Better Tax Benefits Than Real Estate Tax Strategy Implemented By The Wealthy (Ep. 48)

One of the best reasons to invest in real estate is the incredible tax benefits real estate owners enjoy. From 1031 exchanges, depreciation, and expense write-offs, there’s a reason why people, including me, love real estate. But real estate isn’t king, or queen for that matter, when it comes to the tax benefits. That title belongs to passive investments that involve a working interest in oil wells. These passive investments not only allow you to deduct two to three times your initial investment, but you’re able to deduct the investment against active W-2 income, something real estate does not offer. So in this video, my personal and business CPA, Tim Gertz from ProVision, walks us through, number one, what you need to do to qualify for this tax benefit, and maybe more importantly, number two, what are the risks that you must assume in order to get the investment tax benefits? Hope this video opens some eyes. We have Tim Gertz from ProVision joining us today specifically to talk about carbon capture. It almost sounds too good to be true, right? I mean, you get to write off two or three times your active income with your investment. I think the biggest question we all have, Tim, is what’s the catch? So ultimately, the reason, so I think the name carbon capture is a little deceiving, and that’s where a lot of people get caught up in is this idea of carbon capture. What it really is and what they’re doing is they’re ultimately working in unison with a driller, with an operator, and using equipment to ultimately help increase production of that well. And by doing that, they qualify as what’s called a working interest in that oil and gas well. And as such, because they are a working interest, then that affords us the opportunity to use a exception within the tax law to ultimately treat that as an active trade or business without even materially participating in it. So that’s the first step, is to ultimately be able to take this asset and this investment and treat it as active without being materially participated in it at all. So that’s number one, and that’s a huge boon and a huge benefit of the tax law. And then the second one is to be able to use debt to multiply that loss. And it’s no different than real estate. If you look at a multifamily, if you go into a multifamily, traditionally it was 70, 30, 80, 20. So you were putting in 20 percent, 30 percent, and then you were borrowing money from the bank, and that gave you this opportunity to buy up. And because you were borrowing from the bank and there was recourse on those notes in some form or fashion, you were able to use that to create a basis in your partnership or your ownership in that partnership. Which then allows you to take losses. So it’s kind of like three-faceted. You’ve got the working interest in oil and gas that gives you the ability to treat something as active, even if you’re passive in it. You get leverage for using other people’s money to buy more assets. And then the third piece is bonus depreciation. Is now you’ve got this asset that is defined as personal property in the tax law, and as such, we’re able to write it off immediately. Now, 2023 is a little bit different because that has started to phase down and we’re now at 80 percent. But in 2022, we were able to write off 100 percent of that asset in the first year. So that’s kind of the three steps or the three parts of this investment that gives us this huge opportunity and this huge benefit. OK, awesome. Awesome. So then you’re saying that the investment from the investors, that creates active income for the otherwise limited partners? It does. So there’s a couple caveats to it. Number one, you have to be at risk. So you ultimately have to invest as a general partner, meaning that you’re at risk for any of the losses inside that partnership. In order to get that, and it has to be a you know, and it has to be a working interest. So as long as you do that, you invest as a GP, you have no limitation of liability and it’s a working interest in oil and gas. Well, then you can qualify as active, even though that investment is passive to you. OK, is that in every year of the investment or only in certain years? So once active, always active. There’s actually 469 C3B, I think, it cards it out. That specifically says once active, always active. So once you take that loss as an active loss, even if you convert to an LP, which most people do in year two or three and pull that into an, you know, into a holding company or something else, it will always be active income for the life of that investment. OK, OK, so now you talked about some different codes, code section, and I know that there are a lot of people that maybe just don’t know about this or they don’t understand. And of course, that which you don’t understand becomes scary, right? Would you say this is a well-defined and agreed tax position with the IRS? Yes. OK, it’s been in the tax code since 1986. So 1986 created the was the advent of passive activity loss rules. That tax law change in 86 was what created code section 469. And ultimately, this was part of that tax law. So this has been some lobbyist or group of lobbyists were able to kind of put this in there and get this in there and make it a permanent exception to the 469 or passive activity loss rules. OK, OK. So then in your experience, would you say carbon