When I meet a new investor, I always discuss how it is critical to building a team of advisers to support your Real Estate Investment career. One of my advisers is my CPA, John Caylor. As we head into tax season, I decided he should be our first guest writer of 2008 to discuss the tax implications of owning Investment Property:

Let’s Talk Taxes

by John Caylor, CPA

So, you are thinking of buying some rental properties? Or maybe adding a few more to your portfolio? There are many reasons to own real estate beyond the joy of maintaining properties and tenant relations.

A well analyzed real estate purchase can be a great part of your retirement portfolio, and can be very similar to a tax deferred retirement plan, such as a 401(k). The difference is with a 401 (k), the IRS tells you when you can retire and start drawing the income while a rental property

retirement portfolio can be accessed any time penalty free (in other words, you can pick your own retirement date).

An example is a property that is purchased for $100,000. If the property grows at an average rate of 5% per year, you are getting tax deferred asset growth, or investment income. You are not taxed on an increase in property value until a sale occurs. Even then a Like Kind Exchange can defer the taxes even further. If you put that same $100,000 in a mutual fund, you would be taxed annually on the investment income (growth) of the account, and in a 401(k), the income is tax deferred but locked up until IRS defined retirement.

Also, in many cases the tenants are paying for the property for you via rent, so there may be no money out of your pocket to fund your retirement. In a 401(k) setting, almost all of the money to fund the account is directly from your pocket.

In addition to the tax free asset growth, there is current tax benefit to owning real estate. In a rental property situation, you can deduct all operating costs associated with owning the property as well as depreciation of the property. Depreciation is a deduction of the cost of the property over time, normally 27.5 years. Example; a $100,000 property would generate $3,636 ($100,000 / 27.5 years) tax deduction each year.

These tax deductions can be deducted directly against rental income, or other taxable income. Keep in mind there are some limitations to be considered. Please consult with your tax advisor for more details.

Note: If the property is an investment property, rather than a rental, you do not get to deduct current expenses. These costs are generally accumulated over time and upon sale of the property, they reduce the gain on sale, very similar to a stock buy and sell. You also cannot deduct depreciation on an investment property.

Another benefit to real estate is most gains on sale of property are taxed at the favorable capital gains rates, rather than ordinary income. This can make a major difference in total taxes paid and when adding the lower capital gains rates to the operating expense deductions and depreciation, you can see the long term tax benefits to real estate.

In summary, there are many reasons to own real estate, and the tax benefits rank as one of the most significant.

Please contact my office with any questions you may have.

Sincerely,

JOHN D CAYLOR, CPA
JOHN@CAYLORLTD.COM
952-767-9070

You may have heard about homeowners losing their homes to foreclosure or selling them in a short sale, only to be hit with a tax bill afterwards. The IRS saw the forgiven mortgage debt due to foreclosure, short sale, or deed in lieu of foreclosure as taxable income. Therefore, the IRS was adding insult to injury and taxing the forgiven amount. This could amount to tens of thousands of dollars for an already financially strapped family.

Thankfully, President Bush signed bill H.R. 3648 into law, on December 20, 2007, that will eliminate the tax up to $2 million on primary residences only. The new law waives any taxes on these forgiven debts (up to 35%) from now until the end of 2009.

During the signing, President Bush made the following statement:

“When you’re worried about making your payments, higher taxes are the last thing you need to worry about. So this bill will create a three-year window for homeowners to refinance their mortgage and pay no taxes on any debt forgiveness that they receive. And it’s a really good piece of legislation. The provision will increase the incentive for borrowers and lenders to work together to refinance loans – and it will allow American families to secure lower mortgage payments without facing higher taxes.”

Unfortunately, this exemption only applies to primary residence and does not apply to investment properties.  There are no plans to add that waiver at this time.

Assuming you don’t have a pile of cash under your mattress to buy that house to flip, you will need to get it somewhere. These are the most common ways to finance your flip:

1. Hard money lender-These are individuals in the market that finance investors/rehabbers for short periods of time (less than 1 year and typically for 6 months) for higher than bank’s interest rates or a large percentage of the flipping profit. They will generally take a creditor position against the property to protect their investment. Your closing costs will be lower as their is no bank involved to charge fees. If you chose to hold the property, you will replace the hard money lender with a traditional mortgage.  They can also make a great advisor for your first house flip.
2. Construction loan-This is generally the best was to finance your flip to secure as you should be able to borrow not only the initial purchase amount, but much of the rehab costs also. Often you will need to contribute 5-10% of your own money and can then borrow 80-90% of the repaired value of the property. This method is typically easy to convert to traditional financing if you chose to hold the property. The initial construction loan also traditionally has lower closing costs.
3. Traditional loan with flipper infusing cash-Many first-time flippers will make the mistake of using a traditional financing product to purchase the property. They will then spend their own money to fix up the house, waiting till it sells to recoup their cash investment. This method requires the flipper to have all the necessary funds available up front to not only rehab the property but to also hold it during the sales process. Then, if you decide to hold the property, you will no choice but to refinance to pull your cash out to continue doing other flips.

There are many other complex and interesting ways to finance your flip which are beyond a short blog post, such as: self-directed IRAs, credit cards (yes, many people do it!), limited partnerships, and borrowing against the cash value of your life insurance.

Researching your different options for financing your flip in advance will make this process much smoother and should help you put more money in your pocket.