The Small Business Owner’s Guide to Taxes, LLCs, Deductions, & Audit Risks

Mindy:
Many of you have started a small business this year, and that’s super exciting. But if you’re used to working as a full-time employee for somebody else, the transition to business owner can be overwhelming, especially when it comes to keeping track of your taxes.

Scott:
That’s right. So to help ease your way through the transition, that can be very unpleasant for a lot of these small business owners. We have Brandon Hall, CPA to real estate investors on the show to walk us through the different business and tax structures that you have, and options that you have, and choices that you can make as a real estate investor, small business professional. We’ll talk about things like estimated tax taxes, deductions you can and shouldn’t take, and then we’ll have a fun little lively discussion about rep status and all the landmines there. And Mindy, before we get into this episode, I do want to remind everybody that if you are struggling with tax strategy frameworks, filing, bookkeeping, all of those types of things, and you have any real estate related interests, we have created a tax finder on BiggerPockets with dozens, hundreds of real estate specific tax professionals. You can find those at biggerpockets.com/tax, or if that’s too hard to remember, you can find ’em at biggerpockets.com/tax pros.

Mindy:
Alright, Scott and our listeners, hello, hello, hello and welcome to the BiggerPockets Money podcast. My name is Mindy Jensen and with me as always is my always pays his taxes. Co-host Scott Hunch.

Scott:
Thanks, Mindy. Great to be here as always with my counterpart or extension, Mindy Jensen. Mindy, as always, we’re here to make financial independence less scary, less just for somebody else to introduce you to every money story and every tax disaster because we truly believe that financial freedom is attainable for everyone no matter when or where you’re starting. And as long as you pay the IRS

Mindy:
Brandon Hall, welcome to the BiggerPockets Money podcast. I’m so excited to talk to you today.

Brandon:
Thanks for having me, Mindy. I’m excited to be here.

Mindy:
Brandon, we are going to talk about businesses and today you are in the hot seat. To start off, can you give us a walkthrough of the different types of business structures that you can set up your small business as?

Brandon:
So we’ll do just typical businesses, real estate enterprises. Landlords are maybe a little bit separate, but your typical structure is just you’re just going to start off as a sole proprietor. So if you do nothing, then when you go to file your tax returns, you’re going to fill out a Schedule C. It’s going to be tied to your social security number. All those 10 99 payments, the W nine, everything is tied to your social security number and you’re just operating as Brandon Hall, and there’s nothing wrong with that. Depending on where you’re at in the life cycle, you should at some point move that into an LLC structure, typically a single member LLC, so disregarded for tax purposes, but that’s where you get that asset protection. You get the EIN, you can go get a bank account and you’re easier to lend to a lot of benefits if you are running a business.
And then that business is run through an LLC in terms of yourself from a business contract perspective, from a tax perspective, it’s disregarded. It’s the same as if you are running a sole proprietorship, so no change there. And then if you’re an LLC, you can tax yourself as an S corporation or a C corporation, and that’s when we start getting a little bit more complex. So a lot of sole proprietors will set up an LLC tax themselves as an S corporation to avoid a portion of the self-employment taxes that they are paying on the income that they’re earning. So if you are running a sole proprietor, a sole proprietorship, or if you’re an LLC, any dollar that you earn up to 156 K is taxed at a 15.3% rate. That’s self-employment taxes. That’s the benefit of being a sole owner. You get this extra tax tax liability and that is on top of your federal rate in your state, and

Scott:
I just want to call it that. That is also being paid if you’re an employee, it’s just being paid by your employer as part of payroll tax. So that’s why that exists, right?

Brandon:
Yeah, and honestly, a lot of what I have found is that a lot of business owners didn’t even realize, I mean everybody’s heard of social security and Medicare tax, but you don’t really look at your tax return at the end of the year and add 7.65% to it, right? You just go, yeah, my tax bill was X, but we’re all paying this 7.65% tax on every dollar that we’re earning. Your employer just pays an additional 7.65%, but if you are the employer and the employee, then you get to pay the full 15.3. So you’re going to pay 15.3% on every dollar that you earn as a sole proprietor or as an LLC, that’s single member disregarded. If you tax yourself as an S corporation, then you can pay yourself a W2 wage and that is subject to that 15.3% tax. Whatever profit is left over is not. So the remaining profit left over is not subject to this 15.3% tax. You do get some tax savings if you’re running an S corporation, but then you get into how do you actually run an S corporation appropriately and how do you avoid audits or how do you win an audit? The big thing there is reasonable compensation, and that is a two hour episode on how do you determine reasonable compensation? Not $1 all the headliners would tell you. Well,

Scott:
Great. Well, I think what we’re trying to get here is to help someone who’s contemplating this, right? So again, if you’re W2 employee, this is not really relevant to you right now, remember this episode and come back to it when it is time for it. If you are a real estate investor, we’re going to talk about that in a second here, and you’re owning Landlording rental properties. We can get into the nuances there. We’ve already touched a little bit, but if you’re trying to start your own business and you’re going through these options, you have the LLC versus the S corp and the C corp, you have decisions to make and can you provide us with some general guidelines to steer people in the right direction even if they aren’t the be all end all and every situation is unique.

