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Your First Year as a Real Estate Investor

NOTE: You will find some information products listed in this course that are not yet up for sale. Please stay tuned for a special offer just for coaching clients when these Home Study Courses are available.

Why real estate?

There are usually two main reasons why people begin investing in real estate: the desire for passive income and/or the one sure investment that you can do and still keep your day job.

The noblest of ideas can disintegrate fast into a nightmare if you buy the wrong property, don’t pay attention to the management or forget about tax planning.

Or even worse, you take professional advice from a non-professional. You even have to be careful of the professionals sometimes.

No Such ThingA new client booked an initial consultation because he had heard I worked with a lot of real estate investors and personally invested.

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During our first conversation, he told me the story of his current accountant. He was a CPA who had been around for a long time and was ethical and did a good job.

There was just one problem.

My client wanted to start investing in real estate. He got the details of his first possible investment and gave them to his accountant to review.

“Is it a good deal?”, he asked.

“No, it’s a horrible deal!”, the accountant replied.

He did some more research and found a second possible deal. He got the details and the projected ROI (return on investment) and gave the details to his accountant.

“Is this a good deal?” he asked.

“No, it’s not! Run, don’t walk!”, the accountant replied.

Still not disheartened, my client did even more research. He read some books, took an online course and studied how to make


prospective financial statements to see what the possible reward and risk would be.

He gave all of the research to his accountant and asked his opinion.

“This is a horrible deal!”, the accountant replied.

My client then asked the question that he probably should have asked first.

“What makes a good real estate deal?”

“Nothing! All real estate deals are bad. I won’t even own my own home,” the accountant replied.

And that’s when my new client realized he’d been asking the wrong person the right questions.

It’s not just experience and education that makes a good professional advisor. It’s also point of view. If your advisor doesn’t understand or like real estate, he or she should not be your real estate advisor.

Period.


Module 1: What Type of Investor Will You Be? What type of investor will you be? Your initial answer might be “a good one”, “a smart one” or “a successful one.” At least, I hope that’s what your goals will be.

In this case, though, you need to examine what kind of real estate investor the IRS thinks you will be.

There are several possible definitions that the IRS may apply to you:

Real Estate DealerReal Estate DeveloperReal Estate ProfessionalReal Estate Investor

Real Estate Dealer If you are considered a real estate dealer, you have a trade or business, not an investment. This means that you will have to pay self- employment tax of 15.3%, just like any other business. But, what is potentially even worse, you will also have lost the ability to take the installment tax method.

This means that if you sell a property “over time” using any form of seller financing, you cannot pay tax on the gain as you receive payments. That’s the installment method. Instead, you have to


pay ALL of the tax on the gain on the property immediately, even though you have not received any money yet.

Creative Real Estate Investing with Real Estate Dealer Status In times like this, creative real estate investing becomes more important than ever. If you have a property to sell and your buyer can’t get financing, you may be considering a ‘seller carry.’

You’ll want to be very careful on how you set up the deal or you will fall into the Real Estate Dealer category.

Wrap-around MortgagePROBLEM! All tax immediately due.

Rent to OwnWINNER! Tax benefits to you and delay on tax.

Make sure you have an experienced real estate tax advisor helping you and check in with her before you set up any creative real estate deal.

How Does the IRS Determine Real Estate Dealer Status? The IRS determines real estate dealer status based on the intent of the taxpayer holding or buying the property. The characterization of gain or loss on the sale or exchange of real property turns on whether the property was held primarily for sale or for investment. The Tax Courts have come up with their top 15 items that they look at in determining the status:


1. Taxpayer’s purpose for acquiring, holding and selling the property;

2. Number, frequency, and continuity of sales;

3. Duration of ownership; 4. Time and effort expended by the taxpayer in promoting

sales;

5. Taxpayer’s use of brokers;

6. Extent of improvements and amount of subdivision made to facilitate

sales;

7. Ordinary business of the taxpayer;

8. Extent and value of the taxpayer’s real estate holdings;

9. Extent and nature of the transactions involved;

10. Amount of income from sales as compared with the taxpayer’s other sources of income;

11. Taxpayer’s desire to liquidate landholdings unexpectedly obtained;


12. Taxpayer’s overall reluctance to sell the property;

13. Amount of advertising;

14. Use of a business office for sales; and

15. Taxpayer’s control over any sales representatives.

Of these, the most important issue appears to be the number, frequency, and continuity of sales. In other words, if you sell a lot of property, you might be considered a dealer simply because it appears that this is the type of real estate “investing” that you do.

