Posted by Chris in FL on April 17, 2006 at 11:08:34:
That was a great post by uncle sammy… Natalie, generally an “active” investor (in IRS eyes) can deduct up to $25K worth of rental property losses against other income. I believe this is based on income, and the write-off allowance gets phased out at higher income levels. Obviously verify with your accountant, or do some studying. Best wishes all!
tax implications of a rental property - Posted by Tim Kimball
Posted by Tim Kimball on April 15, 2006 at 24:36:45:
I understand that sometimes people intentionally rent out properties at a slight loss in order to use that loss to reduce their taxes. If done correctly, the reduction in their tax bill will more than offset the loss they’re taking on the rental. The result is a net profit in total.
Is this correct? If so, could somebody explain this to me in detail?
The reason I ask is that I am disabled and I want to sell my house to my brother-in-law so he can rent it to me with section 8 allowing me to stay where I live and reduce my living expenses at the same time. This will also let me use my equity to pay off a bunch of credit card debt and hopefully get my credit on the road to recovery. I just want to make this a win-win situation. Otherwise, I’ll have to leave the house I’ve lived in for almost 11 years to go to a assisted living facility.
Re: tax implications of a rental property - Posted by Tim Kimball
Posted by Tim Kimball on April 17, 2006 at 12:05:08:
Thanks everyone for your input. 2 points I want to ask about…
Q: Could a business entity like a llp or corporation be used to get around that?
Q: If the rent is at market rates, would this be do-able?
Re: tax implications of a rental property - Posted by David Krulac
Posted by David Krulac on April 16, 2006 at 17:54:12:
relatives are prohibited from renting to their relatives on section 8
Re: tax implications of a rental property - Posted by John Corey
Posted by John Corey on April 16, 2006 at 10:42:53:
Tim,
Your idea will not work. When renting to a family member the rent has to be the market rent or the property will not be allowed to be declared as a rental property on your brother-in-law’s tax return. Hence he can not rent it to you below market and declare the loss.
As was covered by a couple of folks the tax advantages come from depreciation and the deduction of certain expenses. Hence it might still be a good deal for all if your brother-in-law was to buy the home and you rented it back at market. Section 8 rents would be considered market by the IRS.
I sense that you would get section 8 rental income vs. what ever support you have now as an owner occupant. I am not sure how they will view a sale as they might feel that the profits from the sale will offset some of your benefits. It could still be the right way to go. Just understand how they will view the sale and the profits you will receive.
As this has been your residence for 2 out of 5 years you will receive any profits up to $250K ($500K for a couple) tax free. That could make a big difference and help to address the CC debts.
If you do rent from a relative assume you have to pay a market rent and that if you do not they will evict. Also assume that the Section 8 people will perform an annual inspection and will force your brother-in-law to keep the place up to their standards or you will have to move. Hence it needs to be a professional relationship and there will be costs. It could be very positive all around. Just hold up your end of the bargain and explain to your brother-in-law what they are signing up for if they go section 8.
Ask more questions if any of the responses are not clear. That is the great thing about the forum.
John Corey
Re: tax implications of a rental property - Posted by Gary
Posted by Gary on April 15, 2006 at 20:11:55:
Hi,
The posters have given all good answers. I would like to add one more dimension that the other posters did not mention: the 1031 tax-free exchange for rental property. I will not go into details about this, since it is somewhat complex and you should speak to your accountant about all the restrictions and deadlines connected with the tax-free exchange.
However, you should know that this is an extremely powerful tax instrument. Basically, you can sell your appreciated property, then purchase (within 180 days) another rental property. If the exchange is done properly, and you have competent exchange accommodators, you do not have to pay any capital gains taxes on the appreciated property. (Again, there are all sorts of details and restrictions, so you should discuss the matter with your accountant.)
My wife and I have used the 1031 several times and have done extremely well with it. Obviously, careful planning goes into using the 1031 exchange.
Good luck to you! Gary
Re: tax implications of a rental property - Posted by uncle sammy
Posted by uncle sammy on April 15, 2006 at 15:12:12:
Here’s a simplified, yet detailed, example that I hope helps you understand the process better.
(numbers are made up)
Buyer pays $100,000 for house
Buyer pays mortgage of $700/mo.
Buyer pays taxes, insurance $200/mo.
Total monthly PITI is $900/mo.
Buyer allows $100/mo for expected maintenance costs, capital improvements, vacancy
(The first year he pays out $600 to replace the water heater and $100 for advertising)
Buyer rents out house for $1,000/month, thus “breaking even”.
Buyer sets up depreciation schedule for taxes, $100k/27.5yrs or about $3,600/yr in depreciation writeoff.
Buyer gets these write-offs at tax time:
$ 8,000 interest (12 X $700=$8400 minus $400 to principle - remember an increasing part of the pmt over time will go to principle which is not a writeoff)
$ 3,600 depreciation
$ 700 maintenance costs (supported by receipts)
$ 2,400 taxes and insurance costs
Total: $14,700 writeoffs against property income of $12,000.
This leaves an extra $2,700 of writeoffs ($14,700writeoffs minus $12,000 rental income) which could be used to offset other income of the property owner such as his personal job income. This is one of the joyous benefits of owning rental property that offset the many headaches of rental property ownership. There are basically 4 sources of income available to rental owners: tax write-offs, principle pay down, positive rental cash flow, and appreciation.