Brandon:
Yeah, and I think general guidelines are always dangerous. So take this with a grain of salt. My general guideline is if you are going to gross 40 to 50 KA year or less running your business, you should not be setting up any sort of complex entity structures. You can absolutely set up an LLC, but that’s as far as I would take it. If you feel like you need the asset protection that comes with that, then set the LLC up and run your business through an LLC. Otherwise, just run it as a sole proprietorship if you are going to scale your business up more than that, and you’re going to do it consistently every single year, right? So this becomes a little bit more than maybe a side hustle or a hobby. Now we’re targeting a hundred K, 200 K, 500 K, go ahead and set up an LLC and run your business out of an LLC.
So get your EIN, get your business bank account, set up your W nine to show the EIN instead of your social security number and run it out of an LLC. The reason that I say that is when you tax yourself as an S corporation, the ability to tax yourself as an S corporation is powerful. There’s a lot of limiting issues that come with that too. So don’t just go and tax yourself as an S-corp just to save money on tax, but the ability to tax yourself as an S corporation, you get a lot of flexibility with the timing if you have an LLC set up. So when I set up an LLC from that date, I can tax myself as an S corporation. I cannot tax myself as an S corporation if the LLC does not exist. So here’s an example. Let’s say that I’m going to make a hundred thousand dollars in net income in 2024 and that a hundred thousand dollars, if I were running it through an S corporation, I might be able to save, I don’t know, $10,000 in self-employment taxes.
So I’m going to set up an LLC on January 1st, 2024 if I can, because I can get to December, 2024 and if I hit that profit target, I can retroactively tax my LLC as an S corp starting January 1st, 2024. But if I wait until November, 2024 to set my LLC up, then I can only retroactively tax my LLC as an S corp starting November, 2024. So only since that LLC has been set up, which means only the income earned in November and December is going to enjoy that potential sheltering, which really there wouldn’t even be that much to shelter at that point. So the earlier that you can set an LLC up, the better from this taxing as an S corporation perspective because you can retroactively tax your business as an S corp. But again, that threshold for me is kind of like that 50 K threshold of really starting to get serious about this stuff. And there’s even some cases where you might be netting 100 or more and not want to tax yourself as an S corporation. My business is not taxed as an S corporation, right? So we gross millions of dollars a year. I don’t tax my business as an S corporation and I have many reasons that I do not do that. So you really have to sit down and go through the pros and cons before jumping into that type of a structure because once you’re there, it’s really hard to unwind from it.

Mindy:
Alright, Brandon Hall just broke down for us the different business structures you can explore for your small business. Now stay with us because after the break he’ll walk us through how to estimate quarterly taxes.

Scott:
Welcome back to the BiggerPockets Money podcast. So we have these different structures. I’ve now set up a business, I’ve decided to incorporate it to an LLC, like what is the checklist? What are just some of the items that definitely need to be done? Otherwise I’m wasting my time setting up the structure in the first place.

Brandon:
So first thing you need is an operating agreement. And a lot of people that set up LLCs don’t actually have an operating agreement. You have to have an operating agreement. You have to have an EIN, that’s an employee identification number that takes five minutes to obtain from the IRS and you need a business bank account. I would say those are the big three. You can go and register with your state secretary of state, and then you have to look at any sort of revenue departments that you have to register with employee withholding departments that you have to register with unemployment departments. So depending on the type of business that you’re running also depends on what type of payroll or if you need to register with the various payroll departments. So just be aware of that. But the basic level, just again, it’s LLC is registered with the state. We’ve got an operating agreement, we’ve got an EIN, we have a bank account, and if

Scott:
You don’t have those three things, you’re wasting your time because you’re going to just have ads and complexity to your life that is not going to add any value to anybody in any sense, any protection whatsoever is just going to add some unnecessary complexity and maybe some expense to your life if you don’t have that. Is that right?

Brandon:
Oh yeah. Yeah, a hundred percent. And I think most people setting up LLCs get the EINs, they get the business bank accounts, but they forget to have an operating agreement and that’s the big one. It’s like, well, if you don’t have an operating agreement, you might as well just not even do this thing. So make sure that you have an operating agreement a hundred percent, otherwise you’re just wasting your time and your money.

Mindy:
Okay, so is an operating agreement something that you can boilerplate language you can download from the internet, or is this something that you get from your CPA or your attorney?

Brandon:
So CPAs cannot write operating agreements for you. You do have to be an attorney. Well, really, anybody that’s not an attorney cannot write operating agreements for you. Technically speaking,

Scott:
You can write your own operating agreement though, right?

