter, and then this is how you can feed it back into your operations. This is how you can look across the months laid out, the income statement, and see where are utilities fluctuating too much, where are they maybe out of range.”
We’re actually trying to get much smarter about identifying those opportunities for people, and then sort of bubbling them up in the software so that you don’t have to go hunting in the statement to find them.
Joe Fairless: And Thomas, would you mind telling us a little bit about your background?
Thomas Castelli: Absolutely. I went to school for business and accounting, and during that time I started reading the Rich Dad, Poor Dad books. As I started to go down that rabbit hole, I just kept noticing that real estate was a common theme for building wealth… So I started going to a bunch of networking events; at this one event I met a group that was doing a seminar on real estate syndication. I went to that seminar, and really that point was pivotal because I fell in love with real estate syndication. I also met someone who would become my future mentor.
From there, I invested in a bunch of deals with him as a passive investor, and then that ultimately boiled up to participating in a syndication of an 82-unit property as a general partner, and then right around the time that deal was closed, I came across the Real Estate CPA and really found that it was a great blend of my passion for real estate investing and accounting background, so I joined the team as a tax strategist, and I now provide tax strategy and planning to investors of all sizes – people from one single-family rental, to portfolios of single-family rentals and multifamily investors, syndicators, among other groups. That’s where I am today.
Joe Fairless: What was your role as a general partner on the 82-unit deal?
Thomas Castelli: I worked mainly on the acquisition side of it. I ended up making a lot of phone calls to brokers and developing a relationship with a broker who eventually sent me a good deal out of a handful. From there, I ended up negotiating much of the agreement, and then I helped out with due diligence. From there, we had two asset managers who are the primary asset managers on it, but I’m still on the property management calls and keeping a pulse on the deal day to day… Well, not day to day, but week to week rather.
Joe Fairless: I imagine you’re a good resource for the team from doing checks and balances on the books, as well
Thomas Castelli: Yeah, I take a look at the books every once in a while, just to make sure that everything is flowing smoothly, but we actually have an accountant who works on that, so we’re pretty much covered on that end.
Joe Fairless: So let’s transition into taxes, and the primary focus of our conversation today. I imagine this is going to be for Thomas – what are some key things that all real estate investors should be doing in preparation for taxes?
Thomas Castelli: When it comes to taxes, the first thing is keeping good records. Stessa definitely helps you do that, but at the end of the day when you’re going to file taxes come year-end, if you don’t have your stuff organized it’s gonna be a nightmare pulling receipts out of shoeboxes and trying to get everything into your accounting system, and going back and retroactively trying to remember what transaction this was for, what expenses this was for… So really going into tax season with your books up to date and having everything organized is key. But also, at the same time, a lot of people come to think that taxes is just something you deal with once a year, around tax filing season in January or April… And the reality of the situation is when you file your taxes, at the end of the year you’re simply reporting your income and expenses, your results from the activities that you did in the year prior; once that year ends, your results are pretty much set in stone. There’s of course some flexibility and some things you can do during that time to reduce your tax liability after the year ends, but you really wanna be taking a proactive approach throughout the year, making sure that you’re implementing the right strategies and making sure that you’re taking the right actions that will give you those favorable results come year end, and ultimately reduce your tax liability.
Joe Fairless: Is there anything you can do after the year is over to retroactively influence what you did during that calendar year?
Thomas Castelli: There’s a few things. You can contribute to a retirement account, you can engage in cost segregation studies… Those are pretty much some of the top things you can do during that time, simply because at the end of the day “you spend what you spend, you earn what you earn” type of thing, and you went about the way you did your business throughout the year in a certain way, and that’s already set in stone… But cost segregation studies, for real estate investors, is probably the biggest thing you can do after the year end to affect your tax liability.
Joe Fairless: One other clarification question and then I’d like to ask about some tax strategies you see investors missing… But when you say “keeping good records, making sure your books are up to date”, will you be specific on what exactly good record keeping is?
Thomas Castelli: Devin, do you wanna take that one?
Devin Redmond: Yeah, I can chime in. I met with a lot of investors, especially in the early days building Stessa, and trying to figure out “What does your process look like?” across hundreds of investors, and I’ve found it really broke down into two buckets – there’s the people who are on top of things, keeping track of everything monthly, a lot of them using Google Sheets, a lot of them use Stessa now, and they’re kind of closing out the month and they always kind of know how they’re doing… And then once they close out December, they’re kind of ready for tax time. Then, as Thomas mentioned, there’s this other bucket of people who really kind of come up for air once a year, get everything ready, they’ve got a bunch of back and forth going on with their CPA, they’re wrangling receipts, and that’s a tough spot to be in.
From our perspective, good record keeping is obviously knowing where each expense goes, into what category, and then staying on top of your tenants as well, and knowing who’s late, and making sure you’re collecting all your income.
Joe Fairless: Yeah, and when we take a look at the tax strategies that we should be employing – I imagine this is gonna be for Thomas – what things do you see investors missing on a regular basis, that are low-hanging fruit, that they should not be missing?
