RPF0468-Friday_QA
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00:00:14.720 | After a hiatus due to new baby in the household, summertime Friday Q&A calls are back.
00:00:22.720 | [Music]
00:00:38.720 | Welcome to Radical Personal Finance, the show dedicated to providing you with the knowledge, skills, insight, and encouragement you need to live a rich and meaningful life now while building a plan for financial freedom in 10 years or less.
00:00:49.720 | My name is Joshua Sheets and when I don't have new babies that disrupt my schedule.
00:00:54.720 | Whenever possible we try to do Friday Q&A shows. You call in, ask a question, make a comment, and we chat together about your situation, try to come up with some useful, helpful financial advice.
00:01:05.720 | [Music]
00:01:11.720 | If you would like to call in and join on a call in the future, these calls are generally the best way for you to get – well, for you to get a question answered or to talk directly with me about any subject or topic that you would like.
00:01:23.720 | I open these calls to the patrons of the show, people who sign up and voluntarily say, "Hey, Joshua. I appreciate the work that you're doing. I want to send you a little bit of money to say thank you."
00:01:31.720 | So I open these up to patrons only.
00:01:35.720 | You can sign up to be a patron at RadicalPersonalFinance.com/patron.
00:01:39.720 | However, the reality is many people who are patrons just do it to send a little bit of money my way and thanks for the work that I already do.
00:01:46.720 | And often very few call into the calls. At the moment, I've got one caller on the line.
00:01:51.720 | So today's show will be as short or as long as this particular caller would like to make it.
00:01:56.720 | So I would encourage you if you'd like to get on a call with me in the future, come on by at RadicalPersonalFinance.com/patron.
00:02:02.720 | Sign up to become a patron of the show and that's where you will receive the notifications about these calls.
00:02:08.720 | So you get the call-in number. I record them in advance of them being released on the feed.
00:02:12.720 | So obviously, this is not a live call, but you'll get the call-in number and the time at which I'm going to be recording and then that allows you to call in at that time for us to chat.
00:02:21.720 | So let's go directly to Jonathan.
00:02:23.720 | Jonathan, it's you and me and you've got me for as long as you want.
00:02:26.720 | So kick it off by introducing yourself and let's see what questions you have that I can help you with today, please.
00:02:32.720 | Joshua, how's it going?
00:02:34.720 | Very well, sir.
00:02:35.720 | I've just moved down to Florida after about 20 plus years working as a New York City medical examiner.
00:02:42.720 | And I'm in the process of rolling over my retirement accounts into Vanguard index funds.
00:02:48.720 | And if you roll over more than $50,000 worth into Vanguard funds, they assign you a personal advisor, a personal financial advisor.
00:03:00.720 | And this personal advisor has gone over my statistics and has recommended a certain asset allocation, which I'd like to discuss with you.
00:03:09.720 | But also, he suggested that I incorporate in some way.
00:03:14.720 | He said he wasn't familiar with how incorporation works in Florida, but there were some financial advantages to that.
00:03:19.720 | And also, in addition to doing forensic pathology, I do some consulting work.
00:03:24.720 | And he said that if I were to incorporate, that would provide me with some security, immunity in terms of liability.
00:03:32.720 | I just wondered what you thought about that.
00:03:34.720 | It's an interesting question.
00:03:36.720 | And there's a lot of information, there's a lot of advice that's given on the topic that's good and there's a lot that's not very good.
00:03:43.720 | What I have experienced in working in this area is many people recommend incorporation because it seems like a safe thing to do.
00:03:52.720 | It's kind of like I recommend that you get insurance because it's a safe thing to do.
00:03:56.720 | And especially professional advisors who are going to be judged based upon the content of their advice, we professional advisors have a tendency to always say, "Cover yourself. Cover yourself."
00:04:12.720 | So the answer to the question depends on who you're talking to and depends on the specifics of the situation.
00:04:17.720 | And you'll often find somebody that is – well, it depends on who you're talking to and the specifics of the situation.
00:04:25.720 | So let's talk about the advantages of incorporation and let's break it down for the purpose of our context to just simply talk about using a business entity.
00:04:35.720 | Technically incorporation would usually refer to the establishment of a corporation, either a C-corp or an S-corporation, traditional business corporation or small business corporation.
00:04:48.720 | In what we're talking about here, you mentioned an LLC.
00:04:51.720 | So an LLC is a slightly different animal, but it's basically should I establish a business entity?
00:04:56.720 | That's the fundamental question.
00:04:58.720 | Whether or not you should establish a business entity is going to be driven by the factors of your circumstances, and there are a couple of different reasons.
00:05:09.720 | The first two big reasons are liability exposure and taxation, and these are different decisions.
00:05:19.720 | Let's start with liability exposure.
00:05:21.720 | The idea behind using a corporate entity to run your business from the perspective of liability exposure is to separate your personal finances from your business finances.
00:05:34.720 | If you have a lawn maintenance business and you have five trucks on the road with two workers in each truck and one of your workers – one of the guys runs over somebody's leg with a lawnmower, chopping off their foot.
