Bruce Norris is joined again this week by Susie Leivas. Susie is the CEO of Leivas Tax Wealth Management. She began at age 13 and has nearly four decades of experience. Susie started in the tax business assisting her father Richard Leivas. After completing her education, she and her father became business partners, eventually forming Leivas Tax Wealth Management. Today, she serves as the leader of the team as an enrolled agent, a tax preparer, and a financial advisor with HD Vest Investment Services. She can assist clients with a wide array of services, and she has had Bruce as a client for many years.
Episode Highlights
- What are capital gains, and are there other alternatives?
- What percentage is the state tax currently at?
- Are tax rates identical when you receive a payment that is part interest and part principal?
- What would happen should the capital gains loss change?
- What is the rule for if you exchange a property in another state and decide to move there?
- What is the exchange rule for selling your home if you pass $500,000 profit?
Episode Notes
Bruce speaks in front of audiences all the time, and he can tell people are anxious about equities right now. Bruce has had audiences packed wall-to-wall, standing room only. Either they are really excited about real estate or really afraid something will change. Unfortunately, it is the latter and they are afraid they have a little time to cash in chips or they are in a bubble where they will lose again. This makes for decision-making, such as what they do with what they have. If they have big gains, do they sell it or do they have other alternatives? These are real numbers that have a big impact on how much you can keep. The last thing Susie wants is somebody showing up in February saying what they sold when they could have done it differently.
One example was an investor bought something in 2009 for $100,000. The breakdown was 25% land 75% property improvements. This will set up the depreciation schedule. Come 2016, he now has $200,000 houses and decides to sell. This is $1 million in sales, half a million in profit and you do not get to keep all of it. Bruce asked how bad that sale will hurt him tax-wise. Susie said an example she did with Aaron was his example client bought 5 of those $100,000 properties. She calculated what depreciation would be on the time from 2009 to the end of December of 2015. The reason she did this math is because it is taxed at a different rate.
Everybody thinks capital gain is 15%, but the tax you pay on the accumulated depreciation is at 25% on the Federal side. This means it is a little bit more. This particular client had a lot of trust deeds with the Norris Group and $50,000 in interest in addition to the sale. On that, the Federal tax would be about $105,000. In addition, because of the new tax on the Federal side, the net investment income tax is 3.8% of the money over $250,000. Because the $50 grand of interest got dragged up to the new category, it is also being taxed more. If it was by itself it would be fine, but now it will be hit too. With that 3.8%, we also have another $15,000 of net investment income tax. In addition, we live in California so we would have another $55,000 of state tax. On the 5 properties sold at $200,000 each, the total tax would be about $175,000 in tax.
Bruce asked about the state tax at $55,000 and what percentage it is. Susie said there is no capital gain in California, so their highest rate is 9.3. Bruce asked if it could go up past this, which Susie said he is talking about the million dollars involved with the mental health tax. Any way, this is a lot of money to say goodbye to, especially when you were not expecting it. If you have a job and making another pile, then that money was susceptible. Your interest would be taxed at the highest rate as well as your W-2 income. In all, it has ramifications outside of its own little box.
If, for some reason, he had improved five properties inside of a year and flipped them, thus making $500 grand, it would be regular income. There are no capital gains if it is less than a year. That tax would be at the maximum level plus the bonus, which would be a painful thing. For every rule, there are a lot of strategies and exceptions. Bruce asked what you would do to not pay tax if you are going to flip a house, which Susie said you would not pay a tax on this.
Hybrid number 2 is when you decide to sell, but instead of going the normal rate you become the bank. You would sell for $200,000 and carry for $180,000 in the trust deed. In the example, they did a 10% down payment. In the year of sale, even if you are doing an installment sale you are paying tax on the depreciation you have already taken. They had five homes and were taking depreciation on $75,000 on the structure part. For the part that was depreciation, they had to pay tax on $25,000. Susie did not know the number off the top of her head, but it was under $20,000 of depreciation. They used this number so they would have enough money cash to be paying the taxes.
