Resources Mentioned in the Show
– Hunt Jackson CPA
Here are the questions that we used for the show
1A. What are you hobbies outside of work and investing? Let’s get to know you better to kick things off.
1. Aside from tax returns, how does having a CPA on your “team” as a real estate investor add mass value… we know it does!
2. How is income from flips taxed differently than income from sales of buy/hold rentals or longer term held properties?
3. Are you a fan of 1031x exhcanges?
4. What are the top 1 or 2 questions you get asked by real estate investors?
5. What is depreciation recapture and why should real estate investors care?
6. What is alternative minimum tax and does it apply to investors at all?
7. Is there a good balance between writing off as much as possible to lower your taxable income and keeping your income high enough to maintain your ability to borrow?
8, What are the top 2 or 3 write offs that give the most bang for your “buck”..so to speak?
8. Should everyone pay attention to which “schedules” are used in their tax return prep? Schedule C or Schedule E…what does that mean and should we care for any reason?
9. Any tips on tax return prep for self-employed people vs people who mostly have W2 income?
10. What are the benefits from your point of view of S corp vs C corp vs…?
11. What is the biggest impact on taxpayers related to the new tax laws that just went into effect?
12. Are there any strategies or loopholes that we need to know about as RE investors to help lower our tax bills?
13. How can people reach you to engage you for additional help and review of their personal tax situation?
If you prefer to read… here’s the full transcript
Joe Bauer: Welcome to the Seattle Investors Club Podcast where we talk about the nuts and bolts of real estate investing. My name is Joe Bauer and I’m here with my cohost Julie Clark. Julie, how are you doing today?
Julie Clark: I’m good, but you’re not actually here with my Joe are you?
Joe Bauer: Oh my gosh, I am not, but it sounds like we’re in the same room I think.
Julie Clark: It does, it does, but we’re not. We never are. That’s the secret sauce. We’re always 1000s of miles apart, at least for the last 3 or 4 months here. How long has it been now?
Joe Bauer: To be-
Julie Clark: How long has it been since you left me dear?
Joe Bauer: It has been almost exactly 2 months and 6 days.
Julie Clark: Oh my gosh-
Joe Bauer: And-
Julie Clark: … see to me it feels like four months.
Joe Bauer: 12 hours maybe.
Julie Clark: Yeah, I feel that. Yes. I think all of you know that Joe’s on the road and he is living the dream in his vantastic life. I’ll let you say a little blurb on that and then I want to tell you guys a little funny thing that I’ve been watching lately.
Joe Bauer: I’m excited to hear the funny thing. Okay, I’ll make this quick. If you guys van adventures it’s at thevantasiclife.com or the Vantastic Life on Instagram or Facebook. Right now I’m actually in west Yellowstone. Funniest story, we do a lot of trail running. My girlfriend and I love trail running. We can see things faster, we can get exercise, all that fun stuff. We went to the ranger station just earlier today and asked them about good trails in Yellowstone because we didn’t see many on the map. The longest one was eight miles and we’re usually trying to get deeper into the park so that we can get out of the crowds. What the ranger said, “Is we do not recommend trail running off of the boardwalks because of the grizzly bears.”
Julie Clark: Oh.
Joe Bauer: Yeah, so we will not be trail running in Yellowstone National Park unfortunately.
Julie Clark: God, do you guys carry weapons or bear spray?
Joe Bauer: We plan on carrying bear spray once we get into the less populated parks, kind of like a quick draw bear spray system.
Julie Clark: You know what I’m always afraid of, that’s like pepper spray and all that stuff real estate agents would take into a house. I’m always terrified I’m going to spray it into my own face, that’s my-
Joe Bauer: Totally.
Julie Clark: … fear.
Joe Bauer: I think people probably spray it in their own face more than they spray bears I would guess.
Julie Clark: [inaudible 00:02:49]. Well please be careful.
Joe Bauer: I will be careful, but I want to hear your story. Let’s hear your story, let’s hear you story.
Julie Clark: Well I don’t really have a story, but I have twin girls, most of you guys know that by now. We have been, it’s summer, so we’ve been binge watching. We just got done with “Stranger Things” which has resulted in Mark, who’s on the line with us, might know about this too, but we just bought our first Dungeons and Dragons set.
Joe Bauer: No way.
Julie Clark: You guys know what that is? It’s like a fantasy … I don’t even know how to describe it, demigods and … Anyway, that’s not what I was going to say. We wrapped up “Stranger Things” and we had to look for something else to watch as our little bonding rest time together at night because I’m so busy all the time it’s a nice time to just circle up and relax. I ran into this thing called “Comedians in Cars Getting Coffee”. It is freaking hilarious. The one I just saw was Jerry Seinfeld with President Obama. They’re just kicking around like two guys talking shop. Anyways, it’s hilarious. “Comedians in Cars Getting Coffee.” It actually inspired me to do some sort of … You know how they have that guy James Corden or whatever he does, does the karaoke in the cars, now you go this comedian in cars thing that’s hilarious. I’m going to kick off my own real estate, something to do with real estate in cars. I don’t know what it’s going to be. Whatever the car stuff is, other than just the videos of giving advice from the car is kind of boring. I’m going to come up with something and I’m going to let guys know what that is.
Joe Bauer: That’s what we totally should have pitched to the studios that wanted to have the flipping house people. We should have been like, “Well we could do real estate in cars. It’s actually better than your idea.”
Julie Clark: Right, because all those ideas are boring. I told you that some film maker just called me. Once you start doing these podcasts and stuff guys you get all this stuff coming out of the woodwork, all these … So some film maker who feels like they have a bond with me or something like that because they listen to the podcast has contacted me. I think it’s just a scheme to get me to invest in whatever their movie is. We’ll see what that is. I haven’t called them back yet.
Julie Clark: Speaking of hobbies and stuff that has absolutely nothing to do with real estate, let’s welcome our friend Mark in here and ask him a bunch of random questions to kick this off.
