Landlord Tax Q

[MrFrugalChicago]

So I have a condo, considering renting it when I move. My understanding of how taxes work on a rental, would be I would take my (total rental income) - (total mortgage payment (P&I) + property taxes + HOA + any repairs or other expenses I have on the unit)... and anything left over is "income" that I would pay my normal income taxes on.  Is this fairly accurate?

I have a 30 year mortgage on the place, and after all expenses I expect to make 1k a month in income. Obviously need to deduct some of that to do with vacancies over the long haul and such, but there is clearly a profit being made. I also make over 100k, putting any extra income in the 28% tax bracket.. so I would be getting hit fairly hard for this profit.

Since I don't NEED this money now (I just want to build equity for later Financial Independence), would it make sense to Refi into a 15 year mortgage? This would add another $500 or so to my monthly bill, making it much more likely that I break even.  Or do I take the profit and just invest it on my own to get closer to FI?

If it matters, my 30 year mortgage is at a very good rate (3.625). I would expect the 15 year mortgage to be something like 3.5 today since rates have risen since I got my mortgage (Still a lower rate, but normally you would put a 15 year mortgage at a full point lower than the 30 year rate).

Am I missing anything?  My mortgage interest bill to the bank goes down, but since it is a rental not a primary home - I don't get to use it for a deduction anyway....  hummm

[arebelspy]

The principal part of the mortgage is not an expense.  You will pay income taxes on that part as well.

[MrFrugalChicago]

Interesting, so sounds like I will have some "profit" either way.

So not a huge benefit to go 15 year mortgage then, my interest amount paid per month would be about the same...

[seattlelivin]

You can also take a tax deduction for depreciation on the condo.  That will help bring down your $1K income estimate.

[MrFrugalChicago]

You can also take a tax deduction for depreciation on the condo.  That will help bring down your $1K income estimate.

I've read this but don't understand. The value of the unit is going up slightly every year.. what is deprecating? Some of the interior I guess?  I shall have to read about this...

[arebelspy]

You can also take a tax deduction for depreciation on the condo.  That will help bring down your $1K income estimate.

I've read this but don't understand. The value of the unit is going up slightly every year.. what is deprecating? Some of the interior I guess?  I shall have to read about this...

The IRS says you can depreciate it, whether or not it's appreciating is irrelevant, over a period of 27.5 years.

[MrFrugalChicago]

The IRS says you can depreciate it, whether or not it's appreciating is irrelevant, over a period of 27.5 years.

Oh US tax code, I want to understand...

[Hamster]

The IRS publication on this topic is actually very helpful. www.irs.gov/pub/irs-pdf/p527.pdf

[Cpa Cat]

Most people depreciate most of their profit away. So even though you have positive cash flows on the property and are putting money in the bank on the property, for tax purposes, depreciation wipes that out.

Depreciation reduces your tax basis in the property. When you sell it, you then have to pay income taxes on the gain (the difference between your sales price and your tax basis). In a straight up rental situation, you eventually pay the taxes - but you defer it until you have the big chunk of money from the sale of the property.

That said - there are ways around even that. For example, a landlord could choose to move back into the rental property and make it their personal residence for a couple of years - and utilize the exemption available to people who sell their primary home to avoid paying taxes on the gain.

Some landlords get VERY aggressive with their deductions on their rental, too. Anything that can be remotely assigned to the rental property (mileage, portions of a cell phone bill, business use of home, etc, etc) gets put on the rental schedule in order to generate losses.

I would hazard to say that understanding the tax code portion of being a landlord is a major part of being a profitable landlord.

[dan@themadrealworld]

I used a 15-year mortgage on my primary residence which was my first piece of property.  I regret it and it has caused some problems along the way for me.  It will make your debt load look higher when applying for new loans.

I strongly recommend you get a 30-year and if you want to pay off in 15 years, just make extra payments.  You will have much more flexibility if something were to happen in the future.

You could check this article I wrote for some more thoughts on this.
http://themadrealworld.com/should-i-pay-off-my-mortgage/

[dragoncar]

That said - there are ways around even that. For example, a landlord could choose to move back into the rental property and make it their personal residence for a couple of years - and utilize the exemption available to people who sell their primary home to avoid paying taxes on the gain.

I don't think this works anymore

[arebelspy]

That said - there are ways around even that. For example, a landlord could choose to move back into the rental property and make it their personal residence for a couple of years - and utilize the exemption available to people who sell their primary home to avoid paying taxes on the gain.

