The Wisconsin Investor
Each week, we bring you interviews with some of Wisconsin's top real estate investors who share their tips, tricks, and strategies that you can implement right away. This show is dedicated to helping Wisconsin real estate investors elevate their game. Along with interviews, I'll also dive into hot topics in solo episodes and feature experts from various real estate sectors across Wisconsin.
The Wisconsin Investor
Legally Paying $0 In Income Taxes Through Real Estate Investing with Accountant Jake Caelwaerts
Can understanding the nuances of tax strategies transform your real estate investments? Join us on this episode of the Wisconsin Investor podcast as we sit down with Jake Caelwaerts, a principal at Clifton Larson Allen, to unpack essential tax strategies that every real estate investor should know. Jake shares his fascinating journey into accounting and real estate, driven by his passion for wealth generation and the financial dynamics of property investments. From understanding cash flow and taxable income to navigating the impact of depreciation and repairs on lending decisions, Jake's insights will provide a solid foundation for new investors.
Unlock the power of bonus depreciation and see how it can revolutionize your investment returns. Jake walks us through a hypothetical scenario with a $1 million commercial property, demonstrating how a cost segregation study can result in substantial upfront tax deductions. We not only explore the immediate benefits of bonus depreciation but also compare its advantages against the tax implications of property flipping. Jake’s expertise offers a clear roadmap for preserving cash flow and supporting long-term growth through intelligent tax planning.
Dive into the complexities of passive losses and the coveted real estate professional status. Jake provides a deep understanding of how passive losses can offset future income and the qualifications needed to benefit from real estate professional status. We also discuss the implications of selling properties with prior bonus depreciation and the benefits of strategies like seller financing and 1031 exchanges. Jake emphasizes the crucial role of strategic tax planning in minimizing liabilities and enhancing financial outcomes, making this episode a must-listen for both seasoned and novice investors alike.
Hey everybody, welcome back to another episode of the Wisconsin Investor. Super excited for today's episode, I have my good friend, my accountant from Clifton, larson Allen, mr Jake Calvert's, joining me. Jake, what's up, man?
Jake Caelwaerts:Not much, Corey. How are you doing?
Corey Reyment:I'm doing good, brother, I'm doing good. At the time of this recording we're past the bulk of the tax season, so I get a little chance to sit down and chat with you, man, which is always great. I know you're always slammed for the first half of the year, it seems like, but let's dive right into it. Jake, why don't you tell the audience a little bit about you, what you do and your background? How did you get into this spot you're in now in the accounting space.
Jake Caelwaerts:Yeah, so, as Corey mentioned, jake Calvert's a principal over at CLA in our tax department and focused really on real estate and construction clients here at the firm Really got into it. It's kind of a funny story. I just watched some of my friends really start investing in real estate when they were getting out of high school and I thought it was really something relatable that you know I had a group of friends that were doing it, so you know, discussing tax and items with them why not bring that, you know, to clients? And it really got me excited. So that's kind of how I got into real estate and just yeah, the last eight, nine years now have been a good roller coaster of, you know, expanding client base and so forth. So look forward to you know talking some tax things here today and see where the conversation goes.
Corey Reyment:Yeah, and before we get into that for a second, just because my personality is probably a little bit different than yours, you said you got excited about accounting when it came to real estate. Tell me what do you mean by that? What was exciting about accounting and real estate? It's a hard concept for me to fathom.
Jake Caelwaerts:Well, there's a law of large numbers, right? I mean, in real estate you can see net worth and wealth generation quite quickly. I think that really excites probably a lot of investors and why they're doing what they're doing. So yeah, accounting, I mean I'm a numbers guy, math, that just goes hand in hand.
Corey Reyment:Right on, okay, that makes more sense.
Corey Reyment:All right, I just had to ask because accounting to me is not fun. However, I will say what is exciting to me and what I love talking to people about and I'm excited to have you on here is not paying taxes legally. That, to me, is one of my favorite things in the world, and so I love when we get to sit and talk strategy and talk about. You bring new concepts to me sometimes and I'm like what? I had no idea that you could do this. So let's dive into some of those topics. If you don't mind, Jake, let's talk a little bit like if I'm a budding real estate investor or somebody looking to get into real estate. What are some things I should be thinking about on the front end to set up my tax strategy as I'm diving into this and maybe making this a longer term type of a career I want to get into, maybe, or just investing strategy. What are some things you can see some of your most successful people should do on the front end?
Jake Caelwaerts:Yeah, that's a great question. I think number one you always want to start out keeping it simple and understanding really your intent of what you're trying to accomplish with your real estate portfolio, or whether it's flips or long-term holds it down. Understanding cash flow you know you guys obviously bet deals and understand when you're looking to acquire something, whether a deal is a good deal or not, but also kind of flipping that over to the tax side and understanding your taxable income or your taxable loss and you know how lenders view that. So kind of you know from a starting point you really want to understand both items and understand how your tax return is going to be viewed. You know from a lending capacity. You know all the way down the line ultimately to what you're paying in taxes. So I think just understanding that full picture from the front from the start is crucial.