Joe Bauer: Heck yeah.
Mark Canton: Hello.
Joe Bauer: Hey Mark, how you doing?
Mark Canton: Good.
Joe Bauer: Thanks for-
Julie Clark: Right on.
Joe Bauer: … coming on the show today. Where are you right now Mark?
Mark Canton: I am in a car, so you can say we’re doing real estate in a car, but I’m in a car that’s on a boat. I am on a ferry right now.
Julie Clark: Nice.
Mark Canton: Near [inaudible 00:05:47].
Joe Bauer: Awesome.
Julie Clark: What are you doing over there?
Mark Canton: I am headed across the pond for a little bit.
Julie Clark: Nice, well it’s a good day for it. I haven’t been on a car ferry in a while. I need to do that soon.
Julie Clark: Speaking of nothing to do with real estate Mark, what do you do outside of work, and investing, and riding car ferries, what do you like to do?
Mark Canton: I’m really into boating. I had a sailboat for about seven years. I sold that, now I have a little motor boat, but it’s really a joke. It’s inflatable, it has a little outboard engine. I like to take that out, get on the water, get around nature, meet good people. I also do a fair amount of charitable work. It keeps me busy and I’m always hunting for the next property, so those three things tend to take up most of the evenings and weekends. Of course, I like to travel like everybody else as well.
Julie Clark: Yeah? What’s your favorite travel spot that you’ve been to?
Mark Canton: That’s a tough question. I like to change it up a lot. There’s some people that like to go back to the same cabin, or the same beach, or the same time, I really like to change it up. I’ve been to Europe a few times. I’ve been to Brazil. I’ve been to Mexico a whole bunch of times. Actually, the last three years I decided to try to get through a lot of America because I’ve been to Europe a couple times before I’d even been to the East Coast. I said, “Well that’s kind of silly.” So a year or two ago I actually did a cross country road trip from basically Atlanta to Seattle and that was a lot of fun.
Julie Clark: Nice.
Joe Bauer: Very cool, very cool.
Julie Clark: Are you a fisherman out in your boat or you just tooling around out there?
Mark Canton: No. I’ve gone fishing from time to time, but I just like to go out, relax, soak up some Vitamin D, and enjoy the outdoors.
Julie Clark: I hear that boy. Where has our Vitamin D right now? It’s a little overcast here in Seattle, which I guess is a welcome break. But here we are at work on a … I don’t even know what day of the week it is. It’s a Thursday [crosstalk 00:07:55], normal podcast day.
Julie Clark: Mark, we forgot to introduce. We know Mark guys, Mark hangs with us at Seattle Investors Club and some of our other local real estate investing clubs and part of our network. Mark’s always contributing awesome knowledge and information. We thought, “Hey, it’s time to tap into this guy’s brain.” CPA by trade. Why don’t you fill us in on what you are and how you’re involved in real estate investing. We’ll try and narrow our path here a little.
Mark Canton: Sure, sure. I’m really passionate about real estate. Personally, I pursue buy and hold. I try to be as passive as humanly possible, except for the search itself which is a constant job of course. I don’t do flips, I don’t do big ugly rehabs. There are a lot of people out there that can make a lot of money doing it, I just don’t have the stomach for it, but the for the people who do it that’s great.
Mark Canton: Then by day, as you mentioned, I’m a partner in a local CPA firm here in west Seattle. We focus pretty heavily on real estate, although that’s not all that we do. We probably do well over 300 real estate investor’s tax returns every year. That tends to work pretty well, kind of seeing both sides of it. We do enough of it that I have friends who are clients, and so forth. I get to have a little bit of an ear to the ground. I feel pretty lucky that I get to see what’s going on in people’s lives and beyond just some boasting that you might see when people are out and about. I get to see what the real results were on paper. That’s kind of the fun part, although of course, it’s extremely confidential. And I really enjoy that.
Julie Clark: Do you get-
Mark Canton: In fact … Go ahead.
Julie Clark: … involved in real estate investing because you starting off being a CPA for real estate investors and you saw how much they loved it and you got into it because they clued you in on how awesome it was, or did you always know … Did that rub off on you or did you always have a love for the real estate?
Mark Canton: I don’t think that’s what kicked it off, but it certainly accelerated it. Believe it or not, through my career I’ve tried to steer a little bit away from real estate. I know it’s going to be kind of shocker, but I thought, “Well I don’t want my asset to my day job to be in the same industry, especially if it’s cyclical.” But I’ve never really been able to get too far away for it because when you love something, you’re passionate about it, and you’re glowing, people are just attracted to you. I really do enjoy it.
Mark Canton: Actually, earlier on I was doing a lot more work with big corporations, but real estate has always been there. Now I’ve just decided to let it run its course in that I love the people that I get to work with. I really do enjoy it. Yeah I don’t meet that ultimate goal of having my client base different than my asset base, but that’s okay. I’m doing just fine.
Julie Clark: I like the analogy of when you do something that you love you’re glowing and people are attracted to you. That’s funny because that’s exactly I think how we came to know you is that you were glowing and you were contributing. We were like, “Hey.” You started being in my peripheral vision. I just kept noticing you and your awesome knowledge and contributions and here we are, so that’s a great analogy. I hope I glow. Now I feel like I need to … I want to glow. Joe, you glow.
Joe Bauer: I think you glow and then combust Julie. You’re a combustor or exploder.
Julie Clark: I’m an exploder. I don’t know if that’s good. Is that good or not good?
Joe Bauer: It’s above glowing, it’s just crazy.
Julie Clark: Right on, well that is, because some people call me crazy so maybe it all makes sense to me now. Right on.
Julie Clark: Let’s jump in to a little bit of the accounting, and tax, and investor stuff here. Maybe I’ll kick us off with some basic stuff for our listeners that may be in Seattle and may be in Oregon. I think we’ve got a fair amount of people listening to us now from the Portland area. If you are outside of the Pacific Northwest, welcome. By the way, Pacific Northwest rules so come over and see us.