Brandon:
Yeah. You can’t pay somebody that’s not an attorney to do it. That’s unlicensed practice of law. And the state bar associations are super hardcore about protecting that, which means that if anybody is a non-attorney telling you that they can do it for you, proceed with caution. Everybody’s

Scott:
Googling their go and operating agreement template right now because they don’t have their operating agreement set up for their LLCs. They don’t want to pay a lawyer.

Brandon:
Yeah, I mean, look, could you do all of that? Could you get a template? Could you write your own a hundred percent? You can do whatever you want, your life, your business. What I have learned to do is to reduce my legal costs. I have learned to any sort of contract that I need written, I will build the framework. So the key points that I need to be input into that contract, I’ll bullet point them out rather than having an attorney start from scratch when it gets really, really expensive when the attorney’s like, oh, well how do we want to build this thing? And here’s a million different ways we can do it. So I always start with a framework. I hand it to the attorney and I say, I need a contract for this purpose, and it gives them a really good starting point to build on. But if you want to write your own, if you get templates, I would a thousand percent recommend that you pay a thousand bucks for an attorney to review it. They’ll apply state law to it, and that is the key. You need to make sure that your operating agreement is written in accordance with the states that you are actually operating in and you have certain provisions in there that are needed.

Scott:
And key terms for an operating agreement might include things like who owns the business right in there, who gets to make decisions about various things in the business? What are the exits of the business? How would it be dissolved? And how if there are multiple owners of the business, how would different owners be able to exit their interests in the business in various capacities? What are some other terms that you would,

Brandon:
Yeah, how do we split profits? How do we allocate losses? When do we do capital calls? Who has to do capital calls, waterfall agreements? I mean everything related to the p and l is going to be in there. When do we make distributions? How do we make distributions? But the exits are key too. It’s not simply like what happens when we sell, but what about when somebody dies? What about when somebody gets divorced? There’s a whole bunch of provisions that you can think through and if you are partnering with somebody, by the way, so we’ve been talking about you just doing it all yourself and being a sole prop man. If you’re partnering with somebody, you got to sit down and really go through all of those things. Hey, I love your wife, but what happens if she doesn’t love you? At some point, what are we going to do? And

Scott:
A better way to do it’s you’re not even negotiating against your partner’s wife. You negotiate against their unborn child’s future. How I like to frame it because that person is not going to be reasonable in 25 years and you want to make sure your agreement’s structured to protect you from them,

Brandon:
Right?

Mindy:
Right. Yeah. So what kind of attorney am I looking for to help me set up my operating agreement?

Brandon:
I would say just general business attorney. You don’t need a litigator or anything like that, but just a general business attorney would be a good place to start. Although what I do with the law firm that I use is, so my point of contact is the general business attorney and he works with firms of my size. So that’s the other key too, is to make sure that the attorney that you’re working with actually works with businesses like yours, which can be really hard to fact check and verify by the way. But you do have to check references and call the clients and that type of stuff. But my general business attorney, we will build an operating agreement and then I’ll have him run it by his litigators like, okay, how would you litigate against this operating agreement if you were to do so? And that helps strengthen it at the end of the day, at least I think it helps me sleep better at night.

Mindy:
So I would like to throw in my own 2 cents. If you don’t think you can afford an attorney to write up your operating agreement, then you cannot afford to have a business at this time.

Scott:
I think that’s a great framework and I look forward to seeing hotshot lawyers challenge that in the comment section. But that’s right. If you can’t afford to put together an operating agreement, you have no assets to protect.

Brandon:
Yeah, I think that that’s important in various aspects of life, but absolutely business. There are certain things that are just the cost of doing business and they might be annoying. They might be something you want to or feel like you could deprioritize, but you really shouldn’t. And getting that operating agreement written is certainly one of those things. Bookkeeping’s another one of those things, but that’s a different story.

Scott:
Let’s get into the mechanic. By the way, lawyers for this stuff, this isn’t solved problem. You’re not going to spend 10 grand on your operating agreement. You should spend 800 to 1500 bucks at max for a business that’s small. You’re just getting started with this and someone will have language that has probably solved 85% of what Brandon just talked about and there’ll be decisions for you to make on the remaining balance of this. So this is not, don’t overthink that too much on that front. If you’re listening to this for the most part, for most typical types of businesses. But let’s talk about once you set up an entity and you have your EIN from the federal government, the federal government is going to expect a tax return from you and other things to be completed. You’re Secretary of State is going to require, at least in Colorado, expects you to keep your entity up to date. Can you give us a kind of guidance on what the timeline of key milestones or events that someone has to be keeping track of in order to keep their entity in good standing?

