JF2606: Implications of Investing in Stocks vs. Real Estate | Actively Passive Investing Show 64

In today’s episode of the Actively Passive Investing Show, Travis is joined by Karlton Dennis to discuss why it’s so important to find a CPA that specializes in what you do, the implications of investing in the stock market vs. real estate, why he believes depreciation is the key to all tax deductions, and the benefits of being a real estate professional. 

 

 

 

 

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TRANSCRIPTION

Travis Watts: Hey, everybody, and welcome back to the Actively Passive Show. I’m your host, Travis Watts. And if you didn’t tune in to the last episode last week, we are in the midst of doing a three-part miniseries. This is something that Theo and I did back in 2020, when we did How to Vet a Deal, How to Vet a Market, How to Vet an Operator.

What I’m doing now with the show is a quick three-part miniseries on some guests that I had—if you’re not familiar, I host Masters of Multifamily, which is a multifamily webinar series, that’s a monthly episode. And there’s three guests in particular that I really wanted to share with you guys, because I feel like they bring a lot of insight and expertise to the topics on our show here, the Actively Passive Show.

So last week was Jeremy Roll. He’s a full-time passive investor like myself; we talked about multifamily, why we’ve been investors in this asset class and where we kind of see that heading towards the future. It was mostly Jeremy’s input. I was just kind of there as a facilitator.

This episode is with my dear friend, Karlton Dennis. And what we’re talking about are taxes, basically. And what we’re talking about is finding someone who doesn’t just specialize in what it is you do, but someone who can help you proactively plan. I’ve probably said on the show a dozen times, but years ago, I read a book called Tax Free Wealth by Tom Wheelwright. And that book was all about different tax strategies and how the tax code works, and a lot about real estate, and that book single-handedly has saved me tens of thousands of dollars, probably hundreds of thousands.

So finding CPAs, again, that specialize in what you do—I had a specialty CPA firm back when, when I worked in the oil industry. I’ve got one now that specializes in small business, entrepreneurship and real estate investing, and I just can’t stress how important it is.

So again, I’m extracting some highlights from my episode with Karlton Dennis. And it’s not going to be a full run of the episode. I want to keep some of that exclusive to Masters of Multifamily, but I wanted to what’s most relevant to you, here at Best Ever and with the Actively Passive Show. So I hope you guys enjoy. As always, like, comment, subscribe, send me a message if you like this stuff or if you think I should make any kind of tweaks to this. My email is travis@ashcroftcapital.com.

Quick disclaimer that these guests that you’re going to hear from myself, Theo, anybody here on the show – we are not telling you what to do. We are not financial planners, we are not tax advisers, though Karlton Dennis himself is a tax advisor in this case… But please, always seek licensed advice before making any investment decisions.

Without further ado, enjoy the episode.

Travis Watts: I met Karlton at Best Ever Conference 2021. I think we were speaking back to back slots if I remember right, and we’ve had a few conversations since and I thought, “Oh my God. This is a guy with a lot of content, a lot of knowledge,” and I started tuning in to some of your social media channels. I thought, “I’ve got to have you on the show if we’re ever going to kick the series off.”

Karlton, if you could just give the listeners just kind of a quick snapshot of who you are, what you do, and why multifamily real estate is awesome.

Karlton Dennis: Yeah. Well, first off, thank you for having me here, Travis. To the viewers who are watching, I am a tax strategist, probably different than what you’re familiar with. Most taxpayers are used to going into their tax provider’s office during the months of January through April. But as a tax strategist, I’m actually working all year round, because I primarily service a lot of real estate investors and a lot of business owners, and they’re making financial decisions 365 days out of the year.

So I’m a big real estate investor myself; I got into multifamily at a young age. I was blessed enough to have a mother who understood Robert Kiyosaki’s quadrants and she became a tax accountant herself, and so then all of that rubbed off on me. So I’m working as an enrolled agent and helping out real estate investors reduce their tax bill.

Break: [04:26] to [05:59]

Travis Watts: I know you probably hear it all the time, as do I, but so many people enter this space because of the Rich Dad Company and Kiyosaki’s work. So… Very cool.

Karlton Dennis: I love his teachings.

Travis Watts: Yeah, absolutely. Let’s just go ahead and dive in and get started. I’m speaking to investors daily, every week, every month, year-round. A lot of people have been educated in the stock market, to an extent, right? So they understand their 401(k)’s and their IRAs, and they understand investing in stocks, for the most part… But talk to us about the tax differences, or the tax implications rather, of investing in stocks or maybe being paid in interest and things like that, versus investing in multifamily real estate… Kind of what that looks like from a high level.

