Creative Tax Planning
Anyone in business for themselves - particularly if they
plan on making a good profit - should take tax planning very seriously. Tax
laws change as often as the weather, and these changes will ultimately affect
your eventual wealth.
This section of your program includes the latest
(1997-98) tax changes. Many of you - those who "flip" properties
without holding them - will have an easier time with taxes - your profits are
simply taxed as personal income. Therefore it is a relatively simple matter to
keep accurate records of all costs and expenses, as well as profits. Ads placed
for selling a home, business cards, postage - even the cost of this program -
are tax deductible expenses that will reduce your tax liability. So, keep those
records, earn your profits and make absolutely certain you pay Uncle Sam his
"due".
For the rest of you who may choose to buy and hold, or
who will create and hold mortgages, or even buy discounted mortgages to hold as
an investment vehicle, the rules become a little more complicated. This section
is designed to assist you in keeping your tax liability as low as possible.
PASSIVE INCOME
Much of the income from holding real estate or mortgages
is PASSIVE income - money earned from something other than labor. In general,
you may NOT deduct more than the income earned, even if you suffer losses. In
other words, any excess losses from your investments may not be applied toward
reducing your taxes on other sources of income, such as your salary at work.
So, generally speaking, passive activities cannot shelter other income from
taxation.
However - and this is a "biggie" that will
likely apply to you, property investors, rehabbers, contractors, developers,
landlords, property managers, real estate agents, brokers and appraisers who
spend at least 50% of their work time and at least 750 hours per year
performing the mentioned services as a 5% or more owner and who can show they
materially participate in providing said services CAN offset other income. In
such cases, excess losses - even if they are only "paper" losses such
as depreciation - can be used to reduce your taxes on other sources of income.
To qualify, you must be able to show that you materially participate to the
extent mentioned, such as actually performing the functions of a landlord,
investor, manager etc. However, since the I.R.S treats all rental activities as
passive (regardless of participation) you would be wise to seek the advice of a
tax professional before using such losses to offset other income.
Should you incur losses from passive activities, these
losses can be carried forward indefinitely and may be used to offset passive income
from your activities in future years. Any such losses that are not "used
up" by the time you sell your entire interest in such activities can be
used to offset the gains from the sale of those activities. In other words, if
you have $30,000 in excess paper losses over a period of 7 years that have not
yet been applied to offset passive income, and you sell off your investments
and net a $70,000 profit, the $30,000 in losses can be applied to offset those
gains and your tax liability will be limited to the remaining $40,000 profit.
With capital gains now being taxed at a rate of 10-25%, your taxes on that
$70,000 profit would be no more than $10,000 instead of $14,000. However, you
may not be able to use all your losses to offset gains from the sale of a
passive activity. You may only deduct a proportionate amount. To illustrate,
let's say you have 4 investment properties with the following profits/losses:
#1 = $10,000 loss
#2 = $30,000 loss
#3 = $10,000 loss
#4 = $20,000 Gain
Total losses minus total gains results in an overall loss
of $30,000. If you sell #2 for a $100,000 gain (profit), how much of the losses
can you deduct from your taxable gain of $100,000?
To find the answer, add all losses ($40,000) and divide
by the losses of ONLY #2 ($30,000). The result (.75) is multiplied by the
overall loss of $30,000. The answer, then, is $22,500. This is the amount of
the losses you can apply toward the taxable gains from selling unit #2.
Therefore, instead of being taxed on $100,000 of gains you are only taxed on
$77,500.
For the moderate investor such as yourself, the tax code
allows you to deduct up to $25,000 in net rental losses even though rental
losses are generally disallowed. This $25,000 limit can be used to offset taxes
from other income such as salary, interest, dividends etc. So, even if you
"lose" money from your rental units, Uncle Sam will help you to cover
those losses - up to $25,000 per year, but ONLY if the investor can show that
he or she materially participated in the management of the property and IF the
investors adjusted gross income is under $100,000. If your income is over
$100,000, the $25,000 limit is reduced by 50 cents for each dollar over the
$100,000 in adjusted gross income. So, if your adjusted gross income is $150,000
or more, there is no deduction allowed.
