The Landlord's Financial Tool Kit

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Digitally signed by TeAm YYePG DN: cn=TeAm YYePG, c=US, o=TeAm YYePG, ou=TeAm YYePG, [email protected] Reason: I attest to the accuracy and integrity of this document Date: 2005.03.17 09:21:22 +08'00'

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The Landlord’s Financial Tool Kit

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Michael C. Thomsett

American Management Association New York • Atlanta • Brussels • Chicago • Mexico City • San Francisco Shanghai • Tokyo • Toronto • Washington, D.C.

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Special discounts on bulk quantities of AMACOM books are available to corporations, professional associations, and other organizations. For details, contact Special Sales Department, AMACOM, a division of American Management Association, 1601 Broadway, New York, NY 10019. Tel.: 212-903-8316. Fax: 212-903-8083. Web site: www.amacombooks.org

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold 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 person should be sought.

Library of Congress Cataloging-in-Publication Data Thomsett, Michael C. The landlord’s financial tool kit / Michael C. Thomsett. p. cm. Includes index. ISBN 0-8144-7235-4 (pbk.) 1. Real estate investment. 2. Real estate management. 3. Rental housing— Management. 4. Real estate investment—Accounting. 5. Landlord and tenant. I. Title. HD1382.5.T5645 2005 333.33'8—dc22

© 2005 Michael C. Thomsett All rights reserved. Printed in the United States of America.

This publication may not be reproduced, stored in a retrieval system, or transmitted in whole or in part, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of AMACOM, a division of American Management Association, 1601 Broadway, New York, NY 10019.

Printing number 10 9 8 7 6 5 4 3 2 1

2004006149

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Contents

L IST

OF

F IGURES

AND

TABLES

VII

I NTRODUCTION : W HAT T HIS B OOK W ILL D O C HAPTER 1 T HE N ATURE

OF

Y OU

R EAL E STATE I NVESTING

C HAPTER 2 G ET TING S TARTED

IN

R ENTAL R EAL E STATE

C HAPTER 3 C ASH F LOW : T HE E SSENCE

OF


C HAPTER 4 P ICKING THE B EST I NVESTMENT C HAPTER 5 B OOKKEEPING B ASICS C HAPTER 6 K EEPING T RACK

FOR

OF

C HAPTER 7 C REATING A T IMELY

FOR

FOR

Y OU

R ENTAL P ROPERTY

R EAL E STATE T RANSACTIONS

AND

E FFICIENT A CCOUNTING S YSTEM

v

1

3

21

51

69

89

121

137

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vi

CONTENTS

C HAPTER 8 H ANDLING D EPRECIATION C HAPTER 9 U NDERSTANDING C HAPTER 10 TAX R EPORTING

THE

FOR

FOR

R ENTAL P ROPERTIES

TAX R ULES

FOR

A NNUAL I NCOME

C HAPTER 11 I NCLUDING R EAL E STATE

IN

155

R EAL E STATE

179

E XPENSE

193

AND

Y OUR P ORTFOLIO

225

G LOSSARY

237

I NDEX

241

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List of Figures and Tables

F IGURES Figure 1-1. Sample rental application. Figure 2-1. Average sales prices, new homes. Figure 3-1. Worksheet for cash flow calculation. Figure 4-1. Questions for judging conditions of the real estate market. Figure 4-2. Questions for judging conditions of the rentals market. Figure 5-1. Investment receipts journal. Figure 5-2. Worksheet for loan payments. Figure 5-3. Rental payments journal. Figure 5-4. Year-end worksheet, expense summary. Figure 5-5. Year-end worksheet, expense allocations. Figure 5-6. Sample rental agreement. Figure 5-7. Statement of Condition. Figure 6-1. Automobile log. Figure 6-2. Worksheet for mixed-use expenses. Figure 7-1. Account with subaccounts. Figure 7-2. Account with subaccounts (filled-in example). Figure 7-3. Worksheet for after-tax profit or loss. Figure 8-1. Depreciation limits for passenger automobiles. Figure 8-2. Depreciation limits for trucks and vans. Figure 8-3. Schedule of annual depreciation. Figure 8-4. Schedule of annual depreciation (filled-in example). Figure 8-5. Depreciation worksheet. Figure 9-1. Worksheet for calculating profit on sale of real estate. Figure 10-1. Form 1040.

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17 37 55 74 75 93 95 99 100 104 112 117 123 131 140 141 150 167 168 173 174 175 183 194

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FIGURES

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10-1a. Form 1040 (cont’d). 10-2. Tax reporting for real estate transactions. 10-3. Schedule A. 10-4. Schedule E. 10-4a. Schedule E (cont’d). 10-5. Form 8582. 10-5a. Form 8582 (cont’d). 10-5b. Form 8582 (cont’d). 10-6. Form 4562. 10-6a. Form 4562 (cont’d). 10-7. Form 4797. 10-7a. Form 4797 (cont’d). 10-8. Tax reporting for capital gains or losses. 10-9. Schedule D. 10-9a. Schedule D (cont’d). 10-10. Form 8824. 10-10a. Form 8824 (cont’d). 10-10b. Form 8824 (cont’d). 10-10c. Form 8824 (cont’d).

TABLES Table 3-1. Table 5-1. Table 5-2. Table 7-1. Table 7-2. Table 7-3. Table 8-1.

Table Table

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LIST

Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure Figure

Table Table Table

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Loan amortization, one year. Loan payment breakdown, one year. Impounds accumulated and paid. Single-entry bookkeeping journal. Timing differences, impound accounts. Impound account entries. Depreciation schedule, 5-year recovery period, 200 percent declining balance. 8-2. Depreciation schedule, 27.5-year recovery period. 8-3. Depreciation schedule, 39-year recovery period. 8-4. Depreciation schedule, 5-year recovery period, 150 percent declining balance. 10-1. Summary, rental income and expense. 10-2. Supplemental schedule, depreciation expense: straight-line (SL) method (deductible portions in italics).

TABLES

195 196 197 200 201 203 204 205 208 209 213 214 215 216 217 219 220 221 222

59 96 97 143 146 148 169 171 172 176 207 210

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02LL-Intro-03

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I N T R O D U C T I O N

What This Book Will Do for You Real estate investing is a practical alternative to the stock market for many reasons. If you have lost money by investing in stocks, you already know how quickly paper profits can turn into actual losses, so solid, longterm, and safe investments are paramount in importance. The more capital you have to invest, the more critical it becomes to diversify away from highrisk exposure. Besides the historical profitability of real estate, there are other good reasons to invest in income property. Real estate is unique because it is the only investment that allows you to shelter income and reduce your income taxes. It’s true that as a stockholder, you can control your taxes by planning when to sell or when to wait, but you cannot “shelter” income (that is to say, stock investments do not reduce your tax liability). Real estate investors are allowed to create legitimate tax losses by depreciating property. While depreciation does not require you to pay out cash, it does reduce rental income and may even create an actual loss. Real estate is the only investment that allows you to claim a loss above the limited $3,000 you can claim each year when you lose money on stocks. Another important difference is that stock losses tend to be associated with actually losing cash, whereas real estate losses often consist entirely of depreciation benefits. Before you can realize the many advantages of investing in real estate, though, there are complex reporting demands. You have to keep books and records, not only of the money you spend on maintaining property, but also of the calculations you use to divide expenses among several properties, to figure depreciation expense, and to break down mortgage payments between principal and interest. The tax-reporting rules are also complex,

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THE LANDLORD’S FINANCIAL TOOL KIT

requiring you to fill out many schedules that most people never have to deal with in their tax returns. You have to report gain and loss on the sale of property, income and expenses, and depreciation—all of which have their own tax schedules. This book is not aimed at the tax or accounting expert. It is designed for the individual who simply wants to invest capital outside of the traditional but risky stock market and apart from the safe but low-yielding savings or money market accounts. You do not have to learn a lot of accounting or tax rules to use this book. It takes you through all of the recordkeeping rules; shows you how to evaluate and plan ahead; helps you design a simple but complete bookkeeping system for rental properties; and explains, step-by-step, how to fill out tax forms. You may need to use the services of a tax or accounting expert to complete your tax return; however, by being aware of how taxes have to be reported, you will be fully equipped to supply your tax preparer with everything required, so that you will be able to claim all of the deductions to which you are entitled. In short, this book breaks down the complex matters you need to think about: picking properties with financial concerns in mind, planning cash flow, setting up an effective but basic set of books, keeping track of the money you spend, planning ahead for taxes, understanding reporting and depreciation rules and limitations on losses you can deduct, and working with your accountant or tax preparer. This book cannot replace the expert advice you need; however, it will help you to become a more informed real estate investor. And the more informed you are, the more likely that you will succeed in this potentially profitable market.

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C H A P T E R

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The Nature of Real Estate Investing Real estate is the most consistently profitable investment choice you can make. As long as you research ahead of time, know your market, and pick specific properties carefully, your investment should grow over time. Most people start out with residential property investments. A singlefamily house or small multi-unit property (two to four units) is manageable and affordable, and you can always step up from there to buy additional properties or exchange your initial investment for larger ones. To get started, you want to define what you hope to achieve by purchasing real estate. Property is far more expensive than most other investments, so you will be making a commitment in most cases to a mortgage. The majority of investment value will consist of borrowed money, so you will be depending on rental income to make your investment affordable. Given the potential affordability of real estate (with tenants essentially covering your mortgage payment for you), the consistent historical growth of real estate values, and the exceptionally good tax advantages, the benefits of real estate investing are significant.

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An Overview of the Market Since residential property is, by far, the most common real estate investment, we provide examples of housing as a primary emphasis in this book. Other choices (e.g., raw land speculation, commercial and industrial properties) are much more advanced and beyond the interest of most investors. The residential housing market can be easily studied in any given area. You can readily find information about the local population, employment, 3

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rental occupancy and vacancy rates, and level of new construction under way. These factors add up to the supply and demand for real estate in your city or town. This, then, is the logical starting point if you are thinking of investing in real estate. Key Point: Information about local supply and demand for rental property can be found through local real estate brokers, appraisers, and bankers. Multiple Listing Service (MLS) publications also provide detailed information about property pricing and trends.

Supply and Demand The supply and demand for residential property involves two separate markets. One is the market price trends of housing, and the other is demand for rental units. The first can be evaluated in terms of how prices are changing over time. Are houses selling for more this year than last year? What is the percentage of growth? Housing prices have consistently beaten inflation over many years, putting housing among the strongest growth investments. Assuming, of course, that you’ve selected property on the basis of good research and sound market analysis, you can expect real estate to be less volatile than the stock market, consistent in its growth rate, and safer by far than other alternatives. In some areas, prices have remained flat or even declined, so using national averages is not a safe way to pick a market. You need to check the regional trend to ensure that real estate in your town represents a viable investment. In areas where employment is strong and the population is growing, real estate values tend to grow as well. Market value of property is only the first of two important “markets” in real estate. The second market involves demand for rentals. What is the average vacancy level? A very low vacancy rate is a positive sign, but a fluctuating or high vacancy indicates that there is more supply than demand. If that is the case, then the timing would not be good for investment, at least not right in your city. Key Point: These supply and demand features of real estate are going to vary from one location to the next, often drastically. The next town over may have vastly different real estate features, and even within one city, the supply and demand can (and does) vary from one area to the next. It is essential to understand the population, employment, market value, and vacancy trends—in advance of committing your money.

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The Basic Equation More details on these investigative ideas are covered in later chapters. As an overview, however, this is an important starting point. The short-term market attributes of rental property are going to affect how well you can afford to invest money now. The whole market is likely to look different in a few years, but you want to make sure you have a reasonable expectation of keeping tenants in the property each month. The equation worth keeping in mind is a balance between how much money you receive (in rent) and how much you have to pay out (in mortgage payments and expenses). For that equation to work, you want to keep the property occupied as consistently as possible. Any time the property is vacant represents lost income, but your mortgage payment continues from month to month.

A Landlord’s Point of View The market for residential real estate is not difficult for most of us to understand. Anyone who owns his or her own home knows all about mortgage payments and the importance of being able to afford the house. Anyone who has not yet bought his or her own home knows that landlords expect rent to be paid on time. So the basic economics of real estate are familiar to everyone and are not as mysterious as the market forces at work in other markets, such as the stock market. In evaluating investments, though, you need to look at properties from a different perspective. When you are shopping for your primary residence, you are interested in comfort features, condition, and size of the property. As a landlord, you might be willing to invest in a property that would not interest you as a primary residence, but that is ideally suited for rental purposes.

Example: You have a growing family and need a house with several bedrooms for your own use. However, you have discovered that relatively small houses make excellent rentals. A two-bedroom house in modest condition is relatively inexpensive compared to other types of properties, and easy to keep occupied. A married couple or single person is drawn to such rentals and can afford what you will need to ask in rent, so such properties are easier to keep occupied than more expensive, larger homes would be. In this example, your revaluation of the market would be made with rental income and payments in mind, rather than from the point of view of a homeowner. The investment attributes of your decision are going to be far different from your personal requirements.

