In the United States we have a ritual we put people through age 50 and over. It starts slow and builds momentum. The first indication shows up in the mailbox offering loads of financial information and a FREE! meal. In no time our kind 50 year old has a mailbox full of invitations for free dinners. There are opportunities to screw the Social Security system, opt out taxes, earn huge yields on your investments, and the best ones scream THE SKY IS FALLING!!! and only they can save you.
The answer to each problem, of course, is to invest in what they are selling, usually annuities. I call their bluff and sign up for every free dinner gracing my mailbox. By now I must be the most sought after seminar attendee on Earth. There is a name in the industry for people like me: plate lickers. I love it!
Mrs. Accountant and I rarely go out to eat, but when we do it is usually free. Restaurants I would never try now get scratched off my non-existent bucket list. All because I am a plate licker.
Now before you think ill of me, let me explain. My goal is never to harm the presenter. They offer the free meal and information; all I do is take them up on their offer. If they ever come up with a valuable product I am more than willing to pry open my wallet and blow out the cobwebs.
My dad was born the first year of the baby boom and I was born the last year of the boom. It’s an interesting fact that has nothing to with our story, but something I find interesting. The Baby Boom finally ended because guys discovered coitus interruptus. Child support attorneys have seen declining sales ever since. Back to our story.
As a Baby Boomer I get lots of invites. Tuesday night Mrs. Accountant and I attended one of these free meals/seminars. As always, the food was great. I had high hopes going into this one. The invite promised and 8% return investing in mortgages backed by assisted living homes. I understand the demographic and the profit potential so the idea intrigued me. The vast majority of my money is invested in Vanguard index funds. A few hundred thousand in my portfolio is looking for a home with a fixed rate worth accepting. Eight percent backed by local assisted living homes held promise.
The night went poorly right from the start. The seminar was heavily laced with political opinion which I work hard to avoid. Now it was in my face. Even the food started to smell gamey due to some of the BS I was being served. To protect the guilty I will not mention names.
Before the meal arrived we heard about how old variable, fixed, and index annuities screwed people. I get it. Then the presenter went off the rails. We need to keep gold in a safe at home in case an EMP/nuclear strike ends us. Then he claimed he was really rich and only did this because he loved it. (I understand that part.) It soon was obvious he was not as rich as claimed due to his desire to acquire debt. He was living large. If Mr. Money Mustache were there he would have had an instant coronary.
Then we entered the twilight zone. He started going on about 9/11 and how people could not get ahold of their broker to sell as the market crashed. The new world annuities were better and always available for distributions, unlike the stock market. I bit my lip so hard blood flowed. I was nice. I wanted to say, “Dumbass, ah, I mean sir, I don’t sell when people running around like chickens with their head’s cut off, I actually buy at those times.” Instead, I kept biting my lip and let it pass.
As if things could not get worse, they did. Our presenter, an attorney with plenty of credentials (so he should know better), kept the ball rolling down wind. We were informed mutual funds are no good and no longer a preferred investment. He proved his case by showing how actively managed mutual funds underperform the market over long periods of time. He claimed people were poor because mutual funds have failed us. His proof was how many people reached full retirement age broke. My heart gave out. Once the paramedics applied the paddles I slithered back into my chair. I remained quiet out of politeness. He was wrong! People are not broke because mutual funds failed them; people are broke because they spend too fucking much and never save. Even if people invested in broad, actively managed mutual funds they would still be fine as long they actually saved some money in the darn accounts.
All credibility was lost by the time he reached the part I was interested in: 8% returns on assisted living home mortgages. I lost all trust in the man as I assumed the position. No longer feeling like a Baby Boomer, I felt like a Baby Boober. At least I had a good meal.
The 8% Solution
Long term stock market returns hover near 7%, plus the rate of inflation, according to the Jeremy Siegel, author of Stocks for the Long Run. Once Treasury bonds reach 8% (a really long time from now) I want some of my money locked into these virtually risk-free investments. Solid investments with a fixed rate of return of 8% piques my interest. I am always concerned when a fixed rate investment promises to outperform its peers by a significant amount. Lending money to an investment group secured by assisted living homes fell within the realm of normal at first glance.