It is also possible to be treated as a dealer on one property, and an investor on another. In this case, the IRS will look at the taxpayer’s intent with that particular property. For example, they will look for sales activities that show that property was held primarily for sale if they are attempting to prove dealer status. These activities would include advertising, “for sale” signs, a sales office and employment of sales personnel.

Real Estate Dealer Tax & Business Structure Planning If you are considered a real estate dealer (i.e., your real estate activities are considered to be a business, not an investment), your income is going to be subject to self-employment tax. To


offset that extra payroll tax burden your best options for tax treatment are either a C Corporation or an S Corporation. Now you can structure your income as part salary and part profit distribution.

You can establish a straight C or S Corporation, but the better option is almost always an LLC that elects either a C or a S Corporation tax classification. Now, in addition to the tax benefits, you’ll have additional asset protection from personal creditors. Your ownership in an LLC (and the assets in the LLC) are not generally attachable by a personal creditor. But your shares in a Corporation, on the other hand, can potentially be grabbed by a creditor.

Another option, if you’re in a state where it works, is a Series LLC. This structure allows you to create an unlimited number of subsidiaries, called Cells, under the main LLC. Each Cell can have separate ownership, separate management, and make its own distinct tax election. So you could separate out projects into separate Cells and reduce your formation and maintenance fees.

Make sure your entities are in compliance with Real Estate Professional (REP) guidelines if you are also planning to claim REP status. This means that the LLC must have specific language that allows for active participation so that you can take advantage of the REP deduction.


Real estate dealer status is determined on a property-by- property basis. Real estate professional is determined on a per taxpayer basis.

If you are a member of the USTaxAid Coaching program, you can nail down some of the “generally” comments to find out what is the best strategy for you now. Should you have an S Corporation or a C Corporation? Should have an LLC that elects S Corporation or C Corporation tax status? Is a Series LLC best for you? Who owns what? There is a lot to consider when you’re deciding on the right business structures for your ventures. The Coaching program helps you get the answers you need. Go to www.USTaxAid.com/coaching for more information.

Part Real Estate Dealer and Part Real Estate Investor If you have a concern that some of your real estate projects may be considered to have dealer status and others will not, a good strategy will be to have separate business structures for the two portions of your real estate portfolio. The income from your investment real estate won’t be subject to self-employment tax, and so you can safely hold it in a regular LLC.

Real Estate Developers Real estate developers are similar to Real Estate Dealers, in that they are working with property that isn’t yet in service. And, like


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dealers, while property is inactive, real estate developers lose out on the ability to take many deductions, including depreciation. The development might be sub-dividing property, land improvement or even rehabbing a single-family home. Whatever the property, during the development or redevelopment stage, you are unable to count on certain deductions, and not understanding this can lead to some serious tax consequences.

The strategy to overcome this is to first put the property in service.

Real Estate Developer By Mistake Bob and Ruth found 20 acres with zoning that could easily be changed into that of a mobile home park. The 20 acres would translate into 60 spaces that would rent quickly at an average rent of $200 per month. That meant a gross income of $12,000 per month, less $200 for one space, which would be provided to an on-site manager. Maintenance, landscaping and management costs would eat up about $3,000, and they budged another $1,800 for vacancies. That left a reasonable estimated monthly income of $7,000.

The purchase price was $200,000, and the owner would carry a note at 8% with 20% down. Improvements were estimated at $10,000/space and they had gotten tentative approval for a


construction loan with 30% down. Bob and Ruth had $40,000 for the cash down-payment and liquidated $180,000 worth of stock for their 30% portion of the construction loan. They knew there would be gain associated with the stock sale, but figured that the paper losses generated by the depreciation deduction would offset the gain.

However, things didn’t work out that way, and it wasn’t until tax time that Bob and Ruth realized what they had done.

The park was still being developed and wasn’t open yet. The construction was considered land improvements and could only be expensed or depreciated once it was completed. That meant they couldn’t take a depreciation deduction.

The $200,000 purchase price ($40,000 of it in cash) was all booked as an asset, with no expense to offset it. They also had the gain on the stock sale to deal with. In total, Bob and Ruth had put $220,000 into the property, draining their resources, and couldn’t write off a penny. In the eyes of the IRS, Bob and Ruth were developers, much like someone building an apartment house, and none of their investment would be depreciated until it was put in service.

To top it off, Bob and Ruth discovered that the interest from the land note and the construction project was capitalized with the


asset. It was not currently deductible and would instead be amortized and expensed over time. The money was flowing out, they were investing in a business and none of it was deductible ... yet. They had a horrible tax surprise the first year.”

