In this episode, Millionacres Editor, Deidre Woollard talks with Tom Castelli, CPA of The Real Estate CPA. They discuss the tax advantages of real estate investing and what investors need to keep in mind as they plan their tax strategies.
Thomas Castelli, CPA is a tax strategist and real estate investor who helps other real estate investors keep more of their hard-earned dollars in their pockets, and out of the government’s. He holds equity positions in several multifamily properties and participated in the syndication of an 82 unit apartment complex as a general partner. His real-life real estate investing experience, combined with his ever-growing arsenal of hard-hitting tax strategies, allows him to see eye-to-eye with clients in ways an average CPA never could.
Deidre Woollard: Hello, I'm Deidre Woollard an editor at Millionacres. Thank you so much for tuning into the Millionacres podcast. Today, we're going to delve into a subject that I think a lot of investors tend to dread, which is taxes. Fear of taxes and fear of difficulty. Preparing taxes is something that can stop some real estate investors and their tracks and even stop them from wanting to invest in real estate. I feel it's really important to push beyond that and go from dreading taxes to being strategic about them and seeing the opportunity in them. Before we get started, just a reminder, nothing in this podcast constitutes individual tax advice. Always consult your tax advisor for details on how to handle your specific situation. My guest today is someone who has made it his mission to help real estate investors understand taxes. Tom Castelli is a CPA, tax strategist and real estate investor himself, who helps other real estate investors keep more of their hard earned dollars in their pockets and out of the government. He holds equity positions in several multi-family properties. He participated in the syndication of an 82 unit apartment complex as a general partner. His real-life real estate investing experience really helps him help his clients. Thank you for joining me today. I know you're about to head into the busiest season. Are you finding any different concerns this year than previous years?
Thomas Castelli: Going into 2021, surprisingly, no. We had a lot of crazy things in 2020 happen when a lot of crazy questions, but going into 2021, it's still maybe the eviction moratoriums. People are a little concerned about that from an investment perspective. There's some people who think the market is at the peak still. People were thinking that for years and they are a little concerned about the real estate investment market because interest rates are so low and the market is getting pushed up, the value of real estate, is that going to continue or is there going to be some fall out at some point as a result of the eviction moratoriums and all these delayed forbearance on the loans? But that's all speculation, and many people are just pursuing or moving forward and just going to roll with the punches, I guess.
Deidre Woollard: Is there an additional complexity this year? You mentioned the eviction moratoriums. I know there's also investors who may have had the PPP loans or specific losses due to COVID-19. Is there any of that people need to think about as they start preparing their taxes this year?
Thomas Castelli: For my experience, I work a lot with real estate investors, that's their full-time career. A lot of them weren't eligible for the PPP loans, some of them were able to squeeze in an EBIL loan. But specifically for the PPP loans, something that people want to be aware of if you received one is that, in the original legislation or somewhere leading up to the most recent bill we've seen in December, the expenses you paid with the PPP dollars were not going to be tax-deductible. In other words, that PPP income would become taxable to you, basically taxable income. But the new regulations or the new bill stated that the expenses you paid with the PPP loan are indeed tax deductible, which is very nice. But outside of that, I haven't had many interesting stories regarding that situation. It's just people had to lay off some workers. People had to take advantage of the PPP loans to keep their businesses going. But in terms of interesting story, none really come to mind, unfortunately.
Deidre Woollard: Do you think that we're going to have another delay in tax filings because I know last year there was that delay? Do you think we're going to have an April 15th deadline? Do you feel like there might be an extension this year?
Thomas Castelli: From everything I gathered, I took a look into it before hopping on a podcast here. As far as I can tell, no, everything is business as usual. This year, April 15th will be the individual deadline with 10-15 being the extension deadline. With entities March 15th being the deadline with the extension deadline being 9-15, which is business as usual. I believe barring any major catastrophes that may happen within the next few months, I don't foresee that changing again like last year.
Deidre Woollard: Interesting. Has there been any other guidance from the government about any other changes coming out this year?
