Rent My Home; Buy Another Primary

[Gabriel Wertz]

I have very little experience with investing. I purchased a small single family home with a partner 3 years ago that has a nice little cash flow to it.
With that said; I am looking for someone to tell it is OK to hold onto my current home to rent without possative cash flow & purchase another primary home.
I believe I can charge enough rent to cover all my costs: mortgage, insurance, taxes, & the tenant would pay for all utilities. I am sure a break-even deal like this equates to a poor investment when you factor in all the other variables ie. vacant prop & upkeep.
I owe $123K on the home and had it appraised at $156K. I am guessing most of you folks would say sell it and invest the equity in something more profitable. Here is my dilema: I have put a lot of work into this home and it is a nice, solid home that I believe will continue to appreciate in value. Relative to the single family rental I have that I don't see going up in value for quite some time.
Thank you in advance for your help!

[Jon Holdman]

I usually agree with what Rich has to say, but here I have to disagree a little. I have often seen deals presented where there is negative cash flow or a small positive cash flow. Once depreciation is subtracted, quite large negative taxable income. Then the "negative tax" on this loss is computed. The presenter assumes you'll use that negative tax to offset other income, so adds it back on to the cash flow to make the deal work better.

I see such deals presented using a 25% or 28% tax rate in the calculation. The presenter will neglect a couple of aspects of the full tax calculation, though. One is that passive losses (the negative taxable income from a rental property) are generally not deductible against ordinary income. There is an exception, the "special allowance", that allows a person or couple to deduct up to $25K in passive losses IF their AGI is below $100K. For 2009, you could be in the 25% tax bracket and have AGI under $100K. Above $100K AGI, and up to $150K AGI, this deduction phases out. If your AGI is over $150K, which would be the 28% tax bracket, you cannot take any passive losses.

There's still a benefit, in that the rental income is largely sheltered from taxes. But you have to have some rental income to shelter.

Another little gotcha that is often omitted is depreciation recapture tax. A big chuck of the negative income comes from depreciation. But you sell, the gain on the sale is computed by subtracting your basis from the net sales price (sales price less costs). Basis starts at the purchase price plus costs. But it gets reduced by the amount of deprecation that you take (or should have taken if for some reason you don't). So, your gains on a sale are increased by the amount of the deprecation, increasing the tax on the sale. Further, the amount of gain up to the depreciation is taxable at a higher rate, the depreciation recapture rate. That's your ordinary tax rate, with a upper limit (currently) of 25%.

So, the tax savings associated with depreciation has two problems. One is that you can only take it if you meet the income limits. Two is that you have to pay it back when you sell.

Now, I like a strategy Rich bought up in another post. That strategy is to buy rentals that are more or less break even. Buy one a year for 20 years. Pay them off in 20 years. After 20 years, refinance at an amount that puts the rent and payments back to break even. Now you have the proceeds from the refi to use as you wish. Never sell, so you avoid all capital gains or depreciation recapture taxes. When you die, your heirs inherit the property with a basis that's the value when you die. Keep in mind that after 27.5 years, you have no more depreciation.

Appreciation and principle paydown are long, slow processes. Yes, they matter. At least, we hope appreciation matters, and all evidence is that it will, over the long term and once we've worked off this bubble. But don't count on anything significant from either appreciation or principle paydown over a short time period like five years.