capture has ever raised any red flags for the IRS by virtue of and I keep saying carbon capture, even though you said it’s a little bit of a misnomer? You know, is this is this going to trigger an audit if people are afraid of if I do this, am I going to am I going to get audited because I did this? As long as and I can’t speak to have I has it ever. I’ve never seen it in anything that I’ve done. As long as the contracts and as long as everything, you know, I’ve got to teeth across with the investment, whether it’s carbon capture or any oil and gas investment. And it is drawn out as a working interest in oil and gas. Then ultimately it qualifies for this exception. OK, OK. And so a question that I’ve gotten from a few folks, I think it definitely bears discussion is when when people invest, they need to invest in their individual capacity and not through a disregarded entity. Can you just explain why that is? So the tax law specifically calls out that you have to invest in a way that your liability is not limited. And under state law, and it specifically calls out, you cannot invest through a vehicle that has limitations of legal liability at state level. LLCs are limited liability companies that are created at state level and limit liability in the statutes of those states. So as such, you are not able to invest through an LLC. OK, perfect. So on the I mean, I guess I’ll start it back, because anything I’ve said so far triggered anything like, oh, wait, you didn’t ask about this. I need to know about this. Not really. I mean, I think ultimately, you know, this is this is not this is nothing new. This is something that I’ve been dealing with my entire career, because usually affluent investors are the ones that are making these investments because it has such a benefit to be able to offset ordinary income. You know, high net worth individuals that have high paying jobs have the ability to invest in this and get the benefits from it. You know, the number one thing to make sure is that when you’re going into any investment, you’re looking at the agreements and the contracts and making sure that it does qualify in, you know, as a working interest. And so really, that would be the only thing. And how these investments are structured, you know, they are structured specifically and they are drawn out specifically to be working interest in oil and gas wells. And as such, they qualify. OK, awesome. So give me advice for people who other than fire them and hire you for people who go to their tax preparers who just don’t understand this at all. Like what advice, you know, would you give for someone talking to their CPA about whether or not they ought to invest from a tax perspective? I don’t think you’d find someone that is educated, doesn’t have to be me, doesn’t have to be provisional, can be anyone that has an understanding of the tax law. But ultimately, if you bring this investment to a tax preparer or CPA or accountant or whoever it might be that you’re working with and specifically call out the working at, you know, working interest in oil and gas exception to pass back their last rules and you get a puzzled look, you probably need to start looking for someone else. You know, and it’s not to be you know, it’s it’s just it’s the nature of the beast, unfortunately. You know, in the accounting industry, there’s limitations in those barrier barriers to entry as far as education goes. So typically the sole practitioners and the small businesses don’t have the opportunity or the ability to pay for huge, large research platforms that provide education and guidance for them. The larger firms typically are more educated simply because they can share that cost over, you know, over a large amount of employees. So, you know, so it’s not at anyone’s fault, it might just be that that’s something they’re not used to. Understood. There are a few other questions which really kind of go a little outside, I think, of the tax side of it involving diligence. And we’ll get to those if we have some time. I think we might have operators on here that can maybe ask some of these questions about the diligence. But just from a tax perspective, what kind of diligence would you expect an investor to take a look at prior to making this decision? I realize your lane is the tax side, so you don’t have to go any further than that. I mean, ultimately, it’s it’s making sure that you. Have access to and have the ability to see that this truly is a working interest in oil and gas well, so that they have the contracts in place, that they have dotted their eyes and cross their T’s, because ultimately you as an investor are relying upon them as an operator to do what they’re supposed to do to qualify as a working interest. And so ultimately, I think from a tax perspective, I mean, personally, when you invest, if you want the losses to be active, you need to invest in your personal name or through an entity that doesn’t, you know, doesn’t lessen your liability. And number two, you need to invest as a general partner. And so ultimately, if you can do those two things personally, then you are set up to be able to reap the benefits of this exclusion. But as an investor, you should probably make sure that they are if they’re representing that this is a working interest, that they’ve actually got the contracts in place and are operating as a working interest in oil and gas. OK, awesome, and I’m seeing questions about where