Thomas Castelli: One-big change at the end of the bill, and I think we'll probably get into the bill a little bit later. But going forward in 2021, business meals are 100 percent tax deductible, whereas they were originally only 50 percent for many years. That's the biggest thing we took away from the latest bill, the bill that was push through towards very late year-end in 2020. But as far as whereas not really much relief that the IRS is going to be providing in 2021 specifically.
Deidre Woollard: I wonder if that will change with the new administration and we may see something that will impact 2022.
Thomas Castelli: Have the Democrats ultimately control the Senate is going to make passing tax legislation, I want to say easy, but it's going to make it a clear path within the past tax legislation underneath the Biden administration. We might see some things I would imagine 2022, like you said, just because it's going to take some time to put together the bill, finalize it, push it through Congress and all that, and then ultimately I would imagine anything that's going to go into effect would go into effect in 2022. That's generally how it happens, but who knows. It's a COVID-19's crazy times where we're living in right now. Who knows what will happen?
Deidre Woollard: Yes, exactly. I wanted to start by talking about the K-1 because I think that's one of the biggest hurdles for real estate investors. Can you explain what a K-1 is and when an investor will receive one?
Thomas Castelli: When you invest in a private placement, real estate investment generally it's going to be in the form of a partnership. Partnerships don't pay taxes at the partnership level. They will file the partnership tax returns called the Form 1065, that is typically due on March 15th or 3-15 unless you extend and then you have until 9-15 to file. Now what happens is when that return is filed, each individual partner receives a K-1. That K-1 reports that partner share of income, losses, deductions, credits, etc. the rest of the activities of the partnership and then that K-1 gets reported on the individual tax return, the Form 1040, and they pay taxes according to their individual situation. Generally as an investor, you should expect this. Depending on the sponsor who you're investing with or the investment company, you're going to typically see those right around March 15th. Some of them will get them to you, other ones will move past, extend the return and get them to you later. Ultimately, that will need to be filed with your tax return. It's just a matter of communicating with your sponsor or having them communicate with you as to when you can expect that K-1.
Deidre Woollard: I feel like that is something that I've heard people really complain about. A lot of people say, "What am I supposed to do? I can't file my taxes? Do I have to file an extension?" Would you say that most people who are getting a K-1 have to file an extension usually because sponsors tend to miss that deadline?
Thomas Castelli: The short answer to that question is yes, I can speak for my clients experience, I can speak for my own experience, there has been multiple years. I've been investing in private placements since 2015 now, and I've had extend my tax return almost every year. It's just part of the game. Now what you can do is you can file your return and go back and amend it, but generally that's not preferred. The preferred way to do it would be to extend your return and report the K-1 once it's received and just file it like that.
Deidre Woollard: Do any of the K-1 providers ever miss that extension deadline entirely? If there isn't a K-1 or it never shows up, is there something else that an investor can do?
Thomas Castelli: Yes, it's definitely been missed before and we've seen it missed. At that point, we would generally recommend you file your tax return and then going back and amending it later once you've received the K-1 so that you're not missing your individual filing deadline, which is 10-15 or October 15th generally, that's what we would usually recommend. As for if one never comes, that means there's a problem with the partnership, and you might be at risk for losing your entire investment. At that point, you should definitely seek the advice of not only a tax professional but an attorney because there could be some remedies for you getting that back. But I don't want to go into it here. The process is a little bit complicated, but it is possible. It's doesn't take your attorney likely working together with your CPA or tax professional to sort it all out. That happens in very, very rare cases in my experience at least.
Deidre Woollard: Are there any disadvantages to filing an extension versus filing at the traditional deadline?
Thomas Castelli: The biggest disadvantage is that your tax is going to be due at the deadline, not the extension deadline, but the original deadline, traditionally April 15th. If you don't file your taxes, you might not know what your tax liability is. You'll either be estimating your tax liability at that point and making a payment to the IRS, and hopes that it covers whatever your ultimate tax liability is, when your returns finally finalized and filed. But other than that, there's no major disadvantage of extending outside of that.
