Mindy: Many of you have started a small business this year, and that’s super exciting. But if you’re used to working as a full-time employee for somebody else, the transition to business owner can be overwhelming, especially when it comes to keeping track of your taxes.
Scott: That’s right. So to help ease your way through the transition that uh can be very unpleasant for a lot of these small business owners, we have Brandon Hall, CPA to real estate investors, on the show to walk us through the different business and tax structures that you have and options that you have and choices that you can make as a real estate investor or small business professional. Um, we’ll talk about things like estimated tax taxes, deductions you can and shouldn’t take, and then we’ll have a fun little lively discussion about rep status and all the landmines there.
Scott: And Mindy, before we get into this episode, I do want to remind everybody that if you are struggling with tax strategy, frameworks, filing, bookkeeping, all of those types of things and you have any real estate related interests, we have uh created a tax finder on BiggerPockets with uh dozens, hundreds of real estate specific tax professionals. You can find those uh at biggerpockets.com/taxfinder, or if that’s too hard to remember, you can find them at biggerpockets.com/taxpros.
Mindy: All right, Scott. And our listeners. Hello, hello, hello and welcome to the BiggerPockets Money Podcast. My name is Mindy Jensen and with me as always is my always pays his taxes co-host, Scott Trench.
Scott: Thanks Mindy. great to be here as always with my counterpart or extension, Mindy Jensen.
Mindy: Mindy, as always, we’re here to make financial independence less scary, less just for somebody else to introduce you to every money story and every tax disaster, because we truly believe that financial freedom is attainable for everyone, no matter when or where you’re starting.
Scott: As long as you pay the IRS.
Mindy: Brandon Hall, welcome to the BiggerPockets Money Podcast. I’m so excited to talk to you today.
Brandon: Thanks for having me, Mindy. I’m excited to be here.
Mindy: Brandon, we are going to talk about businesses. And today, you are in the hot seat. To start off, can you give us a walk through of the different types of business structures that you can set up your small business as?
Brandon: So, so we’ll do just typical businesses, real estate enterprises. Landlords are maybe a little bit separate, but your typical structure is just you’re just going to start off as a sole proprietor. Um, so if you do nothing, then when you go to file your tax returns, you’re going to fill out a schedule C, it’s going to be tied to your social security number. All those 1099 payments, uh the W9, everything is tied to your social security number. Um, and you’re just operating like as Brandon Hall. And there’s nothing wrong with that, uh depending on where you’re at in the life cycle. Uh, you should at some point move that into an LLC structure, typically a single member LLC, so disregarded for tax purposes, but that’s where you kind of get that asset protection, you get the EIN, you can go get a bank account, um, and you can, you know, you can you’re easier to lend to, a lot of benefits if you are running a business and then that business is run through an LLC, um, in terms of legitimat legitimatizing yourself from a business contract perspective. From a tax perspective, it’s disregarded. It’s the same as if you were running a sole proprietorship. So no change there. Um, and then if you’re an LLC, you can tax yourself as an S corporation or a C corporation. And that’s when we start getting a little bit, uh a little bit more complex, right? So a lot of sole proprietors uh will set up an LLC, tax themselves as an S corporation to avoid a portion of the self-employment taxes that they are paying, um, on the income that they’re earning. So if you are running a sole proprietor, a sole proprietorship, or if you’re an LLC, uh any dollar that you earn up to 150 like 6k is taxed at a 15.3% rate. That’s self-employment taxes. As a the the the benefit of being a sole owner, you get you get this extra tax tax liability. And and I just want to point out that that is also being paid if you’re an employee, it’s just being paid by your employer as part of payroll tax. So that’s why that is it, right?
Brandon: Yeah, so if you’re in and honestly like a a lot of uh what what I have found is that a lot of business owners didn’t even realize. I mean everybody everybody’s heard of social security and Medicare tax, but you don’t really like look at your tax return at the end of the year and add 7.65% to it, right? You just go, yeah, my tax bill was X. But we’re all paying this this 7.65% tax on every dollar that we’re earning. Your employer just pays an additional 7.65%. But if you are the employer and the employee, then you get to pay the full 15.3. So you’re going to pay 15.3% on every dollar that you earn as a sole proprietor or as an LLC uh that’s single member disregarded. Um, if you tax yourself as an S corporation, then you can pay yourself a W2 wage and that is subject to that 15.3% tax. Whatever profit is left over is not. So the remaining profit left over is not subject to this 15.3% tax. You do get some tax savings if you’re running an S corporation. But then you get into like how do you actually run an S corporation appropriately and how do you avoid audits or how do you win an audit? Uh, and the big thing there is reasonable compensation and that is like a two-hour episode on how do you determine reasonable compensation because it’s not $1 like all the the headliners would tell you.
Scott: Well, great. Well, well, I think I think what what we’re trying to get here is is to help someone who’s like contemplating this, right? So so, again, if you’re a W2 employee, this is not really relevant to you right now. Remember this episode and come back to it when it is time um for it. If you are a real estate investor, we’re going to talk about that in a second here and you’re owning landlording rental properties, we can get into the nuances there. We’ve already covered touched a little bit about that. But if you’re trying to start your own business and you’re going through these options, you have the, you know, the LLC versus the Scorp and the and the C Corp, you know, you have decisions to make and can you provide us with like some general guidelines to steer people in the right direction even if they aren’t the be all end all and every situation is unique?