Julie Clark: Let me kick it off. Mark, basic question, how is income from flips taxed differently from sales of buy and holds, or rental income, or that type of thing? Is there a definite difference for tax purposes on those types of assets and what you do with them?
Mark Canton: Yeah there’s a huge difference. Of course I got to start by saying everybody’s situation varies, but this is one of the areas that is a lot more distinct for 98% of people. When you’re flipping a property, and I’m going to try to keep this 30,000 foot level so I don’t put people to sleep, it kind of starts to look and feel like a job, you’re active in it, you’re going to it every day, so the IRS starts to look at it and tax it as if it was a job rather than a passive real estate activity. There’s a couple of real downsides to that. First of all, they try to hit you with self-employment tax, which is something totally different from income tax, but it could be a lot of money. It is about 15% roughly, and then you get a deduction, so you’re out the door at about 12% on the first $130,000 or so of income and that’s on top of your income tax.
Mark Canton: A very common thing that a lot of flippers do is set up an S corp which you can use to reduce, but not fully eliminate that self-employment tax. Usually if you’re netting more than $50,000 or $60,000 it starts to really make sense to go through the administrative costs and the headaches of setting up and maintaining an S corp. But, again, every situation is a bit different.
Mark Canton: Also, with flips, as you know, well hopefully they’re short-term. Hopefully they’re within your timeline. So when you’re looking at capital gains and that kind of thing you’re basically looking at ordinary income or close to ordinary income rates instead of capital gains, which are much lower. It’s almost like you’re buying and selling a product which is kind of the analogy that I use sometimes to bring it down to English here. It’s really kind of the worst for taxes, to be frank. I don’t like to let the tax tail wag the dog in a way. If you’re great at flipping and you can make a ton of money at it stick to it. Even though it’s a higher tax rate you don’t want to get into something that you’re not good at or not comfortable with just for the sake of a lower rate.
Mark Canton: That’s some of the differences. With buy and hold real estate it’s very different. There is no self-employment tax. Again, 99% of the time you get to depreciate the asset which can oftentimes be your biggest expense and it’s actually my favorite because it’s a non-cash expense, so you get a tax break for an expense that you didn’t actually pay for. That number always surprises people with how large it can get.
Mark Canton: Buy and hold investing has gotten a lot better since the recent Congress tax changes last December. Now there are things like bonus depreciation which make it much more advantageous to do improvement on your property. It makes more complicated topics like cost segregation must more advantageous and application in a lot more situations. There’s a few things like that.
Mark Canton: If you were to choose one just based on taxes alone there’s a very distinct difference there, but I don’t think that’s the sole reason to choose your strategy. You got to see where you can make hay in the first place.
Julie Clark: That’s interesting. A very, very interesting topic that I am super hot on, been talking to our friend, our mutual friend, Albert [Booey 00:16:16] about, the whole buy and hold. I think the only reason that people don’t get into the buy and hold stuff from the start as new investors or the reason why they start with the flips is because that’s what all these real estate gurus and all that stuff talk about. They talk about going into buy and hold and rental properties as a second tier to getting into real estate investing, like flipping houses is the easiest and that’s totally, totally wrong. You can learn to flip or you can learn to be a landlord. Either one can come before the other. Like you said, being a buy/hold operator is much more beneficial cash flow wise, tax wise, and all that stuff. I think people are looking for like they think that they’re going to make that $30,000-$40,000 big hit. What they don’t realize from the start if they flip, I got to get that $30,000 or whatever in my pocket. They think that’s more beneficial to them then having $1000 of cash flow a month on some rental if they’re able to buy it. It’s like they’re focused on a dollar amount rather than the big picture. I think that’s because they’re not educated properly from the start. They’re taught just to look at how to flip how to start with the rest being an add-on later. What I think is that number one thing people need to be taught from the start is where they fit in in regards to their borrowing capacity or where they can borrow money, how they can borrow money. Even if you have no credit and that sort of thing you can always probably borrow hard money, but aside from hard money which is more expensive and still requires some down payment, if you have a day job and you’re getting into this you might very well be able to increase your borrowing capacity or handle your borrowing capacity where you could get started in buy and holds from the start. The truth of the matter is anybody who flips after a couple years of flipping and they realize it’s just a glorified job they all … Can you guys hear that? There’s a buzz going on.
Mark Canton: I can hear you.
Julie Clark: All those guys end up like oh my God, why did I flip all those properties? I should have kept them for taxes, for big picture planning. I’m glad that you brought that topic up that from a tax perspective flipping is like the worst thing to get started in, right? I think that I’d like to change the conversation to teach people from the beginning a different approach to get started so they’re not just staring and learning about how to flip properties or house hack. House hack maybe is better actually than flipping, but that’s a great conversation piece that involves some tax benefits as well, so thanks for bringing that up.
Julie Clark: What do you think about house hacking? Do you have any thoughts on that?
Mark Canton: I think it’s great for beginners. I definitely didn’t mean to knock flipping. I know a lot-
Julie Clark: I did.
Mark Canton: … of people who make a whole lot of money doing it. Oh okay, well fine then. For the record, it was Julie not Mark, right?
Julie Clark: Yeah.
Mark Canton: I think that house hacking is great. I think that with flipping and house hacking I think the other reason why a lot of new people turn towards it is because it requires much less capital up front. If you’re house hacking hopefully you can get an FHA or something like that with a really low down payment. It could be tax advantageous, you need a roof over your head anyways. I think it’s good for people who are beginning. When you look at that trade off to what you would pay in rent anyways, that could be kind of an added benefit.
Mark Canton: I enjoy it. I want to hear that people are doing that. Once you have a few properties you don’t get as favorable loans anymore so you have to put the same down payment, so then you kind of start to wonder. It’s also a lifestyle choice also. It’s up to each person whether that’s a sacrifice they want to make or not if it’s not their ideal living situation.
