How to Pay (Much) Less in Taxes as a Real Estate Investor (5 Ways!)

What if one tax strategy you think is reserved for big investors only could wipe out a huge chunk of your W-2 tax bill on your very first rental? Or maybe you're about to hand a stranger the keys to a property you just spent every last dollar on and you have no idea what to actually put on your tenant application. And finally, what happens if you fall in love with the idea of flipping houses but you want to roll every dollar of profit into the next deal without losing a chunk to capital gain? We're answering all three of those questions and helping you keep more of every deal you do. This is the Real Estate Rookie Podcast. I'm Tony J. Robinson. And I'm Ashley Kerr. And with that, let's get into today's first question. So today's first question comes from Orenze in the BiggerPockets forums. And this question says, I need help making a decision on whether to use a cost segregation or not. I'm still a investor, but I bought a six-unit residential property this year in central Massachusetts and I do plan on holding the property for a long time. I have a high W-2 plus another side of business with six figures. My question is whether using a cost segregation will help in dropping down my taxes. What are the pros and cons? And then what are some referral companies that can do this cost segregation study? I think first, let's talk about what a cost segregation study is. It's basically like an engineering study where instead of taking standard depreciation on a piece of real estate, and I believe for a single family home, it's 27.5 years. I think for commercial property, it's 39.5. Don't quote me on those. Somewhere in that ballpark. But instead of taking the depreciation across that standard schedule, you reclassify different components of the property, the roof, the appliances, flooring, whatever it is, and you accelerate that depreciation. Some get bunched into the first year, some get spread out over five years, but there's a scale there. So it allows you to basically accelerate a lot of that depreciation. So instead of waiting almost three decades, you can get a big portion of that depreciation in year one. Now, the cost segregation study can be combined with something called bonus depreciation, which is where you get all of that. You can take 100% of that in year one. Now, I think the trap here where a lot of folks get confused is that if you generate this massive paper loss from your cost seg study, it typically does not offset your W-2 income or your other forms of active income unless you qualify for what's called real estate professional status, or you use the short-term rental tax loophole. Now, again, we should have said this from the beginning. Ash and I are not CPAs, so go talk to a qualified tax professional for your specific situation. But typically, reps, real estate professional status, or the short-term rental tax loophole are the easiest ways to unlock the benefits of the cost segregation study. If you don't qualify for either of those, well, then all of that paper loss can only be applied against your other forms of passive income from your real estate. So basically, the income produced of cash flow from your property, that can be offset by the cost segregation study. Now, it is incredibly difficult to qualify for real estate professional status if you're working the full-time job because you have to prove that you spent more hours in real estate than you did in your full-time job. So if you're spending 40 hours a week working full-time, well, then you have to prove and show that you've spent more than 40 hours per week every single week working in real estate. And for most people, that's just unreasonable and not possible. That's part of the reason why the short-term rental tax loophole is so popular today because it is significantly easier to apply the short-term rental tax loophole than it is rep status. For the short-term rental tax loophole, there are a few different kind of tests you can meet. One test is the 100-hour rule where you spend at least 100 hours working on your short-term rental. And if you add up all of the other time that other folks have spent, your cleaners, your maintenance folks, whoever it may be, they haven't exceeded the 100 hours. The other approach is the 500-hour rule where regardless of how many other hours other folks have spent, if you spend at least 500 hours for the whole year, you can qualify for material participation through the short-term rental tax loophole. So that was a lot, but I just wanted to make sure I've kind of laid the foundation there for the differences and when you can and can't apply the benefits of the cost segregation study. We actually have a couple of resources, and I was just trying to look for the links of them, but I'm going to put them in the YouTube description. If you're watching this, we do have a sponsor, and I'm going to link their blog post, but you can get discounts on some cost segregations too if you guys are interested in doing that. I did a cost segregation on a property, and when it was my first time going through and doing this process, I invested for so long without ever doing one, and it was such a huge regret of mine that I didn't know about this sooner. I literally found out about this several years ago, and at that point, I'd already been investing for like eight years. So I think this is a really beneficial tool. I recently went to Florida, and I'll go ahead, put your hate comments on about investing in Florida, okay? But I wanted to look at property while I'm there, okay? So when I looked at this market, it's a buyer's market. There's not a ton of cash flow. Your biggest opportunity there is renting to a snowbird for six months out of the year. But the real benefit, if you were to purchase a property there, would be doing a cost seg on the property and getting tax savings. It wouldn't be cash flow. Right now, it definitely wouldn't be appreciation in that market either. So I think that was something that took me a long time to realize are the tax benefits of actually owning a property besides just your regular depreciation that you're getting off of standard amortization of depreciation. Now, one last piece that I'll comment on is that even when we do something like a cost segregation study, we get this bonus depreciation, we qualify for material participation or rep status. It's not like the taxes that are due that they just disappear, right? We're basically just kind of getting a loan from the IRS to say, hey, we're not paying this today. But the IRS is still keeping track of what you owe them, right? It never just kind of goes away. And then if you do sell that property in the future, there's a recapture of those