Module 8: Real Estate Taxes and Legal Considerations

A Beginner's Guide to Building Wealth Through Property

---

Module Overview

Time Required: 120-150 minutes
Difficulty Level: Beginner to Intermediate
Prerequisites: Modules 1-7 completed

Learning Objectives

By the end of this module, you will be able to:

1. Understand the major tax benefits of real estate investing
2. Calculate depreciation and other deductions to reduce taxable income
3. Track expenses properly for maximum tax benefits
4. Understand different legal structures (LLC, S-Corp, etc.) and their pros/cons
5. Make informed decisions about how to hold property
6. Understand capital gains taxes and how to defer them
7. Learn about 1031 exchanges for tax-free property trading
8. Know when and how to work with CPAs and real estate attorneys
9. Protect yourself from liability through proper structuring and insurance
10. Set up systems for tax compliance and record-keeping

---

Part 1: Why Real Estate Tax Benefits Are Powerful

Before diving into specifics, understand that real estate receives more favorable tax treatment than almost any other investment.

The Tax Advantage Overview

Stock Investment Example:

Buy Stock: $50,000
Sell After 1 Year: $60,000
Gain: $10,000
Capital Gains Tax (15%): $1,500
After-Tax Profit: $8,500

No deductions, no write-offs, pay tax on gain.

Real Estate Investment Example:

Buy Property: $200,000 (20% down = $40,000 invested)
Hold 1 Year, Sell: $210,000
Gain: $10,000

PLUS Annual Benefits:
- Cash Flow: $3,000
- Depreciation Deduction: $6,000
- Interest Deduction: $8,000
- Other Deductions: $2,000

Tax Savings from Deductions: ~$4,000
Total First-Year Benefit: $3,000 + $4,000 = $7,000

Plus $10,000 appreciation (can defer tax with 1031 exchange)

Real estate creates income while providing deductions!

Key Tax Concepts

1. Ordinary Income vs. Capital Gains

Ordinary Income:

• Wages, salary, business income
• Taxed at regular rates (10-37% federal)
• Rental income is ordinary income
• BUT: Offset by deductions

Capital Gains:

• Profit from selling assets
• Long-term (held 1+ year): 0-20% federal
• Short-term (held under 1 year): Ordinary rates
• Real estate appreciation taxed as capital gains

2. Deductions Reduce Taxable Income

Example:
Gross Income: $80,000 (W-2 job)
Rental Income: $18,000
Total Income: $98,000

Real Estate Deductions:
- Depreciation: $6,000
- Mortgage Interest: $8,000
- Property Tax: $2,400
- Insurance: $1,000
- Maintenance: $2,000
- Management: $1,800
Total Deductions: $21,200

Rental Loss (on paper): $18,000 - $21,200 = -$3,200

Taxable Income: $80,000 - $3,200 = $76,800

Tax Savings: ~$960 (at 30% rate)

Real-World: You collected $18,000 rent, reduced taxable income by $3,200!

This is legal and encouraged by tax code.

---

Part 2: Understanding Depreciation

Depreciation is the most powerful real estate tax benefit. Let's understand it fully.

What Is Depreciation?

IRS Logic: "Buildings wear out over time. You can deduct this 'wear' annually, even though the property may actually be appreciating."

Residential Rental Property:

• Depreciable over 27.5 years
• Only building value (not land) depreciates
• Straight-line depreciation (same amount each year)

Commercial Property:

• Depreciable over 39 years
• Same principle, longer period

Calculating Depreciation

Step 1: Determine Depreciable Basis

Purchase Price: $225,000
Closing Costs: $5,000
Total Acquisition Cost: $230,000

Land Value (from tax assessment): $45,000
Building Value: $230,000 - $45,000 = $185,000

Depreciable Basis: $185,000

How to Determine Land Value:

• Property tax assessment (shows land vs. building)
• Appraisal breakdown
• Typical ratio: 20-30% land, 70-80% building

Step 2: Calculate Annual Depreciation

Depreciable Basis: $185,000
Depreciation Period: 27.5 years

Annual Depreciation: $185,000 ÷ 27.5 = $6,727/year

Monthly Depreciation: $6,727 ÷ 12 = $561/month

What This Means: You can deduct $6,727 from your taxable income each year for 27.5 years, even if property is appreciating!

Depreciation Impact Example

Without Real Estate Investment:

W-2 Income: $80,000
Standard Deduction: $14,600
Taxable Income: $65,400
Federal Tax: ~$9,200

With Rental Property:

W-2 Income: $80,000
Rental Income: $18,000
Gross Income: $98,000

Rental Deductions (including $6,727 depreciation): $21,200
Net Rental Income: -$3,200

Adjusted Gross Income: $80,000 - $3,200 = $76,800
Standard Deduction: $14,600
Taxable Income: $62,200
Federal Tax: ~$8,400

Tax Savings: $9,200 - $8,400 = $800/year

Plus you collected $18,000 in rent!