Brandon:
So at the state level and the state level is probably the most critical one, to be totally honest with you. Your entity always needs to be in good standing at the state level. Typically that is an annual filing requirement. Now the date is different per state, so I don’t know how to guide on that aside from make sure that you know what the date is and put it in your calendar like six times that week that you get that annual report in. If you have an annual report, some states allow you to file an annual report with the federal tax return or with your 10 40, but you have to be aware that you can actually do that and a lot of people are not. So my suggestion is just make sure you’ve got that state annual filing on lockdown from the federal perspective, if you are a single member LLC, again, it’s disregarded for tax purposes.
So you don’t file anything separately with the IRS. You do have an EIN. The EIN will show up on your Schedule C instead of your social security number, but you don’t file any sort of separate forms if you have a partner, whether the partner be a third party, a friend, a family member, a spouse, a child, now you have to file a partnership tax return. That’s a form 10 65, and that is due on three 15 March 15th every single year. You only have to file if you have activity though. So that’s the other key. I could go and create a hundred different partnerships but do nothing in them and I don’t actually have a filing requirement. So that is a caveat there. S corporations are also due on March 15th, but then C Corp are due April 15th and you can extend the LLCs, the scorps, the C corps, you can extend them for six months, like you can your regular individual tax returns, but that’s when that deadline is.

Scott:
Okay, so we’ve talked about entities at length here and the tools and use cases for them. This is a DIY project to a certain extent. You got to get basically familiar with this before you allow an attorney to bully you into one of these series LLCs or whatever. Those can be the right approaches, but you should be able to know enough to be dangerous and get a couple of opinions that makes sense for you before hearing from those guys on there. They’re making and understand the incentives that go along with all this stuff. I want to go and talk about another construct here for folks. Again, if you think about starting a small business or investing in real estate and you begin to generate profits outside of the payroll system, there are other considerations that you need to think about such as paying estimated taxes here. So for a business that generates income, nobody’s collecting the taxes from your paycheck automatically and you set aside that. Can you walk us through the framework for how to think about this and any recommended tips or tricks for making sure you don’t fall into the wrong side of the IRS for this? As a small business owner?

Brandon:
Yes. The simplest tip that I have is every dollar of income that you earn as a business owner, take 30% of it and put it into a separate bank account and don’t touch it even if you don’t pay estimated taxes, right? Because there’s varying schools of thought, although that’s super expensive to do these days with 8% interest rates, take 30% and put it into a money market account and do not touch it until four 15 where you have to make your payment because at least you’ll have capital to knock the majority if not all of your tax bill down. The worst thing, the worst thing, especially in real estate is when flippers or developers take all their profits and they roll it into the next deal, they’re trying to get the compounding effect going faster and faster and faster. Some think they’re doing a 10 31 exchange and they’re sorely misguided, but they roll ’em all into the next deal and then four 15 comes and they owe 600 K in taxes, but all that money is tied up in real estate and they have no real liquidity options at that point.
Those are always sad stories, so just make sure that you’re withholding that 30%, but if you want to get a little bit more strategic about it, you could take your 30% each quarter and cut a check to the IRS and state, and again, you you’re going to be pretty close to good, if not totally good just with that simple methodology. But if you want to get a little more strategic about it, you hire an accountant to do a quarterly tax estimate for you. And basically what they’ll do once a quarter is they’ll sit down with you, they’ll look at all of your income streams and they’ll say, here is how much you owe the IRS right now. And you go cut that check based on the last quarter of earnings and that is a way to stay on top of your tax bill and mitigate penalties and interest. And that service, the past 12 to 24 months has really started to pay for itself. So before 2022, nobody really bought that service because interest rates were like 3%. So not a big deal. If I don’t make my payment to the IRS, it doesn’t cost me anything, but now it’s costing a lot more money. So people are buying this, Hey, can you help me estimate my quarterly taxes so I can make an accurate payment and reduce or eliminate penalties and interest?

Mindy:
Is there any formula to who owes estimated quarterly taxes? Like who is required to pay them and who doesn’t? I got caught up back when I was 17, I had to pay estimated quarterly taxes and I didn’t, and then I got a big old fine, which was not easy to swing at 17.

Scott:
You must have had a good thing going on as a 17-year-old to have this problem. Mindy, I

Mindy:
Had an awesome thing going as a 17-year-old

Scott:
Next, alright, stay tuned and come back next week and let’s hear about Mindy’s 17-year-old side hustle where she had a big quarterly tax estimation problem.

Mindy:
Well, I mean it was big exchange for my, I think I had to pay a $2,000 fine and that really hurt at 17. I mean, I don’t want to pay a dollar of fines, but so who has to pay estimated quarterly taxes and who does

Brandon:
Not? So in general, if you pay, lemme back up if it gets a little complicated. If you have a W2 job and you’re kind of building a business as a side hustle, the general rule is that you should always pay in 90% of the total tax that you’re going to owe for the current year. And the only way that you’re going to be able to estimate that is if you run those ongoing estimates, which you don’t necessarily need a CPA to do. You could use smart asset or a calculator like that to keep tabs on, but that’s what you would do is every quarter you would say, here’s my projected income for the year, so my total tax bill and I need to be paying a quarter of that every single year between my W2 withholdings and estimated taxes from the business income that I’m earning. The other way to do this is if you pay 100% of the tax that was on last year’s return, then you’re good too. And that’s divided by four. So that’s each quarter. So as long as you’re paying 90% of this year’s tax or a hundred percent of last year’s tax, then you shouldn’t be subject to the penalties or the interest or the underpayment penalties specifically that you might have been subject to. So