Deidre Woollard: In terms of that process, do you recommend that someone meet with their tax professional as if they were going to file at the usual April 15th deadline so they're all prepared and then just file for the extensions, so they have a sense of what they are getting versus waiting for that extension time and then doing it closer to that.
Thomas Castelli: I would recommend engaging a CPA or tax preparer as soon as possible at this point in the year, they do tend to fill up and oftentimes CPAs will work on first-in, first-out. You definitely want to get on their calendars, get on their schedules, and get on their radar sooner rather than later, I would not recommend waiting until mid-year to do that. From experience being a CPA, it can get messy quickly the longer you wait. You definitely want to be proactive, build a relationship with a CPA or tax advisor if you don't already have one now and get on the list of prepared return even if you have to extend it.
Deidre Woollard: Excellent. So in terms of getting K-1s, some people are investing in other states, so they may be getting K-1s from different states. I've heard that some investors are afraid of investing in different states because of those tax concerns. Can you explain what it's like to invest in multiple states and maybe why investors shouldn't be quite so worried about it?
Thomas Castelli: Your state of residency, assuming your state has state income tax, which most states do, there's a handful that don't. But you're going to pay tax on your global income are in your state of residents. Whatever your income is, is subject to your state of residence tax. What happens is though when you own rental property out-of-state, you have to pay tax on that rental property in that state. What happens is that what generally lead to double taxation however, what states do to get around that, is your state of residents will generally give you a credit under your state tax return for the taxes you paid to a different state. So then you're only paying tax in one state and that's generally how it works. Some states they have do it the other way around. Then in some states have reciprocal agreements, treaties whereas if you pay tax in the reciprocal state, you don't have to get the credit. That's the agreement they have, you pay tax on that one state, you don't have to pay tax to the other. You can look that up online or you could find new price. Speak to your tax advisor if how that's going to part of your specific investments. But the end of the day, you're usually not going to have to pay tax in two different states. That's usually what were most people were concerned about and that's not usually how it works. I guess the biggest hurdle or the biggest hassle, "of having investments in different states" is that often you have to file a state tax return for that state. So if you're investing in multiple private placements across various states, I've seen people having to file state tax returns in ten states because they have investments across different states. That's the biggest hurdle. I think when investing out-of-state, but most tax software and most tax professionals should be able to handle that relatively easily.
Deidre Woollard: That would potentially also increase the amount of your bill with your CPA if they have to file taxes in different states, right?
Thomas Castelli: Yes. Some states have like thresholds, that standard deduction for that state where you don't have to file if you're under it. So we'll try to take advantage of that when possible, to not have to file on behalf of our clients. Other times you do want to file a state tax return because you have losses on your investments. Those losses could be used later on to offset, potentially any gains you have down the line on those investments. It depends on whether or not you do actually want to file that state tax return, I'd say by default, do you want to, if I had to give a general answer. The last thing I will say on state tax returns is some sponsors, they will file a composite tax return in that state, not all states offer this. I know like a state like South Carolina does, for example, where they'll file a composite tax return for the entire partnership with that state so that the partners don't have to deal with file for that state. But the downside of that is, generally when you file composite tax return, you're paying taxes at the highest state tax rates, which may or may not be favorable to you, but certainly makes your life easier.
Deidre Woollard: I think that's an important point that you just made about filing the state taxes even when you have a loss. I think a lot of people think if you're having a loss, maybe you don't need to do that. But you made a really important point there that if you have those losses, those losses can then be used later to offset your gains and then limit your tax liability to some extent.
Thomas Castelli: Yes, absolutely.
Deidre Woollard: One question I think that a lot of us think about is when we're preparing for that visit with the tax professional, what do we need to have ready? What should that process look like on our end? How can we best position ourselves for the future so that's not that year-end scramble that so many of us seem to go through.