One more issue for some Real Estate Developers is something called Uniform Capitalization rules. This area is a very complicated and little understood part of tax law. In fact, many tax practitioners are unfamiliar with this as well. In a nutshell, Uniform Capitalization means that a portion of administration expenses must be capitalized (moved from a current expense to an asset) and held as such until the property is placed in service, at which time it is amortized, or sold, at which time it is part of basis. Imagine the shock that can occur when you find out you’re a real estate developer and suddenly your interest, property tax and office expenses aren’t deductible!

Developer? Who, me? Tom and Cecilia had a successful real estate investment and property management enterprise. They had a staff of four people who helped them with the ongoing maintenance and bookkeeping for their investments. They wanted to keep growing their business, but had reached a point where they simply couldn’t find the deals on more real estate investments. So, they decided to build new properties.


Tom had a contractor’s license and they already had the beginning of a staff to work with the sub-contractors he needed.

They bought their first parcel and began construction on a large, multi- unit apartment house. At tax time, though, they discovered that they couldn’t take a deduction for any of the payments on the land, the down payment or the out-of-pocket expenses for construction. But, they also discovered, even worse news. A large portion of the administrative and salaries for their employees were now no longer deductible.

The construction of the apartment building made Tom and Cecilia now subject to Uniform Capitalization on all of their administrative expenses, even those that used to be deductible through the rest of their real estate investment business.”

Real Estate ProfessionalThe Real Estate Professional status is a big one. It’s the tax break that is the golden prize, if you qualify. More on that IRS definition in the next module.

Real Estate Investor The last of the 4 IRS classifications is real estate investor. That’s basically the “everyone else” category. If you don’t qualify to be a real estate professional, and you can’t be classified as a real


estate dealer or developer, you will typically wind up here.

Being a straight real estate investor can be tough at times. If you’re an investor with property that is not yet put in service, you will be subject to the same rules that developers are. That means no deductions until it is put in service, no depreciation and, probably the biggest gotcha of all, a limit on the loss you can take if you sell the property. A property in this stage is treated like a bad stock investment. You’re stuck taking it as a capital loss ($3,000 per year of the amount over capital gains). However, if the property is put in service first, you can take deductions, depreciation and the full amount of the loss, if there is one, when you sell.

Are You Sure It’s Not a Rental?A new client of mine came in with his past tax returns. He had over $70,000 in investment interest expense that was carrying forward. He sold the lot associated with the investment for a $20,000 loss.

Now what?

The real estate investment was actually bare land. He had a loan on the property and rather than capitalizing the interest expense into basis (as should have been done), the prior tax preparer had called it investment interest expense. That is deductible if there


is investment income. He didn’t have any. So the expense was just suspended for a future day when he had investment income to offset it.

On the other hand, if it was capitalized like it should have been, it would increase basis. Increased basis means less gain or more loss when it sells. So, that was the first thing to fix.

Next, we looked at the lot sale itself. With the increased basis, there was now a loss of $90,000 when he sold the property. If a property hasn’t yet been put in service, it’s a capital asset. That means any gain is subject to capital gains (good) and any loss is subject to capital loss rules (bad). Without any capital gains to offset his capital loss against, the loss is just taken at $3,000 per year. Since he’s got $90,000 of loss, he’s going to be writing that off for 30 years unless he has a big capital gain to offset.

The difference between a capital asset you sell and a business real estate property you sell is whether you have put the property in service.

How could he put the property in service? Well, it turns out he already had and he didn’t realize the importance. So, he’d never bothered to tell anyone.


He had a sign apace that he rented for $500 a year that was on the property. Mowing the lot cost $480 per year, and he just never bothered to report the $20 of net income he was receiving.

By not reporting it, and not telling anyone about it, he had a capital property that was not in service. That meant the loss was limited. If it was in service (as it was), the entire loss was allowable against his other income. Right now. If he had sold the property at a gain, he would have received capital gains treatment. It’s the best of all worlds – lower capital gains tax treatment if it sells and fully deductible as an ordinary loss if there is a loss.

The moral of the story is put your property in service. Now.

As if you didn’t have enough reason to put your property in service before any construction or development, let me give you one more. Team up the 2018 Tax Cuts and Jobs Act and the earlier PATH Act, and you can get bonus depreciation of 100% (Yes! ALL of it!) for improvements made to your non-residential real estate. There are some rules:

Property that qualifies for bonus depreciation (“qualified property”) now includes four additional categories:


(1) MACRS (modified accelerated cost recovery system – i.e., depreciable) property with a recovery period of 20 years or less,

(2) Computer software,(3) Water utility property, and(4) Qualified improvement property (to non-residential

real property)

This last one is pretty new and important for real estate investors. The improvements must have been made after the property is put in service.

