Friday, October 12, 2007

Rental Real Estate

Understanding Your Rental Property

Adding real estate to your portfolio can be a smart thing to do. Many do this by converting their first home into a rental when they can afford to acquire another principal residence. As I have discussed before, every portfolio should have 20% invested in the alpha rim (see Do What the Hell I Tell You-Guide to Portfolio Building). The alpha rim is the part of a portfolio that is not invested in stock market products. Therefore, it is not subject to market fluctuations and provides some risk protection to a given portfolio. When adding any new investment to our portfolio, we should take time to learn the basics so that we can make informed decisions over time. Adding real estate to a portfolio definitely requires an understanding of the fundamentals.

Lets begin by taking our first town home. It was purchased right after we were married with the intent that we would one day live in a larger home. Because we were so good at saving, we did not need to sell the first home to get into the new place. We have made contributions to retirement plans and have savings on the outside of the retirement plans. The decision has been made to keep this town house and convert it to a rental property in order to begin investing in the alpha rim. It becomes necessary at this point to understand how a rental property works from its beginning, during its operation, and when a decision is made at the ending its existence in the portfolio.

Putting the Property in Service

If the property is being converted from personal use, as it is in this situation, we must take the lower of cost or market value in placing this property into service as a rental. If we purchased the home originally for $200,000 and its fair market value is $300,000 when we are ready to make the conversion, we will use the $200,000 original cost as our basis. If the fair market value was $150,000 at the conversion date, then this would become the basis for the rental property. Placing a property in service in this case means establishing how much will be available for depreciation and how much will be allocated to land. Lets assume that $200,000 is our basis. We will need to allocate this basis to determine what can be depreciated and what must be land (not depreciated). I like to use the property bill assessment as it normally breaks down the property into what is building and what is land. After reviewing the property assessment, it is determined that 80% of the propertys value is building with the remaining 20% representing land value. This means that we will depreciate $160,000 over a 27.5 year life, or $5,818 per year. If we were to purchase this rental property as opposed to converting, our basis would be calculated based on cost plus settlement charges. Remember, each year that we take depreciation, we are reducing our tax basis in the property. This is important to know as we consider disposition of the property.

Operations of the Rental Property

As one might imagine, everything that relates to the property becomes a tax deduction. Mortgage interest, real estate taxes, repairs and maintenance, insurance, property management fees, and the like become ordinary and necessary expenses for the rental property. It should be noted here that the ideal situation is to have the rents charged to tenants equal not only debt service on the mortgage, but some built-in factor for repairs and upkeep. This of course, will be subject to fair market value rents in the neighborhood, but the goal should be to cover these expenses. In the event that the property operates at a loss, this loss will be able to offset other income on a tax return to the extent that adjusted gross income is $100,000 or less and the loss itself is not greater than $25,000. If adjusted gross income is $150,000 or more, the $25,000 loss limitation is reduced to zero which would make suspended any losses realized. Suspended losses are then carried forward to offset passive income in future years or to be recognized upon termination of the property. When starting a rental property, it is important to know the rules of the game as one might not get the tax benefits expected. If your adjusted gross income exceeds $150,000, you will not currently get any tax benefit from losses unless you have passive income from other sources. If you have a series of suspended loss carry-overs, you might consider adding a passive income generator to your portfolio (see my article, The Most Complete Real Estate Article on the Internet).

Disposition of the Rental Property

Now we are considering the disposition of our rental property. At the time, it is believed that we can get $400,000 for our investment. Do we have exposure to income taxes due to the gain of this property? Of course we do, dont be silly. Lets first calculate what our gain will be. We know our selling price, so we need to calculate our adjusted in the property. If the property has been depreciated for 10 years, our accumulated depreciation will be $58,180 ($5,818x10 years). This would bring a depreciable basis of $160,000 down to $101,820. We will add $40,000 to this for un-depreciated land basis bringing the adjusted basis up to $141,820. The gain exposure for this property is then calculated to be $258,180. This gain is section 1231 gain which will likely mean that it is long-term capital gain. However, this gain will have two tiers of tax. Because of the depreciation taken in prior years, the accumulated depreciation of $58,180 will have a 25% tax rate application. The balance of the gain, $200,000, will be taxed at the long-term capital gains rate of $15%. There is the potential to do a 1031 (like-kind) exchange on this property which would allow for the postponement of the gain providing that a property of greater or equal value is acquired. There is also the potential for netting the capital gain of this transaction with capital losses that might be in the portfolio. Does it make sense to sell outright or do a 1031 exchange? It depends on the facts and circumstances of this particular portfolio. If the alpha rim is well above the 20% mark, and with long-term capital gains at just 15%, it might make sense to just recognize the gain and pay the taxes (see my article on netting capital gains and losses). If we need to buy another property to maintain 20% in the alpha rim, the 1031 exchange could be the right solution. See what I mean when I say one must understand the fundamentals of owning real estate? My way is better.

Ron Piner, CPA
Host of Better Business
Saturday Mornings at 10ET
On WBIS AM 1190