I’m back in action this week on my blog. Thanks for being so patient. Lot’s of questions to answer and great questions at that. Here is a very detailed question from Donald that applies to a lot of people who would like to get their money out of their 401(k) as quickly as possible.

Q: What is your interpretation of Internal Revenue Code section 72(t)(2)(A)(v) that provides an exemption from the 10% early withdrawal penalty from a 401k plan if: "(A) In general.–-Distributions which are–- * * * * * * * (v) made to an employee after separation from service after attainment of age 55?"

Does this mean:
1.The distribution must be after separation from service and after age 55 or
2.Does it mean separation from service must be after age 55 and the distribution is taken after age 55 (which could be the only case). The IRS seems to be interpreting it this way, which seems wrong. If this is the intention it should have been written this way.

Also, what if the separation is involuntary, such as when an employee is laid off before age 55, but takes a distribution from his 401k after age 55?

It would seem that the intention of the code is that as long as an employee separated from service and takes a distribution from a 401k after age 55, the exemption should apply

A: This confusion is why it’s so important to read the Internal Revenue Code on a regular basis if you are really going to understand it (or have a CPA who does so and can interpret it for you). As you suggest, the IRS clearly interprets this as saying that you have to be 55 or older when you separate from service in order to avoid the penalty on early distributions from a 401(k) or other qualified plan. This is one of the cases where I would interpret this section the same way the IRS does for the following reason. If you could terminate from service any time and then take the distribution once you turned 55, then there would be no need for the exception to the penalty for turning 591/2. Everyone would simply rely on the age 55 rule.

I don’t see any exceptions to the rule for an involuntary separation.

As you suggest, the IRS clearly interprets this as saying that you have to be 55 or older when you separate from service in order to avoid the penalty on early distributions from a 401(k) or other qualified plan. This is one of the cases where I would interpret this section the same way the IRS does for the following reason.

Warmest regards,

Tom

When you are doing your bookkeeping and later when you do your tax return, how you classify your expenses can have a serious impact on whether the IRS audits your tax return. There are certain expenses that the IRS does not like so naming them such that they don’t raise a red flag is important. I’m not suggesting that you falsify your return in any way. I’m just saying that a good tax preparer knows which terms are acceptable to the IRS and which ones they don’t like. Make sure your tax return preparer is paying attention to this.

Natasha asks the following specific question about classifying expenses:

Q: Services from ProVision (tax planning coaching etc) could be included under Legal and Accounting services category, right? And asset and tax relief education?

A: Services from your CPA firm such as ProVision definitely are included in Legal and Accounting services. This is a common category and the IRS has no issues with it. The tax and asset protection class you took should be classified as continuing education, provided you have already started your business. Otherwise, it’s a start up expense.

Warmest regards,

Tom

When you are doing your bookkeeping and later when you do your tax return, how you classify your expenses can have a serious impact on whether the IRS audits your tax return.

Self directed IRAs are all the rage these days. People are tired of mutual funds and what to have more control over their investment decisions. This is great so long as you watch out for transactions that are prohibited by the IRS. If you have a prohibited transaction, your IRA will be treated as having been distributed to you in full and you will have massive penalties imposed by the IRS.

Nick asks whether the following transaction is a prohibited transaction:

Q: I've been listening to the Tax strategy CDs, and just thought of this question. Is it legit, tax wise, to loan someone money from a self directed IRA, then partner with them?

A: This would be a prohibited transaction. Any time you do a transaction in your IRA from which you personally benefit or where you render services to the IRA, you have engaged in a prohibited transaction. Stay away from this type of transaction. And don’t think that if you lend someone money from your IRA and then they lend you money from their IRA that all is well. It’s not. This is a disguised prohibited transaction and the IRS will likely catch you and penalize you for it.

Warmest regards,

Tom

Any time you do a transaction in your IRA from which you personally benefit or where you render services to the IRA, you have engaged in a prohibited transaction. Stay away from this type of transaction.

Asset protection is such a crucial element of investing. One of the most important parts of asset protection for real estate investing is holding your properties in a limited liability company (LLC) or a similar entity. Sunshine asks the following question about when to put her property inside the LLC:

Q: Tom,
I am in the process of purchasing a second investment home and also at same time setting up LLC (home is a shortsale). When do I transfer investment property into LLC - can I do this with title company at closing or will the bank frown and not give loan - should I wait til all is said and done and own investment property?

A: You can transfer your property to an LLC immediately after you close on the purchase. Be sure to use a warranty or grant deed when you do it (not a quitclaim deed). The bank will never like it. You are probably violating your due on sale clause when you do it. In all my years of being a CPA, I have never seen a bank call a loan because it was transferred to an LLC. Doesn’t mean they won’t or can’t, just seems unlikely. If you are going to do this, then I would have your title company do it immediately after your closing with the bank so you get the maximum asset protection.

Warmest regards,

Tom

You can transfer your property to an LLC immediately after you close on the purchase.

In our course, Massive Passive Income, we emphasize the need in early years of investing to focus on high-growth assets. Then, as you get closer to your targeted wealth, you sell these an purchase assets that produce more cash flow. Of course, always buy assets that cash flow. Never buy an asset just for the growth.

When you sell the growth asset, it would be nice not to have to pay tax on the gain. In many cases, this can by done through a like-kind (also called a 1031) exchange. Fred has the following question about this:

Q: When turning growth assets into passive income, how would you do it without having to pay all the taxes. You would not be able to do a 1031 exchange unless it is totally paid for or you had enough cash to invest the total value of the sale? This seems to defeat the idea of holding for a time to get the greatest gain on the property.
Thanks.