Passive Activity Loss Rules

The Catch: Rental real estate is generally considered "passive income." Passive losses can only offset passive income.

BUT There's an Exception:

$25,000 Special Allowance: If you "actively participate" in managing the property AND your modified adjusted gross income (MAGI) is under $100,000, you can deduct up to $25,000 in rental losses against your ordinary income.

Active Participation Means:

• You make management decisions
• Approve tenants
• Approve repairs
• Set rental terms
• You don't need to do the work (can hire property manager)

Income Phase-Out:

MAGI under $100,000: Full $25,000 allowance
MAGI $100,000-$150,000: Partial allowance (phased out)
MAGI over $150,000: No allowance (unless Real Estate Professional status)

Example:

Your Income: $85,000
Rental "Loss" (due to depreciation): $5,000

You can deduct this $5,000 against your ordinary income.

Your Income: $120,000
Rental "Loss": $5,000

You can only deduct $3,000 (partial phase-out).

Real Estate Professional Status

If you qualify as Real Estate Professional:

• No limit on rental loss deductions
• Can offset all ordinary income
• Rental activities no longer "passive"

Requirements:

1. Spend 750+ hours per year in real estate activities
2. More than 50% of your working time in real estate
3. Materially participate in rental activities

Activities That Count:

• Property management
• Maintenance and repairs
• Tenant screening and placement
• Bookkeeping
• Travel to properties
• Real estate education
• Marketing properties

Documentation Required: Keep detailed time logs. IRS scrutinizes this status.

Who Qualifies:

• Full-time real estate investors
• Real estate agents who also invest
• Property managers who own properties
• Developers

Not for Most Beginners: If you have a full-time W-2 job, you likely won't qualify.

Depreciation Recapture

What Happens When You Sell:

Depreciation reduces your "basis" in the property. When you sell, you must pay tax on depreciation taken.

Example:

Purchase Price: $200,000
Land Value: $40,000
Building Value: $160,000

Depreciation Taken (10 years): $160,000 ÷ 27.5 × 10 = $58,182

Adjusted Basis: $200,000 - $58,182 = $141,818

Sell Property For: $260,000

Total Gain: $260,000 - $141,818 = $118,182

Gain Breakdown:
- Appreciation: $60,000 (long-term capital gains: 0-20%)
- Depreciation Recapture: $58,182 (taxed at 25% max)

Tax on Sale:
Appreciation: $60,000 × 15% = $9,000
Depreciation Recapture: $58,182 × 25% = $14,546
Total Tax: $23,546

The Good News: You saved ~$14,546 in taxes over 10 years (assuming 25% rate). You break even on depreciation recapture BUT you had use of that money for 10 years (time value of money).

Better News: You can defer ALL tax with a 1031 exchange (covered later).

Bonus Depreciation and Cost Segregation

Advanced Strategies (Consult CPA):

Cost Segregation:

• Breaks property into components
• Some components depreciate faster (5, 7, 15 years vs. 27.5)
• Examples: Carpet, appliances, landscaping
• Accelerates depreciation deductions
• Requires professional study ($5,000-$10,000)
• Worth it for properties $500,000+

Bonus Depreciation:

• Allows immediate write-off of certain property
• Can create large losses in year of purchase
• Subject to change (tax law updates)
• Consult CPA for current rules

For Beginners: Stick with standard depreciation. These strategies are for larger portfolios and higher earners.

---

Part 3: Deductible Rental Property Expenses

Almost every legitimate rental property expense is deductible. Let's itemize everything.

Operating Expenses (Fully Deductible)

1. Mortgage Interest

Annual Mortgage Payments: $15,000
Principal Portion: $3,000
Interest Portion: $12,000

Deductible: $12,000 (interest only, not principal)

Important: Only interest is deductible, not principal paydown.

2. Property Taxes

Annual Property Tax: $2,800
Deductible: $2,800 (full amount)

3. Insurance

Landlord/Dwelling Insurance: $1,200/year
Liability Insurance: $300/year
Umbrella Policy (portion for rentals): $150/year
Total Deductible: $1,650

4. Repairs and Maintenance

What Qualifies:

• Fixing broken items
• Painting
• Plumbing repairs
• Electrical repairs
• Appliance repairs
• Pest control
• Cleaning
• Lawn care

Must Be:

• Ordinary
• Necessary
• Reasonable in cost
• For maintaining property

Annual Repairs: $2,500
Deductible: $2,500 (full amount, taken in year incurred)

5. Property Management Fees

Monthly Management (10%): $150 × 12 = $1,800/year
Leasing Fee: $1,500 (every 2 years) = $750/year average
Total Annual: $2,550
Deductible: $2,550