can we learn more and that kind of thing, what I’m going to do right now, I’m going to open it up to questions specifically for Tim about the tax side of this, because I think that is one of the biggest draws of of these deals is the tax side. And that’s the question. Those are the questions that we get frequently. And then if there’s some time, we can open it up to some of these other questions about diligence and other potential liability, which would either be my lane or the operators lanes. And we have a few operators out here that can answer some questions. So Jared, Jared’s asking, is there pass through depreciation on the assets? Yes, ultimately the losses in this, the losses. So what these deals are doing is they are you are ultimately acquiring the investor or the partnership itself is acquiring assets and those assets are depreciable assets. So in the first year, a large portion of the losses are created because of the depreciation on those assets. So those assets. So, yes, the depreciation pass through. OK, and can you just go through and explain how that can be multiplied by two or three times the investment? If somebody’s asking for some clarification on that. So a perfect example. So let’s say, you know, you and I go into a partnership and we both bring one hundred thousand dollars to the deal. So there’s two hundred thousand dollars in capital that’s contributed to this partnership. And we go to Bank A and say, hey, we want to buy this million dollar asset. Can you lend us eight hundred thousand dollars? Well, we now have the ability to buy an asset that’s worth a million dollars. We only put two hundred thousand dollars into that asset. We took eight hundred thousand dollars from a bank and we have a note. It has some recourse to it. And ultimately, because it is a recourse note, we get basis in that asset. And so now, even though we only put two hundred thousand dollars into this partnership, we have tax basis of a million dollars. And so when we write off that asset, because it’s depreciable in year one, we get a million dollar loss. We share that 50 50. Let’s say you get five hundred thousand dollars. I get five hundred thousand dollars of loss. So we have one hundred thousand dollars that we contributed, but we get a five hundred thousand dollar loss that we can use against other income simply because we have basis in that loss. So it’s just it’s it’s a tax law thing. It’s whether or not you have basis in that asset to be able to take the loss. And that’s where this is being created. You go into these investments, they’re borrowing money, that loan has recourse to it. And as such, it’s giving you tax basis and something that’s called at risk basis. And it gives you the opportunity to take losses against it. Right. OK. And because the LP that limited partnership that’s doing these syndications is the one acquiring the equipment and taking out the loan and and bringing in the capital, they own all those losses. Yeah, they. Yes. So there’s. Yes. I’m sorry. Go ahead. Oh, I’m sorry. I’m trying to get the idea of owning those losses. The investors on the losses. But yes, yes, they the the partnership, because the partnership is a flow through entity. Anything that happens within that partnership flows through and is reported at the personal level. So, yes, the partnership owns the losses, but they pass those losses through to the investors. OK, and no part of those losses are then attributable to the oil and gas company or the other or the operator. No. Well, they technically are the operator or there are a portion of the operator. Right. Makes sense. OK, I’m looking through these questions here. Now, what if I get my share of these losses and I can’t use them all in one year? Would it carry forward? Yes. OK. Is there a cap? Oh, this is a good one. This is one that’s come up a lot. Is there a cap on how much depreciation any one individual can get in a single year? No. You could get one hundred million dollars of depreciation if you wanted. If you had it, if you had the basis and you had money to buy a hundred million dollars worth of assets. But yeah, there is no bonus depreciation has no caps and it’s not limited by anything. So, you know, there are things in the tax law code section 179, which was huge before 2017, had limitations and had a lot of catches that would limit the amount of deduction. Bonus depreciation has no limitations. So you can take it as you know, and if you don’t use it, you carry it forward and then carry it forward and carry it forward until you die. Awesome. So you just invest half your W2 income in carbon capture and pay no taxes. Well, well, let’s talk about that, though, because you talked about phantom income. Can you talk about that for a second? So there’s two things. One thing you did touch on when we say if you can use it or not use it, there is something that came out of the 2017 tax act called excess business loss rules that limits the losses from flow through entities that can offset W2 income, retirement income, portfolio income, interest dividends, things of that nature. That started in 2020 and ultimately it is continuing forward indefinitely at this point. There is an end date, but it’s far enough out that right now it indexes for inflation every year, but it’s somewhere in the ballpark of about five hundred sixty to five hundred eighty thousand dollars that you can offset. So in an example, if you have a million