Walk me through income & tax implications

Tax, SDIRAs & Cost Segregation
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Walk me through income & tax implications

Andrew Taylor
Contractor · Magnolia, TX · Member since 2016 · 279 posts · 155 votes

My wife and I are closing in on our first multifamily property, and I'm really enjoying daydreaming about all the positive cash flow and how I'm going to enjoy it. (Don't anybody burst my bubble.)

I'm curious about a couple of things, though. I understand rental income is considered passive income, versus ordinary income from my employer. Say our property nets $24k/year in cash flow. That's $2k/month after all expenses, debt service, etc.

Income question: How do I make use of the $2k/month? Just spend away? Anything special I need to do (or not do) since that's the "passive income" from the rental?

Tax question, related to income question: How is the $24k/year "segregated" (for lack of a better word) from my ordinary income? I don't want to end up paying ordinary income tax rates on the $24k because I did (or didn't do) something with it during the year.

Random other question: Does the fact that the property is commercial (48 units) have any effect on income and/or taxes?

I'm planning on having a CPA handle this stuff for me when the time comes, but I'm trying to understand it now so I can make their job easier later.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    10y

    Your net income is taxable as ordinary income, it doesn't matter what you "do with it".  BTW, net income equals income minus all expenses (excluding capital improvements), minus interest expense on loan payments (can't deduct the principle payments) minus depreciation, (about 3% of purchase price).  Better to talk to a CPA now, not "after".

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  • Andrew Taylor
    OP
    Contractor · Magnolia, TX · Member since 2016 · 279 posts · 155 votes
    10y

    Thanks, @Wayne Brooks. I was actually just reading on a different tab about the things I can deduct (same stuff you mentioned and more). I doubt very seriously I'll have any actual net income. (I used the term "net" above erroneously. I just meant "cash left over that I can have fun with.")

    Between depreciation, expenses, interest, etc. I think I'll be fine. And CPA is already on board, she's just in the middle of tax season so I can't get in to see her for a few weeks.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    10y

    Just my personal opinion, but any investment that Doesn't have a taxable net income is a horrible, dangerous investment.  The reasoning is, your only "paper loss" (not an actual cash expenditure) is depreciation, which is about 3% of purchase price /year.  Your principle reduction (which a Real cash expenditure, but not deductible) in the beginning of a loan is about 1.5-2%/year, So your "net paper loss verses actual cash expenses" is only about 1-1.5%/year. This doesn't include capital expenditures, which are real cash out of pocket expenditures, but not immediately deductible.  Don't make the mistake of spending money that you should be setting aside for cap ex......roofs, hvac, etc. I used to own heavy equipment, and every few years that excavator and dozer need a new set of tracks, at $25k a pop, you better be ready for it.

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  • Andrew Taylor
    OP
    Contractor · Magnolia, TX · Member since 2016 · 279 posts · 155 votes
    10y

    So let's take an example property, and you let me know if I'm close on the assumptions.

    • $1,000,000 purchase price @ 3.5% for 20 years = $5,799.60/mo
    • $150,000 gross rents
    • 1st year P&I = $34,440 (interest), $35,156 (principal)
    • 1st year deductions
      • $34,440 (mortgage interest)
      • $25,641 (depreciation, $1M/39 years)
      • $75,000 (expenses - I'm using the 50% rule here for the sake of simplicity; property management, property taxes, insurance, maintenance, repairs, etc.)
      • $135,081 total deductions

    So my cash flow is going to be 150k (income) less 75k (expenses) less debt service ($69,595), or roughly $5.5k. Do I understand correctly that none of the $5.5k is taxable income, because of the $135k of deductions? Do I get a refund on the remaining $130k of deductions, or is that where the "real estate professional" designation comes into play? (Or actively managed, can't remember what I read.)

    I realize this is an over-simplified example, but I just want to make sure I have a handle on how the numbers will work in real life.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    10y

    No, your "deductions" get deducted from your Gross income, not your Net income, or cash flow.

