Pay Less Tax to the IRS This Year With THESE Real Estate Tax Strategies

Ashley:
This is Real Estate Rookie episode 368. There’s not a one-size-fits-all approach to taxes for all investors, including rookies, but today, we are going to focus on the small rookie investor in tips for strategic tax planning for this year in 2024, and the tips that are commonly missed too. So, you guys are going to learn it all. I am Ashley Kehr and I am joined by my co-host, Tony Robinson.

Tony:
Welcome to the Real Estate Rookie Podcast where every week, twice a week, we bring you the inspiration, motivation, and stories you need to hear to kick-start your investing journey. And today, we have none other than Natalie Kolodij, who is really like an expert amongst the experts when it comes to real estate tax strategy, and we’re super excited to have her on. So, Natalie, welcome to the show. Now, obviously, we’re going to talk about taxes, but first, I know that you also do a little bit of investing yourself, so I’d love to hear about how you got started.

Natalie:
Yeah. Absolutely. I got into tax and real estate at the same time and kind of on accident. I always knew I wanted to do real estate and literally a week after I graduated college for tax, I did what you absolutely shouldn’t do, which is I signed up for one of those weekend guru seminars where I paid way too much money to just get sprinkled information that isn’t super helpful. But what it did was it kind of kick-started me on that path and it’s actually how I found BiggerPockets, was trying to find the information I needed that they didn’t actually explain to us. So, that’s kind how I started in real estate was just both at the same time, and because of that overlap, I just ended up really specialized in real estate tax. That seminar tried to push us into wholesaling as a starting point. It didn’t go well, and what I actually ended up starting with was flipping mobile and manufactured homes, and selling those on owner financing. So, that was my entry into real estate.

Ashley:
Talk about that kind of mindset you were at. At that point in time, why did you even decide real estate? Was it just because of that guru class? Was there something that happened before that? Then what kind of drove you into mobile homes?

Natalie:
Yeah. I don’t remember where it started. I just knew I always wanted to be involved with real estate, but it always seemed super unobtainable. I just didn’t know anyone doing it, didn’t know how to start. So, when a friend brought up the weekend guru class, I jumped on it, went to it with her, and then of course, they tried to do the big upsell. We were broke college students. We couldn’t be upsold. So, we took our weekend of knowledge and tried to do it, and when that didn’t work, we went with kind of a blue ocean strategy of well, that’s really saturated. I was in the Seattle market, tons of wholesalers. What can we do that has a low barrier to entry and everyone else isn’t doing? We just made a list of possible options and we landed on mobile homes because it was like, “Well, we don’t know what we’re doing yet, and if we absolutely fall on our face, we’re only out a few thousand dollars instead of $500,000.” So, it just gave us a really comfortable starting point to kind of dive in and learn as we went.

Tony:
Natalie, one thing you mentioned that I want to get some clarity on, you said that it seemed unattainable, and unattainable I think is a really important word because a lot of folks in our rookie audience can probably resonate with that, where the idea of getting that first deal feels unattainable. So, two questions. First, why did you think it was unattainable? And then, second, how did you still find, I guess, the courage to take the steps to try and make it attainable for yourself?

Natalie:
Yeah. To me, I feel like it felt unobtainable just because I came from a family where neither of my parents owned real estate. I didn’t have parents who were really successful in investing, so I just hadn’t been exposed to anyone who was sort of doing it. And I remember, I would always see the signs of like, “We buy houses cash,” and being like, “How do people just have $500,000 to keep buying all these houses,” because I didn’t know what wholesaling was. And then, what kind of made it obtainable in that next step and moving forward was starting with mobile homes, and then hopping on BiggerPockets. It was something where I could start with a low dollar amount, so there wasn’t a ton of risk for me, and then feeling like I had somewhere to find answers to all of the things I didn’t know, without having to be on my own for it. So, those were the two supporting factors.

Ashley:
Now, Natalie, were there any tax benefits to mobile homes that made it maybe more attractive to you?

Natalie:
There wasn’t specifically with what I was doing. I jumped into mobile homes just because it was affordable. The last one I bought and flipped, I paid $50 for, so it’s such a cool area that a lot of people ignore.

Ashley:
$50?

Natalie:
$50 for it. Yeah. We bought it for $50.

