All Forum Posts by: Art P.

The buyer signs a promissory note and a mortgage/deed of trust.  The seller would sign a deed transferring title to you at the date the agreement is executed and monies are exchanged. They are essentially first position in the property if you cannot make the agreed upon payments and can foreclose upon you if you do not uphold your part of the contract. 

@Yinna Wang

It appears that as an "active participant" you qualified for the special election by filling out form 8582. You probably made $100k or less total to take advantage of the full $25k PAL (Passive Activity Loss) against ordinary income.

Because your husband qualifies as a real estate professional, your PALs should not be limited in offsetting your ordinary income in any given year that he maintains that status. 

As @Natalie Kolodij mentions, make sure your documentation for Real Estate Professional is kept track of in case of an audit. 

Perform a reasonableness check to determine whether you should or shouldn't get an LLC at this time. If you don't have significant personal assets or equity in the house, usually it makes sense to just operate on a schedule E. Just a reminder if you do operate an LLC to make sure it is operated as a separate business so that no one can "pierce the corporate veil" otherwise you may as well not have an LLC election at all. Example to protect you include: separate business and credit card accounts, expenses paid for on behalf of the business are properly reimbursed back to you, you don't use the business to pay for personal items without proper documentation and reimbursement (classifying it as a loan from the business), etc.

@Kabir Gandhi

@Michael Plaks

In addition to what Michael pointed out, only holding it for 2 months without actual rent received opens you up for the IRS to potentially challenge your position. Advertising it for rent and holding it without any takers could potentially cover you from that end, however unless you actually have the place rented out, you cannot deduct any expenses incurred.

Also, when you sell a rental property at a loss, you are able to take section 1231 losses which offset any ordinary income from whatever source derived. You can essentially argue that the property was indeed held for over a year (under personal use), and was used in rental activity at the time of sale. 

Refer to the IRS definition on section 1231:
"Sales or exchanges of real property or depreciable personal property. This property must be used in a trade or business and held longer than 1 year. Generally, property held for the production of rents or royalties is considered to be used in a trade or business..."

"To determine the treatment of section 1231 gains and losses, combine all your section 1231 gains and losses for the year.

• If you have a net section 1231 loss, it is ordinary loss.
• If you have a net section 1231 gain, it is ordinary income up to the amount of your nonrecaptured section 1231 losses from previous years. The rest, if any, is long-term capital gain."

https://taxmap.irs.gov/taxmap/pubs/p544-015.htm

@Stuart Levine

When you purchase the house, you will most likely need to sign a deed transfer with a purchase price allocated to each parcel (property). You can perform a cost segregation study on each parcel using various methods such as assessed value, net income (estimated net income), sqft of building, sqft of lot, or a mix of building and lot. The method that you choose on this transaction must be consistent on any similar future transactions.

I don't know of any regulation permitting a $0 basis election on property. If the price you are paying for both properties is reasonable (FMV for type of payment and condition of property), use a reasonable method that benefits you with the purchase and potential future sale of the first property to retain the majority of capital gains on the second residence.

Hopefully that is somewhat clear, I can illustrate with an example if you are able to provide a few figures such as total price, rent rate, and sqft of the properties.

@Ashish Acharya @Michael Plaks

Thank you to both of you for clarification and additional research material!

@Ashish Acharya

This truly does feel like a case study. Thank you for your input. Do you have any literature available on the "interest training rule"? Logically it makes sense that the entirety of the service debt amount above acquisition cost should qualify if used for a qualified property (or rental) purpose to "buy, build, or substantially improve". I had difficulty substantiating the refinanced portion use because it was a mixed use property. 

Pub. 936 states: "Interest on home equity loans and lines of credit are deductible only if the borrowed funds are used to buy, build, or substantially improve the taxpayer’s home that secures the loan. As under prior law, the loan must be secured by the taxpayer’s main home or second home (qualified residence), not exceed the cost of the home, and meet other requirements."

Pub. 527 states the following: "You can deduct mortgage interest you pay on your rental property. When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally can’t be deducted as a rental expense."

I wanted to clarify the interpretation you are using. Is it because the entirety of the additional balance of the refinance is going towards a qualified primary residence (or secondary home) and it's secured by the previous residence (the one that was refinanced with a new loan), you disregard the nature of the duplex (mixed use, one part primary other rental) and solely focus on how the proceeds of the refinance amount above the initial acquisition cost are applied? 

My understanding based on your response:

Old debt $140k - stays the same, $70k on each side.

New additional debt $110k (is this applied to the Duplex, the property that secures the debt, or new SFR, the property the debt is used to fund?), assess the nature of how proceeds are used if they qualify for either Qualified primary residence or qualified rental purposes in either "buying, building, or substantially improving" a home/rental. In other words, do not split them based on the operating nature of refinanced property.

Again thank you for your time and clarification.

Hello all tax professionals on BP, I would like to reach out to the knowledge base to see if any of you have dealt with a similar situation as addressed below and how to properly handle it. Thank you in advance!

Topics that this question touches on: Mortgage Interest deduction (limitations), conversion of primary property to rental, multi-unit mixed use tax implications, and cash-out refinancing.