Brandon: Yeah, yeah. and and I think general guidelines are always dangerous, so take this with a grain of salt. Uh my general guideline is if you are going to gross 40 to 50k a year or less running your business, uh you should not be setting up any sort of complex entity structures. Uh you can absolutely set up an LLC, uh but that’s as far as I would take it. If you feel like you need the asset protection um that comes with that, then set the LLC up and run your business through an LLC, otherwise just run it as a sole proprietorship. If you are going to scale your business up more than that, uh and you’re going to do it consistently every single year, right? So this becomes a little more than maybe a side hustle or a hobby. Uh now we’re targeting 100k, 200k, 500k. Uh go ahead and set up an LLC and run your business out out of an LLC. So get your get your IN, get your business bank account, uh set up your um your W9 to show the EIN instead of your social security number and and and run it out of an LLC. The reason that I say that is when you tax yourself as an S corporation, the the ability to tax yourself as an S corporation is powerful. There’s a lot of there’s a lot of limiting issues that come with that too. So don’t just go and and tax yourself as an S corp just to save money on tax. Uh but the ability to tax yourself as an S corporation, uh you you get a lot of flexibility with the timing if you have an LLC set up. So when I set up an LLC, from that date, I can tax myself as an S corporation. I cannot tax myself as an S corporation if the LLC does not exist. So here here’s an example. Let’s say that I’m going to make $100,000 in net income in 2024. And that $100,000, if I were running it through an S corporation, I might be able to save, I don’t know, $10,000 in self-employment taxes. Um so I’m going to set up an LLC on January 1st, 2024 if I can because I can get to December 2024 and if I hit that profit target, I can retroactively tax my LLC as an Scorp starting January 1st, 2024. But if I wait until November 2024 to set my LLC up, then I can only retroactively tax my LLC as an Scorp uh starting November 2024. So only until only since that LLC has been set up, which means only the income earned in November and December is going to enjoy that that potential sheltering, which really there wouldn’t even be that much to shelter at that point. So, the earlier that you can set an LLC up, the better from this taxing as an S corporation perspective because you can retroactively tax your business as an Scorp. But again, that that threshold for me is kind of like that 50k threshold of really starting to get serious about this stuff. Um, and and there’s even some cases where you might be netting 100 or more uh and not want to tax yourself as an S corporation. My business is not taxed as an S corporation, right? So we gross millions of dollars a year, I don’t tax my business as an S corporation. and I have many reasons that I do not do that. Um, so you really have to have to sit down and and go through the pros and cons before jumping into that type of a structure because once you’re there, it’s really hard to unwind from it.
Mindy: All right, Brandon Hall just broke down for us the different business structures you can explore for your small business. Now, stay with us because after the break, he’ll walk us through how to estimate quarterly taxes.
Mindy: Welcome back to the BiggerPockets Money Podcast.
Scott: So we have these different different structures. I’ve now set up a business. Um, I’ve decided to incorporate it to an LLC. Like, what is the checklist? What are just some of the items that I that definitely need to be done, otherwise I’m wasting my time setting up the structure in the first place?
Brandon: So, first thing you need is an operating agreement. and a lot of people that set up LLCs don’t actually have an operating agreement. Um, you you have to have an operating agreement. You have to have an EIN, that’s an employee identification number. That takes five minutes to obtain from the IRS. Uh and you need a business bank account. I would say those are the big three. Uh you can go and register with your state um uh Secretary of State and uh and then you have to look at any sort of um like revenue departments that you have to register with, employee wage uh withholding departments that you have to register with, unemployment departments. So depending on the type of business that you’re running, also depends on what type of payroll uh or or if you need to register with the various payroll departments. So just be aware of that. But the basic level, just again, it’s it’s LLC is registered with the state, we’ve got an operating agreement, uh we’ve got an IN, we have a bank account.
Scott: And if you don’t have those three things, you’re wasting your time because you’re going to just have add some complexity to your life that is not going to add any value to anybody in any sense, any protection whatsoever. Um, it’s just going to add some unnecessary complexity and maybe some expense to your life. if you don’t have those, is that right?
Brandon: Oh, yeah, yeah, 100%. and I think most people setting up LLCs get the EINs, they get the business bank accounts, but they forget to have an operating agreement. And and that’s the big one. It’s like, well if you don’t have an operating agreement, you might as well just not even do this thing. Um, so, so make sure that you have an operating agreement, 100%, otherwise you’re just wasting your time and your money.
Mindy: Okay, so is an operating agreement something that you can like boiler plate language you can download from the internet or is this something that you get from your CPA or your attorney?
Brandon: So, so CPAs cannot write operating agreements for you. Um, you do have to be an attorney. So it well really nobody anybody that’s not an attorney cannot write operating agreements for you, technically speaking.
Scott: You can write your own operating agreement though, right?
Brandon: Yeah, you just you can’t pay somebody that’s not an attorney to do it. That’s unlicensed practice of law and the state bar association are super hardcore about protecting that. Uh, which means that if anybody is not an attorney telling you that they can do it for you, proceed with caution.
Scott: Everybody’s Googling their Googling operating agreement uh template uh right now because they don’t have their their operating agreement set up for their LLCs. They don’t want to pay a lawyer.