Thomas Castelli: It's a good question and I wouldn't be CPA if I didn't say this at least once through this interview and that is, it all depends on your personal situation. Most tax professionals that you work with should be able to provide you a list of everything that you'll need to provide them. However, you would do want to start gathering things as soon as you can. For mogul members, I would imagine K-1s should be the top of your list for the private placements you're investing in. But depending on your business or job, you're going to want to provide them the W-2, if you have a job. If you're self employed, you may need to provide them 1099-MISC. You might need to provide them K-1s for any partnerships that you have that are not real estate-related, they're usually going to request any information on a home office, if you have one. If you have a business, you're going to need your income statement, balance sheet, basically your financials. For retirement accounts, you might need a 1099-R which reports any distributions or journals from retirement accounts or other rollovers. If you have social security, you might need to provide your SSA 1099, which is social security benefits. I could go down the list all day, 1099-DIVs for any dividend as you might receive, 1099-INT for any interest income, 1098s for any mortgages you may have that you paid interest on. I could keep going. For health care you might need to provide them at 1095-A or 1095-B or report your health care for certain credits. You might need that 1098-Es for student loans, 1098-Ts for tuition, childcare expenses. Your CPA should really sit down with you, ask you questions about your situation, what you do for a living, what investments you're doing. Do you have any businesses? Do you have any children? Then that should help them determine what documentation, what information they need to request from you to do their job and file your tax return.
Deidre Woollard: That is a lot. I think that's a really good example of why you actually need to talk to someone and not try to do it yourself always, especially if you're a real estate investor because it's not necessarily just about what you pay, but it's also about how many different credits you can get and just listening to some of the forms that you rattled off there, you can tell that there's all of these different things that people may be missing out on or may not be aware that they can actually deduct or get credits from. I think all of that is really vital, paying a CPA pays off in the long run.
Thomas Castelli: If you guys like, I have a link to a blog article that we have that has that full list that I had just mentioned. But again, you're going to want to speak to your CPA, make sure that they're giving you a list of what they need for sure.
Deidre Woollard: 've been hearing about some potential changes to the 1031 exchange programs. 1031 exchanges, of course, are a way that real estate investors can avoid paying capital gains as they get what's called a replacement property. I know 1031 exchanges are huge tax benefit for real estate investors, especially for those who are trying to keep laddering up into bigger and more valuable properties. Can you explain a little bit about what a 1031 exchange is and what the potential changes that are being discussed are?
Thomas Castelli: Yeah, absolutely. A 1031 exchange high level is basically what it allows you to do is it allows you to sell a property that presumably has appreciated over a period of time. You can use the entire sales proceeds to buy another property and you could defer the gain so you don't pay tax on the capital gain. If I were to give just a high level quick example off the top of my head. Let's say that you bought a property for $100,000, and now it appreciates to $400,000 over 10 years. Let's just say you have a $300,000 capital gain. It's a little bit more complicated than that, but you have a $300,000 capital gain, and you would have to pay tax on that $300,000 capital gain. Let's just say you're paying tax at a 15 percent tax rate on that $300,000 capital gain. Well, now you just lost $45,000 potential buying power. If you divide that by the loan to value ratio potentially on a property you can buy, which is usually a four times multiple. If you get it at a 75 percent loan to value, you just lost $180,000 in purchasing power because you had to pay taxes. The 1031 exchange has been a really good tool for investors to continually trade up they call it to new bigger and better apartment buildings, office buildings, single-family homes, whatever, and just continue to kick that down the road. You can continue to use 1031 exchanges over and over and over again essentially, in theory until you die, and never pay taxes. The challenge is if you're a limited partner in a private placement, for example, you're going to need to have your sponsor or the investment company you work with execute that exchange. Because the same entity or the same individual who basically sold the original property needs to be the same individual entity buying the new property. That's where the challenge comes in. You can't go in 1031 exchange. Your individual interest in the partnership, the entire partnership is a 1031 exchange. You don't see that too often. It does happen, but you don't see it too often in the private placement space. You see this with privately-held partner. Small partnerships or individual landlords, they'll take advantage of this. Now, as for the changes, I'm going to be candid, I am not 100 percent up to date on the changes. I know there's been changes discussed. They've even