Ep. 102 Transcript – Unlocking Real Estate Losses to Offset Other Active Income with Thomas Castelli, CPA

[00:00:00] Evon: Hey, everybody. Welcome back to The Optometry Money Podcast. Where we’re helping ODs all over the country make better and better decisions around their money, their careers and their practices. I am your host, Evon Mendrin, Certified Financial Planner(TM), and owner of Optometry Wealth Advisors, an independent financial planning firm just four optometrists nationwide.

[00:00:25] And thank you so much for listening today. On today’s episode, I am joined by Thomas Castelli, CPA and partner at Hall CPAs, which has a really deep focus on real estate tax preparation and tax planning and accounting. As well as CEO of Tax Smart Investors.

[00:00:43] And Thomas and I dive into different ways optometrists can take losses created by rental real estate to offset all of your other active income like wages or business profit. And as Thomas describes rental real estate income and losses by default is considered by the IRS passive income or passive losses. And the IRS means that in a much different way than I think most people have in mind when going to buy rental real estate.

[00:01:11] So this was a fun conversation highlighting that, although it’s certainly not without its challenges and risks, for the right families, rental real estate can be a successful part of your wealth building.

[00:01:22] I’ve added all of Thomas’s information and the other links we talked about in the show notes, which you can find at the education hub on my website, www.optometrywealth.Com. And while you’re there, check out all the other episodes and resources we put together, and of course, feel free to schedule a no commitment, introductory call. And we can talk about what’s on your mind financially, and I can share how we help optometrists all over the country master their cashflow, proactively plan around taxes and so much more. And without further ado here is my conversation with Thomas Castelli.

[00:02:03] Welcome back to the Optometry Money Podcast. I am your host, Evon Mendrin, and I am excited to have on to the podcast, Thomas Castelli CPA and partner at Hall CPAs, CEO as well of, TaxSmart Investors. Thomas, thank you so much for coming on.

[00:02:18] Thomas: Thank you for having me. It’s an honor to be here today.

[00:02:21] Evon: I’m excited to dive into all things real estate tax planning. And, before we dive into all that fun stuff, just talk to us a little bit about your, your background. Tell us a little bit about the, the work that you’re doing, how you got into this line of work. Just give us a little bit about your background.

[00:02:36] Thomas: Yeah, yeah. So long story short, when I was, I went to college, right? and while I was in college, I was studying accounting and probably around the sophomore year of college, I started to realize I’m like, in order to kind of really build wealth, I’m going to need to do something above and beyond simply having, you know, a job or running a business, you need to invest.

[00:02:53] So I picked up the book, Rich Dad, Poor Dad. It was one of the first books I read, during that track, and it kind of opened up the world of real estate for me. And, from there I started attending local meetup events and at one of the local REAAs the Real Estate Investment Association or the Real Estate Agents Association. there was this group who put on a presentation for real estate syndications. So I went to that three day weekend and studied real estate syndication. They gave us an overview A to Z of how it all worked. So I fell in love with the model, started investing as a limited partner, eventually syndicated a deal with a group.

[00:03:25] and then. Around that same time, I syndicated that deal. I was, I was in accounting and I wanted to switch over to tax. I was looking to get into real estate tax. I felt tax was more appropriate than the general assurance or audit route that I was in. So I ultimately found Brandon Hall, the founder of the firm.

[00:03:42] And, he, he gave me an opportunity and, here I am. That’s how I kind of got into, real estate tax and helping real estate investors use the tax code to save thousands of dollars in taxes.

[00:03:53] Evon: Yeah. Interesting. So you started out with the, the fascination came from the investment side of real estate. And then you said, okay, I’ve got this skill as a, as an accountant, I can get more into the tax planning side of it. Let me merge sort of my two interests in and you kind of took it from there.

[00:04:06] Thomas: 100%, 100%.

[00:04:08] Evon: a question I think is just interesting to think about is that,

[00:04:11] When is Directly-Owned Real Estate a Good Fit?

[00:04:11] Evon: There are a lot of ways. for optometrists to invest and to build wealth. Whether it’s direct business ownership, whether it’s directly owned real estate, whether it’s using retirement accounts and other investment accounts. And. Mutual funds in ETFs and, and publicly traded stocks and bonds and everything like that. And even in real estate, you can invest really actively in directly held real estate.

[00:04:34] You can invest really passively in real estate investment trusts and everything in between. So, when do you see directly held real estate as a good fit for an investor. Who is the right type of individual or family? Who is the right type of optometrist, the right type of individual or family that makes a really good fit for owning directly held real estate?

[00:04:56]

[00:04:56] Thomas: Yeah, that, that’s a great question. I think it’s going to have to be a handful of things. It’s going to have to be somebody or, or a family that has, somebody in the family who could tend to it on at least a minimum of part time, if not a full time basis. because owning a real estate directly can sometimes be, it can take a lot of time because you have to find properties.

[00:05:15] You have to then put them on a contract. You have to, you have to get lending. You have to have property management, whether you’re doing it yourself or even if you’re working with third party property management, at the end of the day, somebody has to interface with them. And if you’re going to grow a serious size portfolio, you need to, you need to be putting in serious effort.