6. Utilities (If Landlord Pays)

Water/Sewer: $600/year
Trash: $300/year
Total: $900
Deductible: $900

7. HOA Fees (If Applicable)

Monthly HOA: $350 × 12 = $4,200/year
Deductible: $4,200

8. Advertising

Zillow listing: $0
Craigslist: $0
Yard sign: $25
Facebook ads: $50
Total: $75
Deductible: $75

9. Legal and Professional Fees

Attorney (lease review): $300
CPA (tax preparation): $400
Property inspection: $350
Total: $1,050
Deductible: $1,050

10. Travel to Property

If you travel to manage property:

Mileage:

Miles driven to property: 500 miles/year
IRS Mileage Rate: $0.67/mile (2024 rate, changes annually)
Deduction: 500 × $0.67 = $335

Or Actual Expenses:

• Gas
• Oil changes
• Repairs
• Insurance (prorated)
• Registration (prorated)

Choose mileage or actual, not both.

Other Travel:

• Parking fees
• Tolls
• Airfare (if out-of-state property)
• Hotels
• Meals (50% deductible)

Document Everything:

• Keep mileage log
• Note purpose of trip
• Save receipts

11. Home Office (If Applicable)

If you have dedicated space for managing rentals:

Home Office: 150 sq ft
Total Home: 2,000 sq ft
Percentage: 7.5%

Mortgage Interest: $12,000 × 7.5% = $900
Property Tax: $3,000 × 7.5% = $225
Utilities: $2,400 × 7.5% = $180
Insurance: $1,200 × 7.5% = $90
Repairs: $500 × 7.5% = $38
Total Home Office Deduction: $1,433

Requirements:

• Regular and exclusive use
• Principal place of business for rental activity
• Actual office/workspace (not just desk in bedroom)

Simplified Option: $5 per square foot, up to 300 sq ft = max $1,500

12. Education

Real estate investment courses: $500
Books: $100
Seminars: $300
Total: $900
Deductible: $900 (if related to rental business)

13. Software and Subscriptions

Property management software: $200/year
Accounting software: $150/year
Market research subscriptions: $100/year
Total: $450
Deductible: $450

14. Bank Fees and Interest

Rental property checking account fees: $120/year
Credit card interest (for rental expenses): varies
Loan application fees: deductible
Total: Deductible

15. Miscellaneous

• Office supplies
• Phone line (dedicated rental line)
• Internet (portion for rental business)
• Postage
• Photography (listing photos)

Capital Improvements (Not Immediately Deductible)

Capital Improvements Add Value or Extend Life:

Examples:

• New roof
• New HVAC system
• Room additions
• Kitchen remodel
• Bathroom remodel
• New flooring throughout
• New windows
• Landscaping (major)
• Driveway replacement
• Swimming pool

Tax Treatment:

• Add to property basis
• Depreciate over 27.5 years (residential)
• Cannot deduct immediately

Example:

New Roof: $10,000
This is capital improvement, not repair.

Add to Basis: $10,000
Annual Depreciation: $10,000 ÷ 27.5 = $364/year for 27.5 years

Not: $10,000 deduction in year 1

Repair vs. Improvement Decision

Key Question: Does it restore property to original condition (repair) or add value/extend life (improvement)?

Repairs (Deductible):

• Fix broken window
• Patch roof leak
• Repair plumbing leak
• Paint interior
• Fix appliance
• Replace broken cabinet door

Improvements (Capitalize):

• Replace all windows
• New roof
• Remodel kitchen
• Add bathroom
• Install central AC (where none existed)
• Room addition

Gray Areas: Consult CPA when unsure. Some items can be argued either way.

Safe Harbor for Small Taxpayers: If your average annual rental income for previous 3 years is $1 million or less, you can deduct up to $10,000 per building per year for repairs, maintenance, and improvements (subject to rules).

Consult CPA about this and related safe harbors.

---

Part 4: Record Keeping for Tax Compliance

Proper records are essential for claiming deductions and surviving audits.

What to Keep

Purchase Documents:

• Purchase agreement
• Closing statement (HUD-1 or Closing Disclosure)
• Deed
• Title insurance
• Loan documents
• Property appraisal

Income Records:

• Rent receipts
• Lease agreements
• Security deposit records
• Late fee income
• Other income (laundry, parking, etc.)

Expense Records:

• All receipts
• Invoices
• Cancelled checks
• Credit card statements
• Bank statements
• Mileage logs
• Home office calculations

Property Records:

• Before/after photos of repairs
• Contractor invoices
• Building permits
• Property inspections
• Appraisals

Depreciation Records:

• Purchase price allocation (land vs. building)
• Capital improvements
• Depreciation schedules
• Cost segregation studies (if applicable)

How Long to Keep Records

General Rule: 7 Years

IRS can audit 3 years back (6 years if substantial income underreported).

