Earning more income usually means paying more taxes. But, with the right tax strategy you can earn more and pay less. How? Ryan Bakke is here to share how you can get some of these tax savings by investing in short-term rentals. Ryan is a real estate CPA and investor helping REIs boost their ROI using the tax code. In this episode, he joins Sam Wilson to divulge the secret to keeping more of your hard-earned money while making more money through investing in this type of real estate. Learn all about how you can pay less in taxes as you earn more by tuning in to this episode!
—
Watch the episode here:
Listen to the podcast here:
How To Incur Tax Savings Through Short-Term Rentals With Ryan Bakke
Everyone knows the saying, “There are only two things certain in life, death and taxes,” but according to Ryan Bakke, what if the only thing that’s certain is death? Ryan Bakke is a CPA and an investor. He helps people boost their NOI and their ROI using the Tax Code. He bought his first investment property at age 23 and he will teach you how to make money with real estate while avoiding taxes. He has a background in Accounting and Finance and has worked in big four consulting. Ryan, welcome to the show.
Thanks, Sam.
There are three questions I ask everyone who comes on. Can you quickly tell us where’d you start, where are you now and how did you get there?
I went to school for Accounting and Finance at a local Christian school. I learned to run numbers, profit and loss statements and balance sheets. I learned how to run and analyze numbers. I’m a first-generation accountant in my family but I learned so much throughout school and it wasn’t until my junior or senior year of college that I found the love for real estate. I was working at a small CPA firm by the school and I had done this tax return.
There was a married couple that made about $200,000 and they had about $30,000 tax bill. I did a tax return for a single guy who had about $400,000 in cashflow real estate. He was single. He made double the amount of money that the married couple that made. He paid less in taxes than the married couple who made half as much as he did. Even though he was in a higher tax bracket and made twice as much money, he still paid less in taxes.
I had asked my boss at the time and he was a CPA himself. I go, “How is this possible? How does this work?” His simple answer was, “It’s because he invested in real estate.” That was that shocking moment of, “I need to know everything there is to know about this particular concept.” I need to know it quickly because I want to be able to help other people achieve that goal and also want to scale up my own portfolio. Ever since then, it’s been game on and trying to figure out ways that real estate investors can save money on taxes. I’ve been guiding and advising people through it. I walked the walk and I bought my first rental property and I’m looking at short-term rental properties. That’s what I have on now.
I’d love to love to stay on the tax side of this equation of our conversation because this is where you’re going to shed some value to our readers. That’s the exciting part of this conversation. Walk us through how did the guy that made $400,000 use depreciation? What were his strategies for reducing his tax liability?
Real estate professional status allows you to use your rental losses that you generate from your rental properties, to offset that ordinary income from your day job or your business income.
First, you got to start off and note the basics of the income. By definition, there are two types of income. You have earned income, which is income that you make working at a day job. Maybe you’re 1099 or you’re an independent contractor and have earned income. That’s also going to include stock gains and capital gains that are all lumped in that ordinary bucket. You have an ordinary income. The other bucket is passive income. There are two types of passive income. By default, all rental real estate income is passive.
Number two, any activity in which you do not participate is also passive. I invest in my friend’s hair salon business. I give $10,000 a year. I’m hands-off. I’m a passive investor in that business, which means that’s passive income to me. It doesn’t have to be just real estate but it could be you being a passive investor. The biggest difference between those two is passive income is not subject to Social Security and Medicare taxes the same way your ordinary income is. If you look at your W-2 pay stub now, you’ll see two items. You’ll see one that says Social Security Tax and one that says Medicare Tax.
The Social Security Tax is 6.2% of your wages up to what’s known as the FICA wage base, which for 2021 is $142,800. Every single year, it gets indexed for inflation a little bit. Social Security and Medicare Tax exists for W-2 employees. If you’re self-employed, a real estate agent or out there flipping, you know that you pay 15.3% in that FICA Tax. That’s a big difference there right away and that’s what I call the working man tax because it’s called FICA Tax. Passive income through real estate doesn’t have that. There’s no FICA Tax.
