Small Business Taxes & ManagementTM--Copyright 2011, A/N Group, Inc.
It's getting to be more common. For whatever reason you've got to move and can't sell your home. Or at least can't sell it at a price that will allow you to come close to paying off the mortgage. Or you just think the market will come back in the next year or two. In this article we'll assume you can't or don't want to sell but are seriously considering renting at least for an interim period. In a future article we'll discuss other options and how to analyze them if you're in financial difficulty. The bad news is that home prices may decline further, at least over the next year. And recovery could be slow. It could take many years to reach the peak prices of 2007. The good news is that rental rates are going up.
While renting a vacant house seems like an obvious option to improve your cash flow, there are a number of considerations that often aren't addressed upfront.
While renting the property will generate cash to offset expenses, you still could end up with negative cash flow. The biggest costs to consider are real estate taxes and mortgage payments. If you've paid off your mortgage, your cash flow is almost sure to be positive. But if the mortgage was taken out near the height of the market or you borrowed additional amounts on a refinancing, there's a good chance your cash flow will be negative. A $300,000 mortgage at 6.75% for 30 years results in payments of $1,945 per month or $23,340 per year. A $200,000 loan at 4.75% has monthly payments of $1,043 or $12,516 annually. We're going to assume the entire mortgage payment is included in your cash flow calculations.
Real estate taxes are the second biggest factor. These vary widely around the country, and even within the same county there can be significant differences. In our analysis we'll budget $4,000.
The next big category is likely to be repairs. If you have a good tenant that renews his lease annually, repairs could be minimal. On the other hand, we know of landlords who have spent thousands to clean up after a tenant was in a property for only a year. The costs also depend on what you do and what you pay to have done. You may not be able to replace plumbing fixtures, but you might repaint rooms, or do heavy cleaning. If you have to hire out all those tasks, the costs can escalate materially. The best advice here is to talk to several landlords who rent property. You'll probably get the straight story. Real estate agents are likely to be biased.
You may have to bring a property up to the town code in order to rent it. For example, you have no railing on your deck since it's only a foot off the ground. Town code requires a railing if any portion of a deck is more than 6 inches above ground level. While you may have done without the railing while you were living there, you need it if you're renting the property. You should consider hiring a house inspector or engineer to point out any deficiencies.
Add an amount for monthly maintenance. That could be cutting the lawn, leaves, pool maintenance, snow plowing, etc.
Insurance costs may increase if you're renting the property. On the other hand, costs for a vacant house are usually much higher than for a rental. Check with your agent.
In the analysis immediately below we're going to ignore income taxes. If you have a profit, so much the better and you can afford the taxes. Remember, the real objective here is to avoid bleeding cash on a mortgage and real estate taxes. If you have a loss, you may be able to deduct it, but there are a number of factors that could restrict deductibility.
How much rent can you ask for the property? Obviously, that varies widely. Old formulas won't work in today's market and location has a lot to do with it. Moreover, ask more than the market and the property could remain vacant for longer, eating into your cash generated. If you're offering a low rent to induce a tenant to sign, consider paying the incentive at the end of the year. For example, market rent is $2,000 per month; instead of dropping the rent to $1,900, you charge $2,000, with a $1,200 rebate at the end of the year. A local realtor is your best source of advice here.
Vacancy can be an critical factor. You've got to build in at least 1 month per year. That works out to a 12% annual rate. You could do better; but you could also do worse. One month could be an optimistic figure. Don't forget, at a minimum you'll probably need that to repaint and do required maintenance. We know one landlord who had the same tenant for five years. But when she left the house was unoccupied for five months--one month for repairs and the rest in trying to get a new tenant. You can reduce the vacancy by encouraging the tenant to provide advance notice with a monetary incentive.
If you don't live in the area or just don't want to deal with the issues, you may need a property manager. That can be from 10% to 15% of the gross rental income from the property. We've ignored that in the example below, but the impact can be significant.
Here's how to compute the annual cash flow using some numbers from a rental property in the Miami, Florida area:
Rent $1950 per month, less 1 month vacancy $ 22,550 Less: Real estate taxes - 6,000 Repairs - 900 Maintenance (lawn, pool, etc.) - 1,300 Insurance - 1,600 Mortgage -12,500 Annual cash flow $ 250Clearly, much depends on the size and interest rate of your mortgage. In this case the net is $250. Positive, but not by much. It wouldn't take much of a repair bill to go negative. Conversely, if you had a mortgage half the size you'd have annual cash flow of $6,500. But many of the expenses listed above would continue if you owned the property and had no income. Using the numbers above, your net cash outflow would be $22,300 if you just had the property vacant. (That would be partially offset by the deduction for real estate taxes and mortgage interest, with the amount dependent on your tax bracket.)