considered removing it completely multiple times in the past, including I think this most in the Biden plan. But the reality is it's never really made it through to changing it. The problem is because, this is from my understanding of it, not only does 1031 exchange has helped real estate investors and drive the economy and basically build business and things because of the advantages of the 1031 exchange, but the 1031 exchange industry in and of itself is pretty substantial. Again, based on my understanding, and by eliminating that, you would be eliminating a lot of jobs. Also, the more I think about if you eliminate 1031 exchange, you're going to really halt transactions or you're going to really dampen the amount of transactions taking place in the marketplace because investors don't want to sell and recognize big capital gains. They'll just hold their property potentially and just not sell and now people aren't buying. If there isn't much transactions, there's not as much demand and that could potentially stall or reduce prices. By the way, it's already been reduced so much. You used to be able to 1031 exchange almost any capital asset, so a car, antiques, all this different stuff, equipment. The Tax Cuts and Jobs Act 2017 passed under Donald Trump's administration, that ended up reducing the 1031 exchange to only real property, to only real estate. They already hamstringed it down to a very small section of the tax code. Now it only applies to real property, real estate. I would personally be shocked if it actually was removed. If it was removed, I think it would have a pretty big impact on the economy.
Deidre Woollard: You made a really good point about jobs. There's all of the qualified intermediaries and I think that doing anything that slows real estate transactions right now probably isn't a good idea. Which brings me to another program that's relatively new, which is of course Opportunities Zones. We've seen that stop and start in terms of how many people have been invested and taking advantage of it. I know in 2020 they extended the capital gains deadline. There may be more changes coming with that one. Are you getting a lot of questions in your practice right now, about Opportunity Zones and about that program in specific?
Thomas Castelli: We've been getting Opportunity Zone questions from the time they were announced. The biggest challenge with the Opportunities Zone is that they really rushed that bill out, the 2017 Bill, and because of that, there is a lot of guidance that was lacking. There was three sets, I think, or two sets of proposed regulations. Then final regulations came out a year-and-a-half or so after it was released. People are still catching up to those. Then you had the Cares Act which extended the deadline basically to your point. If your 180th day to defer your gains fell between April 2020 to the end of December 2020, you had that entire period to invest. But outside of that, I've heard Whispers of potential changes to it coming, but I have not had anything concrete. At this point, what I can say about Opportunities Zones is that on the investor side, if you're going to defer your gains, it's certainly a lot easier to do than if you're actually going to operate an Opportunity Zone, I've seen a lot of mom-and-pop investors, if you will, try to execute the Opportunity Zone strategy and the compliance that you need to actually do it is usually quite expensive to actually the legal and accounting fees that you're going to face. Good news is we see the bigger shops do this really successfully because that's what they do. I think that's really what the Opportunities Zone program was geared towards. Like the investment companies the sponsors that you deal with on Crowdstreet and you'll see through the Millionacres program. But bottom line is mom-and-pop, it's if you're a small investor are really hard to actually operate in Opportunities Zone Fund. But if you are an investor and you have capital gains to differ, if you're investing with a quality sponsor, you should be in good hands and there's not that much you should have to worry about. Because all the regulations usually say in the regulations, if you rely on this regulation and you follow consistently, then you can go back and say we did it based on these regulations at the time and you'll be in good shape. If that makes any sense there.
Deidre Woollard: No, it does make sense. I think part of the reason for investing in a larger fund versus trying to do it on your own too is some of those rules around what constitutes an improvement and what constitutes an improvement to the business, there's a lot of rules inside the Opportunities Zone legislation about what actually qualifies. I think that is a really good reason to want to work with someone who's doing a lot of this and isn't just trying to wing it on their own.
Thomas Castelli: Absolutely. I think you should do that in all of your investments. If you're going to invest with third-party, you should really be setting yourself up with a group that really has their operations built out. I've been on the mobile platform before and I've seen the investments you have and all of them are phenomenon. I'm like oh, I should invest in some of these. But anyway, you want to always be investing with quality sponsors, whether it's an Opportunities Zone or General Private Placement. In my experience, you want to be doing that. If you're not doing that, you want to understand the risks that you are taking by maybe investing with someone who doesn't have their company fully built out or is a little bit newer to the game of real estate.