The problem by this stage of the presentation was trust. He interjected so much political drama into his presentation and followed it with facts that were stretched, or at the very least, misleading, I had to take a pass. When you listened carefully, you soon came to the conclusion the guy was leveraged to the hilt. As an attorney he knows how to structure entities to protect himself and maximize fees to his personal account. I am not saying he was doing this, but he could have and my lack of trust in him caused me to walk away without any further consideration.
What is the difference between him and me? We both claim to have money. He certainly has an awesome resume; my client list has some impressive people on it. He teaches about money through seminars and selling investments products; I talk money on this blog and with clients. Do you cover your crotch when I speak like I did when he talked? I hope not.
There is a significant difference between him and me. His wealth bragging also indicated he needed a strong stream of cash to fund his lifestyle. For example: He thought it was an awesome deal to pay $600 of interest a year just to use $10,000. He said he would do it all day long. Not me. I use debt very sparingly. When I use debt it is a tool to increase my net worth. Credit cards are my favorite way to get free travel and tax-free cash rewards. I pay the cards in full each month, but technically I am borrowing money for a short term.
When it comes to real estate I borrow money sometimes. My office building hasn’t seen a loan on it since 1999. The only reason I ever had a loan on the office building is because the guy who sold it to me demanded I take a land contract so he could spread out the gain on his taxes. Four or five years later I talked him into taking a lump sum payment and he accepted. The building has been debt free ever since. My personal residence has a mortgage and my excuse is the interest rate is 2.375%. I drag my feet on retiring the mortgage because the dividend yield on the S&P 500 is about the same as my mortgage. It is the only debt I have.
If I wanted to build a large number of assisted living homes, I have the resources and financing capability to do the whole thing on my own. This guy needed me to get the job done (in other words he is really broke) or he was spreading risk because he lacked confidence in the outcome. He paid 8% on his mortgages. He also used multiple (as far as I could tell) LLCs to get investors while circumventing private equity rules. There could be legal issues with this strategy. A few of those issues have visited my office now and again. Attorneys can get into trouble with regulators too. My low level of trust caused me to question his setup as well.
Finally, why is he paying 8%? I am a country accountant with a farming background and I can manage lower cost financing! Something is not right here.
For the geriatric crowd and those nearing my age, you know about all the free dinners to be had. It certainly appeals to our frugal nature if you are willing to sit through a lot of BS. I really thought this time would be different. I really thought I might learn something beneficial this time. It was not to be. I guess I have to settle for being a plate licker.
As early retirement and quasi-retirement are easier than ever in our expanding “sharing economy”, the IRS is clarifying the rules on how much you need to share with your least favorite Uncle. For many people “sharing economy” jobs are their real jobs, for others, a way to fill time during retirement or as an adjunct to early retirement.
The goal here is to drive taxes to zero. The “sharing economy” has several opportunities to earn thousands of dollars per year and legally not report it on your tax return. In cases where you are required to report the income we can use tax strategies to significantly reduce or eliminate income or self-employment taxes.
Some areas of tax law are still unclear as the Tax Court is hearing cases determining issues between independent contractors and employees. These major tax issues generally affect large companies like Uber rather than individuals. As of this writing, most “sharing economy” jobs are treated as small business income and are reportable even if you do not receive a From 1099-MISC.
Renting Your Personal Residence
Across the lake from where I live is the City of Oshkosh. Every summer around the end of July the Experimental Aircraft Association (EAA) hosts the EAA AIRVENTURE air show, making Oshkosh the busiest airport in the world for a week. People from around the world flock to NE Wisconsin to see aircraft of all shapes and sizes take to the air. The sky above my home is abuzz for the week; no need for me to spend money on a show I can see from the comfort of my yard.
The EEA air show fills every hotel within a hundred miles. Renting your home or even a few spare rooms is worth a lot on money. Renting out a few spare bedrooms (another reason to move your adult children out) can bring $300-$500 per day! Two thousand dollars for a week in common. Many people want a place to stay for a few days on either side of the air show as well and book 10-14 days.
