Author Topic: Investment vs. Working Class income  (Read 5763 times)

Bearded Man

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Investment vs. Working Class income
« on: November 08, 2015, 12:55:09 PM »
It's great to have a high salaried income if you are saving it and investing it for a FI future, however; it's arguably better to have a high investment income that you can shield from taxes.

For example. You get cash flow from rentals and you withdraw money via refinancing every few years to keep the rental income at the level of your living expenses. Thus your rental income is practically tax free due to tax benefits, and the money you pull out of said rental properties is untaxable gains.

So, someone who makes almost nothing as far as income tax goes looks less affluent than the person who makes six figures on paper. Yet in reality, the person who is living off their investment income is better off in that they get to keep more of the money they make, and they do much less to get it.

But on paper this person looks like they are poor. This seems to be how the rich ultimately operate. They look poor as far as taxable income goes, but in reality, even though they can't say "I made x dollars last year" and throw a tax return on the table, they are just as well if not better off than the person with earned income and a high salary.

Which would you rather be?

arebelspy

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Re: Investment vs. Working Class income
« Reply #1 on: November 09, 2015, 04:57:14 AM »
For example. You get cash flow from rentals and you withdraw money via refinancing every few years to keep the rental income at the level of your living expenses. Thus your rental income is practically tax free due to tax benefits, and the money you pull out of said rental properties is untaxable gains.

You won't get to deduct the interest on this refi though unless you invest the money.

My AGI is really high due to rental returns (much higher than someone who can manipulate their income via Roth withdrawals and rollovers), hurting my ability to get subsidized health care.  Not that I'm complaining, but just pointing out, each method has its benefits and drawbacks.  :)
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Bearded Man

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Re: Investment vs. Working Class income
« Reply #2 on: November 09, 2015, 08:15:32 AM »
For example. You get cash flow from rentals and you withdraw money via refinancing every few years to keep the rental income at the level of your living expenses. Thus your rental income is practically tax free due to tax benefits, and the money you pull out of said rental properties is untaxable gains.

You won't get to deduct the interest on this refi though unless you invest the money.

My AGI is really high due to rental returns (much higher than someone who can manipulate their income via Roth withdrawals and rollovers), hurting my ability to get subsidized health care.  Not that I'm complaining, but just pointing out, each method has its benefits and drawbacks.  :)

You sure about that? How can I not deduct the interest when refinancing a rental property? The money I pulled out should be irrelevant. The loan itself is a business expense.

arebelspy

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Re: Investment vs. Working Class income
« Reply #3 on: November 09, 2015, 11:04:23 AM »
For example. You get cash flow from rentals and you withdraw money via refinancing every few years to keep the rental income at the level of your living expenses. Thus your rental income is practically tax free due to tax benefits, and the money you pull out of said rental properties is untaxable gains.

You won't get to deduct the interest on this refi though unless you invest the money.

My AGI is really high due to rental returns (much higher than someone who can manipulate their income via Roth withdrawals and rollovers), hurting my ability to get subsidized health care.  Not that I'm complaining, but just pointing out, each method has its benefits and drawbacks.  :)

You sure about that? How can I not deduct the interest when refinancing a rental property? The money I pulled out should be irrelevant. The loan itself is a business expense.

I'm sure.  It's only a business expense if you use it to invest.  If you use it to buy groceries, it's not a business expense.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

Landlord2015

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Re: Investment vs. Working Class income
« Reply #4 on: November 09, 2015, 12:18:04 PM »
For example. You get cash flow from rentals and you withdraw money via refinancing every few years to keep the rental income at the level of your living expenses. Thus your rental income is practically tax free due to tax benefits, and the money you pull out of said rental properties is untaxable gains.

You won't get to deduct the interest on this refi though unless you invest the money.

My AGI is really high due to rental returns (much higher than someone who can manipulate their income via Roth withdrawals and rollovers), hurting my ability to get subsidized health care.  Not that I'm complaining, but just pointing out, each method has its benefits and drawbacks.  :)

You sure about that? How can I not deduct the interest when refinancing a rental property? The money I pulled out should be irrelevant. The loan itself is a business expense.

I'm sure.  It's only a business expense if you use it to invest.  If you use it to buy groceries, it's not a business expense.
True same applies in Finland(Europe) where I live. However you can do the trick that if you take investment apartment loan and then sell it you can start a company with that money. However companies in my country are very risky I have enjoyed watching reality shows like Dragons Den. Anyway I am more inclined to increase number of apartments that I rent then start a company... that said seems I will take a entrepreneur evening course that starts December, but I am not sure if I ever will become entrepreneur and that remains to be seen.
« Last Edit: November 09, 2015, 12:19:42 PM by Landlord2015 »

AnEDO

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Re: Investment vs. Working Class income
« Reply #5 on: November 09, 2015, 01:41:20 PM »
"It's great to have a high salaried income if you are saving it and investing it for a FI future, however; it's arguably better to have a high investment income that you can shield from taxes."

We make the best of both worlds by owning rental properties and maxing out our 401k's, HSA and childcare FSA to shield our relatively high income.   Plan is to go part time in a few years, start selling the rentals in 8-10, and invest the money in ETFs to become fully FI.  We will then start the ROTH conversions on our 401k's while we have 4 kids living at home and are only generating small amounts of income.  On our tax return we will appear poor.