Deidre Woollard: Good point. You mentioned earlier a little bit about the most recent Stimulus Bill. I know it also has some disaster tax relief in there. Is there anything else that people need to know about that Stimulus Bill and what are you thinking about potentially another Stimulus Bill coming down the road in a couple of months?
Thomas Castelli: Yeah. This latest bill, the Cares Act 2 they're calling it, that Bill not really much came through, again, on the tax side. We've really dug through it and there's very little amount of things have changed. There's a lot of stuff passed in that Bill. Not much of it was tax-related. The biggest thing I think we've taken away for most people would be that 100 percent. I know I've said that a lot, it's not even that big of a deal, but 100 percent business meal deduction to try and stimulate the restaurant industry, at least that's what we believe it's for. As for the Cares Act original bill, that one had a lot of big tax things. One of the major one being qualified improvement properties, basically the work done to an interior of a commercial property like a retail or an office. That was mistakenly under the tax cuts and jobs that are considered 39-year property and depreciated over 39 years. But it really should've been 15-year property and eligible for 100 percent bonus depreciation that you could just depreciate all in the first year. The Cares Act 1 Bill originally fixed that and they made it retroactive, I believe all the way back to when the bill was originally passed. That was a big thing for commercial investors. There's also another big thing in that original Cares Act Bill, net operating loss carry backs. Long story short if you had a net operating loss, which means that your entire business basically wiped out your total taxable income for the year and you have a total tax loss. You were originally, before the Tax Cuts and Jobs Act in 2017, allowed to carry that back five years and then forward up to 20 the 2017 Tax Cuts and Jobs Act said you can no longer carry back you can only carry it forward, you can carry it forward indefinitely. What the Cares Act did is they said, okay, for 2018, '19 and '20, you can carry that back. If you have NOL you can carry it back five years. A lot of real estate investors who were active, and I mean you qualifies as a real estate professional. To qualify as real estate professional, long story short, you basically have to work in real estate almost full time. A lot of investors in droves took advantage of 100 percent bonus depreciation combined with these NOL carrybacks to really drive their income to below zero in those years and carry that NOL back and get refunds from taxes paid on prior years. I think those two things I just mentioned were the biggest changes specifically for real estate investors in the entire Cares Act legislation both one and two.
Deidre Woollard: Excellent. Thank you. I know that some of our listeners are going to be filing taxes with real estate investment trust for the first time. We've got a lot of real estate winners numbers that are also listeners of this broadcast. Are there anything that REIT investors need to know with REIT versus traditional stockholdings?
Thomas Castelli: For the most part, REIT are similar to stocks, especially if you're investing in our retirement account. There's generally not much else you have to worry about. However, there are some nuances though, when you are investing in taxable brokerage accounts, for example. REIT dividends can consist of three different types of income, three different sources. It could be ordinary income from the operations of the REIT. Ordinary income will be taxed at your ordinary income rates up to 37 percent. Capital gains, which could be taxed at 15 percent or 20 percent capital gains rates, or if it's short-term, capital gains will be taxed at your ordinary income rates or it can also be a return of capital. A return of capital is generally not going be taxable because they're just returning the money you invested. Based on the individual REIT your investing in you can have different portions of those dividends bucketed into those different buckets, if you will. Then there's one more thing with REIT which is nice, and you may be eligible to get the 20 percent pass-through deduction on a portion of your REIT dividends. Generally it's going to be the ordinary income portion. That's something that's nice little deduction for people who invest in rates and taxable accounts. But from a reporting perspective, they actually get down to the brass tax of getting on your tax return, to generally going to be reported on a 1099-DIV. You can either provide that to your tax preparer or report that in the tax preparation software you're using and that's usually easiest keying in some numbers, or depending on the software you're using they might be able to pull it directly from the brokerage. It just plop into the software using their automations. But that's the high level summary of REIT taxations from an investor's perspective.