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Key Point: When you search for investment properties, your criteria are far different from what they are for your primary residence—an important distinction to keep in mind.

The real estate market has grown in value consistently over time. This is a national average, of course, and all real estate is local. This means that it is essential to understand the local features of supply and demand before investing. You cannot depend on national averages or even on local trends for the long term. If local property grows in value over fifteen or twenty years in the future, that is a promising feature. At the same time, you need to ensure that rental demand is strong right now, in order to cover your mortgage payments. As you look for potential rental investments, you should be interested in locating properties that are affordable, are most likely to maintain value (and grow in value), and are appealing to likely tenants.

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Reasons to Invest in Real Estate There are many good reasons to buy real estate. Among the most important reasons—assuming the local market conditions make it a viable choice— are the following:

❒ Diversification and Asset Allocation. Sound investment requires spreading capital over dissimilar investments. You would not want to put all of your capital into a low-yielding savings account, or a single stock, or real estate. You are better off diversifying your capital. You may wonder: If real estate is sure to grow over time, why not put all of your money into rentals? Diversification is important because different investments have different attributes. The stock market is volatile and you can make or lose money quickly; however, your money can be invested or taken out quickly. Savings accounts are very safe but yield very little. Wellselected real estate is going to increase in value over time, but it is very difficult to get your money out if you need it for an emergency. You need to diversify your capital so that you have some funds available as you need them, some funds in very safe investments, and some in investments likely to grow over time. A somewhat more sophisticated view of diversification is called asset allocation. This is a strategic planning technique in which a portfolio is spread among many different markets or segments. While diversification usually refers to spreading risks within one market (e.g., buying many different stocks), asset allocation is broader. For example, you may want

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to have some money in ready-cash accounts as an emergency reserve fund; other capital invested in stocks, whether owned directly or purchased through a mutual fund; and yet more of your capital invested in real estate. These three markets represent completely different markets, and each is going to perform according to very different market forces. Real estate is a superb market for asset allocation because of its strong historic attributes. Your ability to allocate capital among dissimilar markets protects your capital from cyclical changes. In times when the stock market is weak or falling, real estate may be strong. In fact, it is likely. We have seen the offsetting effects of stocks and real estate time and again. When investors want to take money out of the market, they will normally turn to either money markets or real estate. Money markets or savings accounts, for example, are not suitable alternatives if interest rates are low. By contrast, real estate benefits from low interest rates, so it is an excellent market for onetime stock investment capital. Diversification within a single market, and asset allocation among many different markets, are sensible portfolio management techniques. Real estate is a good fit for strategic asset allocation. It is different from the money market, however. Investors wanting to get out of stocks for the moment, but who plan to go back in a few months later, may park capital in an interest-bearing account and move it around without charge. Real estate is a longer-term investment, though. So if you plan to employ real estate in your asset allocation plan, it should be treated as a longerterm decision. You do not want to buy real estate in March and then look to sell in June to put capital back in the stock market. That would be expensive and, given closing-cost levels, a difficult move to make profitably.

❒ Long-Term Growth. A second reason to buy real estate is for long-term growth. You can expect real estate to increase in value over ten, twenty, or thirty years. By holding property over that much time, you build wealth for your own retirement, for college education expenses for your children, or for more leisurely living later on. Individual goals dictate how important it will be to accumulate wealth through real estate. Just as different stock market investors will be drawn to short-term speculation in some cases and long-term growth in others, your personal goals and requirements will dictate how you use your investment capital. For long-term growth, real estate has performed historically far above the growth rates of other investments.

❒ Safety of Capital. Real estate is a safe place to invest your money because it is well protected. You carry insurance to protect against losses from

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fire and other catastrophes, so if such a loss does occur, you are protected. Maintaining condition also protects long-term value, so you must keep an eye on your property on a regular basis, ensuring that tenants are caring for the yard and building and not trashing the house. Land values continue to rise in areas with a healthy economy. As long as your local population continues to grow and jobs are available, you have every reason to expect property values to climb steadily. This growth further ensures the safety of your capital. If land values are not rising, your capital loses buying power because it is eroded by inflation. Well-selected real estate also offsets inflation.

❒ Tax Benefits. Real estate may be thought of as the last remaining legal tax shelter. You are allowed to deduct losses on your tax return (subject to some limitations) whereas other investors are not. If you invest in markets other than real estate, you usually are allowed to deduct losses only to the extent that they offset other gains; the loss cannot be deducted from other income. If you have capital losses through stocks, your annual losses are limited to only $3,000 per year under present rules, a fairly small annual limit. With real estate, though, you can claim up to $25,000 per year in losses in most situations. Because the computation of profit and loss includes depreciation on your investment, it is often the case that you can report a loss and, at the same time, be bringing in more cash than you are paying out. So your paper loss is deductible, but your cash flow is positive. No other investment can match these benefits. Overall, the tax features of real estate make it attractive for many investors, and the comparison to other investment choices is convincing.

❒ Cash Flow. With most investments, you place cash in someone else’s care, then you receive dividends, interest, or capital gains. You are 100 percent invested and there is little or no question of cash flow. With real estate, you usually make a down payment and finance the lion’s share of the investment; so cash flow becomes critical. Most real estate investors depend on rental income to cover their mortgage payment. The bad news: If you do not keep the property rented every month, you have to make the mortgage payment from your other funds. The good news: If you keep the property occupied, then tenants’ rental payments are used to make those mortgage payments. In this situation—and given no unexpected extra expenses—the property pays for itself. When you purchase properties at the right price for your local market, and when rents are high enough to cover your mortgage payment, you will have a positive cash flow. When you consider the tax benefits of reporting losses (which are created because you are also allowed to

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depreciate your rental property), it is possible to have positive cash flow and, at the same time, a net tax loss. This seemingly contradictory situation is quite common. When the tax benefits from net losses with depreciation create monthly tax savings, you can enjoy the best of both worlds: having tax losses to deduct while you collect more cash than you pay out.

❒ Leverage. Most individuals cannot afford to buy property outright and pay cash, just as most homeowners cannot afford to pay for their own homes all at once. One attribute of real estate investing is the need to finance 70 percent or more of the purchase price in most cases. As a strategic approach to investing, leverage is recognized as an important and advantageous method to use. Leverage means employing a limited amount of capital to purchase and control a greater value in investment. You would not be likely to borrow money to buy stocks, because the stock market is an uncertain and risky place. However, properly selected and researched real estate is far less likely to lose market value. Not only does real estate tend to grow in value over time when other economic factors are positive; it is also insured through a fire insurance policy, and investors have direct control over the investment. Ownership in stock is uncertain and less tangible; but given the features of locally owned and managed real estate, leverage makes a lot of sense.

Weighing the Pros and Cons The overall benefits to investing in real estate—combining growth, safety, and tax features—make it a choice worthy of serious consideration. You cannot expect this combination from any other investment. While cash invested in real estate is difficult to take out (because it can be removed only through refinancing in most cases), the overall benefits of real estate make it worthwhile, especially if you balance your capital between real estate and other areas. Even with all of the long-term benefits of real estate investing, however, there are some problems you should expect to face as a landlord. The need to borrow money to buy property is a significant risk, so you must be prepared to live with debt. There can be unanticipated expenses, such as for repairs, property tax hikes, or utility rate increases. Neighborhoods can change for the worse, the local economy can fall apart, or a large employer may close down or move away. Another potential problem area involves dealing with tenants. The landlord-tenant relationship is usually amiable and fair. It is occasionally emo-

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tional or illogical. As a landlord, you accept the risk that some tenants will not be pleasant to work with. This is one feature of real estate that discourages many people from proceeding. If your temperament is inappropriate for dealing with tenants, then you should not buy real estate. At the same time, if the risk of problems can be mitigated by checking references, and if you are willing to go through those steps, then you will increase your chances for a positive, enjoyable, and profitable experience. Key Point: You should be aware of these potential problems, large and small, before you get into real estate investing, but many people find that the positives far outweigh the negatives.

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The Importance of Tax Planning The benefits of real estate are difficult to ignore, and they make a strong case in support of including real estate in your portfolio. Equally important, tax planning requires serious thought and continually looking ahead. Anticipating potential tax-related problems in the future is always a necessary move, not only in managing your investments, but generally as well. Real estate investors need to plan. The obvious reason—to reduce current year tax liabilities—is only one part of the larger picture. Of course, you want to time decisions as much as possible to minimize taxes. The second part has to be kept in mind as well: the limitation on annual deductions. This comes in two forms: dollar amount and your income level.

Annual Dollar Limit The dollar amount is set at $25,000. You can deduct that much per year as long as your family income is at or below $100,000. If you are married but separated, or if you are single, the dollar amount may be lower or it could even disappear completely. So married couples living apart and contemplating divorce need to plan carefully to minimize the tax consequences of divorce when real estate investments are involved. In situations where you believe your tax losses will exceed $25,000, you will have to carry the excess over to future years or to the time you sell your investment property. You can do some planning. For example, you can defer current-year expenses to next year to avoid spending money for deductions you do not need. You can also extend the time you use to depreciate assets, to reduce current-year expenses, and to move deductions to future years.

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Income Level The second consideration is your own income. If your annual adjusted gross income, as calculated for real estate tax purposes, exceeds $100,000, you lose 50 cents in deduction for each dollar above. For example, if your income this year will be $110,000 your ceiling will be reduced by one-half of the income above $100,000. So half of $10,000, or $5,000, is applied against the ceiling of $25,000, and your maximum loss will be reduced to $20,000 for the year. Planning Point: Deferring payment of expenses or extending depreciation until later years makes sense if you cannot take full advantage of those deductions this year. Planning for tax purposes is an essential and important feature of investing in real estate. If you are not thoroughly versed in tax law (including the laws in your state), you should consult with a qualified tax expert and get assistance in planning ahead for tax benefits or the consequences of decisions you make throughout the year.

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Your Credit and Real Estate Investing One important consideration for every real estate investor is often overlooked or not mentioned at all. That is the quality of your personal credit. Because you will be borrowing money to buy rental properties, lenders will be keenly interested in your credit standing. Homeowners, even those with poor credit, can usually find a lender willing to carry a loan. This is because owner-occupied property is very low risk and lenders recognize this fact. In comparison, investment property loans are more likely to be foreclosed. If the demand for rentals falls and investors cannot meet their mortgage obligations, it is possible that the investor will simply walk away from the investment. So lenders are sensitive to the possibility of default on investment property mortgage loans. If an investor’s credit is not impeccable, it will be more difficult to find loans. With the higher-risk levels in mind, lenders require higher down payments for investment property; and lenders may also require higher loan points and other fees, just to offset their higher risks. The standards are higher, and for good reason.

What the Lender Might Require If your credit rating is less than perfect, you may have to meet a series of extra requirements. These could include:

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❑ Higher down payment requirements, so that you have more invested capital at stake, which in turn reduces the likelihood that you will just walk away from the loan obligation if the costs of keeping the property get too high ❑ Higher loan origination and other fees, charged to reduce the lender’s risk of default on your part ❑ Closer scrutiny of financial information and more reporting than usual, so that loan underwriters will be confident that the information you provide is accurate and complete ❑ More appraisal, inspection, and other outside fees, to ensure that the property being financed does not have hidden maintenance costs or is not overvalued ❑ A higher interest rate on the loan itself, due to the higher level of risk to the lender

Income vs. Obligations If your income is too low to qualify for the loan you seek, you will have to put more money down or simply wait until your income level rises. You may also need to start out with a less expensive property so that your income will qualify you for the investment. While different lenders employ many variations of the basic strategy, they all look at the numbers in the same way. They calculate your net monthly income (your take-home pay) and then take a percentage of that as the maximum obligation they will accept for your mortgage payment. (The “obligation” usually includes mortgage principal and interest, property taxes, and insurance.) If the payment goes over that level, the loan will be rejected in its present form. You may need to reduce the obligation by making a larger down payment, for example. When you fill out a loan application, you are required to estimate monthly obligations as well as monthly rental income. A lender is probably going to reduce the estimated income you report to allow for possible vacancies. The degree of adjustment will depend on recent vacancy levels in the area, a statistic that the lender will know or have access to. So your total net income will include your take-home pay, any other income (e.g., from dividends and interest), and rentals (adjusted downward for the vacancy factor). The net total of this calculation is then multiplied by a specific percentage that the lender uses to qualify investment property mortgage loans. If the total obligation exceeds the predetermined percentage of total income, the lender will not approve the loan.

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Key Point: The review of your loan application will be much easier if your credit is excellent. The better your credit, the easier it will be to find acceptable financing. For anyone with poor credit, the flexibility to finance properties, without concern of being rejected, is going to be curtailed. That does not mean it will be impossible to find a loan, but the loan is going to be more expensive and review time is likely to be greater as well.