[00:05:29] So I would say a family that first has the bandwidth to be able to take on that type of role, that type of role, then you also need the capital. right. And so usually what we see is either one or both spouses have a full time job or business that generates significant income, discretionary income that they can use to invest into real estate.

[00:05:49] So that’s the second thing. And then, the third thing I would, I would say is you want to have a long term outlook, right? You want to be able to, to see to the end, right? The most successful investors I’ve seen in the active side or the direct side of real estate, have been in this for decades and they play the long game.

[00:06:07] So when they’re looking at a property, they’re not always looking at just the short term gains. They’re looking at, okay, what’s going to happen in the long term. So they, they’ll use strategies like 1031 exchanges, things like that to build significant wealth over the course of decades. and then that could be passed on to their heirs in a tax advantage way, and build wealth for their family.

[00:06:25] So I’d say those three things, and just to recap that, that’s a bandwidth to be able to put in a significant amount of effort into the space, a capital, and then a long term outlook.

[00:06:34] Evon: Yeah, I really appreciate that. That’s a good just sort of three easy bullet points framework to kind of think through because it’s really easy to hear about the how great real estate is as quote unquote passive, passive income, right? It’s just something that I think people can easily think that you just buy it and it simply just sort of manages itself.

[00:06:54] But, you know, Everything I’ve ever seen or heard about it or seen through clients, like it does kind of feel like you are buying or starting sort of a small business. I mean, in reality, it’s, you not only have to have the, the capital and the long term time horizon, just like someone might start a, an optometry practice, but you also have to have the bandwidth and the time and the energy to put into it.

[00:07:14] Like, is that, like, is a, is a small side business almost sort of a better way to think about it rather than just sort of passively collecting these, these investments?

[00:07:24] Thomas: Yeah, I would, I would say that saying it’s an investment while, while it is an investment, is somewhat misleading in some cases, because really, like you said, it really is a small side business at the end of the day and you want to treat it like a business. I see people who look at it as an investment.

[00:07:38] They look at it like akin to stocks, right? With a stock. You make the decision to invest or the index fund, whatever you click a few buttons of the mouse, you’re into the investment. And that’s really all you have to do. It’s relatively stocks are relatively passive. Whereas the real estate, it’s an ongoing business that even when you scale it to the point where you have it built out, delegated out with systems and property management, you, someone still has to be at the helm or someone has to be.

[00:08:01] You know, overseeing everything almost from like an asset management perspective to make sure everything is, is, is working properly and is optimized. So it definitely is to your point akin to a small business more than it is an investment,

[00:08:14] Tax Characteristics of Rental Real Estate

[00:08:14] Evon: Yeah. And part of the, opportunities or the benefits of taking on that risk and opportunity is that not only the operational profit, right? The, the actual cashflow of owning the, owning the, the real estate, but also the tax planning opportunities that comes from that. And so let’s, let’s use that as a segue to dive on in. it’s probably not uncommon that someone. purchases a real estate property, think thinking about the tax planning benefits, gets to tax time, looks at their tax return and says like, Oh my gosh, these, these losses are stuck, right? They’re not, they’re not offsetting all my other income. Why isn’t it, why is it eating away at my salary? So talk to us a little bit about just sort of the basics of how rental income shows up on the tax return.

[00:08:59] Thomas: Right? Yeah. So let me, let me, let me start here with a quick overview of the passive activity rules, because it’s really, it’s the foundation of this. And then I’ll get into like a little bit more on the actual tax return itself. So, so the passive activity rules, they were put in place under the Tax Reform Act of 1986.

[00:09:12] So they’ve been around for a few decades. And what they did was is they made. All rental activities passive by default. So what that meant is that any income or losses from your rental real estate will be in this passive bucket. And they did this because there’s a lot of high income earners, such as doctors.

[00:09:27] That was one of the targets of this, unfortunately. and, they, they were buying up these properties, and in some cases, not doing much work to them, but taking these losses and using it to significantly off offset their income and it got, it was really controversial. So when that law was put in place.

[00:09:41] All rental activities are now passive, which meant the losses cannot offset your, say, W2 or your income from your business. it can only offset other rental losses. So that’s kind of the foundation, of how, of how this works. So rental properties show up on Schedule E generally of your tax return on Form 1040.

[00:10:00] And that’s where you’ll see them. There’s also another important form called Form 8582, which is where your passive activity losses are stored. And the passive activity losses, the way you can use these traditionally I know we’re going to get into some of the ways you can offset your active income with them.

[00:10:15] But the way it works is when you’re buying a rental property, you have rental income depreciation, which is a non cash expense will shelter your rental income from tax. So give a quick like example of, or flesh this out a little bit more, should I say? Basically what you’re doing is you’re telling the IRS that you’re losing money, but you are actually putting money in your pocket.

[00:10:34] So that, that is the basis of, of kind of, of how, of how this works. So like, let’s say you had a hundred thousand dollars in rental income, right? you might have operating expenses of say 45%. So that means you’d have $45,000 of expenses, money that left your pocket, went to a third party. Now you’re left with say $55,000 left of net income, quote unquote.