One more thing, there are 3 types of improvements that are excluded:

(1) Enlargement of the building, (2) Elevator or escalator, (3) Internal structural framework.

My point here, though, is that you must put your property in service FIRST in order for these improvements to be eligible for bonus depreciation of 100%.

The conclusion of this whole section is a question. Which type of real estate investor are you going to be? Know this before you


start. It’s going to determine what type of business structure you will have and can mean the difference of thousands of dollars in tax.

Module 2: Are you a real estate professional?There are three possible benefits of real estate for the investor:

(1) Cash flow,(2) Appreciation, and(3) Tax benefits.

Having Real Estate Professional status is a way to get great tax benefits, no matter what your other circumstances are.

As a real estate investor, you may already know that one of the biggest tax benefits is your ability to offset your other income against paper losses (primarily caused by depreciation).

If you (or your spouse, if you’re married) can qualify as a real estate professional with material participation you can offset your other income by 100% of your paper real estate losses. If you can’t qualify your offset is limited to $25,000, as long as your income is under $100,000 and you have active participation.

Once your income exceeds $100,000 your deduction begins to decrease as your income rises. By the time your income hits $150,000, the $25,000 deduction is gone altogether. But that doesn’t mean your paper losses go away. They are simply


suspended. When you eventually sell the property, you’ll be able to deduct all the suspended losses from your sale proceeds unless you have made an aggregation election.

It is also possible to take advantage of suspended losses without selling your property if your status changes and/or your income drops below $100,000.

You’ve got to meet certain tests to qualify as a REP, or real estate professional. First, your status is based on hours that are performed in real estate functions. You need to spend a minimum of 750 hours per year to qualify. If you do other things besides real estate, you’ve got to hit this 750-hour threshold, PLUS you must spend more time in real estate activities than in any other paid activity to qualify. That’s why it’s very difficult for people who work full-time to earn REP status. The IRS doesn’t think it’s reasonable for someone with a full-time 40+ hour/week job to also spend that much time in real estate.

You can also qualify as a REP if you own more than 5% of a real- estate related business. If you’re a real estate agent, you are probably being paid via 1099. That means you qualify. You don’t need to own part of the real estate agency. But if you are paid a salary and receive a W-2, then you do need to own 5% or more of the agency to qualify. You will still need to meet the minimum 750-hour threshold, though.


There are two additional items to consider. These are what real estate activities actually are and the rules for participation in the real estate itself.

First, let’s look at what qualified real estate activities actually are. This has been an area under heavy attack by the IRS in recent years.

Qualified Real Estate Activities A qualified real estate activity is any activity in which you “develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease or sell” real estate. That doesn’t mean you need to be physically doing construction work, etc. The key is that you perform personal services in these activities. So you could be supervising, meeting, planning, and so on.

• Develop: Meeting with engineers, architects, planners, equipment operators, construction personnel, drafters, financial professionals, accounting and legal professionals, etc., to discuss and implement development of property. You could be performing some of the development or it could be time you spend hiring, supervising and reviewing the work of other professionals. The development could be anything from subdividing property, with no additional amenities added, to actual construction of real property.


• Redevelop. Meeting with engineers, architects, planners, equipment operators, construction personnel, drafters, financial professionals, accounting and legal professionals, etc., to discuss and implement demolition of structures and/or redevelopment of the property. Again, you could be performing some of the physical work or it could be time you spend hiring, supervising and reviewing the work of other professionals.

Construct. The time spent in meetings, planning, hiring, firing, supervision, or inspection of any phase of construction in addition to actual construction work also qualifies.

Reconstruct. As with Construct, qualified activities under “reconstruct” are any ones that are necessary to this phase of building.

Acquire. Acquiring a property has many phases – meeting with sales people, looking at real estate, preparing an offer, responding to counter-offers, arranging financing, meeting with insurance agents, inspections, and actually closing a property. You don’t need to acquire a property to rack up a lot of hours in this area. Don’t forget to count the time you spend traveling back and forth to the property.

Convert. Conversion of property is similar to redevelopment or


reconstruction, but might have the additional time element of meeting with planning officials. All of that time counts toward time spent in qualified real estate activities.

Rent. The time you spend meeting with your property managers to establish rental criteria, as well as acting as renting agent yourself (including the showing, screening, advertising, etc.), will count as qualified real estate time. The IRS has been challenging ‘arm chair management’. They want to see that you physically are involved in this process.

• Operate. If you spend time as a property manager, or meet with your property manager, then you will spend significant time as the operator of real estate.

• Manage. Similar to “operation” of real estate, if you manage your property, its tenants, prospective buyers, etc., then you are involved in qualified real estate activity.