Also, as you mentioned with depreciation, on the ordinary income side of things, there are only so many things that you can do to lower your tax liability. Outside of investing in retirement accounts, maybe you’ve got HSA or IRA accounts and quite frankly having babies, there’s nothing you can do to lower your W-2 income than it’s going to go. There are only a few things you could do on that side. On the passive income side, there are so many things that you can do to get your tax liability lower. One of those is depreciation. Depreciation is tax-free.
It’s that phantom expense that gets made up out of thin air. We’re not coming out of pocket for but we’re going to get that expense against our rental income. If you’d known about cost segregation studies, there are ways to accelerate that benefit and speed it up a little bit. That’s on a high-level ordinary first passive income but then there are other strategies involved.
If you’re involved in real estate as your primary business and it is what you do on the day-to-day, maybe you’re wholesaling deals, investing in rental properties or fixing and flipping, there’s a thing out there called real estate professionals status, which allows you to use your rental losses that you generate from your rental properties to offset that ordinary income from your day job or your business income.
That’s a combination for a lot of people who do real estate as their primary bread-and-butter. Real estate professional status is a great way because you could have somebody in theory that has $300,000 or $400,000 of income and it gets completely offset or wiped out because they have enough rental losses from their portfolio to offset the income. Remember, it’s not a cashflow loss. All of this is tax arbitrage, it’s speeding up deductions and delaying the recognition of income. It’s a tax loss that you’re able to take against your W-2 or your 1099 income.
That’s one of the things that is the beauty of the real estate. It’s not even a secret. Someone said, “It’s not what you make but what you keep.” That whole idea of a couple making $200,000 a year and paying them $30,000 or $40,000 in Federal Income Tax, that’s brutal. Talk to us about what you’re seeing on the short-term rental side of things. Can you walk us back through that?
It all starts with regular long-term rentals. Your commercial properties, syndication deals and multifamily housing are all long-term rentals. Long-term rentals are garnered under this section of the code that prevents you from taking those losses against your income. It prevents you from taking those losses against your income, unless you qualify as a real estate professional. A real estate professional is somebody who works in real estate full-time. There’s a test in there that says you need to spend at least more than half your working time in real estate.
If I’m a CPA advising clients, I spent 2,000 hours as an accountant. That would mean I would have to spend 2,001 hours servicing my rental properties. That would be 80-hour weeks every single week out of the year. Now, I work 80-hour weeks sometimes because I’m an accountant but I don’t work 80-hour weeks every single week. The IRS knows this so there’s no way I could qualify as a real estate professional. We talk about short-term rentals. Your long-term rentals and your passive losses, if you’re not a real estate professional, you’re not going to be able to use those to offset your W-2 or your 1099.
The short-term rental where if the average tenant says seven days or less in your short-term rental, which is typically an Airbnb or VRBO type managing a property, the average guests might stay a weekend, five days or something like that. If the average tenant is seven days or less, it’s not a rental activity under Section 469, which is where we find the real estate professional status rules. That being said, you have an activity that isn’t garnered under that same subset of rules. Now, all we have to do is meet this thing called material participation.
Passive loss can only be used to offset passive activity gains.
There are seven different tests to doing that. There are two that I like more than the other five because they’re easier to meet. Assuming that you can meet one of those tests, this does require you to manage your property. There are people who self-manage remotely and are able to meet this and just because they may live out of state doesn’t mean they’re not doing the Airbnb listings or taking texts or having phone calls with guests or with contractors. It’s able to meet those standards even if you’re out of state.
There are some people who are from California that their investment properties were in the Smokies and they’re able to meet this requirement but on a high level, what does that do? With that short-term rental, we can go and run our cost segregation study. We can speed up that depreciation. We can take that loss that if it was a long-term rental, we wouldn’t have been able to take but because it’s a short-term rental and it’s not garnered under the same subsection, we’re able to take that loss against our high-earning income.