Keep Forever:

• Property purchase documents
• Major capital improvements
• Depreciation schedules

These affect your basis when you sell.

Organizing Systems

Manual System:

File Folders:

2024 Rental - 123 Main Street
├── Income
├── Repairs & Maintenance
├── Utilities
├── Insurance
├── Property Tax
├── Professional Fees
├── Travel
└── Other Expenses

Digital System:

Software Options:

Free:

• Google Drive folders
• Spreadsheets (Google Sheets, Excel)
• Expensify (receipt tracking)

Paid:

• QuickBooks Online ($15-30/month)
• Stessa ($0-$39/month)
• Buildium
• Baselane

Best Practice:

• Photo every receipt immediately
• Store in cloud
• Categorize expenses monthly
• Reconcile with bank statements
• Summary report at year-end

Spreadsheet Template:

DATE | PROPERTY | CATEGORY | DESCRIPTION | AMOUNT | PAYMENT METHOD
---------------------------------------------------------------------
1/5  | 123 Main | Repairs   | Plumber leak | $150  | Visa
1/10 | 123 Main | Insurance | Annual       | $1200 | Check

Separating Personal and Rental Finances

Essential:

Separate Bank Account:

• Open dedicated checking account for each property (or all properties)
• All rental income deposited here
• All rental expenses paid from here
• Never commingle with personal funds

Separate Credit Card:

• Dedicated card for rental expenses
• Makes tracking easier
• Simplifies record keeping

Why This Matters:

• Clean records
• Easier tax preparation
• Defensible in audit
• Professional business practice

Preparing for Tax Season

Annual Checklist:

By January 31: ☐ Reconcile all income and expenses ☐ Organize receipts and documentation ☐ Create summary report per property ☐ Calculate total income ☐ Calculate total expenses by category ☐ Calculate depreciation ☐ Gather 1099s received ☐ Provide information to CPA

Information for CPA:

RENTAL PROPERTY TAX SUMMARY - 2024
Property: 123 Main Street

INCOME:
Rent Received: $18,000
Late Fees: $150
Other Income: $0
Total Income: $18,150

EXPENSES:
Mortgage Interest: $8,500
Property Tax: $2,400
Insurance: $1,000
Repairs: $2,100
Maintenance: $800
Management: $1,800
Utilities: $0
Advertising: $75
Legal/Professional: $350
Travel (mileage): $268
Office Expenses: $150
Other: $200
Total Expenses: $17,643

NET INCOME (Before Depreciation): $507

DEPRECIATION:
Building Basis: $160,000
Annual Depreciation: $5,818

NET INCOME (After Depreciation): -$5,311 (Loss)

---

Part 5: Legal Structures for Holding Property

How you hold title to property affects taxes, liability, and operations.

Individual Ownership (Your Name)

How It Works: Deed in your personal name. Simplest structure.

Pros:

• Simple to set up (no cost)
• Easy to qualify for loans
• No separate tax return (report on Schedule E)
• Can take advantage of $25,000 passive loss allowance
• Can do 1031 exchanges

Cons:

• Personal liability exposure (someone sues, your personal assets at risk)
• No liability protection
• If married, community property state issues
• Estate planning complications

Liability Example:

Tenant slips and falls on your property.
Sues for $500,000.
Your property insurance: $300,000 coverage.
Excess $200,000 judgment: Your personal assets at risk
(home, savings, investments)

When to Use:

• First 1-2 properties
• While learning
• If you have umbrella insurance
• If liability risk is low

Limited Liability Company (LLC)

How It Works: Create LLC, LLC owns property. You own LLC.

Pros:

• Liability protection (LLC assets at risk, not personal assets)
• Flexible ownership (can have multiple members)
• Pass-through taxation (no double tax)
• Professional appearance
• Estate planning benefits
• Can still do 1031 exchanges

Cons:

• Setup costs ($500-2,000 depending on state)
• Annual fees/taxes (varies by state)
• More complex bookkeeping
• Separate tax return (though pass-through)
• More difficult to get loans (some lenders don't like LLCs)
• Due-on-sale clause risk if transferring property to LLC

Liability Protection:

Tenant sues.
Judgment: $500,000
Insurance: $300,000

Exposure:
Without LLC: Your personal assets at risk
With LLC: Only LLC assets at risk (the rental property itself)

Your personal home, savings, other investments protected.

Important Limitations: LLC does NOT protect against:

• Personal negligence
• Personal guarantees on loans
• Fraud

LLC must be maintained properly:

• Keep separate finances
• Don't commingle funds
• Maintain corporate formality
• Keep good records

Veil Piercing: If you don't maintain separation, courts can "pierce the corporate veil" and hold you personally liable.