Getting Preapproval for Your Loan Prospective first-time homeowners can find a lender to prequalify them. Based on his or her income level and credit history, the borrower can find out what level of home the lender can approve. The lender reveals the maximum loan it will grant based on the borrower’s financial information. The preapproval is conditional, because the lender also wants to ensure that the property being purchased is worth what the homeowner intends to pay and that condition is acceptable for lending purposes. Preapproval of a mortgage loan for investment purposes is not quite as easy. Because the equation includes rental income, it will be impossible for the lender to assess the borrower’s overall income and obligation without the specific property in mind. You may be able to find a very conditional preapproval from a lender. The qualifications will include the usual appraisal and condition standards, but will also go beyond that to place a condition on acceptable rental income after deducting an estimated vacancy factor. Assuming that the lender would qualify you on the basis of a comparison between total income and mortgage obligation, you may receive a type of preapproval when your credit is not perfect. At least a lender may be willing to stipulate that your application will be given serious consideration. Some lenders won’t go that far, making it clear that they will not approve loans if your credit is poor, regardless of property value and condition. Poor credit is also the reason lenders are less likely to approve an equity line of credit. Most lenders limit lines of credit to primary residences, although some allow borrowers to take Home Equity Line of Credit (HELOC) contracts on rental properties—but as a rule, this exception will be allowed only if the borrower’s credit is exceptional.

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Maintaining Investment Perspective In every type of investment, you have to keep your perspective. For example, if you buy shares of stock because a stranger on an investment chat

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room tells you its price will go through the roof, you have no one but yourself to blame if you lose money. If you invest because a stockbroker tells you it’s a “good” investment and that turns out not to be true, then it means your trust was misplaced. The same cautionary warnings apply to real estate. Success in investing is the result of thorough research; identification of sound, sensible investments in strong markets; and proper ongoing maintenance. (In the case of stocks, you want to hold shares as long as value is rising and the fundamental strength is high, and then sell when conditions change. In the case of real estate, maintenance means finding the best tenants and then keeping an eye on the property.) There are no easy ways to accumulate wealth. Yes, some people have made fortunes in real estate by buying in the right place at the right time; but it is also true that those people took risks and had to work to acquire and maintain their properties. If you discover that you are simply not satisfied with your investments, you should sell and get out. For a stock investor, this means selling the shares if you spend your nights lying awake and worrying. For a real estate investor, you should not have to dread your telephone ringing, fearing it is a tenant calling with a complaint. If you have to fight every month to get your rent, or if you even worry about the possibility of such problems, then real estate is not right for you.

Risk Tolerance Maintaining your perspective also has to include an ongoing evaluation of long-term goals and your personal risk tolerance. Keeping real estate for the long term should be coordinated with a specific idea that you have about your reasons for wealth accumulation, matched with your expectations for growth in real estate values (all on an after-tax basis, of course, because real estate tax benefits are significant). Risk tolerance has three major aspects when real estate is involved. These are: 1. Tenant Issues. The most important level of risk involves your relationship with tenants. This is far more important than investment value or cash flow. Even if your investment works well on paper, tenants can affect your quality of life—especially if they are giving you trouble. If your experiences are negative, then you have exceeded your risk tolerance. The problem has to be fixed (which may be as easy as replacing a poor tenant with a good one); otherwise, it makes no sense to keep the properties. In the end, the whole experience has to be enjoyable for you.

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Many investors have problem-free relations with tenants; others have not had universally positive experiences. The potential problems vary by area, due to the relative strength of landlord-tenant laws. In some states, tenants have very strong rights, which may lead to abuse of landlords. In those states, you could have great difficulty if you end up with a tenant who does not pay rent, and it could take many months to evict a problem tenant. In other states, the laws are less complex or even favorable to landlords. 2. Market Value. The best-known form of risk involves market value. Is your property value growing? On a month-to-month basis, tenants are expected to pay rent adequate to make your mortgage payment; so over the long term, you should be able to accumulate equity through rents. However, the risk exposure is only worthwhile if property values are rising as well. If market value is not growing, you might consider selling the property and investing in one with more potential. 3. Cash Flow. Of course, you want rental income to cover your mortgage payment and other expenses. An after-tax positive cash flow is desirable, and a prolonged period of negative cash flow can destroy your family’s budget. This form of risk tolerance has to be well managed in order for your investment to work. Offsetting each of these potential forms of risk requires planning on your part.

Dealing with Tenants You reduce the risk involved in having to deal with tenants through proper selection and by checking credit and personal references. The majority of problems faced by landlords can be traced to lax procedures in checking references or misplaced trust. Screening Tenants. If rental demand is high and stable, you will be able to select from among many applicants. When vacancies are low—5 percent or less—you may receive more than a hundred responses to a single newspaper ad. You need to get a written application from tenants. This is the first step in checking whether tenants can provide the basic information you need—employment verification, current landlord’s name, a bank account reference, and monthly salary verified with copies of recent pay stubs. Use a form such as the one shown in Figure 1-1 and require all applicants to complete it.

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Some applicants will fail to fill out the form, meaning that they know they cannot refer you to their landlord, that they do not have a bank account, or that they have no income. Any of these problems disqualify the person based on even a cursory review. Therefore, requiring a written application is a necessary first step. Key Point: Look for applicants who have jobs, a current bank account, a local address, and a record of no evictions. You will discover that people lacking these important features will apply for your vacant rental, even though they have no reasonable expectation of making rent payments. Verification (including calling the person’s employer to confirm income) is essential.

Checking References. The second step is checking all references. The importance of checking references—even when your instincts tell you that all is well—cannot be emphasized too much. Confirm the bank account to make sure it exists and is not currently overdrawn. Call both current and past landlords to determine whether they will provide positive recommendations. If the applicant does not provide you with both landlord references, or if they simply don’t have references to give you, that should disqualify them. For example, if an applicant claims to have been living with his parents, you have no reliable way to determine what kind of tenant he will be. Another potential problem is that the current landlord might be so motivated to get rid of the tenant that the reference will not be objective or accurate. This is why you also need to talk to a past landlord. Also, talk to the employer. Are the reported salary level and dates of employment accurate? You also want to make sure that the individual does in fact have the job and is in good standing. At this stage, you simply want to verify information the applicant has provided to you. There is no way to ensure that employment will continue into the future, and this step is intended only as a fact-checking phase. If the applicant is self-employed, you cannot verify income in the same manner. You will need to get a copy of the person’s bank statement for the past two or three months to ensure that deposits are going into the bank. There is no reason to reject an application just because the applicant is selfemployed; but as with all forms of information, you need to be able to verify what you’re told on the application. Reviewing Credit History. You may want to collect a small fee from the applicant to run a credit check. The cost is usually about $15, although you will need to subscribe to a service and obtain written permission from the

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Figure 1-1. Sample rental application. Rental Application Name____________________________________________________ Date______________________ Property address _____________________________________________________________________ Your current address __________________________________________________________________ Telephone number (home)__________________________________ (work)____________________

Names and relationships of all people who will be living in the property with you: _____________________________________________________________________________________ _____________________________________________________________________________________ Your current landlord’s name ___________________________________________________________ Address _________________________________________________ Telephone __________________ Dates of occupancy (from) _________________________________ (to ) _____________________ Property address _____________________________________________________________________ Reason for leaving ____________________________________________________________________ Your past landlord’s name______________________________________________________________ Address___________________________________________________Telephone__________________ Dates of occupancy (from) ________________________________ (to ) ______________________ Property address ______________________________________________________________________ Reason for leaving ____________________________________________________________________ Your bank___________________________________________Account number __________________ Bank address ________________________________________________________________________ Your employer _______________________________________________________________________ Employer’s address ___________________________________________________________________ Supervisor or manager’s name __________________________________________________________ Telephone____________________________________________________________________________ Monthly income $___________________ per __________________ Years employed _____________

Signature of applicant ________________________Signature of spouse ________________________

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tenant applicant. If the would-be tenant does not provide all the information you need, or is unable to give you verifiable references, look elsewhere. Checking Legal History. It is also easy in most states and counties to check legal history, since it is part of a public record. You can go to the clerk of a municipal or superior court and provide a name to be searched. From this search, you can discover—usually for no fee—whether a person has ever been evicted in that county or convicted of any crimes. Being Alert to Warning Signs. Some tenants cannot afford the rent you are asking. They may try to barter with you for part of the rent by “doing work around the place,” or performing landscaping chores (which is their responsibility already in most cases), or offering to paint the house. These are warning signals. You are probably not going to have a positive experience in hiring tenants in exchange for rent for any purpose. If the tenant cannot afford to pay the full amount of rent, her application should be rejected. Renting Month to Month. If you are unsure of how long you wish to rent to a specific tenant, offer a month-to-month arrangement rather than a lease. The month-to-month option protects you; if the tenant does not pay rent, it is easier to give notice under a month-to-month arrangement. Having a lease gives you a legal contract, but if the tenant is a deadbeat, it is unlikely that you will be able to collect what the person owes you. The month-to-month idea may make more sense. Using a Management Company. You could also hire a management company to deal with tenants directly. This service will cost you a percentage of rents collected, and some management companies are better than others. So, even if you hire a company, you need to check it out beforehand as well. Join a local landlords’ association if there is one and ask other members for referrals to local management companies.

Keeping an Eye on Market Value The best way to reduce the risk of stagnation in market value is with advance research. You should know your local market before you buy. That market includes the recent historical price trends for housing, as well as occupancy trends in rental housing. While current trends are not going to continue forever, you can certainly determine whether current conditions are strong or weak. You want to buy in a market where properties are avail-

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able for attractive prices, but rental demand is high. This is the best of all conditions, especially if the cyclical supply and demand factors are timed in your favor. If real estate prices rise during the time you own the property, you benefit in several ways: from year-to-year tax benefits, tenant-paid mortgages, and good cash flow. What should you do if and when the market softens? The property value itself may go through many cycles over the long term, so you may need to be patient and wait out the cycles. If employment in your city or town is strong and people are moving in instead of leaving the area, demand will continue to grow for property. If current building trends are exceeding demand but economic trends support long-term holding of your real estate, you may need to wait out the market. The situation is far different when the market for rental units goes soft. If there are more rentals in town than there are people wanting them, you could face a more immediate problem: the loss of rental income. If you believe your investment is not growing quickly enough, or if you experience higher than expected vacancies, you should keep open the possibility of selling. There is no sense in remaining invested in real estate or any other market if you are not experiencing strong cash flow and market value growth.

Managing Cash Flow The real test of real estate investments is cash flow. You need to break even at the very least, when you take tax benefits into account. If you have high vacancies, you have to pay mortgage, insurance, taxes, utilities, and maintenance out of pocket, since these expenses are not being covered with rental income. With the tax benefits in place with fully occupied properties, you don’t need the tax write-off you get when properties are vacant. The solution to cash flow problems is based in careful research before you buy. Be sure you know the demand market for rentals, and pick properties whose mortgage payment, taxes, and interest can be covered through rental receipts. Also make sure that vacancies for rental properties are consistently low before you put money into rental investments. Negative cash flow is never a good thing, so you need to take steps to avoid finding yourself paying out more than you are bringing in.

Doing Research and Advance Planning The nature of real estate investing includes the many benefits as well as risk. Dealing with tenants, keeping an eye on market value, and managing cash flow are all easily handled when you select properties and tenants well. In

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each case, advance research and investigation do the most to reduce or eliminate risk. Always begin by picking properties in strong, healthy markets—that is the essence of sound investing of any type. Stockholders want to pick strong companies whose stock rises consistently through the years. Real estate investors desire strong market demand as well as strong rental demand. Doing your research ahead of time—before committing funds and before signing a rental agreement with a tenant—is really the most important step for anyone contemplating real estate investment. By avoiding problems before they arise, your overall experience will be both positive and profitable.

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C H A P T E R

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Getting Started in Rental Real Estate There is no single way to invest in real estate . Just as the stock market offers a rich variety of methods for the flexible investor, real estate can also be approached in a number of different ways. You can distinguish between types of property, for example, with each having its own supply and demand features. In some cases, one type of property will have very strong demand whereas another may be soft. Consider a situation in which a large portion of the local population consists of college students (creating a strong demand for multi-unit housing), but at the same time, there is very little retail trade or manufacturing in the area (causing a soft market for commercial and industrial property). Real estate, like the stock market, can be set up according to the type of investment you want and the level of risk you’re willing to accept. Every investment has attributes; these attributes define income opportunity as well as risk. Before deciding whether to invest in real estate, you should examine the positive and negative attributes in order to evaluate opportunity and risk—just as you would do with any form of investing. ■

Location, Logistics, and Limitations According to an old adage, the three most important attributes of real estate are location, location, and location. Actually, it might better be restated as location, logistics, and limitations. These are the three attributes that make real estate a sound investment.

