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liz_h_gw

rental property questions

liz_h
16 years ago

As someone who intends to own at least 1 rental house, I appreciate momto6's thread and all the advice there.

The house in question is near us and we plan to manage it, with the exception of some help finding and vetting the tenant.

I have also considered buying a rental house in my hometown. My best childhood friend has grown into a very wise and conscientious woman. She is also a realtor and owns rental houses herself. I know I could trust her to manage it well for me. The benefit to me of having a property there would be (I hope) a deductible trip to visit the property once a year. Would the IRS consider this a legitimate expense against the property? I won't take y'all's advice as the last word here, but this is a great place to get started!

Someone mentioned forming a corporation to own each house. Is this to limit liability? Are there tax advantages to this, as opposed to owning them in your own name?

Comments (22)

  • coolvt
    16 years ago
    last modified: 9 years ago

    As far as a return on your investment I think you would be better of buying a house with 2 or 3 apartments. It's not easy to buy a single family house that will turn a profit in the first few years. Investment wise, I think you are better to get the house close to home where you can learn to manage it. No one will have more of an interest in the house running smoothly that you yourself will.
    Yes, if your visits are reasonable to an investment house in your hometown...2 or 3 times per year, the expenses of the trip to view your property are tax deductible....the travel cost, lodging and meals. Of course if the investment shows a loss of $2,000 or $3,000 per year and you are spending another $2,000 or $3,000 in "visiting" the property, this could be a "red flag" for the IRS. If your main objective is to get trips that can be "written off", I dont' think this is a good reason to purchase. The investment must make financial sense on its own. Then any "trips' are gravy to the deal.
    Forming a corporation...probably an LLC is for liability protection. If you get sued, hopefully the only thing that could be touched is the rental property and not your personal residence or other assets. However if you get financing, the bank will want your personal guarantee so your personal assets and credit rating could be at stake. With an LLC all the financial dealing pass directly into your personal income tax report. In other words, the IRS doesn't consider it something separate from your personal income. So, there is no tax advantage. There are other types of companies that you can set up that could have some tax advantages, but you would have to get a good accountant to determine this.

  • chisue
    16 years ago
    last modified: 9 years ago

    Run the numbers. Which property will provide the greater return? Where is the greater pool of renters? What is the competition for renters? In which town have properties appreciated at a higher rate? How do taxes, utilities, maintenance compare?

    We sold a rental in Illinois six years ago and invested in a vacation rental condo on Maui. Saves us $4000 a year because we don't have to rent from someone else for a month in the winter and the travel expenses are a tax write-off. (Remember the travel isn't free, just a write-off. You still have to PAY for it.)

    This has been a profitable experience, even with employing an on-site management company to clean, inspect, register guests, etc. It's been much less of a headache than any long term rental we had. The real benefit has been that the value has increased nearly three-fold, although that's more a factor of accidentally buying at a low and the recent "bubble" in real estate that is attractive to Boomers buying second homes. Had we invested in a couple of apartments in Chicago, the appreciation would have been minimal.

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  • liz_h
    Original Author
    16 years ago
    last modified: 9 years ago

    coolvt and chisue - thank you for many good points to consider. The nearby house is our former home. We have just moved to a new house that we built. I realize I wasn't very clear earlier. I'm not trying to decide between the 2 properties, more on whether or not to add a 2nd one in another state as opposed to nearby. I would like to go back to my home state once and occasionally twice a year, and if those expenses were deductible, that would be plenty of benefit for me. Especially since total income affects if and how much my social security income is taxed. The economics of the two areas are fairly similar, with perhaps this area being potentially more profitable.

    I honestly hadn't thought of buying a house with 2 or 3 apartments. It certainly makes sense. I know there are plenty of older homes in my home town that have been divided up into apartments, I've no idea about newer properties. There are some nice duplexes in my area, though I think they sell as townhouses, i.e. each side independently. It's definitely something to talk to my realtors about.

    Now I have a question as to financing. What type of underwriting criteria is typically used for rental property? Would we be expected to have sufficient income to make a mortgage payment with or without rental income? Would a lender consider cash assets in lieu of income?

    A property in Maui sounds delightful - though probably way beyond my means at this point. I'm glad you were able to benefit from the timing of your purchase.

  • mariend
    16 years ago
    last modified: 9 years ago

    Check with your tax person. When we had a rental, we could only deduct the items if we managed it 100%. If anyone else did it, 0 deducatable from IRS. Also, when you sell, you could get stuck with huge capital gains. We had to pay over 12,000.00 so it bascially wiped out any expenses. Again, check with the tax person.
    If you manage it, there are good books at Staples to keep tract of it and also Quicken has a program for rentals.