Single-Member LLC:

• Most common for rental properties
• You are sole owner
• Disregarded entity for tax (report on Schedule E like individual)
• Still provides liability protection

Multi-Member LLC:

• Multiple owners
• Files partnership tax return (Form 1065)
• Issues K-1s to members
• More complex

Setting Up LLC:

Steps:

1. Choose state (usually your state)
2. Choose LLC name (check availability)
3. File Articles of Organization
4. Pay filing fee ($100-$500)
5. Create Operating Agreement
6. Get EIN from IRS
7. Open bank account
8. Transfer property to LLC (consult attorney)

Costs:

• Filing Fee: $100-500 (varies by state)
• Attorney: $500-1,500 (recommended)
• Annual Fees: $0-800/year (varies by state)
• Registered Agent: $50-300/year (if needed)

Naming: "[Your Name] Real Estate Holdings, LLC" "[Your Name] Properties, LLC" "123 Main Street, LLC" (property-specific LLC)

S Corporation

How It Works: Elect S-Corp tax treatment for LLC or corporation.

Pros:

• Liability protection
• Potential self-employment tax savings
• Professional structure

Cons:

• More complex
• Required payroll (must pay yourself reasonable salary)
• Separate tax return
• Annual costs
• More difficult for real estate rentals

When to Use:

• Not typical for passive rental properties
• Better for active real estate businesses (flipping, property management company)
• Consult CPA

For Beginners: Not recommended for buy-and-hold rentals.

Trust

How It Works: Property held in trust. You (or trustee) manages property for beneficiaries.

Types:

Revocable Living Trust:

• You control during lifetime
• Avoids probate
• No asset protection
• Estate planning tool

Irrevocable Trust:

• You relinquish control
• Asset protection
• Complex tax implications
• Used for wealth preservation, estate taxes

When to Use:

• Estate planning (high net worth)
• Multi-generational wealth
• Not for beginners
• Consult estate planning attorney

One Property per LLC?

Debate:

One LLC per Property:

Pros:

• Maximum liability protection
• One property problem doesn't affect others
• Can sell property easier (sell LLC)

Cons:

• Expensive (multiple LLCs = multiple fees)
• More administrative burden
• Multiple tax returns (if multi-member)

Multiple Properties in One LLC:

Pros:

• More cost-effective
• Simpler administration
• One tax return

Cons:

• All properties at risk if one has issue
• Less isolation

Practical Recommendation:

Beginners (1-3 properties):

• Start with individual ownership + umbrella insurance
• Form 1 LLC when you have 2-3 properties
• Put all properties in that LLC

Intermediate (4-10 properties):

• 1 LLC holding all, OR
• 1-2 LLCs grouping by location/type

Advanced (10+ properties):

• Multiple LLCs
• Consider series LLC (where available)
• Work with attorney for structure

Most Important: Good insurance > complex structures for most investors.

Umbrella Insurance

What It Is: Extra liability coverage above your regular insurance.

How It Works:

Property Insurance: $300,000 liability
Umbrella Policy: $1,000,000 additional
Total Coverage: $1,300,000

If Sued for $800,000:
Property Insurance Pays: $300,000
Umbrella Pays: $500,000
Total Covered: $800,000

Cost:

• $1 million coverage: $150-300/year
• $2 million coverage: $300-500/year

Extremely affordable protection.

Requirements:

• Maintain minimum underlying coverage
• Usually $300,000+ property liability
• $250,000+ auto liability

Recommendation: EVERY investor should have umbrella policy.

• Minimum $1 million
• $2 million if higher net worth

This is often better protection than LLC for beginners.

---

Part 6: Capital Gains and 1031 Exchanges

When you sell property, understanding capital gains and deferral strategies saves huge money.

Capital Gains Tax Basics

Short-Term Capital Gains (Held Under 1 Year): Taxed as ordinary income (10-37% federal)

Long-Term Capital Gains (Held 1+ Year): Taxed at preferential rates:

• 0% if income under $44,625 single ($89,250 married)
• 15% if income $44,625-$492,300 single ($89,250-$553,850 married)
• 20% if income above those thresholds

Plus:

• 3.8% Net Investment Income Tax (if income over $200k single/$250k married)
• State capital gains tax (varies by state)

Effective Rate: Typically 15-23.8% federal for most investors.