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1. Location, of course, is the central defining element of a “good” real estate investment. The vast difference in land values between 400 acres of Texas scrubland and a quarter acre in downtown Dallas make this point. Whereas the scrubland is virtually valueless, the location of the urban land creates a demand that drives up its value. 2. Logistics is the second defining attribute. It does not matter how desirable land is in terms of its size, topography, and vegetation if it is not logistically viable as an investment. This means that you need services— roads, utilities, and public services—to ensure that the land will grow in value. You cannot build a house in the middle of an area that does not have access to needed services. The logistics dictate that such a property is not a practical investment. 3. Limitations are the third attribute that defines investment value. In areas such as Manhattan, San Francisco, and Tampa Bay, the proximity of land to water naturally limits how much development can occur. There is a limitation on the amount of land. As a result, land becomes increasingly valuable as more demand for improvements comes into play. When the land has been fully developed, further construction has to move upward, or prices simply rise in response to the situation: The limitation of land means the supply is not enough to meet the demand, so land values rise. Other Considerations: There are many additional aspects to real estate investing, of course. You also need to consider tax advantages; limitations of capital to invest; and the unavoidable aspect of dealing with tenants, lenders, and local economic changes that could lead to vacancies. Real estate investment requires careful planning. In turn, planning demands that investors understand how to keep accurate records, plan ahead for taxes, and make the right decisions today to protect the value of their investments, possibly for many years to come.

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Financial Planning The decision to become a real estate investor is usually made as part of a larger personal financial plan. Many considerations have to be involved: available capital, family income, comfort levels with owning real estate and carrying a large dollar amount of debt, other assets (e.g., stocks, retirement accounts, and savings), and long-term goals. Once you decide that you want to include investment real estate in your financial plan, you also accept the attributes that go along with your decision. The financial planning considerations include:

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❑ Capital Limitations. If you have little or no money to invest, real estate will not be a serious prospective market for you. Because of the inherent risks of cash flow and debt financing, you will be in better shape when you have savings and adequate other investments available. Few people would seriously consider beginning a real estate investment plan without first establishing more liquid investments. As a practical matter, it is most difficult to begin a real estate investment plan until you have adequate capital resources. Whether those resources are acquired through inheritance, savings, sound investment strategies, or other means, they are essential. Some investors are unwilling to face the reality and to acknowledge the potential problems of getting into real estate before they are ready. The tendency is to limit the question to having enough cash for a down payment; but the problem of capital limitation is far more complex. If you don’t have any cash reserves or income available to cover a month or two of expenses when no rent is coming in, then the risks of rental real estate are too high. If you cannot qualify for a mortgage loan because you lack assets as well as a high enough level of income, then there is no point in pursuing creative alternatives to overcome the financial limitations. The risks are real. The best choice is to wait until you are better situated and put real estate aside for the moment.

❑ Family Income. You need to balance all investment programs with your personal income level. Of course, someone earning a very low monthly wage would not be able to qualify for the mortgage loans needed to begin a real estate investment program. Family income, if too low, would preclude your being able to qualify for loans. Of equal importance, when you live on a tight budget, you cannot afford to carry a large debt whose payments depend on rent payments by tenants. In that situation, two or three months’ vacancies could destroy the family budget. The level of family income has to dictate the types of investments appropriate for you for all of these reasons. In analyzing future income, you want to consider likely salary raises or higher income derived from changing a career, getting an advanced education degree, or pursuing other opportunities. You should also consider changes such as alimony (which may be received today but will cease at a known date in the future) and the potential for loss of half your family income in the event of divorce, disability, or the death of a spouse. In analyzing likely changes to family income, the financial-planning process usually includes insurance. If your budget depends on a spouse’s income, that spouse should be insured. The primary earner should definitely be car-

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rying life insurance and, possibly, disability insurance as well. Health insurance should be carried on both spouses as well as children.

❑ Personal Risk Tolerance. In any type of investment, the program has to be a good fit for your risk tolerance level. This is the amount and degree of risk that you can afford to live with—and that you are comfortable taking on. There is an inescapable relationship between risk level and potential profit. The greater the risk, the greater the opportunity for price movement. So a very volatile stock may gain or lose many points in market value on a daily basis, but can you afford to live with the associated risk? Real estate, if well selected in a strong market, is likely to rise slowly but steadily in value over many years, but the market risks are fairly low. So, in trying to match investment decisions to personal risk, you need to know the risk attributes of the market first, and then match those attributes to your financial goals.

❑ Debt Tolerance. Another tolerance level involves debt. Real estate investors are usually in debt for the majority of the investment value of their properties. Some people are completely comfortable carrying large debts and depending on tenant receipts to make mortgage payments on time. Other people worry continually about what might happen if they could not afford to keep up payments. If an individual worries about these potential problems, real estate is not a good choice. Debt tolerance describes your ability to live with debt itself. Another way to look at debt tolerance involves overall credit and debt levels. For example, if you are carrying so much debt on your personal residence and other investment properties, you may have difficulty qualifying for credit elsewhere. Your ability to buy a new car, increase the limit on your credit cards, get a home equity line of credit, or gain approval for a retail credit line may be limited if you are already carrying the maximum level of debt you can handle, given your income.

❑ Asset Balance. The concepts of diversification and allocation have to be part of your financial plan. The defining attributes of risk and debt tolerance result in mandating how and where to invest available capital, the level of capital in each market that seems appropriate, and whether you should be using leverage. If you determine in studying asset balance that it would be proper to leverage your capital, you will also have to determine how much leverage is appropriate. The higher the leverage, the higher your profit potential—and the higher your risk.

❑ Long-Term Goals. The central purpose in going through the financialplanning process is to identify specific personal and family goals, then

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identify ways to get there and structure the decision within a framework of risk tolerance. Your goals in thinking about buying real estate may include hedging inflation, saving for retirement or financial independence, or simply being active in a market you believe will grow substantially in the future. Goals are going to vary from one person to another, so it is rarely safe to just assume that advice given to you by a stranger applies to you, especially if that individual does not know a) your experience, b) your risk tolerance levels, c) your annual income and financial resources, or d) your personal goals. Your personal goals are also going to change, sometimes drastically, when you experience a major life change: marriage, the birth of a child, a career change, the loss of a job, divorce, illness, or death. All of these events also change all of the aspects of your financial plan: allocation of assets; need for cash; available capital; income level; risk tolerance and debt tolerance levels; need for insurance (and levels of coverage); and, in some cases, your entire point of view about the process of investing and planning.

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The Commercial Property Market The market for commercial property has to be reviewed on a different standard than the market for residential property. Even when demand for housing is high, that demand does not necessarily translate to an equally strong demand for commercial rentals. You may have experienced this discrepancy in your own town. It often happens that a downtown area has many vacant properties whereas nearby shopping malls are fully occupied and doing a robust business. In commercial real estate, locational trends often are more important than areawide demand. If most people in your area shop at the mall, the downtown area could be a ghost town. So, if you review demand for commercial space on an areawide basis, it might not reflect these differences. It is unlikely that you will be able to acquire an equity interest in a mall, which is probably financed through a partnership, a corporate entity, or an investment trust. Therefore, your choices of directly owned real estate will be limited to other areas. Clearly, if the downtown commercial area is suffering from locational problems, it would not make sense to buy investment property in that area—even though the prices could be quite attractive. One possibility for commercial space may be found in an industrial park, which may include commercial and retail properties. It is possible to locate commercial investments that will be more affordable than a multi-acre shopping mall by look-

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ing at buildings outside of the downtown area. The trend toward mall shopping is not universal, either. Depending on where you live, it may be practical to look for commercial properties in the center of town. Areas too small to support a shopping mall often have a healthy retail economy because highways run through the downtown area or because malls exist nearby.

Evaluating Commercial Property Commercial property valuation may be more difficult than it would appear at first. In the most simplified form of evaluation, the comparison is made between supply of property and demand for space. For example, merchants want to locate on desirable streets with plenty of parking and foot traffic; that drives up rents in the area, so commercial property values are higher. Another example: A once-robust street benefited because a state highway went right by the stores. But when a bypass was constructed, traffic dried up and values of commercial properties have now fallen. Even with these obvious examples, the comparison between supply and demand is complex. Additional market forces might be at play as well. For example, a community located on either a state border or a border with Mexico or Canada might be valued based on cross-border considerations. Oregon has no sales tax, so buyers from adjacent Washington add to the volume of Portland-area commercial activity. If Washington appealed its sales tax or Oregon added one, there would be an immediate change in the mix of commercial supply and buyer demand. In the case of the international border, monetary exchange has a significant impact on commercial activity and value. As long as the Canadian dollar is weaker than the U.S. dollar, the cross-border trade trends have an impact on both sides of the border. Valuation of commercial property has to be made on a basis entirely separate from the basis used for other types of property. Demand for residential housing depends on employment and population trends, whereas commercial property value is affected to some degree by local, state, federal, and international tax policy and monetary exchange; therefore, proximity to dissimilar economic areas (states or other countries) is an important factor in value. Economic cyclical change also affects the whole picture. A commercial property is valued based on existing economic circumstances, but subtle changes outside of the immediate area can affect valuation. Outside Factors. As an example, a community whose revenue is derived largely from tourism may suffer big losses in retail trade due to national economic conditions, political turmoil, and other outside causes. The effect on commercial values, even if temporary, is very real. It’s even possible that

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commercial values could be more volatile than comparable values in communities that are more self-sustained. For example, an antique store located in Niagara Falls is likely to be more vulnerable to economic change than one carrying the same items in Omaha, Nebraska, or Philadelphia. Basis for Valuation. Another important difference in valuation between residential and commercial properties is the basis for valuation itself. Appraisal of residential property is usually done on the replacement or cost basis. The appraiser finds comparably sized homes with similar features, located in similar neighborhoods, then makes needed adjustments to arrive at an approximation of value. However, commercial property valuation has to take different factors into account. A well-constructed building has little commercial value if a highway bypass keeps traffic away, whereas a poorly constructed, outdated building located right in the middle of vehicular and pedestrian traffic lanes will have a higher value than property located a few blocks away. Key Point: Investors in commercial property cannot depend on residential criteria for selection and valuation. They need to have, or to hire, expertise that can be used to set value based on income generation potential, local trends, and economic or political or cyclical factors, if applicable, that will affect a property’s value.

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The Residential Property Market Residential property, in comparison to commercial property, is usually the preferred starting point for investors. Understanding the commercial market, valuation of property, and demand features may be too complex (and the risk factors too high) for the beginning real estate investor. Most people more easily understand residential property. Buying a house or duplex as a starting point is often a more comfortable choice. Important: Assessing the demand features of real estate in terms of the need for rentals (versus the separate market controlling price trends in housing) is the key to selecting properties in the right place.

Demand may vary within a single community as well as from one area to another. Many tenants need to be close to public transportation and shopping. Students prefer to be close to their college or university. Elderly or low-income families prefer housing close to public facilities and local

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assistance offices. Consequently, properties in more remote areas of town may experience greater vacancies than those closer to the conveniences that the mix of tenants finds desirable.

The Many Aspects of Location Location is not limited to the city or town alone; it may also vary by proximity within a city or even within a fairly small town. Most experienced real estate investors have discovered that it is easier to pick properties wisely if they are intimately familiar with these subtle but important distinctions. Demand can be lower than average just because a specific property is a mile away from the closest bus line, school, or shopping center. A property that is well located in terms of conveniences is likely to remain occupied at a higher rate; when markets begin to soften, the better-situated properties tend to stay occupied longer. In addition, location will also affect market rent levels, so that property will produce better cash flow as well. The point is, you may think of “location” as having several aspects. Regional. In the broadest sense, location refers to the region of the country—a specific city, town, or even a state. In fact, national statistics break down trends in residential real estate values by regions in that manner: Northeast, Midwest, Northwest, etc. The broadly defined location is of little value in picking properties. Just as stock indexes reveal overall trends in the stock market, national and regional real estate trends provide an average view; but averages consist of strong and weak markets, collectively. City to City. When we get down to more localized definitions of location, we can study real estate from city to city. If you have studied the market at all, you already know that values can and do vary significantly from town to town. Two cities, one next to the other, may have vastly different markets. One city may have consistently strong growth and property value trends, whereas the other is stagnant. Subtle differences in economic conditions or the political environment can make a big difference even when geography is not great. One city may be governed by a council that encourages employment and new housing, and its real estate market is likely to be robust. Another may not encourage new employment or building, so that people move away and there is no reason to expect real estate prices to grow. A lack of demand—generated from employment growth and the related population growth—means there is no real market for housing, so there is no reason to expect growth at any time in the near future, either.