Julie Clark: Right. My point on the flips, of course I love flips. We’ve done plenty of flips. I own rental properties, and apartment units, and all that stuff too. Definitely have survived through every downturn because of it, of owning rental property. I’m just saying that from the beginning I’d like people to be educated about their tax position and what lane they can be moving to, as well as understanding where they fit in in the debt world. Understanding where you fit in in your borrowing and your debt can open up so many more doors for you if you know what you’re able to do. I don’t know. I wasn’t knocking flipping, but I’m saying that you guys might have so much more available to you from the start then you realize and we just need to help you understand what I’m talking about a little bit more.
Julie Clark: All right, so we know that flips get taxed heavily, would that be at the ordinary income level of tax, whatever your personal tax bracket is is what you’re going to get nailed with there in addition to … Mark, on the self-employment tax, let’s say you have a day job and you flip, you do both. You still have the possibility of getting hit with the self-employment tax if that part of your business flipping earns a certain amount of money or how does that work? Because it’s called self-employment tax.
Mark Canton: Unfortunately it still looks and feels like a day job. Again, this isn’t a blanket statement. There are some circumstances if you do one flip a year or if you’re very, very passive with it, if you are a passive investor or even better yet, you just loan money to a flipper than it’s a whole different ball game. There’s a number of things that go into it and there is some slight gray area. If you ask 100 CPAs you’ll find two very aggressive ones that might let you get away with it, but I don’t think that makes it a right answer. I’m not in the business of inviting people to get audited. It kind of is what it is.
Mark Canton: Far and wide, there are some instances where let’s say you fix it up, you move into it, you sell it a few years later, that kind of thing. There’s some other strategies like that that you can use to lower your tax burden. But I like to tell people, and as you can probably tell, I try to look far beyond the tax numbers. I say, “Is this really a place where you want to live in for a few years? Is it really worth the tax savings, or taking a risk of whatever the market might do in a few years.”
Mark Canton: What I like to start with is actually a lot more broad than whether to flip, or to house hack, or whatnot. You had a great point which is what’s your lending situation, what’s your capital because that’s obviously going to restrict you a whole lot. I like to just ask what are your goals, what are your big or long-term goals. That will dictate it. I think that a tremendous amount of time is wasted in investing, looking at strategies before you’ve really identified those goals. If you want to build capital versus cash flow or maybe build capital first and trade in for cash flowing efforts later, what’s your time horizon, how involved do you want to be, what’s your gut level comfort for risk. We all define risk differently. I think that those tend to narrow down the question of what strategy do you use much more than just what the best taxes are.
Julie Clark: Good answer, love it. That’s why you’re here brother, we love that. Awesome stuff so far. I love it.
Julie Clark: Do you have clients that … Can you 1031, this doesn’t make any sense, you can’t 1031 or something out of a flip can you? Does that make any sense? I have no idea.
Mark Canton: Well it’s gray. I’ll kind of leave it at that.
Julie Clark: Look at that [crosstalk 00:24:49].
Mark Canton: A lot of people want to do that. It’s more of a question of can you change the character of what it is. If it’s a rental for a few years becomes a little more likely. I don’t mean to be wishy washy with my answers here but I don’t want to give an ultimate statement and have somebody go out and take action based on something they’ve heard on the podcast.
Julie Clark: Fair enough.
Mark Canton: So the answer is no. However, there are some squirrely circumstances where if you are willing to make some of those sacrifices like holding onto it, changing the nature of it, having it be a rental, moving into it for a while it could help your case. But-
Julie Clark: You know what bothers me about all that stuff is, in general, I don’t know if I’m old and lazy, maybe I’m both, maybe my glow has exploded to not come back, but I get tired of trying at game situations so hard. You know what I want? I just want to know the rules and I want to know the rules to make my life easy just because if I know the rules then I can play by the rules. I can plan by playing by the rules. Trying to game every situation and pull out every trick is so tiring to me. I have kids, I have family, I have friends, I want to do stuff, I want to sleep at night. Honestly, same things goes with being a wholesaler, and a real estate investor, and an agent. I don’t need to play a bunch of games and know every dark corner and gray area. I don’t mind sticking my toes on the line, but that’s an educated toes on the line, not too far over. I appreciate where you’re coming from on that is you can probably find a way to do this or that, but you’re going to be turning left, then right, then taking a circle, and then doing a jumping jack. It’s kind of stupid, right?
Mark Canton: Yeah [crosstalk 00:26:44].
Julie Clark: I’m saying it like I think I’m cranky today you guys. What’s up man? You know. I got to tell you what, this changing shift in the real estate marketing is making me have to work a little harder if you know what I mean. I think I’m cranky, I apologize, but I do love you guys. I want you to know that. This is all for your benefit.
Julie Clark: How about in general, no flip 1031s, but let’s say 1031 exchanges is what we’re talking about guys. That’s when you’ve owned a property, a rental property let’s say for a while, could be any type of property as long as it’s not your personal residence, and you exchange that when you go to sell it and you trade across or up I think. We just had William Exeter on the podcast. I don’t think it’s come out yet, but that was a good one coming up for you guys, or it should be out by the time you’re hearing this. So go back and listen to that, major nuggets in there.
Julie Clark: Do you have a lot of your clients that are steady Eddy investors doing 1031s not out of flips but out of their rental properties? Do you recommend that? Obviously it’s a way to differ taxes.
Mark Canton: I saw look at what the tax bite is going to be. I got a phone call from somebody a month or two ago and their capital gains tax was going to be $5000 and they wanted to do a 1031 to avoid the $5000. I said, “Well, the problem right now is that it’s still a really strong sellers market despite whatever’s been happening the past month or two and you’re really rushed into getting a property, so what are the odds you can find a quality property that you like? More likely than not you’re going to end up with something you’re not as happy with. Is that worth $5000 to get into a junky property? Of course not.”