Brandon: Yeah, I I mean, I mean look, like like could you do all of that? Could you get a template? Could you write your own? 100%. You can do whatever you want. your life, your business. Um, what I have learned to do is to to reduce my legal costs, I have learned to any sort of contract that I need written, I will I will build the framework, so the key points that I need to be input into that contract, I’ll bullet point them out rather than having an attorney start from scratch because that’s when it gets really, really expensive. Um, when the attorney’s like, “Oh, well, how do we want to build this thing?” And here’s a million different ways we can do it. So I always start with a framework, I hand it to the attorney and I say I need a contract for this purpose. Uh, and it gives them a really good starting point to build on. Uh, but if you want to write your own, if you get templates, I would I would 1000% recommend that you pay a thousand bucks for an attorney to to review it. Uh, they’ll apply state law to it and that is the key. Um, you need to make sure that your operating agreement, um, you know, is written in accordance with the states that you are actually operating in. Uh, and and you have certain provisions in there that are needed.
Scott: Yeah, and key terms for an operating agreement might include things like who owns the business, right? on there. What who gets to make decisions uh about various things in the business. What are the exits of the business? How would how would it be dissolved? And how would if there are multiple owners of the business, how would they how would different owners be able to exit their interests in the business in various capacities? Right? What are some other terms that you?
Brandon: Yeah, how do we how do we split profits? How do we allocate losses? When do we do capital calls? Who has to do capital calls? Um, waterfall agreements, prefs, I mean everything related to the PNL is going to be is going to be in there. When do we make distributions? How do we make distributions? But the exits are are key too. It’s, you know, it’s not simply like what happens when we sell, but what about when somebody dies? What about when somebody gets divorced? Um, there’s a whole bunch of provisions that you can think through. And if you are partnering with somebody, by the way, so we’ve been talking about you just doing it all yourself and being a sole prop, man, if you’re partnering with somebody, you got to you got to sit down and really go through all of those things. Hey, I love your wife, but what happens if she doesn’t love you at some point? What are we going to do?
Scott: And you’re not And and by the a better way to do it is like you’re not even negotiating against your your partner’s wife. you’re negotiating against their unborn child’s future ex-spouse. That’s how I like to frame it. because because that person is not going to be reasonable in 25 years and you want to make sure your agreement is structured to protect you from them.
Brandon: Right. Right.
Mindy: Yeah. So who is what kind of an attorney am I looking for to help me set up my operating agreement?
Brandon: Uh I would say just general business attorney. Um, I I you know, you don’t need like a litigator or anything like that. Uh, but just a general business attorney would be a good place to start. Although what what I do with the law firm that I use is so my my point of contact is the general business attorney. um, and he works with firms of my size. so that’s the other key too is to make sure that like like the attorney that you’re working with actually works with businesses like yours. Um, which can be really hard to fact check and verify by the way, but you do have to check references and call clients and that type of stuff. Uh but my general business attorney like will build an operating agreement and then I’ll have him run it by his litigators like, okay, how would you litigate against this operating agreement if you were to do so? Uh and that helps strengthen it at the end of the day at least, I think it helps me sleep better at night.
Mindy: Yeah. So I would like to throw in my own two cents. If you don’t think you can afford an attorney to write up your operating agreement, then you cannot afford to have a business at this time.
Scott: I think that’s a great framework. And I look forward to seeing hot shot lawyers challenge that in the comment section, but like that’s right. Like, if you if you can’t afford to put together an operating agreement, you have no assets to protect.
Brandon: Yeah, I I think that that’s important in I mean in various aspects of life, but absolutely business. There are certain things that are just the cost of doing business, uh and and they might be annoying, they might be something you want to or feel like you could deprioritize, uh but you really shouldn’t and and getting that operating agreement written is certainly one of those things. Bookkeeping’s another one of those things, but that’s a different story.
Scott: let let’s get into the mechanic by the way, lawyers for this stuff like this is a solved problem. Like you’re not going to spend 10 grand on your operating agreement. you should spend 800 to 1500 bucks at max for a business that’s small that you’re just getting started with this. And someone will have language that has probably solved 85% of what Brandon just talked about and there will be decisions for you to make on the remaining balance of this. So this is not like don’t overthink that too much on that front if you’re listening to this um for the most part, for most typical types of businesses. Um let’s talk about once you set up an entity, you now are you you and you have your EIN from the federal government. The federal government is going to expect a uh tax return from you and other things to be completed. Your your secretary of state is going to require, you know, at least in Colorado, um expects you to stay keep your up to date. What are can you give us a a a kind of guidance on what the timeline of key milestones or you know, events that someone has to be keeping track of in order to keep their entity in good standing?
