Tax Report 2018

I've been doing a blog post after finishing our taxes each year for most of the existence of this blog. It usually runs in April. I obviously didn't run one this April. The first reason why is that I didn't finish our taxes until September. Due to missing K-1s, I had to file an extension this year for the first time. The second reason is that due to the financial success of WCI, LLC these last few years a detailed discussion of our tax return would come across as more of a humblebrag than an educational opportunity for most of our readers who have a fraction of our income.

While I don't like writing quarterly estimated tax payment checks that I could live very well off of for an entire year, the truth is that the only thing worse than having to write big tax check is not having to write a big tax check. Unlike many tax-naive doctors, I love having a big tax bill because it means I made a lot of money and have even more to spend, save, and give even after paying all those taxes. At any rate, as I completed my tax return I did have a few observations that I thought readers would find useful.

Filing for an Extension Is Not a Bad Thing

This was our first year filing for an extension. Not only was it no big deal, it might even be preferable to trying to meet tax return deadlines. I may just start doing it routinely even if I don't have to. This year I was able to finish up the tax return at my leisure on a date of my choosing in the early Fall. No standing in a line at the post office. No cramming it in at the last minute. No hounding your employer or partnerships for tax forms. If I wasn't doing my taxes myself, I would have all the time I want with my tax preparer because they are no longer in their busy season. In fact, it turns out that filing an extension is one of the easiest things to do. Many states don't even require you to send them a form (just a check)!

The one downside to filing an extension is that you have to actually pay the tax due by April 15th. How can you know how much is due if you don't have the information you need to file the return? Well, you can't. Like filing quarterly estimated payments, it's really a guess. You try to be close so you don't loan the government money tax-free and so you don't end up paying a bunch of interest (or even penalties), but you probably aren't going to nail it exactly. In my case, I ended up getting refunds back from two states and the feds and paying more money (and interest) to one state.

A Kinder, Gentler IRS

I don't actually file just one tax return a year these days. As an S Corp, I file a ton of them. Probably the most burdensome is Form 941. This is a quarterly tax return filed by S Corporations. We pay ourselves salaries once a quarter and I file the return at the same time. After doing these for a couple of years, I think there has been a screw-up on it more often than not. But guess what? Half the time I make the mistake and half the time the IRS does. So we've basically become pen pals and we send each other a letter every quarter or so and get on the phone every now and then.

One thing that increased interaction with the IRS has done for me is made me MUCH less afraid of them. These are just regular people doing their job. If you are actually trying to follow the rules and you respond appropriately to their communications with you, it's just no big deal. You know that sinking feeling you get in your stomach when you see a letter from the IRS? (It's similar to the one you get when you see a letter from an attorney or your colleague asks “You remember that guy you saw last week?”) I no longer get that, at least from the IRS.

However, I do think my general guideline that

If you (as a high income professional) can't declare at least $100K of your income as distribution instead of salary, filing as an S Corp probably isn't worth the hassle

is a pretty good rule of thumb. 941s and associated chores are enough of a hassle that if I wasn't saving at least a couple thousand in Medicare taxes a year from incorporating I wouldn't bother.

The $3,000 Limit on Tax Loss Harvesting Sucks

Remember that very brief bear market back in December 2018? Well, I did a lot of tax loss harvesting that month. About $80K. Unfortunately, I only get to use $3,000 of it as a deduction this year. The rest I just have to carry forward. While it can also be used to offset capital gains, it could take me 25 years to use up all of those losses. This is a nice break for those with small taxable accounts, but the law of diminishing returns kicks in pretty quickly.

The 199A Deduction Can Be Huge

I paid a lot of attention to the rules surrounding the 199A (Pass-Thru Business) Deduction when it came out and arranged our finances such that we could maximize it. I was sure glad I did, especially since it was one of our few deductions for 2018 and by far our largest one.

As you may recall, when our tax bracket was reduced from 39.6% to 37% at the end of 2017, we bunched our usual charitable contributions all into 2017 and then took the standard deduction for 2018. So instead of six figures worth of itemized deductions, we had just the $24,000 Married Filing Jointly standard deduction. We still got to take deductions for our retirement account contributions and self-employed health insurance premiums, but that was about it. Except for the 199A deduction, a larger deduction than I think I've ever had from retirement accounts, mortgage interest, property and state income taxes, and charitable contributions combined. Suffice to say we were highly rewarded for paying attention to that one. While it specifically excludes most of the income of most readers of this blog, if you are an exception like I am, get your head wrapped around this deduction.