What is meant by material participation? It simply means
that you, the investor, make final decisions regarding the property. You may
hire a rental agent so long as YOU make the final decisions. (This rule does
not apply if the investor owns less than 10% of the property.)
Any taxpayer may fully deduct interest on the mortgages
of his first and second home (if used as his personal residences). Therefore,
the more you owe on these homes and the higher the interest portion of your
monthly payment, the larger your deduction will be. And the deduction of
interest on those two homes does NOT apply toward the $25,000 limit mentioned
earlier. Therefore, if your total losses exceed the $25,000 limit, it would be
prudent to re-mortgage your own homes and use the money to pay off some of the
debt on your income properties, as the $25,000 limitation does not apply toward
your own residence.
DEPRECIATION
Although in the real world real estate appreciates in
value, the IRS takes the stand that since the components of the property age
and eventually wear out, the property depreciates. So, we make deduct this
depreciation from our income. The hook is that only the improvements - like the
buildings - can be depreciated. Land does not depreciate. Therefore, if your
$100,000 investment property consists of $45,000 in land value and $55,000 in
improvements, you may only depreciate the $55,000.
The depreciation term for residential property is 27.5
years and 39 years for non-residential real estate. Residential property is any
property from which at least 80% of the gross rental income is from residential
living units (except for hotels, motels and inns, which are considered
non-residential because the tenants are transient).
For depreciation, the property is considered to have been
purchased on the 15th of the month, regardless of when it was really purchased,
and the same amount of depreciation can be used each year. This is called
"straight-line" depreciation. The formula for figuring your
depreciation for residential property is as follows:
First year that property is placed in service:
Jan. - 3.485% of the property cost can be depreciated the
first year if purchased in January
Feb. - 3.182% of the property cost can be depreciated the
first year if purchased in February
Mar. - 2.879% of the property cost can be depreciated the
first year if purchased in March
Apr. - 2.576% of the property cost can be depreciated the
first year if purchased in April
May - 2.273% of the property cost can be depreciated the
first year if purchased in May
Jun - 1.970% of the property cost can be depreciated the
first year if purchased in June
Jul - 1.667% of the property cost can be depreciated the
first year if purchased in July
Aug - 1.364% of the property cost can be depreciated the
first year if purchased in August
Sept - 1.061% of the property cost can be depreciated the
first year if purchased in September
Oct - 0.758% of the property cost can be depreciated the
first year if purchased in October
Nov - 0.455% of the property cost can be depreciated the
first year if purchased in November
Dec - 0.152% of the property cost can be depreciated the
first year if purchased in December.
Each additional year that you own the property - up to
27.5 years - you may deduct 3.636% of the cost of the property (improvements).
Note that most of the appliances in a rental unit can be
depreciated over 5 years, so depreciate these separately for maximum tax
advantages. Most furniture can be depreciated over 7 years. For this reason,
take this advice when buying rental properties - do not offer one price that
includes appliances, furnishings etc. Instead, list these items separately and
assign an appropriate portion of the purchase price to each. For example, on a
$100,000 property you might write it as $15,000 for the land, $4,500 for the
personal property (appliances, furnishings etc. - be sure to get a bill of
sale) and $80,500 for the improvements (buildings). This way, you are in a good
position to depreciate the personal property faster, for greater tax
advantages. Be sure, however, that the amounts assigned are fair. If necessary,
go to the tax assessor's office to determine the actual value of the land.
You may note that we have been talking about losses as if
losses are good. Well, in real estate they often are, provided they are paper
losses. Depreciation is an expense that is fully deductible, yet it costs you nothing
because real estate appreciates in value (if you maintain it). This is a paper
loss. And here is how it helps you achieve wealth.
