All Forum Posts by: Dave Toelkes

@Josh M.

It appears that your property taxes are paid in arrrears.  All of your 2018 property tax bill paid in 2019 would be deducted as a personal expense on Schedule A if you itemiize.  For 2019, you have three months of personal use and nine months of rental use. Allocate your 2019 tax bill between the periods of personal use and rental use. The personal use question in your tax software is designed to help you allocate certain annual expenses between personal and rental use.  For example, if you tell the tax software that your first year was 90 days personal use and 275 days rental use, then the software will take your annual tax bill and annual hazard insurance premium and allocate those amounts between your personal use and rental use and put the appropriate amounts on Schedule A and Schedule E.  If you want to manage the allocation yourself, then answer 0 to the personal use question.

Amortization applies to the costs of refinancing.  Loan fees and other closing costs when you originally purchased the home should already be included in your original tax basis for the property. If you did not refinance the property, you have no amortization costs to expense.

Basis for depreciation is your adjusted tax basis OR the FMV of the property whichever was less at the time of conversion from personal use to rental use. Your tax basis (or FMV) minus the portion allocated to the land is the depreciation basis for the dwelling structure. If you did any capital improvements (not repairs) to the home while it was your primary residence, then the cost of those improvements would be added to your depreciation basis for the dwelling structure. The IRS will accept use of the tax assessor's ratio of the dwelling structure to the property value times your original tax basis (or FMV if lower) to determine the depreciation basis for the dwelling structure. Whatever method you use to determine your depreciation basis must be defendable to the IRS should you get audited, so don't get too creative here.

If your flipping business is set up as a corporation or an LLC treated as a corporation, transferring the property out of the corporation may be deemed a sale of the property at FMV.  Profit will be taxed as a dealer transaction; self-employment taxes may apply if you are operating as an S-corp.

You don't hire a CPA just to do your taxes.  You hire a CPA for strategic tax planning before you act.  In the future, consulting your CPA to determine the potential tax consequences of a planned acquisition strategy may help you avoid unwanted tax consequences.

While this may be the case for the majority of rental property owners, it is not exactly accurate.  There are scenarios in which some or all of the depreciation taken (or that should have been taken) is not taxable.  It would be more accurate to say depreciation that did not occur is recaptured at the time of sale. 

If you are planning to hold these properties as rentals

Capex and renovation costs are capitalized (added to your cost basis) then recovered through depreciation. You depreciate your actual costs, not the new value. the value of the land is never depreciated. For this major renovation project, IMO, the project cost is a renovation that would be capitalized. You can expense property taxes and loan interest on your Schedule E. If this property is owned by your flipping business, I would transfer it to a new buniness entity that you set up for the rentals you will hold. Get a new CPA on this right away. You don't want to conduct rental activities under your flipping business umbrella.

If you are planning to rehab then flip these properties,

All of your costs are accrued as cost of goods sold and recognized in the year of sale.  None of your direct property costs are expensed, everything is included in the tax basis when the property is sold.

@Simond Wong

Not clear in you post is your Mom's motivation here.  

As far as capital gains taxes are concerned, your Mom will transfer the capital gains burden from herself to you and your sister should she sell you the house for below market value or gift you the house outright.  In this method of transfer, your Mom's tax basis in the house becomes yours.

The best tax outcome occurs if your Mom puts the house into a revocable trust and designates both you and your sister as beneficiaries upon her death.  You and your sister inherit the house at its stepped up basis and avoid probate costs in addition to capital gains if you decide to sell the property shortly after her death.

Inheritance taxes are state specific.  You need to consult a local tax advisor for assistance with this question. 

If your question is prompted by your Mom's impending transfer to a nursing home, then you will also want advice from an eldercare attorney.  Medicaid lookback can upset a property transfer up to five years later if not properly planned and managed.

Commercial loans do have pitfalls.  Generally speaking, your net operating income needs to be about 130% of your debt service to qualify for the loan.  While the loan may be amortized for 20 to 30 years, it will be reviewed and subject to renewal every five years.  If your loan review fails to meet the lender's criteria, your loan will not be renewed and the lender will call the note due.  

Advantage of a commercial loan is that the property is the only recourse for the loan so you are not required to personally guarantee the loan.  Property financed with a commercial loan does not count against you if you are using a commercial loan to purchase a property.

I believe it is your entitlement you should be looking at. As a general rule, VA loans are intended for veteran owner-occupants purchasing a primary residence. Regardless of the cost of the property you are purchasing, all of your entitlement is used when you make the purchase. If all of your entitlement is used for your first purchase, you have none left for another VA loan unless you sell the first property or refinance your VA using a conventional loan, then have your entitlement reinstated.

@Matt W.

Cashflow is the amount of money you have left over from your monthly rent collection after you have paid all your expenses.  In your scenario, Your monthly cashflow is your rent collection minus all rental property ownwership and operating costs you incurred during the month.  So for any given month, your cashflow would be 

cashflow = collected rent - PITI - repairs - maintenance - HOA fees - utilites -rental lisence - legal fees - advertising - property management - anything elese you had to pay during the month

At the very least, your monthly casflow is $556 ($1350 - $794) if PITI in your only expense during the month. After one year of operation, total your monthly cash flows and divide by 12 to calculate your expected average monthly cashflow.

Taxable income is not the same amount as your cashflow. Start with the total annual rent collected and subtract the annual amount you actually spent for all of the following:

• mortgage interest expense,
• repairs, cleaning, maintenance,
• legal services, hazard insurance, 
• property management, HOA fees,
• postage, advertising, supplies,
• and any other property related expense you paid for during the year.  