Hypothetical scenario: I own a duplex that I house hack, I treat one side (side A) as personal (schedule A) and the other side (side B) as rental (schedule E). For simplicity, lets say I purchased the property in 2010 for $200,000 ($140,000 loan remaining at time of refi). I want to cash-out refinance the Duplex for $350,000 and take out $250,000 (leaving $100,000 in equity) to use in purchasing another personal SFR (second home to become primary) priced at $400,000 using remaining funds after paying off previous mortgage in the amount of $110,000 ($250,000 cash-out - $140,000 previous mortgage) as the down payment and later rent out side A. If all this transpires in 2019, the question is how much of the debt service amount in interest can I deduct from the new refinanced amount on both Schedule A and Schedule E and going forward in subsequent years if side A is rented?

Assumptions: 
1) I have lived in side A for more than 14 days or 10% of the days it has been rented out (whichever is greater) allowing me to treat side A as a primary residence for the full year.
2) Total personal debt service is under the new TCJA limits of $750,000, no partial limitation to new refinanced amount.

Research and background:

IRS publication 936 alludes to cash used as part of refinance towards a secondary home purchased under a refinance of the primary residence counts towards the mortgage interest deduction on schedule A. In the case above, I am under the understanding that the refinanced amount on the duplex was used "to buy, build, or substantially improve a qualified home" as part of the SFR purchase.

My understanding is that because the new property is not used to "buy, build, or substantially improve" a new or existing rental, then the additional refinanced amount on the rental side is disallowed.

Based on IRS tax codes and the new TCJA, is my understanding correct on the debt service limitations on the individual properties?

Tax year ended 2019:

Schedule A:
Previous Mortgage Side A - $70,000 (50% of $140,000)
New cash out refinance - $125,000 (50% of Cash-out refi of $250,000, $70,000 old mortgage + $55,000 qualified residence mortgage interest)
SFR - New mortgage of $290,000.
Total deductible debt service interest on - $415,000 ($125,000 + $290,000).

Schedule E:
Previous Mortgage Side B - $70,000 (50% of $140,000)
New cash out refinance - $125,000 (50% of Cash-out refi of $250,000)
Total Deductible debt service interest on - $70,000.

Tax year 2020 when side A is rented:

Schedule A:
SFR Mortgage - $290,000
Grandfathered qualified primary residence cash refinance - $55,000
Total deductible debt service interest on - $345,000

Schedule E:
Duplex Mortgage side A - $70,000 (limited to acquisition debt)
Duplex Mortgage Side B - $70,000
Total deductible debt service interest on - $140,000

If I misunderstood Publications 936 and 527 or if there is other authoritative guidance that addresses any specifics on the scenario above please let me know.

@Brandon Kmiotek 

@Michael Ealy

Brandon, I'm not exactly sure where your property is located, but it seems you might be a little high on water and sewer costs. With that said, you are still missing property management (paying yourself), and CapEx costs. You might be a little low on the % for repairs, the building is 1901 so look to use 12-15%. Are you providing in unit laundry or coin operated in a separate attachment? If separate attachment, you will be paying utilities, and maintenance on the units.

I am under the assumption your calculations are with renting out all 4 units and not house hacking (hacking with those numbers may make a difference). Will you be able to substantially raise rents within the next year after improvements? You will need most likely a minimum of $1,100/unit (assuming the $3,315 rent roll is for all 4 units) to even begin looking at this as potential for a rental.

Because you are still missing some factors, it will only hurt the bottom line. Remember that you want to find a deal that cash flows from Day 1 (with the exception of building in house hacking one unit where you have decreased rent), otherwise you are gambling on appreciation. What happens in a downturn? You lose equity and continue to lose money on the rental. 

I would recommend to continue searching for a better deal unless you can provide further clarification on the numbers used. 

@James Teutschmann

As @Taylor L. suggests, formulate a partnership agreement ASAP and have it looked over by an attorney. This agreement will spell out your share of equity based on terms you set. For example, you contribute $10k, and your partner contributes $90k. You can agree to split profit 50/50 even though equity contribution is not equal. When liquidating the deal, you will equally split the profits/losses and distribute initial equity invested, $10k back to you, and $90k back to the partner.

From a tax standpoint, regardless of whether this is a partnership or LLC running transactions through a business bank account is highly suggested. A partnership will be a pass-through entity which will report all share of profits to your individual 1040's regardless of whether you distributed the money or not.

Similar to a partnership, an LLC is taxed the same way, however, you are able to get limited liability protection on the venture. Remember to run the partnership under an LLC as a separate legal entity and not as an extension of your personal accounts.

Either you and/or your partner will be subject to self-employment taxes. The general exception to the rule is individuals who have merely invested money but don't provide services or make management decisions for the LLC may be exempt from paying self-employment taxes on their share of profits.

I am getting better at trying to tag individuals in replying to posts, but is it difficult to include the tagging feature when editing or updating a post? Currently there is no option to do so and I believe it may benefit some of the newer BP members that may either forget to do so at the beginning, and reduce any duplicate posts for the same content just to tag an individual.

If anyone has any workaround or other suggestions I would appreciate any feedback.