Brandon: So at the state level, uh and the state level is probably the most critical one to be totally honest with you. Uh, your your your entity always needs to be in good standing at the state level. and typically that is an annual filing requirement. Now, the the date is different per state, so I I don’t know how to guide on that aside from make sure that you know what the date is and put it in your calendar like six times that week that you you get that get that annual report in if you have an annual report. Some states allow you to file an annual report with the federal tax return, um, or with your 1040, but you have to be aware that you can actually do that and and a lot of people are not. So my suggestion is just make sure you’ve got that state annual filing on lockdown. From the federal perspective, uh if you are a single member LLC, again it’s disregarded for tax purposes, so you don’t file anything separately with the IRS. Uh you do have an EIN, the EIN will show up on your schedule C instead of your social security number, uh but you don’t file any sort of separate forms. If you have a partner, whether the partner be a third party, a friend, a family member, a spouse, a child, now you have to file a partnership tax return, that’s a form 1065 and that is due on 3/15, March 15th every single year. Um, you only have to file if you have activity though. So that’s the other key. Like I could go and create a hundred different partnerships, uh but do nothing in them and and I don’t actually have a filing requirement. So that is a a caveat there. Uh Scorp are also due on March 15th. but then uh C Corps are due April 15th and you can extend the LLCs, uh the Scorp, the C corps, you can extend them for six months like you can your regular individual tax returns. um, but that that’s that’s when that that deadline is.
Scott: Um, okay, so we talked about uh entities at length here and the the the tools and use cases for them. Um, this is a DIY project to a certain extent. You got to get basically familiar with this before you allow an attorney to bully you into one of these, you know, multi-series LLCs or whatever. Those can be the right approaches, but you should be able to know enough to be dangerous and get a couple opinions that make sense for you before hearing from those guys on there. They’re making like and understand the incentives that go along with all this stuff. I want to go and talk about another context construct here for for folks. Um, again, if you’re thinking about starting a small business or investing in real estate and you begin to generate profits outside of the payroll system, there are other considerations that you need to think about such as paying estimated taxes here. So for a business that generates income, nobody’s collecting the taxes from your paycheck automatically. and there’s, you know, you you set aside that. Can you walk us through the framework for how to think about this and any recommended tips or tricks for making sure you don’t fall into the um wrong side of the IRS um for this as a small business owner?
Brandon: Yes. uh the simplest tip that I have is every dollar of income that you earn as a business owner, take 30% of it and put it into a separate bank account and don’t touch it. Even if you don’t pay estimated taxes, right? because there’s varying schools of thought, although that’s super expensive to do these days with 8% interest rates. Um, take 30% and put it into a money market account and do not touch it until 4/15 where you have to make your payment. because at least you will have capital to knock the majority if not all of your tax bill down. The worst thing, the worst thing, especially in real estate is when flippers or developers take all their profits and they roll into the next deal, right? they’re trying to get the compounding effect going faster and faster and faster. Some think they’re doing a 1031 exchange and they’re sorely misguided. But they roll they roll them all into the next deal and then 415 comes and they owe 600k in taxes, but they’re all all that money is tied up in real estate and they have no real equity options at that point. Um, that’s those are always sad stories. So just make sure that you’re withholding that 30%. But if you want to get a little bit more strategic about it, uh, you know, you could take your 30% each quarter and cut a check to the IRS and state, and again, you’re going to be you’re going to be pretty close to good if not totally good, just with that simple methodology. But if you want to get a little bit more strategic about it, you hire an accountant to do a quarterly tax estimate for you. And basically what they’ll do, once a quarter, as they’ll sit down with you, they’ll look at all of your income streams and they’ll say, here is how much you owe the IRS right now. And you go cut that check based on the last quarter of earnings. Um, and that is a way to stay on top of your tax bill and mitigate penalties and interest and that service, this like the past 12 to 24 months, has really started to pay for itself. So before, uh, 2022, nobody really bought that service because interest rates were like 3%. so, you know, not a big deal if I don’t make my payment to the IRS, it doesn’t cost me anything. But now it’s costing a lot more money, so people are buying this taking you help me estimate my quarterly taxes so I can make an accurate payment and reduce or eliminate penalties and interest.
Mindy: Is there any formula to who owes estimated quarterly taxes, like who is required to pay them and who doesn’t? Cuz I got caught up back when I was 17, I had to pay estimated quarterly taxes and I didn’t, and then I got a big old fine, which was not easy to swing at 17.
Scott: You must have had a good thing going as a 17-year-old to have this problem, Mindy.
Mindy: I had an awesome thing going as a 17-year-old.
Scott: That’s on the next, all right, stay tuned and come back next week and let’s hear about Mindy’s 17-year-old side hustle where she had a big quarterly tax estimation problem.
Mindy: Well, I mean it was big in exchange for my, um, I think I had to pay a $2,000 fine and that really hurt at 17. I mean, I don’t want to pay a dollar of fines, but So who has to pay estimated quarterly taxes and who does not?
Brandon: So, in general, uh, if you pay so, let me back up. If you it gets a little complicated if you have a W2 job and you and you’re kind of building a business as a side hustle. Um, you the general rule is that you should always pay in 90% of the total tax that you’re going to owe for the current year. Uh, and the only way that you’re going to be able to estimate that is if you run those those ongoing estimates, right? Which you don’t necessarily need a CPA to do, like you could use smart asset or a calculator like that, um, to keep tabs on, but that’s what you would do is is every quarter you would say here’s my projected income for the year, so my total tax bill and I need to be paying a quarter of that every single year between my W2 withholdings and estimated taxes from the business income that I’m earning. Um, the other the other way to do this is if you pay 100% of the tax that was on last year’s return, then you’re good too. Uh, and that’s divided by four, right? So that’s each quarter. So as long as you’re paying 90% of this year’s tax or 100% of last year’s tax, uh, then you shouldn’t be subject to the penalties or the interest, um, or the underpayment penalty specifically that you might have been subject to.