Thomas Castelli: Yeah, absolutely. So it’s not always a tax strategy necessarily if they’re missing — sometimes it’s just deductions; sometimes people think that simply by not taking the depreciation deduction, that they’ll avoid depreciation recapture tax upon sale. And for those who don’t know, depreciation recapture is a tax up to 25% on the portion of your gain that’s attributable to the amount of depreciation you took over the time you owned the property.
Sometimes they decide to omit or not take the depreciation in hopes to avoid that, but the reality is the IRS was going to assume that you took the depreciation and then recapture it anyway when you sell.
Joe Fairless: But what if you didn’t and their assumption is incorrect? Do you then get that money back?
Thomas Castelli: No. You have to take it. Basically, take your depreciation deductions; don’t miss it.
Devin Redmond: But Thomas, if in the past you didn’t take the depreciation, you can file amended returns and recover that, right?
Thomas Castelli: Correct. You can do that. You have to go back then and amend your returns. The bottom line is you just want to make sure you’re taking depreciation deductions each year, and just be proactive about doing it… Making sure you’re also maximizing depreciation through cost segregation, but… Yeah, just make sure you’re taking depreciation.
Another strategy we see people missing is not taking advantage of a home office. When you have a rental business, often you can take a home office deduction, which not only reduces your taxes, but it makes your home a place of business. And when your home is a place of business, your commute to other business locations such as the bank, such as your rental properties, meeting with a broker, going to Lowe’s to pick up supplies for your rental business – these trips all become tax deductible.
The standard amount of deduction in 2019 is 58 cents per mile, so if you drive a lot for your business, especially when you work from home, in that type of situation, you definitely don’t want to miss out on that combo of having a home office and also taking those miles deductions.
Joe Fairless: Okay. Fact or fiction – when you put a home office on your tax returns, it increases your likelihood of being audited.
Thomas Castelli: That these days is more or less considered fiction. What happens is a lot of people who do have a home office often have Schedule C, which is for an active trade or business. Schedule C is actually the most audited part of Form 1040, which is your individual tax return, so I think there’s a lot of misconceptions that because you have the home office in and of itself is really the trigger for increased audits, but in reality it’s just the fact that most people who do have home offices have schedule C, which might not be the case for a lot of real estate investors, because rental real estate is filed on Schedule E of your tax return.
Joe Fairless: Let’s talk about the 20% tax deduction. What is it, how does it work, and what do people need to know?
Thomas Castelli: I can take that one. The 20% QBI deduction (Qualified Business Income deduction) is a deduction that allows you to take 20% of your business income, a deduction of 20% right off the top of your business income if you’re single and you’re making less than $157,500, or if you’re married it’s $315,00. Above those thresholds you still may receive a partial deduction; it’s usually going to be less than 20%, and the calculation to get there is super-complicated, we won’t go into that today.
One of the things for landlords that was up in the air was whether or not your rental business will actually qualify as a trader business for the purposes of this deduction. The IRS recently released a safe harbor that clarifies that and says “If you meet the safe harbor, you will qualify as a trader business for the purposes of this deduction.” Quickly going through what that is – to qualify, you need to meet the following criteria: the property has to be held through your personal name or through a disregarded entity or another passthrough entity such as a partnership.
Joe Fairless: Like an LLC?
Thomas Castelli: Like an LLC. A single-member LLC would count. Commercial and residential real estate mentor may not be part of the same enterprise, so you have to keep separate businesses for your commercial activity and your residential activity. You also have to keep separate books and records for each enterprise. An enterprise can consist of multiple properties, as long as they’re all commercial or all residential.
You’re gonna also have to spend — well, not you specifically, but 250 hours of rental services must be performed in that enterprise for the year, and you also have to maintain records that include the hours of those services performed, a description of the services performed, the dates in which the services are performed and who performs them. Now, the good news is you as the owner don’t have to specifically do all the work; those hours will also count if your employees, agents or contractors do it. So all the hours worked by those folks will also count towards the 250, and the last thing to note there is that it must be rental services. That includes advertising for rent, negotiating leases, reviewing tenant applications, collection of rent, daily operation and maintenance of the property; things like financing and reviewing financial statements do not count toward those 250 hours.
Joe Fairless: How is the IRS defining residential? Because I’m wondering if that includes multifamily, or if that’s just like one to four-units?
Thomas Castelli: There’s often some confusion in that because brokers consider 5+ units to be commercial, and 1 to 4 to be residential… But for the IRS, the purpose of it is if it’s single-family or it’s multifamily, it’s residential.
Joe Fairless: Okay. If anything, is there anything else that real estate investors should know when it comes to their taxes that we haven’t talked about? And I know that’s a broad question, so maybe some top of mind things…
Devin Redmond: I can weigh in on that… We see a lot of our investors doing 1031 exchanges, and we haven’t talked about that much… The sort of special treatment under the IRS is very powerful, and over time it’s one of the best ways to create wealth. It’s a long-term strategy, something you stick with through ups and downs and cycles and cap rates… And even with the new opportunity zone designations that are also open to deferred capital gains, my read on that is that 1031 is still the best strategy if you’re committed to real estate in the long run. Thomas, you may wanna weigh in on that as well.