Let's say you own a $100,000 rental unit. The income is
$10,000 per year. From this you deduct your expenses (taxes, insurance,
mortgage payments etc.) which might equal $9,000 per year. This leaves you with
a positive cash flow of $1000 per year. But for tax purposes, you would not
deduct the principle part of your mortgage payments (say, $500 per year), but
you WOULD deduct $2900 depreciation (3.636% of the $80,000 value of the
building alone). So your tax records would show $11,000 in expenses, or a $1000
loss. Even though you actually made a $1000 profit, the IRS says you lost $1000
which you can use to reduce your tax liability. If you are in the 28% tax
bracket, this saves you $280 in taxes in addition to your $1000 profit. And, if
your property appreciated by $5000 that year your total profit is $6,280.
DEPRECIATION VS. EXPENSING
Personal property can be depreciated as we have seen. But
the IRS also allows us to expense part or all of the value (cost) of the asset.
This means that instead of charging off a portion of the cost each year, you
can charge it all off in one year, reducing your taxes for that year. The flip
side is that you won't have the depreciation in future years which will
increase your taxes then. You still pay the same amount of tax either way, but
by expensing you can defer those taxes - perhaps indefinitely.
Currently, a business can ordinarily expense up to
$17,500 in personal property each year. If you choose to expense your personal
property, the taxes you save now can be used as a down payment toward another
property, which in turn gives you more deductions and more personal property to
expense. If you continue doing this, the taxes you saved by expensing can be
postponed indefinitely. You have the money now, to use for growth. If you
eventually do pay the taxes, it won't be until after the money has already made
you more money. This is the Time Value of Money at work once again.
In order to be eligible for expensing, the asset must be
personal property. It also must be property that is used in a trade or
business. This could even include your automobile (if used for business - the
amount you may expense is proportional to the percentage of the assets use for
business purposes), office equipment, office furniture, a lawnmower used to
service rental units etc. Finally, the asset must be tangible personal property
with at least a three year or longer recovery period.
Expensing is limited to the income that is derived from
the business or trade in which it is used, and expensing is not permitted if
your total aggregate cost of qualifying property placed in service during that
year exceeds $217,500. Costs between $200,000 and $217,500 result in a dollar
for dollar reduction (example: if your costs are $210,000, you may only
expenses $7,500).
In cases where an asset costs more than the $17,500
expensing limit, the remaining balance may still be depreciated in future
years.
If you purchase new equipment or appliances or otherwise
add to the value of the property, the expense should be capitalized
(depreciated over its recovery period). However, if these repairs or
replacements are necessary in order to simply maintain the property, you may
expense it. The rules are complicated, so get together with a good tax
professional.
DEDUCTING INTEREST
Generally speaking, there are three types of interest for
tax purposes - personal interest such as loans for autos, interest on credit
cards etc., business interest such as interest on loans for business
operations, and investment interest such as the interest paid to buy and/or
hold investments such as real estate, stocks and bonds.
Personal Interest
The only personal interest that is currently deductible
is mortgage interest on your primary or secondary residence. This is limited to
the interest incurred on the principle provided that principle does not exceed
the original cost of the home and any improvements, plus interest on home
equity loans provided these loans plus your other mortgage(s) do not exceed the
fair market value of the property. One further limitation - the total value of
your first and second residence may not exceed $1,000,000. If the cost of your
two homes exceeds this amount, the interest paid on the excess is not
deductible.
As a home owner you may also be able to deduct other
costs incurred in purchasing your primary and/or secondary residence, such as
loan fees (points) provided (a) the loan is for the purchase or improvements on
the home and is secured by the property, (b) the fees are designated as points
on the statement of closing, (c) the points must be calculated as a percentage
of the loan amount, (d) the points are paid directly by you and not paid from
the loan proceeds, and (e) the points charged are in accordance with local
practices. Points paid on a refinance loan are not deductible in the year the
points are paid, but can be deducted on a prorated basis over the life of the
loan.
Business Interest
All interest incurred to procure loans to operate or
maintain a business, including interest on credit purchases for business
purposes is fully deductible under current law.
Investment Interest
Under current law, investment interest is deductible only
to the extent of net investment income. However, this restriction is removed on
activities that are subject to the "passive loss" rules mentioned
earlier. Therefore, this restriction will not apply to most real estate
investments because the effect of the passive loss rules create virtually the
same result. On the plus side, the passive loss rules, as stated earlier,
provide many real estate investors with a $25,000 exclusion.