Corey Reyment:So when you say that understanding what the lender is looking at, what are some things you mean by that? Can you expand on that a little bit?
Jake Caelwaerts:Yeah, I mean. One big item that you guys are going to see is depreciation. When you acquire that building, you're going to start writing off or deducting the cost of the building. A lender is going to typically add back those depreciation deductions. In reviewing what your true cashflow is when they're looking to lend, you know, on the net income or the cashflow of the property, Right.
Corey Reyment:So they're not. They're going to see a loss on that. Maybe let's say even the property is a loss, but when you add back depreciation you're actually positive cashflow. They factor that in on the lending side. Is what you're saying.
Jake Caelwaerts:Correct. Yeah, and even you know, think about repairs. There's items that, from a tax standpoint, you can, you know, be aggressive on and deduct instead of maybe capitalizing and depreciating If those are one time not reoccurring. Calling those out and being able to call those out and know what the details are is going to provide a much more fluid conversation with the lender. Do you mind if?
Corey Reyment:we dive into that, kweje, because I didn't actually understand this. I've been investing now for like seven years and I don't think even up until recently. I just kind of like hand it the stuff to you, I have a bookkeeper, they do the books, and then I hand it to you, and then you guys figure out what to capitalize, what not to. I didn't know the implications. I'm like oh yeah, let's capitalize it, but that's actually not what we want to do, correct? Because what is that? Can you explain what that means and some examples?
Jake Caelwaerts:Yeah, so you're looking at a general. After you acquire a property and it's been placed in service for its intended use, let's just say it's a long-term rental right. Sure, you know. For its intended use, let's just say it's a long-term rental right. Typically a lot of the repairs, whether reoccurring or not, might be able to fall into a repair expense, so you're not capitalizing and depreciating that cost.
Corey Reyment:Yeah, to your point right away. Correct, Spread it out.
Jake Caelwaerts:Yeah, so you're taking that deduction immediately in the year that it's incurred and paid In, you know, prior to 2023,. You know 100 percent bonus depreciation was in play for for federal purposes, so for federal you may have not got a different answer. Right, you may have gotten to the same taxable income but, depending on what state the property is, not all states conform to that bonus depreciation that federal allows, so you might kind of have a whipsaw effect for state purposes where now you're not getting nearly as much of that deduction. So yeah, to your point, a repair and immediate write-off, both for federal and state purposes, is going to be a better tax answer. Um, in the short, short run so good.
Corey Reyment:What are some things that you see people typically maybe miscategorizing like they're pop, they're popping it into capitalization. But if you want to be aggressive again, I'm sure this is all dependent and probably the disclaimer is you know, I'm not a cpa, you are, but like talk to right, sure, but what are some of those things? You see, if you had some example for that of like yeah, I think, a unit unit turnover.
Jake Caelwaerts:You know, if you have a an existing rental property, property that you're just changing tenants over, you know, think about some of those, those maintenance items that you're going to attend to to get the new renter in, A lot of times those items can be expensed. You know there was a pretty big overhaul in 2014 or 2015 with the repair regulations that you know you can look at what a unit of property is. You know. One example maybe tends to lean towards a little commercial, but an easy one would be you know, if you have a commercial building that has 10 HVAC units on top of you know, on the roof right, and you're only going to replace four of those, you can actually likely expense the cost of all four of those, even though they might equate to a 50, 60,000 dollar bill. So they look at the unit of property as all of the units together and you're only replacing four of the 10, or maybe 40%, and you can expense that cost.
Corey Reyment:Wow, is that like? So now, if you got the six of them, then you would have to capitalize it? Is there like a breaking point there where they're saying, like of the 10, now the majority you replaced. So now we're going to say that you have to capitalize that?
Jake Caelwaerts:Yeah, there's some different terminology that they use in terms of betterment of the unit of property. I mean, I think in each case it will depend. But yeah, you're on the right path. I mean, there's going to be a review of how, how much you've changed that unit of property and basically prolonged its life.
Corey Reyment:So yeah, you're on the right path. That is crazy, like even I'm thinking, even in my apartment buildings. If I went in and just said like I'm gonna replace all these, you know if I've got a bunch of water heaters or something like that right, would that be a similar example? Or if I just replaced, you know, a third this year, a third this year, a third the following year, a third the next year, I'd have a better tax.
Jake Caelwaerts:Correct. There's a planning opportunity on on how you stage and plan out those repairs.
Corey Reyment:That's really cool, see, I love this, so I love doing this. Learn something new every time we talk. Jake, that's great. What about like well, okay, any other thing you want to talk about on the pre side? Or like what about as you're? We kind of got into as you're, as you're owning, but is there anything else with as you're owning that you thought of when we were talking about having this conversation?