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Neighborhoods. Location can be even more finely defined. Within one city or town, certain areas are thought to be more desirable than others. Older, more established neighborhoods, those with their own grocery stores and other outlets, on quiet streets, will bring higher prices, and their market value will outpace the local averages. Homes located near highways, in high-crime neighborhoods, or close to downtown congestion or noise are going to grow at a slower pace. Individual Houses. In addition, you can look at two houses in the same neighborhood and see considerable differences in value. Consider two houses only one block apart: One house is on a very busy thoroughfare and directly across the street from a school. Every morning and afternoon, dozens of buses and cars fill the street. During the recess and lunch periods, you can hear the sounds of children playing. The older children walk by the house, so lawns often are littered. The second house is one block away from the school, noise, congestion, and littering problem. While both of these houses are identical, the second house—because it is one block removed from the problems—will grow in value faster than the one on the busy street in the school zone. Other Houses in the Area. The houses next to the house you’re thinking of buying also affect value. If they are well maintained and the neighborhood has a consistently high level of cosmetic maintenance, then your house will benefit. By the same argument, if neighbors do not care for their properties, that will hold down value in your investment property. Owner-occupied housing tends to increase in value more than rental properties. With this in mind, it is strategically wise to invest in singlefamily properties in largely owner-occupied areas. That factor, a subtle interpretation of “location,” will help maintain your property’s value in line with the larger neighborhood trend. As long as you keep your property in good shape, it is likely to grow in conformity with other homes. In comparison, if you buy a property in an area characterized by other rentals, market growth is likely to be lower than it would be in neighborhoods with a majority of owner-occupied houses. Key Point: The location factor cannot be overlooked in the property study. It determines the ultimate value of the investment. Just as one stock will outperform other stocks in the same business sector for a variety of specific reasons, one house will perform better for you because of its location, condition, and neighborhood.

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These observations are general rules of thumb. They do not dictate all markets, and you will find that every situation is unique. Real estate is truly a local investment that is affected not by national averages but by what is going on right there in town: employment, population demographics and trends, crime levels, transportation, shopping, and condition of the property and neighborhood. All of these factors affect long-term investment value, rental demand, and the likely occupancy and vacancy rates.

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Direct Ownership of Rental Property The best-known and most popular form of real estate investment is direct ownership. This normally involves financing the major portion of the purchase and paying the mortgage with rental income. This traditional approach is appealing to most investors—as long as rents continue to cover the cash flow demands—because it also involves favorable tax benefits (see Chapter 9). Lenders are likely to apply much higher standards when you invest than when you buy a home and occupy it yourself. These standards apply to credit history, income, down payment requirements, and debt-to-value ratio. When you buy your own home, you can normally finance 90 percent of the purchase price and sometimes even more. Veteran’s Administration (VA) and Federal Housing Administration (FHA) loans, for example, often allow you to finance practically the entire purchase price. For nonoccupied housing or for commercial property, you may be required to pay a higher interest rate and come up with a higher down payment as well. The most practical way to begin investing in income-producing real estate is through direct ownership of a single property. Most people start out buying a single unit or duplex because residential real estate offers the highest and most diverse level of demand; everyone needs a place to live, so there is a continual need for housing. Affordability also affects the decision to start in residential real estate. Houses are often cheaper than commercial or industrial properties, and raw land does not generate income.

Advantages of Direct Control While there are other ways to invest money in real estate, direct ownership has the greatest appeal. Stockholders own equity in a public company, but they have no real control. The ownership of a small fraction of stock provides the potential for appreciation in market value and dividend income, and stockholders have the right to vote on certain decisions, but they have

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no say in the day-to-day operations of the corporation. In comparison, when you own rental property, you do have direct control. You maintain the house by keeping the roof, landscaping, and internal systems in good repair; selecting responsible tenants; paying for homeowner’s insurance; and keeping an eye on the property itself. You determine whether to paint the house a different color, add structural improvements, or refinance the mortgage to take out equity. In other words, the management of the investment is in your hands. For the purpose of market value, appreciation depends to an extent on local supply and demand as well as the three L’s (location, logistics, limitations). Yet, to an equal degree, the value of the investment also depends on your individual effort in keeping the property in shape, well maintained, and properly cared for.

Handling Problems As a real estate investor, direct control also means that you need to deal with both expected and unexpected problems as they arise. The mortgage payment has to be made on time every month, even if your tenant does not pay rent or, equally troubling, if your property is vacant. The heating system breaks down, the roof begins to leak, or you discover an infestation of termites or ants. All of these expensive problems—none of which will be covered by your insurance—cannot be planned for, but they all occur. If you own your own home, you already know that maintenance never ends; it only pauses for a few months. Build a Reserve: When you invest in rental property, you want rental income to be consistent and adequate to cover your mortgage payment—and it is wise to also establish a reserve fund for repairs.

Minimizing Maintenance If you purchase a newly built home to use as an income property, you should not experience any expensive repairs for several years. Properties go through maintenance cycles, and the first cycle tends to arrive about seven years after a house is built. To avoid the more expensive repairs, then, you could buy new homes and sell them after six years. Of course, this is not always a practical strategy. It may not be possible to afford new homes for investment, especially if older homes in your area are available for less money. You also cannot control the real estate cycle. Demand for housing could be low in six years when you would like to sell. You cannot control

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supply and demand, so the plan of timing investments to avoid unexpected maintenance costs is probably not practical.

Choosing Properties Carefully On balance, the advantages of direct control outweigh the problems if you select properties carefully. This requires that you inspect the properties and critically check their condition. For older homes especially, it is worth requiring an independent home inspection as part of the buying process. A qualified and independent inspector prepares a written report and has to disclose the condition of all systems in the property. If maintenance is needed, you can require it to be performed as a condition of buying the property. This protects you from the shock of unknown and expensive repairs you’d otherwise need to perform only a few months after you buy the property. Important Resource: The American Society of Home Inspectors (ASHI) licenses individuals to perform professional home inspections and to guarantee their findings. To locate a licensed inspector, contact ASHI online at www.ashi.com or by telephone at 800-743-ASHI.

Once you have ensured that properties do not have any hidden flaws, you are able to eliminate the potential problem of buying properties only to discover that they need expensive repairs. This reduces your risk, at least in the immediate future. You should recognize, however, that properties do need ongoing maintenance, and this fact should be considered in evaluating the entire idea of investing in rental properties, especially for the long term.

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Financing Your Rental Investment Few people have enough cash available to buy properties outright, so they have to borrow the money, which means they purchase rental real estate with a mortgage. The selection of a competitive mortgage and terms will determine the long-term cost, because a fractional change in interest adds up over the years. Here are some guidelines worth remembering when you finance or refinance your investment property, as compared to the same rules for your residence:

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❑ Lenders apply a different standard to investor qualification. Homeowners with excellent credit and strong income can usually find attractive terms—low rates and low down payments. However, when you buy investment property, you are expected to pay a higher interest rate. Since the property will not be owner occupied, lenders will view the mortgage loan as having greater risks. ❑ Down payment requirements may be higher. Lenders usually expect investors to pay more down for their properties than they would ask of homeowners. For example, you might be able to locate an 80 percent or 90 percent loan for your own home (and sometimes even 100 percent). With rental property, some lenders are going to demand 30 percent as a down payment. As a general rule, if lenders will grant a mortgage for less down, they will also expect a higher interest rate. ❑ You may need to seek nonconventional financing sources. You may find the best rates by shopping online for a mortgage. A simple Internet search under “mortgage” will reveal dozens of sources for mortgage loans, with competitive rates. You can narrow down the market for nonowner-occupied financing, but even then you will find that the traditional sources often exclude you if you want to borrow money for rental investments. You may consider private sources or even looking for seller financing. (Be careful, however. If a seller offers to carry the loan, that could mean the property has defects that need to be fixed. Such defects would become your problem if you buy the property.) ❑ You may not be allowed to remove cash upon refinancing. Typically, homeowners can refinance their loans when rates go down and even take out cash because their equity has increased. With rental real estate, many lenders will not allow you to remove cash upon refinancing, even if the equity is there. This more conservative policy reflects the perception that nonowner-occupied property presents greater risks for lenders. ❑ It will be more difficult to find lines of credit. Homeowners can find equity lines of credit, which are excellent alternatives to refinancing. They can draw on the credit when they need to, borrowing only as much as they need and then paying down the debt when they can afford to. In fact, some lenders allow homeowners to take out an equity line of credit up to 100 percent of their equity and, in some instances, even more. For investors, however, it is more difficult. Most conventional lenders restrict their lines of credit only to owner-occupied housing. You may be able to find such a line of credit, but it will require some research.

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Understanding Lending Rule Restrictions Rules for conventional financing are restrictive because lenders themselves have to meet specific rules. Most loans are not kept by the original lender but are resold to the secondary market. Even if lenders continue to service a loan (i.e., collecting payments and impounds), the debt itself usually ends up being sold to an organization such as the Government National Mortgage Association (GNMA), also known as Ginnie Mae, or the Federal National Mortgage Association (FNMA), or Fannie Mae. Mortgages are pooled together and shares are then sold to investors. With this secondary market dictating terms for mortgage loans, it is not always up to the lender whether to grant your loan. If the lender intends to sell your mortgage debt on the secondary market, the specific terms have to be met. These terms relate to credit rating, interest rate, down payment, and type of property. Key Point: The lowest risk—from a lender’s point of view—is a loan granted on an owner-occupied house, with a large down payment, and with a borrower whose credit is excellent. Not everyone meets all of these conditions, so varying degrees of approval are possible. The higher the risk, the higher the interest rate will be, and the more down payment you’ll be required to deposit.

Homeowners borrowing for their primary residence can make little or no down payment and, quite often, get financing with little trouble. Investors will have more difficulty financing properties at a level of 80 percent to 90 percent. Whenever your equity in the property is less than 20 percent, you are going to be required to carry a form of mortgage insurance designed to pay the lender in case you default. So, even though you are required to make a larger down payment, you also escape having to pay expensive insurance in addition to the fire and casualty insurance you have to carry on the property.

Starting with Your Primary Residence Some landlords have figured out that they can simplify the approval process by getting loans on their primary residence rather than trying to meet the higher standards of investment property. For example, if you currently live in a house and you’d like to begin an investment program, one solution is to locate a new primary residence and go for financing based on your plans to move into the new property. As soon as the transaction is complete, you move into the new home and convert your current residence

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into a rental. You will be able to continue making the same mortgage payments on your current home (which was financed originally based on your occupying the property as your primary residence) and rent the property out. It is entirely possible to accumulate a series of rental properties by simply moving into a series of new owner-occupied homes as the timing and your own financial situation dictate. The only requirement on the part of conventional lenders is that the property being financed must be your primary residence at the time the loan is approved. In theory, you could change your mind the day after the loan was approved and convert the new property to a rental. But this could be interpreted as making a false claim on your loan application. It is safer and wiser to move into the new home and convert your current primary residence to a rental as a bona fide change of status, even if only for a few months. The decision to treat a specific property as a rental or as your primary residence should be based on practical considerations. If you ask your family to move to a property that is poorly located, too small for your needs, or too uncomfortable, then you are risking personal dissatisfaction and conflict at home. One advantage of moving to a series of acquired new homes is that you apply the same standards to rentals that you apply to your own home. If you have maintained your current primary residence well, it will be a pleasant place to live; a tenant will be willing to pay a reasonable level of rent based on how well you have cared for the property. Important: The suggestion that investors can perpetually finance properties as primary residences and move from one property to another should be viewed cautiously. You should plan to actually move into the new property in order to avoid being accused of misleading your lender. Once you have completed the transaction, the lender will be satisfied, especially if you continue making timely mortgage payments. When you are established in the new property and you convert your previous residence to a rental, the lender on that home will not care whether you live there—as long as you keep the property insured and as long as the payments continue arriving on time.

Getting the Best Deal As a general rule, you have to expect to do more work and meet a higher standard to finance your real estate investment. At the same time, you also want to shop for the best possible deal. Look for a loan with the lowest possible up-front costs. Loan origination fees (points) are charged as an alternative to higher interest rates. A point is equal to one percent of the loan.

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For example, if you are borrowing $100,000, each point will cost you $1,000. That can add up. It makes a comparison between two different loans more difficult. If one lender charges 6 percent and no points, and another charges 5 percent and three points, which is cheaper? The only way to make a valid comparison is to calculate the overall interest payments over the terms of the loan, plus points. This is an easy calculation involving three steps: 1. Multiply the monthly payment by the number of months in the loan term. 2. Subtract the amount being borrowed. (The remaining dollar amount is total interest.) 3. Add the points the lender wants to charge you. (The result is overall interest. Once calculated, you can determine whether one loan is going to be a better deal than another, or a worse one.) When you study the overall interest expense of mortgaging a property, you soon realize that the cost of the investment is not limited to the sales price. You will pay far more in interest over thirty years than the original price of the property. So investigating beforehand and finding the best deal is more important than finding a house that costs a few thousand dollars less. Basing the comparison on overall costs, you can save more money by finding the best interest rate deal than you would in trying to save a few dollars on the purchase price. If you get a “good deal” in your price but pay too much for interest, you will be spending more in the long run. Key Point: You must make your mortgage payments whether you have paying tenants or not. You can readily see that vacancies—especially long-term vacancies—could be a big problem. The “cash flow risk” of real estate can be very significant unless you are able to locate a market in which vacancies are extremely low (e.g., less than 5 percent on average). Before deciding to become a real estate investor, you need to research the local market in terms of prices, rental demand, and the current pattern of value appreciation.

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Investing in Residential Real Estate Why is residential property the most popular form of real estate investment? There is more demand for this type of property than for any other as an investment. Of course, the American Dream is home ownership, so the majority of today’s tenants would like to buy a home one day.