Mark Canton: That’s an extreme example but it could be very valuable and especially when you get to something like estate planning, they say differ until you die, you just 1031 forever and then when you pass away there’s step up basis so that your heirs inherit the property. It might be subject to estate tax, but the point is you’ve created all this wealth without ever paying capital gains tax on it. It can certainly help in a lot of situations, but sometimes there’s a property where you just need out of it. Depending on the dollar amount of the tax I would say be really careful about rushing into a property that might be subpar. That’s the thing that’s happening into today’s market and everybody’s got kind of the same challenge with it. It could be very powerful, especially over time, but again-
Julie Clark: Well I-
Mark Canton: … it’s not the end all be all.
Julie Clark: I have clients that were actively looking for 1031 right now properties and really what I think people are doing these days even though it’s more expensive because you’re almost forced to is do a reverse exchange because you almost have to find something to exchange into before you actually initiate the process on the other side. That could be changing here though as the market is shifting [crosstalk 00:30:04] a little bit, but something we’ll keep you guys updated on.
Julie Clark: In general, a 1031s great. I guess, like anything we’re talking about, you need to look at your global picture. Maybe you need your $50,000. Maybe you need that money because you have other opportunities in your global picture to go … Maybe you need the money for something. Paying tax isn’t a bad thing, although, I tell you, sometimes I feel like I can get my bills paid, all my annual bill paid in the first five months of the year or something like that, or six months of the year, then I got to work another couple months to, and I have big bills guys, and then I got to work another couple months just simply to now cover my tax bill associated with the fact that I made all that money. Then I’m working for a while to cover that. Its like chasing your tail all the time, except, as you know, except that’s with ordinary income, when you’re generating ordinary income.
Julie Clark: I’ve benefited for years, and years, and years of having massive cash flow off apartment projects that had, as we were talking about tax losses or taxes lower so you can actually collect monthly cash flow without having it affect your tax bill at the time and that all feels good until you go and sell it and you have to recapture that depreciation. Why don’t you tell people what depreciation recapture is so they understand that while owning rental properties is awesome and you feel like you’re on cloud nine where you’re collecting your cash flow with your low tax bill, it does catch up with you in the form of depreciation capture at the end.
Mark Canton: While you’re owning or rental out a rental property you’re charging a ton of depreciation expense, which is great because you’re getting this big tax break during all this time. That’s a subject in its own of course and there’s certain limitations to it, but it’s a great thing. What happens when you go to sell, and I don’t know why more people aren’t talking about this, there’s this thing call depreciation recapture which means that if you’re selling for $1 million and let’s say the basis, which is the depreciated value’s at $700,000 you have this $300,000 gain. Normally, hopefully, you would get that to qualify for long-term capital gain.
Mark Canton: However, IRS says wait a second, your income rate was let’s say 32% or whatever it is and you were getting a break at that 32% all these years because you were depreciating this asset, now you want to pay the taxes on 15%, that’s arbitrage. What they said is you have to pay a slightly higher rate, not for the whole gain, but only for the depreciation amounts that you’ve taken. So you’re essentially paying back the breaks that you got, but it’s not all bad because it’s at 25%. If the marginal rate is higher than that you still make some money on the spread, plus you have the advantage of you’re getting the breaks in the past throughout history and you’re only paying for it now. It’s almost like a free loan in a sense. It’s not-
Julie Clark: But it’s important for people to understand that, that you’re not going to be just taxed at your gain, whatever capital gains tax is at. You’re going to get also taxed at a rate of 25% on whatever the amount was you depreciated over the term of your hold, right?
Mark Canton: Yeah. So-
Julie Clark: That’s not in addition to is it? It’s not like you get taxed both ways. You get taxed up to the depreciation amount, recapture it 25% and the rest at capital gains, or how does that work?
Mark Canton: Yes, you got that.
Julie Clark: Okay, got it. You guys follow that? It’s not like you’re paying your full $300,000 of gain times your capital gains right, then you got to tack on 25% recapture of the depreciation tax rate on top. You take the depreciation recapture tax rate first and then whatever’s left over gets taxed at the capital gains rate, is that right?
Mark Canton: Yeah all it means is that your blended rate’s not going to be 15%. It’s going to be close to the 20% or 25% at the end of the day. It’s really helpful to just do a back of the napkin calculation to figure out what this is going to be before you get serious about selling.
Mark Canton: A lot of things that we said so far today are probably really surprising for most people because they’re probably like, “Wow, this CPA is going to tell me how to do all this super aggressive tax stuff,” which we can certainly get to. But I’m really concerned with first and foremost, protecting people. I think that if I just pushed the most aggressive tax things on earth a lot of times it would either be too aggressive and attract an audit or it would completely ignore all these other factors which are really important.
Mark Canton: One thing that I tell people sometimes and their eyes really widen is I say, “Why don’t you just refi it and just cash out?” Because if you’re looking at a big gain and you’re going to pay at least 9% when you sell, between buyers, sellers, brokers, commissions, closing costs, 1.78% of basically sales tax in the state of Washington, and then whatever you had to fix it up for, then you’ve got a month or two of vacancy, so you’re losing 10% at least just in the selling usual, a normal 1 to 4 unit rental. Then I say, “Well if you could borrow 75% of the value you get to keep the asset and it’s a non-taxable event so you don’t even worry about capital gain.” So there’s some times when that makes sense where you get [crosstalk 00:35:52] almost all the liquidity that you wanted.
Julie Clark: People go, “I’m tired of being a landlord.” I say, “Well then hire it out.” You don’t have to manage it yourself.
Mark Canton: Yeah.
Julie Clark: I don’t know why people … “I don’t like property managers.” Well it’s kind of like geez … People get so, I don’t know, jaded on things I think. We’re so lucky to be in the positions to even be talking about the ability for us all to do this. I’m cranky today guys, so I don’t want to hear your shit. [crosstalk 00:36:27].
Mark Canton: I feel like my whole job revolves around dealing with Cadillac problems so that’s okay.