A: Good news, Fred. You don’t have to have an asset that is totally paid for in order to do a 1031 exchange. The rule is that the new property must cost at least as much as the sales price on the old property. You can use debt as part of the purchase price. So if you sell a property for $200,000, you don’t have to pay tax on the gain so long as you buy a new property for at least $200,000 and follow all of the other 1031 rules. You can still use debt on the new property. You just can’t take any cash from the sale of the old property and use it for something other than the new property.

Warmest regards,

Tom

You don’t have to have an asset that is totally paid for in order to do a 1031 exchange. The rule is that the new property must cost at least as much as the sales price on the old property.

Lots of people are wondering what to do with their money in these days of a turbulent stock market and terrific uncertainty in the economy. Susan asks a question related to this that is on the mind of many:

Q: We have a very large amount of money in Ira acct I realize this is not a good position to be in. We are ages 49 & 51
We are in high tax bracket this year. If you were in this position would you take your money out and if so what would you do with it? I have a feeling you will say yes and reinvest in commercial real estate. It would be hard to stomach paying $200,000+ in penalties, taxes. Would like your best advise

A: Get educated. Before you do anything, you must have the education to be able to decide what you are going to do with the money. Next, you must have a wealth strategy. This is a plan of action to get from where you are today to where you want to go. It includes a decision about which asset class you will invest in, whether it is business, real estate, stocks or commodities. It include a decision about which type of asset you will invest in within the class you decide upon, e.g., will you invest in commercial, residential or industrial real estate.

Only when you have a clear wealth strategy can you make a good decision about whether to pull your money out of your IRA. For example, if your wealth strategy is based on investments in gold and silver, there would be no reason to pull your money out of your IRA. You can invest in gold and silver inside your IRA and defer the taxes (or eliminate them if you choose to convert to a Roth IRA). The same is true if your strategy revolves around the stock market. On the other hand, if you are investing in real estate or business, you may want to pull your money out of your IRA, pay the taxes and penalties, and reap the tax savings and investment returns that come from the leverage you can get in business and real estate.

So don’t do anything until you first have the education and the wealth strategy to know what to do. For education or If you would like help with creating your wealth strategy, feel free to call our office at 866.467.5809 or send us an email at cs@provisionwealth.com and we will be happy to give you some additional direction.

Warmest regards,

Tom

Many of our clients use Quickbooks accounting software for their investments and business. I also recommend using it for your personal bookkeeping. Mike & Della were wondering which version of Quickbooks we recommend.

I prefer that our clients use QuickbooksPro. This version allows you to do payroll and many other tasks that could be important to your tax strategy and investing. We are going to discuss how to use Quickbooks in our next AskTom LiveTax call on December 19th. Be sure to join us.

Warmest regards,

Tom

I presume this question relates to whether rental properties qualify as a business for tax purposes. The answer is yes. The expenses you incur related to your rental properties are deductible as a business expense against your rental income (and potentially against other income if you have a loss) so long as they meet the standard tests for trade or business expenses, namely they have a business purpose and are ordinary and necessary.

Warmest regards,

Tom

One of the biggest challenges for those starting out in real estate is financing their real estate purchases. Banks prefer to lend to individuals, not entities. And they want to see as much income as possible so they can be assured their loan will be repaid.

From the investor side, the investor wants to maximize the number of properties he/she can purchase with cheap bank financing. In our last Ask Tom Live call, I mentioned to Harold that he and his wife should purchase their properties separately instead of jointly. June wants to know why.

Q: You told Harold (the farmer) that he and his wife should buy houses separately because they would be able to buy more. If they have the same pile of funds to draw upon to purchase the houses, how would they get to buy more if they did it separately and not jointly.

A: Most banks want to qualify their loans under the FHA rules. FHA guidelines restrict the number of loans held by any one borrower. If you purchase the homes jointly, you are both charged with the loans. So, you can effectively double the number of homes you can buy using cheap bank financing simply by purchasing them in the name of a single spouse. Of course, you still have to meet the income requirements of the bank, but for many couples this is a fairly easy test to meet for each spouse. So we suggest you always purchase the properties in the name of one of the spouses to maximize the use of cheap bank financing.

Warmest regards,

Tom

One of the great aspects of limited liability companies (LLC’s) is that we get to choose how they should be taxed. So, we can get all of the great asset protection from an LLC and still choose to be taxed as a sole proprietorship, partnership, S corporation or C corporation. Paula just had her LLC’s set up and is now asking this question:

Q: Tom we created 2 LLC's. One in the state of Fl and the other in WY. The WY LLC is the Manager of the Fl. LLC and my husband and I are the managing members of this WY LLC.

Garret structured both entities for asset protection purposes thus I want to ask you, the tax expert:

How does these entities should be taxed? FYI, the Fl LLC is for investing and holding RE (for passive income purposes) and is the pass through entity. The WY LLC is for distribution when the time comes (Fl. LLC provides a little over a thousand in cashflow and is owing us the properties and initial expenses in cash and personal credit). Should we tax them both as a S corp.?

A: I don’t know. I’m a little confused about how you are using the LLC’s and what your plans are for future investing. My suggestion would be to develop a tax strategy with a qualified tax strategist (CPA) as soon as possible. A tax strategist will ask you many questions about your business, your goals and your personal situation to determine the best use of these entities.

As a general rule, I prefer to have ProVision clients do their tax strategy before they do their asset protection strategy. The reason is that we may recommended different entities or changes to the entities that will require additional work from your attorney. You can avoid this additional legal expense by doing the tax side of your tax and asset protection strategy first.

That said, it’s not to late for Paula. She simple needs to sit down with a qualified CPA and develop her tax strategy. This strategy will allow her to reduce her taxes for decades to come. If you would like help finding a good tax strategist (CPA), please feel free to contact our office at cs@provisionwealth.com and we would be happy to refer you to someone.

Warmest regards,

Tom