Scott: So your estimate is only as good as your projections, right? So if you have a very variable income, you could run into a problem no matter what, right? Um with this. So it’s only it’s just a guess at the end of the day. But the way I do it is I just list all my different sources of income, like, hey, dividends here, if I’m going to realize a capital gain, I’ll list that. I’ll I’ll add up the appropriate tax rate, so long-term capital gain would be 20% plus another 4.55% for Colorado state tax. I put this all into a spreadsheet, multiply it out for the end of the year, and then set aside the the the the funds that I’ll need, chunks chunks of those into a separate savings account, which I called my tax savings account. I probably should do it in a money market because I could get a few extra basis points of return. and I just keep it there. And then at the end of each year, I’m generally a little bit more conservative and can take some of that money out and put it back into investments. Um, but I like that. Last year, I actually screwed up and got a small refund. So, um, I’ll take that. But I like to I like to pay a little bit. Uh, I like to just just the perfection is being within 10%, but closer to the bottom of that 10% and knowing on the rest of it at tax time, uh for me. Let’s move into another area here. So, suppose that I’m a uh you know, I have federal and state taxes, which everybody who’s listening to this podcast probably is aware of at this point. But there can also be city taxes and when we’re a small business owner, we begin to introduce a really bad kind of salt into our world. Can you explain what salt is and the pain that goes along with this?
Brandon: Yeah, so salt is state and local income tax. And when you are, when you’re running a business, you can end up with state nexus, uh depending on what type of business you run and where you are conducting that business. Uh so like like e-commerce businesses, for example, the the Wayfare versus United States basically found that e-com businesses are doing business in all these different states that they’re selling their products in, even if they don’t have a physical presence in that state. So that means that all those states and those localities can now go and collect tax from that business. Um, this can get pretty gnarly pretty fast depending on what states you’re talking about. So Ohio, for example, has rita taxes. Basically, every um every like jurisdiction has its own separate tax rate, which is separate from the state rate. Uh Pennsylvania has something very similar. So various states can have a a state tax, a city tax, and a local tax on top of that, and you could be subject to all three. Um, and you really have to like you you really have to work with either an accountant or you have to be really good at DIY your research to understand what your exposure is. Uh, because that type of stuff can come back to bite you multiple years down the road if you’re not careful.
Scott: Let me give you an idea of how how gnarly as you put it, this world can be. So like BiggerPockets, right? We sell uh I’ll I’ll just one example, we sell ebooks, right? So in some states, you only you pay state and local tax on the sale of a item like a physical book. Like if you go and buy a book from a bookstore, there’s state tax that’s supplied to that. Some states consider an ebook to be a physical piece of property that then has to have state tax charged on it. Some states consider that to not be a physical product. Some states will say any service essentially that’s provided digitally will be like so like every state and many of these cities have different jurisdictions. And then when you get over a revenue threshold from customers in that specific state, you create Nexus, which means not only are you supposed to be charging sales tax uh on there, but you also now have to file a tax return um for your business in that state if you’re a partnered business, for example, and up there. So and then by the way, you reach that nexus in several different ways in many states. So in like California, if you hire an employee, you automatically have Nexus in California. And then you are now subject to paying tax on all the revenue you generate in California, um, on there in that scenario. If you sell more than like I think it’s 500,000, don’t quote me on that, in California in revenue, you also create Nexus uh in California. I might be some I I forget the exact numbers here um for there. But like this is where you get to really get into like some big trouble. And like that’s something that if you’re a business owner and you’re starting to expand into another state or you’re starting to to see your business mature a little bit, you really got to be on top of this stuff, otherwise you could be accruing a huge liability uh for state and local taxes that’s going to come back and bite you really hard in a couple years.
Brandon: Uh, also applies to real estate investors. If if you buy a rental property out of state, you now have state taxes that you have to file for. Um, now generally you’re not going to owe any tax because rental real estate produces a tax loss. uh, but there are absolutely situations where I mean you you most states have like a a gross revenue filing threshold, so it’s not necessarily based on net. So even if even though I have a rental that produces a loss, I might still have to file with that state. Um, but even still, like in future years that you cash flow, you could also be subject to those state taxes. Uh, where partnerships we were talking about LLCs and partnerships, you could be filing in states where you were doing no business, where you have no assets, if a partner lives there, right? So New York, New Jersey, all the syndicators and the funds, well, they bring on New York, New Jersey people, you’re you’re filing now, the the entire partnership now has to file in New York, New York, New Jersey, even though they don’t have any assets in New York, New Jersey. Um, short-term rental owners, not only are we talking about income tax, but we’re also talking about uh lodging taxes, uh sales taxes. So yeah, if you’re if you’re running off platform, not through an Airbnb or VRBO or similar, uh you have to go and figure that out for yourself too and make sure that you’re remitting the appropriate tax. Yeah, these these local jurisdictions can be very painful, um, if not if not appropriately, uh planned for and dealt with. Um, so definitely don’t take that piece of it lightly if you’re doing business in multiple states.