I don't think this works anymore

No.  You'd save taxes on the portion you lived there, it's prorated.  And - in fact - in another thread someone pointed out that it's the opposite case now - if you move back in you pay the prorated part, but if you DID live there in the first place and don't move back in and sell within 3 years (so that you've still lived there 2 of the last 5).

So to utilize the strategy now you'd have to move into a rental, live there 2 years, then rent it out 3 more years, then sell (without moving back in).

[BlueHouse]

If it matters, my 30 year mortgage is at a very good rate (3.625). I would expect the 15 year mortgage to be something like 3.5 today since rates have risen since I got my mortgage (Still a lower rate, but normally you would put a 15 year mortgage at a full point lower than the 30 year rate).

mortgage rates for investment properties are higher than for primary residences, so you likely wouldn't get below 4%, even for 15 year on a rental.  If there's some way around this, I don't know it. 

[dragoncar]

That said - there are ways around even that. For example, a landlord could choose to move back into the rental property and make it their personal residence for a couple of years - and utilize the exemption available to people who sell their primary home to avoid paying taxes on the gain.

I don't think this works anymore

No.  You'd save taxes on the portion you lived there, it's prorated.  And - in fact - in another thread someone pointed out that it's the opposite case now - if you move back in you pay the prorated part, but if you DID live there in the first place and don't move back in and sell within 3 years (so that you've still lived there 2 of the last 5).

So to utilize the strategy now you'd have to move into a rental, live there 2 years, then rent it out 3 more years, then sell (without moving back in).

Which thread was that?  I was unaware of that extra wrinkle.

Edit:  Didn't find the thread, but saw this in the Trulia article below:

The Housing Act is intended to restrict gain exclusion when property is transferred from a nonqualifying use to a principal residence, so the new provisions do not restrict gain exclusion when property is transferred from a principal residence to a nonqualifying use. Again, this provision only applies to nonqualified uses beginning January 1, 2009.

[clarkfan1979]

That said - there are ways around even that. For example, a landlord could choose to move back into the rental property and make it their personal residence for a couple of years - and utilize the exemption available to people who sell their primary home to avoid paying taxes on the gain.

I don't think this works anymore

I don't think this works anymore either. I think the tax code was adjusted a few years ago. Anyone know specifically when this changed?

[MrFrugalChicago]

mortgage rates for investment properties are higher than for primary residences, so you likely wouldn't get below 4%, even for 15 year on a rental.  If there's some way around this, I don't know it.

Well I still live there.. so I would refi with it as my primary, move into a new place and get a new primary mortgage, then make the current one into a rental..

[dragoncar]

That said - there are ways around even that. For example, a landlord could choose to move back into the rental property and make it their personal residence for a couple of years - and utilize the exemption available to people who sell their primary home to avoid paying taxes on the gain.

I don't think this works anymore

I don't think this works anymore either. I think the tax code was adjusted a few years ago. Anyone know specifically when this changed?

This was the first relevant article I found: http://www.trulia.com/blog/gracemorioka/2009/04/before_you_sell_your_hom

[Nords]

You can also take a tax deduction for depreciation on the condo.  That will help bring down your $1K income estimate.

I've read this but don't understand. The value of the unit is going up slightly every year.. what is deprecating? Some of the interior I guess?  I shall have to read about this...

The IRS says you can depreciate it, whether or not it's appreciating is irrelevant, over a period of 27.5 years.

And to raise the ante even higher for new landlords, the IRS assumes that you're depreciating it and will assess depreciation recapture taxes when it's sold... whether or not you actually depreciated it.

[arebelspy]

That said - there are ways around even that. For example, a landlord could choose to move back into the rental property and make it their personal residence for a couple of years - and utilize the exemption available to people who sell their primary home to avoid paying taxes on the gain.

I don't think this works anymore

No.  You'd save taxes on the portion you lived there, it's prorated.  And - in fact - in another thread someone pointed out that it's the opposite case now - if you move back in you pay the prorated part, but if you DID live there in the first place and don't move back in and sell within 3 years (so that you've still lived there 2 of the last 5).

So to utilize the strategy now you'd have to move into a rental, live there 2 years, then rent it out 3 more years, then sell (without moving back in).

Which thread was that?  I was unaware of that extra wrinkle.

Edit:  Didn't find the thread, but saw this in the Trulia article below:

The Housing Act is intended to restrict gain exclusion when property is transferred from a nonqualifying use to a principal residence, so the new provisions do not restrict gain exclusion when property is transferred from a principal residence to a nonqualifying use. Again, this provision only applies to nonqualified uses beginning January 1, 2009.