Julie Clark: Yeah, exactly, exactly. I’m going to just go back to it. We just broke it down how the 25% depreciation recapture is the first hit and then you get your capital gains tax beyond that as opposed, I’m just going to circle it back up, to what we were talking about with flip income getting taxed at your full whatever tax bracket you’re at plus then on that one you add on top, not blended, but add on top that self-employment tax, right?
Mark Canton: Yes. There’s certain limitations within the self-employment tax. The lion share of it is Social Security and the other one is, what is it, Medicare/Medicaid, it’s a government health program. The Social Security is the lion share and that phases out after your income is right around $128,000 I think these days or so. If you’re already really high income your self-employment tax might only be about 3% rather than the 15%. I’m using really round numbers and I have to apologize for that because I am in the car and a little distracted at the moment. That’s kind of it in a nutshell. There’s a lot of moving parts, but you can be hit really hard. You could be hit for 40% plus out the door on a flip. If you made a ton of money and if you could do it in a short period of time, and it more money than you can make at a day job or with a buy and hold, power to you, pay the tax and move on. I think that people should know when they’re getting started with their strategy…
Mark Canton: You had mentioned briefly about the gurus earlier and I get kind of irked by gurus sometimes because I feel like they’re very incentivized to talk about all the best things that could happen in the top 1% of examples. I feel like they don’t always talk about the downfalls of things, even tax gurus, to be frank, as well as financial gurus and different strategies. There’s certainly some good ones out there, but I do get irked a little bit because as you can tell by the way I’m talking my goal is to first defend people and then secondly, try to annihilate the taxes to the best extent that we can. I think that some people have that backwards. I kind of owe them a certain amount of discipline in that. I don’t know, maybe that’s just me. It might sound a little boring than what you were expecting.
Julie Clark: No I’m [crosstalk 00:39:05]. I’m loving this stuff. I was telling Mark earlier that I was actually an accounting major, passed the CPA exam myself, it did take me a few tries, I’ll be honest. I was almost ready to give up. That was not easy, so more power to all you CPAs out there that grind through that stuff. It was not easy.
Julie Clark: The point of the matter is you guys is this, is that everybody’s situation is different. It’s the same thing we’ve talked about before on what you’re borrowing situation is, which lane you are in as an investor based on your skillset, your borrowing power, whatever you can bring to the table. Your situation is going to change over time, that’s why having a CPA on your team like Mark that is super investor friendly is … You guys hear that?
Mark Canton: Yep.
Julie Clark: My daughter stole my phone and changed my ringtone. Listen. That’s her singing. That happens to me in important meetings, such as this. It’s a joy.
Julie Clark: Everybody’s in a different situation and you’re going to need to check in over time as you make more money, or you have changes in your family and all that stuff. Your CPA is as important as your doctor, or your attorney, or as anybody else. When you’re starting out it’s never too soon to just get a check in of where you’re at and have them help you with a little bit of some … Tell you what your options are maybe on the path that you can take and what happens when you hit certain thresholds. It’s so valuable. It’s actually more valuable you guys than learning how to flip a house. I promise you because learning this stuff from somebody like Mark early on or listening to podcasts like this where we do deep dives on this stuff, you will find out later that you wish you would have known it from the start. I don’t know why I feel like I want to rearrange the starting gates for investors. I’ve been talking about that a lot lately, just trying to touch on these things on these podcasts and hopefully people will get what I’m talking about and ask more question. We’ll keep moving on here.
Julie Clark: Let me ask you, with that in mind, one thing investors are are cheap, bunch of cheap asses that’s for sure. You guys know it. It’s amazing how many people will shop around to save $100 on a hard money loan fee. It’s like, what? Come on guys. But one thing that investors like to do, and I hear this all the time is let me see how low I can get my tax bill. I’ve always been somebody who was like, “Oh my god, let me see how high I can keep my income,” which probably isn’t a smart necessarily approach to it either. The reason why I do that is because I’m an investor, and I want to live my life, and I want to be able to borrow money. If I write off everything on the planet then makeup reasons to write off this and that, and partials this, then all of a sudden, I find myself with a sweet deal in my lap and I can’t borrow any money to make a killing. What do you think about that Mark? Is there a balance?
Mark Canton: I think that’s a trade off that a lot of people don’t think about. It’s not an A or B type question. There’s a lot of middle ground there. There’s certain things about a presentation of your tax return that will really hurt your ability to bother and there are other things that you could do that will reduce your reported income, but lenders typically add it back into there.
Mark Canton: This is actually a little more of question for a lender or Albert [Booey’s 00:42:45] comments, who was on the podcast a little while ago. But there’s a balance. I think a lot of people go into this not necessarily thinking about that. If you restricted your ability to borrow you might have put a strangle hold on your business. That’s going to be really annoying when you come across a really good deal and all of a sudden you’re having trouble borrowing or you need to take on a partner and so forth just because of a stupid thing like the way you presented something on your tax return.
Julie Clark: When you say [crosstalk 00:43:12]
Mark Canton: So it’s not just a matter of … Go ahead.
Julie Clark: Are you talking about using a Schedule C versus a Schedule E, versus some other Schedule?
Mark Canton: Yeah and the way that you run through some personal expenses. People have an office and all these other expenses which they say, “Well it’s related to my real estate business. Do I take it in here or do I take it against my brokerage business?” A lot of people don’t like to admit this, but there’s definitely some murkiness in there.
Mark Canton: Other things like depreciation, every lender knows how to add that back, but it’s some of these other things that get a little weird. It also kind of begs the question about using [inaudible 00:43:55] and how … That’s a whole bigger topic, mostly around asset protection, but it could also change your ability to borrow.