Deidre Woollard: Are there ever any delays with REITs reporting? Is it a situation similar to the K-1s where sometimes they're a little late, or do they tend to be a little more timely?
Thomas Castelli: In my experience, they tend to be a little bit more timely. Usually, when you get to the level of REIT, you have a little bit more of a professional organization around you, or at least you should. You want to get those out, the 1099-DIVs out in time. That's just my experience. I know there could be some small private REITs out there that might not get it to you on time, but generally speaking, especially with public REITs, they're going to get it to you on time.
Deidre Woollard: As we wrap up, I wanted to get some advice from you on how people can best set themselves up not for last year's taxes because that's already over, but in terms of we've got brand new year. How can people be better prepared for taxes all year long? How should they keep their record? Should they have them online? Should they have them in paper? What's the best way to keep track throughout the year so that you don't end up with that end-of-year panic situation?
Thomas Castelli: Tax return in our view is just a report card of the previous year's activities. Basically, it reports the income or the losses of the various things you did throughout the year. While there's a few things you can do after the year ends to reduce your taxes, it's generally going to be the things that you do, the actions that you take, the strategies that you implement throughout the year, and sometimes even years in advance that are going to impact the results of your tax return. What I would generally suggest is that you have a conversation with your CPA, financial advisor, tax attorney, whoever access your financial, your tax advisor regarding your current situation and where you stand today in 2021. Obviously it's January 2021 now. Speak to them about that and what your goals and plans are for 2021. Then work on a plan with them to implement strategies that can minimize your tax liability or to seek advice what little things can you do to make sure you're putting yourself in a good position when that tax return finally is filed at this point in 2022. One thing I will say is that if you're in any private placements that might be being sold this year or any type of real estate investments really that are being sold this year outside of maybe REITs, you want to speak to your CPA about what you can do to mitigate that, and I'll give you a quick strategy you could use. When you sell private placements, you're going to have hopefully a capital gain, hopefully the investment went well, and you can use passive losses that you may have had from that investment or other real estate investments, other private placements or direct real estate investments that are generally going to be unlocked and offset that capital gain when you sell that investment. The good news is, you could find out on Form 8582, how much passive losses you have right now on your 2019 return and what you're going to have on your 2020 return once that's filed. You could say do I have enough passive losses to offset this potential gain that I might get? If the answer is no, and there's a significant gap, what you could do is invest either in a direct real estate investment that you buy yourself, or invest with another sponsor, another private placement. If they do a cross irrigation study and they generate losses on that property, those losses that you receive, you'll receive that on your K-1 for 2021. That K-1 on 2021 will be reporting your return and you can use those losses as well to offset your capital gain. I'd say that's a strategy that most people I would imagine who are doing private placements want to look in to take advantage of.
Deidre Woollard: That's probably easier to get than trying to find an Opportunity Zone fund to put us capital gains in?
Thomas Castelli: Yes, you could definitely Opportunity Zone. I'm sorry I didn't mention that. You could use that or you can use that strategy. It's really what's open to you. I guess it really depends on what your objectives are. With the qualified Opportunity Zone, you're deferring taxes. You're deferring the tax you have to ultimately pay in 2026, or if you sell the investments sooner, and then the gains on that qualified Opportunity Zone investment itself. Say you invest $100,000 of deferred gains, hold it for 10 years or more, and it appreciates to $500,000, now you've got $400,000 of capital gains will generally be wiped out. Qualified Opportunity Zones are definitely consideration. The strategy I just mentioned with the passive losses, that's completely wiping out your gain on that specific investment and you no longer have to worry about that specific gain. I think both options are very viable, I think it just depends on what your long-term goals are and what investment opportunities are available to you at any given time, and you have to make the best decision based on those factors.
Deidre Woollard: Fantastic. Thank you. Do you have time for two quick listener questions that I have?
Thomas Castelli: Absolutely.