I see a lot of doctors, nurses, physicians and lawyers that they’re making $500,000 on W-2. They’re making $250,000, they’re buying short-term rentals and they’re participating in them. They’re able to take the tax loss to offset their ordinary income. The numbers that I’m running, assuming that a high-earner bought $500,000 purchase price on a cabin, the average client’s saving anywhere between $35,000 to $50,000 per cabin.
That’s independent of straight depreciation or even accelerated depreciation.
That’s wholesome of the accelerated depreciation that the accelerated depreciation of what’s dropping us down to that amount. That’s not including your management fees or your expenditures and interest deduction. That’s just that accelerated depreciation.
One of the things that are unique in a short-term rental space is that you can get a secondary home loan like 10% down.
There are lenders that do 10%. That will factor in your debt-to-income ratio. You got to play that dance of making sure you don’t over-leverage yourself. With that 10% down in factors in your DTI, you’re also not able to include the rental income for purposes of the calculation most of the time. If you move up to the 15% investment loan then they will take into account the income that the property will generate or could generate per se.
Your tax savings alone on the deal of the $500,000 acquisition, it’s a year and a half until your break even.
I was running through this with clients. It’s almost absurd how it comes out to be about 10% that you put down on a 10% property. I had somebody put about $1.2 million worth of property into service and ended up coming out to be $115,000. I had a client who had $115,000 in tax savings by putting $1.2 million a property in the service, you do $1.2 million times 10%, there’s your $120,000. Uncle Sam funded your short-term rental ventures for that year.
Robert Kiyosaki had said there are two sets of tax laws, one for the informed and one for the uninformed. It pains me even when I’m talking to friends and people not in real estate going, “You pay more in taxes than I do. It’s simple. I know you make less money than me and you pay more in taxes. It’s not because I’m particularly smart or bright.” Watching them begin to educate themselves is fun when suddenly the conversation you’re changing like, “There’s a different way to do this.” You mentioned something that I wanted to circle back to, which is on the long-term multifamily syndications.
We get accelerated appreciation. We get bonus depreciation until the end of 2023 or something like that now. You said that there’s no way to take those passive losses unless we are a real estate professional. How does that work inside of syndication? Even if you are a real estate professional is there a way to break that out? I’m missing something here but can you circle that thought again and see if you can clarify that for me?
The whole idea behind that is to prevent your doctor or lawyer from making $1 million or $500,000 and investing in syndications, generating a tax loss, the bonus depreciation from the syndication and using it to offset his or her W-2 income. That’s the IRS has a whole workaround for that. They don’t want people doing that. Remember what I said that a passive loss can only be used to offset passive activity gains. It can’t go against your ordinary W-2 income unless you qualify as a real estate professional. If you’re in syndication and you’re not in the real estate field, there’s no way you’re going to qualify as a real estate professional.
A common misconception that I’ve heard from a lot of people is that, “Get your bonus appreciation and take those things.” You’re telling me that it only singularly applies to passive income. If you’re a passive investor, you’re not a real estate professional and you get a $50,000 write-off, it’s $50,000 and other passive income you may have made that year.
There’s a small exception for people who make less than $100,000 a year. It’s called the mom-and-pop exception but it only applies to people that make less than $100,000 or $150,000 a year. I’m not saying that it’s not a lot of money but that rule prevents your doctor or lawyer person from investing in syndications and using the bonus depreciation loss that completely offsets their income.
Can people retain that bonus depreciation? Can they bank that for five years and use it over the course of five years or it’s only good for the year?
That’s a great tax planning opportunity and also a great question. Let’s say I’m a doctor, I make $500,000 a year and I invest in syndication. I have no other rental income or passive income. Let’s say the syndication kicks me out of a $50,000 passive loss. I received rental income but I got a K-1 showing I have a $50,000 passive loss. I cannot take that against my W-2 because I don’t qualify as a real estate professional. What happens is that $50,000 loss gets suspended and carried forward indefinitely on Form 8582. If you’re a real estate investor, this is the most important form that you can have on your tax return.
