DEATH, TAXES, AND THE IRS

They say there are only two things in life that are certain, death and taxes. The problem is you only die once, but you pay taxes every year. Then you die and they tax that.

There are a lot of reasons people get into real estate investing. Perhaps they’ve had friends that did well flipping houses and they wanted to see what it was all about. Perhaps they’ve watched those shows on HGTV which, by the way, are really bad resources when it comes to getting accurate information. Crazy as it sounds, maybe they have always wanted to be a landlord. Maybe they are building a portfolio for retirement income. Whatever the reason, most people are not going to say that they got into real estate investing for the tax benefits. Well, surprise, real estate has some of the better tax benefits out there. It’s to your advantage to know and understand what they are so you can take full advantage of them. When it comes to real estate, tax planning isn’t something you start thinking about in January so you can prepare your documents in February and present them to your accountant in March so he/she can file for you in April. Tax planning should be something you think about year-round. Anytime you are thinking of buying a new property or incurring any kind of business expense you should ask yourself, what are the tax consequences?

Since it is the tax season, let’s start off by looking at some of the basic tax advantages of owning rental property. First of all, if you are just starting out, I always recommend making that first rental property a multifamily home. Duplex, triplex, or a quad. Really, the best way to do it is to buy a multifamily home, live in one of the units, and let the other unit(s) pay your mortgage. Even if you don’t live in one of the units, the advantage of owning a multifamily is that, in the event of a vacancy, you still have other unit(s) making all or most of the mortgage payment. Say you have a single-family residence, and it is your first rental. You have the misfortune of renting to the tenants from hell. Trust me, they are out there, I think they are a whole tribe. Anyway, after they trash your house, you have to spend $5,000 to $15,000 on repairs, plus make the mortgage and insurance payments the three months the house is vacant while getting repaired, and then on the market, waiting for a new tenant. Most beginning investors could not take that kind of financial hit.

You just bought your first rental property. It’s a single family, against my recommendation, but most people start out this way anyway. When you were first considering it, you were probably making a mental list of things you would need to repair. Most of them were small and you’re handy so you can do them yourself. A couple you would probably have to hire a handyman and anything major and you’re looking at a contractor. I hope you considered future expenses as well. How old is he HVAC unit? What about the roof? It’s not leaking now but how many years does it have on it? At some point in time, you will probably have to replace it. How is the plumbing and electrical as well? They may be fine now but are you going to need to upgrade in the future? Those are the major systems and can run into thousands of dollars if they need to be replaced. I always recommend getting a home warranty. Especially if this is going to be a rental property which will incur a lot more wear and tear. Especially if it is an older house where things tend to break down. A homeowner’s warranty, which should generally cost you less than $100 a month and is deductible, will cover much, if not all, of the cost of those major repairs. Before you sign, though, make sure you know what is and what is not being covered.

You paid $200,000 for this gem with a $50,000 down payment. Here’s a little tip. If you bought the property as a rental the bank is going to consider it as a commercial loan and want you to pay 25% as a down payment err the $50,000. If you want to go in with a smaller down payment you can buy the house as your personal residence. That way a conventional loan would require a 10% down payment ($20,000) and FHA even less. You would have to live there for a year after which you could turn it into a rental. The upside is your out-of-pocket is less money, the downside is you will have a larger mortgage payment each month.

You opt for the 25% down payment, which means you have a $150,000 loan. For the sake of argument, you closed escrow on January 1, 2021. You had a tenant move in during the escrow and collected $21,000 in rent last year. That is against $16,000 in expenses. These include your mortgage payments, taxes, insurance, homeowners’ warranty, and some repairs and/or upgrades not covered under the warranty. That’s $5,000 in taxable income. But wait! Let’s talk depreciation. Depreciation is defined as recompense for wear and tear on the asset. The most common method is called the modified accelerated cost recovery system. It allows you to depreciate residential property for 27.5 years (3.646% per annum) and commercial real estate for 39 years. This means that you have an additional $7,292 that you can write off against that $5,000 gain. So, for 2021, you actually had a net loss on the property (but $5,000 in your pocket) and no taxes to pay.

You had $16,000 in expenses on the property. So, what does the IRS consider legitimate expenses that you can write off? Pretty much anything that you spend on the property. Property taxes and mortgage interest are probably going to show up as the two largest write offs. That means you can deduct those costs dollar for dollar against any profit you make, in this case, the $21,000. If you use a property manager that cost is also a write off. Property insurance, which would include the cost of your warranty. When the tenant moves out you will have to do some cleaning. If you had a good tenant and they leave the house in reasonably good shape, you may actually have to return their deposit. If they were there for any length of time, you will probably have to replace the carpet and paint at the very least. Unfortunately, those are considered normal wear and tear and cannot be deducted from the deposit. Anything you spend to clean the place up outside of their deposit money is a write off, including that carpet and paint. And any money you spend to advertise the vacancy is a write off.