00:05:54.720 | And the other guy is so surprised by that that he crashes the truck while he's driving by into the person's house.
00:05:59.720 | Now you've got a lawsuit on your hands for the damage of property to the house and the damage of property to the foot and all of the associated lawsuit along with that.
00:06:09.720 | Well, you can expect to get a lawsuit, and if they find that you were – your workers were liable and negligent in their action, you're probably going to lose the lawsuit and they're going to take out a judgment against you.
00:06:21.720 | Well, if they win a million-dollar judgment, the idea behind using a corporation is to disconnect your company from your person and say, "Well, they can sue my company, but they can't sue me personally."
00:06:33.720 | That's the fundamental aspect of liability protection.
00:06:37.720 | The reason that's so important is not all actions and not all companies are the type of things where somebody is going to actually face a liability exposure in their company.
00:06:50.720 | If you have employees and you have trucks and equipment, et cetera, on the road, then yes, without question, you need and should value that liability protection of the corporate entity.
00:07:01.720 | But there are professions in which there's not so much corporate liability as personal liability.
00:07:08.720 | I come from the world of financial advice.
00:07:11.720 | When I was a professional financial advisor, I was not – my most likely – my biggest liability, my biggest risk exposure was in the context of my giving bad advice.
00:07:25.720 | If I gave fraudulent advice or I steered somebody in the wrong direction, then I would be – I could be held potentially liable for that bad advice, especially if there was harm and especially if I had committed some sort of criminal act as well.
00:07:39.720 | I could be held liable for that.
00:07:40.720 | But it wouldn't matter whether or not – it wouldn't matter whether or not that action occurred shielded by an entity, Joshua Sheets Financial Advice Incorporated, or whether it was just Joshua Sheets because that would be an act of professional liability.
00:07:57.720 | This is the same thing that physicians face, which is the world that you're in.
00:08:02.720 | You would – if a physician who has a – makes a mistake or an error that winds up causing somebody a medical problem, their corporation is not going to be sued.
00:08:14.720 | They're going to be sued personally for an act of personal liability.
00:08:18.720 | So that's why a physician will need to carry medical malpractice insurance, or that's why an insurance agent will carry errors and omissions insurance, and that insurance protects me as an individual.
00:08:30.720 | And as an insurance agent or a financial advisor, it doesn't really matter from the perspective of liability if I had – if I had no employees and no office, etc.
00:08:40.720 | If I had the corporate entity, it would just simply be my personal liability.
00:08:44.720 | So you got to ask yourself the question from a liability perspective, "Do I face the risk of – do I face liability exposure that goes beyond my personal actions?"
00:08:55.720 | Generally, this is going to be – you're going to have greater exposure if you have employees, if you have equipment, if you have employees' equipment, locations, things like that that could expose you to more contact with the general public.
00:09:10.720 | Then you're going to have a greater liability exposure there.
00:09:13.720 | If you're just running a small consultancy, a small individual practice, you don't have – you're not working with the public, you don't have public-facing property, etc., then perhaps your liability exposure is minimized, and it may not be the big risk that it's portrayed to be.
00:09:31.720 | That doesn't mean that you shouldn't go ahead and set up an LLC to do business in.
00:09:35.720 | LLC is cheap and easy to use, minimal formality.
00:09:40.720 | So chances are it's probably a good solution regardless.
00:09:45.720 | But in terms of the strict answer to your question as far as liability, it depends on the nature of the company.
00:09:51.720 | Now we'll go to taxation in a moment, but let me pause.
00:09:54.720 | Does that make sense to you?
00:09:55.720 | Do you have any further clarification needed?
00:09:57.720 | That was really impressively articulate.
00:09:59.720 | Now I think I understand it.
00:10:00.720 | What is umbrella insurance?
00:10:02.720 | I mean, what I do is most frequently lawyers come to me with wrongful deaths where there's an issue, and I give my opinion to the nature of the death, as to the cause of the death, and the manner of the death, and they will use that opinion in terms of presenting the case in court.
00:10:16.720 | So I don't know what sort of liability that incurs.
00:10:20.720 | It's my opinion, but I'm not actively involved in treating people.
00:10:23.720 | I'm not going to blind someone or cut off their – with the wrong foot or something like that.
00:10:27.720 | So would umbrella insurance be something I should consider?
00:10:31.720 | That's a different – umbrella liability insurance is different than what we're talking about here.
00:10:37.720 | The answer to should you consider it, yes.
00:10:40.720 | I was taught by CFP instructor when I was going through the certified financial planner curriculum.
00:10:46.720 | He gave us one simple rule.
00:10:48.720 | He said if you ever read on the certified financial planning curriculum a question wherein the answer is umbrella liability insurance, you can just skip everything else, select that, and move on.
00:11:00.720 | Because an umbrella liability policy that you purchase from your insurance agent that covers you – it covers you from a broad range of risks related to the use of your car, the use of your home, your personal actions, some aspects of lawsuit, et cetera.