Scott: Yeah, salt salt ain’t fun. Um, but if you have large complex salt problems, you also probably have very good business problems. So, but just something to be aware of as you as you build these businesses and as you think about hiring, right? like you definitely should be aware of what that is going to what what consequences are going to happen to your business in terms of tax preparation and tax payments if you hire your first when you hire that first employee in California, for example. Like that’s something you really got to be thinking about as an employer.
Brandon: California is a state you don’t want to mess with. If you’re doing business in California, do not mess with California. get it right.
Scott: I don’t live there, but I definitely contribute to their quality of life.
Brandon: Yeah, same. That is a state where, you know, we were talking about setting up LLCs and you know, you don’t have to No, if you if you’re doing business in California, get it right from the very beginning.
Scott: All right, we’re going to take a quick ad break and when we’re back, we’re talking deductions.
Scott: Welcome back before we hop back into this conversation, we wanted to remind you about our tax finder. If you’re looking for a tax professional, this is the simplest way that you will find credible tax professionals who understand real estate. Go to biggerpockets.com/taxfinder to find your perfect tax match.
Scott: All right, let’s talk about uh tax deductions here. So again, LLC is a pass through entity, but I think a lot of people have a lot of misnomer about uh how a business can then expense personal items and those types of things. So walk us through some of the general frameworks. What’s true? What can I believe here? What should I be thinking about um and doing from day one? and what are some of the shenanigans that you have to kind of steer your clients away from um because they they take this this theom a little too far and and uh get too giddy about it?
Brandon: Um, yeah, so so the general rule is that in order for an expense to be a business expense, it needs to be ordinary and necessary for your business. So any any expense that you have, you can kind of pass through those two filters. Uh is this ordinary meaning that are other businesses like mine deducting this same thing in order to run their business? And is it necessary? Uh is it necessary for my business to deduct this thing to run my business? So, for example, meals are an ordinary expense for most businesses. Extravagant meals are not necessary expenses for a lot of businesses, right? Maybe you’re an Hvac contractor. Why do you need an extravagant meal that costs $1,000 per plate? You know? you probably don’t. unless you’re an Hvac contractor in super, super, super, super rich areas and that’s your go-to market strategy. Um, but that’s how you kind of evaluate that, right? So home office, yeah, if you if you have a if you have a legitimate business need for a home office and you work out of your home office and you use it exclusively for that business, that’s where everybody blows it up is the exclusivity piece. Uh then you can absolutely deduct the cost of a home office. I’m sitting in mine, right?
Scott: What does exclusively mean?
Brandon: Exclusively means that this is all you do in this home office is business. And that that was that was my butt.
Scott: What what if you also do your morning yoga in the office? Like how how how what what is the what is the cutoff there?
Brandon: you’re you’re you’re probably going to be fine. The the the challenge is when I have a if you have a separate room and like like I have a door, right? that that I can close. Uh I can basically prove if I were to ever be audited that I do use this as an exclusive home office, uh or exclusive use. I’m not really like I don’t have like a bunch of personal stuff. I don’t have exercise bikes in the background. It is business, right? Where people screw this up is they have like a a little corner of a room uh that they use as their home office. and there are there are uh there there is authority that says that you can potentially do this, but where they screw it up is they have a little corner of a room and uh and they’ve got a bunch of personal papers on there and it’s not really it’s not really for business use. They don’t even need a home office for their particular business. Maybe it’s more of a hobby than it really is a business anyway. Um, that’s where people mess this up. So it’s it’s it’s claiming additional tax deductions uh from the wrong source if that makes sense. Like a home office, I don’t think of it as like a tax strategy if that makes it’s not really like like like this cool great thing to deduct additional dollars. It’s just if you have one, deduct it. If if you’re stretching to prove it, don’t because again, now our hassle bar is increasing. We’re we’re increasing our hassle but the reward is pretty low.
Scott: maybe maybe the best way to kind of like think about this is can you give us an example of a client who has clearly taken this to an outrageous limit and you had to walk them back? And can you give us an example of someone who wasn’t taking enough?
Brandon: There was a time where there’s an investor that had an RV, uh, and they were traveling around in their RV and they said that half of their RV was their home office. Um, but the RV, uh that half of the RV was also where their bed was and their dressers, they changed clothes there. I think they had like a like I don’t know it’s like a bunch of cookwear and crap like that. Um, not a home office, right? Like it’s it’s your personal living space. That’s not a home office. Um, on the flip side, I mean we have we have a lot of investors actually that that we say, hey, you can take this home office. You can claim an extra few thousand dollars. you know, it’s not much but it’s something because you do have a big enough home and you do work out of this one space and it is its own separate room and it’s a very easy like win at that point. It’s not something that we’re stretching. Um so that that actually happens pretty frequently. I would say that happens more often than it does not. Most people aren’t claiming it because they think that it increases audit risk. But it’s not going to increase your audit risk. It’s just but it is something that under audit uh would be looked at. So you just have to be prepared for that.
Mindy: Okay, let’s say that I have done my taxes and I have claimed I have I have a split-level house I have claimed this entire level as my office but it really isn’t a home office. And I get audited and I they come in and they’re like no that’s not allowed. What happens to me if I take more deductions than I should have?
Scott: Yeah, and let’s let’s also zoom out and in the context of answering that question and just talk about like, okay, what’s going to flag the audit and then what is life like while I’m being audited um, as part as part of Mindy’s great question here.