Here in Sol's thread: https://forum.mrmoneymustache.com/real-estate-and-landlording/seeking-rental-property-evaluation-advice/

JasonW's post today (4/17) at 7:15am.  Blew me away.

[BlueHouse]

mortgage rates for investment properties are higher than for primary residences, so you likely wouldn't get below 4%, even for 15 year on a rental.  If there's some way around this, I don't know it.

Well I still live there.. so I would refi with it as my primary, move into a new place and get a new primary mortgage, then make the current one into a rental..

Okay, you should be aware of what you're signing though and watch the timeframe.  Look for the following wording in the Deed of Trust, the document you sign when you pledge the property as collateral:

Occupancy. Borrower shall occupy, establish, and use the Property as Borrower’s principal residence within 60 days after the execution of this Security Instrument and shall continue to occupy the Property as Borrower’s principal residence for at least one year after the date of occupancy, unless Lender otherwise agrees in writing, which consent shall not be unreasonably withheld, or unless extenuating circumstances exist which are beyond Borrower’s control.

[rachael talcott]

Another tax thing to look out for:  repairs are deductible but improvements have to be depreciated.  It's not always obvious what counts as repair and what improvement.  Paint is repair, but replacing worn flooring is an improvement.  If an appliance dies and you replace it, that's an improvement as well. 

[Hamster]

Another tax thing to look out for:  repairs are deductible but improvements have to be depreciated.  It's not always obvious what counts as repair and what improvement.  Paint is repair, but replacing worn flooring is an improvement.  If an appliance dies and you replace it, that's an improvement as well.

These issues are detailed in IRS Pub 527

[CWAL]

And to raise the ante even higher for new landlords, the IRS assumes that you're depreciating it and will assess depreciation recapture taxes when it's sold... whether or not you actually depreciated it.

Wait..  What?...

I'm renting a single room in my primary residence?  Does any of this apply to me?  I did not depreciate because I didn't want to deal with the hassle. 

I just took the proportion of expenses allocated to that room and deducted them. I chose to allocate based on a per person basis for simplicity, and because square footage is roughly the same.  Utilities are included in roomates rent.  So basically I took as deductions (Taxes, Interest, HOA, Utilities)/2 and repairs only to the rented area deducted in full.  Very simple, very easy...

Reading the IRS rules, that seemed like the right thing to do as far as I could tell.  Is that going to come back to bite me in the future when I sell?  I plan on probably keeping it as a primary residence for a decent amount of time, not sure if I will continue renting the room, but probably will for some portion of time..

[Hamster]

And to raise the ante even higher for new landlords, the IRS assumes that you're depreciating it and will assess depreciation recapture taxes when it's sold... whether or not you actually depreciated it.

Wait..  What?...

I'm renting a single room in my primary residence?  Does any of this apply to me?  I did not depreciate because I didn't want to deal with the hassle. 

I just took the proportion of expenses allocated to that room and deducted them. I chose to allocate based on a per person basis for simplicity, and because square footage is roughly the same.  Utilities are included in roomates rent.  So basically I took as deductions (Taxes, Interest, HOA, Utilities)/2 and repairs only to the rented area deducted in full.  Very simple, very easy...

Reading the IRS rules, that seemed like the right thing to do as far as I could tell.  Is that going to come back to bite me in the future when I sell?  I plan on probably keeping it as a primary residence for a decent amount of time, not sure if I will continue renting the room, but probably will for some portion of time..

Maybe one of the CPA's can weigh in, but I am pretty sure you are technically liable to pay depreciation recapture on the business use portion even if you didn't take the deductions.

See:http://www.bankrate.com/finance/money-guides/home-office-can-have-hidden-tax-costs-3.aspx.
That's a discussion of home office, but they also talk about how the same rules apply to rental use.

[CWAL]

It's bullshit like that that makes people like me want to just tell my roommate to pay all cash and stop giving the IRS their cut at all.  If there's always another complication, why even bother?

[dragoncar]

It's bullshit like that that makes people like me want to just tell my roommate to pay all cash and stop giving the IRS their cut at all.  If there's always another complication, why even bother?

The real question is why you wouldn't want to defer your taxes.  That's all the depreciation/recapture is.

[CWAL]

Because the complication and record keeping required and chances of messing it up somehow do not have a good cost-benefit ratio to the very small amount of money I'd likely be saving...

My tax situation other than the rental is extremely simple (1040A), so I've always filled out the fillable PDFs by myself, and I'd kind of enjoy keeping it that way.  Even with the rental, is was just the schedule E, which was also more or less quite simple.