investment property rent and taxes

[Alan]

Is investment property rent income taxed at normal income rates, or at capital gains rates?

I've just begun considering my first investment property purchase and I'd like to start running some numbers.

While trying to search for an answer myself, I found an article that mentioned renting to family or friends would lose me almost all tax deductions. Can anyone explain this as well? The article did not go into details, unfortunately.

Thanks in advance.

[arebelspy]

Normal income, but via depreciation much or all of that can be tax sheltered (and it can even shelter some of your normal income).  Rentals are generally a tax benefit, not hurt.

Idk about the family thing, as I don't rent to family.  Google has an answer, I'm sure.

[Nords]

Is investment property rent income taxed at normal income rates, or at capital gains rates?

Rental income is taxed on Schedule E as part of your normal income.  You reduce gross rental income by expenses and by depreciation and then add the net result to your AGI.  You should take the depreciation because the IRS will assume (later on) that you've been taking it.

On Oahu we also pay 4.5% excise tax on the gross rental income before paying regular state income tax on the net rental income.  You'd have to watch out for your state/local sales taxes or excise taxes in addition to income taxes.  Your local area probably has an online landlord guide (and landlord-tenant code) to help you keep track of the issues, and you may also be able to read about it in the tax forms.

If you later sell the property then you pay a 25% "depreciation recapture" federal tax on the depreciation you took while you were a landlord.  The IRS collects this tax whether or not you've actually been depreciating the property so... depreciate it.  You'll also pay capital gains taxes on the profits.  Your cap gains on the rental property may also push you into AMT as well as higher state/federal tax brackets.

I've just begun considering my first investment property purchase and I'd like to start running some numbers.

Read Frank Gallinelli's blog.  It's designed to scare you straight.  (http://realdata.com/blog/ten-commandments-for-real-estate-investors-commandment-1/)  If you're hard-wired to be a landlord then none of this will scare you and you'll leap right in.  If you're a normal human (or if you're forced to be a landlord because you can't sell the property) then it gives you enough math considerations to avoid fooling yourself.

My other two favorite landlord books are:
(1) Investing in Real Estate, 4th edition or later, by Andrew McLean & Gary W. Eldred (who's taken over the new editions) and
(2) Landlording by Leigh Robinson (7th edition or later).

They should be available at a library.  There are probably newer landlording books but I'm not sure that they're necessarily better... and they're certainly not cheaper.

While trying to search for an answer myself, I found an article that mentioned renting to family or friends would lose me almost all tax deductions. Can anyone explain this as well? The article did not go into details, unfortunately.

Run it like a business and be able to show that nobody got any special breaks. 

When you rent to family or friends, have a signed lease (ideally a standard lease for your area) and charge (at least) a market rent.  It's important to raise the rent every year or two to keep up with market.  Document your expenses and be able to show that you'd make repairs/improvements for any tenant, not just family/friends.  If you run it like a business instead of like a family compound then you'll be fine.

Having said that, our worst tenants ever were my parents-in-law.  Renting to family or friends will definitely put a price on the relationship.

[Alan]

Thanks for the answers.

It's an odd situation and I'm not sure what I want to make of it.

My aunt inherited some property a few years ago, no mortgage. She's been letting my brother and his wife live there for 1/3 the rent that's standard for the area, because my brother is spending his own money and time to fix the place up, he's put about $5,000 in costs and $15,000 in labor into the place already.

She's getting older though and wants to sell the property. My brother doesn't make enough to qualify for a mortgage, but I've been fortunate enough to have my small business really take off and could pay cash for the property.

My idea was to purchase the property from my aunt, and continue to rent it out to my brother at the reduced rent while he maintains and repairs the place in exchange for the reduced rent.

I like this because my aunt is only asking half the market value for the house, as it needs repairs. And my brother is more than willing (and technically able) to make all those repairs in exchange for the continued reduced rent. So I won't have much cashflow from the low rent, but my costs (property taxes, insurance) are covered by what he is paying now. And when it comes time to sell (I would not want to look for new tenants when my brother's family expands beyond the means of this house (approx. 3-5 years)), I would double my initial investment.

[Nords]

Sounds like a great deal to buy the place and flip it in a few years, but taxes are a significant issue requiring professional help.

You're essentially bartering rent for home improvement.  The IRS has long felt that citizens should report their barter gains and pay taxes on them, and they've tried to reduce the "unreported barter" by requiring landlords to issue 1099s to contractors.  I don't remember the latest status on that law, but it's either being held in abeyance or not being enforced.

It would appear that you're screwed either way.  If you continue the status quo then I'm not sure you're entitled to all the benefits of Schedule E deductions, including depreciation.  Yet I know that the IRS will charge you depreciation recapture tax upon sale.  If you charge your brother market rent and then pay him for his upgrades, then he's receiving reportable (and taxable) earned income. 

Then there's the whole issue of what your aunt has been doing on Schedule E.  If she's been depreciating the place while letting a relative rent below market, then she could be subject to some sort of audit.  If she has not been depreciating the place then when she sells she's still going to pay depreciation recapture, cap gains taxes, and maybe even some AMT.  When she sells out and pays a huge pile of taxes, then how will she feel in five years when you sell and double your investment?

I guess the good news is that the IRS does not computer-match tenants and landlords real-estate addresses for family connections.  So whatever she's been doing, she'd probably get away with it until she sold the place and had to address the issue of the property's cost basis.

You and your aunt need to take this situation to a tax accountant and figure out the most tax-efficient way for her to fix her cost basis in the property and calculate her cap gains & depreciation recapture.  Then you need to figure out if you want to purchase it and how to continue renting it out.  But once she gets a look at the tax implications of her desire to sell, then she may either decide to hang on for another 3-5 years or find another way to unload it.  She may even want to do a 1031 exchange for a small trickle of cash flow from another real-estate investment instead of paying humongous taxes.  If you're a small-business owner then your own accountant could probably run the numbers or give you a trusted referral.

It's black humor, but my cynical assessment of the exit strategy of most landlords is "probate".

Again, you being landlord to your brother could put a price on your relationship.  I wouldn't do it.