The IRS has special rules when you rent your personal residence for fewer than 15 days in a calendar year. You don’t report rent income of your personal residence if it is for less than fifteen days. In other words, the rent is tax-free! You are not allowed expense deductions either, but mortgage interest and property taxes are still deducted on Schedule A, same as always. If you have a local event similar to the EAA air show in your area you can rake in $3,000 – $5,000 tax-free every year! Not bad for a week or two.
More Tax Benefits From Your Home
The above example should have business owners thinking. This 15 day rule on a personal residence opens some juicy opportunities to convert taxable income into tax-free (not even reportable) income. Every year after tax season my team gathers at my home for a day of good food, games, and conversation; no phones, clients, or demands allowed. I also host a summer picnic and the Christmas party at my home. With a stocked pond Karen can wet a line while Chris hikes the trails I cut in the back 10. The get-togethers are great fun and a way to build camaraderie.
Many years ago I held these events at a local restaurant or hotel. It was expensive! By hosting the event at my home I am able to charge the company a normal rate for renting my place for a day, plus the cost of food and beverages provided. The normal rate charged by a hotel or restaurant for a room for the day is around $750. That means for three days a year I rent my home to my business $2,250. The company writes off the expense and I don’t have to report the income. (Note: This only works if your company is an LLC or corporation; sole proprietorships do not count.)
Even More Home Goodies
Having a home is really a major tax advantage when you start thinking about it. Let’s say you use your home for doggie daycare on the side using DogVacay. To deduct the business use of the home the area used must be “regular and exclusive”. What this means in words normal people use is that the area of your home you want to deducts expenses against for business use must be used for the business on a regular basis and for nothing else. The corner of the living room does not count.
However (the tax code has a lot of these however’s), if you engage in more than a cursory amount business you can organize your sideline, part-time business as an LLC. (Don’t worry about extra tax returns and such; you will not need them.) You do nothing as a single member LLC treated as a disregarded entity for IRS purposes. Again, in English, this means you report your business income and expenses as a sole proprietor. But, you can rent part of your home to the LLC! Now the rules are easier than “regular and exclusive”; now it just has to be for the benefit of the business. By charging a reasonable rent you get a deduction on the business return and claim the income on Schedule E as rental income. Pro-rate home expenses to the rental portion: insurance, property tax, mortgage interest, et cetera.
Removing the income from the business and turning it into passive rental income saves 15.3% self-employment tax on the rental portion. You must have a rental agreement. It does not have to be anything special. The contract between you and the business needs to cover all the points of a normal commercial lease. You can find one online. You sign as landlord and tenant. Wasn’t that fun?
Remember the Saturday morning cartoon from the 1970s? “Conjunction junction, what’s your function…” Yeah, it warped my brain, too. Today we have a different tune: deduction junction. And we know your function. To cut our tax bill.
There are so many things you can deduct when you have a business, and income from the “sharing economy” is a business entitled to all the deductions a normal business gets. The IRS said so. Each business is different, but let me throw a few nuggets out there for you to get a firm idea of what you might be missing.
Uber drivers know to deduct either their business miles or actual expense of the business use of their vehicle. If memory serves, Uber sends a nice form in January listing your income (Form-1099-MISC) with a note on how many deductible miles you have. But the Uber number is WRONG! Yes, you deduct the miles for carting around clients, but you get more than just the miles when a client is in your vehicle. ALL business miles are deductible! That means miles driven to the accountant’s office to discuss business issues or to Office Depot to pick up a mileage logbook. It also means all miles driven for your Uber business whether Uber includes all the deductible miles or not. Keep a mileage log.
Any training or educational programs are now deductible when you have a business as long as it is connected in some way. Business seminars generally count for all business owners.