Tony:
We got to pause in this story, right? $50? I don’t think I’ve ever met anyone that purchased property before, so just give us a quick backstory. How did you find a piece of real estate for $50?

Natalie:
Yeah. It was in the Seattle market, so I was just running both ads saying, “I buy mobiles for cash on Facebook marketplace,” and had an RSS feed set up to send me listings for any mobiles that were listed for under 10 grand. A lot of people inherit them and it’s just costing them money every month if it’s in a park to maintain it, and they can’t live in it. Agents don’t really want to sell them because their commission’s going to be $12. So, it’s just this cash outflow, so a lot of people reach a point where they’re like, “Just take it. Please take it.” And she was at that point. It needed work. She didn’t want to deal with it. She just wanted it off of her plate, so I said, “All right, I’ll give you $50. I’ll Venmo you right now to hold it, and I’ll be there in an hour with a contract.” That was all it was. It wasn’t anything crazy. I just got the alert as soon as it was listed and reached out sight unseen, and said, “I will take it. I’ll buy it.”

Tony:
I mean, $50, I’d put a $50 on anything sight unseen, but I think what’s so cool about that story is I asked you first about the unattainable piece, but what you just described, anyone walking the streets right now should be able to hustle up $50. So, it’s never a matter of will real estate investing work for me? The bigger question is what strategy, what steps should I be taking that match my current situation? And then, you approach the goal that way. So, man, I love that. I think you might hold the record right now for smallest EMD that I’ve ever seen on a property before. We’re here to talk about taxes, so we definitely want to jump into that, but first, let’s take a quick break, so we can hear a word from our show’s sponsors.

Ashley:
Okay. We’re back from our short break. Natalie, before we get into tax stuff, and I know Tony is super eager, he’s got his spreadsheets all laid out ready to go, but what happened with that mobile home? Tell us the outcome of that $50.

Natalie:
Yeah. I bought that mobile home for $50. The day I bought it, I put a sign in the window that said for sale by owner. Literally that same day, probably four hours later, someone showed up and said, “I’ve been looking for something in this area. I’ve wanted to move to this park. My daughter and grandkids live here. It’s too expensive to buy a house because I’m retired. What are you selling it for?” And I was like, “I don’t know, man. I’ve owned this for four hours. I have no idea what I’m going to sell it for.” So, I just had-

Tony:
$55.

Natalie:
… to come up with the… Yeah. Great for taxes, no gains. I just came up with a price that I thought left me enough kind of buffer there and I think that one was $25, $27, something not huge, and it was sold that same day and we had just a 30-day window to finish the updates we were doing, but it was sold within a few hours of buying it. And just knowing that, I probably could have not done any updates and just sort of kept doing that with the homes of getting them under contract and just kind of doing a double close almost and wholesaling them essentially that way. Yeah. So, it went really well. It sold immediately just because of where it was, high demand area.

Ashley:
Wow. Well, thank you for sharing that story for us. Tony and I get really bad shiny object syndrome, and usually, Tony veers off an episode and starts googling. He’s probably got mobile homes pulled up in his area right now. But back to focus on tax strategies, what is one maybe common misconception or something that smaller investors don’t do that they should be doing, something that is impacting the rookie investor? Because it’s easy as a small investor to just say, “I just have one property,” or, “I don’t have any properties yet. I don’t really need tax planning because it’s not going to be that big of an impact on me.”

Natalie:
Yeah. I would say the big early on things I see with investors where they just don’t know they can do this is that you don’t need an LLC to write off your rental expenses. A lot of people think they do. Even if it is just a property in your name, there’s no difference. So, you still get to write off all of those qualifying expenses, even if it’s your only property. Even if you’re not doing this on a large scale, you still get those same write-offs. On that same note is depreciating the property. That’s one of the biggest things tax wise, which is basically the IRS’s way of saying, “If you own a big asset that’s going to make you money for a bunch of years, it should wear out over time, so you get to write off part of it every year.”
That’s how when you hear people saying, “Your rental should have a loss on paper,” that’s what it is. We don’t want to actually lose money. Just you get to write off kind of the wear out value on that property. Even if it’s your only property and it’s brand new and that’s all you’re doing, you still have to depreciate it. It’s not optional and you don’t want to miss that write-off. So, those are probably the two big items that I see people not think they’re entitled to because they’re just a smaller or a newer investor.