00:11:19.720 | And it's very inexpensive to have a high amount of coverage.
00:11:22.720 | So you should always consider and research an umbrella liability policy.
00:11:26.720 | But that's not connected to an LLC.
00:11:29.720 | So to answer the LLC question, what you just described sounds like you have minimal risk, minimal risk, especially related to your business activities.
00:11:38.720 | You're much more operating as an individual, not so much there as a company with lots of employees.
00:11:43.720 | So I wouldn't – if I woke up in your shoes, I wouldn't freak out about my liability exposure in a context like that.
00:11:48.720 | You're just working as a personal consultant, sharing your opinion, in many ways getting paid a consultancy fee, serving as an expert witness, et cetera, minimal risk.
00:11:57.720 | Now let's talk about taxation and explain that because often these two things get confused and people talk and say, "Well, you can save money by setting up an entity. You set up a business entity."
00:12:10.720 | Did the advisor also talk to you about taxation?
00:12:13.720 | Yes. I'm just blanking on what it was that he said about the taxation because when he raised the issue of liability, of course, one of the things doctors hate is being sued.
00:12:22.720 | So that was one of the first things that – it kind of set off alarm bells in my head when he mentioned it.
00:12:27.720 | But yeah, he said there was a taxation advantage too.
00:12:29.720 | OK. So to explain the taxation advantage, it's a little misleading to say that the LLC framework has a taxation advantage because when you establish an LLC, you actually get to choose how you're taxed.
00:12:45.720 | You file a form with the IRS and you can choose to be taxed as an individual, just a person.
00:12:51.720 | You can choose to be taxed as a traditional corporation or as what's called a pass-through corporation.
00:12:59.720 | So an individual who has an LLC can choose to be taxed in the same way that they would be if they were a sole proprietor or a C corporation or an S corporation.
00:13:10.720 | An LLC has to actually make that election and choose the taxation model.
00:13:15.720 | So let's talk about the different taxation models.
00:13:19.720 | The simplest way to do business is just to work as what's called formally a sole proprietorship.
00:13:24.720 | That means that you go and you do some sort of work and you get paid for it.
00:13:29.720 | Any individual, you, me, my son, my neighbor, any of us can really have an unlimited number of businesses.
00:13:39.720 | And from a taxation perspective in dealing with the US government, all we need to do is track and record the amount of compensation that we receive from the business, whether that compensation is measured in terms of sales or payment as a contractor or a barter.
00:13:57.720 | What's the value of the barter instrument that was used to give us whatever it was?
00:14:02.720 | We just simply track the total income and then we track any expenses that are related to that business and we fill out in the US tax system, we fill out what's called for federal purposes a Schedule C.
00:14:14.720 | And a Schedule C is just simply a profit or loss from business statement.
00:14:18.720 | And you fill out a Schedule C for each individual business that you may be in.
00:14:24.720 | So if I have a car washing business going around my neighborhood washing my neighbor's cars, I just put car washing business.
00:14:30.720 | I had $800 of income and I had $100 of expenses associated with that, the cost of the car washing supplies, the cost of the new hose, and the cost of the miles driven in my vehicle to go and do that business.
00:14:46.720 | Now I have $700 of profit from that business.
00:14:48.720 | And I could have another business.
00:14:50.720 | That's the sale of fruit trees from my driveway.
00:14:53.720 | I could have a business that's the sale of any product that my household creates or any service that we provide.
00:15:00.720 | Maybe I code things, do web programming, or maybe I do jobs on Fiverr.
00:15:05.720 | Whatever it is, I just have the income and I just file a separate Schedule C for that.
00:15:10.720 | That's called a sole proprietorship.
00:15:11.720 | Now, when you do that, the tax that you pay is twofold.
00:15:16.720 | First, you pay your employment taxes, and when you file a Schedule C as a sole proprietor, you'll pay self-employment taxes.
00:15:25.720 | And this represents the Medicare, Medicaid, and Social Security taxes that are paid for you in a job.
00:15:34.720 | So, in the individual market, that means that you're going to pay a 15.3% self-employment tax, total of your income right off the top.
00:15:48.720 | So, that's the total on your profit.
00:15:50.720 | You're going to pay that self-employment tax.
00:15:52.720 | Then, in addition to that, you're going to pay your federal income tax, and all that income is going to be lumped in with your other income.
00:15:59.720 | You're going to pay federal income tax at whatever rate your tax return calculation would say that you owe.
00:16:08.720 | That's the basic function and that's the simplest way to run a business.
00:16:13.720 | You don't need to file anything.
00:16:15.720 | You don't need to do anything.
00:16:16.720 | But you pay that self-employment tax, which is a significant cost.
00:16:21.720 | Usually, when you're working in a job, your employer will pay half of it and you will pay half of it.
00:16:28.720 | Usually, your employer will pay 7.65%.
00:16:31.720 | You'll pay 7.65%.