Bearded Man

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Re: Investment vs. Working Class income
« Reply #6 on: November 09, 2015, 02:31:00 PM »
Looking at this it says if you use the money to buy a car, that allocatable portion is not deductible. Didn't see where it says unless you invest it? Also, didn't see a specification of what it has to be invested in? I plan on investing it in index funds. But perhaps they consider only pouring that money back into the house as investment.

https://www.irs.gov/publications/p527/ch01.html

beltim

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Re: Investment vs. Working Class income
« Reply #7 on: November 09, 2015, 02:37:36 PM »
From your link:
Quote
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 cannot be deducted as a rental expense.

Bearded Man

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Re: Investment vs. Working Class income
« Reply #8 on: November 09, 2015, 05:35:09 PM »
Yes, but like I said, it doesn't say anywhere that there is an exemption if you re-invest the proceeds like ARS said there was. And it doesn't say what is considered an investment in this context? Real estate? I know with a like kind exchange you have to buy other real estate with the money, not stocks, but I didn't see any of this spelled out in the publication. ARS said there was an exemption if you reinvest.

Cathy

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Re: Investment vs. Working Class income
« Reply #9 on: November 09, 2015, 10:54:56 PM »
The "general rule" is that all interest paid or accrued (as the case may be) is deductible. 26 USC § 163(a). However, for an individual taxpayer, the so-called general rule is subject to a very significant exception: "no deduction shall be allowed ... for personal interest paid or accrued". 26 USC § 163(h)(1). "[P]ersonal interest" means all interest other than interest that falls into certain enumerated categories. 26 USC § 163(h)(2). Thus, for an individual, the true general rule is that no interest is deductible, unless it falls into one of the permissible categories. For the purpose of this thread, there are three permissible individual interest deduction categories that are worthy of discussion: interest "taken into account" when computing net passive income (§ 163(h)(2)(C)); interest allocable to a trade or business (§ 163(h)(2)(A)); and "investment interest" (§ 163(h)(2)(B)). I discuss the possible application of each of these three categories below.

The general rule is that "any rental activity" is a passive activity, subject to certain exceptions. 26 USC § 469(c)(2). This applies regardless of whether the rental activity is a trade or business and regardless of whether the property is held for the production of income. However, in order for the computation of net passive income to take into account interest allocable to the passive rental activity, the interest needs to have been paid (among other things) "for the management, conservation, or maintenance of property held for the production of income" or as an "ordinary and necessary expenses paid or incurred ... in carrying on any trade or business". §§ 212(2), 162(a). If the interest expense passes either of those tests or certain alternative tests, then the interest is "taken into account" when computing net passive income under § 469, which in turn means that the interest is deductible under § 163(h)(2)(C).

As mentioned, the preceding paragraph analyses the case where the rental activity is a passive activity. However, what if the interest is allocable to a rental activity that is not a passive activity? In this case, we need to determine whether the non-passive rental activity is a "trade or business" within the meaning of § 163(h)(2)(A). As a matter of logic, the fact that a rental activity is not a passive activity does not imply that the activity is a "trade or business" within the meaning of § 163(h)(2)(A). Some old Tax Court cases address this issue. "[T]he operation of a single piece of rental property may constitute a trade or business ... or may constitute the holding of property for the production of income ... if the taxpayer's activities are sufficiently passive". Hoopengarner v. Commissioner, 80 TC 538, 543 n 8 (1983). The reason this issue is only addressed in old cases is that, as a practical matter, in order for a rental activity not to be a passive activity, it usually has to be a trade or business. However, this is not a logical consequence of the activity being non-passive. That said, if the non-passive rental activity is indeed a trade or business, then interest expenses properly allocable to that activity are deductible under § 163(h)(2)(A).

For completion, I will also briefly discuss the final case, even though it is probably only of theoretical interest. If a rental activity is not a passive activity and is also not a trade or business, then interest allocable to the activity is deductible under § 163(h)(2)(B) if the property is "held for investment", subject to certain limitations set out in § 163(d).

Everything in the above discussion is subject to certain exceptions that I have not discussed.
« Last Edit: November 09, 2015, 11:04:02 PM by Cathy »

arebelspy

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Re: Investment vs. Working Class income
« Reply #10 on: November 11, 2015, 01:15:12 PM »
Yes, but like I said, it doesn't say anywhere that there is an exemption if you re-invest the proceeds like ARS said there was. And it doesn't say what is considered an investment in this context? Real estate? I know with a like kind exchange you have to buy other real estate with the money, not stocks, but I didn't see any of this spelled out in the publication. ARS said there was an exemption if you reinvest.

Interest paid to invest (like margin interest, etc.) is deductible.  If you refi a mortgage on a house to a higher amount and cash out, you need to keep track of which interest was for the house (already there) and which part is for the cash out, and if you reinvest it, you can deduct it like you would any other investment expense.  If you spend it, of course you can't.

IRS Form 4952 IIRC.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
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Cathy

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Re: Investment vs. Working Class income
« Reply #11 on: November 11, 2015, 11:01:29 PM »
Interest paid to invest in a rental property is generally not deductible as investment interest. This is because the definition of "investment interest" specifically excludes interest "taken into account" in the computation of net passive income, and the general rule is that "any rental activity" is a passive activity. 26 USC §§ 163(d)(3)(B), 469(c)(2).

In my post above, I described the more common grounds on which interest paid to invest in a rental property may be deductible.

arebelspy

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Re: Investment vs. Working Class income
« Reply #12 on: November 12, 2015, 12:59:55 AM »
We may need some CPA opinions then. :)
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

Cathy

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Re: Investment vs. Working Class income
« Reply #13 on: November 12, 2015, 01:38:36 AM »
Investment interest is subject to certain limitations that other forms of deductible interest are not, so it's actually a good thing that interest paid to invest in rental property is usually not investment interest. As described in my posts above, interest paid to invest in rental properties is potentially deductible on other grounds.