Brandon: What flags the audit is generally speaking for real estate investors, it’s either you’re just unlucky, uh, or, and that and that’s frankly like a lot of it, or, um, it’s you’re showing non-passive losses, like losses from your rental real estate, but you have W2 income. That’s typically going to be the the flag. Um, and then through that process and this is why like if you get audited, stop talking, hire an accountant that understands how to work this process because you the words that you use are very important uh to limiting the scope of the audit. If you use the wrong words, the auditor goes, “Oh, yeah, thanks for reminding me about that thing.” and now we’re going to go look at that thing too. Um, so be really careful if you are facing an audit, make sure that you have professional help. But in terms of getting pulled for an audit, it’s really just you’re either unlucky, um, or you have these these large losses while you have W2 income. Now, every year the IRS will kind of put out here’s who we’re looking at over the next period of time, uh, and they do update taxpayers with that. And I will also say with the advent of AI and the IRS’s multi-billion dollar investment into AI, I think that the audits, I have nothing to point to for this theory, um, but I I believe that the audits will become less, um, uh, less just like rolling the dice. They’re going to become a little bit more targeted. Uh, so I would expect like like short-term rental owners, real estate professional folks, uh real estate developers and flippers to maybe see an uptick, um, in audits as AI is further developed in this examination process.
Scott: That’s great you mentioned that because I wanted to spend the second hour of this podcast talking about rep status and all the shenanigans people get themselves into uh on that front.
Brandon: I can I I can talk that topic, man, we could we could sit down and have some beers and talk for hours. there’s all sorts of stuff. real estate professional status and people want to claim it and you got a whole can of worms you open there. We we’ve uh I think we’ve talked about this in the past. We’ll talk about it again in the future, but we’re not going to cover that today. Just know that if you have a W2 job that’s not in the real estate field, please don’t claim rep status and just save yourself a bunch of trouble.
Brandon: The other part is what what actually qualifies as a real property trader business? And uh the regs are pretty clear and uh I think some some accountants don’t read the regs. And when I say regs, treasury regs.
Scott: So Mindy Mindy just declared her whole top of the floor, uh, uh, there. She claimed rep status, she she has declared a big loss from rental property. She has a big W2. IRS has flagged her because the AI machine is like red flag, red flag, red flag. I’m after it. Mindy’s also spoken, you know, sort of trash talk in the IRS agent and now they open up the whole camera room. She’s hired you. How do you advise her out of the situation? What do we do?
Brandon: Um, so, so so basically what we would do is we would go, okay, Mindy, uh, you claimed all these things. Uh, we have to figure out how hard we want to push, how hard we want to fight on all of these things. So, send us all your documentation that you have to substantiate X, Y, and Z. So send us your home office documentation, send us the, you know, the vehicle that you purchased, the G wagon. I I like to write about this on Twitter every once in a while. Always goes viral whenever I do. It’s like here’s what happens when you write off a G wagon. So, so send us all all the information about that, all your mileage logs, like everything. If you’re a real estate professional, send us your time log. Um, do you have does do your credit card statements and bank statements align with that time log? Meaning, I say that I’m at a rental property on a Saturday, but my credit card statement says that I’m in London traveling, you know? Like do all of our documents tie out here. So we’re going to have that conversation, then we’re going to go to the auditor, we’re we’re not going to tell them that we have all this information. We’re going to go and we’re going to figure out what do they want to see specifically. And they’re going to start saying, well I want to see your rep log and then we’re going to say here’s our rep log, as fast as we can do it, right? Because we’re we’re trying to build credibility with the auditor. We don’t want them to be digging through every single piece of information. We want them to look and go, wow, these guys are really really well documented. So, okay, I’ll like audit a few of these and then I’m going to move on. Um, and that’s the game, right? And and through that process too, we might say, okay, Mindy, as a real estate professional, um, you took you took you had 10 rentals and you did cost segregation studies and you did bonus depreciation and you took losses from these 10 rentals. Did you make a grouping election, Mindy, under section 1469-9? And Mindy, most likely, maybe not you, but most of the people that we do this with go, what are you talking about? Um and so we’ll then go and look through all their prior tax returns and we’ll go, Mindy, you did not do the grouping election. If the IRS figures this out, then you lose because you have to materially participate in every single rental separately if you don’t do the election. So, Mindy, when we’re talking to the IRS, don’t you dare say the word group. Don’t mention it. Don’t mention the regs. We’re going to stay as far away from this as possible and we’re gonna we’re gonna do this little song and dance and hopefully maybe maybe Mindy, we’ll just say, you know what, screw the home office. Here, Mr. Auditor, you can have the home office. We we will you have to win something for your boss, so you have the home office, but we’re going to keep this grouping thing secret.
Scott: What what is winning and losing mean?
Brandon: Winning winning is not losing that.
Scott: so so yes, so but like like tell me like what is what what is the what is losing look like? Like am I going to go to jail? I’m sorry, Mindy, is Mindy going to go to jail? Is she gonna go?