    Using your numbers, taxable income:

    150,000 gross income

    (75,000) operating expenses

    (34,400) interest

    (30,909) depreciation (85% assumed bldg value /27.5) residential, not comm'l

    9,961 Taxable net income-

    -but, realize that maybe $7500- $15,00 (5%-10% of gross income) of those expenses (part of your $75k) are for reserves for Future capex expenditures that you didn't Acrually spend this year, so that number is not deductible, so it gets added back in.

    So taxable income is really $17461 to $24,961

    3.5% is probably an unrealistic interest rate also.

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  • Andrew Taylor
    OP
    Contractor · Magnolia, TX · Member since 2016 · 279 posts · 155 votes
    10y

    Thanks, @Wayne Brooks. That clears things up a bit for me. (BTW, it is a commercial property, not residential, and the interest rate is what my lender quoted. All the other numbers are made-up, though.)

    That's a good catch re: the CapEx / R&M money not being spent in the year it's earned. That would've snuck up on me.

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  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    10y

    You mentioned multi family residential.....for IRS depreciation purposes, the "use" is residential, even though your loan may be "commercial".

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  • Andrew Taylor
    OP
    Contractor · Magnolia, TX · Member since 2016 · 279 posts · 155 votes
    10y

    Ah. Gotcha.

    And that net income figure you quoted above, that's taxed at ordinary income rates?

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  • Daniel Chang
    Professional · Riverside, CA · Member since 2009 · 254 posts · 273 votes
    10y

    Your net income is taxed at ordinary income rates.   What's different about this from earned income is that you don't get Social Secrurity / Medicare taxes.  So hence passive income is advantageous to earned income.  

    It will all segregate out on your taxes (passive income goes on Schedule E).  

    What you should consider is quarterly tax payments, since you are unable to meet with your accountant for a few weeks.  The 1st payment is due on 4/18/2016.  Depending on your situation, you may need to submit a payment, or else may get fined/penalized for underpayment at tax year end.  

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  • Jeff B.
    Buy & Hold Owner · Redlands, CA · Member since 2015 · 5k+ posts · 2k+ votes
    10y

    Use some accounting package (like Quickbooks) to track income and expenses.

    After collecting YE Dec rents and paying all related bills and the mortgage,

    print a PnL report (QB:  Menu->Reports->PnL std)

    This report now contains everything needed for your 1040 Schedule E filing.

    The net result (Sch E) will then be copied to the 1040 line 17

    I track capital expenses (ie items that get depreciation treatment) via a spreadsheet with the different Class Life values grouped together.  There are others that track depreciation within the accounting system - - it's a matter of preferences.

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  • Michael Elliott
    Investor · Edmond, OK · Member since 2016 · 14 posts · 4 votes
    10y

    First post, sorry everyone :-)

    How do you account for future expenditures? So there is no way to have the equivalent of "retained earnings", since all profit goes to your 1040. 

    I'm doing some research before cash-purchasing my first single family property
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  • Patrick H.
    Investor · Erie, CO · Member since 2016 · 9 posts · 2 votes
    10y

    If I understand correctly with the above assumptions of roughly $5500 cashflow/yr and taxable income of around $17,000 to $24,000 - if you live in a high income tax state (6% or more) and are in say the 28% tax bracket you may be paying about $5500 to $8000 in taxes out of your $5500 cashflow? Sounds like you have to dip into your capex reserves just to pay taxes if you can't shelter this thing in a self-directed IRA. Furthermore, if you are in the 28% tax bracket (AGI over $200K) does this affect the ability to use depreciation in the taxable income calculation?

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  • Gita FaustBusiness Member
    Accountant · Richboro - Philadelphia, PA · Member since 2008 · 901 posts · 246 votes
    10y

    If this is a tax question - you should talk to your CPA as we do not know your personal info. Take it from someone who had a tax practice, sold it and doing what I enjoy the most. But still playing with numbers and coaching.

    Yes it does make a difference if is a residential or commercial property. Cost segregation is very important at every stage.

    As J Beard mention - use QuickBooks - learn to budget and forecast by property right in one software. It is a win win!

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  • Andrew Taylor
    OP
    Contractor · Magnolia, TX · Member since 2016 · 279 posts · 155 votes
    10y

    @Gita Faust, I will absolutely be filtering all of this through my CPA when the time comes. For now, I'm just spitballing. We made our first offer on a property last night and are anxiously awaiting the seller's response. I'm just trying to get a handle on what the situation will be if they accept the offer.