Maybe outside of the one that reports your rental activity, it’s Form 8582. That takes all the passive losses that you weren’t able to take and it carries them for. Let’s say the next year, now the indication has income. I’m getting $30,000 of net income. My $50,000 loss from the prior year rolls forward and I can take that loss and offset that income from the next year.
Remember, I said all passive income. I have a $50,000 loss. If I went and invested in a friend’s business and I’m a passive investor, that’s passive income to me. I can use that loss carry forward to offset that income. If I bought a little long-term rental duplex by my house and it had income, I can use that carry forward to offset that income.
Think of the tax code as your road map to wealth.
Odds are especially if you’re young and getting started in your working career, your tax rate is never going to be as low as it was. Ideally, you could generate tax losses in years where you were only paying 12% to 22% federal taxes and carry forward that loss into years where you’re in the 32% or 24% tax bracket. Any loss that you’re not able to take, it’s not for nothing. It gets carried forward until you can offset it with other passive income.
That’s the difference between having just an accountant that you hand your taxes to once a year and someone that helps you tax strategize. Doing that planning ahead of time is critical. Is there anything else that comes to the top of mind that you say, “This is something that people should hear, know and think about in the tax planning or tax strategy world?”
There’s the option to self-direct your retirement account. Let’s say you have an IRA account or a 401(k) account, it’s sitting on Wall Street and you’re like, “I hate this. I’m giving this money. There are guys that are controlling it. I have no idea what they’re doing.” You can self-direct your retirement account and buy real estate within your retirement account. Your retirement account is not limited to Wall Street. You could take your retirement account and buy crypto, other businesses, real estate, gold or whatever you want to buy with it. There are only a few things that you can’t.
One of the most practical things as far as planning goes is you have to think of the Tax Code as your roadmap to wealth. You could buy books on it to understand it or you can hire smarter people to understand it for you and pay them handsomely. If you’re traveling on your real estate journey in your car, what’s slowing you down? Those are stopping for gas and tolls. Think of the IRS as tolls. We want to stay away from the IRS.
The name of the game is if we have income, how can we defer income as long as possible? If I receive a dollar, I want to push it off. I don’t want to recognize income because that means I have to pay taxes. How do we defer income as long as possible? We can do that through cash-out refinances. If my property goes up in value and if I sell at the top of the market, I also have to buy at the top of the market. It’s something I don’t want to do.
One thing to defer recognition of income is to do a cash-out refinance that the IRS treats alone as a non-taxable event. You can pretty much harvest your equity gain in there without realizing the event. That’s one way. Another way to defer income for a later time is the 1031 exchange of being able to swap your property. It’s almost like playing Monopoly when you trade up your four greenhouses for the red hotel. That’s a lot of 1031 exchanges. If we come out of pocket for something like an improvement or the kitchen sink goes out, we want to take that expense immediately because expenses nowadays are generating tax savings.
Know the name of the game, that’s the rule. Our roadmap to wealth is our trucks moving along. We want to stay away from gas. We don’t want to make gas stops if we don’t have to or pit stops and tolls. We have to stay away from tolls, which are the IRS. You’re moving around that roadmap and steer clear of Uncle Sam.
Ryan, thank you for your time. Thanks for breaking down some of these nuanced items for us. I certainly appreciate that and the advice and insight you bring to the table here. If our readers want to get in touch and learn more about you, what is the best way to do that?
The best way is to find me on Instagram and Twitter @LearnLikeACPA. I have tons of content on the real estate tax, real estate investing and overall building generational wealth. It’s on my platform over there. I respond to all my DMs so go ahead and reach out.
Ryan, you’re the man. Thank you and I do appreciate your time.
Important Links:
- Instagram – Ryan Bakke
- @LearnLikeACPA – Twitter