Advertising in the “sharing economy” is different from past businesses. You may pay a fee to Uber or the company providing the client. The fee can be monthly or based on sales or per client; it is all deductible. If you use DogVacay, but also use Facebook or other social media to advertise you need to track and deduct the expense. I know it is so easy to set it and forget it, but check that credit card statement and get every deduction you can get your fingers on. Be sure to download a receipt for your tax records.
The Big Time
That quasi-retirement or sideline business sometimes takes on a life of its own. I know what you mean. I wanted a part-time seasonal job 30 years ago and can’t get away from the thing.
Once your business profit exceeds $30,000 you need to consider alternatives to your business structure. For most people, once you cross $50,000 it becomes a no-brainer. Taxes on a sole proprietorship are high; the highest anywhere in the tax code. The sole prop is also audited more frequently by the IRS. They tax the crap out of ya and then audit you blind until they put you out of business. I have a better idea.
Remember that LLC I asked you to set up? Well, now might be the time to tell the IRS you elect to be treated as an S-corporation from now on. I covered this topic in the past. You can review that article here.
A Good Start
The largest number of questions I receive now involve people working in the “sharing economy”. Covering every facet of every opportunity is impossible in one short post. Hopefully I provided a flavor for what is possible. The points I touched seem to be the ones most often overlooked. If you want to run something by me in the comments section I will do my best to give a solid answer.
When it comes to passive income, real estate is king. A small investment can be leveraged into a massive cash cow. This is the second in a series of posts on lessons learned. Some lessons in life come from clients or from watching clients deal with issues. With investment properties I pull from personal experience. Over the years I have owned over 100 single family homes, numerous duplexes, a few multi-unit buildings, a storage facility, commercial property, and farm land. The lessons I have learned buying, selling, and leasing real estate over the last 28 years should provide a few nuggets of wisdom you have not read before. This added wisdom hopefully flows to your bottom line.
Residential Real Estate
We will start with residential investment properties because I have more experience in this arena and most readers own/manage the same; I will address commercial property in a future post. The issues I raise are only a sampling of the issues I find most relevant; a full review of investment property issues is beyond the scope of one blog post. The best approach is to start from the beginning and move through the lifecycle of an investment property, from purchase, to renting, to eventual sale.
Buy Right: The first step is the most important. Buying the right property at the right price will determine the profitability of your investment property. This is a good time to research rent rates in the neighborhood. Many landlords use the 1% rule to determine if a property is worth buying; I use a different method.
The 1% rent rule simply states rents should be 1% per month of the purchase price/value of the property. This is a good starting point. Low interest rates today turn more properties cash flow positive under this rule.
My rule is a bit more involved, but provides more assurance you have a good property. First, I only use the current rents of the building. Sellers always point out the ability to raise rents. If rents should be higher the seller should have raised them. I also check rents in the area to affirm the current rent rate is sustainable. Once I feel comfortable with the rental income situation I look at expenses. I always assume a no-money-down deal even if I pay cash for the property. By assuming the property is leveraged to the hilt I can determine if the rent minus expenses supports the property’s value. My calculations always include a 3% miscellaneous expense to cover deferred expenses such as a roof, furnace, siding, flooring, or improvements unless a higher percentage is warranted due to the condition of the property. The formula looks something like this:
- Annual rent income, minus
- Mortgage payment as if 100% leverage used,
- Landlord paid utilities,
- Management fees, if any,
- 3% miscellaneous deferred maintenance
- Other known expenses
Once all known expenses are deducted from the annual expected rent you get a number that must be positive. A negative number is a money loser before you even start. If the number is above water you have a decision to make. It is enough? Remember, a breakeven number means your cash investment portion is earning what a mortgage would earn. That is why I assume 100% leverage. If I pay 100% cash I expect my money should earn at least what the bank charges in interest. Of course a cash deal will cash flow if you do not consider your cash investment as worth anything?
The real trick here is determining any special events. Road construction or other city improvements can cause cash flow problems down the road. Research before you sign.
Finding the Right Property: Many communities have properties where the rent does not justify the property’s value. Still, deals can crop up here and there even in tight markets. Buying right takes time. It is easy to lower your standards when ideal properties are scarce. Bad idea! I would rather miss a deal than buy the wrong property. Remember, there will come a day when you want to sell. Issues when you buy frequently stick around and bite you when you sell.