Ashley:
To kind of follow up with that, if you are a new investor, maybe you just bought a property and you’ve just gone to your same CPA every year to do your taxes, what are some questions you should ask your CPA to see if they’re still going to be a good fit for you as you continue real estate investing and growing your portfolio?

Tony:
Ash, before Natalie jumps into that, because it’s a really important question, I do think that people, they’ve been using the same CPA from their W-2 job for whatever a decade, and it’s almost like your barber. Once you get a barber, you never want to leave that barber, so you just kind of stick with them. I see people have that same relationship with their CPA, but I think it’s really important that as your financial position changes, as your financial goals change so should your advisors that you’re working with.
I know so many people who have, whatever, high income W-2s, and they have these financial planners who only focus on the stock market. And when they ask that financial planner like, “Hey, I think I want to diversify into real estate,” they say, “Yeah, that’s too risky.” So, you definitely want to make sure that you’re aligning yourself with folks who not only understand those goals but every single day are working with people who also are working to achieve those goals as well. I just wanted to frame up that piece as well now, so please go ahead and jump in.

Natalie:
Yeah. I love that piece. That is my hill I will die on is finding someone who not only knows how to do what you want but understands it because I worked for those CPA firms where they would be like, “Oh, real estate’s stupid. I used to own rentals and I sold them all.” And I think back and I’m like, “Man, my prior boss who lived in Seattle sold off a bunch of rentals in 2000. If he would’ve kept those today, what they would’ve been?”
So, as a starting point, if your current accountant has that mindset, if they’re like, “Oh, this is risky,” or, “You shouldn’t do that. It’s not worth it. It’s a pain in the butt,” whatever, they’re not on your side. They’re not going to be hyped up with you. And if you’re going all in to hit this goal and you’re focusing on it, and they’re actively veering the other way, they’re working against you. So, I would say that’s the first point is see sort of just their mindset about what you’re doing and if they’re going to real estate shame you or if they’re going to be your hype man.
The next thing I tell people to ask is what percentage of their clients are real estate investors? Every accountant, if you ask them will say they can do rentals. They’ll be like, “Oh, yeah, we do those all day long,” and they’re missing 40 write-offs and they’re costing you a bunch of money, so don’t ask that. Ask what percentage of their clients are investors? I would say two kind of good test items are ask if they know what the short-term rental loophole is. If they immediately are nothing, just deadpan, that’s kind of a red flag or if they write it off as just, “Oh, that’s not real. It’s just something you see on social media,” that’s also a red flag.
I think the final big question that’s worth asking an accountant… Because there’s lots of good accountants who just aren’t up in the know on real estate. This isn’t their niche. They don’t keep up on things. And a big one I see kind of scoffed at a lot is cost seg. So, ask them at what point they think a cost segregation study is worth it because a lot of accountants will say, “Oh, it’s only worth it on a $2 million multifamily or a big building.” And that was the case 15 years ago, but it hasn’t been the case since Tax Cuts and Jobs Act, so for the last several years. So, if that’s their response, they’re just kind of out of touch. So, any of those would be kind of the red flags or green flags depending on the answer.

Ashley:
Natalie, what would be the actual answer to the last two there, to the short-term rental loophole and to doing a cost seg?

Natalie:
Yeah. The short-term rental loophole… Gosh, I hate calling it that because accountants hear loophole and automatically, they don’t think it’s a real thing. But if you have a short-term rental, a rental where the average guest stay is seven days or less, and this is on a calendar year basis, and if you materially participate in it, there’s a handful of rules for that. But typically, if you’re self-managing is sort of the easiest blanket term, it by default becomes not passive, which normal rentals, when your income’s above a hundred thousand, you can’t always use losses they generate. If it’s non-passive, you don’t have that same loss limit, so this means if you have one of these short-term rentals that qualify where you materially participate, you can create losses with it. You can do a cost segregation. You can bonus out, which is basically writing off all at once your furnishing costs, and then take that loss and reduce your W-2 income. So, tons of benefit, and a lot of accountants just don’t know what it is.
And then, with the cost segregation, there’s no one-size-fits-all. That’s the answer to most things in tax, which is what makes this hard, but it’s not only on $2 million multifamily anymore. You can get a cost segregation study done by a firm for a couple of thousand dollars, so it depends on your circumstance. So, there’s a few sort of times that really makes sense, and that’s if your income is under that hundred thousand dollars, you can typically use $25,000 a year of losses, that’s a time it’s worth looking at a cost segregation because if you’re creating a loss, you want to be able to use it. If you have a short-term rental, that’s another time it’s worth looking at. You’re going to want to use it, or if you qualify as a real estate professional, if this is what you do full-time.
Those are the three big-ticket items, and the price point of the property, it really varies. It just is going to depend on the specific property and how much its land value and building, but your accountant should be able to run an analysis and say, “Worth the money,” or, “Don’t bother.” So, it’s always worth looking at.

