Here’s How I Got $83,000 Back on My Tax Returns

By Daniel Smith, WCI Columnist

At the risk of triggering an audit (my numbers are tight, Fed), I wanted to write about how my wife and I got a tax return of $83,000+ last year from combined federal and state returns. There are, of course, several ways to do this: severely overpay quarterly estimated taxes, not pay attention to the withholdings on Form W-4, give away lots and lots to charity, lie to the IRS, etc. I never said they were all good ways. Fortunately, my methods are less sinister, silly, or salacious. Instead, they are a response to Uncle Sam’s proclivity to incentivize businesses, particularly real estate. Spoiler alert: we used REPS status.

Being a W-2 doc married to a W-2 PT, we already maxed out available retirement accounts and HSAs, contributed up to the deductible state limit for our children’s 529 accounts ($10,000 for Alabama, FYI), and gave yearly to the church and other charities. What to do? There aren’t many alternative tax strategies available that haven’t come under a considerable amount of fire (looking at you, conservation easements). Yes, you can deduct losses for day trading or oil and gas exploration investments, but taking losses just for a tax advantage is like icing a cake before you bake it.

We’d been passive real estate investors for years with a few single-family homes and a small commercial property, piling up passive losses and waiting for an event like a sale to use them. My wife had been talking about doing something flexible so that she could spend a little more time with our two boys, and everyone knows that real estate is an easy gig, right? Work 750 hours a year in real estate with 500 in your own properties, work real estate more hours than anything else, and claim Real Estate Professional Status with the IRS. Suddenly, passive real estate losses become active losses!

I figured she could work a fairly flexible 750 hours in real estate and, as much as she wanted, as a physical therapist, provided it was less than she worked in real estate. Along with lowering our tax bill, this would have the added benefit of saving us the cost of a property manager.

Framing — ‘Real Property Trade or Business’

Among real estate gurus and aspirants alike, Real Estate Professional Status (REPS) has the aura of the Mickey Mantle rookie baseball card, the crème de la crème of tax minimization, hyped to gilded absurdity like a Trump Hotel bathroom: aureate, embellished, excessive. The problem is that for REPS, you have to be engaged in a “real property trade or business,” and we were just two medical professionals with some real estate. We started by looking into a real estate license so that my wife could sell a few houses, search for more rentals for us, and have a legitimate profession upon which REPS hours could be built.

To her credit, she completed all the coursework and passed the exams with ease. For a brief, sanguine moment, we even had access to the vaunted MLS, which operates with the finesse of an ‘80s Celica.

Then reality struck. Like Icarian wings in the blistering light of the sun, her designs on becoming an agent melted once my wife realized the job required networking, marketing, and—worst of all—small talk! I find it remarkable that my wife can spend an hour with a patient in the PT gym and converse as glibly as a politician but absolutely freezes at the thought of talking with the Joneses about an extra half bath. I digress . . .

In a twist of fortuitous irony, my wife ended up turning into Rosie the Riveter and working for a local contractor doing everything from drywall to paint and from trim to flooring. She never worked plumbing, framing, or electrical, but she can probably hang sheetrock with the best of them. To wit, if anyone needs a putty knife, we now have a collection. She also learned how contracting worked: how bids are made, the cost of materials, managing and communicating with subcontractors, their labor rate, etc. Her pay was initially unskilled labor rate (because that’s what she was) and steadily rose as she got better at her jobs and began to manage small tasks.

Electrical and Plumbing — All Stubbed Out and Nowhere to Go

Our real estate personal portfolio consisted of four single-family homes that we started purchasing in 2020 after I began my first job as an attending. We’d also recently purchased a small commercial building which had previously been an optometrist’s office. My side hustle, Drip, went into it, sharing that space with another medical practice. My wife was the property manager, lawn service, bill collector, handywoman, and bookkeeper. For one property, we had a tenant who broke the lease, and my wife actually filed all the legal paperwork for eviction proceedings and represented us at the courthouse.

After this, she informed me that I was buying her a new kitchen, and I told her that as long as she did the trim, we had a deal. I will admit that I underestimated the amount of time that she and I had to go somewhere on the nights and weekends and attend to problems with the properties. I thought it would be perhaps once every few months, and it ended up being more like once every couple of weeks.

We’ve fixed flanges, changed light fixture ballasts (she made me do this because it was my idea, and if anyone got electrocuted, it should be me), laid flooring, pressure-washed parking lots, changed multiple locks, straightened leaning doors, and (of course) patched and painted lots of walls. During one weekend, we had a torrential rainstorm, and the high volume of rainwater pulled a gutter off the commercial property, spilling water onto the covered walkway and getting in through one of the exterior doors. One of our tenants flooded the top floor of a rental because the gentleman didn’t know the drainage hose from the washing machine needed to feed into the laundry standpipe. Apparently, he’d only lived in apartments which included a coin-operated laundry area.

Looking back, it’s incredible what common sense notions we took for granted.

Sheetrock, Mud, and Tape . . . And the Mud Again, Twice

We meticulously logged hours, tagged expenses, and ended up with her having around 800 hours of work just in real estate (along with around 300 hours working as a physical therapist). That doesn’t count my hours or “investor hours.” Note that the IRS considers those routine things that passive investors do as “investor hours” and don’t count toward REPS: bookwork, driving miles, scouting properties, educational time, etc.

Once one spouse gets at least 750 hours of work and works more in real estate than in any other profession, they can claim REPS status. At that point, you can count both spouses’ hours for “material participation” hours, which have to number at least 500. While several material participation tests exist, the 500 work hour test is probably the easiest to substantiate.

Paint, Trim, and Fixtures

The last step was to perform cost segregation studies for our properties. Cost segregation studies separate out component parts of a building so that you can depreciate them differently.

For example, residential HVAC systems generally depreciate over 27.5 years, but a window unit depreciates over seven years. So, items on different depreciation schedules are separated out based on their usable life. Once the studies were performed on our properties, we claimed bonus depreciation (accelerated depreciation losses on property with a usable life of 20 years or less) to capture what was, at that time, 60% bonus depreciation (thanks to the Tax Cuts and Jobs Act).

If an item had a five-year lifespan, we could deduct 60% of the value of that item up front and the remaining 40% over the next four years (technically, it’s 60% plus straight-line depreciation of the remaining 40% over five years, [40% divided by 5 years is 8% per year], so 68% the first year and then 8% per year for the remaining four). Since I know someone will ask, we did deduct a portion of my wife’s new car using bonus depreciation, but only to the extent that she used it for business.

Turn the Key

In the end, we got around $73,000 from the federal government as a refund and an additional $10,000 from the state. My wife told me unequivocally that she appreciated all she’d learned but never wanted to manage our properties again. The unpredictability definitely dampened the luster of that fat tax refund. Aside from the money, I feel like my wife and I both gained confidence in handling small disasters and most routine maintenance and repair for the home (replacing a disposal is surprisingly easy).

We invested about half of the refund, and the other half went to a “light” update of our kitchen. Would we do it again? If my wife wanted to do it another year, I would be game for it. However, her answer was and is unequivocally no, and the best return on my time and money is a happy wife.

The post Here’s How I Got $83,000 Back on My Tax Returns appeared first on The White Coat Investor - Investing & Personal Finance for Doctors.