New Laws and IRS Position Creates Unusual Opportunities
A year ago, I would have told you that you needed to avoid real estate dealer status and that you should always take advantage of the capital gains exclusion for primary residences.
Boy, things have changed. And as commonly happens when law and policy changes rapidly, not all of the loopholes are thought through. In fact, there are a couple of loopholes right now that I’m not sure Congress and the IRS intended. But, nevertheless - there they are.
Loophole #1: Real Estate Professional status being challenged by IRS auditors. I wish you could sit where I am. I’m hearing case after case every single day of IRS audits that are just randomly disallowing real estate losses. In most cases, I’m not sure what the real reason is. Most people say it’s because the REP status was not allowed. But I suspect there could also be underlying issues with Limited Partnerships, Operating Agreements, income allocations, material participation or any of the other dozen or so problems that the IRS auditors are trained to spot.
There is one way out of all of that, though. Become a real estate dealer and have an LLC that elects S Corp status to hold your property. I still urge you to NOT do this if you have a partner, because it’s too hard to unravel an S Corp with a partner. Or if you do it, make sure you have an experienced tax advisor working it through with you.
If you’re a real estate dealer, you have a business and that means you get 100% deductibility NO MATTER WHAT. So, instead of trying so hard to be an investor, it’s actually better to be a dealer these days.
Loophole #2: Now this is an amazing one. Let’s say you bought your primary residence at the right time in one of the really appreciating markets like S Cal. It went up a couple of million dollars and you refinanced to take the money out. Now the property value has gone down and you’re faced with a choice if you want to sell. You could pay money to sell it AND pay tax on the excess cash you had previously taken out OR you could just stop paying and let the bank foreclose. Please note: I”m not recommending this strategy. It’s just interesting that if you did that and if you really had taken $2 mill our of your property, you’d be looking at $300K or more in tax out of pocket. But if you walked away, you’d owe nothing. I know…I know it would still impact your credit for years to come. But isn’t it interesting that this tax law is actually encouraging people to walk away from over leveraged properties?
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Fascinating indeed! #2 almost looks easier than trying to sell in this market.
Interesting story on how this blog post started. Bill (my partner in Diane Kennedy’s Tax Services) and I were having a conversation about how ironic it has become about real estate dealer status. For years, we went out of our way to get OUT of it and now we want people to get IN it. I’m going to write some more on this particular strategy in the future.
On the second one, Richard and I were in the pool a couple of nights ago (in the summer we turn into children of the night, going outdoors when the sun goes down). We were talking about how many people had gotten upside down in their homes, particularly in S California. If they don’t have to sell, it’s okay. But, life events happen and people need to sell. This downturn has been longer than most of us (including me) thought it would be. As time goes on, more people are having to figure out what to do.
The downside of walking, though, is what it does to your credit score. My hairdresser declared bankruptcy and bought a house 2 years later. Of course, that was when credit was easier to get. I don’t know how long it will take for someone to recover if they walk from a house in today’s market.
Yeah. However, in the multi-million dollar home example, maybe the seller/forclosee doesn’t need good-looking credit. He’ll just go out and pay cash for his next house.
Good point luckystar.
Bankruptcy is more of a stigma for the hard-working middle class. The very rich and corporations have used bankruptcy to their favor many times. I remember when K-Mart declared bankruptcy to get out of some bad store leases. One of Donald Trump’s companies went bankrupt.
In our local area, a investment banker who held a lot of big-time developer’s monies recently committed suicide. It’s not completely clear if there was malfeasance or just a lot of chaos because he’s gone. But, developers who had problems before have LOTS of problems now. In one example, a developer had $120 million with this banker and he now has to pay for completion of a development. Everything is all tied up in the mess at the investment banker’s. It’s possible that he might have to leave a lot of people hanging, but I can guarantee it won’t mean he loses his private jet.
There’s a moral dilemma wrapped up in this as well as a lesson in having financial control, I think. The person who has a business has a good opportunity to create cash and recover quickly from a loss. Maybe walking is the best thing that ever happened to them financially.
Interesting conversation.