00:16:33.720 | But when you're self-employed, you pay both parts, and that's primarily for Social Security.
00:16:38.720 | And then a total of the 15.3%, 12.4% is for Social Security and 2.9% for Medicare.
00:16:46.720 | The problem with the self-employment tax is it's a straight tax that comes in and you can't do any of your other federal income tax payments.
00:16:55.720 | So one thing that many people want to do is they want to reduce that tax, and that's where the use of an entity comes in.
00:17:00.720 | So keep what I just described in your mind as a sole proprietorship and let's flip to a traditional corporation, what's called a C-corp, a traditional corporation.
00:17:10.720 | A traditional corporation pays tax at what's called the entity level.
00:17:14.720 | So Coca-Cola Corporation, when they do business all around the world, they receive income.
00:17:19.720 | Then they have expenses and they pay a corporate tax based upon the corporate tax rate of the government under which they're jurisdiction.
00:17:27.720 | Then in addition to that – so let's just say they're paying 30%.
00:17:31.720 | They pay a 30% corporate tax on their profits.
00:17:35.720 | Then after they pay the tax, they take the profits and they send those profits out as dividends to their stockholders.
00:17:42.720 | So you and I, if we own shares of Coca-Cola Corporation, we receive our nice little dividend check.
00:17:48.720 | That dividend check then gets added to our personal tax return and we pay an additional tax on that income.
00:17:56.720 | So that's why corporate income is double taxed.
00:18:00.720 | You hear this in the arguments and debates.
00:18:02.720 | There's a double taxation.
00:18:03.720 | The income was taxed first at the corporate level paid by Coca-Cola.
00:18:07.720 | Then the income was taxed again at the personal level and we pay another layer of tax.
00:18:13.720 | So you can do exactly the same thing in your personal business.
00:18:18.720 | Depending on the corporate tax rate or the personal tax rate, this may be a good idea for you to do or it may not be a good idea for you to do.
00:18:27.720 | When personal tax rates are low, generally you don't want to pay the double tax.
00:18:33.720 | But when personal tax rates are high, sometimes you'll find that corporate tax rates are lower.
00:18:38.720 | And so in some cases, it actually is good advice to say, "Let's use the traditional model of taxation and let's use and pay the tax at the entity level because we'll pay less total tax by paying it at the entity level first."
00:18:55.720 | That's not usually applicable to most of the situations that we're – like we're talking about.
00:19:00.720 | So that – but that's – those are the extremes.
00:19:02.720 | The first was everything is personally taxed and you pay your self-employment tax.
00:19:05.720 | Then at the other end was the corporate tax.
00:19:07.720 | So what's happened is over the last – a few decades ago, the writers of the tax code came out with a model of what's called a flow-through business entity.
00:19:19.720 | And we usually just refer to this in short as what's called an S-corporation.
00:19:24.720 | In an S-corporation, there is no corporate tax that's paid.
00:19:30.720 | All of the income from the corporation flows through directly to your tax return.
00:19:37.720 | If you and I were business owners in an S-corporation and we each owned 50 percent of the company, then 50 percent of the income would flow through to your tax return.
00:19:47.720 | 50 percent would flow through to my tax return.
00:19:50.720 | S-corporations have a limit on the number of tax holders – sorry, number of shareholders.
00:19:55.720 | It can't be more than I think 100.
00:19:57.720 | Anyway, it can't be a lot of people, so this never works for a big company like a Coca-Cola.
00:20:03.720 | It's only for small – basically for small businesses.
00:20:06.720 | The benefit of this from a tax planning perspective is primarily in the saving of self-employment tax.
00:20:16.720 | Let me explain why.
00:20:17.720 | Let's say that we have a total income of $100,000.
00:20:21.720 | If we pay – and I'm the sole owner of – well, you.
00:20:27.720 | You're the sole owner of the S-corporation.
00:20:29.720 | You have this consultancy income.
00:20:31.720 | You establish yourself as an S-corporation.
00:20:33.720 | In this context, you have $100,000 of income and you pay that to yourself as wages.
00:20:40.720 | Well, because you're paying that to yourself as wages, you're both the employer and the employee.
00:20:45.720 | So you as the employer are going to pay 7.65% of the income as wages and you as the employee are going to pay 7.65% of the income in employment taxes for a total of 15.3%.
00:21:04.720 | If all $100,000 on your tax return were characterized as wages, you would pay the same cost in an S-corporation as you would in a sole proprietorship because the 15.3% of self-employment tax is identical to what you pay as an employer if you pay both the employer and the employee side.
00:21:26.720 | But in an S-corporation, you have a choice to declare a dividend.
00:21:31.720 | A dividend is not wages.
00:21:34.720 | The way that you do this is you're supposed to pay yourself a salary that's equivalent to the other – that's comparable to other people in your similar situation.
00:21:45.720 | So let's say that in your business, the comparable salary that somebody in your situation, if you were going to hire someone to replace yourself, would receive is $50,000.