Thomas Castelli: Absolutely. 1031’s are a great strategy, and ultimately what it allows you to do is it allows you to continually defer the capital gains upon sale of a property, assuming you invest the entire sales proceeds into a new property. You can do this over and over and over again throughout your life, and in theory – albeit it is harder to do in practice – you can not pay any capital gains on the sale of any of your properties throughout your life, and then later when you pass away and you leave the properties to your heirs, they’ll receive it at what’s called a stepped up basis, which is the fair market value of the property at the date of your death, and it will eliminate all of the capital gains that you should have took throughout your lifetime when they receive it, so… Definitely a powerful strategy.
Also, something else to throw in there, something else that people sometimes overlook is the power of the combination of the real estate professional status and the cost segregation.
Joe Fairless: Before we get into that, will you just elaborate a little bit on when you die, after 1031-ing your whole life, you said your heirs get the property at a stepped up basis, which effectively eliminates… Will you just repeat that and just elaborate on it?
Thomas Castelli: Yes. What happens is when you do a 1031 exchange, your basis in that property decreases after each exchange, because [unintelligible [00:20:55].20] the dynamics of the way the exchange works, you’re gonna end up having very large capital gains at some point if you fail to do a 1031 exchange… But what happens is your heirs get it; their basis in their property goes from that very low basis that you had, to its fair market value.
Let’s just say for instance throughout your lifetime you did several 1031 exchanges, and the building you have now is worth, say, two million dollars. Your basis in that property might only be $200,000. So if you were to sell it —
Joe Fairless: Because you started with a smaller property?
Thomas Castelli: Yeah, because basically you started with that smaller property, and that basis just continued to roll over after multiple exchanges. So you might get to the end of the line, if you will, and say “I have a two million dollar property, but my basis is so low because of the original property I started with.” So you might have a huge capital gain of, say, in this instance, 1.8 million, and when your heirs receive it, your basis goes from that $200,000 mark to two million dollars. They receive it at two million dollars. So if they were to sell it, usually shortly after you pass away, they’re gonna pay little to no taxes.
Now, if they were to hold it, they’re gonna eventually have to pay capital gains on that fair market value when you die and the fair market value when they sell, but it’s gonna be significantly less than it would be if you were to fail to do a 1031 and have to recognize that gain throughout your lifetime.
Joe Fairless: Why does the IRS do it that way?
Thomas Castelli: That’s a good question. You know, there’s just a ton of tax advantages for real estate, because one of the things the IRS does is – the Treasury or Congress rather – they want to keep as much stuff in the private sector as possible, and by offering these advantages to real estate investors, real estate investors will build properties, and develop properties, and participate in real estate activities and provide housing to the population of America, without the government having to take that on as a public project, if you will.
Joe Fairless: Sorry, I interrupted you just a little bit ago… What was the other thing you were gonna mention?
Thomas Castelli: Yeah, so the real estate professional status – if you work full-time in real estate, you essentially elect to be treated as a real estate professional for tax purposes, which allows you to take the losses from your rental real estate against your ordinary or active income… So what you can do is you can buy a bunch of properties, you can have a cost segregation study performed, which is simply a breakdown of the components of your property into their individual class lives, which range anywhere from 5, 7, 15 to 27,5 years. And generally between 20% and 30% of the property can be broken down into that 5, 7, 15 year mark, which is not only depreciated over a shorter period of time, but can also be accelerated, increasing your depreciation deduction, and now with 100% bonus depreciation, that 5, 7 and 15 year property can actually be depreciated in full in that first year you purchase that property, which would give you a massive loss. That loss as a real estate professional can be used against your active income, whether it be from you or your spouse.
Joe Fairless: You two put together a tax guide and a bunch of resources to help the Best Ever listeners… Where can the listeners find the tax guide and resources you two put together?
Devin Redmond: You can find that at www.stessa.com/taxes. All of our existing users have gotten a free copy of that. You do need to sign up for an account, but it’s pretty quick and easy. Then we’ll give you the PDF, and there’s also a separate document with the 11 top tax deductions for real estate investors.
Joe Fairless: Excellent. Well, Devin and Thomas, thank you so much for being on the show. I learned a lot, especially the reinforcement of the 1031 and the stepped up basis – that’s really powerful stuff. I have spoken to some investors and they mention 1031-ing is like kicking a can down the road; you’re eventually gonna have to pony up. But not so much. When you die, your heirs don’t have to, and that’s very powerful… As well as other things and things that you two talked about.
Thanks for being on the show. I hope you have a best ever weekend… And Thomas, how can the Best Ever listeners learn more about what you’ve got going on as well?
Devin Redmond: They can head on over to therealestatecpa.com. On there we have a blog, we also have a podcast, The Real Estate CPA Podcast – Joe was actually one of our first guests – which includes a lot of great tax strategies and other information regarding accounting and taxes.
Joe Fairless: Awesome. Thanks for being on the show you two. I hope you have a best ever weekend, and we’ll talk to you again soon.
Thomas Castelli: Great, thank you!
Devin Redmond: Thanks for having me!