[00:10:55] now in most businesses, you’re going to pay taxes up to 37 percent plus state, federal, and perhaps local taxes, if you’re in a state like New York, or a city like New York rather, on that. And it could easily go from, you could easily be paying taxes on that income between 40% and 50%. I’ve seen it happen a lot.

[00:11:09] And, with rental real estate, thanks to that non cash expense called depreciation, it can put you at a loss. So, again, if you had $100,000 in rental income, $45,000 in real expenses, then you have this depreciation expense. Let’s just call it $60,000 for the sake of example. You would then have a tax loss of $5,000.

[00:11:27] So you put $55,000 of cash into your pocket, and you told the IRS, Hey, I lost five grand. So, you didn’t pay tax on that income. And now the question from here is, well, what do you do with that loss?

[00:11:39] Evon: Yeah. So that’s, it’s one of the unique things about real estate but the IRS says, okay, we’re going to silo your income into these different silos, your active income, portfolio income, like capital gains and losses, and then your, your passive, your passive income. And You can only use those losses by opening certain doors, right?

[00:11:58] There’s only certain situations where you can take those passive losses and offset some of your other income. I guess it’s important to confirm that you can use those passive real estate losses to offset other types of passive income. Is that right? Even if you have passive ownership in a, in another optometry practice, for example, or something like that, right?

[00:12:19] Thomas: Yeah, absolutely. So the best thing about passive losses is that they can be used to offset other rental income you have, perhaps from other properties. They can be used to offset capital gains from the sale of your rental properties, or if you have other passive investments, which are usually in the form of LP investments in partnerships, or perhaps maybe you even have a general, partnership interest in a, in a, in a, in another business, but you’re not meeting one of the material participation tests, then that’s going to be passive.

[00:12:43] And those rental losses could then offset. That passive income too, which can be quite powerful. And I know a bunch of people who just played that game. Like that’s their entire strategy. They invest in real estate, generate these losses, have these other passive income generators as they’re sometimes called pigs.

[00:12:58] and, they’ll just use the losses from the rental real estate to offset this other passive income.

[00:13:02] Evon: Got it. Got it. Okay. So now let’s talk about these doorways, right? What are some of the ways that we can take these losses from real estate, this really tax efficient investment or small business, however you want to think about it. What are some ways that we can use this, these losses generated from these real estate activities to offset some of our other income, like wages from, from, working in a practice or owning a practice, then income from owning a practice.

[00:13:28] Thomas: Yeah, absolutely. So, there’s really two primary ways to do this.

[00:13:32] Real Estate Professional Status (REPS)

[00:13:32] Thomas: the first one is going to be the real estate professional status, also known as REPS. And the way the real estate professional status works is. It makes your rental losses non passive, and that’s how, that’s what allows you to offset, say, your wages or income from a business or other income that you might have.

[00:13:46] And, the way to qualify for the real estate professional, there’s really two key parts to this. you have to spend more than 750 hours in a real property, trade, or business. And you have to spend more than 50 percent of your total working time. And I just want to comment briefly on that last point, more than 50 percent of your working time, because that’s where a lot of people get tripped up.

[00:14:05] So if you have a full time job, the IRS considers your, your job to be 2080 hours per year, which is roughly 40 hours per week. Now, if you, if you want to spend more than 50 percent of your time in real estate and you have a full time job, you’re going to need to prove that you spent 2081 hours in real estate.

[00:14:23] Which means you’re working 81 hours per week for the entire year. And for that reason, through tax court cases, IRS audits, it’s almost impossible to qualify for the real estate professional status if you have a full time job, because they’ll go to your employer, they’ll ask for your employer’s records and stuff like that.

[00:14:37] And your employer will say they were, they were working 40 hours per week, and then you have to go and, you know, They’re going to take your employer’s word for it. And that’s proven in task force cases. But so the way around that for the real estate professional status is we see a lot of people, there’ll be a couple, right?

[00:14:50] you’ll have maybe one, one spouse who’s a high income earner, perhaps an optometrist, for example, and you might have another spouse who’s working part time or perhaps not working at all. And they take the reins on the real estate side of things, they’re able to qualify as a real estate professional.

[00:15:04] And if you’re married filing a joint tax return, you’re able to use the losses, from the rental properties, offset the high income. and that’s, that’s an effective strategy that we see a lot of people using.

[00:15:15] Evon: Got it. Yeah. So for an optometrist working full time, impossible basically to qualify as a real estate professional, but a spouse potentially, if a spouse has interest in real estate, maybe the skills to manage all these different properties, the spouse can potentially qualify as a real estate professional, use those losses to offset the other household income. You’re talking a lot about tracking hours and certain qualifications around, you know, meeting certain hour requirements and time requirements, especially versus other types of work. What, what’s the documentation like for all this? Because I would imagine, documentation is not something that’s exciting and can easily just sort of get pushed aside when, when, trying to use these really fun, exciting, tax strategies.

[00:15:59] So what does documentation look like when you’re trying to go for something like real estate professional status?