Julie Clark: Right. Basically guys, in a nutshell, check in with your CPA because like we said everybody’s situation is different. Do you do the return for real estate agents who are not investors, just regular old agents? Do you do any of those, does your…
Mark Canton: Sometimes. For them it’s actually pretty simple. A lot of them are 1099’d and then sometimes they’ll set up an S corp to play that game in lowering the self-employment tax, like we talked about earlier. Then they tend to have a lot of unreimbursed expenses, so they have cell phone, internet, auto, Nielsen entertainment, and things like that that they’re talking through. It’s looking at what’s the best way to capture all of that, if you’re just a real estate broker and not investing and have any other tax complications. That’s kind of it in a nutshell for them. I could think of more if I give it some more thought, but it’s not the most complicated thing when it comes to taxes.
Julie Clark: Right, so it all comes back guys to maybe what we’re picking up if you’re picking up what we’re putting down, if you know what I mean, is that understanding when self-employment tax comes into play are not, just Google it or look it up on Bigger Pockets or whatever. Read some articles about it and learn some more about what self-employment tax means, because that seems ugly, the rotten grape in the vine here a little bit, and just knowing what that means and how it might apply to you now or in the future might be something for you guys to check up in on.
Julie Clark: Let’s say we do like writing off stuff, what do you think are the top two or three write offs that give the biggest bang for the buck, aside from maybe your home mortgage interest deduction or something like that? Does that question make any sense that I’m asking? Is there anything that you can-
Mark Canton: Yeah, yeah. Well it really depends on what kind of activities you’re involved in. If you just work a day job and you haven’t started investing or anything it’s really limited, especially since Congress’ recent tax changes six months ago. It’s really hard to … You can’t really deduct miscellaneous expenses like you used to. If you have a rental business or you have a real estate brokerage business and so forth, or your own little business, even if it’s not in an entity, if it’s like a Schedule C, that gives you an opportunity to apply much more expenses against it.
Mark Canton: People look at mileage, you reduce depreciation, home office is very common. People spend a lot of time talking about meals and entertainment, I don’t think that’s a really big one even if you’re doing a ton of it. You no longer get to deduct entertainment and you only deduct 50% of meals. So if your marginal tax rate is lets say 1/3, about 32% and you spend $100 on dinner you only deduct $50 and you only take 1/3 of that. So you essentially get $12 back from your $100 dinner, so it’s really not the best [inaudible 00:47:11] in the world.
Julie Clark: What about the-
Mark Canton: I don’t know why people are talking about it so much.
Julie Clark: This gets down to some nitty gritty stuff. I get what you’re saying there. What about [crosstalk 00:47:22] here’s a big one though Mark, what about real estate education, what if you’re a full-time investor or proven considered a … what would be the word they use for tax purposes for real estate? Isn’t there a … I’m drawing a blank on it.
Mark Canton: Education is a great write off, whether it’s seminars, books, any kind of thing like that, mileage and travel related to it. Where it gets a little sticky is if you go to Hawaii for a real estate conference and really you’re on the beach. Technically, you need to be spending over half the days doing a real estate activity. Your travel day might count if it’s enough hours and enough time from door to door travel.
Julie Clark: Basically you got to be [crosstalk 00:48:08] a journal it sounds like if you got audited. What about if somebody spends $30,000 joining Fortune Builders or one of these things, can they write that off?
Mark Canton: Usually it really depends on how they’re presenting their tax return, to be frank. A lot of the times they can. What I mean by that is I would say look into it before you join a certain program. Don’t join the program and look at how you can write it off afterwards because I would say most of the time you can, but there are a few times when you can’t. It’s worth the question. Like I said, talk to a CPA even if it’s not me, I don’t care. Within a few minutes they could answer it based on learning just a little bit more about your situation.
Julie Clark: What about S corps versus C-corps, I see most investors try to go the S corp route, as we talked about, to avoid or minimize, or whatever you want to say, the self-employment tax. I do see some investors that use a C corp. What would be the reason for that?
Mark Canton: When it comes to real estate c corps are bad news. It’s not 100% of the time but it’s a good 99% of the time. C corps were favorable for real estate 30 or 40 years ago and that has all changed since. Sometimes you see some of these partnerships on commercial buildings downtown and things like that. They’re a C corp only because they’ve been a C corp forever and have never got around to changing. Aside from that, you don’t want to use one for flipping. You don’t want to use one for buy and hold. It’s just bad news. It’s a lot more expensive to maintain and administer. The tax rate is still not advantageous.
Mark Canton: You might have heard the buzz of course about a 21% corporate tax rate. That’s when it earns money. When it gives you a distribution it’s taxed again at at least 15%, so you’re already at a minimum of 36% tax right out the door. It would be very rare to have a kind of scenario where that would be advantageous.
Julie Clark: I’ve got you. We’ll leave it at that.
Julie Clark: How about the biggest impact on tax payers in general? If we can loop in real estate investors in specific related to the new tax laws that just went into effect? What’s the biggest impact, or is it a benefit or is it a negative?
Mark Canton: I think it’s a net win for real estate investors for sure. As you probably know, our rates went down. Most people across the board are getting some money back. As it relates to real estate investing, like I said, your improvements bonus depreciation has been a pretty hot topic when you’re doing any kind of an improvement or even if you’re buying real estate assets that have a shorter useful life, which is not going to be apartments or commercial property, that people buy things like gas stations, believe it or not. They can write off the entire gas station in the year that they buy it. That is a really big deal instead of depreciating it over 20 or so years. I know that’s kind of a weird nuanced thing.
Mark Canton: Another thing that happened is [crosstalk 00:51:27].
Julie Clark: Is there anything with mobile homes, is that just considered just like another straight up rental type of situation like multi-family?
Mark Canton: That’s a good question. With mobile home parks of course a big part of it is the land, but a lot of it is actually land improvements. Land improvements have a shorter useful life as well, so there’s a lot of opportunity on that as well. It’s gotten better.