• Lease. The time spent meeting with your property managers to establish leasing criteria, as well as acting as renting agent yourself (including the showing, screening, advertising, etc.), will count as qualified real estate time.

• Sell. All of the activities involved in selling a property (getting ready for sale, setting up and/or holding open houses, placing ads, meeting with real estate brokers and prospective buyers)


count toward qualified real estate time.

Material Participation The second test is the Material Participation Test.

In addition to being a REP, you’ve also got to have material participation on the property. There are three possible ways to qualify for material participation:

(1) You spend 500 hours or more in material participation with the property,

(2) You spend 100 hours or more in material participation and more than any other one person with the property, or

(3) You spend more than all other people combined.

If you have a property manager for the property, your only option is the 500 hour one. Otherwise, the IRS assumes that the property manager works more than you do. That’s a hard one to overcome, but in rare instances it has been done.

It bears mentioning that there is also a lower standard of active participation that is available if your AGI is under $100,000 and you are not qualifying as a REP. Additionally, if you have a real estate business, you need to only prove active, not material participation. Unfortunately, this has confused both taxpayers and tax preparers alike.


The active participation rules require just 100 hours of participation per property. This is the standard that is used if the real estate is an active trade or business and/or you make less than $100,000 per year.

In the case of the active trade or business, the IRS is looking for you prove that your real estate is a business, not an investment. You have an active business if you are involved in flipping properties, are a real estate dealer or the rentals themselves are businesses, such as is in the case of a motel or any very short-term stay that provides daily services.

If your adjusted gross income is under $100,000 per year, you still need to prove active participation to take advantage of the up to $25,000 loss offset. That means you need to prove real estate activity of at least 100 hours per year and your interest cannot be held solely as a limited partner in a limited partnership or as a member only inside a limited liability company.

The third test is that each property alone must qualify. You can make an aggregation election to group your properties together so that you only need to meet one material participation test.

IRS Challenges to Real Estate Professional Status During the boom years of real estate in the early 2000s, many investors found themselves with a declining rental pool and


skyrocketing purchase prices. That meant ongoing monthly losses on their real estate properties, before depreciation was even taken. That led many people to ‘stretch the truth’ a little when it came to claiming REP status. Having REP status let them take the losses and they figured the IRS wouldn’t be checking.

Unfortunately, the IRS did check and found enough people who had improperly taken the deduction to determine that it was now worth the time to mount an audit campaign targeting REPs.

The challenges appear to come in a number of ways:

1. Invalid Material participation due to wrong entity set-up. In general, the IRS is looking to make sure that the property is held in the proper entity and that the entity’s agreements are written properly. Being a limited partner in a Limited Partnership won’t work, and even being a passive Member in an LLC might not work if the Operating Agreement isn’t written in a specific manner.

2. Invalid material participation due to missing aggregation election. The aggregation election is made on your return. If it’s not made and attached to your tax return, you can lose the deduction. However, if you’re audited, the IRS auditor will allow a late aggregation election at the time of the audit.


3. Invalid material participation due to ‘inactive’ activities. You can’t count the time you spend researching real estate, or Internet surfing as real estate activity. You need to actually be active and working on or in the properties.

4. Undocumented REP hours. It’s important to keep a Day-Timer and track your time to clearly show at least 750 hours per year. Other tracking methods can help here, too. For example, take pictures of yourself at your properties, or at meetings with construction workers, property managers, etc.

5. REP hours not active. This is similar to the inactive material participation activities.

6. REP Hours Exceeded by Other Activities. Remember, it isn’t just 750 hours period. If you have another income-producing business or job, you must spend more time doing your REP activities than other activities.

The IRS also tried to attack some of the real estate activities claimed by REPs. For example, initially the IRS took the position that a real estate agent could not broker a deal if he or she wasn’t also a licensed broker. Time spent as a real estate agent didn’t count. Fortunately, the Tax Court shot this IRS argument


down, and the IRS has now conceded that a real estate agent is truly a real estate professional. Material Participation for Real Estate Professionals The Real Estate Professional definition is actually comprised of two separate tests. First, you or your spouse, if you’re married filing jointly, need to qualify as a REP. Second, you and your spouse (again, if you’re married filing jointly) need to have 500 hours of material participation per property per year unless you aggregate the properties.

There is a subtle language difference there. In the case of REP hours, you cannot add hours with your spouse to come up with the minimum required load. But in the case of material participation, you are allowed to add your and your spouse’s hours together.

Material participation means actively working with your real estate investments. It doesn’t mean sitting back in your home office, reviewing websites or doing research. The IRS wants to see you put the active in the activity. They also are going to look at how you hold the ownership.