Jake Caelwaerts:Yeah, going back to the intent and kind of your holistic picture of of you as an investor you know big tax items to understand is are you going to be a passive investor or are you more active in the management and in operating? You know your portfolio. I think we hear a lot of. You know there's a lot of terminology out there about passive income is good income, which 100% would not disagree with that. But when you're going and actually looking at the tax consequence of that, a lot of real estate investors want to change that passive income to actually be non-passive so that they can maybe take advantage of losses or depreciation deductions that they can accelerate. So I think, going back to the intent, understanding you know what you're trying to get out of your portfolio or your investments or your real estate, you know and just having that conversation or dialogue with your CPA, yeah, I think what you're alluding to and you're starting to dive into is bonus depreciation here, jake, is that what I'm hearing?
Jake Caelwaerts:Yeah, yeah.
Corey Reyment:Yeah, eighth wonder of the world when it's at a hundred percent.
Jake Caelwaerts:Correct yeah, when it's at a hundred percent, it's. It's definitely a very powerful tool and you know I kind of let off what gets me excited about generating wealth. I think that that bonus depreciation and immediate write write off, you know can really propel real estate investors. That you know personal balance sheets, you know you're able to continue to build on what your portfolio is and pay, you know spend little to no of your cash flow on taxes. Yeah, so it's. Yeah, it is the eighth wonder of the world when it's at a hundred percent.
Corey Reyment:Yes, and I want to dive into this because I think even for a lot of people that I talk to on a regular basis here I'm I'm based in Northeast Wisconsin, as you know, but for the audience, go to networking events, that kind of stuff, and I start talking about bonus appreciation and, like people, like it is hard to wrap your brain around when you first understand it. And so, like we just had a gentleman who left our company to do real estate full-time. It was awesome, I love it. And so now he's flipping and he's got some rentals right that he's doing both, which I love, that strategy right For him.
Corey Reyment:Let's just talk through an example of a real life example. I was explaining it to him but I want the audience to hear from you as a CPA, how powerful this could be. So let's just use rough examples. Let's say he makes a hundred thousand dollars in flips flip profit in a year and he's got a building worth a million dollars as a long-term rental that he's managing. So he's putting the hours and managing that kind of thing and we can get into how to qualify for bonus depreciation in a minute. But let's just, for this purpose, say he qualifies to take this and then we'll get into the details of it. After, what is the financial impact for somebody like him if he wants to fully utilize bonus depreciation, and this year, as we're recording this, it's at 60% correct?
Jake Caelwaerts:Correct.
Corey Reyment:Years prior it was was 80 and then 100%. So let's just use 60% for this year as an example and let's see if we can make. Let's see if we can do some. Put you on the spot with some math here.
Corey Reyment:Rough ball numbers, just gonna throw some rough ball numbers around Jake and let's see if we can get the audience to actually track with us here now, because this is gonna be the challenge. We're gonna throw some numbers around. So $100,000 active flip income, million dollar building worth a million, or his cost basis, we'll say, is a million dollars. On that building, what?
Jake Caelwaerts:are the implications for him. Yeah. So if you're acquiring a million dollar commercial property, your general allocation on that purchase is going to be to land and the building. Typically, I think most CPAs would probably tell you their first item to review is probably the assessed value of the land versus the improvements. So let's just say that warrants 20% being allocated to the land and 80% being allocated to the building.
Corey Reyment:Okay.
Jake Caelwaerts:So, of your million dollars now you're looking at depreciating the $800,000, 80% of the million.
Corey Reyment:So we're throwing away the $200,000 of land. We're saying we can't do anything with land. It's not depreciable.
Jake Caelwaerts:Don't say throw it away. It's still there but it's not depreciated. So the land component is not going to get recapped. You're not going to recoup the cost basis until an eventual exit or sale, okay, um. So of that 800,000, let's just say you did, you know, engage somebody to do a cost segregation study on on the building, generally speaking and you know I'm just using a percentage here, but generally speaking, based on um, you know the different industry or sectors right let's just say, 20% of that building is going to get carved out as short, shorter life property.
Jake Caelwaerts:Okay so, and even backing up a step, the tax depreciation on that 800,000 is going to generally be at 39 years. So when we talk about depreciating and writing off the building costs, it's going to be 800,000 divided by 39 years. So every year for the next 40 years you're going to get a sliver of that $800,000 as a deduction. And when we talk about cost segregation studies and what that entails, we're going to try to carve out different components of the building so that we aren't stuck with that 39 year life on everything. But we might have some five year, some seven year and maybe some 15 year assets that the bonus depreciation does apply to so kind of keep keeping going with our example. So if we have an $800,000 building or improvement cost allocation, which is, say, 20% of that gets allocated to five, seven or 15 year assets, that's $160,000. That's allocated to those asset classes. And in your example here, where we currently sit, with 60% bonus depreciation for federal, percent bonus depreciation for federal, 60 percent of the 160 is $96,000.