Scott:
Your estimate is only as good as your projections. So if you have very variable income, you could run into a problem no matter what with this. So it’s just a guess at the end of the day. But the way I do it is I just list all my different sources of income, like hey, dividends here. If I’m going to realize the capital gain, I’ll list that. I’ll add up the appropriate tax rates. So long-term capital gain would be 20% plus another 4.55% for Colorado state tax. I put this all into a spreadsheet, multiply it out for the end of the year and then set aside the funds that I’ll need chunks of those into a separate savings account, which I called my tax savings account. I probably should do it in a money market because I get a few extra basis points of return and I just keep it there.
And then at the end of each year I’m generally a little bit more conservative and can take some of that money out and put it back into investments. But I like that last year I actually screwed up and got a small refund, so I’ll take that, but I like to pay a little bit. The perfection is being within 10%, but closer to the bottom of that 10% no and on the rest of it at tax time for me, let’s move into another area here. So suppose that I have federal and state taxes, which everybody who’s listening to this podcast probably is aware of at this point, but there can also be city taxes and when we’re a small business owner, we begin to introduce a really bad kind of salt into our world. Can you explain what salt is and the pain that goes along with this?

Brandon:
Yeah, so salt is state and local income tax, and when you are running a business, you can end up with state nexus depending on what type of business you run and where you are conducting that business. So like e-commerce businesses, for example, the Wayfair versus United States basically found that e-comm businesses are doing business in all these different states that are selling their products in even if they don’t have a physical presence in that state. So that means that all those states and those localities can now go and collect tax from that business. This can get pretty gnarly pretty fast depending on what states you’re talking about. So Ohio for example, has Rita taxes. Basically every jurisdiction has its own separate tax rate, which is separate from the state rate. Pennsylvania has something very similar. So various states can have a state tax, a city tax, and a local tax on top of that. And you could be subject to all three and you really have to work with either an accountant or you have to be really good at DIYing your research to understand what your exposure is because that type of stuff can come back to bite you multiple years down the road if you’re not careful. Let

Scott:
Me give you an idea of how gnarly as you put it. This world can be so BiggerPockets we sell, I’ll use one example. We sell eBooks. So in some states you pay state and local tax on the sale of a item, like a physical book, you go buy a book from a bookstore. There’s state tax that’s applied to that. Some states consider an ebook to be a physical piece of property that then has to have state tax charged on it. Some states consider that to not be a physical product. Some states will say any service essentially that’s provided digitally will be. So every state and many of these cities have different jurisdictions. And then when you get over a revenue threshold from customers in that specific state, you create nexus, which means not only are you supposed to be charging sales tax on there, but you also now have to file a tax return for your business in that state if you’re a partnered business, for example in there.
And then by the way, you reach that nexus in several different ways in many states. So in California, if you hire an employee, you automatically have Nexus in California and then you are now subject to paying tax on all the revenue you generate in California on there. In that scenario, if you sell more than, I think it’s 500,000, don’t quote me on that in California and revenue, you also create nexus in California it might be, I forget the exact numbers here for that, but this is where you get to really get into some big trouble. And that’s something that if you’re a business owner and you’re starting to expand into another state or you’re starting to see your business mature a little bit, you really got to be on top of this. Otherwise you could be accruing a huge liability for state and local taxes that’s going to come back and bite you real hard in a couple of years.

Brandon:
Also applies to real estate investors. If you buy a rental property out of state, you now have state taxes that you have to file for. Now generally you’re not going to owe any tax because rental real estate produces a tax loss. But there are absolutely situations where most states have a gross revenue filing threshold. So it’s not necessarily based on net. So even though I have a rental that produces a loss, I might still have to file with that state. But even still in future years that you cashflow, you could also be subject to those state taxes. Partnerships. We’re talking about LLCs and partnerships. You could be filing in states where you are doing no business, where you have no assets if a partner lives there. So New York, New Jersey, all the syndicators in the funds, well they bring on New York, New Jersey people that you’re filing now, the entire partnership now has to file in New York, New Jersey, even though they don’t have any assets in New York and New Jersey. Short-term rental owners, not only are we talking about income tax, but we’re also talking about lodging taxes, sales taxes. So yeah, if you’re run an off platform, not through an Airbnb or VRBO or similar, you have to go and figure that out for yourself too and make sure that you’re emitting the appropriate tax. Yeah, these local jurisdictions can be very painful if not appropriately planned for and dealt with. So definitely don’t take that piece of it lightly. If you’re doing business in multiple states, yeah

Scott:
Salt ain’t fun. But if you have large complex salt problems, you also probably have very good business problems. But just something to be aware of as you build in these businesses and as you think about hiring, you definitely should be aware of what consequences are going to happen to your business in terms of tax preparation and tax payments if you hire your first, when you hire that first employee in California for example, that’s something you really got to be thinking about as an employer.