If you are a limited partner in a limited partnership with no management designation or a member in a limited liability company without a management function, then by definition, the real estate activity is passive. In general, we recommend that you


hold a general partnership interest in a limited partnership or move to a manager-managed LLC, where you are a manager. If you are in a member-managed LLC, we recommend that you change to a manager-managed LLC and make sure you are designated as one of the managers.

You might have noticed that one of the requirements was 500 hours per property. Clearly, if you have a lot of properties that is going to be an impossible requirement. The IRS does allow you to make an election to aggregate the properties so that you only need to meet one 500 hour requirement. Don’t make this election lightly, however. If you later sell a property at a loss, the loss will not be immediately available to offset other income. It first goes against the aggregated group.

Like so much with real estate tax strategy, you have to carefully consider what works for you best now and what will work best in the future.

Module 3: Are you investing with pension funds?In the last couple of years before the real estate market turned, many investors were looking at their pension funds as a way to grow real estate income. The beauty of investing through your pension is that you’re either investing with pre-tax dollars, meaning you’ve got more to invest, or you’re investing with after-tax dollars but the money will grow tax-free. Which way you go


depends on the type of plan you have. A tax- deferred plan, like a 401(k) or IRA, may give you more money to start with, whereas a tax-free plan like a Roth IRA or a Solo Roth 401(k) will give you better back-end tax treatment.

There are three important things to consider if you’re going to invest your pension money:

(1) You cannot actively participate in the property. You can be the person doing the fix up, if you’re doing a fix and flip. If it’s a rental, you can’t be the person that fixes the toilet if it breaks.

(2) You cannot manage the pension if it’s inside an LLC. This is the type of ‘checkbook control’ you might have heard associated with pension investments. If you’re going to invest in real estate with your pension, use an LLC. But make sure it’s the right kind of LLC.

(3) If you leverage the investment with a loan, you can’t guarantee the loan yourself. And if the pension has a loan, there could be an additional tax referred to as a UDFI tax.

You’ll find a complete Home Study Course on pension investing at USTaxAid.com or as part of the updated Real Estate Accountant in Box also available at USTaxAid.com.

Module 4: Know Your Numbers


In the USTaxAid course “Start Where You Stand”, you’ll examine your current financial situation. How much do you have and what is your current rate of return? The premise is that there are two things that come into play when it comes into your passive income: the pile of cash you have to invest and the rate of return on that cash.

Do you need more cash to invest or do you need a better rate of return? That’s part of what you examine in this exercise. It all comes from knowing your numbers.

One of the important measurements is cash on cash return (COCR). Here is a sample exercise from this Home Study Course.

The COCR (cash on cash return) exercise is designed to look for under used assets. You’ll find that the COCR changes over time because it’s determined by two things:

The rental market, and The real estate values.

It’s not enough to make a ‘good buy’. If you’re investing you need to make sure the property will provide cash flow. Your due diligence should include talking to at least two different property managers regarding average rents and checking Craigslist to see


what is currently on the market for rentals and who is looking for a place to rent.

You need to decide if you’re the one who is going to manage the property or you’re going to use an outside company to find a tenant and maintain the management or you’re going to do some kind of hybrid between the two. In our case, we have either used property managers to do everything or hired a firm to find the tenant and do the due diligence and then managed it on our own from there on out.

If you’re using a property manager, the property management fee needs to be included in your estimated COCR calculation.

To calculate an estimated COCR, start with the estimated cash flow:

Estimated annual rent __________________ Less: Vacancy est 5% __________________Less: Repair est 5% __________________ Less: Prop Mgmt 5% __________________ Less: Property Tax __________________Less: Property Ins __________________Less: HOA fees __________________ Less: Other Op Expenses__________________ Less: Mtge Payment __________________


Net annual cash flow __________________

Don’t take the listing agents word that the property insurance or property tax will be cheaper, check with an agent and regular tax rolls. If you have a lot more repair to do, like in a fix n hold, the cost for the repairs and improvements and the cost to hold the property while you’re doing those repairs and improvements should both be considered part of the cash you’ve had to put into the property.

Assuming you have just purchased, or plan to purchase the property, you’re going to have to guess at some of the numbers.

Let’s assume that you’re buying a property for $80,000 and have had a home inspection done which listed the things to be repaired. It totals $4,000 and will probably take less than one month according to the building contractor.

You have to pay 20% down, $16,000, and the repair cost will be $4,000. That gives you a total of $20,000.

This is your cash invested amount. Divide this into your net estimated annual income and you have your COCR.

Annual net cash flow/Total out-of-pocket invested


If you’re losing money, you don’t have a positive cash flow. You’re paying out cash and that’s the wrong way to build passive income.