00:21:54.720 | In that situation, you pay yourself a $50,000 salary and then at the end of the year, your business has a profit of $50,000 and you can pay that $50,000 to yourself in the context of a dividend.
00:22:06.720 | Dividends, because they're profits, not wages, dividends do not – you don't have to pay employment taxes on dividends.
00:22:16.720 | And so what you get to do is you get to save the cost of the employment taxes on those dividends because they're paid out to you not as wages but as profits.
00:22:27.720 | And so in that context, on your $50,000, you would save yourself $7,650 of tax by paying it to yourself in the form of a dividend rather than as a wage.
00:22:39.720 | These barriers between these two things are somewhat arbitrary in terms of do you pay yourself $100,000 of salary, $50,000 of salary and $50,000 of profit or $100,000 of profit.
00:22:53.720 | You as the business owner, you get to decide that because you're in charge.
00:22:56.720 | But the auditors from the IRS are very – this is an area where there is a lot of abuse.
00:23:04.720 | And so this is one of the primary things. And so your accountant will tell you, "You need to research what is comparable pay."
00:23:11.720 | If you're a physician and you're saying, "Well, I'm only going to pay myself a $20,000 salary and $300,000 of profit," that ain't going to fly.
00:23:19.720 | But you can do this reasonably and as long as you're reasonable with the numbers, it allows you to save on your self-employment tax.
00:23:26.720 | So that's the theory behind why people say if you use a corporation like an S corporation, then you can save a little bit of money on your taxes rather than working in it individually.
00:23:42.720 | Now, the tricky thing, as I explained in the beginning, is an LLC can choose any one of these models.
00:23:48.720 | So an LLC can choose to be taxed as a sole proprietorship, an S corporation, or a C corporation.
00:23:54.720 | And the benefit of an LLC is it gives you some of the liability protection that a traditional corporation gives you.
00:24:04.720 | But you have fewer corporate formalities that need to be observed.
00:24:08.720 | If you're running a corporation, you must have an annual meeting of your board of directors.
00:24:13.720 | You must have proper business books tracking the number of shares of the corporation that are issued, the minutes of the annual meeting of the directors of the corporation, etc.
00:24:24.720 | You need to file a separate corporate tax return.
00:24:26.720 | So these formalities are significant with a corporation.
00:24:31.720 | And so that's why there's such a growth in the LLC marketplace because an LLC doesn't have such onerous corporate formalities that need to be observed.
00:24:39.720 | It's a much simpler entity.
00:24:41.720 | But that's the explanation as to why people refer to an LLC and say that it can be helpful.
00:24:49.720 | Your turn, Jonathan.
00:24:51.720 | That was really compelling and pretty clear cut, I thought.
00:24:55.720 | Okay, I have another question if you want to continue.
00:25:00.720 | So I had a small loft in New York City for 22 years, and I sold that to move down to Florida.
00:25:07.720 | And when I sold it, I made like 600% increase in the value of my property.
00:25:14.720 | And I just assumed that when you sold a house, you could then roll over the profit into the new one.
00:25:19.720 | But my accountant tells me that's not the case.
00:25:22.720 | And now I have a really large tax debt from the IRS.
00:25:27.720 | And I put probably a couple of hundred thousand dollars over the years into improving it and making it better.
00:25:35.720 | And when I go before the IRS, I want to argue that – at least when I file my taxes on this, I want to argue that I've put this money into upgrading the house and making it more valuable.
00:25:47.720 | But I don't know how that works.
00:25:49.720 | Do you file a tax return as a single person or as married filing jointly?
00:25:54.720 | Single person.
00:25:56.720 | Single person.
00:25:57.720 | So the first – basically, you're out of luck.
00:26:01.720 | It's not going to work.
00:26:03.720 | In the US tax code, as a single person, a single taxpayer filing singly, you can ignore up to $250,000 of gain from the sale of a personal residence that you have lived in.
00:26:18.720 | For taxpayers who are married filing jointly, you can ignore $500,000 of gain from the sale of a residence.
00:26:28.720 | So that's a tremendous planning opportunity if you fall into those situations.
00:26:35.720 | That money in terms of tax-free money, some of the best tax-free money that you can ever get is related to those gain numbers.
00:26:45.720 | I've known people who – you can do this.
00:26:49.720 | If you want to have a truly income tax-free life, you can – in your handy, you can buy a handyman special house for $100,000, move into it, live in it for three years, and then turn around and sell it for $350,000.
00:27:07.720 | If you're an individual single person, that $250,000 would be truly income tax-free.
00:27:14.720 | There's no employment taxes due.
00:27:16.720 | There are no income taxes due on the money.
00:27:20.720 | However, for – in your purposes, when you have a gain that exceeds that, you will owe tax on that increase.
00:27:31.720 | So that's – most people, that's the situation that most people face, which is the simplest where they can just avoid the gain.
00:27:38.720 | In your situation, you do need to calculate and substantiate your numbers carefully, and you got to calculate your tax basis.