Brandon:
California is a state you don’t want to mess with. If you’re doing business in California, do not mess with California, get it right. I

Scott:
Don’t live there, but I definitely contribute to their quality of life.

Brandon:
Same. That is a state where we were talking about setting up LLCs and yeah, you don’t have to now if you’re doing business in California, get it right from the very beginning.

Scott:
Alright, we’re going to take a quick ad break and when we’re back, we’re talking deductions.

Mindy:
Welcome back. Before we hop back into this conversation, we wanted to remind you about our tax finder. If you’re looking for a tax professional, this is the simplest way that you will find credible tax professionals who understand real estate. Go to biggerpockets.com/tax to find your perfect tax match.

Scott:
Alright, let’s talk about tax deductions here. So again, LLC is a pass through entity, but I think a lot of people have a lot of misnomers about how a business can then expense personal items and those types of things. So walk us through some of the general frameworks. What’s true, what can I believe here, what should I be thinking about and doing from day one? And what are some of the shenanigans that you have to steer your clients away from because they take this theme a little too far and get too giddy about it.

Brandon:
So the general rule is that in order for an expense to be a business expense, it needs to be ordinary and necessary for your business. So any expense that you have, you can kind of pass through those two filters. Is this ordinary meaning that are other businesses like mine deducting the same thing in order to run their business? And is it necessary? Is it necessary for my business to deduct this thing to run my business? So for example, meals are an ordinary expense for most businesses. Extravagant meals are not necessary expenses for a lot of businesses. Maybe you’re an HVAC contractor, why do you need an extravagant meal that costs a thousand dollars per plate? You probably don’t unless you’re an HVAC contractor in super, super, super, super rich areas and that’s your go-to-market strategy. But that’s how you kind of evaluate that, right? So home office, yeah, if you have a legitimate business need for a home office and you work out of your home office and you use it exclusively for that business, that’s where everybody blows it up is the exclusivity piece, then you can absolutely deduct the cost of a home office.
I’m sitting in mine. What does

Scott:
Exclusively mean?

Brandon:
Exclusively means that this is all you do in this home office as business and that was my butt.

Scott:
What if you also do your morning yoga in that office? What is the cutoff there?

Brandon:
You’re probably going to be fine. The challenge is when if you have a separate room and I have a door that I can close, I can basically prove if I were to ever be audited that I do use this as an exclusive home office or exclusive use. I’m not really like I don’t have a bunch of personal stuff, I don’t have exercise bikes in the background. It is business. Where people screw this up is they have a little corner of a room that they use as their home office and there is authority that says that you can potentially do this, but where they screw it up is they have a little corner of a room and they’ve got a bunch of personal papers on there and it’s not really for business use. They don’t even need a home office for their particular business. Maybe it’s more of a hobby than it really is a business. Anyway, that’s where people mess this up. It’s claiming additional tax deductions from the wrong source, if that makes sense. Home office, I don’t think of it as a tax strategy if that makes, it’s not really this cool great thing to deduct additional dollars. It’s just if you have one, deduct it. If you’re stretching to prove it don’t because again, now our hassle bar is increasing, we’re increasing our hassle, but the reward is pretty low.

Scott:
Maybe the best way to think about this is can you give us an example of a client who was clearly taking this to an outrageous limit and you had to walk ’em back and can you give us an example of someone who wasn’t taken enough?

Brandon:
There was a time where there was an investor that had an RV and they were traveling around in their RV and they said that half of their RV was their home office, but the rv that half of the RV was also where their bed was and their dressers, they changed clothes there. I think they had, I dunno, it’s like a bunch of cookware and crap like that. Not a home office. It’s your personal living space that’s not a home office. On the flip side, I mean we have a lot of investors actually that we say, Hey, you can take this home office, you can claim an extra few thousand dollars. It’s not much, but it’s something because you do have a big enough home and you do work out of this one space and it is its own separate room and it’s a very easy win at that point. It’s not something that we’re stretching. So that actually happens pretty frequently. I would say that happens more often than it does not. Most people aren’t claiming it because they think that it increases audit risk, but it’s not going to increase your audit risk. But it is something that under audit would be looked at. So you just have to be prepared for that.

Mindy:
Okay, let’s say that I have done my taxes and I have claimed I have a split level house, I have claimed this entire level as my office, but it really isn’t a home office. And I get audited and they come in and they’re like, no, that’s not allowed. What happens to me if I take more deductions than I should have?

Scott:
And let’s also zoom out in the context of answering that question and just talk about, okay, what’s going to flag the audit? And then what is life like while I’m being audited as part of Mindy’s? Great question here.