Here are a few ways I found a large quantity of prime properties. My first rental property was a two-unit townhouse on 833 E. North Street in Appleton, Wisconsin. The owner was a man in his young 30s. He died of an aneurism. The family did not want the property so the bank got it back. I made the bank whole by paying $50,000. The rent was $485 per unit. I made money on the deal. Two years later I sold for exactly $75,000. I think we can agree I had a wonderful introduction to the investment real estate world.
I found the above deal because I introduced myself to half the bankers in town. I tend to be a bit obsessive-compulsive when it comes to numbers. I talked with bankers every day. The North Street property turned a $10,000 down payment into a $25,000 capital gain and over $400 of positive cash flow per month. Nice. The only reason I got the sweetheart deal instead of someone else is because I was in the right place at the right time. I was in the banker’s office when the property came in.
My biggest source of reasonably priced properties was Veteran’s Affairs. Back in those days landlords could only get adjustable mortgages on rental properties and interest rates were close to 10%. The VA offered 7% fixed with only a small down payment. The buildings were also priced to move. The best news was I could buy the properties even though I was not a veteran. It was normal for us to buy 3-5 properties per month from the VA.
The only way to get the VA properties was through a real estate agent. My agent, in his infinite wisdom, bragged to the VA office in Milwaukee about my large profits. Within a few months the rules were changed. Now more money is needed down and only veterans need apply. The rules have probably changed again since those days, but it outlines how a great property source can be screwed away by an idiot.
There are many ways to find awesome properties. Always do the math. My own rule is: Never chase a property. It’s a rental; they will make more. No one property is worth chasing.
Saying No to Bad Deals: Pressure will be applied to convince you to buy. Real estate agents get paid when you open your wallet, not before. Sellers have a long line of BS to move their property. Learn to say no. Take your time in reviewing the property. A bad investment gets worse the longer you own it. A negative cash flow only increases your original investment in the inappropriate property. “No” is the most powerful work in the English language when it comes to investing in real estate. It is normal to review multiple properties before buying. As good as the VA repo deal was, we did not buy every property dangled before our eyes.
Sellers say a lot of things when it is not in writing. Get it in writing! And a property inspection is a must unless you are qualified to do the inspection yourself.
Determining Rent Rates: Before purchase you should have a good idea of the range of rents in the neighborhood and how they match the target property. Craigslist, newspapers, “You’re Renting” and similar magazines are a good place to start your review of local rents. The real estate agent is also a resource with one caveat: the agent may pump you full of it to make a sale. You have to determine if the agent is honest; most are.
The rents for my buildings were always on my mind. A good tenant may face fewer and smaller rent increases. Tenants that pay on time and keep the place well maintained are a bonus for landlords. Bad tenants did not face larger rent increases; instead, I refused to renew their lease.
Finding the Right Tenants: I was picky when I rented my properties. I did a background check and verified income. Compared to the banks before the financial crisis in 2008, I was a tough nut. The alternative is more damages, unpaid rent, evictions, and court costs. My time was worth too much. An investment in time now paid off later a hundred fold.
Evictions: Late rent is never tolerated. Follow the laws of your state/city when involved in an eviction. Whatever the law allowed I used. The longer a bad tenant stays in your property the greater the damage. In some cases you may need an attorney. When you owned as many investment properties as I have there are eviction stories to tell. I will leave them for another day.
Regulations: Local governments have rules regarding landlords. Smoke alarms and lead paint in older building are all considerations. Your local apartment association is a great resource into the rules in your market.
Property Managers: Property managers should handle the regulation issues. Verify your manager is screening prospective tenants adequately without discriminating. Owning properties in outside markets requires a local manager. Income properties are considered passive income for tax purposes, but any landlord can tell you the work involved is anything but passive.