Corey Reyment:So that'd be a $96,000 federal deduction just for the bonus depreciation piece. So his federal taxable income would be $4,000?.
Jake Caelwaerts:Yeah. So kind of go into what your example was. Assuming that we can immediately benefit from that loss, you were netting the two on your individual return and, yeah, you would be sitting there with a net $4,000 income item example.
Corey Reyment:let's say they didn't use bonus depreciation, they were just flipping. They're just doing active income, flip, flip, flip, right. What would their tax implication roughly be, not knowing any of their write-offs or anything?
Jake Caelwaerts:Let's just say they're $100,000 on their tax.
Corey Reyment:What are they looking at for having to pay roughly in taxes?
Jake Caelwaerts:Yeah, so $100,000 of basic call flip income, right, that's going to be reported on a Schedule C trader business. Schedule C trader business is subject to self-employment tax on top of your regular income tax. So if that is the case, on $100,000 of income, you're likely paying $15,000 in self-employment tax on top of you know you're going to get 80% times I would say probably another $17,000 of income tax. So you're looking at $15,000 plus $17,000, roughly, you know, $32,000, $33,000 of federal income tax.
Corey Reyment:I like not paying that more and holding an asset. So would you say generally the folks that are doing this full-time flip and buying and holding rentals and utilizing this bonus depreciation thing is that? I mean, if somebody can do that, is that what you would recommend from a CPA's perspective?
Jake Caelwaerts:Yeah, it kind of goes back to the intent and kind of your what you're, what you're trying to accomplish. I do think a lot of investors, if they're going to ramp you know kind of ramp up their portfolio and keep acquiring, you know, bonus depreciation and taking those upfront deductions is a huge tool that allows you to preserve cash flow and buy more deals. Ultimately, on the flip side, I'd also say, once you have an established portfolio, the deductions it's a big timing item. Right, we talked about the $800,000. It wasn't like you're losing out on the full $800,000 deduction deduction. It's just spread over the full 39 years, right.
Jake Caelwaerts:And investors then start to think about okay, well, where are rates and you know where are my deductible items today versus what they will be, you know, 15 years from now? And if you do acquire slowly over time, you're going to build a base of those 39 year deductions, right, you're? You know you're, as you acquire, that base of what's deducted over 39 years is going to continue to grow. So I think it does kind of go back to the intent and really your cash flow needs and so forth. But I would agree with your statement that a lot of people, probably in the shoes of our listeners utilize the bonus depreciation to really jumpstart their investment in their portfolios.
Corey Reyment:Awesome. I want to get to recapture in a second, but before I get there, let's just clarify for the audience how does somebody qualify to be able to take bonus? Because you can't just buy rentals and then take it right.
Jake Caelwaerts:What do they have?
Corey Reyment:to do to be able to qualify for this bonus depreciation.
Jake Caelwaerts:So the acquisition is going to qualify, I guess, in terms of bonus depreciation if you're looking at kind of tax regulation, you know kind of tax regulation, but I think where you're going with that is really the passive, the passive and non-passive rules, right? So if in general, general terms and general rule is any rental activity is deemed passive and the passive, passive loss regulations do not allow a taxpayer to take passive losses in excess of passive income, so if you're a doctor and you're making 500 G's a year, you can't write off your rental losses against your 500 G's a year is what you're saying.
Jake Caelwaerts:Correct. Yeah, if you, let's just say a single, single taxpayer. In that scenario, a W-2 employee at a you2 employee at a hospital is making that W-2 and they buy one building, that's going to be a passive loss for them, right? Let's just say we get the bonus depreciation, they go through the steps to accomplish that and they generate a large loss in year one. They're not going to be able to take that loss and offset their W-2 income because that's a passive loss that's going to be disallowed. Now, it doesn't go away, right? That passive loss is able to be carried forward, so it will offset next year's income or the year after, you know, and so forth. So it's, it's it is a nice way.
Corey Reyment:That's income off of passive activities, right. So stock dividends rental income, but not future W-2 income.
Jake Caelwaerts:Correct. So it's. It's going to offset future passive income which you know it could be from a different rental, it could be from a different investment and so forth. So it's just really understanding what, what buckets of income or loss you're going to, you're going to be generating and making sure that you know, if you can't use them in the immediate year, how you're going to be able to, you know, divest and use those. You know whether it's next year or the year after Sure.
Corey Reyment:Cool. Tell me a little bit, because we see this strategy all the time. Jake, there's a spouse who's making a really good W-2 and then another spouse who maybe is working but not making a ton. Talk about some of those scenarios and how they can get this bonus depreciation.