00:27:48.720 | The problem is how to represent this number accurately because most people are not going to have the records to be able to calculate it accurately or not because you're going to owe your tax on the increase in property, the difference between the sales price and the actual basis in the house.
00:28:06.720 | So the first most obvious point is what you paid for it, what was the actual sale price of the home.
00:28:12.720 | And then that basis is adjusted in tax terms.
00:28:17.720 | It's adjusted based upon various costs.
00:28:20.720 | Certain things that can reduce your basis is if you ever took any depreciation on the house, if you ever rented it out, if you ever received any insurance payments.
00:28:30.720 | So you had a fire. You received $10,000 of insurance payments. Well, that would reduce your basis.
00:28:36.720 | Let's say you paid $500 for it. That would just drop it by $10,000, and you would have to owe the tax on that or for – there are a couple of other things.
00:28:48.720 | You can increase the basis if you can substantiate them as additions or improvements.
00:28:55.720 | So let's say that you renovated and you made substantial changes that were additions or improvements.
00:29:00.720 | Then that could increase your basis.
00:29:03.720 | You paid $500,000 for it, but you improved it and a cost of $100,000.
00:29:08.720 | Now your basis is $600,000 and you sold it for a million.
00:29:11.720 | That will increase it as well as any money that you've paid for a few little things, legal fees, money that you paid to fix anything that was a casualty loss, fire, theft, etc., things like that.
00:29:28.720 | But general repairs do not count as a change to your basis.
00:29:34.720 | So what you've got to do to make your best case is go back and try to figure out how much money was actually spent on improvements, not repairs.
00:29:44.720 | You can never account for the money spent in repairs, but you can account for it improvements.
00:29:49.720 | So depending on your records, if you can go back through and you can prove, "Oh, look.
00:29:53.720 | In 2009, I hired a contractor to do such and such an improvement, and I spent money at the Home Depot, but here it was for an improvement," that will qualify.
00:30:04.720 | But just normal repairs do not adjust your basis, and you're going to owe the tax on the income.
00:30:10.720 | We're talking going back to 1992 or 1993 when I first started renovating the place.
00:30:20.720 | Are they going to demand proof of all of this all the way back to 25 years?
00:30:25.720 | Well, have you filed the return yet? Have you filed your tax return after the sale of the property?
00:30:30.720 | Well, I paid $250,000 extra in tax and filed a return, but I have to follow up on that and file a definitive return.
00:30:38.720 | Meaning, has this return been audited?
00:30:45.720 | No, it hasn't. They're still waiting for a final return for me to pay the balance of what I owed.
00:30:54.720 | I filed it estimating my improvement cost at around $200,000.
00:31:01.720 | So you're doing the right – you're certainly doing the right thing in terms of estimating them.
00:31:09.720 | Your basic line of attack is this.
00:31:12.720 | In dealing with the IRS, a lot of people have this question of, "What should I do with the IRS?
00:31:17.720 | Maybe if I underreport my gain or underreport – sorry, underreport my expenses, maybe I won't get audited," et cetera.
00:31:24.720 | The way I look at it based upon my study and experience is you should take with vengeance every single tax credit that you can
00:31:36.720 | and you should take with vengeance any tax deduction that you can.
00:31:41.720 | The only legal authority that I'm aware of that will actually affect your freedom is if you don't report income.
00:31:51.720 | So the IRS will throw you in jail if you don't report income.
00:31:54.720 | But the actual occurrence of that seems to be very, very small.
00:31:58.720 | Anything beyond that is a matter of a fight between accountants.
00:32:03.720 | So in terms of actually calculating things, you should sit down and make your best faith estimate of what you actually spent
00:32:12.720 | based upon any records and situation that you have.
00:32:16.720 | Sit down and figure it out to the very best of your ability and then file your taxes for that.
00:32:21.720 | Statistically, you have a very low likelihood of ever being audited.
00:32:25.720 | The audits are way down.
00:32:27.720 | The IRS is overwhelmed, and audit rates are way, way down.
00:32:31.720 | So statistically, your odds are pretty good that you're never going to be audited.
00:32:35.720 | The only point in which you would actually have to prove how much you actually spent is going to be if or when you were to get audited.
00:32:42.720 | If you get audited and they say you owe us more money because you said that you spent $200,000 on property improvements
00:32:48.720 | and you actually can only substantiate with perfect receipts from 1992, you can only substantiate for us $100,000 of property improvements.
00:32:57.720 | Well, that means they charge you the tax on $100,000 plus a small penalty fee, which is basically negligible and not that big of a deal.
00:33:08.720 | So the IRS gives you no benefit for you keeping your money with them as hundreds of millions of –
00:33:15.720 | tens, perhaps hundreds of millions of people do in the United States where they give the IRS an interest-free loan.
00:33:23.720 | But at least on the flip side is that when they actually charge you penalties and interest on your money, it's not really that expensive.