Calculating Gain on Sale

EXAMPLE SALE:

Purchase Price (2015): $200,000
Closing Costs (Purchase): $5,000
Total Basis: $205,000

Land Value: $40,000
Building Value: $165,000

Capital Improvements (2018):
New Roof: $10,000
HVAC: $6,000
Total Improvements: $16,000

Adjusted Basis: $205,000 + $16,000 = $221,000

Depreciation Taken (10 years):
Building + Improvements: $175,000
Annual Depreciation: $6,364
Total Depreciation: $63,640

Adjusted Basis After Depreciation: $221,000 - $63,640 = $157,360

SALE (2025):
Sale Price: $300,000
Selling Costs (Commission, etc.): $20,000
Net Sale Price: $280,000

GAIN CALCULATION:
Net Sale Price: $280,000
Adjusted Basis: $157,360
Total Gain: $122,640

GAIN BREAKDOWN:
Appreciation: $280,000 - $221,000 = $59,000 (long-term capital gains)
Depreciation Recapture: $63,640 (taxed at 25% max)

TAX CALCULATION:
Appreciation: $59,000 × 15% = $8,850
Depreciation Recapture: $63,640 × 25% = $15,910
Total Federal Tax: $24,760

Add State Tax: ~$6,000-10,000 (varies by state)
Total Tax: ~$30,000-35,000

Ouch. But there's a better way...

1031 Exchange (Tax-Deferred Exchange)

What It Is: Swap one investment property for another without paying capital gains tax.

Named After: IRS Code Section 1031

The Deal: Sell property, buy "like-kind" property, defer ALL taxes (capital gains and depreciation recapture).

Requirements:

1. Like-Kind Property: Any real estate held for investment or business use qualifies.

• Rental property for rental property
• Commercial for residential
• Land for building
• Etc.

Must be:

• Investment or business property (not personal residence)
• US property for US property

2. Timeline:

45 Days to Identify: From sale closing, you have 45 days to identify replacement property (in writing).

Can Identify:

• Up to 3 properties (any value), OR
• Unlimited properties if total value ≤ 200% of relinquished property, OR
• Unlimited properties if acquire 95% of identified value

180 Days to Close: Must close on replacement property within 180 days of selling original (or tax return due date, whichever is earlier).

3. Qualified Intermediary:

Cannot Touch Money: You cannot receive sale proceeds. Must use Qualified Intermediary (QI).

Process:

1. Hire QI before selling
2. Sell property
3. Proceeds go to QI (not you)
4. QI holds money
5. QI buys replacement property
6. You receive new property

QI Cost: $800-2,000

4. Equal or Greater Value:

To Defer 100% of Tax:

• Buy property ≥ sale price
• Use all equity (cash) in new property
• Maintain or increase debt

If you "boot down" (receive cash or reduce debt), pay tax on that amount.

Example:

Sell Property: $300,000
Equity: $150,000
Loan Balance: $150,000

To Defer All Tax:
Buy Property: $300,000+
Use all $150,000 equity as down payment
Take new loan: $150,000+

OR:
Buy Property: $400,000
Use $150,000 equity + new loan $250,000
(Increased value and debt - full deferral)

5. Investment Intent:

Both relinquished and replacement properties must be held for investment, not immediate resale.

1031 Exchange Example

YOUR SITUATION:
Selling Rental Property
Sale Price: $300,000
Loan Payoff: $120,000
Equity: $180,000
Capital Gain: $122,640
Tax Without 1031: $30,000

1031 EXCHANGE:
Identify Replacement Property Within 45 Days:
New property at $400,000

Close Within 180 Days:
Use $180,000 equity as down payment
New loan: $220,000
Purchase price: $400,000

RESULT:
Tax Paid: $0 (deferred)
New Property Value: $400,000
New Equity: $180,000
Debt: $220,000

Depreciation Basis: Carries forward (complex calculation - use CPA)

Tax Deferred: $30,000 (more money to invest!)

Deferred vs. Eliminated

Important: 1031 defers tax, doesn't eliminate it.

When you eventually sell without doing 1031, you pay tax.

BUT:

Strategy 1: Keep Exchanging

• Do 1031 from property to property to property
• Never pay tax during lifetime
• Build larger portfolio

Strategy 2: Die (Seriously)

Step-Up in Basis: When you die, heirs inherit property at current market value (stepped-up basis).

Accumulated gains disappear. Heirs owe no capital gains tax.

Example:

You bought property for $200,000
Did 1031 exchanges for 30 years
Now worth $2,000,000
Accumulated gain: $1,800,000

You die.
Heirs inherit at $2,000,000 basis.
No tax on $1,800,000 gain. Ever.

This is why "die with your real estate" is common advice.

Reverse 1031 Exchange

What if you find replacement before selling?

Possible but complex:

• Buy new property first (via QI)
• Sell old property within 180 days
• Requires more cash upfront
• Higher fees
• More complex

Consult 1031 specialist.

Delaware Statutory Trust (DST)

Can't find replacement property?