Bruce said of the $500,000 gain, he would receive $100,000 in cash and a $900,000 trust deed, $400 of it being gain. With the exception of having to pay tax on the depreciation in the year of sale, with an installment tax you will bring it into income as you receive the principle. In the example, Susie did a sale on December 31 so she would not have any additional but only the 10% down payment. They then took $100,000 in cash and had a note for $900,000. Now, they only owed $10,531 on that $100,000 and none of the 3.8 net investment income tax anymore.
Even though the client still has that $50,000 of interest that he gets from the Norris Group, he is still under the $250 and does not owe the 3.8% at all. They would then owe the California tax at a little over $3,000. They take the tax liability from $175,000 to $13,670 and will defer it. They will then start paying tax on it as they start receiving the principle in interest. They will then spread it out over time.
Bruce asked about when you receive a payment that is part interest and part principle and if the taxes are at identical rates. Susie said no and that they stay in character. This means interest is always interest and will go on that line in the tax return. When doing an installment, you calculate what the gross profit percentage is. If you bought it for $100 and sold it for $200, you would have a 50% profit. If you received $1,000 of principal, only 50% of that is taxed and the form in the return helps you keep track of the math. This is how you have a principal basis in your note because you are getting your money back and not being taxed on it. The actual rate of tax is not regular income, it is still capital gains and stays in character. This is really good for a long period of time.
The guy who cashes out and now has all this money is now wondering what to do with all the money. In a way, he will create a much bigger pile moving forward and getting interest. He would then take a big hit and have to figure out what to do with it after the fact. Bruce asked what happens if the note has a due date 5 years out. This could mean you are loaned $900 grand and you will pay for it like it’s a 30-year advertised, but it is 30 due in five. At the end of the fifth year he would refi, and you would have a big pile of money. Susie said Uncle Sam wins at this point because you are taking that big principal payment and paying the balance of what you owe at that time.
Bruce asked what would happen if the capital gains loss changed in the interim. Susie said this would be a problem and chances are you would be taxed at the new rates. Right now capital gains are for 15, although it can be 0 if you have really low income, but she does not see this much. The top cap rate is 15, and the state does not have a capital gain rate. Bruce asked if she sees this changing. You go away every year for a week and hide yourself for the new studies, so Bruce asked if there is any sense they will get another piece of the pie from people who have dough. Susie said considering Congress is not working very well together and we really don’t know who is going to be president, it is subject to change. Susie does not know if anybody really has a feel for it yet.
Bruce had done a study on the history of capital gains, and there was 1 year that it was the same as regular income. The idea was that it was going to raise a lot of money, and instead it raised less. You cannot push it too far or it will not generate revenue and people will just say they will keep what they own. The other thing you can do if you are about to sell a property is not sell it to get cash or carry paper but rather exchange it. This is a pretty common thing. Bruce asked what makes a property eligible for a 1031 exchange, which Susie said it has to be non-personal. You cannot do it with your house, nor would you want to do it this way. It has to be an investment property, so something like a rental or piece of land would be perfect.
What is interesting with the exchange rules is that real estate is a very broad term, unlike business assets. You can do this in business and farming, but it is much more difficult because the asset class is more defined whereas real estate is very broad. You can go from a rental property, single-family to commercial or commercial to land. The definition is very broad.
The Norris Group deals with clients in all different situations that they run by them. One thing asked is when residents go up past the $500 grand. After you pass this $500,000 profit and sell your residence, Bruce wondered if you can exchange the difference. You cannot, but you will only declare the gain that will be long-term capital. Bruce also asked if there are any boundaries as far as location. He asked if he owned a house and California and wanted to exchange it, could he exchange it to anything in the United States. Susie said yes he would be able to do it.
California knows this and does not like to lose any of its future revenue. Something new they added was a tracking. If you exchange your California properties for something in Florida, in the exchange paperwork on your California tax return there is a new form to sign for California to track. Every year that will be a part of your tax return. If you sell one of the properties you exchange to in Florida, California will want their tax at that point. If you stay invested, it is no problem. However, if you sell, California will get their share. Bruce asked what would happen if California forgot to file that paper one year, which Susie said they would have to figure out a way to do it.
