Intentionally Paying More Taxes?

Question

I had a funny thought pop into my head as I began to prepare for the upcoming tax season: should I intentionally pay more taxes (by not taking all deductions/credits claimable) so as to be able to leverage that income into more investments?

I am at the beginning of both my real estate and professional career; now that I have a decent bit of rental income to show, I am thinking it would be most beneficial to me in the long run to overpay in taxes, showing as much income as possible for two years or so (two is typically what most Banks require). Thus, I would be able to leverage that income into greater investment capital for myself.

Sure, taking on leverage entails risk and I recognize the potential perils of it. But, I have a background in Finance and if I'm comfortable with the risk being taken with these investments, why not work with these low rates and depressed prices early in my career and get the proverbial "snowball" rolling down hill ASAP?

I recognize there are upfront costs in overpaying the IRS, but the long term benefit, with regards to the time value of money and the like, seems greater.

Thoughts?

Steven Hamilton II · Answer

Jimmy H.,

It is one thing to miss an expense and forget it.

It is a whole other thing to intentionally mislead the lender.  Bottom line it is misrepresenting your income.

-Steven

Account Closed · Answer

It's a costly mistake to not take the depreciation deduction.  Not only do you pay more taxes currently but you will be required to use the depreciation allowed over the live of the asset not the depreciation actually taken.  So you pay more now and later.

Bill Gulley · Answer

I've seen this by applicants, if they are in business they are "fluffing" the return and not taking usual and customary expenses says a few things;

1. The borrower is attempting to mislead the lender intentionally, that is fraud, depends on how significant the omissions are; or

2. It's an error, that reflects on the management of the applicant, if the errors are significant, failing to take depreciation, the deal can be turned down if management is a significant part of the deal.

3. A loan originator may not be the sharpest tool in the box and miss it, the errors may slide through, but a review by compliance folks later on will catch it, if they feel the omission could be intentional and the amount is significant, to ratios, the loan can be called due.

Lenders are not tax people, but they see hundreds if not thousands of tax returns of similar business operations. There are ratios for NIBT and NI by industry to the size of operations that can be assessed at a glance by lenders, if you fall outside the norm, either way, the situation will be looked at more closely.

If you have a portfolio loan at a bank, you're betting bank examiners will miss it in a loan audit, highly unlikely. If the amount is significant there can be problems, if they can prove the case, it could be fraud.

Often, if I saw that an expense didn't seem right, I'd just increase it in underwriting, that's what usually happens and a note is made in the loan file. The applicant may or may not be informed of adjustments.

If the loan is made, you may think you got one over on them, probably not and nothing will be said, but you made an impression that will be hard to change.  :)

Steven Hamilton II · Answer

Jimmy H.,

I can understand your reasoning for this; however, many mortgage lenders can and will consider that to be mortgage fraud by misrepresenting your income.

-Steven

Account Closed · Answer

This approach may backfire on you.

Consider who may ask for your tax returns.  Lenders, underwriters,  IRS, potential partners, potential buyers, etc.

While the IRS may not come after you for overreporting income currently.  It can effect future tax periods.  Not sure what you plan not to report.  Not reporting depreciation for instance is a bad idea.  Not reporting auto expenses on the other hand may get little notice.  It is quite possible you didn't keep adequate records or didn't know to deduct these.  In this situation the IRS is not going to advise you that you could deduct these expenses.

Lenders and underwriters may question normal expenditures that are missing.  There not just looking at net rental income.  They want copies of schedule Es for a good reason.  Depreciation is often added back to your income.

You may not want to partner with someone or sell your investment properties to an investor, but if you did it will become clear that the expenses are light compared to the norm.  As a potential buyer I would then still factor in normal expenses and may be more likely to estimate high because I have no historical background, but would still want to cover myself.

Geoffrey Murphy · Answer

David Beard, Charles Perkins- i agree a 1000% with you.

Why reinvent the wheel.

Geoff

David Krulac · Answer

Jimmy H.

Simple answer no.

One way to reduce your expenses is to reduce deprecation.  However, do it wrong and you just screw yourself.

This happens sometimes when people claim the the home office deduction and forget to claim the depreciation for that portion of their home.

The regs on deprecation says "allowed or allowable", which means if you were allowed to take depreciation but for any reason you didn't tough luck, you still owe recapture on depreciation that you didn't take.

But there is another way and that is take a longer deprecation schedule that the IRS recommends.  Currently residential is 27.5 years and commercial is 39 years.  These are minimums established, but you can always take monger deprecation schedules which will reduce your depreciation expense.  Say you used 50 years or 100 years schedule instead of 27.5, that would reduce your depreciation expense  and increase your current income and reduce your future income in the year you sold the property.

Just a thought.

Jimmy H. · Answer

@David - Essentially I just want to lower my DTI to improve the terms of financing and ensure that DTI never becomes a limiting issue - I'm riding the max DTI line fairly close based on my home mortgage/salary and even though my properties are NCF positive, I still want to lower my DTI as much as possible to allow me to potentially pursue more unconventional, creative and larger investments.

@Mike - That's a really good point: simply defer those expenses wherever possible.

@Tom - I appreciate your perspective and I can see where your town got it's name, LOL. I wouldn't do anything I would lose sleep over but, like most things i life, there's a large subjective grey area there.

Tom C. · Answer

You have to sign your return stating that it is correct (to your knowledge).  I would encourage you to be honest in every representation you make, especially to the IRS.  Try not to get caught up in the perceived benefit you give the IRS... You ultimtely are doing that to take advantage of a lender...  You wouldn't want your tennants doing that to you.   You have a long time to make money and the funny thing is that you have to live with yourself that whole time too!

As a side note, I recently was pre-qualified for a loan on an investment property and they also substantiate your sources of income.   I provided my two most recent returns (including the most recent year's K1s and W-2), 2 most recent paychecks and then the standard suite of bank statements.

There is some peace of mind you get from not over-extending yourself as well.

Mike H. · Answer

One other option you can try is capitalizing your repair expenses. It allows you to show more net income but still get the same deductions - just that the expenses are depreciated over a period of time.

There's nothing they can do to say thats fraud. Its definitely allowable both for the IRS and the banks.

The downside is you'll have less of a writeoff for the current year but you will not lose that writeoff. Its just going to spread out over time now.

Given that I max out at 25k anyway and, with depreciation, I show a larger loss than that, I'm doing it now and haven't had any problems with banks the last 2 years.  I have a CPA that does it though and he's be reminded several times that I don't do anything that risks getting in trouble.

Intentionally Paying More Taxes?

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