Tax laws on investment interest are complex, so it is
wise to consult with a tax professional.
Note that if you finance a rental unit, the deduction is
limited by the investment income and the $25,000 passive loss exception. If,
however, you refinance your home to purchase that rental unit, the interest on
the refinance is fully deductible.
For those who do not have a "second" home,
realize that any unit that can sustain life can be deemed a second home and the
interest payments can be deducted. If it has a bed, toilet and kitchen, it
qualifies. This includes many boats, trailers, mobile homes etc.
TAX CREDITS
If tax deductions are good, tax credits are better, While
a deduction reduces your taxable income, a tax credit is a reduction of the tax
itself. For example, if you are in the 28% tax bracket and you have a $1000
deduction, you save $280. But if you have a $1000 tax credit, you save $1000.
One of the best known tax credits is the Rehab Credit.
Money you spent to rehab a property that was placed in service prior to 1936
earns you a 10% credit. For example, if you spend $20,000 to rehab a building
built in 1930, you receive a $2,000 credit. Better yet, if you rehab a
certified historic structure, you receive a 20% credit. As an investor, it may
be worth your while to research prospective properties to see if you can get
them included in the national register as an historic site. This would greatly
increase the value of the property and provide you with some great tax
advantages.
Another tax credit is the low income housing credit.
Residential units placed into service after 1986 but before 1992 qualify for
these credits provided the units are for low income families. There are three
different credits:
1) a tax credit of 9% per year for ten years for the
construction or rehabilitation of qualifying low income housing projects
2) a credit of 4% per year for ten years for the
construction or rehabilitation of qualifying low income housing financed with
tax exempt bonds or federal subsidies
3) a credit of 4% per year for ten years for the
acquisition of low income housing units.
These credits fall under the same exception to the
passive loss deduction as those who take the $25,000 loss for rental units,
with the exception that you need not actively participate in the management,
and the maximum income allowed can be as high as $200,000 with a 50 cent
phase-out for every dollar above $200,000 up to a maximum of $250,000.
Installment Sales (Contract for Deed, Wraparounds etc.)
You may sell a property in such manner that you will
receive payment over a period of years. You might think that you would only pay
taxes on the amount received each year, but this is not necessarily so. If you
own a large amount of mortgaged property in addition to the property you are
selling, you will be required to pay tax on the full profit from the sale, even
if that profit is not yet in your pocket. But many smaller investors and the
average home seller are not subject to this.
If you are buying or selling your personal residence, tax
is due only on the actual amount received each year. Also exempt are rental
properties that sell for less than $150,000 (one of the reasons we recommend
buying homes in blue collar neighborhoods). And, if the property you are
selling is the only rental you own, or if your others do not have mortgages,
the property is exempt and tax is due only on the amount received each year.
This is one of the reasons why we recommend that
investors "flip" properties, rather than hold them. If you hold a
few, and they are mortgaged, you will pay taxes on the entire profit when you
sell a property even if you do not receive all of that profit at the time of
sale.
Here is a point to remember - avoid buying properties
from "big" owners - those with a number of properties. Due to this
tax situation, they will not be able to sell the property under good terms such
as owner financing. If they did, they would take a big hit from the IRS. The
exception, of course, is a property that sells for less than $150,000.
But what if you want a property that costs $159,000?
Simply talk the seller into accepting $150,000, but increase the interest due
on his note so he still gets $159,000. Only the FACE VALUE of the note is
considered when calculating the taxes due on a sale.
TAXES ON OPTIONS
Options are a little unusual from a tax standpoint. When
an option is granted, the money or consideration paid for the option is not yet
taxable to the seller, or deductible by the optionee. Tax liability occurs only
when one of two things occurs:
1) The option is exercised, or
2) The option expires without being exercised.
