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People serious about early retirement turn to rental real estate to turbo-charge the process. Saving and investing can get you to retirement fast. With real estate you can go from zero to retired in a few years. It does require careful planning to make it work.
There are three steps in successful income property ownership: buying right, management and taxes. Over the years I have seen many people lose money, even go broke, due to rental properties. I have also seen ordinary people make more money than doctors or lawyers with real estate.
From the late 1980s to the late 1990s I owned well over 100 pieces of property in a partnership with dad and brother. Real estate is a passive activity according to the IRS. In reality it is planning and work. The number of rental properties required for a comfortable retirement is not all that large. I currently own two properties (other than my homestead) generating over $36,000 of passive income a year. This is profit, not gross rents.
You need to buy the right property at the right price if you want to make money. The lowest price is not always a good idea. The oil patch of North Dakota is a good example of a rare market to avoid due to the freefall of oil prices. Most communities, however, have opportunities to purchase quality real estate.
It is all about the math. Any income property you buy must cash flow from day one. Don’t let a Realtor (or anyone else for that matter) talk you into buying a property with the hope of future appreciation. The right property at the right price will have a positive cash flow before any tax advantages from day one.
Find a good accountant with experience in real estate. Sometimes accountants are called deal-busters. What we really are is a professional willing to review the facts with brutal honesty. You might get caught up in the hype of buying a piece of property; a good accountant will not. My wealthiest landlords pay me to review every deal before they make an offer. My job is to point out what can go wrong. Your accountant should be your best friend in business.
When researching a property, use caution when assuming rents. Sellers frequently like to tell buyers the rents are low and can be raised. Buyers then use inflated rent rates in their analysis. When I consider a property I use the current rent rates only. If you raise rents too much (because the seller said you could) you may lose tenants. Also, build in a reasonable vacancy rate and an honest maintenance budget into your analysis.
Real Estate Management
There are two choices when managing your properties: do-it-yourself or hire a property manager. I have seen both methods work. Managing your own properties will keep more money in your pocket. You must educate yourself by joining/attending your local apartment association. Each state and some cities have their own set of rules/laws. Running afoul of these laws can result in expensive lawsuits and/or fines.
The same care is needed when hiring a property manager as when you bought the property. Not all property managers are qualified. A good manager will pay for themselves many times over. With a manager you will have only a small amount of time invested into your rentals. Most management firms collect the rent, subtract expenses (mortgage, property taxes, insurance, maintenance, etc.) and send you a check for the remainder. The manager will also fill your vacancies and handle non-paying tenants.
You can handle some of the maintenance and repairs to save money (and give yourself something to do while retired). Know your limits. I handled most minor repairs myself with my properties, but left bigger projects to the pros. For example, I never installed carpet. (Okay, I installed carpet once. It was not pretty.) I enjoy painting, light plumbing and minor electrical work. Depending on the project, I may handle the job myself or hire a helper or even work with a plumber or electrician.
Now to my favorite part of the story. Buying the right property at the right price and management are local issues determined by the community you are buying in. The tax laws cover the entire United States. Most states are what I call “me, too” states; whatever the federal tax code does, the state says “me, too”.
The tax issues involving rental real estate are significant. By understanding what you can deduct and what must be capitalized (a fancy way of saying the expense must be depreciated over a number of years) you can pay down the mortgage you have faster and greatly increase your cash flow after tax.
We will start with the basics. Rent is reported as income; the security deposit is not. If you keep some or all of the security deposit after the tenant moves out for back rent, damages, unpaid utility bills, etc., you recognize the retained portion as income at that time.
Expenses are harder to understand. Things like property taxes, mortgage interest, mileage and utilities are deductible when paid. The two complex areas we need to address are repairs/maintenance and depreciation.
About once a year a new client comes to my office with rentals he did not depreciate. They mistakenly believe if they don’t take depreciation they don’t have to worry about recapture on sale. Wrong! Depreciation is “allowed or allowable” with real estate. This means if you don’t take depreciation you must act like you did when you sell, causing double taxation on the depreciation amount. If you are reading this and discover you depreciated wrong, don’t worry. You can fix the error by filing Form 3115. You claim all the missed depreciation in the current year; no need to amend back tax returns. Also, you must fix the mistake before you sell the property.
Depreciation of your property causes your tax return to show a lower profit than your cash flow. In my experience investors are reluctant to depreciate a building while angry when they can’t deduct remodeling or other repairs to their building. We will now turn our attention to deducting all the things we did not know we could.
