A year ago, I would have told you that you needed to avoid real estate dealer status and that you should always take advantage of the capital gains exclusion for primary residences.
Boy, things have changed. And as commonly happens when law and policy changes rapidly, not all of the loopholes are thought through. In fact, there are a couple of loopholes right now that I’m not sure Congress and the IRS intended. But, nevertheless – there they are.
Loophole #1: Real Estate Professional status being challenged by IRS auditors. I wish you could sit where I am. I’m hearing case after case every single day of IRS audits that are just randomly disallowing real estate losses. In most cases, I’m not sure what the real reason is. Most people say it’s because the REP status was not allowed. But I suspect there could also be underlying issues with Limited Partnerships, Operating Agreements, income allocations, material participation or any of the other dozen or so problems that the IRS auditors are trained to spot.
There is one way out of all of that, though. Become a real estate dealer and have an LLC that elects S Corp status to hold your property. I still urge you to NOT do this if you have a partner, because it’s too hard to unravel an S Corp with a partner. Or if you do it, make sure you have an experienced tax advisor working it through with you.
If you’re a real estate dealer, you have a business and that means you get 100% deductibility NO MATTER WHAT. So, instead of trying so hard to be an investor, it’s actually better to be a dealer these days.
Loophole #2: Now this is an amazing one. Let’s say you bought your primary residence at the right time in one of the really appreciating markets like S Cal. It went up a couple of million dollars and you refinanced to take the money out. Now the property value has gone down and you’re faced with a choice if you want to sell. You could pay money to sell it AND pay tax on the excess cash you had previously taken out OR you could just stop paying and let the bank foreclose. Please note: I”m not recommending this strategy. It’s just interesting that if you did that and if you really had taken $2 mill our of your property, you’d be looking at $300K or more in tax out of pocket. But if you walked away, you’d owe nothing. I know…I know it would still impact your credit for years to come. But isn’t it interesting that this tax law is actually encouraging people to walk away from over leveraged properties?