Tony:
Yeah. Natalie, I just want to circle back because you mentioned some really, really important things here, so I want to make sure our rookies understand. There’s a special provision in the tax code that says if you own a short-term rental, an Airbnb property and you qualify for material participation, you can then use… I just want to make sure I’m understanding this correctly, that our rookies understand it. If you qualify for material participation, you can then take the paper losses from your short-term rental, your cost seg, all the expenses, those things and apply that paper loss towards all other types of income. So, that includes your W-2 income, right?

Natalie:
Yep.

Tony:
Does it also include income? Say, you own a long-term rental. Can I use, I’m sorry, the paper loss from the short-term rental against the long-term income?

Natalie:
Yep. All is now in the same bucket.

Tony:
What if I do a cost seg? Maybe, I’ve got a multifamily that I own and I get a big paper loss from that. Can I now use that as well? Does that now get added to that bucket as well? Does it unlock all of that or where does the line get drawn?

Natalie:
Yeah. What it is freeing up is the losses from the specific short-term rental that qualifies. Those losses now get taken out of your passive category where there’s all these income limits and moved into non-passive, which means that no matter how much you’re making, up to… There’s an excess business loss limit, but that’s $480,000. But just shy of that, you can take these losses and offset your W-2 income. You can offset other business income. It’s now just there for the taking without that income cap. So, it’s a super powerful tool and it’s just the losses from that property. It doesn’t free up everything from any of your other rentals or do anything like that, but what I tell people to kind of supercharge that is, like we said, if your income’s under a hundred, you can use some of those long-term losses. So, if you’re a short-term rental, you qualify and you can use those losses and it brings your income down under a hundred, you now also get to use a chunk of your passive long-term losses.
So, there’s a lot of planning, even if you only have one or two rentals, where if you’re working with the right professional, they’ll line this up for you and this can save you thousands of dollars of taxes every year by just sort of… You have to look forward for these things. This isn’t something you show up in April and bring up with your accountant. You want to work with someone during the year and plan for these things, and then have that savings.

Tony:
We definitely had a mad dash at the end of 2022, I think it was. We were trying to close in a property and get that first guest to check in, and literally the guest checked in on December 31st, which gave us the ability to use that cost seg from that property as well. So, yeah, you don’t want to be up against the 11th hour like that.

Natalie:
Nope, for sure.

Ashley:
Okay. Those were the big three things. Just recap, the first thing was percentage of your clients are in real estate and ask that percentage amount, the short-term rental loophole, and then also doesn’t make sense to do a cost seg. So, write those down. Everybody ask your CPA. Call them. Do you think it’s better to call them or talk to them in person than send an email? Does an email give them too much time to actually look up the answer?

Natalie:
I mean, I would give them either option if they’re willing to learn it and implement it for you, but either way, I would say just as long as that question’s in front of them and they’ve got some kind of response to it, you can be on the right track.

Ashley:
Okay. Let’s talk about the price of this tax planning of having a CPA that’s qualified, compared to your tax savings. How do you know, since you are looking forward as to what’s a good amount do you pay for this service? Is there any way that you can give some guidance to a rookie as to saying, “Okay, you want to maybe stay within this threshold”? Or how do you determine when you’re actually getting your value, and you pay someone X amount of money throughout the year to do your tax planning, and then you end up not saving any taxes? What’s a good way for a rookie to judge that as to how much they should be spending?