Karlton Dennis: Yeah. Well, first off, from a high level, I think most people start off investing in stocks in some capacity, because you typically go into a W-2 job, or they have a 401(k) plan and you start to learn about stocks, and that’s pretty much where you first get your feet wet. And then maybe you’ll roll up and start opening up your own brokerage account on one of these apps such as TD Ameritrade, and that’s when you start to get your feet wet.

But when you start to bring in the tax conversation, you have to look at the differences between stocks and real estate. When you’re investing in stocks – yes, you’re getting the favorable long-term capital gains if you’re patient enough to hold on to the stocks for longer than 365 days. But what you’re not getting on the backend is you’re not getting depreciation. So those who have sacrificed and placed their money and parked it into real estate – yes, they are getting the appreciation just like stock investors are. But on the backend is when they decide to sell their real estate, they can 1031 Exchange. When they’re earning passive income, they’re leveraging depreciation to offset the taxes. So they are kind of getting a bit more tax advantages than those that are in the stock market.

Travis Watts: So let’s dig into that a little bit more, because I know a lot of people even ask me, and I’m not a licensed tax professional, about depreciation and cost segregation. These are two terms thrown around. I would argue they’re not widely understood by most passive investors. So talk to us a little bit about that.

Karlton Dennis: Yes. Well, first off, understanding depreciation is the most important thing if you’re trying to save money and get to a place of financial freedom in real estate, because depreciation is the king of all deductions. If you search through the tax codes, you’ll come to find that depreciation has to be the strongest vehicle that the IRS gives you for offsetting your income.

But how it works is – when you decide to place your property into business purpose, which means someone has signed over a lease and they said that they want to rent from you, you now are a business owner. However, you have placed your income into a property that is passive. So the government is going to give you an incentive for the building that you have purchased, and that incentive is called depreciation. The building, if it’s residential, is depreciated over the course of 27.5 years, and if it’s a commercial building in commercial use, the building is depreciated over 39 years.

Now 27.5 years and 39 years sounds like a really long time. And if you’re a savvy real estate investor, you may partner with a tax strategist to perform a cost segregation study on your investment property. A cost segregation study is where you’re performing an allocation of the building and segregating different components into different depreciable lives. The government has given us a five year, seven year, 10 and 15 year depreciable buckets, and if you perform a cost segregation study, you can allocate the building’s use life into different depreciable buckets, causing a bigger loss on the tax return, saving the taxpayer dollars.

Travis Watts: Thank you so much for clarifying that and a little bit on this bonus depreciation. Can you just kind of highlight that a bit?

Karlton Dennis: Yes, bonus depreciation. So bonus depreciation was perfected year after year. I would say Donald Trump was the last person to put his final touches on it. And a part of his Tax Cuts Jobs Act, he stated that “If you place any item into business service that has useful life of 20 years or less, you can write off that item in one year, as opposed to depreciating that item.”

So let me give you an example, Travis. If I decide to go buy a new washer, a new dryer, a new stove or countertop for my apartment or for my rental property, I can now depreciate that item in one year, by leveraging bonus depreciation, as opposed to having to write off that purchase price over the course of five or seven years. So in return, I might be able to get a bigger depreciation right off, use that additional tax savings to get myself into an investment property sooner.

Travis Watts: Well, I appreciate that very much. So let’s move into this next topic, because I get asked about this all the time, with kind of the same disclaimers that I have to throw up, which is these passive losses that we’re all receiving as passive investors in these apartments syndications… So talk to us a little bit about being a real estate professional – what that means, how do you qualify… What are the benefits to being a real estate professional?

Karlton Dennis: Absolutely. And first off, I love the real estate professional status, because it’s one of the ways in which a lot of my real estate investors have gotten to a place of being completely tax-free. However, when you think about real estate professionals, sometimes you might immediately think, “Well, does that mean I need to have a real estate agent’s license?” And actually, it does not. There are qualifications that you need to execute in order to have a status, a checkbox that you mark on your tax return, that allows for you to turn your passive losses into active losses. And when you think about it, if you have active losses now, active losses can offset active income such as W-2 income, Bitcoin income or stock income. And if you have enough passive losses that you’ve turned to active losses, you can end up offsetting 100% of your earned income, putting you in a place where you’d be tax free.