Invest in DST:

• Fractional ownership in large commercial property
• Managed by professionals
• Qualifies for 1031
• Lower minimum ($100,000 typical)
• Backup option if running out of time

---

Part 7: Working with Professionals

Tax and legal matters are complex. When and how to get professional help.

When to Hire a CPA

You NEED a CPA If:

• You own rental properties (yes, that's you!)
• Your finances are at all complex
• You want to maximize deductions
• You want to minimize audit risk
• You're doing 1031 exchange

What CPA Does:

Tax Preparation:

• Prepares Schedule E (rental income/loss)
• Calculates depreciation
• Ensures maximum legal deductions
• Files your tax return

Tax Planning:

• Strategies to minimize taxes
• Entity structure advice
• Retirement planning
• Estimated tax payments
• Multi-year planning

Audit Support:

• Represents you if audited
• Communicates with IRS
• Provides documentation

Cost:

• Tax Preparation: $500-2,000 (depending on complexity)
• Hourly Consultation: $150-400/hour
• Worth every penny

Finding a Good CPA:

Look For:

• Real estate investment experience
• Investor clients
• Proactive (not just reactive)
• Communicative
• Licensed (CPA, not just "tax preparer")

Interview Questions:

1. Do you have investor clients?
2. How many rental property returns do you prepare?
3. Do you invest in real estate personally?
4. Are you familiar with [your entity structure]?
5. Do you provide year-round support or just tax season?
6. What's your process and timeline?
7. What's your fee structure?
8. Do you handle audits?

Red Flags:

• No real estate experience
• Discourages record-keeping
• Promises unrealistic deductions
• Very cheap (quality matters)
• Poor communication

Where to Find:

• Ask other investors
• Real estate investment clubs
• Online investor forums
• Local CPA firms (interview multiple)

When to Hire Real Estate Attorney

Situations Requiring Attorney:

1. Entity Formation:

• Setting up LLC
• Operating agreement
• Multi-member entities
• Complex structures

2. Purchase/Sale:

• Complicated transactions
• Commercial property
• Seller financing
• Partnership agreements

3. Tenant Issues:

• Evictions (in some states)
• Lawsuits
• Lease disputes
• Fair housing complaints

4. Property Disputes:

• Boundary issues
• Title problems
• HOA disputes
• Zoning issues

5. Asset Protection:

• Structuring ownership
• Multi-property strategy
• Estate planning

Cost:

• Hourly: $200-500/hour
• Flat Fee (LLC formation): $500-2,000
• Flat Fee (eviction): $500-1,500

Finding Attorney:

Look For:

• Real estate investment focus
• Landlord-tenant experience
• Business entity experience
• Local expertise (knows local courts)

Questions:

1. What percentage of your practice is real estate?
2. Do you represent landlords or tenants? (Want landlord attorney)
3. Have you formed LLCs? How many?
4. What's your eviction experience in [County]?
5. What's your fee structure?

Where to Find:

• State bar association referral
• Other investors
• Your CPA may have referrals
• Local real estate investment clubs

Building Your Professional Team

Core Team:

1. CPA/Tax Advisor

• Annual tax preparation
• Tax planning
• Entity advice

2. Real Estate Attorney

• As needed basis
• Entity formation
• Complex transactions
• Legal issues

3. Insurance Agent

• Property insurance
• Liability insurance
• Umbrella policy
• Regular reviews

4. Real Estate Agent (Investment-Focused)

• Finding properties
• Market expertise
• Transaction management

5. Lender/Mortgage Broker

• Financing
• Refinancing
• Portfolio loans

6. Property Manager (if not self-managing)

• Tenant placement
• Property management
• Maintenance coordination

7. Contractors

• Handyman
• Plumber
• Electrician
• HVAC
• Roofer

Extended Team:

8. Bookkeeper

• When you have 5+ properties
• Monthly reconciliation
• Expense tracking
• Frees your time

9. Financial Advisor

• Investment strategy
• Retirement planning
• Portfolio diversification
• Estate planning

10. 1031 Exchange Facilitator

• Qualified Intermediary
• When selling properties

Team Communication:

Your CPA and attorney should communicate about:

• Entity structure
• Tax strategies
• Legal compliance

Give each permission to talk with the other when needed.