Finally, subtract the one expense that did not cost you any money out-of-pocket:  depreciation.  The final answer is your taxable income.  

I think it is easy to see that you can have a positive cash flow, yet, still have a net tax loss for the year.

You are lot allowed to deduct the cost of any labor that you did yourself.  Repair or replace something, you can deduct the cost of the item but not the cost of your own labor.  Paint a room yourself, only the cost of the paint and painting supplies is deductible.

@Alexander Reyes

For a primary residence, but only if you itemize deductions

• Mortgage interest on your acquisition debt can be deducted
• Property taxes are deductible
• Owner occupied property may qualify for a discounted property taxes
• Captial gains on sale of home are eligible for Section 121 exclusion

For an investment rental property

• Mortgage interest on acquisition debt is deductible
• Property taxes are deductible but not discounted for non-owner occupied property
• Repair costs, maintenance and upkeep expenses are deductible
• Home owner's association fees, rental license fees, and certain postage costs are deductible
• Fees paid to property manager, accountant, and attorney are deductible
• Depreciation is deductible against rental income
• Up to $25K in net losses from a residential rental activity can be used to offset other taxable income subject to certain income limits.
• Capital gains on sale are taxable but may be deferred indefinitely using a qualified 1031 exchange

@Wade G.

I can apporeciate your dilemma.  You are in aquisition mode.  You need cash to make downpayments on the next rental properties you plan to purchase.  My question for you is, do you have a strategic plan, or, are you just in buy mode with no coherent plan in place?

If you don't really have a well-defined plan, let me ask you what your financial goal is.  Are you tyring to generate enough rental cash flow to replace the income from the W-2 job you want to quit?  Are you buying properties to provide a sustainable income for your retirement?  Since you are investing in rental properties, I assume you know that buy and hold investing is a slow road to wealth, and, by default, your investment strategy is a long term undertaking.  If you have a long term goal in mind, when do you declare success?

If these questions are giving you pause. then let me give you a plan to think about.  Let's say your ultimate goal is to be financially independent (not the same as rich or wealthy, but better).  You want to have your passive income support your lifestyle so you never need to ever work, or put a deal together to put food on the table.  Sound good?    

How much passive income will you need?  If you think you will need $4000 per month to maintain your retirement lifestyle, then how many rental properties will you need in your investment portfolio to provide that income?  If a financed property generates $100 monthly cash flow per door, then you will need 40 properties.  If a free and clear property generates $500 per door, then you only need 8 free and clear properties.  

Once you have identified the number of properties you will need. we can put together a strategic plan to get to your goal of financial independence so you can retire.  Let's say you have 30 years before you want to retire.  Start by using the 50% rule (rule-of-humb, not absolute).  Half of your rental income will be needed to pay the costs of ownership and rental operation (repairs, vacancy, upkeep, major systems replacement, property taxes, insurance, property mgmt, advertising, etc.).  Half of your rental income will be needed to pay the debt service on your financing and leave enough to meet your cash flow requirement.  If market rents in your rental market are about $1000 per month, then your debt service can not exceed $400 per month.  If your fixed rate financing is 4%, then the most you can afford to pay for a property is $105K with a $21K downpayment.  Your monthly principal and interest payment will be about $401.  

Let's say you are able to save the downpayment to buy one property per year for the next ten years.  Let's also contribute all your excess cash flow from the property (properties) you own toward the downpayment savings for your next property.  At the end of ten years, you have ten financed properties, all producing at least $1000 per month gross rent.  If during the ten year acquisition period, financing rates increase, then lower your maximum purchase price for the next property. 

With 10 properties in your rental portfolio, you can stop the acquisition phase and begin your debt reduction phase.  For the first property you purchased (the property with the lowest loan balance) use all of your excess cash flow to pay down the principal balance on that loan.  When that property is paid off, establish an "escrow" fund for the property taxes and insurance premiums that your mortgage company used to pay for you.  Contribute to this fund monthly.  When the first acquired property is free and clear, you have more excess cash flow to contribute to debt reduction on the next lowest loan balance.  Regular rent increazes will let you keep pace with increases in property taxes, hazard insurance premiums, and general operating costs.  At the end of twenty years of debt reduction, you may find that 5 of your 10 properties are now free and clear with 5 more still with a loan balance.  At this point, you should be able to sell two of your financed properties (pick the least productive properties).  Use the proceeds from the sale of those properties to pay off the loan balance on the remaining three properties.  

At this point, it has been 30 years since you began your trip down this slow road to wealth.  You have eight free and clear rental properties generating all the cash flow you expected to need to support your retirement lifestyle.  You don't have to work or put together a flip to put food on the table.  Your primary residence should also be free and clear.  You should not have a car loan, nor much (if any) credit card debt that you don't pay off every month.  

If you need more money than you have in savings, take out a home equity loan on one of your rental properties for $25K tax free.  Arrange your payment schedule to pay this loan off in seven years or less using the rental income from the property you refinanced.  You can even do this every year for the next seven years.  When you are refinancing the eighth property, you are paying off the refi on the first property so you can refi it again the next year and start the cycle over again.  If your rents are high enough, it should be fairly easy to keep this $25K per year tax free income stream going for the rest of your life.

Notice, I did not offer an opinion on whether it is best to take on more debt or to pay off what you own first.  I think there is a time and place for both depending upon your goals and the circumstances.

Just food for thought.