You have set this up as a business. There are a number of ways to do this. I prefer the LLC. There are pros and cons, especially in the state of California, but the LLC provides me with a level of protection with which I am comfortable. That’s a discussion for another blog. The main thing is, it is a business, and you should treat it as such. So that means separate banking accounts and even credit cards dedicated to business only. Do you have a spare bedroom or an actual office space in your home? Set that up as the office from which to run your real estate empire. You can write off the square footage as a business deduction. How about that new printer you just bought? You use that strictly for the business, right? You bought a laptop or a tablet to track your business. Perhaps you bought some software for accounting. Office supplies like paper and ink are also potential deductions. You don’t use a property manager, you manage it yourself, which means you have to drive to and from the property, probably several times a month. The mileage also is a write off. Things break and need to be fixed, and you buy tools to fix them. Write off! At some point you get so many properties and spend so much time working on them you need to buy a truck, which you can write off as a company expense. In some cases, meals can be a write off.

Let’s talk about some other deductions not directly related to that one property. If you work for someone you get a paycheck and you have probably noted the FICA deduction. FICA stands for federal insurance contributions act. It is a 15.3% tax that is evenly split between you and your employer. When you are self-employed, say you are a plumber, you are responsible for the entire 15.3% tax. Rental income is considered passive income and therefore not subject to FICA. This means you can pocket that 15.3% tax the government would otherwise be taking.

In 2017 legislation was passed known as the tax cuts and jobs act. There were a couple of benefits the legislation provided as relating to real estate. One is known as the Opportunity Zone Funds. The United States was divided up into approximately 9,000 opportunity zones. This is an incentive to use the capital gains, from the sale of another investment, and deferring the taxes by re-investing those funds in this Country’s most rural and financially distressed areas. The passive income and the pass-through deduction is another benefit of the act. Passive income would include rental income and property owners may be able to deduct up to 20% of net rental income received. That is something best answered by your accountant.

I wanted to touch on long-term and short-term capital gains just for the sake of clarity. A capital gain is the amount of profit you make on the sale of a property. You buy a property for $100,000 and sell it for $250,000 your capital gain is $150,000. You can offset some of that with capital improvements such as kitchen upgrades, a new roof, new HAVC, etc. Check with your accountant to see what qualifies. The cost of those upgrades is added to your basis or purchase price. After $30,000 in capital improvements your cost is $130,000 and your gain is $120,000. By definition, long-term capital gains are any gains made on a property held longer than one year. A short-term capital gain would apply to a property held for one year or less. For the sake of simplicity, your short-term capital gains rate is taxed at whatever your current tax rate is. If you are in the 30% bracket, then you pay 30% on your gain. Long-term capital gains are bit more complicated and can range from zero to 20%. For example, if you are single and earn between $40,401 dollars and $445,850 or married and filing jointly earning between $80,801 at $501,600 the tax rate is 15%. There are other qualifications for other rates, and it is best to talk to a tax professional about these.

There is also something called the primary residence tax exemption. This is an exemption on capital gains taxes when you sell your personal/primary home. There is a limit, however. If it is just a single owner, the exemption is $250,000. For a husband and wife, it is $500,000. This means that if you sell your personal residence, you can make up to $500,000 in capital gains and you don’t have to pay taxes on any of it. We took advantage of this when we sold our house in Simi Valley a few years ago. We purchased it for $110,000 in 1986 and sold it for $430,000 in 2017. That’s $320,000 gain and we didn’t pay taxes on any of it. AND you can use it more than once. There are some rules to qualify though.

• The home must be your primary residence.
• You must have owned it for at least two years.
• You must have lived in it for at least two of the previous five years, not necessarily consecutively.
• You cannot have taken this exclusion in the past two years.

I want to quickly mention the 1031 exchange. this is a tax strategy whereby you sell a rental property and use the funds to buy a second property of equal or greater value. It has to be a rental property, not your primary residence. This way you are deferring the taxes, meaning you will pay the taxes at a later date. But if you never sell that second property you never have to pay the taxes. Or you could sell that property and do another 1031 exchange and keep doing that as many times as you like. These types of transactions are fairly complex. I have never personally done one, but I will be doing one later this year, I hope. In the meantime, I will write a more thorough blog on this subject later this year.

The last thing I would like to stress is the importance of accurate record keeping. Keep all of your receipts. Try not to comingle funds. Use spreadsheets! This is a favorite tool of mine and I think I probably drive my account of crazy with spread sheets. I keep a spreadsheet on every property we own, and we own several properties under one corporate name, Kevin’s Hat. We pay the monthly expenses for each property out of the same business checking account. Each month on each spread sheet details what our expenses were and what our rental income was for that property. At the end of each month, I show the total gain/loss for that month. At the bottom of the sheet, after the month of December, I break our expenses down on an annual basis. How much we spent annually on mortgage interest, mortgage principle, utilities, maintenance and repairs, property taxes, insurance, etc. I also use a spreadsheet to track my vehicle milage, maintenance, and gas expenses. The other tool I highly recommend is a solid accounting program I use QuickBooks. I am probably somewhat over organized. But I would rather have it and not need it than need it and not have it. Can we say audit.

This is primarily directed towards those of you out there that don’t have a lot of experience. Getting a good accountant is not a bad idea either. Preferably one that has experience in real estate transactions. For the last three or four years we have been using Brown Armstrong here in Bakersfield. I must say, they do a bang-up job for us. A couple of times in this blog, I referred you to seek advice from an accountant or tax professional. That really should go for this entire blog, so here is my disclaimer. I am not a professional accountant. I am one of those people you might call a Jack of all trades and master of none.