A Dollar is a Dollar is a Dollar

If you don't know, now you know

Happy Tax Day!

If you’re like most folks, the 1040-EZ and TurboTax were your best friends during tax time during your early working years. Straightforward, simple, and more than enough to get the job done.

Fast forward a decade or two, and you’ve likely acquired a few things beyond a broader perspective. What kind of things?

Maybe real estate, maybe a spouse, maybe dependents, maybe retirement funds, maybe privately held stock, heck - maybe you own your own company now.

Why do I bring this up?

Because not taking the time to understand the tax code either via self study or via hiring a professional CPA can mean leaving thousands of dollars on the table year after year after year. Furthermore, errors made when filing tax returns tend to be repeated (e.g., mistakenly including the value of land when setting up an initial depreciation table will carry forward indefinitely until fixed) and the penalties assessed by the IRS are steep and getting steeper.

So, not only are you potentially missing out on valuable deductions, you may be shooting yourself in the foot by inadvertently incurring penalties, which accrue interest, which compounds DAILY. Ouch.

If thinking about this makes your eyes glaze over, it might not be a bad idea to consider hiring a CPA. After all, the tax code changes annually so unless you particularly enjoy digging into the IRS archives and working through example problem sets, it’s probably worth hiring out!

Word to the wise: if you decide to go this route, it’s a good idea to have ‘walk away’ criteria defined in advance so that you can avoid the mistakes I made earlier on (basically, hoping that the person I’d hired would do better despite no evidence that they would or could). To this day I am still learning about missed deductions and retroactively correcting errors from returns filed with him.

A bit more on that: after I started investing seriously in real estate in 2018, I hired my first CPA. We’d met through a family member and chatted briefly over the years at various professional events, so there was already some trust.

He came highly recommended with a boatload of professional designations, and had recently left a larger accounting firm to start his own practice, presumably because the demand for his services was there.

At our first meeting he even told me that I was exactly the archetype he was looking to add to his firm. I was stoked!

To say that he was a disappointment is the understatement of a century. Firing him after three years of blatant, costly errors and going completely dark for weeks at a time (with no explanation before or after) was one of the best decisions I’ve ever made. I only wish I’d done it sooner, though surely COVID added to the complications.

Bottom line, if I’d thought through clear criteria in advance (e.g., do not continue engagement if CPA is unavailable for quarterly planning calls) I would have gone a different direction quickly, and have saved a lot of time and money. Don’t be me!

I asked him for our depreciation tables in 2021 knowing the clock was ticking on finding someone new and I had no one lined up. It definitely felt scary but I figured rolling the dice was better than signing up for another year of chasing and second guessing.

While on vacation a few months later, a chance run-in with a business school classmate that my husband and I both forgot was a CPA (!) provided the answer.

I can tell you with absolute certainly the value of his advice to our family is well into the hundreds of thousands of dollars in our few years working together.

Though I know plenty about the tax code (I was qualified to sit for the CPA in California after all) there are so many changes and nuances that I was blind to until working through multiple in depth planning sessions with him.

Now, instead of looking at April with a sense of dread, I don’t think twice about it.

I know my taxes will already be done by late March-ish after working through our engagement letter and intake form in February.

I know an extension will have been pre-emptively filed on our behalf in case something crazy happens.

And I know that I’m executing a plan that we’ve put in place together based on the best information we have for the upcoming several years. Having a plan that’s strategic and opportunistic vs. reactive is incredibly freeing and makes decision making exciting instead of overwhelming.

Here’s an example that I still am having a hard time wrapping my head around because it’s just that good - but am full speed ahead on in 2025:

For a married couple filing jointly, if one spouse qualifies as a ‘real estate professional’ according to the IRS in a given year, losses generated by that couple’s real estate in that same year may be used of offset the other spouses actively earned income.

This is insanely beneficial if you know what you’re doing.

Easy, simplified math:

Spouse A earns pre-tax W-2 income of $150,000 and expects to pay around $30,000 in taxes (~20%) in 2025. Spouse A works 50-60 hour weeks and travels frequently.

Spouse B expects to qualify as a real estate professional in 2025 by working for at least 750 hours in their own real estate business (can include activities like managing a short term rental, soliciting bids / working with contractors, etc.) and by dedicating no more than 750 hours to any other paid work. Spouse B has a ton of flexibility day to day because they set their own schedule and work less than 20 hours a week. The real estate portfolio that Spouse B manages throws off cash flow of around $50,000 after factoring in all expenses.

Because Spouse B knows they will qualify as a real estate professional for this year, they scope renovation, repairs and various capital projects that need doing over the next several years to all occur in 2025. Lets assume these expenses add up to $100,000. Lets further assume that day to day operating expenses are another $50,000.

Thanks to depreciation, the real estate portfolio managed by Spouse B generates net income of $0 (vs. cash of $50,000) and therefore a tax liability of $0.

The further $100,000 of renovation expenses plus $50,000 of operating incurred during the year drop the performance of the portfolio from $0 to a -$150,000 loss.

Because Spouse B qualifies as a real estate professional, that -$150,000 loss can be offset against the actively earned income of Spouse A. $150,000 - $150,000 = $0.

Instead of paying $30,000 in taxes, this couple will pay $0 in taxes.

And, Spouse B’s total income generation is the equivalent of $80,000 ($50,000 cash in, and $30,000 shielded from taxation). Earning an after-tax $80,000 would mean working the 9-5 grind required to earn $100,000 vs. the 20-ish flexible hours a week afforded by the real estate professional designation.

So which one sounds better?

Scenario A: Two people working 50-60 hour weeks and juggling travel schedules and childcare to bring home $200,000 after paying cumulative tax of $50,000? OR

Scenario B: one person working a regular 50-60 hour/week schedule, with another working a flexible 20 hour/week schedule, to bring home $200,000 after paying cumulative tax of $0?

It’s hard to place a value on freedom of time.

For what we can quantify, though, remember that this couple will continue to own the assets they’ve invested that $100,000 in, which are now worth that much more.

Because lenders will typically extend 65-80% of the value of a building in the form of a loan, these buildings being worth more means that they can be used as collateral to borrow more (also tax free, by the way) in the future.

Because the buildings are now in better shape, they can likely can command higher rents (so the $50,000 of cash in the pocket becomes, say, $52,500 in 2026).

Meanwhile, tenants will continue to pay down the mortgages on those assets. Rents increase over time as loan balances decrease - if this isn’t an effective inflation hedge, I don’t know what is (hint: not cryptocurrency).

Spouse A and B maintain flexibility and a strong balance sheet, plus significant tax savings, plus passive (and increasing!) cash flow. See how powerful real estate is?

Anyone that tells you that the only way to earn a living is by working for someone else absolutely does not know what they’re talking about - and really, they probably just don’t know how the tax code works.

Do yourself a favor and start interviewing CPAs for fiscal 2025 now. Their schedules should free up significantly after today!