Jake Caelwaerts:Yeah, so similar to your example here, with a high paying W-2 earner, the rules allow, whether the taxpayer or the spouse is able to meet certain criteria to be that real estate professional. That's going to be what allows them to potentially change that passive income or passive loss to non-passive. And yeah, like you said, it is a typical scenario that we see because, going back to even your $100,000 example, paying 30, some thousand in taxes, you can see that number just to continue to climb and multiply. So, yeah, it does become a powerful tool to be able to use, whether it's the taxpayer or the spouse and able to potentially qualify for that real estate professional.
Corey Reyment:Yeah, we had another investor couple we were mentoring for a while and they were making a really good W-2, and their spouse was doing okay. They were making decent money but didn't really like what they were doing. It was just a job. So when we looked at the taxes and we said, man, for as much real estate as you guys are buying and as much as you make actively over here, what if you just quit your job that you really don't care about and you manage all of your real estate yourself and now, instead of making X amount of dollars at your job, you're just saving that amount of money in taxes and you don't have to work a crappy job?
Jake Caelwaerts:and it was like like this light bulb moment for that we're like what we did and like two weeks later she quit her job and hasn't looked back in a couple years, but uh those are some fun scenarios that yeah let me, let me, let me, let me, let me speak to the kind of the qualifications and, yeah, the items that at least you don't want to just go to your cpa blindly and just maybe ask about it. I mean, it is nice to understand a little bit. Um, you know where you are at in kind of that, that spectrum of being a real estate professional or just a passive investor. So there's a couple of criteria to meet to ultimately be able to make that real estate professional election on your tax return. And note again that the big reason you're doing this is to change the character of those passive losses to now make them non-passive right, so that you're able to use those losses against any of your other income that you have on your return.
Jake Caelwaerts:So the big criteria is you have to be spending more than 50% of your time throughout the year in real estate activities and I use the word real estate activities loosely there because that doesn't strictly mean rental property management or rental operations. Real estate for that test is fairly it's not fairly broad, but there's other items that can be included is a good example is if you own a construction company, or at least a 5% owner in a construction company. That time then counts as real estate activities. So you need you need 50% of your time in more than 750 hours during a year for that that test. Right, that's real estate activities. Once you clear that hurdle, then you're looking at your rental real estate activities and making sure that you can be what they call a material participant in those rental activities than 50% of your time. Then we're going to flip over to another test.
Corey Reyment:Okay.
Jake Caelwaerts:And that test is going to be the material participation rules outline seven various rules that you can hit that test. You know, check the box yes, the main one being 500 hours. So if you think about, if you think about what we just kind of did, we had 750 hours over here and now we're doing 500 hours over here in rental real estate activities. If all you do is property management, those are gonna be the same hours, right, but if you're a construction individual, that's not going to translate to the 500 hours of property management. So it's just kind of understanding what a full year looks like for you, you know, in terms of time commitment and are you a W-2? Are you an owner, are you self-employed, et cetera. But if you can hit those requirements, that's where that real estate professional election can be made. And, like I said, the main goal is to turn those passive losses which would have been disallowed to non-passive and offset your other income so that could be.
Corey Reyment:That could be a big savings every year. Now, the government's always going to get paid unless we die right, that's the only idea that we can avoid that Talk about what happens. So I actually had a property that we sold in Florida this year and we had done a cost seg study and we had got the bonus depreciation was a hundred, if I don't 1031. Exchange that into something, what are my tax implications that, because I took that bonus depreciation a couple of years ago, this is the downside now. This is the downside.
Jake Caelwaerts:Yeah, so, like I kind of commented before, the depreciation deductions are a timing aspect, right. So kind of to Corey's point, if we are taking a big upfront deduction, you can guess that if we sell the property we're going to have to kind of recoup those accelerated deductions. So it is called depreciation recapture. So, based on various asset classes or lives that we talked about the five, the seven, the 15, 39, et cetera anything that's five or seven year is going to be subject to this depreciation recapture under one of the IRS regulations. So what that basically is going to tell you is you can't convert what you already deducted as an ordinary item and convert it to capital gain. Okay, Right, so the IRS recognizes that we've just allowed you to accelerate a bunch of ordinary income deductions.
Corey Reyment:Yeah.
Jake Caelwaerts:Right At ordinary rates and we don't want you to be able to sell that off in a few years and basically say that's all capital gain, which we know. You know capital gains are taxed at a preferential tax rate, a lower tax rate than ordinary income.
Corey Reyment:Okay.
Jake Caelwaerts:So they're going to look to what did you take for accelerated depreciation in that prior year and how much gain do you essentially have within those five, seven and maybe 15 year assets that now has to be recaptured and picked up as ordinary income? Okay, so it's the government making sure that we're not converting ordinary income items to capital gain is really what the structure of that depreciation recapture is.