Depreciation

I was surprised by how many different ways real estate partnerships/funds/syndications can calculate out depreciation. One of my investments depreciated a third of my investment! While I didn't have a ton of unsheltered income from other real estate investments, if I had, that would have been very welcome. There is a surprisingly amount of leeway in what can be done with depreciation and it can really be frontloaded if the owners want. I had a substantial amount of real estate income that I expect to grow over the years but didn't pay any taxes on it at all this year thanks to depreciation. That's one great reason why equity real estate (not REITs despite the fact that their income also now qualifies for the 199A deduction) can be reasonably held in a taxable account just like total market index funds and muni bonds.

1231 Gains

One of my K-1s for a syndicated real estate equity deal went full circle in 2018 and the final K-1 for it included a “1231 Gain.” I didn't know what that was, but it turns out it is usually pretty cool. Section 1231 is another one of those cool real estate tax breaks that are always alluded to but not fully described. 1231 property is real or depreciable business property held for at least one year. That qualifies you to pay gains on it at long term capital gains rates. But if you happen to LOSE money, you get to deduct the loss at ordinary income tax rates. You are really getting the best of both worlds here. It's not quite as good of a deal as if I had been able to do a 1031 exchange into another property, but it's not terrible.

However, there is one major downside to a gain being classified as a 1231 gain. I can't use all those capital losses I got from tax loss harvesting my index funds to offset it! Capital gains/losses go on line 13, but Section 1231 gains/losses go on line 14. Bummer!

Tax Inefficient Debt Funds

The return also reinforced just how tax-inefficient real estate debt funds can be. High income and 100% taxable at ordinary income tax rates in this year. To make matters worse, I discovered that these funds also tend to send you a state K-1. No big deal for the fund that lends in Utah (where I'm filing a return anyway) and Colorado (where it does a composite return). But the one in California? That's a bummer. Not only did I have to file a California return but I have to pay state tax on that income at twice my usual rate. It's enough that I'm seriously considering getting out of the fund just to avoid that tax hassle. Moving forward, I'll likely try to place these investments inside my self-directed individual 401(k).

Rich Pay Lots of Money in Taxes

There is this sense out there in the news and on social media that people who make a lot of money are somehow skirting the tax laws and not paying their fair share. Now I'm sure there are a few hedge fund managers out there taking advantage of carried interest laws, some real estate tycoons covering all or most of their income with depreciation, and plenty of retirees who minimize taxes by only selling high basis shares with long-term gains and borrowing against assets instead of selling them.

But having had a very wide range of income, I have found that the more I make the more I pay, both in absolute terms and as a percentage of my income. Despite the lowering of the tax brackets and our substantial 199A deduction, our tax bill this year was 34% (29% federal/employee payroll, 5% state) of our gross income. That doesn't actually include the employer half of payroll taxes we paid through the S Corp, another 2%. So 36% total of our income went to income and payroll taxes for 2018.

By comparison, in 2012 I was able to brag that I paid a lower percentage of my income in tax than Mitt Romney did, paying just 15.5% (8% federal) of my attending physician income in taxes. I'm now paying well more than twice that much as a percentage of income. That seems like a lot more money, right? You have no idea. In actual dollars, I paid 23 TIMES AS MUCH in federal income taxes for 2018 as I did in 2012.

Now whether I'm paying “enough” or not depends on your political persuasion, but my point is that the vast majority of the well-to-do have substantial tax bills like mine. Again, I'd rather have the income and pay the taxes than not have the income, but it seems weird to think there are people out there who think I'm somehow not paying taxes at all.

The Postcard Thing Was Dumb

One of the political talking points with the recent tax reform was that they were going to get Form 1040 onto a postcard. They didn't quite make it, but they did cut it from two pages to one. The problem is they took all that stuff from the additional page and split it onto 6 more pages. Few will have to file all 6 of those schedules, but I had to file four of them (1, 3, 4, and 5.) So 5 pages instead of 2. Really great tax simplification guys.

State Taxes Could Kill a Tree

When I hit print on Turbotax, 188 pages came out of my printer. The PDF file with all the worksheets was even worse–337 pages. A ream of paper is only 500 sheets. So between what was sent to the IRS and the copy they tell me to keep myself was over a ream of paper. That's insane and a whole lot more than a postcard. A big part of the reason why the return was so long is that state tax returns often require you to include other returns with them. Both California and Minnesota required me to include a copy of my federal return. Thankfully, Utah doesn't, but they did require me to include a copy of my California and Minnesota returns. It cost me $9 just to mail the stupid things.

Now I know it's almost time to start working on 2019 tax returns and most of you filed your 2018 returns months ago, but hopefully, some of the things I learned this year will be useful to you going forward.

What do you think? What did you learn from doing your taxes this year? What changes did you see under the TCJA? Comment below!