00:33:31.720 | So in general, I think you should be – you should sit down, figure out what do I think I actually spent, whether you can prove it or not,
00:33:38.720 | and then file your tax returns on that basis, recognizing the fact that there's a risk that if I'm audited, I won't be able to prove this.
00:33:46.720 | This deduction will be disallowed. So what? You owe the money that you'd pay anyway.
00:33:50.720 | The chances of you getting audited are pretty small and getting smaller by the day.
00:33:55.720 | Joshua, thank you very much. I really appreciate your time and your expertise.
00:34:01.720 | Thank you, Jonathan. Before we go, I just want to talk – expand on this question of repairs versus improvements with a clarification.
00:34:09.720 | Everything in what I – the advice I just gave to Jonathan was related to his personal residence.
00:34:16.720 | As you could hear when talking about the idea of an improvement, as you could hear in that context, it should be obvious to you that as a personal homeowner,
00:34:27.720 | you want any changes or work done on your house to be characterized as an improvement rather than a repair because the cost of an improvement can be added to your basis,
00:34:37.720 | which will be calculate your gain at the time of sale and will either reduce your tax – it will reduce your tax.
00:34:45.720 | That's exactly the opposite than what you generally want as a real estate investor.
00:34:51.720 | As an investor, you generally would rather have – if you had the choice, you generally would rather have your – the cost of some work that's being done on your property.
00:35:04.720 | You'd rather have that characterized as a repair rather than an improvement.
00:35:09.720 | The reason here with an investment property is that the cost of any repairs on your property, that cost is immediately deductible.
00:35:19.720 | Whereas the cost of any improvements has to be amortized based upon the standard amortization schedule of 27.5 years for a residential rental property and just 39 years for a commercial property.
00:35:34.720 | So if you are a real estate investor and you're trying to do careful tax planning, you want repairs.
00:35:41.720 | So what's the difference between a repair and improvement?
00:35:45.720 | Depends. And there's – here there's not really any bright line test as they say.
00:35:51.720 | There's not a guaranteed way to know whether or not something is a repair or whether it's an improvement.
00:35:58.720 | Rather, there are some general guidelines and some things that you can focus on that if you follow the general guidelines, it'll make a difference.
00:36:06.720 | Hold firmly in your head your personal residence. You want improvements and you're tracking with the goal of improvements.
00:36:15.720 | Commercial or rental real estate, you want repairs from the perspective of tax planning.
00:36:20.720 | The first thing to do is to segregate your costs to the best degree possible.
00:36:26.720 | Remember, all of this is only going to come in if you are – generally if you're actually audited.
00:36:31.720 | But in an audit, your best strategy is comprehensive, overwhelming, substantiation of every single decision you made in filling out your return.
00:36:42.720 | And that starts with keeping a careful paper trail.
00:36:45.720 | And the little things count.
00:36:47.720 | If you are hiring somebody for a series of repairs and improvements and they're a worker for you, make sure that those bills are segregated.
00:36:56.720 | Make sure that the estimates are different estimates so that you can properly allocate them to the proper accounting framework.
00:37:04.720 | If you are buying supplies to fix up your house or to fix up your rental property, make sure that if you're checking out at Home Depot and you're about to spend $1,000,
00:37:15.720 | make sure that to the best degree possible that you are making different receipts, that you're checking out in different orders.
00:37:26.720 | And on the back of one receipt, you write materials for the repair of blah, blah, blah.
00:37:31.720 | On the other receipt, you write materials for the property improvement project of blah, blah, blah.
00:37:37.720 | Then of course, because you're a good bookkeeper, you would take those receipts home.
00:37:40.720 | Those receipts would be perhaps ideally scanned into your computer.
00:37:45.720 | It would be attached to your accounting software, saved in a file of everything that's related to your house.
00:37:52.720 | The simple non-techie solution to that is you just simply keep a file with all of the paperwork of everything related to the cost of your house.
00:38:01.720 | You have for your personal house and for each rental house.
00:38:04.720 | And you need to take that little heat printed receipt that you got from the home improvement store, copy it on a photocopier so that it becomes ink on paper rather than heat created ink on paper.
00:38:18.720 | And that goes in your file. That way, it won't fade over time.
00:38:22.720 | And then it gets entered into your spreadsheet.
00:38:24.720 | So you want to segregate your repairs from your improvements in any way possible.
00:38:28.720 | That's the starting point.
00:38:30.720 | There are other things that you can do though which would help to substantiate your claims.
00:38:35.720 | Now, we're getting very – I don't expect the majority of people to keep these things straight in their head.
00:38:42.720 | But if you want to be a tax nerd here, here's what you do.
00:38:45.720 | And of course, you document all these things.
00:38:47.720 | If you're trying to get a repair, then you focus on making sure that you're only fixing just a little bit of the problem.
00:38:55.720 | If there's a hole in the wall, you want to make sure that you don't take out the whole wall.
00:38:59.720 | You want to make sure that you just fix the hole and that would be in your best interest in getting something classified as a repair.
00:39:08.720 | On the flip side, if you want an improvement, consider taking out the whole wall.