Corey Reyment:So now a way that I can avoid paying that this year is possibly buying enough real estate and doing more cost eggs is possibly buying enough real estate and doing more cost eggs.
Jake Caelwaerts:Yeah, so a great exit strategy for real estate investors that are looking to continue to build their portfolio is a 1031-like kind of exchange. So to Corey's comment, if you potentially don't want to pay any gains whether it's capital gains or whether it's ordinary income recapture an easy and effective tool is the 1031 exchange. And the basic mechanics of the 1031 exchange are you're going to relinquish your property that you're selling, selling the cash or the equity is going to go into an escrow account with a qualified intermediary or title company. You are going to use that cash equity to acquire a replacement property within a stated time period and, as long as you are acquiring something of equal or greater value and using all of the equity, you are going to actually be able to defer the gain that would ultimately have been generated on that relinquished property. So you know, throw a simple example If you had a half a million dollar property that you were going to sell and say we accelerated a bunch of depreciation, we had 250,000 of it was gained.
Jake Caelwaerts:So we would have a $250,000 taxable event with probably some ordinary income and probably some capital gain If we roll all of our equity into that escrow account with the QI and then acquire something of whether it's. Let's just say, we acquire a property worth $600,000 within the 180 day period. That $250,000 gain that we were looking at paying tax on is ultimately deferred into the cost basis of the new replacement property, so you're able to build on your portfolio roll the equity and not have to pay Uncle Sam and come out of pocket for that extra cash flow.
Corey Reyment:Yeah, no, that's awesome. I love that. And I want to ask you something on seller finance. So there's two questions I have with 1031s and seller financing. Number one if I'm talking to a seller, let's say, or I am the seller and I have that exact scenario where I'm looking at hey, if I sold this, I got a $250,000 gain. Let's say I'm on social security, I'm thousand dollar gain. Let's say I'm on social security, I'm not making much money, right? Is that 250k count to bump me up in all my tax brackets? That is income. How does that affect my all my other income I made in the year?
Jake Caelwaerts:yeah, it's going to be, if you are recognizing that gain let's say I'm not selling finance, I'm just taking it all yep, yep. So two comments there. One, it is going to be a capital gain item on on your tax return, right? If you're recognizing that it will have, um, it may have other effects on, like you just commented, um, you know, social security et cetera. You see, you want to be cognizant of what your, your, your tax situation looks like and what that might generate, Maybe the negative consequences of recognizing that gain.
Corey Reyment:Yeah, Because I'm thinking about this. I thought this is how it always works and I wanted to ask you this because my thought process if somebody is later in life, they're not really making a ton anymore as far as active income or anything, and they're in let's call it I don't know 20% tax bracket, and then they sell off a building, Does that then bump them way up into the highest tax bracket, potentially, if it's enough gain?
Jake Caelwaerts:Yeah, so capital gain tax brackets are 0%, 15% and then 20%, 15% and then 20%, so I wouldn't say it's jumping them up to the highest tax bracket. I mean, it is a staggered.
Corey Reyment:So it doesn't affect their other income because it's capital gain.
Jake Caelwaerts:So yeah, the ordinary income piece is viewed separately on what they're paying ordinary income on. But in a situation like that, I mean you were bringing up the seller finance piece. So when we talk about seller finance or in tax terminology it may be an installment note You're able to take the capital gain component and kind of marry those up with when the seller is actually receiving payment on the seller financed note.
Jake Caelwaerts:So kind of to your comment, where I've seen this work out really well is you have a retired married couple that doesn't have much other income but maybe had this investment property of sorts, right Mm-hmm, and we know that as a married filing joint taxpayer they can basically pick up $80,000 of adjusted gross income and if that's all capital gain in nature they actually would pay zero tax because that 0% bracket for capital gains is up to that threshold. So we're able to kind of look at what a seller note or installment note might generate for them and try to target how much capital gain those individuals are ultimately recognizing in a given year and hopefully then not pay any capital gains tax on that sale. So yeah, it can be a powerful tool in understanding where their other income really lies, Wow.
Corey Reyment:So in that exact scenario this guy's popping around selling it maybe. The benefit for me as a buyer to offer to the seller is up to $80,000 a year in payments and there's no tax on it.
Jake Caelwaerts:So now the correlation between the payment to what the actual gain is. So there is a computation that's going to look at what the overall sales price is for the property relative to the gross profit or the gain. So an example here if we were to sell a $100,000 property that the gain was going to be 20,000, right, that's a 20% gross profit margin. So for every dollar, if they sell or finance the whole 100,000 for you, so for every dollar that you receive or they receive, 20% of that's going to be their taxable portion.
Jake Caelwaerts:So, it was just understanding what that gross profit margin is and every dollar that they receive, what that actually means to them in terms of taxes.
Corey Reyment:Okay.