[00:16:05] Thomas: Yeah, a absolutely. So you definitely need to track your time in such, in, in, in a, in, in some way. The IR in the. Regulations for this. They say by any reasonable means. And they, they say things like time logs, calendars, appointment books. However, I would say from a practical standpoint, if, if you’re full time in real estate, you’re, you’re doing this for real, for real, like this is like what you do, you could probably get away with your calendar.

[00:16:29] because, your calendar is going to, it’s going to show that you’re in real state all the time. however, if you’re doing this, if, if you, if you’re not like, if you’re not all in on this and you’re, it’s not your true full time endeavor, you’re going to want to make sure that you’re using a timelog and that’s proven to be the more effective, way to substantiate your, your, your, your time.

[00:16:47] because, that’s, it’s going to give you clean, it’s going to give you a clean list of everything. You have everything nice and documented out. And if you are ever under audit, it’s going to be really easy to provide, that documentation. now there’s a few ways you can go about doing this. You can use an Excel spreadsheet, for this, for example.

[00:17:00] you can use time tracking software. There’s a lot of them out there. I know QuickBooks online has one there’s, there’s toggles and other clockify, the list goes on. There’s a lot of them out there that you can use to track your time.

[00:17:12] Evon: Got it. And is it when, in terms of like the 750 hours of, real property trade or business, like what type of work? goes into that. Is that like researching properties? Is it maintaining properties? Is it,buying and selling real estate? Is it working as an eight, like a, as a realtor? Like what, what actually goes into that 750 hours?

[00:17:32] Thomas: Yeah. So that’s a, that’s a great question. So there’s 11 real property trades or businesses. I’m not going to go through all of them. but there’s basically like development, construction, brokerage. So if you are a real estate broker and agent, rental properties, property management, flipping for example, is in there too.

[00:17:46] so if you’re working in one of these real property rentals in there, if you’re working in a real property trader business, it’s possible that you might, End up getting to the, I’m gonna get into the specific things in just a second, but if, if you, it’s possible that you can be working, say as an agent, full-time, and you qualify as a real estate professional, as an agent, right?

[00:18:03] but if you’re not materially participating in your rental activities, then your loss could still be passive.

[00:18:10] So really at the end of the day, The 750 hours, it’s, it’s, it’s, I’m trying to break this down the best way that, that it could be broken down is it could come from any of those real property trades or businesses, but the key is you need to be proving that you’re actually actively involved in your rental activities as well.

[00:18:24] Now, specifically where a lot of scrutiny is, is around what time counts. As material, material participation on rental activities because again, this is heavily scrutinized. They put things in place, the real estate professional status in place to make it challenging to do and people take advantage and abuse it.

[00:18:40] So things that count are general, are generally gonna be things that impact the day-to-day management. of your rental business, right? And that’s going to be things like property. It’s good. A lot of it’s going to fall under property management. So things like finding and screening tenants, performing maintenance and capital improvements, or coordinating others to do those.

[00:18:57] it’s going to be marketing for your property. It’s going to, it’s going to be Things of, it’s going to be things within that realm, collecting rent, evicting tenants. a lot of things, if it’s falling under the property management umbrella, then it’s likely to count towards the real estate, professional status material participation requirements.

[00:19:14] things that do not count, that’s maybe a little bit easier to, to go through, is going to be things like research. It’s heavily scrutinized. If you’re on like LoopNet or MLS or you’re on, These other ones like Zillow, and you’re just researching properties all the time. That time’s not likely to count, and oftentimes it’s going to be dismissed.

[00:19:31] Bookkeeping and financial management does count if you are involved in day to day management. So if you have a property manager, that time often won’t count. But yeah, education as well is another sticking point. Education, so like listening to a podcast or going to an event. typically won’t count either.

[00:19:47] And this is just documented in tax court cases. And then the last one that I’ll mention, I think is important to mention is travel time, which is contested. the IRS says travel time does not count, tax court cases. there’s a number of them that support this, support the IRS. And then there’s one called Labor’s Commissioner where travel time did count.

[00:20:05] And that was when she was in that case, she was traveling back and forth to her local properties within her local market, and it was material or it was essential for her to actually do this, to make those properties run and the task court allowed it. so if the bottom line here is if you’re traveling back and forth to properties in your local market, that time is, is there’s an argument for that time to count, but if you have to hop on a plane and say, fly from New York to California, for example, to check on a rental property, that’s time on the plane generally won’t count.

[00:20:36] so it’s like the local travel that there’s the case. So that’s like, that’s kind of in a nutshell.

[00:20:42] Evon: Yeah. So unfortunately listening to this podcast episode does not count towards your hours, listener. Got it. Okay. So professional, real estate professional, you have to meet the criteria to be a real estate professional, which is the hours under a real, real property trade or business. And then you also have to be materially participating in the properties.

[00:21:02] So you can’t just own them passively and, and go from there. anything else the listener needs to know about the real estate professional status?

[00:21:10] Thomas: the, the other thing is documentation is the biggest part of this. And I know we just covered that. I can’t say it enough. it’s the most litigated area of the tax code. The most, probably, probably one of the areas of the tax code that’s most ripe for abuse.