Bruce asked about deciding to live in the state you exchanged to once the exchange has happened. It was always true that California was probably owed that money, but they just never tracked or chased it. Susie did not think this was the rule before and that it is new, at least for California. She does not know if anybody has challenged it yet, and Bruce asked if there has been any push back. Susie said years ago California tried to do the very same thing with retirement and California pensions. If you left, they wanted to continue to tax it and tried and it was abolished. There can be push back on this as well, but who knows.
If you have retirement and go to a non-taxable state, that can be a very significant amount of money. This could even be the case in a state that is taxable. If you left California and went Arizona, you will now pay your Arizona tax but California wanted it too. They determined, however, that it was not legal.
Bruce gave four examples of exchanges that change only a little but change the ramification of how it turns out. In the first example, there are no loans on the existing property. When you sell something, you may sell the particular property for $200,000 and are buying another one for $200,000. There are no loans when you sell, and you do not need a loan when buying. It is a transaction that is simple as possible. Bruce asked how the basis goes forward and where the exchange costs filter into, whether it adds to the basis or a deduction. Using the example of a property acquired in 2009 for $100,000. By the time they sold it on December 31, 2015, after depreciation they had unused cost of $81,138. If they had just sold it, they would have had a $200,000 sale price and their adjusted basis of $81. They also would have had about $5,000 of expense to sell. This means they would have had a gain that was taxable at $113,000.
However, if they did a like kind exchange and acquire a property for the same price as what they sell it for, they can defer it to the new property. Instead of having a gain, they bought this new property for $200,000 and subtracted that $113,000 profit, they would have the new asset placed in service that would have a lesser basis. Its basis is $86,000, so it will come creeping back on you later if you sell it later on. Your $113,000 does not go away, but rather it is on hold and deferred. You would be able to exchange yet again and again, and ultimately you can become part of an estate that becomes non-taxable under certain guidelines. Once you pass, it can go to your heirs.
There are a lot of properties out there held by older families, and even though they do not want them they can’t afford to sell them. They are not willing to pay the tax. Bruce met somebody who had a commercial property he owned for over 30 years that totally depreciated. Bruce said the only way he would ever sell it would be if he carried 100% of the paper, made it his estate, and let the trust deed become non-taxable. You would have an installment sale and be paying the tax on a little piece of it, but once it passed away it would result in the same thing.
The next example is property that you used to buy for $200,000 that you now buy for $180,000. Bruce asked what the ramifications of this change would be. Using the original example, if she still had a cost basis on the original purchase of the $81,000 and $5,000 for expenses. She would still have the same gain of $113,000, but now that she has bought down by 20 she can subtract the buy down by the expenses sale. This would put you down by 15, so you would have to pay tax and capital gains on $15,000 and your basis is $81 grand going forward.
In another example involving financing, you have a $200,000 sale but an $80,000 loan on the property you are selling. You are also buying a more expensive property with a $130 loan. If you took all the money and equity from your sale and invested it in the new property, it is often easier to find a more expensive deal than a lesser deal. You might be looking for a $200,000 property but find a $250,000 property. You still put all your money in the deal, and the accommodators holding the money will take it all. You would need a bigger loan, but the outcome will be non-taxable because you did not take any money out of the deal. Therefore, you can go up.
The fourth example is if you have the same sale price and the loan is bigger. You have a $200,000 sale and purchase, and the loan is bigger on the purchase side. The reason this is a taxable event is because the taxpayer walked away with money. If you walk away with the deal and have money in your hands, you have a taxable event. Bruce asked if this is considered boot, or is it the opposite of where you sell a property and don’t have loan replacement. Susie said this would not be a taxable event because in order to close you have to put more money into the deal.
Bruce asked Susie what her recommendation would be if an investor is facing this type of situation. Susie said you should call your tax preparer before you actually do the transaction and let them calculate the numbers before doing the deal. These are very complicated, and for every rule there are a lot of exceptions. Get the facts before opening escrow.
For more information, you can call her office at 951-300-9600.
