Am I thinking about the tax benefits of renting real estate correctly?

Question

Question on rental income taxation:Thank you in advance if you can clarify if I am thinking about this right or not...-Assume I own a rental property in my LLC.-The property earns 2,000 in net rental income after paying mortgage/Maintenance/insurance/taxes/mgmt fees.-The total sum of the maintenance/insurance/taxes/mgmt fees is 5,000.  The total mortgage interest paid on the loan for the year is 1,000.  So total tax deductions are 6,000 for the year.

Thank you in advance if you can clarify if I am thinking about this right or not...

-Assume I own a rental property in my LLC.

-The property earns 2,000 in net rental income after paying mortgage/Maintenance/insurance/taxes/mgmt fees.

-The total sum of the maintenance/insurance/taxes/mgmt fees is 5,000.  The total mortgage interest paid on the loan for the year is 1,000.  So total tax deductions are 6,000 for the year.

-My tax marginal tax on earned income is 46.7%

-At the end of the year I have 2,000 in actual rent income offset by 6,000 in tax deductions.  According to the IRS, I have lost (4,000) on renting the property.

My question...

-Is this loss carried over against other earned income for the year?

If it is carried against other income...

-In trying to compute my return on the investment, is it correct to say:

I earned 2,000 in rental income for the year, which is taxed at 46.7%.  So I net earned 1,066 for the year.  Plus I had 6,000 in tax deductions for the year, which saved me 2,802 in tax dollars.  So my actual return on this investment is 3,868 (1,066+2,802).

Steven Hamilton II · Answer

Your accountant is smoking something.  It will be based upon the type of transaction. If you are flipping it is considered inventory and is taxed at your marginal rate. If you are a landlord you will pay capital gains tax Short term or Long-term.

You have recapture on depreciation taxed at a maximum of 25%.

Dave Toelkes · Answer

Joe,

Not sure exactly what your accountant told you, but your understanding is imperfect.  For a fix and flip, your sale profit is taxed at your marginal tax rate plus self-employment income taxes, REGARDLESS of your holding period.  In your case, your sale profit will be taxed at your ordinary bracket rate of 39.6% plus medicare tax (with surcharge) of 3.8% for a total tax of 43.4%.  Profit on a flip is NOT a capital gain; but rather, ordinary income and therefore the capital gains holding period does not apply.  If you had not already maxxed out on your social security income tax, then your flip profit would also be subject to another 10.4% for social security income tax.

Dave Toelkes · Answer

Account Closed

Beginning in 2013, a new 20% rate on net capital gain applies to the extent that a taxpayer’s taxable income exceeds the thresholds set for the new 39.6% ordinary tax rate ($400,000 for single; $450,000 for married filing jointly or qualifying widow(er); $425,000 for head of household, and $225,000 for married filing separately).

Since you say your marginal bracket rate is higher than 39.6%, not only will the 20% long term capital gains tax rate apply to your profit due to appreciation, but you may also have an additional Medicare surcharge tax of 3.8% on your investment income.

Lastly, the portion of your capital gain that is due to depreciation is currently taxed at a maximum 25%.

You may want to refer to IRS Publication 550 for specific details.

Regarding your other questions:

1.  At your income level, all your net rental losses are carried forward to the next year when they can be used to offset rental income.

2.  Your net rental losses are NOT deducted against other ordinary income.

3.  There are several ways to compute return on investment.  Most landlords look at the cash-on-cash return as the ratio of their net cash flow divided by the total capital investment.  Some try to project the internal rate of return by adding the annual cashflows to the projected capital gain when sold, then computing the discount rate needed to have a Net Present Value of zero over the holding period for the property.  Still others equate the cap rate with return on investment, which is only correct if you paid cash for the property at acquisition.  Regardless of how you decide to compute return on investment, at your marginal tax bracket, a net tax loss for your rental activity does not reduce your total tax liability (remember tax losses are carried forward, and, do not offset your other taxable income.).

Jon Holdman · Answer

The "tax benefits" of rentals are WAAAY overblown, IMHO.

First, lets get straight on taxable income.  You write:

So you're double counting a bunch of things, and including the non-deductible mortgage principal payments.  You don't give quite enough information to do the calculation correctly, so I'll make a couple of guesses.

First you start with total collected rent.  From what you wrote that's $2000 (net rental income after all actual payments) + $5000 (maint/ins/taxes/PM) + $1000 mortgage interest + mortgage principal payments.  I'll guess mortgage principal at $1000 just to make the number round.  So, I'm guessing total rent at $9000.

From that you subtract actual expense (maint/ins/taxes/PM) of $5000, mortgage interest of $1000 and depreciation.  That's $3000 positive income before depreciation.

You're starting with net income, which is rent less mortgage/maint/ins/taxes/PM and then subtracting some of those same things a second time.  You only get to subtract them once.  And you don't get to subtract the principal payments at all.

If your AGI is under $100K (I'm guessing its not, if your total marginal rate is 46.7%) you can use a passive loss against other income, up to $25K.  Over $150K AGI you can't.  In between the $25K limit is reduced by $1 for every $2 of AGI over $100K.

If you can't use the passive loss against other income then it carries forward and offsets taxes when you sell.  Which may be higher than you think because depreciation decreases your basis and increases your basis when you sell.

For computing pre-tax ROI I take rent less all actual expenses and divide by the cash invested.  For post tax, subtract the actual tax bill from the numerator of the pre-tax calculation.

Steve Babiak · Answer

The duration for which you hold a rental before selling is what determines the tax rate IIRC.  One year plus one day before selling makes it a long term capital gain.

But let's summon some tax experts to see their opinions: Dave NA

Anthony Dooley · Answer

Capital gains taxes do not apply to a flip, but if you own the property for longer than a year (which I recommend) capital gains applies because that is not a flip.  Maybe in your state, but where I'm from, passive investment income is not subject to FICA or Medicare taxes, only income minus depreciation, taxes, and expenses. The trick to the original question is the $25K limit.  Learn the rules and stay out of trouble. This is not the forum for legal advice.

Larry Turowski · Answer

Account Closed Your rental income is total Gross minus $6,000.  So, say you got $12k in rent.  Then your taxable income, before depreciation it a positive $6K (I assume from what you said that $2K would be cash flow and $4K would be principal pay down).

Yes, any loss, though it doesn't sound like you have one, would go against other income (assuming your are using pass-through accounting for the LLC).

ROI is based on earning before taxes.  Otherwise it would mean something different for every investor as every investor is taxed differently.  Your ROI, technically, is your cash flow plus any principal pay down, even though that does not translate to money in your pocket.

Sylvia B. · Answer

"Improvements" means anything other than the land. RE consists of land plus improvements. Land is not depreciable, improvements are.

Jon Holdman · Answer

Yes, that's correct about the taxes when you sell.  But wait, there's more.  In your example, you have a gain on the sale of $11,090.98.  Of that, $1090.98 would be subject to the tax on unrecaptured depreciation, currently capped at 25%  (it really your ordinary income rate.)  The remaining $10,000 would be subject to long term capital gains tax, currently 15%.  That extra 272.75 in tax on the unrecaptured depreciation is exactly what I was referring to.

The depreciation is only on improvements.   If you paid, say, $100k for a property, the simplest rule of thumb is the improvements are $80K and the land $20K.  So annual depreciation would be $2909.09.  A better way to split this up is to look at tax assessor data.  They usually split improvements and land.  Don't use their values, but use them to calculate the ratio for your property, then compute the split based on your purchase.

Am I thinking about the tax benefits of renting real estate correctly?

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