Hiring a property manager eliminates most time issues with your property. The manager should screen prospective tenants, collect rent, evict when necessary, pay the mortgage and other bills, and submit the remainder to you monthly. There are times when you will need to cover a major expense like a roof or furnace out of pocket.
I used several managers at a time. When you own over 100 properties across a metropolitan area you will need help. I screened and reviewed my managers on a regular basis. Most were good, but a few were not. Investing time up-front before you hire a manager cannot be understated. Property mangers usually have contracts locking you in for a period of time. It is a relationship. Make sure you want to be in the relationship before you make a commitment.
Maintenance: Money is saved when you handle maintenance on your own. To actually save money you need to know your limitations. Roofing was my favorite work; flooring was a disaster. I installed carpet once and realized it would be easier, faster and cheaper to hire a professional. I am okay at drywall and painting. A large portfolio of real estate will require an army of contractors. I spent as much time checking prospective contractors as I did researching a property prior to purchase. Every job was in writing.
Major maintenance issues are reduced when handled before they become large. A roof replaced when shingles were thin beat waiting a few more years and then replacing roof boards, too. Regular painting keeps properties looking nice and rents where they belong. My properties were always improved. Buyers of my properties received nicer looking buildings than what I originally bought. I also had better rents, better tenants, and a better sale price. Maintenance does pay for itself.
Selling Right: Selling is buying in reverse. Before listing or offering a property for sale you need to research your market. Pricing a property for maximum gain without a long duration on the market takes legwork prior to listing. Review other properties in the neighborhood. A real estate agent can help. Today, online resources are numerous. Realtor.com, MLS, Zillow, Homefinder, and Trulia are good research tools in determining a good selling price. These are the same tools used in your property purchase search.
A realtor is a valuable asset in selling your property; they also have a fee, normally a percentage of the sale price. Selling on your own is more work, but you save the fee. The choice is personal.
Debt Issues: Debt was a tool when I owned a pile of real estate. I rarely came to a purchase closing with money. The bank covered the entire amount, using equity in other properties, so closing went faster. Then we paid down the mortgages fast, building equity. I understand investors want to juice their percentage return with leverage, but leverage also brings risks. Investment property should have at least 20% equity from day one. Once you own the property for a few years equity should be larger than debt. Also, debt-free rentals really cash flow. A cushion shields you from unforeseen market forces and vacancies. Real estate is a great source of passive income as long as you are not mortgaged to the hilt non-stop. High debt is an accident waiting to happen. The winners of the housing crisis a decade ago were the people with cash ready to buy when opportunities presented.
Partnerships: Yikes! I owned income property in a partnership with my dad and brother. I knew going in I would do 99% of the work. The partnership worked, but that is the exception to the rule. Most partnerships are woefully lopsided. The one doing all the work get grumpy when the other partners want an equal share without doing the work. Partnerships can work, but remember you are married to your partners and divorce is messy.
Entity Selection: Real estate should never be held inside an S-corporation; only rarely inside a regular corporation. Liability protection, tax advantages, and ease of transfer are available with a LLC. Due to local laws and regulations a real estate attorney should be engaged. Real estate held in an LLC does not require preparation of an additional tax return; a box is checked in the tax software informing the IRS the property is held in a single-member LLC as a disregarded entity. In the future I will address entity issues in greater detail as they pertain to real estate.
Training Courses: The Wealthy Accountant is a lucky guy. He gets to see all the crazy stuff floating around. Expensive investment real estate courses are all the rage. Many of these programs sucker you, ahem, cost $25,000 or more to teach you how to make a killing flipping real estate. All I can say is “don’t.” There might be a good program out there, but the ones I have seen are junk. Worse, they turn you tax work into a nightmare. I’m busy enough. No more free seminars offering a free meal, guys. They cost too much.
Clean Up Crew: I did my best to stay brief, but investment properties have too many issues. I will break down the issues into small, more easily digestible bites, in future posts. Commercial property, farm land, and land held for development are different creatures from residential investment property. Most readers here are interested in residential property so I stayed on point.
Real estate investing has great opportunities for wealth creation and steady passive income if proper planning takes place prior to investment.
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.