Deidre Woollard: Cool. First one is from Deb and she purchased her home in 1996. She refinanced it a couple of times, and she asks with a 27.5 year depreciation coming to an end, should she focus on paying off a mortgage, saving to pay more in taxes, or should she sell or move to restart the depreciation deduction?
Thomas Castelli: First thing you could do, do you want to look at your return equity on the investment? Are you still earning an acceptable rate of return on that investment? After tax is probably you want to answer that question. If not, then you want to move to sell it. You either do a 1031 exchange while you still can assuming they actually try to remove it, or you're going to want to try to utilize another exit strategy to minimize your taxes. The other thing you could do is if you want to keep the investment property, say it's a good investment, you could buy another investment property or you might even have investment properties, and you can use the losses or force the losses throughout your cost segregation study on those properties to then mitigate the taxes that you could potentially pay on the income from that property because the depreciation expense is no longer there.
Deidre Woollard: Can you explain just quickly what a cost segregation study is?
Thomas Castelli: When you buy a property, there's going to be two components. It's going to be the building, and it's going to be the land. The land never depreciates, but the building does. Generally residential property 27 and a half years years and for commercial property 39 years. When you buy the building, there's more than just the building. You have the structural components, you have the furniture, you have the equipment, you have the cabinets, you have appliances, all these various things, and the landscaping for example. What a cost segregation study does is someone traditionally comes down to your property, an engineer, basically inspect your property is basically what happened, surveys it. Go back to their headquarters, wherever they go and they do their analysis, and they say, well, this 20 percent of your property is going to be allocated to five year property, tangible personal property. Things like an appliance would be a good example of that. Then some of it might be allocated to land improvements, which is 15 year property and land improvements, things like landscaping, maybe underground sprinklers, pools, things of that nature. Basically, those two items, five and 15 year property can be depreciated all in the first year thanks to 100 percent bonus depreciation. That's what a cost segregation study does. It basically takes the components of your building and breaks it down to their different class lives. Depending on the asset you're dealing with, multi-family, for example, usually anywhere between 20-30 percent of the asset's purchase price could be reallocated into these five and 15 year buckets. If you were buying a million dollar property, you're getting somewhere between a 200 and $300,000 deduction on that first year if you use a cost segregation study.
Deidre Woollard: Awesome. Thank you. One last question. This one comes from Gustavo and he says, "I withdrew $25,000 from an IRA. As I figured, I have three years to put the money back in the account without any penalties. My intention is to invest that money in my brokerage account because it offers better opportunities in my IRA. Question is, if I hold on to those funds for three years and they grow inside the brokerage account, and then I transfer the $25,000 back to the IRA, do I have to claim anything on taxes?"
Thomas Castelli: If you put the $25,000 back in, I think it's by the end of 2022. I think that's the year. Whenever the three-year period is, it might be 2023. I'm sorry, don't quote me on that one. At the end of three years, as long as the money is back in the account, you're not paying taxes on the IRA investment. The way it works is you have to go back as it is today, and they might add another way to do it, but you have to go back and amend those two prior year returns to get the refund for the taxes you did pay on that IRA. Now, if you have to sell stocks to get that $25,000 back out, you might have capital gains. You might, depending on how those investments performed. But that's going to be taxable on your taxable accounts, not going to necessarily deal with IRA if that makes sense.
Deidre Woollard: Yeah, that makes sense. The original $25,000 goes back to the IRA, and then anything that's leftover that is then cashed out would be taxable. Is that right?
Thomas Castelli: Yeah. If you put the $25,000 in, it appreciated to $100,000 over the three year period, and now you sold, you had to sell a portion of it. Some of that potentially could be subject to capital gains tax when that investment is sold.
Deidre Woollard: That makes sense. Well, this was great. Thank you so much for your time today. Just a reminder for listeners, you can find out more about the work that Tom Castelli does at therealestatecpa.com. They put together some great classes on how investors should handle taxes and talk to their tax professionals and they are really worth checking out.
Thomas Castelli: Thank you for having me on here. It was an honor.
Deidre Woollard: Thank you. Stay well and stay invested.