dollar loss from a carbon capture investment and you have a million dollar W2, the most that loss is going to offset is five hundred and sixty thousand dollars. The remainder is going to be considered taxable income. And what’s not used is going to carry forward next year. OK, it’s confusing. It’s a little it’s it’s a calculation we have to do and it’s kind of confusing, but the best way to remember it is. If you are a W2 employee, if you make more than five hundred and fifty thousand dollars a year, you are going to pay tax on a portion of it, even if you have one hundred million dollars of losses falling through from an investment. Got it. OK, so this is why it’s important to to have a CPA who who one really understands this this asset class, but two is somebody pointed out is not afraid to apply the at risk rules, which somebody had pointed out here a moment ago. And I lost your question. I forget you asked something. What was it? Which is you did answer it, which was if I if I make a million dollars a year, can I just invest five hundred thousand and pay no taxes? What you answered? OK, not exactly. So it’s been asked, you cannot ten thirty one into these deals, correct? You can you can. OK, so oil and gas is considered real estate, so it does qualify. But ultimately, you have to find someone that’s willing to do it. And typically when you ten thirty one, you don’t have basis. I mean, the goal of ten thirty one exchanges to roll that basis over. And so ultimately, if you have an asset that you have a base of one hundred thousand dollars, but it’s worth a half a million dollars, if you sell that in ten thirty one into oil and gas, your basis in oil and gas is only one hundred thousand dollars. So you’re not going to be able to write off half a million dollars in the first year. You’re going to be able to write off one hundred thousand. That makes sense. Yeah. Yeah. And honestly, and I’ve said this and now it’s. Might not be right anymore, but ten thirty one exchanges kind of became obsolete. In the last five years now, they might be come back, come back into, you know, into. Into the fold as bonus depreciation starts, you know, starts to fade out if it doesn’t get kicked down the road some more, but ultimately there was really no need, especially in this type of asset class, recognize the gains, choose how much you want to ultimately pay tax on, invest the rest in something that’s going to give you bonus depreciation in year one. And so there was really no need for a ten thirty one exchange. The complexities, the restrictions on ten thirty one exchanges didn’t really make sense unless it was something that, you know, ultimately you’re selling a multifamily and, you know, and buying land makes us do ten thirty one exchange or you’re selling something in December and don’t have the opportunity to buy something for the end of the year. Makes sense to do a ten thirty one exchange. But if you’re doing apples to apples or investing in something that has bonus depreciation, there really isn’t a lot of opportunity to do an exchange. OK, got it. Let’s see here. We’ve got so many questions. This is such an interesting topic. Everybody seems to be excited by it. So can you somebody was asking, where did it go? James was asking, I’m not sure I understand the question. What about percentage depletion allowance? Does that question make sense to you? Yeah, somewhat. And so ultimately, oil get is so think about any asset that you have. Depreciation is just the IRS is saying the way of saying we’re going to allow you to deduct the expense of this asset over its useful life. And the same thing with depletion. Depletion is the same thing. Depletion is basically saying we know you’re pulling minerals out of the ground and you’re depleting the asset. And as such, we’re going to give you the opportunity to take a offset in the form of depletion on an annual basis. There’s a calculation for it. It’s based typically on the gross receipts or ultimately the oil and the money you receive from the oil that you sell. But yes, there is an opportunity for depletion because it is it is depleting a mineral. OK, aside from a personal guarantee, is there anything else that would cause the debt to be considered recourse? No, that’s it. I mean, that’s that’s that’s the definition of recourse is you’re personally at risk for it. And that’s. I could get I’m not going to get deep into there’s tax base and that risk basis and ultimately recourse gives you at risk basis. So that’s the reason that it needs to be recourse is so that it gives you at risk basis. OK, got it. So, Andrew, thank you. Andrew actually reminded me of the question that I was asking that we then started talking about something else, which is is there is there phantom income from from getting distributions? Yes. So ultimately, when you take a loss using someone else’s money, you’re getting the benefit of that other person’s money. And in order to ultimately, as you repay that debt, you’re repaying that debt using income. So it’s money that is going to someone else. But you as an investor and an owner of that partnership are going to pay tax on it. So, yes, in your simple example, if you have one hundred thousand dollars of capital, let’s just say it’s a fifty fifty leverage. So you get one hundred thousand dollars of money from the bank and you take two hundred thousand dollars in year one. Well, over the course of that investment or the term