The bottom line is to know your numbers. Know precisely what you’re looking for and do your due diligence before you buy. Plus, periodically look at your return for assets you hold. Are your assets working for you?

Module 5: Get the right business structureThe right business structure begins with understanding where you fit into the IRS’s 4 real estate classifications. If you find that you fall into more than one category, you will probably want more than one business structure, so you can take advantage of all available tax breaks.

For example, if you’re classified as a dealer, who is in the business of real estate (rather than investing in real estate), your income is considered earned income. In that case, you want a structure that is best adapted to active business operations, i.e., C or S Corporation tax treatment. There is a lot to understand about running a corporation that is different than running an LLC with passive investments. Know the difference!

If you’re earning passive income, you’ll want the exact opposite


type of structure. In this instance your income will not be subject to payroll tax, so getting into a structure that forces you to take a salary, like with a corporation, is just a way to pay more in tax than you need to. Passive income runs best through an LLC that elects either partnership taxation (where there is more than one owner) or single-member disregarded taxation (where there is just one owner).

It’s also critical to understand that changing your business structure doesn’t change the character of the income being earned. For example, say you’re a real estate investor, who falls into the passive income category. You are not a real estate professional. You lose money, but the real estate loss is not deductible against your other income. If you put the condo in a business structure such as an LLC or an S Corporation, you will still have a real estate passive loss. Putting it in a business structure does not make it suddenly deductible.

Tax classifications for real estate dealers and investors are pretty straightforward. But what if you’re a real estate professional or a real estate developer? The classification can change, depending on the nature of your income. If you’re a real estate agent, picking up income through a 1099, for example, you’re best off in the C or S Corporation tax structure. But if you’re a real estate professional who has a portfolio of properties that you manage personally, you’re more likely to be generating passive income.


In that case, you’ll want the partnership or single member taxation.

If you’re a developer, you may be both. On the one hand you’ve got a construction/rehab business going on, but when the project is completed the income stream will turn passive. In your case, splitting the operations into a construction/rehab business operating as a C or S Corporation and a separate entity, electing partnership or single member taxation, to hold ownership of the real estate. If you’re in a state that supports the Series LLC, it’s easy – create two Cells – one to operate the active business, and the second to hold title to the real estate. The key point to take away from all of this is: • FIRST determine your type of income you will receive, and • SECOND, create the most beneficial business structure to contain that income.

Get this one backwards, and you can almost guarantee a higher tax bill.

The last thing to note on business structures is jurisdiction. In other words, where do you set up your entities?

Generally speaking, it’s best to set up the entities where the business work is being done, or where the property is located. You can’t escape state nexus (and corresponding taxes) simply


by creating a business entity in another state. If you’re earning money from real estate properties located in Ohio, you won’t gain anything by setting up your LLC in Wyoming. You will still have a duty to register the entity in Ohio at the Secretary of State level and with state tax authorities, and pay tax on the Ohio-sourced income. Instead of saving money you’ll actually pay more, as you’ll have to keep the entity alive and in good standing in both Wyoming and Ohio.

Module 6: Get your EINYour business needs an EIN (employer identification number.) It’s like the social security number for your business. Even if you’re just going to operate your business as a Sole Proprietorship (without a partnership or corporation) at first, don’t just do this through your personal social security number.

If you have a business structure, you need an EIN in that name.

If you don’t have a business structure, go to the next module first and get a dba (doing business as) and then come back and get the EIN.

You can apply for the EIN online at: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Apply-for-an-Employer-Identification-Number-(EIN)-Online


https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Apply-for-an-Employer-Identification-Number-(EIN)-Online



During the online process, the IRS gives you 15 minutes to complete the form. If you don’t finish in 15 minutes, it erases where you are and kicks you out of the program.

You may want to first have a printed version of the information to input so you can make sure you finish in the allotted time. The form you’ll complete is SS-4. Here is a link to a PDF copy of the form for you to use to prep ahead of time. https://www.irs.gov/pub/irs-pdf/fss4.pdf

Module 7: Set up your bookkeepingThe short answer to any question you might have about required bookkeeping is that you need it for your real estate investments. You need to be able to track the income, the expenses, the basis, the accumulated depreciation and the improvements per property, at a minimum.

There is something rather ironic and sad that taxpayers are more likely to invest in real estate than they are to start or buy a business. The irony is that there are a lot of new real estate investments and real estate bookkeeping is not only required, it’s hard.

Business bookkeeping is almost always much easier. But most people given a choice of starting a business or investing in real


https://www.irs.gov/pub/irs-pdf/fss4.pdf

estate, pick real estate. And suddenly have a new tough bookkeeping requirement to manage.