[00:21:21] The IRS knows this, the tax courts know this. So if you’re going into this, you want to, you wanna, you know, dot your t excuse me, cross your T’s and dot your i’s, and have everything, have everything in, in place. So that’s the biggest thing that I, that I could, that I could say there.

[00:21:33] Evon: Yeah. It’s almost just like anything, right? A lot of these. tax strategies, and you hear about using the Augusta Rule in the practice, or paying children and things like that, you need to be documenting the legitimacy of these things, like these are legitimate tax planning strategies, but you do need to be documenting them, so that if you were to face an audit, you can easily show them, okay, this is a legitimate use of, of this deduction, It’s not fun though. It’s probably the least fun part of all this, right? Is doing all that documentation. Okay. So we have real estate professional status. Let’s talk about the other one that you’d mentioned. I think that was the short term rentals, right?

[00:22:10] Short-Term Rentals

[00:22:10] Thomas: Yeah, absolutely. So the short term rental loophole, it’s called, people don’t like calling it a loophole, and I can get into why it’s called that, but long story short, what this does, there’s the definition of rent, there’s an exception, there’s a few exceptions, but there’s exceptions to the definition of rental activities under the tax code that move it out of this passive by default bucket, which means you don’t need to qualify as a real estate professional in order to turn the losses non passive. And there’s kind of, two, two things here, two requirements, if you will. First, you have to approve, you have to meet one of the exceptions to the definition of rental activity.

[00:22:41] The most common is your property has an average period of customer use or an average stay of seven days or less. or, or 30 days or less, and you’re materially, excuse me, and you’re providing substantial services to your guests, which are services you’d find typically in a hotel, like daily cleaning, daily meals, concierge services, tours, things of that nature.

[00:23:01] one of those two will make your, make your property, out, it will no longer be considered a rental activity, and it’ll move it out of that bucket.

[00:23:07] The second thing is you have to prove you materially participated. Now, the material participation tests here, are not as stringent. If you will, as at 750 hours, there’s three tests that are most relevant.

[00:23:17] There’s seven total, but three are most relevant. it’s going to be the first one is you spend more than 500 hours on the activity. The second one is you, you do substantially everything yourself, which is like your one person band. and then. The third one is you spend more than 100 hours on the activity and no one else spends more time than you.

[00:23:34] And that’s by far the most popular in my experience because it allows people to have, to do this remotely and have cleaners and handymen come in and handle issues, while they kind of run the show. And then, If you meet those things, you meet one of the exceptions and then you meet one of the material participation tests, then you can, then your losses will be non passive on your short term rentals.

[00:23:55] And that, this is a very powerful strategy for, for, for the reason for, because the fact that you don’t have to work full time in real estate to make this work, and I’ll say a few more things here along those lines is for these material participation tests, your. You and your spouse’s hours count as one person for these tests.

[00:24:11] So if you spent 50 hours and say, you know, your wife spent 150 hours and you had 250 hours and you met the, you met the 100 hour requirement, assuming no one else worked more than you and your spouse in that 250 hours. So that, that, that is why this strategy is so popular. conversely with the real estate professional status, and I forgot to mention this before, but I’ll mention it now, is 750 hours has to be met by one spouse.

[00:24:35] That all by, you can’t combine hours, that’s 750, but for these tests, you can.

[00:24:40] Evon: So we have, two parts of that, right? It’s, it’s the average period of customer use either seven days or less on average. So, you know, Airbnb’s VRBOs are probably going to be fitting under that or the, the 30 days and significant personal services. Talk about what that is. That’s while the guest is staying there, right?

[00:24:59] It’s more like hotel level services while they’re staying there. Is that correct?

[00:25:03] Thomas: Right, right. 100%. So it would be things like, It would be things like, say, daily cleaning. So while somebody, so I say you go out for the day, there’s a, you know, a cleaning service that comes in and cleans while you’re staying at the property. And, the other one is going to be, say, say daily meal. So like a real bed and breakfast where somebody comes in and provides meals for you every day, or say concierge, where they’re picking up clothing for you.

[00:25:26] So on and so forth. And, those, that’s kind of like, that’s typically what would constitute substantial services.

[00:25:33] Evon: Got it. And then that material participation test, which that that’s keeps coming up. That’s a common theme around here is materially participating in these rentals. And, if you are doing the, the seven day average stay versus like the 30 day average stay and the, the services that you talked about, like a real bed and breakfast, does that change how it shows up on the tax return?

[00:25:57] Thomas: Yes, absolutely. It can. So, typically, if you’re not providing substantial services, it’s going to be reported on Schedule E of your tax return, which is the same form that your long term rentals are reported on. whereas if you are providing substantial services, now you’re more, In a business, and that’s typically going to be reported on schedule C of your tax return.

[00:26:16] And when you are providing substantial services, another thing to note is you will be subject to the self employment tax, typically. And, that’s because now you’re operating a business, whereas rental income is, is not, subject to the self employment tax.

[00:26:28] Evon: So it sort of changes the nature of what you’re actually providing. I mean, you’re,

[00:26:32] you’re providing a real hospitality business essentially. And, are you able to, you know, something I’ve seen come up as sort of like a, a creative idea, to try to get the, around these average days is trying to swap days with other short term renters.