Jake Caelwaerts:One thing I do want to go back then and touch on, though, is if you have an installment, note ordinary income recapture, so our whole depreciation recapture that we talked about cannot be deferred on an installment so they still are going to have to so it's kind of a trip.
Jake Caelwaerts:Yeah, there's potentially a trap. A kind of a trap for the unwary there is. If you know your, your seller has taken all these accelerated benefits on depreciation. They're going to have to make sure and understand what that looks like if they were to sell or finance the whole deal.
Jake Caelwaerts:Because there could be a scenario where, let's just say, you guys agree to not paying any principal payment for 12 months and they could be sitting there holding a tax liability because they have the depreciation recapture that doesn't get deferred and you not have paid them any cash yet. So it's just making sure they understand that the capital gain portion is all that can be deferred on an installment sale. But still a very, a very great tool I've seen used quite a bit. It's power. Yeah, it's another powerful, powerful tool when you're looking at exit strategy.
Corey Reyment:So in your opinion, is it best if, like buyer, seller talk to their CPA? If there's trying to structure something you know, yeah, a hundred percent.
Jake Caelwaerts:I've I've advised, I think, some individuals on your team before about about that same thing. You know, when you're talking to sellers, you definitely don't want to get them. You want them to understand and talk with their CPA or some professional in their lives to make sure that you have all the facts. Just because you might not understand what they did from a depreciation standpoint, you know in the past.
Corey Reyment:Oh, that's really good. That's really good to know. On that same note, I actually have a scenario right now I want to run by Jake. So we've got a potential 1031 exchange into a property. Okay, we would like the seller to give us some cash back for rehab on it. Is that possible in a 1031 or is that an IRS? No-no.
Jake Caelwaerts:So you want cash back outside of not just being a purchase price reduction.
Corey Reyment:Is that? Yeah, so what we're kind of starting to think about is like how can we make this deal work for them? Because they want a higher price than we want to pay, right? So I'm like, well, there might be a way we could do it. If they would sell our like we could 1031 probably let's call it half, so call it $400,000. We could get them from some sales of some properties. Let's say he wants 800 for it, but it's going to be 100,000 in rehab. What we're saying is like, hey, man, how about you sell or finance the other 400 and then get us a credit of 100K back? Or we will give you 900 for the property. You give us 100K credit at closing to do the rehab and we'll take 400 of our 1031 and put it down, yeah, so that, yeah, so that way the transaction is going to work.
Jake Caelwaerts:Um, because you, you guys, are. Your scenario is you're relinquishing of properties that are going to bring 400 000 to the table, right, and you're going to roll all of that equity into this new property. That's eight or nine hundred thousand dollars, right, you're gonna have to backfill the additional equity or, or, let you know, loan, right, yeah, to acquire that up that upside so that that transaction works. Works, uh, seamlessly. What I what I always caution people is just understanding that they can't take. If they take cash from the relinquished sales, that part's going to be deemed taxable, yeah, so we just want to be cognizant of what that looks like. You know that they're rolling all the equity, et cetera.
Corey Reyment:Okay, cool, well, that's good. That was one thing we just thought of as a way we could potentially still make it work. Cool, well, that's good.
Jake Caelwaerts:That was one thing we just thought of as a way we could potentially still make it work. I do want to note that we've seen a lot of what they call improvement exchanges. Okay, so it's the same concept 1031 on the surface, right, you sell a property and acquire a property. But on that acquisition, let's just say you were going from that $400,000 and you were only acquiring into something for $300,000, but you knew it needed that extra $100,000 of improvements. Yeah, so when we talk about an improvement exchange, you could encompass the outright acquisition of $300,000 plus identify the $100,000 of future improvements. Now, they do have to be done within that 180 day window, but it's a nice. It's a nice. Hey, I'm already going to be spending this money when I acquire it, because I need to, whether it's build out, tenant improvements, you name it. It's an easy way to still capture those items within the 1031 exchange.
Corey Reyment:That's awesome.
Jake Caelwaerts:I love that idea.
Corey Reyment:That's really cool. I had no idea you could do that, but that's huge. I mean it's great for us burr investors out there. Now, what about refinancing? A 1031 exchange, let's say, bought a property for 250. My 1031 was 240,000. I paid 10 grand of cash for this new property. Now I want to pull all that equity back out of there and go use it for something else. What's the rule or the guideline you would give somebody on something like that?
Jake Caelwaerts:Yeah, so the IRS regulations don't fully address how the refinance is going to be viewed. But I would say, in practical client interaction, what we've discussed is, you know, kind of waiting until after that exchange is completed and giving it some time to season. Okay, you know so that when you do refinance, you know a month later you're not the IRS can collapse that transaction and be, you know, essentially viewed as one that transaction and be essentially viewed as one. So we would just want some time period to lapse after you close out the exchange.