  • coolvt
    16 years ago
    last modified: 9 years ago

    On the financing....the bank will like to look at what the rental history of the building has been for the past few years. If it hasn't been rented then it becomes a little tougher...they will want to look at your experience in running a rental. If it looks like the property will generate enough money to pay expenses, mortgage and unexpected or expected replacements (capital items) then they will use a vacancy factor for your area. In other words, they won't expect you to have enough personal income to cover the mortgage payment. If it's a single house they might expect you to have enough funds to cover a few months in case of a vacancy.
    If you are not going to live in the building, remember that it will be treated differently from a residential mortgage. Essentially you will be asking for something closer to a business loan and that is how the bank will look at it. Is this a good business and can this person run the business. The interest rates will be higher than a residential mortgage and the required downpayment might be higher.
    The easiest way to get into the business is to buy a duplex and move into it. Easy to get financing (treated as a residence) and a better interest rate.
    As far as paying capital gains tax....if you want to get rid of it, do a 1031 exchange into another investment property and you will pay no taxes.
    Meriend....not sure on this managment thing you mention not being deductible. Much of the property that I own is out of state and being managed by management companies. All the expenses are deductible including the management expense and any trips I take to the properties. Probably 90% of commercial and large residential properties are managed by management companies. In the some cases the owners have never set foot on the property (I've personally had this experience) and all expenses are deductible.

  • momto6
    16 years ago
    last modified: 9 years ago

    Liz h: Please keep in mind that I am not an expert by any criteria, and anything I tell you is based only on my experience. =0)

    Since you already have the mortgage on your old house (I'm assuming at a good rate), I think it's the prefect way to start. We deduct everything having to do with our rentals on our taxes (it's a different form), including the management fees when we have them.

    I personally would wait and see how you like being landlords before diving into another house ANY where. It's an individual thing and not really a put your money in it and leave it kind of investment. I would also research what kind of rent you could charge for your area and any you are considering as an investment. Will what you can charge for rent make the mortgage? Add the management fee on top of the mortgage, and then a little more to put in savings for the water pipe that bursts in the wall, or painting in between tenants, of whatever. Do you intend to return to your "hometown" at some point? Retire there? Or is it simply for visiting?

    I would also talk to your friend about the real ups and downs of rentals. If she is a VERY good friend and you can ask her about such things, ask her how many months she has to make ends meet without rent, and her horror stories about tenants, and houses. Look at what is renting...houses, apartments, etc.... before buying. Apartments are great, but if there are a great deal of apartments that are unrented in the area, well then, yours will likely just be a few more. If there are a great deal of unrented houses in the area, same. Your friend could be a real asset in helping you answer these questions.

    The mortgage company did not figure our rental properties at full rental value, but only as a percentage of it for our bills. Like 25% of the mortgage was used and treated like an expense. Did that make sense? BUT we also lived in both our rentals before they became rentals.

    When we looked into helping my BIL by buying his house, allowing him to get on his feet and then buy it back, I was absolutely shocked at the amount of interest they wanted. They also HAD to have 20% down (even though the house was appraised at a far greater value than the loan). The local borough had to inspect the house for livability, and had all kinds of restrictions and requirements that I had no idea were out there. Now the areas my rentals are in do not require such things. So it was a rather rude awakening, and I will never own a rental home in that state. I tell you this so that you can understand that different areas have different requirements and you need to know about all of them before deciding. Sometimes it's not the tenants that makes being a landlord difficult. =0)

    Make sure you research tax records on any house you buy, especially out of the location where you live and KNOW what the taxes are. The BIL situation had taxes that each month were higher than the monthly mortgage payment.

    Now I personally, just me, and I have no idea about legalities, or investments, and compound interest still has my brain in twists, so I'm sure many folks here have ideas on how to make your money work better for you.... Talking as a mom and wife..... I would not consider buying a house that did not fit into MY budget, no matter what the mortgage company said we could afford. No matter what the possible rent would cover. The bank does not have your best interest at heart, they have their bottom line. And there will be months that the house is unrented. I would not buy a house without a through inspection (and I find that by being there, I get to have all my questions answered instead of wondering if the guy saw it or not). I would set up an account for the house and ONLY the house. The security deposit goes in there, as well as at least $2000 for repairs (If home repairs are more expensive in your area, plan on more). Every 10-12 years or so plan on replacing the carpet. Every 3 years plan on fully painting, and occasionally a room or touch up between tenants.