---

Part 8: Key Takeaways from Module 8

Core Principles

1. Real estate has huge tax advantages:

• Depreciation deduction
• Expense deductions
• Capital gains treatment
• 1031 tax deferral

2. Depreciation is powerful:

• $6,000-8,000 annual deduction typical
• Offsets rental income
• Can create "paper losses"
• Must recapture when selling (or 1031)

3. Track every expense:

• Almost everything is deductible
• Keep detailed records
• Separate personal and business
• Use software or system

4. Entity structure matters:

• LLC provides liability protection
• Individual ownership is simpler
• Umbrella insurance is essential
• Consult professionals

5. 1031 exchanges defer taxes:

• Swap properties tax-free
• Must follow strict rules
• Use Qualified Intermediary
• Powerful wealth-building tool

6. Professional help is essential:

• CPA for taxes
• Attorney for legal
• Team approach
• Worth the investment

Your Action Steps

Before proceeding to Module 9, complete these tasks:

1. ✅ Understand Your Current Tax Situation

• Review last year's tax return
• Calculate your marginal tax rate
• Project rental income impact
• Estimate tax savings

2. ✅ Set Up Record-Keeping System

• Choose software or spreadsheet
• Create expense categories
• Set up separate bank account
• Implement receipt tracking

3. ✅ Calculate Depreciation

• Determine building value
• Calculate annual depreciation
• Understand impact on taxes
• Plan for depreciation recapture

4. ✅ Research Entity Structures

• Understand LLC benefits
• Compare costs in your state
• Decide on structure
• Timeline for formation

5. ✅ Get Insurance Quotes

• Property insurance
• Liability coverage
• Umbrella policy
• Compare costs

6. ✅ Interview CPAs

• Find 2-3 candidates
• Ask about real estate experience
• Discuss your situation
• Get fee quotes

7. ✅ Interview Attorneys (If Forming Entity)

• Find real estate attorney
• Discuss LLC formation
• Get cost estimate
• Timeline

8. ✅ Learn About 1031 Exchanges

• Understand requirements
• Find Qualified Intermediaries
• Save for future use
• Plan exit strategies

9. ✅ Take the Module 8 Quiz

---

Module 8 Self-Assessment Quiz

Test your understanding. Answers provided at the end.

1. What is the residential rental property depreciation period? a) 15 years b) 27.5 years c) 30 years d) 39 years

2. What can you depreciate? a) Land and building b) Only the building c) Only improvements d) Only land

3. Which is deductible: mortgage interest or mortgage principal? a) Both b) Neither c) Only interest d) Only principal

4. The $25,000 passive loss allowance is available if your income is: a) Any amount b) Under $100,000 c) Under $150,000 d) Over $150,000

5. What does LLC stand for? a) Limited Legal Corporation b) Limited Liability Company c) Legal Landlord Company d) Limited Land Corporation

6. What is the primary benefit of an LLC? a) Tax savings b) Easier loans c) Liability protection d) Lower costs

7. How long do you have to identify replacement property in a 1031 exchange? a) 30 days b) 45 days c) 90 days d) 180 days

8. What is a Qualified Intermediary in a 1031 exchange? a) Real estate agent b) Attorney c) Third party who holds proceeds during exchange d) Lender

9. True or False: Repairs are immediately deductible but improvements must be depreciated.

10. What happens to capital gains when you die? a) Heirs pay immediately b) Estate pays c) Heirs get stepped-up basis (gains disappear) d) Tax doubles

---

Quiz Answers

1. b) 27.5 years
2. b) Only the building (land doesn't depreciate)
3. c) Only interest (principal is not deductible)
4. b) Under $100,000 (phases out $100k-$150k)
5. b) Limited Liability Company
6. c) Liability protection
7. b) 45 days
8. c) Third party who holds proceeds during exchange
9. True - This is the key distinction
10. c) Heirs get stepped-up basis (gains disappear)

Scoring:

• 9-10 correct: Excellent! You understand real estate taxes and legal structures.
• 7-8 correct: Good work! Review missed concepts.
• 5-6 correct: Fair. Re-read sections about depreciation and 1031 exchanges.
• Below 5: Review the entire module before proceeding.

---

Conclusion: You Understand the Tax and Legal Framework

Congratulations on completing Module 8! You now understand the powerful tax benefits of real estate investing, how to protect yourself legally, and how to work with professionals.

You've mastered:

• Depreciation and how it reduces taxes
• Deductible expenses and record-keeping
• Legal structures (LLC, individual, etc.)
• Capital gains and depreciation recapture
• 1031 exchanges for tax-free trading
• When and how to work with CPAs and attorneys
• Asset protection strategies

This Knowledge Will Save You Thousands: Proper tax planning and legal structure can save more than any other strategy. The professionals you hire will pay for themselves many times over.

The Journey Continues: You now have the complete foundation: finding properties, analyzing deals, financing, negotiating, closing, managing, and optimizing taxes and legal protection.

The final modules focus on scaling your portfolio and building long-term wealth.

---

You're ready for Module 9: Building Your Real Estate Portfolio.

In the next module, you'll learn how to scale from one property to multiple properties, use equity to grow, manage a portfolio efficiently, and overcome common obstacles to growth.

You know how to invest. Now let's learn how to build wealth systematically.

---

"The best investment on Earth is earth." — Louis Glickman