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Single-Family Homes This desire for home ownership helps to strengthen the market value of single-family rental investments. The home you rent out today will be someone else’s primary residence at some point in the future. The single-family home is also desirable because tenants who can afford the rent can have a yard and garden; it is a better environment for children than apartment living; and if the landlord allows it, they can have a pet. Note: If rental demand is relatively low in your area, allowing tenants with a cat or a small dog could push your property to the top of the list—especially if the majority of housing forbids pets. Even with these reasons in mind, however, the fact remains that real estate has increased consistently in market value over many years. National averages reveal a steady increase in the sales prices of new homes. Figure 2-1 summarizes the growth rates since 1989. Note that these are averages. There is no guarantee that prices are going to go up everywhere or at the same rate. But if we assume that a) you research the market before you buy, b) you conclude that the market is strong and growing, and c) you select properties carefully, then you have a

Figure 2-1. Average sales prices, new homes.

SOURCE: National Association of Realtors

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promising start. Real estate does grow in value over time, and it combines the best features of taxation, risk, and market value. Mobile Homes. Mobile homes are an alternative form of investment. However, they are not really comparable to permanent housing. Mobile homes, by definition, are personal property and not real property. If you invest in a mobile home, its value is going to decline over the time you own it, just as a car’s value declines. If you buy the land where the mobile home is situated, it is possible that land values will grow. Some investors have discovered this as an alternative to buying more expensive houses. They buy the land and then place a mobile home, renting it out. Over a period of years, the payments for both land and mobile home are covered by rent. Ultimately, the investor owns the land free and clear and can either continue renting out the mobile home, or sell it and use the land for other purposes—to build a permanent home or sell the land at a profit, for example. Condominiums. Another way to go is through purchasing a condominium unit and renting it out. A condo might seem cheaper at first glance, but it could end up being more expensive than direct ownership. When monthly association fees are added to your mortgage payment, the overall expense adds up to much more than it would be to simply buy a home. Using a loan payment table, find the total payment and you will see what you could have afforded if you had purchased a single-family home. The total of payments would buy much more house than you could afford paying mortgage plus fees for the condo. Co-ops. Finally, a cooperative unit might be convertible to a rental. However, co-op owner associations tend to be more restrictive than typical condo or planned-unit associations. The rules of the co-op housing association might prevent you from renting out your unit. So you need to check the sublet policy before buying a co-op. Key Point: Condos and co-ops have historically grown in value, but they have not kept pace with the rate of growth in single-family housing. For most first-time investors, the single-family home is by far the best and safest method for getting into real estate investing for the first time.

Multiple-Unit Housing A two- or three-unit building is similar to a single-family house because it may also have a yard and other homelike features. At the same time, it

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shares features with apartments, such as lower rents than single-family housing, shared utility costs, and less privacy. So there is a trade-off among the different types of housing. From the investment point of view, a duplex or triplex is likely to produce far better cash flow than single-family housing yet still attract tenants who want some of the features associated with a house as opposed to an apartment. Many tenants express a desire to have a garden, for example. (Some never get around to planting anything, but if they have been living in an apartment, they see houses or duplexes as providing them more flexibility.) For people who cannot afford to buy a house, renting a duplex or triplex is a reasonable compromise. These units are affordable (rents are usually more than an apartment but less than a house) yet offer many features of home ownership. In a market with varying or weakening demand, duplex or triplex units are likely to have less vacancy than apartments (because of the desirable features they provide) or single-family housing (because of the higher cost of renting the entire house).

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Two Essential Factors to Consider When you begin comparing one type of housing to another, you need to keep two separate investment considerations in mind. First is the long-term market value of the investment itself, and second is the more immediate rental demand and cash flow question.

Long-Term Property Values How will your rental increase in value over time? Based on historical averages, single-family housing tends to increase in value more than multi-family units and other types of rental properties. Single-family houses are likely to be the most profitable long-term investment based on the averages. If properties are growing in value in your area, buying single-family rentals makes sense. You pay your costs by collecting rents, and you can wait out the market. When values are far higher than they are today, you can sell at a profit. Because rents tend to increase over time due to local cost-of-living trends, your mortgage cost is fixed (if you obtain a fixed-rate loan) or the costs are limited (in a variable-rate loan, the rate cap will limit the interest rate increases over time). So as a long-term investment, single-family houses are likely to increase in value more favorably than other properties.

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If we study mortgage costs, we realize that most of the payments go to interest in the early years. A thirty-year mortgage, for example, is only half paid by the twenty-fourth year; the other half gets paid off more rapidly in the last six years. At first glance, this looks like bad news. How can your investment appreciate if you are paying so little to decrease the mortgage debt? As a homeowner, the argument does apply. You gain very little in equity from paying down your loan during the first few years you own your home. The average homeowner moves within five years from the time of purchasing a first home, so almost no equity is accumulated through payments. As an investor, you have to keep three points in mind: 1. You claim interest expense as a deduction on your tax return. As an investor, you are allowed to deduct all of your interest as an expense— in addition to property taxes, utilities, depreciation, and other expenses. So payments of interest shelter rental income and produce net losses rather than taxable gains. The deduction of interest is an attractive benefit, effectively reducing your “real cost” of the mortgage. For example, if your federal and state combined effective tax rate is 40 percent, then an $800 monthly interest expense is reduced to $480 after taxes (because you reduce your personal tax liability by $320, or 40 percent of the total interest expense). 2. Mortgage payments are made for you by tenants. Even though you collect rents and then make your own mortgage payment, you can look at the situation a little differently: Rent receipts are used to pay your mortgage payment. In this regard, the fact that most of your payment goes to interest does not really matter because it is paid for you. In practical terms, you are always better off paying less interest, meaning your loan gets paid down more rapidly and your cash flow improves. However, with the offset between interest expense and rental income, the high cost of borrowing money is not as much of an issue as it would be without that income. 3. Appreciation occurs from market price changes. It is a mistake to assume that you accumulate equity only by paying down your mortgage loan. In fact, there is far more appreciation potential in market value growth. In some areas, that growth has been extraordinary, with multiple-year double-digit growth in market prices of homes. In other areas, prices move more slowly or, in some cases, fall. Well-selected real estate is going to grow in value as long as the local economy is vibrant and jobs are available so that people are moving in instead of moving out. The

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longer you hold investment property in these circumstances, the greater the market appreciation is likely to be.

Current Demand for Rentals Growth in market value has been impressive historically. However, the second investment consideration—rental demand—could be far more important in the month-to-month evaluation of your investment properties. You want to acquire properties that will pay for themselves in terms of rental income versus mortgage payments, property taxes, insurance, utilities, and other expenses. If you cannot make cash flow work, you will have an unending cash flow problem. A vacancy for a few months will have a similar negative impact on your personal finances, so cash flow risk is a serious matter for every real estate investor. This is why the question of cash flow (see Chapter 3) should be more important than long-term market value. Vacancy Rates. Real estate investors are keenly aware that vacancy rates affect your ability to make the investment program work. If you have chronic vacancies, it means that you are asking too much in rent or that the area has more supply than demand. This is a troubling problem if it occurs, because it makes real estate investing far less practical. Unless you can afford to carry the mortgage debt without a full year’s rental income, you could be in big trouble. The more properties you own, the more severe the vacancy problem would become. Key Point: Before beginning your investment plan, investigate vacancy trends. Also look at current and planned new construction. If hundreds of new apartment or modest housing units are going to be built during the next year or two, what does that mean for the prospect of vacancies? The threat has to be taken seriously, especially if vacancies are already high in your city or town.

To investigate trends in vacancy, check with a real estate broker or loan officer at your bank. Both have access to updated information about housing and should know the current vacancy rates. More important, they have statistics on rental and vacancy trends, including average rents for housing of certain sizes and features, often broken down by neighborhood. The trend is important because you can track how the situation is changing over time. For example, if vacancy rates have been low but have increased lately, what is the cause? Are more units being built or are people moving away?

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How does the vacancy rate compare with the local employment rate? These are critical questions that define whether the timing for starting a real estate investment plan is good or bad. The real estate agent, whether using local Multiple Listing Service (MLS) data or consulting with an in-house rental specialist, should be able to advise you on the significance of the trend. What if vacancy rates are low or decreasing? At first glance, this would seem to indicate a positive environment for you to begin buying rental housing. It is wise to check with your planning department and local economic or community groups and investigate the situation a little further. Are new construction plans going to change the picture? Are new employers coming to town, or are established employers closing up shop and going elsewhere? A sudden, large layoff and resulting unemployment can turn a good historical vacancy trend into a disaster. So while you need to have a grasp on what is occurring in your local building, you also need to be informed of employment and population statistics. Additional help in getting statistics for real estate vacancy trends can be found in a local landlord’s association, if there is one in your community. Also, check with the chamber of commerce and any local tenants’ organizations or rental referral services. (Incidentally, if you register with referral services, you will get many free tenant referrals, as an alternative to paying for an ad in your local paper.) The tenant referral service makes its money by charging people a fee in exchange for a list of local apartments and houses available for rent. These agencies have a very good idea of vacancy levels, because they experience both supply and demand and are aware when one side or the other moves. Cash Flow vs. Investment Value. Cash flow is definitely affected by the vacancy rate. The “market” is not a singular concept. It includes the housing value market, or the prices people pay for homes. It also includes the demand for housing units, which operates on separate assumptions and does not always move in the same direction as housing prices. With this in mind, the compromise of investing in a duplex or triplex could make sense. Even though the long-term market value for these multi-unit properties may not be as healthy as that for single-family houses, the cash flow will be far more favorable. You also spread your cash flow risk. For example, if a triplex has one vacancy this month, you continue to collect rent on the remaining two units. Depending on the relationship between rent and cost, this can make a huge difference in your cash flow. A vacancy in a singlefamily house is always a 100 percent vacancy. In a duplex, a single vacancy takes 50 percent of your monthly rental income; and in a triplex, a single vacancy is only one-third of total income.

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The balance between long-term investment value and immediate cash flow requirements has to be considered before you buy a property. While both of these issues are important, they often contradict one another. If you believe you can afford to live with the risk of vacancies in a single-family home, you can create a more profitable long-term investment. But if that risk would be too much for your monthly budget, you are better off compromising by accepting a potentially more modest long-term profit in exchange for more certainty in immediate cash flow.

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Part-Year Rentals and Vacation Homes Many people who own two properties rent out their homes while they live in their secondary location. From a record-keeping perspective, this situation presents some potential problems. These issues can be solved with careful and thorough documentation based on a logical division between personal use and rental use. The records need to reflect how you make these divisions, so that you can support what you report on your tax return. Because many expenses that are deductible for investment properties are not deductible for your home, you need to be able to divide those expenses between rental and personal use. Even expenses that are deductible—such as mortgage interest and property taxes—are reported separately. For the time you use a property as a rental, these expenses are reported as part of your investment income or loss. For the time you use the property as your home, the expenses are reported as itemized deductions.

Dividing Your Expenses The most reliable and accurate way to divide these expenses is on the basis of the number of days a property is used during the year for each purpose. The exact number of days you live in a property would count as residential. The remainder of the year would be assigned to treatment as a rental property. Note: Even if the property is vacant for part of the remainder of the year, the applicable expenses (e.g., utilities, insurance, taxes, interest) are deductible as rental expenses—as long as the property is available to rent. The calculation should be based on the actual days you use the property as your residence versus the full year—and the time the property is available as a rental.

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Vacation Homes Under federal rules, you are allowed to claim itemized deductions for your primary residence as well as for a second home. Besides applying to a home used partly as a residence and partly as a rental, the rule also extends to vacation homes. By definition, a vacation home is a second property that you use for only part of the year. If you do not rent out your vacation home at all, then the property taxes and interest are claimed as itemized deductions. However, if you rent out your vacation home, then you can claim deductions as rental expense for property taxes and interest, as well as for insurance, utilities, and other expenses. Two Important Qualifications: First, any property taxes and interest claimed as rental expense have to be deducted from the amount you report as itemized deductions. Second, you can deduct rental expenses only for the portion of the year that your vacation home is available as a rental.

Making the House Available for Rent The period in which you are allowed to claim rental expenses is not automatically the whole time you do not use the house yourself. It has to be available as a rental in order for you to properly claim a rental expense. Even if you don’t have a tenant for the entire time, you must be able to show that the property was available. The best way to establish that it was available for rent is by keeping copies of classified ads you place to try to find tenants. To document your claim that a rental was available, be sure to list in the ad the exact dates you want to rent out the property. As long as you can establish availability, and as long as you do not use the property during the same period, expenses for a vacation home can be deducted as rental expenses. If you make the property available for rent only three months of the year, and live in it for only three months, what happens to the remaining six months? Because it is available for rent only three months, you would be allowed to claim a deduction of only one-fourth of total expenses (or actual expenses occurring during the period the property was available for rent). The remaining nine months would be assigned as personal expenses, so you would be allowed to claim three-fourths of property taxes and interest as itemized deductions. These distinctions are important because you are allowed to deduct additional expenses while the property is available as a rental. Those expenses—which include utilities, insurance, and depreciation—are not deductible as itemized deductions. So, from a tax standpoint, the longer

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the period of time a second home is available as a rental, the greater the advantage.

