What effect will rental property have on my personal income which is over $150k?

Question

Hubby and I purchased one duplex 6 yrs ago.  After mortgage payments/insurance/taxes/expenses.  We are at 0 profit at best, some years have been at a loss which helped cut our personal taxes.

Want to purchase 2nd prop which after calculations will gross $300/month income.  Our income is over $150k what can we do to minimize our taxes?  Can creating a business entity help us?

Jon Holdman · Answer

Angie Brown, you can write off all your expenses whether you create some entity or not.  A C-corp allows you to write off fringe benefits like health insurance.  But any actual expenses can be written off against the rental income whether you have an entity or not.  And some entities, like S-corps and LLCs don't have any impact on taxes whatsoever.  That's actually a good thing.  Some gurus preach BS like having a corporation that owns a rental lets you deduct your vacations.  It does not.

Read in the rental property forum about the 50% rule. That says 50% of your gross scheduled income will go to vacancy (rent you never actual collect), expenses (money you spend in one year the IRS lets you deduct in that same year) and capital (money you spend in one year that has to be depreciated over several, stuff like carpets (those only last 3-5 years) and roofs).  Now, a big chunk of that 50% is property management and you can earn that for yourself, if you're willing to do the work.  But a $700 rent property will only generate $350 in net operating income.  From the at remaining $350 you have to pay the P&I part of your payment.  From the bit that's left, you get to deduct the depreciation on the purchase.  If there's still something left, that's taxable income.

So, lets actually do the numbers on your deal.  $40K for $700 in rent (good deal, by the way, I can tell from just those numbers.)  I assume no rehab.  20% down and a 30 year, 5.2% loan (that's high, but this is a small loan.)  That gives a P&I payment of $176 a month.  $700 in rent, less 50% for vacancy, capital and expenses leaves $350.  Less the $176 payment leaves $174 in real cash flow.   That's $2091 a year.  That's a cash on cash return of 26% on your $8000 down payment, which, IMHO, makes this a very good deal.

Now, the rule of thumb is 80% of the purchase price goes to improvements.  So, that's $32,000.  You depreciate residential property over 27.5 years.  So, that's $1164 of depreciation for the first year (its more complex on your taxes, unless you close on January 1, but this is just quick and dirty calculations.)  So, subtracting that from the $2091 in real cash flow leaves $927 in taxable income.  If you're in the 28% bracket, that's $260 in tax.  In the 33% bracket its $306.  So, subtract the cash from the $2091 cash flow and you have $1831 or $1785 in real spendable money.

Now, some, probably most, years will be better.  You'll make more, but have more tax.  But you will still end up with more money in your pocket.  Once in a while, you'll have some big expense like a roof or furnace and that will be a bad year.  But the good years will outweigh the bad ones.

If you do the PM yourself your income will be higher and so will your taxes.  But you will end up with more money in your pocket.  Sometimes people get the idea they want to blow money in order to reduce their taxes.  Like paying out $100 in interest in order to save $28 in taxes.  My math says you're still $72 poorer, so, as far as I can tell, that's just dumb.  I think they call that "cutting off your nose to spite your face."

Now, if you have ten of these bringing $7000 a month, multiple all these number by 10.  So, you have an extra $2,600 to $3,060 in taxes, but another $17,000 in your pocket.  With ten, one of them will have a "bad year" every year.  Meaning you're buying a new roof, furnace, or sewer line every year.

Realize at some point you won't get 30 year fixed rate mortgages.  You'll have to do 15 year commercial mortgages.  That will hurt your cash flow, but may still work for deals like this.  And will get you to being free an clear on these properties sooner.

I strongly recommend a CPA who's knowledgeable about real estate investments, if you're going to be in the business.  It may cost you another $500 a year (some of which is deductible against the rentals.) But a good CPA will help your through all of this.  Trying to do rental property taxes with TurboTax is penny wise and pound foolish.

Jon Holdman · Answer

Because this question is related to what Angie is asking, I'll answer here.  But best to start your own thread for your questions to avoid it getting overlooked.

With three units, unlikely.  The IRS requires 750 hours per year.  That's 15 hours a week.  Even when I'm doing a turnover I rarely spend 15 hours in a week.  I might spend 15 hours total on a turnover.  Most months my two units require less than ten minutes.  The IRS knows this - its specifically mentioned in their audit guidelines for people trying to claim real estate professional status.

Lets be clear on something else.  "Depreciation" is an amount you put onto your tax return as an expense.  It subtracts from the rental income just like taxes, insurance, maintenance or interest.   You don't have to take this deduction, but makes little sense not to.  That's becuase it also decreases your basis, increasing your gain when you sell.  Further, when you sell, the total amount of deprecation taken, OR ALLOWED if not taken, is subject to a depreciation recapture tax.