Natalie:
Yeah. This is a tricky one because you’re paying a professional because they should know what you don’t know, but how do you know if what they know is right or good and if they’re worth the money? You’re stuck. What I typically tell people is it is really hard early on to justify the high dollar tax planning firms. A lot of the real estate specialized firms are going to be $5,000 plus a year, but in theory, a good CPA, a good EA, a good tax strategist is going to save you more than they’re costing you. That should sort of be the ballpark estimate. So, when you’re looking at what they can offer you, if they say, “Yep, we are really confident we can save you $40,000 this year. It’s going to cost you five,” that seems pretty good. If they can’t give you an estimate or if there’s nothing in your circumstance that really has wiggle room and it’s really straightforward, you might not want to spend that amount.
And when you’re a new investor, I would say that while tax savings is incredibly important and a big piece of real estate, you don’t want to let the tax tail wag the investing dog. So, that’s important and get someone on your team you trust and can work with for it, but focus on the deals. Focus on that piece. I see a lot of new investors early on, they’re so… Because they hear all of this, right? You hear the big investors being like, “I didn’t pay any taxes. I set up all these things.” And they want to do that. Focus on the deals first, and then find someone you trust to build up the rest.
Something you don’t want to do and a big mistake is setting up 40 LLCs day one, doing these really elaborate things, creating a bunch of partnerships. Now, you’re spending $10,000 on tax filings for two rentals that made you $40 last year because they’re not stabilized yet. So, just don’t get ahead of yourself but grow into your need, and if you’re working with someone who knows real estate or is at least comfortable with it, you should sort of be able to build that level of advising you need as your complexity increases.

Ashley:
Natalie, this has been great so far and we have to go to our second ad break here, but when we come back, I want to talk about what are some of the common mistakes that your CPA may be missing? What are some questions they should be asking you and information they should gather from you? We’ll be right back after this quick break.

Tony:
All right. We just heard Natalie break out what are the things you should be asking to really drill down and understand if your CPA is good, and now, I just want to get into some of those commonly missed items. But before I do that, you mentioned one thing before the ad break, Natalie, that I thought was just super insightful that again, I just feel like I’m doing this a lot, but it’s really important the rookies understand this as well. But you said you need to grow into your need when it comes to the LLCs, when it comes to tax strategy. And I can’t tell you, Ash, I’m sure you’ve seen this a million times as well, but how many people who have zero deals who are so worried about asset protection, who were so worried about like, “I need the Wyoming LLC, and I need the Trust, and I need this and I need that”?
All of those things become important, but what’s most important is you actually get the deal. It doesn’t matter if you have the world’s best asset protections, if you have no assets to protect. So, let the first focus be getting the deal. So, I love that, grow into your needs. I just wanted to highlight that. Now, we see a lot of rookies who kind of maybe miss some of these items, these important tax things as they’re starting to go on this journey of tax strategy. So, I guess what do you feel, Natalie, maybe are some of those things that a lot of new investors miss?

Natalie:
Yeah. I would say some of the biggest things that are worth looking at and things worth mentioning upfront is look over your tax return in depth before you sign it. I think a lot of people sign off because they’re like, “I hired someone. Done.” And then, when you go back and look at it, there’s no insurance expense. Well, you probably insured your property, so there’s little things that if you know paid for something and you can’t easily see it on there, ask them. They should be able to tell you why it’s not somewhere you can see it or maybe there was a document missed like you forgot to give them a piece of paper or the proof that you paid that.
So, there’s this disconnect between accountants don’t know what you have if you don’t tell them, and a new investor doesn’t know what they can write off if the accountant doesn’t ask. So, as a starting point, give them everything. If it’s not deductible, they’ll tell you, but if they don’t have it, they won’t know. So, the first big thing, it sounds simple but look over that return. Look for things you know you paid like insurance expense and property taxes, things that any rental should pretty much have. Start there.
And then, The other big thing to look at is your depreciation schedule. Like we talked about, this is a big strategy, a big benefit related to real estate. So, you’ll want to see that. A lot of accountants don’t include it as the default client version you get. They don’t put that copy in there. Ask for it. Ask to see it because, for example, you can’t depreciate land. Land doesn’t go anywhere. In theory, it just hangs out forever, so you have to separate out the building and land value. If you look at that schedule and there’s nothing for land and they’re depreciating all of it, well, you know they’re not doing it right, and that’s worth asking about because you don’t want to have to pay it back later when it gets fixed.
So, those are kind of some big ones. Another thing new investors don’t either know they can do or their accountant doesn’t ask for is break apart your renovations. If you know you bought a rental and this is your first property and you spent $25,000 fixing it up, getting it ready to rent, and your accountant just lists renovation, $25,000 like it’s one item, there’s probably parts of that that you can write off on a quicker timeline like your appliances. Appliances are only five years. So, instead of if you spent a thousand dollars on a refrigerator writing it off across 27, which is what would happen if it stayed lumped together, you get to take that thousand dollars across five, and that bumps up your annual expense.
So, those are kind of starting things that I think are really important is just make sure everything you paid for is on there, review that depreciation to make sure you’re not depreciating land, and that if you did a big renovation, it’s kind of getting separated out because there’s a good chance you did more than just one big lump sum. You put things in there. You put flooring. You put appliances. Break it out and see if that helps you tax wise. That’s a good starting point.