    The property is a 48-unit apartment complex; is that considered commercial or residential?

    Re: QuickBooks, why use that as opposed to Buildium or VerticalRent, one of the applications specifically tailored for landlords/property managers? I like a lot of the landlord-specific features offered by those two web-based applications, but I'm not sure how well they handle the bookkeeping side of the business. QB, on the other hand, seems like it would handle all the bookkeeping but maybe not necessarily the landlording parts (i.e. leases, maintenance requests, etc.).

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  • Jeff B.
    Buy & Hold Owner · Redlands, CA · Member since 2015 · 5k+ posts · 2k+ votes
    10y

    @Andrew Taylor "QB, on the other hand, seems like it would handle all the bookkeeping but maybe not necessarily the landlording parts (i.e. leases, maintenance requests, etc.)."

    YEP!  I use Excel for the rest, but  my small 6-units allow that.

    If I had many more doors, I would use a CRM, like Espo CRM (but it as software dependencies most at BP could not deal with).

    Point is, a CRM product creates document relationships like 

    • Tenant -> contact info
    • Tenant -> lease
    • tenant -> maintenance
    • tenant -> letters / notices
    • building -> tenant list

    Because they use a database, these systems will expand as necessary

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  • Gita FaustBusiness Member
    Accountant · Richboro - Philadelphia, PA · Member since 2008 · 901 posts · 246 votes
    10y

    @Andrew Taylor

    I let my clients decide which software to use - specially when it comes to another application. After they have three on their plate, we sit down and help them through the maze of zoning in, setting it up, get them caught up to current, with their management and accounting. 

    To answer part of your question - I have always said that you can use QuickBooks as a property management software and accounting/bookkeeping software. One of our clients have 300 commercial tenants with CAM using QuickBooks. Yes you can manage your lease, print from QB, attach it to your tenant, enter your maintenance request, get lease expiration reports and the list goes on. Apartment are considered commercial unless someone tells me different.

    You can use any software, remember take the time to learn, educate yourself and find the right employee to do the work. I have seen clients property management software all messed up as well. 

    In the end - what do you want for your business. Ask on BP, make a list and check it twice.

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  • Jose Ramos
    Property Manager · Cambridge, MA · Member since 2016 · 20 posts · 6 votes
    10y

    @Andrew Taylor thanks for mentioning Buildium. I'm on the Business Development side and have worked with a number of PMs who were first on QBs and then switched over to Buildium for a more integrated solution. We definitely help you handle the bookkeeping side of your business. 

    I'd recommend checking out this post on excellent bookkeeping. Let me know if I can be of any help. 

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  • Dave Toelkes
    Investor · Pawleys Island, SC · Member since 2008 · 1k+ posts · 837 votes
    10y

    @Andrew Taylor,

    Just checking your arithmetic.  You have $150K in income.  You have $135K in deductible expenses.  Your net taxable income is about $15K in this scenario.  However, your $35K principal repayment expense is not deductible, yet still takes money out of your pocket.  On the other hand, your $25K depreciation expense was a deduction that did not take any money out of your pocket.   So, you have a $15K rental income taxed at your ordinary tax bracket rate, but only about $5K in cashflow that may be just enough to pay the sate and federal income taxes on your taxable rental income.  Depending upon your marginal tax bracket, you may have a little bit left over after taxes.  The first time you have a major replacement expense, your net cash flow is negative.     

    IMHO, this would not be a good investment under the terms and the numbers are using. You asked us not to burst your bubble, but if it warns you against a bad investment ... .

    Just how I see it.   

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  • Andrew Taylor
    OP
    Contractor · Magnolia, TX · Member since 2016 · 279 posts · 155 votes
    10y

    Dave, these numbers are entirely made up, but I appreciate your working through the math with me. 

    If / when we get a favorable response on our recent offer, I'll update with more realistic numbers for review, but they're more like $345k gross income, $94k expenses, and $184k debt service. I'm left with something like $47k.

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