00:39:13.720 | That's going to make a big difference.
00:39:15.720 | Repairs are going to be involved in fixing damage.
00:39:19.720 | So in a rental property, you want to – if there's damage to the property, you just want to fix it.
00:39:25.720 | However, in a personal property, you might want to go ahead and improve it.
00:39:29.720 | Use the idea of damage, the faucet and the sink broke.
00:39:33.720 | Use that as a time to go ahead and upgrade the kitchen if you've been wanting to upgrade the kitchen.
00:39:38.720 | Don't just fix the damaged cabinets.
00:39:40.720 | Of course, be careful with something like that.
00:39:43.720 | Another classification that has been looked at in IRS tax cases has been what was the initial impetus for the change.
00:39:52.720 | Generally, a repair is something that's going to take place after a specific damaging event whereas an improvement is probably something that was planned in advance.
00:40:01.720 | So on your rental properties, if you want repairs, just do the repairs when there's damage and on your personal residence, plan the improvement in advance.
00:40:10.720 | Schedule it for a time that is appropriate to you.
00:40:14.720 | Even the materials that you use are going to make a difference.
00:40:17.720 | If you're trying to get a repair on your rental property, you want to make sure that you don't come in and swap out all of the cheap entry-level stuff with fancy upgraded fixtures.
00:40:30.720 | You want to just use similar materials, perhaps even less expensive.
00:40:35.720 | That way, you'll get the repair cost.
00:40:37.720 | In your personal residence, if you are facing the need to adjust something and change something, perhaps this would be the time to go ahead and make the upgrades and upgrade the fixtures, etc.
00:40:49.720 | Then, make sure that the amount of the extent of your work is adjusted based upon which you're trying to get to.
00:40:59.720 | Another thing that the IRS has looked at in tax cases for repairs in rental properties has been, "Was the tenant still in the home?"
00:41:08.720 | If the tenant was still in the home and you're just sending a tradesperson in to do some fixes, that will help you in your case of getting repairs.
00:41:14.720 | A good thing to do is just take pictures.
00:41:17.720 | Take those pictures and keep those pictures filed away in your file.
00:41:21.720 | Anytime you do something on your house, you should take pictures, the before and the after.
00:41:26.720 | Document these things in your notes, in your records.
00:41:32.720 | Make sure that you're keeping segregated financial records, having those receipts, things like that.
00:41:37.720 | It could be very much in your best interest to be careful with this along the way.
00:41:43.720 | Let me give you an idea of why.
00:41:46.720 | If you're in a situation like Jonathan was facing, let's say that you live in a house and over time, you're going to spend $100,000 upgrading that house.
00:41:55.720 | If you had a gain of $600,000 because of that $100,000 of expenses versus a gain of $500,000, if you're at a 30% tax rate, there's a $30,000 tax bill right there.
00:42:08.720 | Is it worth it for you to track these expenses that you're making and enter them in your financial record-keeping system?
00:42:16.720 | It can be simple. Just keep a manila folder for the house and any money that's spent on the house gets filed properly in that folder.
00:42:23.720 | It's very much in your best interest.
00:42:26.720 | The tax exclusion where you can exclude either $250,000 or $500,000 of gain from the sale of a primary residence is really, really valuable.
00:42:37.720 | One of the most valuable – it's hard to get completely tax-free income.
00:42:43.720 | That's a good way to get it.
00:42:46.720 | You can use that tax exclusion every two years in the United States.
00:42:53.720 | If you have the ability or the desire to move, change houses frequently, and if you have the ability or knowledge to figure out how to sell your houses when you move for more than you paid for them, this could be a valuable thing for you to consider.
00:43:12.720 | Tax advice doesn't necessarily equate to good financial advice in deciding what to do or what not to do.
00:43:20.720 | You'll have to look at that.
00:43:22.720 | But if you want to put a pool in or if you want to upgrade the kitchen, et cetera, it's possible that may make a difference in your ability to sell your house in the future.
00:43:31.720 | It might be well worth your considering doing and it could make a difference.
00:43:35.720 | All of that stuff is local market-dependent and you have to be careful because it's easy always to take tax advice and flip that over into spending more money than you should.
00:43:46.720 | After all, you should buy a house because you get to deduct it, right?
00:43:50.720 | Most people that do that wind up buying more house than they probably should given their financial situation.
00:43:56.720 | So you've got to factor that in, but hopefully, this tax advice points you in the right direction.
00:44:03.720 | One of the most interesting areas.
00:44:06.720 | Thank you all for listening to today's show.
00:44:08.720 | I'd love for more callers to come on in future shows.
00:44:11.720 | Every now and then, I've opened these up to people on the email list.
00:44:14.720 | So if you don't want to send me any money, then you can sign up for that and I have every now and then open them up.
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00:44:30.720 | Closing announcements.
00:44:32.720 | I don't have any.
00:44:34.720 | I can't think of anything else to say, so I'm just going to go.
00:44:38.720 | [Music]
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