Corey Reyment:Cool. So, there's no set rule on that or anything. No, okay, okay, well, that's good to know, man. Last thing I'll touch on here, quick, jake, and then I don't want to keep everybody too long here, but there's so much we could probably sit here all day and talk to myself. Just a real quick thing. You mentioned early in our example of the $100,000 flipper and having to pay self employment tax. How can they avoid that? What's the, what's the structure they could use to avoid that?
Jake Caelwaerts:Yeah. So self-employment taxes view this as anything that the taxpayer is generating in terms in terms of income right and that income after expenses, it's basically the payroll taxes that the equivalent W-2 pays right or have withheld from their paycheck. As a self-employed individual, you're on the hook for both the employer and the employee portion. So you do get a deduction later on on your tax return. But you know I talked about 15.3%. I mean that's the FICA, your Social Security, medicare items that you're going to be on the hook for for every dollar of net income.
Jake Caelwaerts:Okay, so a lot of people out there use S-corporations as a potential tax planning strategy on how to avoid self-employment tax. And two things on the S-corp is you do have to have other people that are generating the income for you. So what you wouldn't want to see is you know just a sole proprietor that is out there, you know, generating revenue all by themselves. They have no team underneath them. You're going to have a hard time arguing to the IRS if you're just the sole owner and you make an S-corp election and now all the income is the same right and now you're just pulling the income via tax-free distributions rather than having that income be taxed at the self-employment tax. So I mean there's a lot of variables that would factor into that. But you definitely want to review with your CPA how the S-Corp may benefit you. You know you do have to.
Jake Caelwaerts:then the other item I was going to mention was if you do become an S-Corp, you do have to pay yourself a reasonable comp. Okay, so you know, you, Corey, are the sole owner of an S-Corp that has, you know, 10 employees. We still need to pay Corey a W-2 for his services and the value of what he's bringing to the S-Corp.
Jake Caelwaerts:So paying some payroll tax, because that's going to be ultimately what you're paying payroll taxes on. Got it, okay so, but the the larger the income number, uh, it within an s corp. You know that that self-employment tax, um, you're escaping it, okay, um. And yet one, one other thing I'll note is there is always a cap on the overall social security that you're, you're, you have to pay in every year, okay, I think, uh, you know, this year it's probably, I think, 170, some thousand dollars. So once you, once you make, once you're making over $170,000, you're not paying the whole 15.3% anymore, it's, it's going to only be the Medicare piece. So I mean there's, if you always know the incomes above that, you know there may be some risks that we don't need to take. You know, understand where you're over, you're ultimately at with your self-employment income.
Corey Reyment:So ultimately get a good CPA, sit down and discuss all this stuff, even if you're just starting out. That was one of the best pieces of advice we ever got was hey, get a real estate specific CPA If you think this is something you want to do for a career and and start planning before you have a problem. Yeah.
Jake Caelwaerts:I 100% agree and I think if you look at real successful investors out there, you, you see that they have, you know, they understand the full picture. They probably have the professionals you, you know on their team as well. Yeah, um, but you know they, they know how to present that to lenders right, which allow you to continue to, to grow and, you know, have your personal financials in order and understand what that looks like for you. And, yeah, you start building out systems and processes with your, with your team. Um, you're gonna it'll, it'll take you a long way and really create that wealth that you're looking to generate, absolutely.
Corey Reyment:All right, jake. Last question we ask on the podcast what is your favorite place to visit in Wisconsin or a favorite Wisconsin tradition?
Jake Caelwaerts:Favorite place to visit. Every year we go up to Eagle River with the family. I think you know the Chain of Lakes is. It's a. It's a cool atmosphere up there. The kids can relax, kind of get that outdoors time the whole week. And I think sometimes at home we get stuck just running around to different things and you don't just sit back and relax. So yeah, I would say that's my favorite place and really favorite tradition that we've been doing for the last five or six years here.
Corey Reyment:I love it, man. That's like my heaven and earth. We travel a lot and I always say that's one of my favorite places, no matter where we travel. Eagle River, monaco area, northern Wisconsin. It's tough to beat man. It's tough to beat man. It's tough to beat. Well, guys, thanks so much for checking out this episode. I know we went a little long today, but there was a ton of information here. Jake, I appreciate all your time. Man, if somebody wants to get a hold of you or talk tax planning about their stuff, what's the best way for them to get a hold of you, jake?
Jake Caelwaerts:Yeah, you can reach out via our website, claconnectcom, or my direct line number is 9 2 0, 4, 5, 5, 4, 2, 3, 2. So look forward to it.
Corey Reyment:Beautiful. So, guys, if you enjoyed this episode and you want to learn more about just real estate investing in general, just go to our website wisconsindiscountpropertiescom. Fill it a little contact us form and somebody from our team will reach out. We would love to try to help you get started in real estate here in Wisconsin or expand your current Wisconsin investing goals. Again, this is another episode of Wisconsin Investor. Thanks for tuning in and we'll see you on the next episode.