Brandon: No, you don’t have to fear that. Unless you’re committing fraud, if you are committing fraud, uh, you you should fear jail and you won’t know that the IRSCI, their criminal investigation unit, is on to you until it’s too late. So they’ll actually start investing the the the auditor would refer the case to the CI, uh, they will start their investigation during the audit, um, and then you’ll realize it later. Uh, so as long as you’re not like doing really wacky stuff, and by wacky, I mean like, you know, I I’ve got fraudulent yeah, like the the whole loan the RTC credit and stuff or or I’ve got part I’ve created sham partnerships that I’ve prepared my own tax returns for and they’ve got $200,000 tax losses that have no actual basis in reality. So like you’re not going to get you’re not going to get thrown in jail for messing up a real estate professional status or short-term rental or something like that. Um but if you if you don’t have substantiation for it and and we can’t prove it to the auditor, then the auditor’s going to reverse that deduction, right? And through that reversal, uh you’re going to owe the back taxes, you’re going to owe the interest on the back taxes, uh and you’re going to owe most likely a 20% accuracy related penalty. Uh and that is where it can get pretty painful pretty fast. When people say, oh well like if it gets reversed later, no big deal, I’ll just pay the bill. Yeah it it’s the bill, the original bill that was now mind you three years ago. So we’ve got three years of interest that has accrued. And interest at 8%, right?
Brandon: 8% now. Yeah, so super expensive.
Mindy: Is there a legitimate way for W2 employees to also claim passive losses?
Brandon: Uh, only so so being a W2 employee is not necessarily the the the issue, right? That’s going to that could be a trigger for the IRS audit. But the real issue is are you a full-time or a part-time W2 employee? Um, if you are a full-time W2 employee, no chance that you’re going to qualify as a real estate professional. Uh meaning that you spent 2,000 hours a year working at in in like for somebody else. Um, because to qualify as a real estate professional, you have to spend more time in real estate than you do at your any other job that you might have. And so even if you could justify or even if you do work in an additional 2001 hours in real estate, you have to justify that to the auditor. And the auditors are not like, I mean, they’re smart people, don’t get me wrong, but they’re not like I’m working 80 hour a week people and then you have and then if even if you lose, which you would, cuz they’re going to say I don’t believe you, then you have to go and argue it in tax court and the tax court judge is not going to believe you. Many people have tried, every single one has lost in tax court. So the way for W2 employees, if you are a full-time W2 employee, to use losses from rentals is to buy a short-term rental because short-term rentals are a carve out to real estate professional status. Uh, which means that you don’t have to spend more time in the short-term rental than you do at your day job. You still have to materially participate, uh which is a lift, but it’s not it’s not qualifying as a real estate.
Scott: This is great because I wanted to spend a third hour today on the short-term rental uh loopholes and deductions and how to use those to offset uh other gains. So, this is perfect.
Brandon: I got a lot of thoughts on that one, too. Yeah.
Scott: Brandon, where can people find out more about you?
Brandon: Uh you can hit us up at www.therealestateCPA.com. You can also find me on Twitter. Um I’ve been trying to build that account and it’s been a lot of fun because Twitter is its own special place, or X, I guess. Uh and it it’s at BhallCPA.
Scott: Well, thank you very much for the very fun discussion. I can see that you are a little salty about some of the practices that have been uh discussed and bandied about here in the real estate tax advice world. Um, and really glad to get uh your opinion here. had a lot of fun and and uh good animated discussion. So, thank you very much and I hope you have a great rest of your week, Brandon.
Brandon: Thanks guys for having me on.
Mindy: All right, Scott, that was Brandon Hall and that was a lot of information that we just dove through. What did you think of the show?
Scott: I think it’s super fun. I I spent like 10 years learning a lot of things about real estate and some percentage of it was allocated to tax strategy. We’ve gone through a lot of transitions for tax bills and all those types of things here at Bigger Pockets. So, I’ve developed a lot of frameworks around this. You could I hope I I hope that folks can tell that while I’m not a tax professional, I have kind of gathered a lot of this and know enough to be dangerous. Um if that’s not you, again, the shortcut that we want to shamelessly plug and self-promote here is the Bigger Pockets Tax Finder. biggerpockets.com/taxfinder. Um where we have curated a network of real estate specific tax professionals that can help you with tax planning, strategy, bookkeeping, and of course, filing um here, and God forbid, if you need it, uh defending yourself from the IRS audit or way worse that CI team, that sounds super scary. I do want to put a shout out here for that um last bit, if you know somebody who works at the CI team, we would love to have them on the episode here. Uh we think we’re doing the IRS a favor because we’re going to scare so many listeners into filing their taxes and paying them on time and avoiding those things. We would love to hear horror stories there and um uh of those types of things and I think it would be fascinating to get a look from the inside from the IRS if anybody was willing to ever do that.
Mindy: And you can email Mindy@biggerpockets.com or Scott@biggerpockets.com to discuss your uh job at the CI department and uh we can we can navigate a lot of things to get you on the show. We’re just trying to present this information so our listeners can make an informed decision. All right, Scott, should we get out of here?
Scott: Let’s do it.
Mindy: That wraps up this episode of the Bigger Pockets Money podcast. Of course, he is the Scott Trench and I am Mindy Jensen saying, best wishes, little fishes.
Announcer: Bigger Pockets Money was created by Mindy Jensen and Scott Trench, produced by Hajar L. Edited by Exodus Media, copywriting by Nate Winetrab, and lastly, a big thank you to the Bigger Pockets team for making this show possible.