Break: [12:05] to [14:44]

Travis Watts: I see this a lot too in married couples. Maybe a spouse isn’t working, but they work on the real estate portfolio actively where the other has a high W-2. So that seems to be a pretty common way that people qualify and that can be a huge benefit. Would you agree?

Karlton Dennis: Yes. So when it comes to qualifying for the real estate professional status, one of the easiest methods that we’ve seen is having one spouse who is currently not working to be the real estate professional. And part of the reason why is because of the time needed to be spent in real estate. When you try to quantify 750 hours throughout a 365 day period, it comes out to about 13 hours a week. So if we need someone spending 13 hours a week in real estate, but you’re working a 40-hour job – and it’s going to be really hard to justify you being a real estate professional and spending a majority of your time in real estate. So if you happen to have a spouse who may be working part-time or taking care of the children who could qualify as a real estate professional, this is a route in which it makes it easier for both the taxpayers to file a joint return.

When it comes to being a real estate professional, there are two tests that you need to pass; the first test that you need to pass is the 750-hour test, and here’s the reason why. The IRS has deemed 750 hours to be the allotted amount of time to be considered a real estate professional. So the person who is spending time actively managing that real estate property needs to be conducting real estate tasks for 750 hours out of the year.

The second item that we need to make sure that we’re executing is that we are spending more time in that rental property than any other person. If we can justify these two different tests, then we can qualify as a real estate professional, activating our passive losses into active losses.

Travis Watts: Makes a lot of sense. Alright, so let’s talk about the famous 1031 exchange; major benefit, widely used strategy for real estate investors. I believe, don’t quote me, but it’s been in place in the tax code since the ’20s or something. And now we’ve got the Biden administration talking about, is this going to get removed or changed or altered? Don’t know what’s going on. But talk to us a little bit about what a 1031 is, how it works, what the benefits are. And if you want, into the Biden stuff.

Karlton Dennis: Yeah, of course. Well, when it comes to the 1031 exchange, first thing you have to understand is that it’s a tax code, IRC 1031. And this tax code was created as an incentive for rental real estate investors to get into more real estate. As you know, anytime you sell a property, you are going to experience capital gains. And for many real estate investors, they have rental real estate, so they’re claiming depreciation. And anytime you sell an investment property, you have to recapture depreciation, which is taxed at unfavorable tax rates.

So in order to avoid having a huge capital gain, where you’re subject to the long-term capital gains, plus the unfavorable tax rates of depreciation recapture, you can choose to elect to do an IRC 1031 Exchange, where you’ve identified a property of equal or greater value to the current property you’re looking to sell within a 45-day period, and then you close on that transaction in 180 day period.

What this allows for my clients to do or taxpayers to do is it allows for you to sell the asset that you are trying to sell, get into a new asset that’s going to give you more cash flow, without causing a taxable event. And in return, you now have depreciation that you get to take on that new investment property to offset this new cash flow.

Travis Watts: Alright. So with the Biden administration, what’s being talked about? And what impact could that potentially have?

Karlton Dennis: So as you guys know, Biden is directly trying to target business owners and investors, because he’s trying to collect more tax dollars. Now, one of the items that he has proposed is an exclusion tax, which means that if you have a 1031 exchange that you perform, that ends up resulting in less than half a million in gain, then you’re excluded from his capital gain’s tax.

However, if you perform a 1031 exchange, like we’ve discussed, and you have a gain that you’re rolling over into your new property in excess of half a million, there is going to be this unfavorable capital gains tax rate that you could experience.

Now, all of this is a proposal, but what savvy real estate investors are doing is they’re connecting with tax strategist to figure out what things that they should be putting in place right now, or what things that they should be considering right now… Because the 1031 is a great strategy to avoid capital gains tax. However, now Biden is coming in the way of investors being able to utilize that 1031 exchange strategy.

Travis Watts: Certainly an impactful and major change should that occur, but we’ll tune in and see what happens. You can visit Karlton at karltondennis.com.

Karlton Dennis: Thank you so much, Travis.

Travis Watts: Well, there you have it, folks, Karlton Dennis. I hope you found a lot of value out of that episode. As always, feel free to share your comments, like, subscribe to the show here, the Activity Passive Show. Thank you so much for being part of the Best Ever community, showing your support every week here. We’ve got one episode left of the three part miniseries here on the Actively Passive Show that’ll be next week, and we’ll see you then. Have a best ever week, everyone.

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