    While I may consider letting a really good friend weed out unsuitable properties, or tell me when something good hits the market, I'm not sure I would risk the friendship for the sake of a few dollars. MY family comes first, always, and that while a great ideal, is a little tougher in practice with friends. There are too many unknowns in owning property. There may be things that you expect from her that you would not expect from anyone else, and things that she expects from you or things she expects you to allow to "slide" that she would not expect from anyone else. She can keep an eye on your property as a friend without being the manager. Take a real close look at your relationship and have a really frank talk, before you decide to allow her to manage your property. If married, get your husband's input too. As your friend there may be things that you are overlooking for the sake of friendship that hubby may not. If you are uncomfortable talking about this with her, maybe she isn't the one to manage it. It's easy for the disappointment due to whatever to turn into resentment when dealing with a friend. Be very careful and very sure.

    Now that I've done all the doomsday stuff..... I actually enjoy having the properties and renting them out. I may never be a multi-millionaire, but that's ok with me. I've met lots of great people, helped a few through some hard times, and there are rewards that can't be measured through dollars and cents. Though, those are nice too. For 2.5 years worth of payments, the house will belong to me. I have no idea what kind of return that is though. And I can see and touch this investment, which has a certain appeal to me.

    Good luck.
    Mil

  • coolvt
    16 years ago
    last modified: 9 years ago

    Mil,
    And the nicest part of RE rentals is that you do the managing and as a reward, the renters make the mortgage payments for you.
    People can talk about all kinds of investments, but in my book, RE is the best. I'm going to be selling an apt. house (12 small apts) this summer that I've owned for 28 years. I bought it for $125,000 with $10,000 down. The mortgages (two) have been paid off for 8 years. I have been clearing about $55,000 per year for the past 8 years. The house just appraised for $925,000.
    The way I figure it, I put down $10,000. Everything above $10,000....the rents I've been clearing and what I clear on the sales price is profit.
    You said ..."I have no idea what kind of return that is though." I don't know what kind of return I've had either, but it doesn't take a genius to figure out that this is a pretty good business to be in.

  • C Marlin
    16 years ago
    last modified: 9 years ago

    I completely agree with you coolvt, I also own rentals. I love it, I put a small downpayment on a building, mortgage the rest, my tenants pay my mortgage then give me spending money. I don't pay income tax, because according to the IRS, I'm not making money, but it sure looks good in my checking account each month.
    I can't even describe the appreciation we've seen since purchasing our first apartment ten years ago.
    Coupling the basic income, tax advantage, and appreciation in value, I can't find anything better either.
    My first apartment cost $450k (this is expensive CA) I put $125k down, I've since refinanced (to buy another) taking back out my downpayment, and more money. With increased rents, my tenants still pay my mortgage and give me plenty of income and the building has quadrupled in value.
    I can't see that kind of return in the stock market, I see my RE investments as low risk, they will always have value, I can sell or refi if I want money.

  • chisue
    16 years ago
    last modified: 9 years ago

    Tell me, coolvt, are you going to pay the $120K capital gains on your sale? Or do a 1031?

    I'm wondering how long to let a similarly low tax base ride. I know I should ask an attorney or accountant, but you might know: If a 1031 property is in a trust that is appointed to a survivor, does the tax base on the property get re-evaluated as it would for inherited property NOT in a 1031? I'm guessing it does not, that someday you have to bite the bullet and pay the capital gains based on that ancient, original base.

  • C Marlin
    16 years ago
    last modified: 9 years ago

    "Tell me, coolvt, are you going to pay the $120K capital gains on your sale? Or do a 1031?"

    I was wondering that also, if it worth it to you to buy something else, or do you want to pay now, take the money and run.
    We are considering selling a building, and are weighing paying taxes or doing a 1031. The 1031 is looking good, but we are still undecided until we sell.

  • coolvt
    16 years ago
    last modified: 9 years ago

    I'm not going to pay any taxes on the sale of the building. I'm doing a 1031 exchange into one or two TIC investments. Not sure if many of you have heard of them. I have some properties that have been rolled over 4 times through 1031's so it's been years since I've ever paid capital gains although I've sold many buildings.
    I think you have to figure what your goal is. If you are looking to have a monthly income with just about no work, then a TIC investment might be what you want. If you need the cash for something then you won't be doing a 1031 and will have to pay the capital gains.
    And...I have no idea about property going into a trust and getting a new basis.
    About 30 years ago I sold a duplex to one of my tenants. This couple was very nervous about buying realestate. I ran into the wife last year and asked if they still owned it. She told me that over time they had refinanced it three times... once to raise money to open a restaurant, once for a downpayment on their present house and then just refinanced it last year to raise money for their daughter's college expenses. She said buying that house was the best thing they ever did.

  • jlhug
    16 years ago
    last modified: 9 years ago

    I've owned rental property for about 20 years, done a 1031 exchange, and been a tax preparer for 13 years.

    My only concern about 1031 eschanges is what will happen to capital gains rates in the future. I can see the potential for the favorible 15% rate that we now enjoy being raised or eliminated. I don't see it going down. So, in my humble opinion, I can see some justificaiton for selling property and paying taxes at what could be a lower rate than a future tax rate.