[00:26:46] Like, I, I would imagine that’s not something you can actually do. Can you comment on that?

[00:26:51] Thomas: Yeah. Yeah. So that’s actually not allowed. There’s, in, I believe it’s section 280, 280A in that section of the tax code that says that, if you swap, if you basically, I won’t get into legal jargon, but basically what it says, if you, if you, if you swap properties, like with somebody else, then you can, then it’s considered a personal use day and a personal use day.

[00:27:11] will, can harm you, right? So, personal use, if you have a property where you have more than 14 days of personal use, typically it’s going to be considered a residence. And when you have a residence, and you’re renting a residence, your losses are going to, or you’re, you can’t generate a loss on a residence.

[00:27:27] Your expenses will be limited to the amount of income that you generate from your property, which kind of blows the short term rental, the whole entire purpose of it out, out of the water. So, the bottom line there is that you cannot, you cannot swap days. It will, it will, it will kind of hurt you in the long run.

[00:27:44] Evon: Got it. Talk more about personal use days, because I would imagine, okay, someone’s getting a, you know, cabin around a lake. Yeah, they’re going to be renting it out as a short term rental, but you know, maybe they want to take their family there now and then and create memories and spend family time and all that. And how does that personal, personal use time impact it? You mentioned that there is a sort of a day threshold, right? 14 days and under, you know, you can use up to that amount of personal days. without impacting the tax, characteristics. Like talk to us a little bit more about how families can or shouldn’t use their personal time at some of these rentals if they’re using it as a short term rental.

[00:28:23] Thomas: absolutely. So, personal use, if you basically, if you, if you spend more than 14 days or 10 percent of the days rented, as personal use of the property, then that’s where it goes into that residence category. And it doesn’t only include you. It includes the time that your spouse, your parents, your grandparents, your children, if they spend time at that property, then so if you allow them to use it, it’s a personal use day.

[00:28:46] Another day that’s a personal use day is any day that you’re renting it, for less than, For less than fair market rent. So if you’re giving your friends a lofty discount, that could be considered a personal use day. Additionally, if you do rent it to your, your, your family, that can, that’s typically also considered a personal use day if it’s on a short term basis.

[00:29:05] Now it’s not considered personal use if that’s their primary residence. So for example, if you were to rent, you know, a house to your brother, it’s their, on a long term basis and it’s their primary residence, that’s not going to consider be considered personal use, but if it’s on a temporary basis, like a short term rental, that will be considered personal use, even if they are paying fair market rent.

[00:29:25] So, there’s a lot of implications there.

[00:29:28] Evon: interesting. So another thing that might come up is that, you are going to your, your short term rental to work on it while you’re staying there. Like, is there a certain amount of hours you should be expected to work on it to not be a personal use day? How, how should you track that?

[00:29:42] Thomas: Yeah, that’s, that’s a great question. that, so if you’re spending time at your property for repairs, maintenance, and like capital improvements, things like that, so you’re working on your property, that’s typically not considered a personal use day. Now in the tax code, in the regulations, it says on a substantially full time basis.

[00:29:58] Now it doesn’t quite define within the regulations what substantially full time means. So, what we kind of did was we looked, we looked at what is substantially You know, what does substantially full time mean from other parts of the regulations? And it’s typically somewhere between four to six hours is where other people would, is what other parts of the regulations would consider full time.

[00:30:16] So there’s not a definitive, there’s not a definitive amount of hours, but I’d say somewhere between four to six, if you want to play it safe, the longer, the better. but, that’s what, that’s kind of those days that you’re spending there. Even if your family’s there with you or other people are there with you during those days, is not considered a personal use day.

[00:30:35] Evon: Got it. And like everything else, documentation is key, right? Document, document, document. So, let me ask you this. If a family’s trying to decide between, like, they know they want to invest in a property and they’re not sure which direction to go, whether it’s short term rentals, you know, more the creating the experience route versus long term rental with a more longer term established renter. Like what, what factors should they think about in terms of deciding which way to go?

[00:31:02] Thomas: Right. Okay. Yeah, that, that’s a great question. I think it comes down to a handful of factors. the first one is tax benefits. That’s a consideration, although it’s not the primary consideration. How do you need the tax benefits from short term rentals today? could you qualify as a real estate professional?

[00:31:15] Those are questions you have to consider. But it’s also, you have to look at the, the long term viability. short term rentals are certainly more active businesses. there’s a lot more work that goes into it. People are coming and going on a short, you know, on a weekly, if, or on a short term basis.

[00:31:29] So there’s a lot more work, a lot more coordination, a lot more wear and tear on your properties. but also, with the short term rental market, it’s being, highly regulated right now. So there’s a lot of cities, localities that are restricting the ability to, for you to have short term rentals. And that’s sometimes it’s spring people, it’s springing up on by surprise and people aren’t seeing it coming.

[00:31:50] So, you have to ask yourself, are you comfortable with that risk tolerance or do you want to invest in markets like vacation markets that typically are not going to be regulated? So for short term rentals, it’s an active business. So you have to use that to be aware of that. There’s a lot of work that goes into it.