taxes that'll be applied. But in order to, again, continue to delay those taxes due, you can do what's called the 1031 exchange, where you're able to defer both the recapture and the capital gains on that sale. So a lot of folks, they'll use the 1031. It's called swap to drop. You basically never actually sell. You're just recycling that capital into the next deal. Or you can just hold the property forever, like just never sell the property. And you can do things like a refinance to try and get some of that equity back. But I just want to highlight that because people think that, okay, hey, if I do this and it's just like free money from the government, when that's not quite the case, it's just deferring that tax liability to some point down the road. I've heard several people that have retired and they said the second best day of their life was when they bought their rental property and the best day of their life was when they sold it. But you're going to hold it forever and you're going to keep that, not have to recapture that depreciation. That's not going to work. But you could also put it into a trust for a family member, your kids or whatever, so that when you pass, they get the benefit of the trust or the beneficiaries. And they will only pay taxes on what the value of the property is when they inherit it. So instead of paying taxes on what you bought it for 20 years ago compared to what they could sell it today, that can be a huge difference. So you can even continue on the tax benefits until after you have passed away. Our next question comes from the Bigger Pockets forums. Good morning, all. I am set to close on my first investment property tomorrow. This is a two-unit multifamily with one unit occupied and the other has been turned over and is ready for rent. What criteria does everyone here set for tenants? Minimum credit score, criminal history, income amount, and so on. I have a good idea of what I want, but would love to hear input from some more seasoned investors on anything to look for or to avoid at all costs. Okay. So to recap, set to close, two-unit multifamily. They don't need to start screening tenants to look for them. So it is very important to set your criteria. Easiest thing to do, go into AI Chat GPT, go into Quad, and have them give you a checklist. Create a checklist of what is the screening criteria I should have. Now, I don't want you to use what it actually says for your screening criteria, but I want you to look at these different things and see if it maybe even gave you more. But you want to set a minimum credit score. You want to set criminal history, and you want to set if they have violent criminal past, you're not going to accept them, what the income amount is. And by this, I usually do it as to how much more income they need than what the rental is. So common is three times what the rent is or three and a half times what the rent is. This also depends on your class and your neighborhood too that you're investing in. So these are different criteria that you want to set and I would put it right into your listing. So it's very clear what it is. When someone fills out the application, I would put it in there. So they're not wasting their time and you're not wasting your time. But also you don't want to violate any fair housing laws. So this criteria cannot be no kids allowed or anything like that. You want to check your state laws as to how specific you can get on what you can deny for criminal history too. But also evictions. In New York State, you cannot deny someone a rental because they have been evicted in the past. It has to be for some other reason. So you can't say no past evictions if you're in New York State. So I would start with that as to kind of setting your criteria for what you want and then set up some property management software that has the screening process. There are companies out there that are just the tenant screening. I really like it integrated with the property management software because you can go ahead and do the full process from start to finish of renting out your unit. So you're going to set the listing inside. You're going to hit one button and the property management software is going to push it out to multiple websites. Every time you get a lead, someone clicking that they're interested, it will go right into the property management software. So even though you're listed on Apartments.com, Facebook Marketplace or Realtor.com, Zillow.com, whatever it is, it all comes into one place for you. Craigslist, even. And so then from there, you could send a pre-screen. You could send the application. You can send them a link to schedule a showing for the apartment. And then from there, when they fill out the application, you can select the screening to be done. So a background check and a credit check. I like to do a verify their income. Some property management software has that integrated where it will do that for you based on their pay stubs. It will verify that. If not, you're going to want to call and verify any documents they give you. So their pay stubs. I've had people before submit to me fake pay stubs. I would literally just Google that the address they put on there didn't even match the company. And then I would call the company and ask, and they would have no record of this person at all. So sometimes it's that easy to catch them, but I would verify as much as you can. References, you know, ask them for personal references, ask them for past landlord references. I also like to, the character references, I don't take much weight in because they can literally put down anybody and they're usually going to put down people, give them a good recommendation. But the previous landlord, I tried to do a little research and make sure like, okay, this is where they said their last address was. I look up who actually owns that property. See if I can find any correlations in the name they actually gave me. The phone number to coordinate with the address or whatever. And then when I am doing the phone call, verifying, you know, with the landlord, I try to ask some questions that don't make me accused the landlord of being an imposter, but like maybe the something they, you know, would only know about the property if they were the landlord or something like that. You know, you can look up the tax record history or, you know, something like that. But I'm more just trying to compare that they actually own it. It's not just their friend's phone number. They're giving me to pretend to be their landlord. Ash, have you ever actually experienced that where you like caught someone red handed in that kind of situation? Um, not for a landlord, but for an employer reference. I thought I did. I thought I did because it was so sketchy