The Logistics of a Part-Time Rental Equally important, you should think about some of the logistics involved with the use of property as a part-time rental. Vacation homes often are located far from your primary residence, perhaps hundreds of miles away. As a general observation, the farther you live from your rental property, the more difficult it will be to manage it and to work with tenants. Even a relatively minor repair, for example, is easy to take care of if you live a few blocks from your rental; you may even choose to do the work yourself. But when the same repair has to be done on a house far from where you live, it is more complicated. You have to trust the tenant’s description of the problem. You also have to either hire someone you trust to perform the repair or allow the tenant to find someone. In other words, you have less control over the situation. Timing of a changeover from rental to personal use is another potential problem area to keep in mind. For example, if you want to rent out the property from September through May, but use it yourself for the months from June through August, you must find a tenant willing to agree to that schedule. This means there is a chance you won’t be able to keep the property occupied for all the months you want to rent it out. You might also discover that tenants don’t want to leave even if they have agreed to a monthto-month situation. Key Point: Potential logistics and timing problems don’t make it inadvisable to use properties for dual purposes. They only require more planning and, possibly, greater expense as well. If the alternative is to simply leave a property vacant most of the year, then you lose the rental income, which is not a practical alternative.

Renting Out Part of Your House If you rent out part of your house, you face different potential problems. Because you and your tenant will be sharing common areas, you will want to be compatible in order for the arrangement to work. A rental that is selfcontained, with its own entrance but located on the same lot, simplifies the issue. However, many landlords discover that it is not advantageous to have tenants living so close by because they tend to require higher maintenance, another potential problem to consider. Even so, having a tenant residing in

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an in-law unit—or, as it is called in some places, an additional dwelling unit (ADU)—can make the difference between your home being affordable or not. Rental income relieves your mortgage burden while providing tax benefits. Key Point: The part-time rental or shared rental arrangement helps many people to afford their mortgage, reduce monthly home maintenance expenses, and ease into rental investments in an affordable and practical way. Planning ahead and thoroughly screening tenants are the keys to creating a positive experience.

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Real Estate Speculation Most people who enter the real estate market are seeking the safety and advantages normally associated with this investment: direct control, positive after-tax cash flow, significant tax advantages, and steady appreciation in market value. These features make real estate one of the best investments available and present an excellent way to diversify your portfolio. However, some people would prefer to speculate in real estate. For those with higher-than-average risk tolerance, there are several ways to become a speculator. One method is to buy rental properties in a market where prices are rising quickly. Some speculators are willing to take on negative cash flow in the belief that market price will outpace the monthly drain of cash. If they are right, they can make a lot of profit in a short period of time. However, if they are wrong, the market will top out and may even decline. In that case, they are stuck with inflated property and negative cash flow. This is a high-risk form of speculation. Key Point: With any form of speculation, the greater the potential for profits, the greater your risks. This is the basic investment equation: Risk and opportunity expand or contract together and are different attributes of the same tendency. Real estate speculation can lead to fantastic profits, but only if you are also willing to take significant risks. Most people are not well suited for the high-risk, highreward aspects of speculation. The few who are will tell you stories of big profits but may be less likely to tell you about those times when they lost large sums of money.

Speculation is a form of gambling. To make a profit, you know you must beat the odds, so you take a chance and hope that luck is on your side. When combined with a degree of skill and experience, the luck factor can be reduced somewhat, but it cannot be eliminated entirely. Most real estate

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investors are impressed enough with the benefits of buying single-family housing, taking the tax advantages, and waiting out market appreciation. Those who are attracted to the roller-coaster ride of speculation should be willing to take the whole mix: fast and high profits, as well as fast and potentially high losses.

Fixer-Upper Properties One method of speculation that is usually less risky is buying fixer-upper properties for fast turnaround. This investor looks for rundown houses that need cosmetic care—painting, yard work, and minor repairs. By fixing up the property and then marketing it as soon as possible, a speculator can make a good profit, assuming that market values hold and there is a strong demand for housing. If you go into the fixer-upper market, you need to become an expert at identifying what types of properties are the best candidates for a healthy profit, and what types of repairs will produce the best return. Of course, you also need to be able to perform the work yourself or hire someone who can do the work for you. These three important qualifiers are at the heart of a successful fixer-upper investment and deserve to be discussed in more detail. Finding the Best Properties. The most likely fixer-upper property is a single-family home that is structurally sound but that has been neglected. To make the investment worthwhile, the ideal candidate should be priced far enough below the typical market value for homes of the same type, and located in the same neighborhood. Finding the worst house on a good block, in other words, is the primary guideline for locating a good fixerupper. To determine whether it is going to be worth your time and effort, there has to be enough spread between the home’s cost and the cost of other houses; otherwise, you won’t be able to make a profit. How much is enough? That is going to depend on a) the types of repairs that need to be done, b) the time it is going to take, and c) how much of the work you are able to do on your own. It is quite difficult to find an appropriate fixer-upper property in areas that are kept up and in good shape. Because property values tend to be high, few if any properties are being neglected. Another problem is that the difference between fixer-upper values and current market values of wellmaintained homes could be too slim to justify the strategy. You are far more likely to find promising fixer-upper candidates in more rundown neighborhoods. In these areas, property values are going to be lower than

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in nicer neighborhoods, the market for housing is likely to be weaker, and the potential for dollar amount of profits could be limited as well. However, the rate of return will be greater because the difference in market values will be more significant. So you may be able to trade fixer-upper properties in greater volume and realize a profit in poorer neighborhoods, given the varying market risk factors. So there’s the dilemma. Better neighborhoods hold higher market value and represent lower-risk investments over time. Poorer neighborhoods offer naturally lower-priced homes but have greater potential for appreciation. Just as higher-priced homes make poorer candidates as rentals (because the mortgage payments may be far higher than market rental levels), the same higher-priced homes are far less likely to work as fixer-uppers. Identifying the Best-Yielding Repairs. The most profitable repairs are those that are strictly cosmetic. A house with overgrown weeds in the yard seems overwhelming, but landscaping is among the fastest and easiest of problems to fix. A house needing to be painted is also a good candidate, especially if you are willing to do the painting yourself. Properties requiring inside paint jobs and minor repairs are also good. Once you move beyond the range of cosmetic fixes, the question of affordability becomes more important. If you need to replace major plumbing and electrical systems, the roof, or other expensive features of the house, you are going to have difficulty making the fixer-upper plan work. The cost of hiring a plumber or an electrician is so high that your return would be too marginal to make the move a practical one. You are going to make the most profit working with fixer-upper properties if you have the skills and the time to do the work yourself. Performing the Work Yourself. The more types of repairs and improvements you are able to perform, the more practical the fixer-upper market becomes as an alternative. Simple repairs (e.g., yard work, painting inside and outside) cost little and are easy to do. If you have carpentry and other skills, then you can take on more complicated repairs. If you are skilled at kitchen cabinetry, roofing, electrical work, or plumbing, the fixer-upper market available to you is far broader than for most people. But if you are going to need to hire experts to put the house back in working order, that will cut into your profit margin and may even offset your potential profits completely. By specializing in fixer-upper properties needing the types of work you can perform on your own, you will be able to earn far higher profits than an unskilled investor.

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Other Factors to Keep in Mind ❑ What about closing costs? An important consideration for fixer-upper investors is that of closing costs. You have to pay some costs when you buy and even more when you sell. In evaluating whether the idea makes sense, you must factor in the time involved and the estimated closing costs to ensure that you have a good chance of making a profit. Merely breaking even isn’t acceptable, considering all of the work you have to do. Why place yourself at risk if you don’t have the likely outcome of a decent profit? ❑ Should you live in the fixer-upper? Some people like to move into the fixer-upper while they are working on it. The advantage to this approach is that you can continue paying on the mortgage while living in the property. Then, if it takes longer than you expect to resell the property, it is simply your primary residence and the pressure is off to sell quickly. The major disadvantage to living in the fixer-upper is the stress it may cause for your family. Moving frequently and living in homes that are continually being repaired and fixed can cause significant tension and adversely affect your personal quality of life. To succeed as a fixer-upper investor, you should also consider how your decision will affect your family. If you and your spouse are fairly young and don’t have children, and you both want to work on fixer-uppers, it is the best possible situation. But if you have small children and your spouse does not want to move from house to house—and won’t participate in the project—the whole venture will soon deteriorate into an ongoing argument over dust, noise, and disruption. No amount of profit can justify the stress that will result. ❑ How long should you keep it? The fixer-upper investor also has to decide how long to keep a property, especially if it will be used as a primary residence. If you live in your home for two years or more, any profit you earn upon sale is tax free up to $500,000 for a married couple. You can execute as many tax free sales as you want as long as you meet the twoyear requirement. There also is no age restriction on the two-year rule. Homeowners of any age can take advantage of this tax rule. For the fixer-upper investor, though, there is a dilemma. Without the two-year rule, the goal would be to resell properties as quickly as possible, take the profit, and reinvest elsewhere. But if the profit is substantial, it could also make sense to use each property as a primary residence and wait out the two-year period so that the profit will be completely tax free. (Rules will vary by state, so even if you escape federal taxes, you could still be liable for state capital gains tax from selling your primary residence.)

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Key Point: The potential conflict between tax breaks and quality of living needs to be resolved. If you make decisions based only on tax questions, your investments will become counterproductive. If you determine that quality of life is a priority and, as a result, you do not invest in real estate at all, then you lose potential profits and tax benefits. So there needs to be a balance between the two sides.

The attractive features of rental real estate include a wide variety of choices. Whichever way you decide to go—commercial property or residential, single-family house or multi-unit buildings, part-year rentals or fixer-uppers—you must keep thorough records of your transactions. Record keeping is vital not only to track cash flow and profit or loss, but also to document the expenses you claim as part of your tax return. Subsequent chapters will provide you with a wealth of practical guidance to help you understand the various financial aspects of investing in and managing rental real estate.

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C H A P T E R

3

Cash Flow: The Essence of Rental Real Estate For a landlord, the need for positive cash flow —to have more money coming in than going out—is in many ways more important than month-to-month profit. As a rule, real estate investors do not mind a paper loss for tax purposes. In fact, the perfect situation is one in which you achieve positive cash flow and report a net tax loss. Is this possible? Yes, and in fact, it is the most likely scenario if you plan properly. Ideally, positive cash flow should be generated from the properties themselves. This means that you do not need to invest more and more cash each year just to maintain your real estate investment. In some markets, achieving positive cash flow requires higher down payments than you would like; in some other markets—where property values are too high but market rents are too low—positive cash flow is simply not possible. In those situations, it doesn’t make sense to embark on a real estate investment plan. Only those who have owned property for many years can afford to rent out property, because they bought the property before prices rose. The interaction between rental income and mortgage payments is the starting point in an analysis of cash flow. Your first goal should be to generate rent adequate to pay your monthly principal and interest, property taxes, insurance, and utilities. Even if you achieve this offset, it does not allow for unexpected repairs or vacancies, which are the unpleasant realities of real estate investing. When you calculate the tax benefit of investing in real estate, however, it is possible that your tax savings may be enough to cover maintenance and repairs.

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Analyzing Cash Flow Before Investing How important is it to analyze the cash flow situation for your rental properties? It is the critical first step in the process—the very analysis that determines whether you should even proceed. If you invest in a property that does not produce enough income to cover your known expenses, you may create a financial hardship for yourself. At that point, you have two concerns. First, how can you afford to continue carrying the property indefinitely with negative cash flow? And second, is the property value increasing beyond the monthly outflow of money? If it is not, then by design, you would have created a losing situation.

Defining Investment Value Investment value has to be defined for real estate in ways much different from other investments. With stocks, investment value may refer to longterm growth prospects, meaning today’s price per share is a good value and is likely to grow in the future. You can buy stock, collect dividends, and simply wait; there is no requirement to put more money into the investment each month. In real estate, investment value has to be defined in terms of a) supply and demand and b) cash flow. Supply and demand may be applied to property values and their growth rates, or to the separate demand for rental properties. Both tend to move in similar cycles, but not necessarily. You may find situations in which prices are rising but rental unit demand is relatively low, or vice versa. The second way to define investment value is to evaluate cash flow. If your mortgage payment is significantly higher than what you can expect to collect in rents, you have to determine whether you can afford the extra payment each month. It only makes sense to accept a negative cash flow situation if and when you are convinced that property values are growing so quickly that they outpace the monthly negative cash flow.

Comparing Rents to Housing Prices When you analyze the typical level of rent paid for housing in your area and compare that dollar amount to the typical price of housing, you can tell whether it makes sense to buy real estate, keeping the need for cash flow in mind.

Example 1: In your city, the typical small home (two bedrooms, one bath, 1,400 square feet) can be purchased for $85,000. An 80 percent mortgage

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($68,000) will cost you $475 per month, assuming a thirty-year loan at 7.5 percent. If rents for such homes run about $500 per month, then the rental income will cover your mortgage payment. (For the sake of simplicity, this example does not include an allowance for insurance, property taxes, utilities, and repairs.)