of that loan, you’re going to pay that one hundred thousand dollars back to the bank. That one hundred thousand that you’re paying back to the bank is going to come from income. So it’s income that you’re going to pay tax on, but you’re not going to be able to distribute to yourself because it’s going to the bank. Got it. OK. So a lot of these questions are really not necessarily tax related. So when I ask you, feel free to just parse out the part that you’re comfortable answering and then you can skip the rest and we can save the rest for either a later time or at the end. And one of them is, is what is the liability when investing personally? Worst case scenario. Now, I recognize, you know, equipment could blow up or whatever, but from a tax perspective, from a tax, I mean, there’s not a liability from a tax perspective. But ultimately, personally, there’s liability. And the definition is that you’ve got to be at you have to have unlimited risk. Now, that’s not to say an operator is not going to have insurance to mitigate that risk. But, you know, by pure definition, from a tax perspective, you have to have unlimited risk. That means someone dies on that oil field, someone gets maimed on that oil field. There’s an explosion on an oil field. There’s environmental contamination because it’s something that’s done on an oil field. You are liable for it as a general partner. Now, my understanding, though, is that that most of these deals have the personal guarantee capped at two times. There’s a personal guarantee agreement that caps the the risk at two times the investment. So that’s for the debt. That’s not you can’t have that in the investment simply because you have to have unlimited risk as a general partner. Got it. OK, so that would be a question that I think for for the operators here to to ask about. And by definition, so by definition, being a general partner in a partnership, you have unlimited risk for anything that happens within that partnership. So that’s the ultimately, as long as you’re a general partner and it is a partnership and not an LLC or any other entity that limits liability. From a tax perspective, you’re good. And from a legal perspective, I defer to you on that, whether or not you have exposure. Yes. And yes, in the event of that, we can talk to the operators on here about what’s in place. If anything, to protect against that towards the end here, if people have no more tax questions. So one of the questions is and you may have touched on this, is there a cap on losses applied to capital gains? No, no, I mean, no. So ultimately you have when you think about the tax law, there’s three buckets of income, got ordinary income, ordinary active income, you’ve got passive income and you’ve got portfolio income. Ordinary active income is W2, any flow through entity that you materially participate. So provision for me, from here for you, anything that you are materially participating in is ordinary and active. Oil and gas because the carve out is ordinary and active. Passive losses or passive income is anything you don’t materially participate in. So any investment you do in real estate, anything, you know, if you invest with me and I open up a car wash and you do nothing, you’re passive in it. So that’s passive investments. Portfolio is the third bucket. That’s interest, dividends, capital gains, on equities, things of that nature. So when you look at that, I always tend to say it’s a waterfall and ordinary active is the top of the waterfall and everything that is an offset spills over to the next. So ultimately, if you have. A hundred thousand dollars of ordinary losses, you have no ordinary income, it will offset a hundred thousand dollars in capital gains, and ultimately, if there’s no more capital gains, it will offset passive income. So it makes its way down the waterfall and ordinary active income or losses will offset anything else. Got it. OK, since we mentioned bonus depreciation dropping to 80 percent and then for the next few years, has there been any real talk about legislation reinstating the 100 percent? Is that are we stuck with 80 percent and diminishing or does it look like it might go back up? There’s been there’s been chatter about it. There’s been thoughts about it. I mean, it’s something, you know, most appreciation came out of a tax act in 2002. So it has been bipartisan. It is something that came out of the Bush administration in 2002. It was re-upped, you know, it was re-upped again by the Democrats. It was re-upped again by the Republicans. You know, we’re back to a Democrat president. And there’s never been any discussion of getting rid of it because it spurred the economy. It was designed to spur U.S. manufacturing initially. And it has been it’s had different iterations based on what was trying to be done at that time. Ultimately, in 2017, it was designed to spur the economy in any way, shape or form as long as you’re investing in personal property. So do I think it’s going to get bumped back up to 100 percent? I’m not sure. There’s been a lot of chatter. This year is not going to be a huge deterrent, because ultimately, if you get to write off 80 percent in year one, the 20 percent that you didn’t write off is still going to be depreciated. And if those are short life assets, like a five year asset, so equipment, there’s a percentage, depending on when that asset is placed in service, that you’re going to get in that first