and it was so weird. And I'm just like, and it was like a, the email was like a Gmail account, not for like a company or anything. And I actually called where the, it was for a bakery that they said they were starting employment at. They just moved to the area or whatever. But like any interaction with the landlord was like through a Gmail or like a text. Like it was very, very weird. And I'm, I thought I was catching them lying. Cause like they didn't even have a first pay stub yet. They just had like a letter written up and um, then they went and then I called the bakery and they actually, like I asked to speak to that person. And so I got to talk to them there. But the, the fake pay stubs, like I found that I got the fake pay stubs before and I just, I didn't even, you know, take it a step further because they were fake. I wonder if you could run them through AI, like some of this verification and like ask, do you see anything that like stands out that this is fraudulent? I wonder. I mean, I was going to say the inverse, if like, it might be even harder now to catch those things because of AI, where someone can make an incredibly easy looking, uh, not only a pay stub, but someone could build out an entire fake website, you know, with like a few prompts to say like, Hey, I was the VP of finance at, you know, this, this, this company. Um, and there's a whole kind of, you know, digital presence behind it now. Um, but yeah, I was just curious if you've ever kind of caught I mean, look at the people that there's like documentaries on where they've like inserted themselves into the, the wealthy of New York city or whatever. And like, pretend that they are, you know, part of that society and everything. People believe it, it goes along with it and then all this stuff. And it's like, someone can do that. Someone can easily rent an apartment on fraudulent information. Fake it till you make it at the, like the highest level. Unless you're renting from me. Don't do that. Let's jump back in. Our last question today is one that could save you maybe a lot of money in your taxes as well, or cost you if you get it wrong. So the question says I purchased an off market fix and flip property in New Jersey using hard money. And I plan to list it, uh, within about, uh, two months or a month, eight weeks, give or take, uh, after closing. I'm wondering if I can utilize a 10 31 exchange when I sell it to defer capital gains taxes. From my understanding, 10 31 exchanges are typically for investment properties held for rental or business use. But I'm curious if there's any way my flip could qualify, especially since I haven't sold it yet, but holding it for a short term period automatically disqualify me or are there strategies to structure the sale to make it eligible? Has anyone ever done a 10 31 exchange with a flip? Okay. So we talked a little bit, about 10 31 exchanges, um, in the first question. So this is kind of like a good kind of part B to that. Um, the, the short answer is no, uh, you, you, you cannot leverage a 10 31 exchange on a flip property, right? Uh, flips are, are inventory, right? They're, they're, they're commodities. They're not true investment properties. And because of that, they don't qualify for a 10 31 exchange. So again, just to clarify, going back to question one, the benefit of a 10 31 exchange is that you can defer any capital gains taxes on the sale of a, of a rental property. Uh, if you use those proceeds to buy another rental property, um, when you're flipping that, that's not quite the case because it was never truly a rental and the IRS looks at intent, not just timing. So even if you hold it for say 14 months, um, if your plan was always to sell that property within, you could still very quickly get disqualified. Uh, we've actually done a 10 31 before on a property that we held for, I believe it was nine months. Um, but we bought that property with the intention of renting it out and we didn't rent it out. Uh, but the market shifted, uh, in our favor where we had a lot of equity during that nine month period, there was another larger kind of set of properties you want to purchase. And we were able to 10 31, the proceeds from that property to be held for nine months into another rental. But we had a lot of proof, like, you know, this is a short-term rental for us. It was on a bunch of platforms. We had a lot of guests coming in and out, but like, you know, whenever questioned our intent, it was very clear from the beginning that as soon as we bought it, we immediately put guests into it. It was never listed for sale, right? Like we didn't even do any renovations on it. So it was very clear what our intent was. So for a flip, uh, there's basically no way to, uh, I think to avoid that. Now, if you want to do like, like a delayed flip, that could be an option where say you buy a property, you renovate it, you immediately place a tenant in there, and then maybe you hold it for, you know, 24 months. Uh, then maybe there's an opportunity for you to sell that on the backend and still be eligible for 10 31. But again, you, you want to talk that over with your, your qualified tax professional to make sure that, um, that, uh, that you're, you're setting yourself up appropriately, but, uh, flipping and 10 31, typically don't go together. One thing that I've been, um, thinking about doing is, so I doing a live in flip right now, and I'm already got my next property set up, but it hasn't been two years yet. So it's been over a year. So I fulfilled my mortgage requirements by living here for a year. But I, if I move out right now, I will have to, you know, pay capital gains tax when I end up selling the property, because it hasn't hit that two year mark. So what I think I'm going to do is move out to my new house when it's done, but rented this property for several years. And then I'm going to go ahead and sell it into a 10 31 exchange. So I'm still avoiding taxes and then investing into another property. So it's not, you know, I'm not getting just cash for free. I still have to do the 10 31 exchange to put the money into another property, but honestly, I'd probably do that with the proceeds anyways of this property. So there are different ways that you can, you know, work to make something work out if you do have to pivot or change your, your strategy, but I would definitely not risk it with a flip of like just doing the rehab, listing it and selling it. And then saying, I'm doing a 10 31 exchange that if you're audited, it will definitely be called out. Okay. Well, thank you guys so much for joining us today on this episode of Rookie Reply. If you have questions, make sure to check out the BiggerPockets forums. I'm Ashley, he's Tony, and we'll see you guys on the next episode.