If the owner in this example was to take less in rental income he would of course have more left over to write off on other income, but he would also have to pay out-of-pocket to cover his PITI and maintenance costs which need to be paid during the year as they come due. How much would that $2,700 or more in writeoffs save the owner which could then be used to offset a lower rent? That all depends on the income and tax bracket of the owner. See a tax accountant who could give you a precise answer. There are always complexities in tax law.
However, let’s do a simple example saying the tax bracket is 28%. That means that for every taxable dollar you writeoff you are saving 28 cents in tax that you’d otherwise have to pay Uncle Sam. $2700 would equate to about $756 or roughly $63 per month ($2700 X .28=$756/12 mos.) If you reduced the rent in half giving you another $6,000 in writeoffs, you’d save another $1,680 or $140 per month. However, the rental owner would actually be losing money at $360 per month ($500 rent reduction minus $140 saved in taxes) - not counting the $63 saved. Hope this helps you understand a little better how it basically works.
Re: tax implications of a rental property - Posted by Bigfoot
Posted by Bigfoot on April 15, 2006 at 08:14:39:
Tim- There are a whole slew of things that a landlord can deduct that homeowners can not. Things like depreciation, repairs, improvments, mileage,etc. These are in addition to things that homeowners can deduct like interest and prop taxes. There are however restrictions on how much may be deducted if the landlord is in a high income bracket. As far as I’m concerned, you must have an accountant review these things with you. The rules change every year, and I don’t presume to be an expert on such matters. I have a business to run. I won’t waste my valuable time trying to comprehend the intricacies of the tax code. You also may be able to deduct the cost of the tax preparation. Hope this has been useful for you. Bigfoot
Re: tax implications of a rental property - Posted by David Krulac
Posted by David Krulac on April 17, 2006 at 23:05:27:
not really. if you are the controlling interest in an llc or corp its the same as you for determining “arms lenghth” transactions. Not to be confused with corp. veil.
fair market rent is not just one figure. for example a 3 bedroom house may rent from $500 to $1,200 in one town. If you can justify the rent charged through an audit then there is no problem. Sometimes the same houses on the same street are rented at different rents because it is an imperfect market. There is one place that I know where 2 houses very similar next door to each other are rented for $550 and $850. Another place I know of a house rented fro $600 next to a house rented for $860. All those rents are market rents IMHO. Now if you’re charging $200 for a 3 bedroom that would be very difficult to justify as market rent. In my area a 1 bedroom rents for about $400+, so a 3 bedroom for less than that would not hold up in an audit. The auditor could look in the daily classified to discredit your below market rents.
here’s what you do to get around the section 8 rules. this is NOT really getting around, however. You rent your house section 8 is a NON-relative and get a friedn to rent section 8 to your relative. All legal everybody goes home happy, literally.
Re: tax implications of a rental property - Posted by John Corey
Posted by John Corey on April 16, 2006 at 10:35:22:
Gary,
Assuming a legal and well executed 1031, how will Tim be able to pay off his CC debts?
If he sells now he gets the benefit of not paying the tax on the $250K of profit when you sell your primary residence.
John Corey
Re: tax implications of a rental property - Posted by marc
Posted by marc on April 19, 2006 at 09:15:16:
Uncle sammy wrote: “There are basically 4 sources of income available to rental owners: tax write-offs, principle pay down, positive rental cash flow, and appreciation.”
This is something that is not clear to me - in what sense is a tax write-off “income”? The only reason you can deduct certain items from your income is because you actually incurred the expense. In other words, you are taxed less because you earned less; that’s all. Depreciation is another matter. You are allowed to deduct 1/27.5 of your property value each year, even though in most cases the property probably increased in value. This is a genuine tax break and is basically the IRS giving you something for nothing.
In the situation Tim decribes there could be value in being able to shift expenses from personal (which are not deductible) to business (which are deductible). But a loss is still a loss; and this would be a strategy of mitigating that loss. I don’t think it qualifies in any sense as a profit. Am I misunderstanding something here?
Re: tax implications of a rental property - Posted by Natalie-VA
Posted by Natalie-VA on April 16, 2006 at 11:44:16:
Uncle Sammy,
Great post with a great example. I would question the ability to write off the $2700 loss against his job income. Take this for what it’s worth (I’m no CPA), but I don’t think you can write off passive losses against ordinary income.
Can someone else clarify?
–Natalie
Re: tax implications of a rental property - Posted by speednxs
Posted by speednxs on April 15, 2006 at 08:52:17:
Depreciation is probably the tax advantage that was mentioned. Mostly likely this will lower the losses, not turn them into profits. If the investor has more than a six figure income they may lose this deduction. Always check with a professional. Taxes are complicated.
Most people use 27.5 year straight line depreciation. The cost of your building (not land) can be depreciated over 27.5 years. If the building is worth $137,500 he can deduct (depreciate) $5,000 a year as a rental. There is depreciation recapture when he sells. A tax of about 25% is put on the depreciated amount when the house is sold (assuming the price hasn’t actually gone down). Because of the time value of money and inflation, the longer you delay a fixed expense, the less it really costs you.