High rental income.. Pay income tax or buy another property?

Question

Hey all your savy investors out there, I have officially completed my first "BRRRRRRRR" after 2 years. I did all the work myself and what a learning experience it has been. I was able to take the annual gross rents from 45,000, to 60,000 while increasing the value of the property by about 250k. While I was living there, I had rent coming in off of one unit, and had a lot of deductible expense every month while fixing the property up, but now that I am moving out, I do not have the monthly rehab expense and I now have an additional 2500 per month for the unit I was living in. My concern is that after I deduct all my monthly maintenance expense + mortgage interest, insurance, tax, + depreciation + anything else i forgot, I am still going to be showing a large net gain. I'm just at step 1 right now, so sorry about my ignorance on the subject matter.

I have decent w2 income, so I really don't need the income off this property, so my thought was that I possibly get a heloc, high out refi, or something else in order to buy another property and in turn lowering my taxable income. Thank you for any help you can provide!

Basit Siddiqi · Answer

@James M.You normally don't want to make a decision only based on tax implications.Buy another investment property because you think that investment will further your finances. Don't buy a bad investment property because you can use the losses to offset the income earned on your first property.You may also find it that your rental is still showing a tax loss. Before you were not eligible to deduct mortgage interest, real estate taxes, home owners insurance, depreciation on the side of property that you lived in. That will free up once you rent out the unit you lived in.

Adam Kakuska · Answer

take your money and pay taxes on it man...AND buy another property. Having to pay taxes is a good thing. It means you’re making money.

Dave Foster · Answer

@James M., You've lived in part of that property for 2 years so if you sold part of the profit would be tax free. That's huge. You can do a 1031 exchange on the remaining percentage and that will get tax deferred treatment. So you . bought it improved it. And sell it tax free and tax deferred. That's a hall of fame swing for your first one.If you want to lower your income go find a dog that isn't producing anything that you can replicate that value add with.

James M. · Answer

@eric, thank you for your response! I fully intend to buy more properties, and I think that I need to start exploring either a refi, helix, home equity loan, etc to buy something else. I was unaware of the new tax laws as it pertains to depreciation.

Eric Carr · Answer

Also remember that you will now get the depreciation on the portion that you will be vacating. You could consider a cost segregation analysis and start depreciating other assets on the property faster, which would offset your on paper gain at the end of the year, for the next several years. Since you bought the property before Aug. 2017, you won't get the full 100% bonus depreciation that the new laws allow, but you would if you bought another property now. A new $1m rental and 100% bonus depreciation, could give you a several hundred thousand in bonus depreciation - in the first year. Long term, do you want to own more rentals? I look at it this way. You could pay tax on it and put the rest away, pay tax and roll profits back into the P&I, or not pay tax and buy more. My choice would be to buy more and use the current tax laws and magic of RE to the fullest. The tax laws want you to buy more. If that is part of your plan, don't wait. Roll that money into something that is going to pay you, not the government.

Aaron K. · Answer

Buy another property if you want another property not to lower your income tax because unless you buy a loser it won't lower your taxes in the long run.

James M. · Answer

All, Thank you for your extremely informative responses. I would love to 1031 exchange, but I’ll be honest, after working my a$$ for 2.5 years and living in this property and getting it to produce like it does, I have a big emotional attachment (I know bad for real estate and investment). I instead I’m now starting the process of a refi or heloc. Based on what kind of capital I have will determine what property I go after. Still a lot of research ahead and I will be leaning on a lot of you wizards. Thanks!

Dan H. · Answer

My recommendation is to do exactly as you indicate, do the Refinance (one of the Rs) at the highest LTV that you can get. After extracting out a decent percentage of the $250K value add and thereby increasing your loan amount, your paper profits will be much less and you will have extracted the money to do the Repeat (another of the Rs). It could be possible that you even show a paper loss.If you have a paper loss then you should look at the requirements to qualify for a Real Estate professional. I know that doing a $250K value add took a lot of time. It likely took a lot of your and/or your significant others (SO) time. It is not easy to qualify as an RE profession with a full-time W2 job but is fairly easy if you or your SO does not have a full time job. My wife works our RE and is a mom/home maker. Because she does not have a full time W2 job, it is fairly easy for her to qualify as a RE professional (I think it requires 750 hours for the year which is less than 15 hours a week). The designation allows us to write off any paper loss which was the result of us extracting money (increasing the loan amount) and therefore increasing our monthly payment.Note a 1031 exchange has complications because you lived in one of the units. Similarly, the home sales exclusion has complications because it was also a rental while you lived there.Good luck and congrats on what appears to have been a successful BRRRR.

Ron Trinh · Answer

@James M. - Have you considered a 1031 exchange? You could take that equity and put it to more efficient use, tax deferred. @Michael Swan used it to convert his appreciated San Diego condos to apartment complexes in a market that made more sense cashflow wise.Higher returns and less taxes sound good to me!I recommend having a chat with a real estate tax CPA.

James M. · Answer

Cool, thanks guys!