    Now if you plan on owning the property til you die, then the 1031 might make sense. However, even if you hold it til you die, your estate could end up paying estate taxes depending on when you die, how big your estate is and what happens to estate tax law in the coming years.

    Dang, I wish my crystal ball was clearer.......

  • chisue
    16 years ago
    last modified: 9 years ago

    jlhug -- Thanks for peering into your crystal ball for me! I'm pretty sure that once you avoid capital gains by doing a 1031 you are stuck with that tax base -- the property involved doesn't get re-valued when the owner dies, as happens with non-1031 property. Does that sound right? I know we could move into the Maui rental and make it our "home" for 24 months and avoid the capital gains as a 1031. (Sure, but what about our real primary home in Illinois? We'd have to sell that first. Not sure I want to live in a small condo for two years even if I would avoid big taxes!)

    To look at coolvt's situation, won't he have to pay up SOME day? If he leaves his 1031 properties to someone, won't THEY have to pay up?

    Inquiring minds, etc. without advantage of crystal balls.

  • jlhug
    16 years ago
    last modified: 9 years ago

    I don't know the answer to the 1031 property basis in the case of a deceased tax payer. I see if I can find any info tomorrow. I have a guess, but without something to back it up, I don't want to say anything.

  • coolvt
    16 years ago
    last modified: 9 years ago

    As far as I know, the IRS doesn't care how someone inherits property, the property gets a stepped up basis. I don't ever plan on paying capital gains. I will always do 1031's. True there will be some inheritance taxes, but a life insurance policy owned by my trust will cover most of that.
    That's the great thing on depreciation and 1031's....it's like getting a loan from the IRS and you really never have to pay it back if you don't sell. Now when you start selling larger properties with almost no basis left and you can be facing tax bills of $500,000 and $600,000 people will do anything they can to postpone that taxes.
    Now this is assuming that my high priced advisors haven't make a mistake on the current law;-)

  • chisue
    16 years ago
    last modified: 9 years ago

    I don't know if it makes any difference, but our 1031 adventures have all been within a separate trust that was established by my late mother, of which I am trustee with power to appoint. The trust sold one property. The trust bought a second property using 1031 exchange laws.

    The value of the property is now more than 12 times the base cost -- a very hefty capital gain even at the current 15% rate. I know we could sell and reinvest only a portion, and pay taxes on the rest.

    I know I could appoint this property out of the trust to, say, our DS and DIL or our DGS (age 2). What I'm wondering is if it isn't best to let them "inherit" the trust holdings. What I don't know is if they will also inherit the tax base or if the 1031 property resets to date of inheritance.

  • C Marlin
    16 years ago
    last modified: 9 years ago

    chisue, will your decisions change if your decendents inherit the tax base or the step up? I always think it is best to delay, unless the crystal ball tells us the tax is is going to change. Do you care if your children inherit lots of property, but will need to pay taxes on it in the future? I don't.
    Basic tax planning, delay, delay, delay.

  • jlhug
    16 years ago
    last modified: 9 years ago

    Chisue, I can't find anything that says property acquired in a 1031 exchange is treated any differently in an estate than property that is purchased outright. It might be there, but either it's buried deep in the regs or I didn't look in the right place.

  • coolvt
    16 years ago
    last modified: 9 years ago

    We do know that in an exchange that the new property takes on the basis of the old property. Of course, if the new property costs more, then the basis can be steppped up. So, the game is to take the proceeds from an exchange and use it as a downpayment on the largest investment property you can. Assuming of course that it's a good property. Use the exchange proceeds as a 25% downpayment and you can buy something that will give you a basis of 3 times what you are giving up. This should give you enough depreciation and interest deductions to off-set all of the profit from the property and probably off-set much of your other income.

  • jlhug
    16 years ago
    last modified: 9 years ago

    Another strategy if you want to "move your eggs from one basket to several" is to do a 1031 exchange from 1 property to 2 or 3 properties.

  • coolvt
    16 years ago
    last modified: 9 years ago

    I agree with the 2 or 3 properties. It's nice sometimes to have the risk spread around. If the properties are at a distance, however, then it's a little harder to manage them.

  • chisue
    16 years ago
    last modified: 9 years ago

    Thanks for the free research, jlhug! I'm still not clear about the difference between 1031 and non-1031 inherited property. Coolvt seems sure that his 1031 property will get re-valued when it is inherited. I'm not so sure. If that's the case, I have no worries; we'll just let the 1031 ride and let our kids inherit at a stepped up base. (That sounds too good to be true.) If it's not true, maybe it would be wise to appoint some of the 1031 to them now while they are in low income brackets. (Our grandson is industirous, but there's a limited market for his fingerpaintings.)

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