year. And it could be 20 percent. So if you get 20 percent of 20 percent, you get four percent. So ultimately, in the first year, your reduction is not 80 percent. It’s 84 percent, which isn’t a huge deterrent. I do think you’ll start hearing more chatter towards the end of the year, especially as we start rolling in 2024. But I do think it’s something that will get picked back up. I just don’t know if it’s going to be this year. But thank you for that. Jake is asking for a clarification. I think we touched on it, but maybe just provide a little more color on with cap gains, not having a cap. Would that mean that the five hundred and sixty thousand dollar cap or whatever it ends up being on ordinary income would flow to capital gains above and beyond the cap, which I think you just talked about with the waterfall, right? It depends. So unfortunately, it depends on what the capital gains are. If it’s if it’s capital gains on business property, it’s different than capital gains on equities. So if you have a million dollars of gain on the sale of Tesla stock, you’re only going to be able to offset five hundred and sixty thousand dollars of that million dollar gain. If you have a million dollar gain on the sale of a piece of real estate, then that is different. It’s considered it’s considered either active or passive gain. And ultimately it it can offset as a flow through entity or flow through income. It can be offset unlimited by this investment. OK, so if anybody if I’m not asking your question correctly, just please go ahead and clarify for me. So a couple of questions from Julie, can an investment in these carbon capture deals eradicate passive income gains? Yeah. OK, if it flows down, I guess. Yeah, ultimately, if it’s up at the top of the waterfall, you have no other income in that bucket. It’s going to flow down and continue to flow down. And if it doesn’t get utilized, carry forward to the next year and start back at the top and rolls its way down. OK, and then it keeps rolling over. Does that ever end the rollover? Does it expire at any point? In 2017, they changed it used to carry back and then carry forward. The CARES Act did a little trickery, but ultimately the 2017 tax law did away with carry back. And now it’s an indefinite carry forward. OK, every time I think we’re out of questions, we get another one. So if anybody has any additional and again, feel free to unmute yourself if you have tax specific questions. And then we can get to some of the other ones. Questions, comments or use the hand raise feature if you. Well, as I can kind of go back up. All right. So I’ll start back with the top. And some of these, Tim, you might have to you might have some color on and some of them you might you might you can pass or play. So what does due diligence look like for the project? And we talked about that a little bit in terms of making sure it’s a working interest. I think much like anything else, you’re going to always want to do diligence on your syndicator. You want to make sure that you know who you’re investing with to make sure that they’re going to be good stewards of your money, to make sure that they’re going to do all the things that are required in order to get this right off, right. In order to make it a working interest or whatever is required that they’re following Tim’s instruction. And beyond that, you’re going to want to make sure that you feel comfortable in in the offering materials that you get to make sure it’s just like any other investment. Right. Make sure you’re comfortable with where the cash is coming from and who you’re investing with. Every one of these operators will be giving you a pitch deck or a business plan that will tell you how it all works. And then you’ll be getting offering documents prepared by PLG and just make sure that you review all of the risks and ask any questions that you have. Make sure you get your advisors, your tax advisors, your financial advisors, any of your personal attorneys in on the conversation early so that by the time you’re ready to put in your capital, you’re comfortable. But just make sure you ask the questions. Right. Every operator I know is more than happy to answer whatever questions they can for you. James is asking which oil and gas companies are involved. And I don’t know that. I don’t know that necessarily I actually don’t know the answer to that question. If somebody wants to jump on and answer that question, I don’t know. It could be different for every I guess every bit of equipment. Yeah, I know the ones we’re doing is Exxon. I think Courtney put it in the chat, too. I don’t know. Yeah. OK, awesome. Thank you, Julie. So how is it possible for people to go from a GP to an LP? I think we answered that one, which is you can’t change the nature of the investment itself. You can you can switch from a GP to an LP and thereby then limit your your personal liability once you’ve taken the benefit of the write off. But the income continues to be active. Is that an accurate for the entire life of the investment? So you typically see it’s a legal document you convert. So you sign a legal document that says I’m converting my interest from a GP to an LP. And as such, we noted on the tax return or it would be on your K1 that you’re a limited partner, not a general partner. But yeah, it’s no matter what, whether or not it’s in your personal name or if it goes into an entity and LLC, anything else, it will alwa