USTaxAid has a 250 page manual and home study course called “Easy Accounting for Real Estate Investors.” It takes that many pages to discuss accounting for real estate investors.

So instead of trying to condense all of that information into a small portion of this home study course, let me review some of the key points to consider. And, of course, I want to stress that you need someone to help you set up your books. You may be able to keep the records current but chances are that, unless you’re a trained accountant or bookkeeper, you’re going to need some help setting this up.

You’ll need to form some habits that may be new to you. You have to keep records of where you spend money. With smart phones these days, that’s a whole lot easier than it used to be.

You need to have a system for record keeping. Know what to keep and for how long.

Know when you actually buy. This may be more difficult than you might assume if you are using creative real estate techniques. The same is true of a sale. Is it a sale or is it a lease option? The lines can blur.


You will need to keep records (either virtually on some kind of cloud service or actual paper files) for up to 10 years, or in some cases as long as you own the assets.

The most important thing to know about accounting is that you need to do it. And you don’t have to be the one to actually do the bookkeeping. In fact, unless you have a lot of time on your hands and experience, I recommend you do NOT do the bookkeeping. Focus on your investments and making money. Let the bookkeeping experts do what they do best.

Along the way, though, pick up the skills needed to read your financial statements. It will help you identify problems early in the process while you can still do something about them early.

We cover Understanding Financial Statements at least once a year as part of the business coaching sessions of our monthly coaching. Even if you don’t have a business, per se, you might really benefit from this information.

Module 8: How much loss can you take?This is a shorter module, but don’t skip it. Your whole tax strategy for your real estate investments hangs on this.

How much loss can you take?


If your adjusted gross income (the last line on page 1 of your Form 1040) is under $100,000 and you actively participate in the property management, you can deduct up to $25,000 in real estate losses against your other income each year.

If your adjusted gross income is over $150,000, you can’t deduct any of the real estate passive losses.

The deductible amount phases out when your income is between $100,000 and $150,000.

If you or your spouse can qualify as a real estate professional (provided you are married and file jointly), then you get to deduct an unlimited amount of real estate loss against your other income.

For now, this is the most important thing to know and you need to know it before year end.

How much can you deduct?

Module 9: Understand the 3 types of expensesFor purposes of this Home Study Course, there are three types of tax deductions you can take. The more of your other income you


write off using real estate deductions, the lower your taxable income will be. That means lower tax.

These expense categories are:

(1)Direct expenses(2)Indirect expenses(3)Phantom expenses

Direct expenses are the expenses directly related to the property. These are the same expenses that you accounted for when you did the COCR calculation. Always claim all of these on your tax return, even if it means a loss.

Indirect expenses are expenses that are part of you being in the business. They are expenses not directly associated with the property and are often missed. Included are home office, office furniture, computer, printer, cell phone, ISP, cell phone plan, business travel, business meals, tools, software, education programs, investing books, accounting and business software, legal, accounting, and tax preparation fees and even the fee for the coaching. If you have a loss, don’t miss reporting it even if you can’t use it this year. Losses carry forward forever and can be worth their weight in gold when you later sell a property.


The phantom expense is best of all. It’s depreciation. You can take normal “MACRS” depreciation, you can front end load depreciation with a cost segregation study, you can take straight line depreciation, you can catch up depreciation and you can postpone depreciation. There are seven proven strategies with depreciation. You can create deductions when you want and, to a certain extent in the amount you want. It’s really that simple.

In the case of direct and indirect expenses, I recommend that you always take all of those deductions even if it creates a real estate loss that doesn’t currently help you. In the case of the phantom expense of depreciation, I recommend you make sure you know what you want first.

Module 10: Year-end Tax Planning for Real Estate InvestorsThe biggest tax break for real estate investors comes from depreciation. And unlike deductions you might have in your business, you can wait until you file your tax return before you decide what strategy to use.

Before year end, there are some things you need to do:

(1) Catch up your bookkeeping so that there is a good estimate of your income or loss from the direct and indirect expenses,


(2) Determine whether you or your spouse will qualify as a real estate professional and make sure your records support that fact if so,

(3) If you want to fund a pension based on your real estate investments, pay yourself a salary before year end and set up a pension plan right away, remember you are limited in the amount of your pension deduction to the salary you take.

(4) If you can handle the loss or increased loss, consider prepaying your real estate tax and make any necessary repairs to your property, and

(5) Talk to your accountant.

Your first year in real estate can be confusing with a lot of new things to learn and do. This Home Study Course was a beginning guide. There is more information on each of these subjects in the USTaxAid coaching courses and the comprehensive Real Estate Accountant in a Box product.


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