[00:32:02] And then, B, there’s a lot of regulations around it. And, those are the two considerations, of it. however, it can cashflow a lot better than long term rentals. So yeah. It’s, it’s, it’s hard, it’s hard to say, you know, which route you should go. You have to ask yourself just what type of business do you want?

[00:32:17] Do you want something steady, like a long-term rental that you know is, is more tried and true or do you want to, put in a little bit more work on the short-term rental side because they’re both great investments and from an investment standpoint, it, it just depends on what you want, what type of lifestyle you wanna have.

[00:32:32] And if you want, are willing to put in the extra work for the short rentals.

[00:32:35] Evon: Got it. Yeah, that definitely makes sense. And I would imagine some people just enjoy creating that experience for the guests, right? And that might factor into, wanting to go to the direction of, of short term rentals plus all of the, the tax benefits that come with it. okay. So we’ve got real estate, professional status, short term rentals, anything the listener, anything else the listener should know about the short term rentals specifically?

[00:32:55] Thomas: I think we covered a bunch of it. it’s just, including the fact that it’s just a lot more active work. there’s a few things that, that few more things to mention there. so a lot of times people they’ll find out about this strategy, they’ll find out, okay, in the first year, because thanks to cost segregation studies and bonus depreciation, a lot of the tax benefits from REPS of the real estate professional status or the short term rental loophole come in that first year you buy the property and you place in the service and you start operating it.

[00:33:18] with short term rentals. It’s possible to shift that to a long term rental, perhaps the next year, or shift it to your residence, in a subsequent year so that, you know, it’s no longer a short term rental. So that’s something to consider as well. It’s not always, if you buy a short term rental, it’s not always stuck as a short term rental necessarily.

[00:33:35] So, there are ways to flip it over to another business, but you want to be careful with what you, how you do that. a lot of people, they’ll buy a short term rental towards the end of the year. they’ll make a short term rental for a very short period of time, and then they’ll flip it to a long term rental property the following year.

[00:33:51] And while we don’t have any tax court cases yet to, to, substantiate whether or not that’s going to be a good thing, there’s some tax professionals out there that believe that, that could be seen as a sham transaction or a, There’s pretty much just like, it’s, it’s not, it’s not real. You’re doing it.

[00:34:06] You’re using as a tax shelter just to get the tax benefits. And that could be potentially problematic. So that’s not something we typically recommend people do. but just something to be aware of. If you’re going to buy, if you’re going to have a short term rental business, you want to plan on operating as a short term rental for a significant period of time.

[00:34:21] At least, you know, I would plan to save at least one to three years, before you want to flip it into a long term rental. And if, if there is something. like a market regulation that forces you to flip it into a long term rental. That’s probably going to be okay because you’re going to have a clear evidence, say this is a business decision.

[00:34:38] This wasn’t based on taxes. We weren’t using it, you know, as a tax shelter. So

[00:34:42] Evon: Yeah. The less it looks like a tax avoidance scheme, the better off it is, right? And so they can sort of strategically like use it as a short term rental over the short term, like you said, with bonus depreciation and otherwise to accelerate that depreciation into the potentially the year that you’ve purchased it, although that’s changed. bonus depreciation has, has come down a little bit, but they can accelerate some of that depreciation. Take those tax savings and put them back to work, right? Take advantage of that time value of money and, which is a huge benefit. And then down the road, if needed, or if planned, to convert that something to more like a longer term rental with more of a stable income over the long term, that’s, it’s really interesting to think through.

[00:35:25] Self-Rented Commercial Property

[00:35:25] Evon: And, okay, so we’ve got short term rentals, one more thing I wanted to ask you about, and this is more specific to practice owners. who, quite commonly will have their, their practice, you know, eventually, most likely it seems, taxed as an S corporation in some way. And then they’ll own the, purchase the commercial real estate that their practice operates in, hopefully having it in a separate LLC, and then the practice is paying rent to the LLC. So they’re, they’re self renting it to themselves. What are some opportunities available specific to those practice owners that own the LLC that their business operates in and are simply renting it to themselves?

[00:36:05] Thomas: yeah, that’s, that’s a great question. So the biggest opportunity there is there’s a grouping election under one, under section 1. 4, 1. 469 4. That says that if you own 100%, or the ownership’s the same, right? So say, say you’re an individual and you own 100 percent of the practice, you own 100 percent of the real estate, or if you own it 50 50 with a partner, and then you own the real estate 50 50 with a partner, you can combine these two businesses.

[00:36:27] And you can, if you’re materially participating in say the optometry practice, then the losses associated with that piece of real estate that you own, the commercial building will be non passive. So that is, that is a powerful strategy and it’s, it’s applicable for a lot of small businesses, but it’s particularly powerful for optometrists, doctors, attorneys, things in those types of practices.

[00:36:49] Evon: Yeah, that makes sense. And this is something they have to elect in the, in the first tax return,

[00:36:53] right,

[00:36:54] From the very beginning.