Tony:
Natalie, one thing I’ve seen is that sometimes people get into real estate investing… Maybe they’ve already got a business like they’re doing, whatever, lawn care or they’ve got a pool cleaning company, they’ve got something else, it’s like active income. And then, they’re just kind of throwing their real estate investments into that same LLC. What are the benefits or disadvantages of kind of mixing? So, you’ve got another business that’s active income with the passive income from real estate.

Natalie:
Yeah. Typically, anything that’s completely different activity, you’ll want to keep separate. I’m not an attorney caveat. This isn’t legal advice, yada yada yada. Keep them separate for that reason alone, right? That if you are operating amateur cage fighting studio, you do not want the risk of that on your rental properties. These should be separated. But then past that, for tax purposes, they’re different and they’re going to be taxed differently. Your ordinary active income and your passive rental income are taxed totally differently, so putting them in the same container is not going to be able to benefit either and can have a big downside. Often, you’ll hear with active income, you want an S corporation that can save you money on your earned income. So, if you are an agent or if you’re house flipping or if you own a hotdog stand, any kind of regular business, that can save you money.
The way it saves you money is by saving on self-employment tax. Rentals don’t pay self-employment tax, so there’s no benefit there. And if you put your rentals into an S corp, you can never get them back out without paying tax. So, even if you just want to put it in your name to refinance it, you get taxed as though you just sold yourself your own property, and that would make me so mad if I got paid to sell myself my own thing. So, you typically almost never want your rentals in an S corp and you always want your different buckets of income just separate. Just keep them in separate entities.

Tony:
One other question that kind of jumps up to me… We’ve done a lot of partnerships in our real estate business and at this point, I think, I don’t know, we’ve got 16 different partners that we’ve bought properties with, and I opted not to create a new LLC with each partnership because I mean, that would’ve been ridiculous. So, instead, what we’ve done is we’ve created joint ventures with all of these people. But I guess just from a tax strategy perspective, what do you feel kind of makes more sense? Is there a tax benefit? Maybe should I have gone down the route of creating new separate LLCs for each one of these partnerships or am I fine doing this a joint venture between my entity and theirs?

Natalie:
Yeah. Just to kind of clarify for newer investors, the joint ventures where you both just own the property together, you and the partner are just both on title, both owning it together versus you and a partner owning an LLC together and that owns the property. So, it’s sort of six or one half dozen of the other. If you have a partnership, it has its own separate tax return. There’s more administrative. There’s more bookkeeping. There’s more cost to file it. So, if you are doing a bunch of different projects with a bunch of different partners, then doing it as a joint venture can absolutely make more sense. It’s just less paperwork, less additional costs. It keeps it cleaner. If it’s going to be the same partner, if you’re buying 50 properties with the same partner and that’s the plan, it might make sense to have it in a partnership, just so it’s combined. Tax wise, there’s no difference between one or the other.
I’ll also just note that for a joint venture like that where you partner with someone to own a rental, rentals kind of have their own little exception in the code to be able to do that. If you partner with someone on a flip or an active business, you probably have to file a partnership return either way even if there’s not an LLC. So, just be careful if you’re going to partner with someone on a flip or wholesaling or an active business versus rentals. On your rentals, doing it as a joint venture can be a much easier route to it, especially if you’re not going to keep doing deals with that same person.