If the rental generates a profit, you'll pay tax at ordinary income rates. Of course, after tax you'll still be better off than if you had no income from the property at all. Report the income and expenses on Schedule E. If you have a loss you can deduct it against your other income, subject to a couple of restrictions which we'll discuss below.
Depreciation. Once you decide to change the property to a rental from your principal residence, you'll be taking depreciation. The good news is that depreciation can lower any income without currently reducing your cash flow. Depreciation is computed on a straight-line method over 27.5 years. If you purchase a property and immediately use it for business, your "basis" in the property is what you pay for it. If you convert a residence, it's a bit more complicated. The rule is your basis is the lesser of what you paid for the property (plus any capital improvements over the years) or the fair market value at the time of conversion.
For example, you bought the property in 1989 for $60,000. It's worth $220,000 today. Your basis is $60,000. Or, you might have purchased the property in 2005 for $300,000 and it's worth $225,000 today. Your basis is $225,000.
The second twist is that not all of the property is depreciable. You must allocate a portion of the overall basis to the land. Often your real estate tax bill will show the split by the town which can be used to determine the land value.. If not, you'll need an appraisal. Consult your tax advisor. Thus, of the $225,000 basis in the second example, only $175,000 may be depreciable.
Assuming a depreciable basis of $175,000, your annual depreciation deduction would be $6,364. Unless you own the property free and clear or the mortgage has been significantly paid down, that's likely to create a loss for tax purposes. The same may not be true if you bought the property some years ago and have a low basis like in the first part of the example.
Fair market rent. You must charge a fair market rent. If the rent is slightly lower than comparable in the area you can argue that you wanted the space occupied as quickly as possible. But if you're renting to relatives or friends that may not work. If the rent is below market, the IRS can argue that you didn't intend to make a profit and any losses could be permanently disallowed.
Passive activity losses. This is a complex topic. Basically, the law doesn't allow you to offset ordinary income with rental (passive) losses. But there's a special exception. You can deduct up to $25,000 in real estate rental losses annually. This exception is phased out for taxpayers with modified adjusted gross income over $100,000 on a 2 for 1 basis. That is, for every $2 of income over $100,000, the $25,000 exemption drops by $1. That means if your modified adjusted gross income exceeds $150,000, no deduction is allowed currently.
All is not lost. Any disallowed deduction is carried forward and can be used to offset income from the property (or other passive activity losses) or used against ordinary income in a year your modified adjusted gross income drops below the threshold. You can also use any disallowed losses against ordinary income when you sell the property.
Depreciation recapture. Each year you take depreciation your basis in the property is reduced. That depreciation is recaptured on sale of the property at a maximum rate of 25%. For example, you put a $300,000 building in service in January 2012 and sell it in December 2016 for $350,000. Your total depreciation would be $53,634 (special rules apply to the year of purchase and sale). The depreciation recapture of $53,634 would be taxed at no more than 25%; the $50,000 in long-term capital gain rates. (Your basis after depreciation would be $300,000 less $53,634 or $246,366. Your total gain on sale would be $350,000 less $246,366 or $103,634. Of the total gain, $53,634 would be depreciation recapture leaving a long-term capital gain of $50,000.) In the calculations we've ignored the value of the land to simplify the math and assumed the property was held more than a year.
Computing profit or loss. You can generally deduct the costs associated with maintaining the property. In the example above we subtracted the total mortgage ($12,500). That included both interest and payments on principal. For tax purposes you can only deduct interest. You can't deduct capital improvements such as a new roof, replacing the water heater, a new kitchen, etc. Those items have to be capitalized and depreciated. Repairs, such as fixing a hot water heater, are deductible. Whether an item is a repair or a capital improvement depends on the facts and circumstances.
You can also deduct homeowners' association dues, utilities not paid directly by the tenant, and travel to the property for maintenance, inspection, interviewing new tenant, etc. Caution. If the primary purpose of the travel was for personal reasons, your deduction will be limited. Talk to your tax advisor.
Loss of gain exclusion. The first $250,000 ($500,000 if married filing jointly) gain on the sale of a principal residence escapes taxation if you owned and lived in the property for two out of the last five years. We won't go into all the variations here, but, depending on how long you rent the property, you could lose the exclusion. If you're concerned about losing the exclusion (e.g., if you sold the house now you'd have a gain or if you held for a few years you'd have a gain), you should work through the numbers carefully. In the example above you'd have a cash outflow of $22,300 per year by leaving the property vacant. While the actual calculations are likely to be much more involved, assuming a 15% capital gain rate you'd have to pay tax on a $149,000 capital gain to offset the cash outflow. It may make sense to generate cash by renting and pay any tax due on sale. There's no rule of thumb here.
Copyright 2011 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 12/21/11