Once an option is exercised, the seller figures his gain
or loss on the property to include the amount paid for the option, and computes
his tax accordingly. For example, if the optioner received $2000 for the option
on a property optioned at $100,000, and the optionee exercises that option, the
seller will compute his tax liability based on $102,000. By the same token, the
optionee can only deduct the $2,000 as an expense only at the time the option
is actually exercised, and ONLY if the option is on an investment property. If
the optioner is buying the property as a personal residence, the $2,000 becomes
part of the price of the property and is depreciated accordingly (less the
portion allocated towards the cost of the land, itself). For example, if the
land is valued at $12,000, the optionee may depreciate $90,000 over the next
27.5 years.
On the other hand, if the option is never exercised, the
optioner incurs a tax liability for that $2,000 at the time the option expires.
It is treated as personal income. The optionee, on the other hand may deduct
the $2000 as a loss only if the option was on an investment property and the
cost of the option can be considered a business (investment) expense.
1031 Exchanges
Taxes on the disposal of a property can usually be
deferred by exchanging one property for another. Properly executed, the gain on
the property is not recognized because the investor's gain simply reduces his
basis in the next property (the exchange piece). However, when you finally do
cash out, your taxable gain will be greater, so you are not avoiding taxes -
you are merely deferring them, so you have more money to use for additional
investments. There is one exception - if you still own the property at the time
of your death, the gain will be avoided altogether. Your heirs will be subject
to taxes only at the property's fair market value, not your old basis. If you
continue making exchanges until you leave this world, you and your heirs can
permanently eliminate the taxes on your gains. Sad, though, that you won't be
around to take advantage of it. But your heirs will.
In most exchanges, three parties are involved and some cash
or debt (or both) changes hands. The parties are a) you, b) a seller of a
property you want, and c) a buyer for the property you are exchanging. Here's
how it would work if the deal is consummated simultaneously at a single closing
(this is another form of multiple escrow).
You find a larger property that you want. You talk the
seller into participating in an exchange whereupon he will sell his property
for all cash. You also find a buyer for your property who will participate in an
exchange. It works like this:
At closing, you pay the seller of the property you want
the difference in value between your property and his. You now only owe him the
value of your property. You sell your property to your buyer, but the money
goes to the seller of the property you are buying. As you can see, your seller
gets all cash for his property and he is satisfied. Your buyer gets your
property and he is satisfied. And you get the larger property. This is an
exchange, even though you and the seller really did not exchange properties.
In many cases, however, it is not possible to get a
seller and a buyer at the same time. In such cases, the exchange process is
spread out over a period of time, as follows:
You locate a buyer for your property. At closing, the
money you receive from the sale must enter a lawyer's trust account - you must
not take the money. Within 45 days of this closing you must find another
property and have your offer accepted. Then, with 180 days from the first
closing you must close on the new property. The money in the lawyer's trust is
paid to the seller and you get the seller's property. Of course, if the
seller's property is more expensive, you will owe the seller an additional sum
to cover the difference.
There is a catch to exchanges, and it is known as
"like kind". To qualify as an exchange, the properties being
exchanged must be of like kind - an apartment building for an apartment
building, for example. However, you are probably safe if you exchange any rental
real estate for other rental real estate. But, if you exchange vacant land for
an apartment building, it will likely be disqualified.
"At Risk" provision
Naturally, Uncle Sam does not want you to deduct any more
than what you have "at risk". At risk means the money you,
personally, stand to lose, including your down payment, any mortgage(s) you are
personally liable for, and any other cash you may have invested in the
property.
Second or Vacation Homes
A vacation home can fit into one of three categories
1) a second home strictly for your own personal use. In
such a case, like your principle residence it cannot be depreciated, but you
can deduct interest and property taxes.
2) a second home that is rented out periodically, but is
primarily a personal residence. In such as case, you must occupy the home a
either 14 days (or more) or 10% of the days rented, whichever is greater. For
example, if you rent this home for 180 days, you must occupy the property for
not less than 18 days for it to be considered a personal residence. Otherwise,
it is a rental unit. Note that "personally occupy" means that it is
occupied without rent being charged, even if it is a friend or relative that
occupies the home. You do not have to personally occupy the property for those days.
3) a rental unit primarily, but sometimes used for your own
purposes. This is a rental unit. The property is subject to the same tax rules
as any other rental property.