Ashley:
Well, I think that was all great right there, as to certain things that you can bring up to your CPA, but now I want to know what are some common misconceptions that the CPA may have or you may have as the rookie investor? I believe there are some that have to do with house hacking. Can you enlighten us?

Natalie:
Yeah. This is a big one and this is what… It’s just so frustrating because new investors start with house hacking because it’s an awesome way to start investing or keep investing. I still house hack. But for taxes, it can actually be more complicated because you’re now mixing up your business and your personal, and a lot of accountants don’t know all the nuances to it. So, when you’re house hacking, we use the same term for two different situations I think, whether you’re renting out spare bedrooms in your single family house or whether you’re purchasing a fourplex and living in one unit and renting the other, and we just use that term for both. But for taxes, they’re very different situations. So, that’s an important one is if you tell your tax professional you’re house hacking, and they don’t ask a follow-up question, what are they doing? What’s happening with what you give them?

Natalie:
So, make sure they understand the difference there. When you’re house hacking, you get to depreciate and treat like a business. The square footage, that is fully business like those specific bedrooms in your house, if you’re renting those. Any of the shared spaces, you don’t like your living room, if you and your roommates both have access to it. So, you get to basically split up your costs for the house between schedule a rental and schedule for your personal costs, for your personal home mortgage interest and stuff. That’s just when you’re occupying it.
Then on the backend when you go to sell it, one of the biggest tax benefits in the code is the 121 exclusion, and this says, if you own and occupy, so if you’re living in your primary home for two of the most recent five years, you can pretty much sell it tax-free. If you’re single, you get to exclude $250,000 worth of gain, and if you’re married that bumps up to $500,000, and there’s very few ways that you can make a half million dollars tax-free legally. So, a huge benefit there.
If you’re house hacking, something that I’ve seen a lot of tax professionals not always understand the nuance of is if you are doing it, where you’re renting other units in a multifamily and you occupy a unit like a unit in a fourplex, when you go to sell, only your dwelling unit qualifies for that 121 tax-free. So, if they’re all the same size, only one quarter of your gain is going to qualify as tax-free. The other three quarters would be taxable. So, I think new investors should be really aware of that piece because that is a really, really unfortunate surprise to get when you sell.

Tony:
Yeah. Let me just ask one follow-up question to that, Natalie. Say, you have the same example, right? It’s a fourplex. You live in one unit and rents out the other three. You get this section 121 exclusion on your unit, but can you then 1031 the funds from the other three units?

Natalie:
Yep, you absolutely can.

Tony:
Okay.

Natalie:
So, what I tell people is if you have that circumstance where you have multiple separate dwelling units, separate legal entrances, fully separate, think of it as though you own a single family home you live in and three rentals and you just happen to be selling them all at the same time. Mentally, if that’s how you think of it, that’s how it works. Your specific unit, you get the primary home benefits. The others, you get to treat like a rental, so you can 1031 that and buy other rentals, otherwise, you’re going to pay gain on it.
But if you are renting rooms in your house, it’s a different scenario and a lot of tax pros miss this. There’s kind of an exclusion to that code section where it says, “You have to prorate this and part of your gain will be taxable,” where it specifically says, “Unless the business or rental use is within your dwelling unit.” So, if you’re renting space in the same unit you occupy like bedrooms in your house, when you go to sell, you still get that full exclusion. There is no prorating. There’s no, the gain related to the bedrooms is taxable. You still qualify for the full amount. You just pay back the amount of depreciation you took, but you still qualify for that full exclusion.
So, there can be a big difference between if you’re selling one version of house hacking versus the other in how the tax on the sale is going to be, and a lot of tax professionals don’t know this difference. So, if you are a house hacker who’s selling and your accountant says, “Oh, you rented two of your three bedrooms, so two-thirds of your gain is taxable, sorry,” push back. That is not correct. Do not pay tax on something you lived in, until you kind of double-check because often, you shouldn’t have to.

Ashley:
Natalie, are there any other codes like that that may be misinterpreted?