Brandon:
What flags the audit is generally speaking for real estate investors, it’s either you’re just unlucky and that’s frankly a lot of it, or it’s showing non-passive losses, like losses from your rental real estate, but you have W2 income, that’s typically going to be the flag. And then through that process, and this is why if you get audited, stop talking, hire an accountant that understands how to work this process because the words that you use are very important to limiting the scope of the audit. If you use the wrong words, the auditor goes, oh yeah, thanks for reminding me about that thing. And now we’re going to go look at that thing too. So be really careful if you are facing an audit, make sure that you have professional help. But in terms of getting pulled for an audit, it’s really just you’re either unlucky or you have these large losses while you have W2 income.
Now every year the IRS will kind of put out here’s who we’re looking at over the next period of time, and they do update taxpayers with that. And I will also say with the advent of AI and the IRS’s multi-billion dollar investment into ai, I think that the audits, I have nothing to point to for this theory, but I believe that the audits will become less just rolling the dice. They’re going to become a little bit more targeted. So I would expect short-term rental owners, real estate professional folks, real estate developers and flippers to maybe see an uptick in audits as AI is further developed in this examination process.

Scott:
That’s great. You mentioned that because I want to spend the second hour of this podcast talking about rep status and all the shenanigans people get themselves into on that front.

Brandon:
I could talk that topic, man, we could sit down and have some beers and talk for hours to all sorts of stuff,

Scott:
Real estate professional status and people want to claim it. And you got a whole can of worms. You open there. I think we’ve talked about this in the past. We’ll talk about it again in the future, but we’re not going to cover that today. Just know that if you have a W2 job that’s not in the real estate field, please don’t claim rents status and just save yourself a bunch of trouble.

Brandon:
The other part is what actually qualifies as a real property trader business. And the regs are pretty clear, and I think some accountants don’t read the regs. And when I say treasury

Scott:
Regs, so Mindy just declared her whole top of the floor there. She claimed rep status. She is declaring a big loss from rental property. She has a big W2 IRS has flagged her because the AI machine is like red flag, red flag, red flag. I’m after it. Mindy’s also spoken, started trash talking the IRS agent, and now they opened a whole can of worms. She’s hired you. How do you advise her out of this situation? What do we do?

Brandon:
So basically what we would do is we would go, okay, Mindy, you claimed all these things. We have to figure out how hard we want to push, how hard we want to fight on all of these things. So send us all your documentation that you have to substantiate X, Y, and Z. So send us your home office documentation, send us the vehicle that you purchased, the gwa, and I like to write about this on Twitter every once in a while always goes viral whenever I do. It’s like, here’s what happens when you write off a G wagon. So send us all the information about that, all your mileage logs, like everything. If you’re a real estate professional, send us your time log, do your credit card statements and bank statements align with that time log, meaning I say that I’m at a rental property on a Saturday, but my credit card statement says that I’m in London traveling.
Do all of our documents tie out here? So we’re going to have that conversation, then we’re going to go to the auditor. We’re not going to tell them that we have all this information. We’re going to go and we’re going to figure out what do they want to see specifically. And they’re going to start saying, well, I want to see your reps log. And then we’re going to say, here’s our reps log as fast as we can do it, right? Because we’re trying to build credibility with the auditor. We don’t want them to be digging through every single piece of information. We want them to look and go, wow, these guys are really, really well documented. So okay, I’ll audit a few of these, then I’m going to move on. And that’s the game, right? And through that process too, we might say, okay, Mindy, as a real estate professional, you had 10 rentals and you did cost segregation studies and you did bonus depreciation and you took losses from these 10 rentals.
Did you make a grouping election, Mindy, under section 1 4 69 dash nine? And Mindy, most likely, maybe not you, but most of the people that we do this with go whatcha talking about. And so we’ll then go and look through all their prior tax returns and we’ll go, Mindy, you did not do the grouping election. If the IRS figures this out, then you lose because you have to materially participate in every single rental separately if you don’t do the election. So Mindy, when we’re talking to the IRS, don’t you dare say the word group, don’t mention it, don’t mention the rank because we’re going to stay as far away from this as possible and we’re going to do this little song and dance and hopefully maybe Mindy, we’ll just say, you know what? Screw the home office here, Mr. Our auditor. You can have the home office, you have to win something for your boss. So you have the home office, but we’re going to keep this grouping thing secret.

Scott:
What does winning and losing mean?

Brandon:
Winning is not losing bad.