[00:36:55] Thomas: Yeah. Timing, timing of this is critical. So if you’re, if you’re buying, if you have a practice and you’re buying a piece of real estate or vice versa, you’re going to want to make sure that you, you’re going to want to make sure that you speak to your CPA, your tax preparer, and you’re getting that, you’re getting that done in that first year.

[00:37:10] Cause if you miss it, as far as I’m aware, there’s no way to go back. So that’s it, you’re toast. So you want to make sure you have that timing, right.

[00:37:18] Evon: Okay, very cool. anything else, practice owners should know about, about that opportunity owning that real estate? This is a, a great way to get around that sort of natural default of, of having those losses and income as passive losses and being able to use that to offset your practice and other income.

[00:37:34] Anything else that practice owners should know about that opportunity?

[00:37:38] Thomas: Yeah. So this area of the, this area goes pretty deep. I would say the biggest thing to just be aware of is that if you’re going to be doing this, you want to make sure that this is what you want to do. because once you kind of make this election, it’s kind of hard to wind it back. It can be, wound back, but it’s complicated.

[00:37:52] It’s complicated process. so just be, just be aware that once you kind of do this, this is a more permanent shift. I say completely permanent, but it’s a more permanent shift. and then there’s some issues with the self rental rules, that could come into play. I can get too much into that today into the weeds there, but there’s just some other implications of that, that you’re ultimately going to want to just speak to your CPA and tax preparer about just to make sure you’re aware of how all that works.

[00:38:12] But again, the biggest takeaway from this is you’re able to use the losses from your rental property from that specific property, against your active income. If you could group these two together.

[00:38:21] Evon: Got it. Potentially very useful if you have no other passive income, right? If you don’t have a lot of other passive, passive real estate income to offset this is a good way to use those losses, more efficiently. Okay. That’s, that’s super helpful there. I mean, we, we talked about a lot here. I, I really appreciate you going through all these different things.

[00:38:36] And I know from having followed your content, and just listened to the way that you talk about these. Like we were sort of barely scratching the surface on a lot of this. Like you said, you can go pretty deep into, into all the different rules around all these. anything else that listeners should be aware of, or, or just any final thoughts that you want to leave to the listeners about some of these different ways to use, use real estate losses more efficiently.

[00:39:01] Thomas: Yeah. What I would want to say is that this is really the icing. These two strategies we just discussed today are really icing on the cake of really what real estate is for for investors. we go back to kind of a little bit of what we discussed earlier in the episode. you’re able to generate passive income from these properties and shelter it with losses from the non cash expense called depreciation, which could significantly reduce your effective tax rate.

[00:39:22] So I’ll go through a quick example of what that looks like. And I’m going to use basic, simple numbers just for the sake of illustration here, right? Let’s just say, for example, that you were making $500,000 and you had an effective tax rate of 40%. Right? So if you, if you look at that 40%, you’re paying $200,000 in taxes.

[00:39:41] Now, say you add another $100,000 to that, in active income or income from your practice or income from, from your job, you’re now paying $240,000 in taxes. However, let’s just assume that you, you added another $100,000 of rental income and not. active income. Now you have $600,000 in income, but you’re still paying only $200,000 in taxes.

[00:40:03] And now your effective tax rate drops from 40%. It’s going to drop down to 33 and a third. So that means you’re effectively paying less taxes. So while the ability to use real estate to offset your active income is without doubt powerful and help you build your wealth, just the fact that you’re in real estate and rental real estate using depreciation to shelter your income from tax, you’re already putting yourself in a very favorable tax position.

[00:40:30] So I’ve worked with a lot of investors and sometimes We get to the point where we realize, okay, REPS is not viable. Short term rental is not viable. And I go up real estate’s useless for me. and that couldn’t be further from the truth. real estate getting into real estate directly or through syndications, whatever is going to be extremely powerful way for you to build wealth in a tax advantage way.

[00:40:49] Evon: Yeah, that’s a great point, right? It doesn’t make it useless. You still own an investment property or, or like, like we talked about earlier, like this small business, you still own something of value that number one is hopefully giving you operational profit. Like you’re, you’re getting some return from owning these investments.

[00:41:05] And number two, there are still pretty strong tax benefits of owning real estate directly. even though they’re in this passive silo does not make them useless. Like it’s, it’s still a very useful tax efficient way to build wealth. Thomas, that was great.

[00:41:19] I really appreciate you coming on. Where can people find and follow and learn more about what you’re doing?

[00:41:26] Thomas: Yeah, absolutely. I think the best way is probably the Tax Smart REI Podcast. We go through all of these strategies discussed in depth, on that show. And then also, if you do want to connect with me, I have all my links for everything, the podcast, newsletters, all the, all of the resources, at thomascastelli.com/links. It’s basically just a link tree. So you go there and you could connect with me further there.

[00:41:45] Evon: Got it. I will throw links to that in all the show notes and for the listener, it definitely worth a follow. Thomas, your, you and your whole team are just phenomenal at creating really good educational content and on social media, on podcasts, wherever you’re at. I, I love following along. So throw links to all of that in the show notes, but Thomas really appreciate your time. And for the listener, we will catch you on the next episode. In the meantime. Take care!

[00:42:09] ​