Natalie:
Yeah. There is another really similar one that relates to again, your primary home, and this is what is nonqualified use. This goes both directions. So, I’ll hear a lot from people… Because again, the general overview of that code for your primary is if you lived in it two of the last five years, tax-free. That’s sort of what everyone has stuck in their head, but then there’s 80 pages of more that everyone just sort of, “We’re just not going to worry about that.” So, the one downside to it is that you can’t just move into a rental for two years and sell it tax-free. Anytime there’s rental use before you use it as your primary, that’s what nonqualified use is. It’s anytime when it’s not your primary home. So, if you had something as a rental for 40 years and you’re like, “Oh, I know what I’m going to do. I’m going to move in for two years, and I’m not paying tax on this,” you are paying tax on it. You’re paying tax on 40 out of 42 years worth of the gain.

Tony:
Can you imagine doing that, upending your whole life to try and save on taxes, only to realize that it didn’t work that way? But I’m always so impressed with good CPAs who really understand all the nuances because there is so much nuance to this. And I guess for all the people that are listening or watching right now, I don’t think the goal of this episode necessarily is to get you to remember section 121-E-Q of the tax code. It’s really just to have a general understanding, and then at least know what questions you should be asking your CPA because they are the ones who are going to hold all the knowledge. Ash and I both have relatively decently sized portfolios, but I’ve never heard of this tax code before. It’s not our job as a real estate investor to have all the answers, but it’s to be smart enough to know what questions to ask, so you can get the right advice. Obviously, now you’ve given a lot of that so far throughout the episode, so what other, I don’t know, I guess tax codes maybe should we know about in addition to that one?

Natalie:
Yeah. The flip side to that same code section that says if you rented it first, that part’s going to be gain years is there’s another exception that says unless the period of rental use is after the last time you used it as a primary. So, since it’s a two out of five year, basically from the time you sell, it’s a five-year look-back. What this means is if you’ve lived in your primary for two or more years, and then you move out and turn it to a rental, you have a three-year window where you can still sell and have it qualify as fully tax-free. You still get that full 121 exclusion. The only thing you would ever pay back would be the amount of depreciation. It is three years, but it’s calculated for any of these primary home sales. It’s calculated based on number of days, so be careful with this too. It’s not tax years or ballpark. So, if you lived in it 365 times two days, and then you have three years at that same calculation, if you’re five days over, you can lose it, so be careful of that.
So, the flip side to this that I see a lot of tax professionals miss is if it was your primary first, and then you rent it for three years, that still fully qualifies. So, if they’re saying, “Oh, sorry, because it wasn’t your primary when you sold it, it was a rental, you pay tax,” or, “Oh, three out of those five years were rental, so those are taxable,” if it was primary first, you have up to three years of rental, not taxable. So, be really cautious with this because it’s where a lot of new investors start. It’s selling their primary home and using that gain and cashing in on this, and it’s super common and a lot of tax professionals miss it, so you don’t want to pay tax on $300,000 or something where you don’t have to. So, just be really cautious with that. Again, if you’ve lived in it and they’re telling you you owe tax, just ask why. Ask for details. Push back a little bit.

Ashley:
Well, Natalie, thank you so much for taking the time to give us that little mini masterclass for rookie investors on things you should know and what you should be asking your CPA. I think Tony gave a really great point as to you don’t need to have all of this knowledge and to read the tax code and know exactly what to do, but you are responsible as the investor for your investments to find somebody who does know what they’re doing. And that’s kind of the hard part there is to know what questions you should be able to ask and have some knowledge to know with what they’re saying is if that’s true or not or if they really understand what you’re trying to do.
To wrap it all up here, Natalie, some of the notes that I took down that I think are great for the rookie investors here is just the short-term rental loophole and how losses can be deducted against your W-2 job. A lot of rookie investors start out with the W-2 job, and really relatable. And then, specific questions to ask your CPA and also having some knowledge of what they should be asking you also. And then, just going over those common misconceptions on tax code. Especially with social media today, I feel like it is so easy to have those misconceptions come out, and a million people telling you different things that’s happening with tax code and tax laws and not knowing what to believe, so clarifying a lot of those misconceptions was great, and those included ones for short-term rental, house hacking, and primary residence. So, Natalie, thank you so much.
We are going to put Natalie’s information in the show notes or in the description if you’re watching on YouTube or listening on your favorite podcast platform, so you can reach out to Natalie if you have more questions or want to learn more about her. I’m Ashley and he is Tony. Thank you so much for listening to this week’s Rookie Podcast.