Scott:
Yeah, but what does losing look like? Am I going to go to jail? I’m sorry, Mindy, is Mindy going to go to jail? Is she going to

Brandon:
Go? No, you don’t have to fear that unless you’re committing fraud. If you are committing fraud, you should fear jail. And you won’t know that the I-R-S-C-I, their criminal investigation unit is onto you until it’s too late. So they’ll actually start investing, the auditor would refer the case to the ci, they will start their investigation during the audit and then you’ll realize it later. So as long as you’re not doing really wacky stuff, and by wacky, I mean I’ve got fraudulent the whole the ERTC credit and stuff, or I’ve created sham partnerships that I’ve prepared my own tax returns for and they’ve got $200,000 tax losses that have no actual basis in reality. So you’re not going to get thrown in jail for messing up a real estate professional status or short-term rental or something like that. But if you don’t have substantiation for it and we can’t prove it to the auditor, then the auditor is going to reverse that deduction. And through that reversal, you’re going to owe the back taxes, you’re going to owe the interest on the back taxes and you’re going to owe most likely a 20% accuracy related penalty. And that is where it can get pretty painful pretty fast. When people say, oh, well if it gets reversed later, no big deal. I’ll just pay the bill. It’s the bill, the original bill that was now, mind you, three years ago. So we’ve got three years of interest that has accrued and

Scott:
Interest at 8%,

Brandon:
Right? 8% now. Yeah. So super expensive. Is there

Mindy:
A legitimate way for W2 employees to also claim passive losses?

Brandon:
So being a W2 employee is not necessarily the issue, right? That could be a trigger for the IRS audit, but the real issue is are you a full-time or a part-time? W2 employee? If you are a full-time W2 employee, no chance that you’re going to qualify as a real estate professional, meaning that you spent 2000 hours a year working for somebody else. Because to qualify as a real estate professional, you have to spend more time in real estate than you do it any other job that you might have. And so even if you could justify or even if you do work an additional 2001 hours in real estate, you have to justify that to the auditor. And the auditors are not like, I mean they’re smart people, don’t get me wrong, but they’re not like I’m working 80 hour a week people. And then even if you lose what you would because they’re going to say, I don’t believe you, then you have to go and argue in tax court. And the tax court judge is not going to believe you. Many people have tried. Every single one is lost in tax court. So the way for W2 employees, if you are a full-time W2 employee to use losses from rentals, is to buy a short-term rental. Because short-term rentals are a carve out to real estate professional status, which means that you don’t have to spend more time in the short-term rental than you do at your day job. You still have to materially participate, which is a lift, but it’s not qualifying as real estate. This

Scott:
Is good. I wanted to spend a third hour today on the short-term rental loopholes and deductions and how to use those to offset other gains. So this is perfect. I

Brandon:
Got lots of thoughts on that one too. Yeah.

Scott:
Brandon, where can people find out more about you?

Brandon:
You can hit us up at www.therealestatecpa.com. You can also find me on Twitter. I’ve been trying to build that account and it’s been a lot of fun because Twitter’s its own special place or XI guess, and it’s at B Hall cpa. Well,

Scott:
Thank you very much for the very fun discussion. I can see that you are a little salty about some of those practices that have been discussed and bandied about here in the real estate tax advice world and really glad to get your opinion here. Had a lot of fun and good animated discussion. So thank you very much and I hope you have a great rest of your week, Brandon.

Brandon:
Thanks guys for having me on.

Mindy:
Alright, Scott, that was Brandon Hall and that was a lot of information that we just dove through. What’d you think of the

Scott:
Show? I think it’s super fun. I spent like 10 years learning a lot of things about real estate and some percentage of it was allocated to tax strategy. We’ve gone through a lot of transitions for tax bills and all those types of things here at BiggerPockets. So I’ve developed a lot of frameworks around this. I hope, hope that folks could tell that while I’m not a tax professional, I have gathered a lot of this and know enough to be dangerous if that’s not you. Again, the shortcut that we want to shamelessly plug and self-promote here is the BiggerPockets tax finder biggerpockets.com/tax finder, where we have curated a network of real estate specific tax professionals that can help you with tax planning, strategy, bookkeeping, and of course filing here. And God forbid if you need it, defending yourself from the IRS audit or way worse that CI team.
That sounds super scary. I do want to put a shout out here for that last bit. If you know somebody who works at the CI team, we would love to have ’em on the episode here. We think we’re doing the IRSA favor because we’re going to scare so many listeners into filing their taxes and paying them on time and avoiding those things. We would love to hear horror stories there, those types of things. And I think it’ll be fascinating to get a look from the inside, from the IRS if anybody was willing to ever do that.

Mindy:
And you can email [email protected] [email protected] to discuss your job at the CI department. And we can navigate a lot of things to get you on the show. We’re just trying to present this information so our listeners can make an informed decision. Alright, Scott, should we get out of here?

Scott:
Let’s do it.

Mindy:
That wraps up this episode of the BiggerPockets Money Podcast. Of course, he is the Scott Trench and I am Mindy Jensen saying Best wishes little Fishes. BiggerPockets money was created by Mindy Jensen and Scott Trench, produced by Hija ELs, edited by Exodus Media Copywriting by Nate Weintraub. And lastly, a big thank you to the BiggerPockets team for making this show possible.