After you subtract all your expenses, including depreciation, from the income you receive, you're left with your net taxable income.  In your case, Angie, if this amount is positive, it gets added to your income and taxed at your marginal rate.  If you're right on the edge of one of the tax brackets, that income might push you up into the next bracket.  So the amount over the bracket boundary would get taxed at the higher rate.  It would have not effect on the tax on your other income.

Now, if the net rental income is negative, you have a "passive loss".  Under some circumstances, you can use that "negative income" to offset other income.   But your AGI must be $100K and the total passive loss must be less than $25K.  AGI between $100K and $150K phase out this $25K limit by $1 for every $2 of AGI over $100K.

Creating an entity won't help, and may make matters worse.  An LLC is a pass through entity for taxes.  So, it has no effect at all.  If you create a C-corp, you could keep the income inside the C-corp and have it pay the taxes.   That might indeed be at a lower rate.  But if you then want the money for yourself, you would have the C-corp pay dividends.  Those taxable for you.  So, the total tax may be higher than if you just put the money directly on your tax return.

A financed, $700 rent property isn't going to produce enough income to have any significant effect on your taxes, if your AGI starts over $150K.  You will have, over the long term, LOTS of other expense than taxes and insurance. And you won't collect $700 each and every month.

Steven Hamilton II · Answer

Angie Brown,
Thomas Blue,

Being incorporated will not allow you to deduct anything other than what you normally deduct; however, if you have a large profitable portfolio, you can offer any employee of the corporation some fringe benefits or pension/401k plans.

Thomas, yes you can deduct those flights.

Bottom line no matter what you should keeping good track of your expenses and have thorough record keeping.

-Steven C. Hamilton II EA

Jason Watson · Answer

Be careful. In Tax Court Summary 2012-94 (Wallach), the court denied these expenses on two fronts. First, the taxpayer did not do a good job on recordkeeping (imagine that). Second, these expenses were considered "investment" expenses subject to the 2% AGI rule, and not rental activities.

Read an expanded KnowledgeBase article detailing this and several other real estate professional court cases at-

http://www.watsoncpagroup.com/kb/What-are-some-of-the-tax-court-cases-for-real-estate-professionals_163.html

Thanks,
Jason

Jon Holdman · Answer

Glad to help.

I don't recommend one of those big agencies.  Find a CPA who has RE investor clients or (better still) has rentals of his or her own.  Now, in reality, a LOT of their job is just punching numbers into a souped up version of TurboTax.  The trick is knowing what numbers to put where.  A knowledgable CPA will probably help you find deductions you're not aware of at all.

Jon Holdman · Answer

If your AGI is over $150K you won't be able to offset your ordinary income with the passive losses from your rentals.  But if you have one property that's producing passive losses you can use those to offset taxable income from another property that's producing taxable income.

Good rentals produce taxable income.  Crummy ones produce passive losses.  Now there may be reasons to hold a property that produces passive losses.  But all too often sellers in this business slap on some "tax benefit" lipstick on a pig of a rental.

There is a way to use passive losses even if your AGI is too high.  If you or your wife can be a real estate professional, you can deduct these losses regardless of AGI.  That means doing at least 750 hours a year on real estate activities OR more than you spend doing anything else.  So, this is essentially impossible if you have a full time job.  Its difficult if you have just a handful of rentals.  The IRS know rentals don't actually take very much effort.

Angie Brown · Answer

@Thomas....I have always written off trip expenses when taking care of my rentals.

Thomas Blue · Answer

Jon Holdman - so even if you don't have a corp setup, you can write-off stuff if you own property?  For example, I am going to fly out to Austin to check out some properties.  I can write off my hotel and flights?

Angie Brown · Answer

Wow!!! Jon that was absolutely fabulous!  Well said.  Thank you for breaking everything down.  Recent years I have done my own taxes and there has been years we carried a profit maybe 2 of the 6.  One year when we first purchased our property we used HR premium, to give me a guideline of the years to come.  I've always shyed away from those types of tax agencies, b/c (in my experience) they do little more then punch in numbers.  I will be seeking out a CPA immediately.  I am trying to formluate a plan, a long-term plan investing in real estate.  Thank you for breaking down all of the numbers.  It's a funny thing that in the few days I've been on this site I've tried to figure out this 50% rule and 2% thing and it didn't quite make since to me until now, however, having one property already under my belt I KNOW this is a good deal.

Steven Hamilton II · Answer

Jon put it perfectly.

What effect will rental property have on my personal income which is over $150k?

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