Mark Canton: Another big thing that’s happened in the blog world, this has been all over the place, of course, is that most people are losing their benefit from itemizing deductions, so they’re losing a tax benefit from their primary home. That’s basically because the standard deductions increased so much. The way it pencils out is if you buy a new home and it’s $800,000 or less and you write off your interest in your property taxes you’re probably still below $24,000, which is your standard deduction if you’re married anyways. If you buy a $1 million home it will probably be a little over $24,000, but not that much. It’s certainly not a reason to buy a house. The answer behind that is with leverage it makes a lot more sense now more than ever to leverage your investments rather than your primary home because you can write off the interest on your investments still.
Mark Canton: Then the other benefit you get is from an asset protection standpoint. I’m not a lawyer, but you have less equity in these rental properties. Now different things like that look a lot more advantageous to push whatever of those expenses you can do legitimately to your real estate business rather than trying to take it on at the Schedule A. Does that make sense?
Julie Clark: Yeah that makes sense, yeah. Wow. Just another reason to own rental properties. I think it’s all interesting, I’d like to do a Seattle Investors Club meeting where we almost draw this big mind map, almost like this, I don’t know if it’s possible, but if this is the ideal path, if you were to set yourself up with this ideal path and everybody’s going to have different reasons on what’s ideal, but making some assumptions, and then show people a roadmap to get there that would be something cool. I don’t know if that’s doable because everything is individually specific, but it’s all fascinating to me.
Julie Clark: Every time I do one of these podcasts talking about tax stuff, or debt, and things like that I almost get lost up here in my own head. I can’t even barely focus because I think it’s such great information and so informative. There’s so much to learn that I hope that people who are out learning how to be real estate investors are putting quality time and time blocking aside some time to learn about these topics, debt, leverage, your personal borrowing situation, meeting with a CPA, learning about S corps, and self-employment tax, bonus depreciation, all these things. If you’re just a person who’s going to investing here or there maybe you can just … You don’t need to get all deep dive on this, but I think it’s fascinating. I think lots of people who are investors actually are just as big of geeks as we are Mark. They love learning about this stuff as much as they love learning … In fact, people after a while start loving the strategies and how to make their money through smart strategies with tax, and planning, and asset protection versus just swinging a hammer and doing a house hack or a flip. It’s kind of almost a more educated way of making your money, I don’t know.
Julie Clark: I’m not saying it PC correctly, but you guys get what I’m saying. Don’t forget the geeky stuff when you guys are thinking about how to grow your business. You might be able to do nothing and just change the way you hold things or the way things show up on your tax return. You might make some money just doing that, if you learn about your situation, I guess that’s my point.
Julie Clark: Let’s see, is there anything else we want to wrap up here? I think that’s probably it because you’re probably coming to the end of your fairy ride and I just got the silent get off the phone I need to go take you to get your car that’s in the shop signal from my crew here. That sounds like a good time to wrap up here. Mark, anything else you want to add? It’s been awesome. I’ve thoroughly enjoyed your very straightforward, level-headed, obviously very smart and passionate guy with a wonderful glow. So-
Mark Canton: Oh you can keep going.
Julie Clark: We want to do more with you. We’re going to get you to an SIC meeting and have maybe present something to crowd, especially as we’re getting here towards the end of the year and people are more excited to stay awake to talk about their tax situation and learn about what’s going to happen and impact down here towards the end of the year. Does that sound like something you’d be interested in?
Mark Canton: Yeah sure. I think this has been just barely the tip of the iceberg today. Of course, we can get into strategies that are a little bit more on the investment side. Like I said, I like to first start with the big picture because real estate investing has to be [inaudible 00:57:13]. We have to look at it, we can’t make these decisions in a vacuum. You have to look at how it’s going to affect all these different parts. That was kind of the gist of my message today. I’m sure everybody’s wondering, “Okay well now what? Now what about those strategies to be addressed?” That’s something we could cover in a later meeting if you like.
Julie Clark: Yeah, for sure. Let’s do it. Sounds good to me. Sounds good to me.
Julie Clark: I’m going to turn it back over to Joe who’s going to tell all you guys how you can get the awesome information.
Julie Clark: Actually Mark, if people want to engage you for additional help, and guidance, and review of their personal situation how can they reach you? Is there a way that you’d like to send them to a website or your contact information?
Mark Canton: Sure. If anyone would like to me my name is Mark Canton, C-A-N-T-O-N. My firm is called Hunt Jackson CPAs, I’m one of two partners, that’s Hunt as in going hunting, Jackson as in Andrew Jackson, CPAs. Our phone number is (206) 932-1314. If you need a CPA and you’re just seeing wow this is complicated, if it’s not, just give me a call. I’m happy to have a quick chat. To be frank, there’s a lot of people that I send away saying, “Here’s a little bit of info. I think you can probably figure this out yourself on Turbo Tax.” I’m really not in the business of pushing sales on people. Usually [inaudible 00:58:47] we’ve got one that’s complicated enough that it’s time to talk to an expert. If you’re out there feel free to reach out to me and best of luck to everybody.
Julie Clark: Awesome. Joe, where can they find all these awesome show notes?
Joe Bauer: Heck yeah, so everybody thanks for listening. You can find the show notes at seattleinvestorsclub.com/43. That’s seattleinvestorsclub.com/43. We’ll have all of the questions and show notes in that location. Remember that we love iTunes reviews, so if you love this podcast you can head over to seattleinvestorsclub.com/itunes and give us a review because every five star review we get helps us to get this message of real estate investing out there to more people.
Julie Clark: And it helps us get more killer guests on our podcast, so let’s keep throwing this things together guys. We need your help. Give us a review.
Joe Bauer: Heck yeah.
Julie Clark: Heck yeah.
Joe Bauer: Good stuff.
Julie Clark: Right on. All right-
Joe Bauer: All right.
Julie Clark: … that’s about it. I’m going to go get my car that’s in the shop and then I’m actually going to an appointment for us Joe. How do you think about that? There you go.
Joe Bauer: Awesome, awesome. I’m going to get some more of our podcast pushed out. So high five.
Julie Clark: Mark, thanks again and we’ll see you in a few.
Mark Canton: My pleasure, take care.