If you already own rentals you know some expenses are not deductible. Well intentioned accountants tell their clients they must depreciate remodeling, roofs and carpeting. The recent repair regulations have made significant changes for landlords. Landlords never had the ability to expense assets like businesses under Section 179. Now, with the new repair regs, landlords have the ability to deduct more than ever before.
The de minimis safe harbor for a current deduction is $2,500. This means all those stoves and refrigerators under $2,500 no longer have to be depreciated. A computer, desk or other property used for the rentals is now deductible as long as the item costs less than $2,500.
Another problem area is remodeling, repairs, roofs and flooring. You can now make an election on your originally filed tax return to deduct up to $10,000 for repairs, maintenance and improvements to qualified buildings. There are ways to deduct even larger amounts in limited situations which go beyond the scope of this post. This means an $8,000 bathroom remodel can be currently expensed rather than depreciated. Same for a $10,000 roof replacement or a $4,000 carpet upgrade. (Note: this strategy only works for taxpayers with gross annual receipts of $10 million or less.)
Tangible Property Rules
Now that you are making a good profit on your rentals, you need to roll up your sleeves to reduce your tax liability. Once you own properties for a few years the rents go up, the mortgage goes down and profits start to exceed depreciation. Now you start paying tax on part of your cash flow. It does not take long for profits to explode once you reach this critical mass.
Enter the repair regs again and the tangible property rules. This is a complex tax maneuver and requires a seasoned tax professional. I will give you the Reader’s Digest version.
If you have a property with a building basis of $250,000 or more you can call in a firm to do a cost segregation study. In laymen’s terms this means engineers come in and break out the building elements. When the study is completed the components of the building are depreciated at their class life. A rental property is depreciated over 27.5 years. After the cost segregation study, a large part of the building is depreciated over 5 or 7 years with a small portion still depreciated over the longer 27.5 years. This also works for additions to existing properties.
There is a case study in my office where a $15,100,000 apartment complex created a $570,288 tax savings. Of course I cherry picked the example. What I want to convey is the possibilities of reducing taxes for landlords and businesses with real estate.
As the years go by you may want to sell some of your investment properties. The capital gains can be large as the years add up. A property bought for $500,000 twenty years ago and is now worth over $2 million will generate a significant tax bill. Enter the Like-Kind Exchange, otherwise known as a 1031 Exchange.
The Like-Kind Exchange allows you to transfer the profit on the property given up to the replacement property purchased. In the future I will deal with Like-Kind Exchanges in more depth.
Step Up in Basis
All those unrealized capital gains and unrecaptured depreciation are real tax problems. You can avoid these taxes if you keep the properties (and profits) for life. Investment property throws off a generous stream of income if there is no mortgage. A property manager can handle the work while you enjoy your retirement. Why sell the property and kill off the goose that lays the golden egg? By keeping the property, you enjoy current income, and when you leave this world, your children can take over. They get a step-up in basis when you die. Remember all the crazy stuff you did to lower your taxes because you read a blog from some accountant over in Wisconsin? Well, since you decided to keep the money flowing into your account your entire life (a man has to eat), you passed from this world to the next while owning those wonderful cash cows. Now the kids get to start depreciating those properties at what they were worth when you died. All the capital gains and depreciation from your lifetime goes away and we start all over as if the kids bought the property themselves on your date of death at full value. Not only did you manage a life-long stream of income, you gave your heirs a heck of a financial boost, too.
Real Estate Professional
I see a few people moaning in the back of the room. All these ideas are great if you have a profit or your income is lower. What about people with higher incomes? I’m glad you asked.
Loses on your investment properties are limited to $25,000 per year if your income is below $100,000. The $25,000 loss limit begins phasing out at $100,000 until it is completely phased out at $150,000. Don’t worry. The losses are only suspended; you will use them eventually.
There is a way to use them now. The IRS considers you a real estate professional if you spend half of you time working on real estate and at least 750 hours per year. A real estate professional can deduct all investment property losses, regardless of income.
A Few Good Tax Men
I threw a lot of stuff out there for you guys. I only scraped the surface. This post is meant to give you an idea of what questions to ask your tax pro. The complex nature of tax laws relating to income property requires a tax professional well versed in the tax issues relating to real estate. I have written several articles on the subject in the past. If you want more information on real estate professionals, passive activity rules or material participation rules, use the hyperlinks to view my past articles on the subject.