Example 2: If the same house costs $150,000 in your city, your 80 percent mortgage of $120,000 would cost about $840 per month. If average rents run at $600 for such homes, it would not be practical to invest under these terms. You would begin with a negative cash flow of $240 per month, even before calculating taxes, insurance, and the rest. These two examples demonstrate that cash flow is a fairly straightforward test: If property values are so high that a mortgage payment will exceed the level of rents you can reasonably expect to earn, it will not be practical to buy rental property.

Keeping Cash Flow in Mind While there is a tendency for rental levels to track property values, it is not always the case. In some situations, rental demand can be quite high while property values remain relatively low; in other cases, property values may outpace what you could expect to bring in through rents. For example, in a suburban town in the Midwest, where a large portion of the population consists of college students, rents may be relatively high due to demand, but property values relatively low—the ideal situation for rental investing with cash flow in mind. However, in areas such as New York City, San Francisco, or Los Angeles, property values are quite high, and although rents are high as well, cash flow simply won’t work out. If the typical starter home costs $300,000 (so that you would have to find a mortgage of $240,000 at the 80 percent level), mortgage payments would be $1,678 per month (based on a thirty-year term at 7.5 percent). If you could only expect to get $1,000 per month, then clearly it would not make sense to consider investing. One way to overcome this problem is to make a larger down payment, thereby lowering your monthly payments. However, many would-be real estate investors cannot afford to make down payments of 30 percent, 40 percent, or more. While that would go a long way toward easing the cash flow problem, it is simply not a viable solution for most people. Key Point: The very first step in determining whether to consider real estate investing is to go through this preliminary analysis. What is the cost of property? What level of rental demand exists? And finally, do the numbers work out?

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Calculating Rental Property Cash Flow The next step involves making comparisons between current market value of likely rental properties and the rent you are likely to receive—based on your analysis of the market. You want to be able to estimate the most likely cash flow experience you will have in real estate. This process includes calculating monthly rental income, property taxes, insurance, utilities, and other expenses; the mortgage payment; an amount to have in reserve for repairs or vacancies; and the tax benefit you will gain from investing in rental property.

Breaking Down Monthly Payments To estimate cash flow, you must divide monthly payments into several categories. These are:

❑ Deductible Expenses That You Pay. Examples are payments for interest on your mortgage loan; property taxes, insurance, and utilities; applicable other expenses, such as accounting or legal fees, office supplies, or car and truck expenses; and the cost of supplies you need for small repairs. Where to Look: Free instructional manuals can be ordered on the Internal Revenue Service’s (IRS’s) Web site at www.irs.ustreas.gov. Request Publication 527, “Residential Rental Property,” for more information about deductible expenses.

❑ Deductible Noncash Expenses. You can deduct depreciation on the value of the property but not the land; on the car or truck you use to conduct your real estate business; and on computer, landscaping, or other equipment required to do business. While you do not make actual payments for depreciation, you calculate the amount you are allowed to deduct and claim it as an expense (see Chapter 8). You also amortize points paid at closing if you are required to claim that expense over several years (see Chapter 11). ❑ Payments That Are Not Deductible. You make monthly payments on your mortgage, and while interest is deductible, the portion that goes to principal cannot be deducted. You may also pay for equipment that you have to depreciate over many years; such payments are not deductible in the year you spend the money. For example, if you purchase a $600 lawn mower, you can depreciate it but you cannot deduct the payment the year it is made.

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Plugging in Actual Figures These different types of transactions have to be treated differently to calculate cash flow—not only because it involves a mix of cash and noncash, but also because you want to calculate your tax benefits as well. For real estate investing, the tax benefits are part of the overall equation, so you need a worksheet to accurately determine the outcome. A cash flow calculation worksheet is shown in Figure 3-1.

Figure 3-1. Worksheet for cash flow calculation. Description

Cash In/Out

Tax Basis

Rent Income

_______________

_______________

Expenses: Property Taxes Insurance Utilities Other Expenses

_______________ _______________ _______________ _______________

_______________ _______________ _______________ _______________

Depreciation

_______________

Amortization

_______________

Purchase of Assets

_______________

_______________

Mortgage Payment: Principal Interest

_______________ _______________

_______________ _______________

Subtotal

_______________

_______________

Tax Savings

_______________

_______________

Net Cash Flow Per Month

_______________

_______________

To fill in this worksheet, let’s begin with a few assumptions:

❑ Rent of $700 per month is realistic. ❑ Property taxes average $45 per month. ❑ Insurance averages $13 per month.

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❑ Utilities that you, as landlord, will pay average $12 per month. (This figure may seem low, but remember that tenants usually pay most of the utilities, including gas and electric, water, and cable TV. As a landlord, you will probably pay very little, if any, utility bills.)

❑ You estimate “other” expenses at $30 per month. ❑ Your property can be purchased for $120,000. Of this, $30,000 is the estimated value of land and $90,000 is for improvements; you are allowed to deduct $273 per month for depreciation.

❑ Amortization runs $30 per month. ❑ You do not plan to buy any equipment during the first year, so the estimated additional asset cost is zero.

❑ Your mortgage payment is based on 80 percent financing ($96,000) and a 7.5 percent rate. Payments will be $671.25 per month (assuming a thirty-year amortization).

❑ Your tax rate (federal and state combined) is 40 percent, based on a 33 percent federal and 7 percent state tax. (Of course, this figure will vary by state, as well as by your taxable income each year.) With all of these assumptions, we can complete the worksheet using monthly averages. An example follows: Description Rent Income

Cash In/Out $700.00

Tax Basis $700.00

Expenses Property Taxes

–45.00

–45.00

Insurance

–13.00

–13.00

Utilities

–12.00

–12.00

Other Expenses

–30.00

–30.00

Depreciation

–273.00

Amortization

–30.00

Purchase of Assets Mortgage Payment Principal Interest Subtotal

0 –74.00 –597.00

–597.00

–71.00

–300.00

Tax Savings

+120.00

Net Cash Flow Per Month

+$49.00

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In this example, the after-tax cash flow is positive. This occurs because the net loss for tax purposes of $300.00 per month translates to a reduction in your overall tax liability of $120.00 per month (at the 40 percent tax rate). So, in the example, you report a net loss but have marginal positive cash flow. Risk Factors: If you believe that rental demand is quite strong and that you are not likely to suffer vacancies in your rental property, the overall assumption shown in this exercise is reasonable. However, as a landlord, you have to live with the risks of possible vacancies, unexpected repairs, and tenants who fail to pay rent each month. The higher your down payment (and the lower your mortgage payments), the better your cash flow, which also translates to lower risks.

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Determining Interest and Principal In the previous example, we used the average interest and principal payments each month. How do you know what your interest and principal will be? Some lenders break down the monthly payment for you, which gives you the current month’s division. Other lenders provide no details, except an annual summary of interest for tax-reporting purposes. You may need to calculate monthly interest and principal payments on your own to be able to estimate cash flow. The calculation is not difficult. Step 1. Multiply the beginning balance by the interest rate. In the example in the previous section, the original loan balance was $96,000 and the interest rate was 7.5 percent. We further assumed a thirty-year amortization rate, so that monthly payments would be $671.25. (Amortization tables showing monthly payments can be found in interest rate books or online, by searching for “mortgage amortization tables.”) In our example, the first year’s calculation would be: $96,000.00 x 0.075 = $7,200.00 Step 2. Divide the annual interest by twelve (months) to calculate the current month’s interest expense: $7,200.00 ÷ 12 = $600.00 Step 3. Subtract the current month’s interest expense from the total payment to calculate the current month’s principal payment: $671.25 – $600.00 = $71.25

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Step 4. Subtract the principal payment from the loan balance to calculate the new loan balance: $96,000.00 – $71.25 = $95,928.75 These calculations can be carried forward twelve times to determine the full year’s total payments, interest, principal, and ending balance. This calculation is shown in Table 3-1. Once you know the full year’s interest and principal payments, calculate the monthly average by dividing each total by twelve. (This is how we determined the totals for interest and principal in the cash flow worksheet.)

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The Difference Between Cash Flow and Profit Any business—whether real estate owned for profit or a retail shop— demands planning and carefully detailed management. At first glance, it would seem that cash flow and profits are the same thing; cash comes in and cash goes out. But in practice, the two are vastly different. In real estate, as the previous section demonstrated, just determining an estimated tax benefit requires considerable calculation. So it is commonly the case that cash flow and tax-based net profit are quite different. The principal paid on your mortgage, and money paid for capital improvements, decrease cash flow because money is paid out without being deductible. Depreciation expense, on the other hand, is possibly your largest annual deduction after interest, but it does not involve payments in cash.

Demonstrating the Difference In the previous example, cash flow was positive $49.00 per month after tax savings; but the tax-based net loss was $300.00. This means that you have $49.00 per month more coming in to your checking account than you’re paying out—good positive cash flow. At the same time, you are able to claim a tax loss of $300 per month—a worthwhile tax benefit. We cannot confuse cash flow with net profit in real estate because they are distinct and different from one another. Cash flow can be thought of as the overall effect on your funds (e.g., $49 more coming in than going out), but profit or loss is an entirely different matter. Because of the differences in our two major elements (nondeductible payments offset by deductible noncash expenses), the two calculations are distinct from one another. The distinction, then, between cash flow and net loss comes out to

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Table 3-1. Loan amortization, one year. 30-year amortization, 30-year term, 7.5% Month

Payment

Interest

Principal

Balance

96,000.00 95,928.75 95,857.05 95,784.90 95,712.31 95,639.26 95,565.76 95,491.80 95,417.37 95,342.48 95,267.12 95,191.29 95,114.99

1 2 3 4 5 6 7 8 9 10 11 12

671.25 671.25 671.25 671.25 671.25 671.25 671.25 671.25 671.25 671.25 671.25 671.25

600.00 599.55 599.10 598.66 598.20 597.75 597.29 596.82 596.36 595.89 595.42 594.95

71.25 71.70 72.15 72.59 73.05 73.50 73.96 74.43 74.89 75.36 75.83 76.30

Total

8,055.99

7,169.99

885.01

$4,188.00 per year. If you multiply the monthly cash flow and profit by twelve (to see the full-year effect), you find that your annual cash flow is $588, but you were able to claim $3,600 in net losses at the same time. This is not profit by any means; it is just the difference between actual cash flow and reported tax losses.

Comparing Different Properties Since cash flow and net profits (or losses) are different, why even make the comparison? Because as a method for measuring the cash flow and tax benefits, a property-to-property test reveals the benefit of holding onto a specific investment for the long term.

Example: You own two properties. Property A produces positive cash flow of $588 per year and also provides you with a tax loss of $3,600. The combination of the two is $4,188 per year. Property B provides an annual net loss of $1,020 (an $85 loss per month), but produces annual tax losses of $4,410.

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That adds up to $3,390 (after deducting the negative cash flow from the tax loss). Let’s compare the two properties: Property

Cash Flow

Tax Loss

Combined

A B

$ 588 ($1,020)

$3,600 $4,410

$4,188 $3,390

Clearly, property A is more advantageous because it provides positive cash flow. In comparison, property B suffers a negative cash flow each year. You may justify holding onto the second investment if property values are increasing at a rate greater than the negative cash flow, assuming that you can afford to carry the excess each month. Taken together, the properties produce a monthly net negative cash flow of $36 ($49 positive less $85 negative). It makes no sense, though, to keep a property whose market value is being outpaced by negative cash flow. The tax benefits are not worth the loss. (Remember, monthly cash flow has already included a calculation of the tax benefit.)

Best of Both Worlds If you are able to limit your investments to only those properties that produce both positive cash flow and tax-based losses, you get the best of both worlds. For example, if you duplicated the positive $49 per month outcome for five rentals, you would experience a positive cash flow of $245 per month and a net loss for tax purposes of $1,500 per month, or $18,000 per year. Owning and managing five rental properties is not unrealistic, so this level of comparison between profit (or loss) and cash flow and tax loss is a goal worth striving for, and one that can be achieved in the right markets. Important: There are limitations to annual losses you can claim under the law. The maximum net loss you are allowed to claim each year is $25,000, and that goes down if your taxable income exceeds $100,000 (see Chapter 9).

The point worth making in regard to cash flow is that the monthly net losses can add up to a substantial reduction of your tax liability. The calculations also demonstrate that the difference between cash flow and profits can be large, so you need to keep these differences in mind when planning ahead.

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Should You Invest in More Than One Rental Property? This question ultimately comes up. Does it make sense to invest in four or five properties, or even more? If you can finance an infinite number of properties and mortgage payments are covered by rents, why not? Many promotions offering to show you how to get rich in real estate depend on the highly leveraged approach, but in practice, it does not always work out. In planning cash flow, be aware of the potential effects of: ❑ Vacancies. If your area has a very low vacancy rate, you probably do not need to be concerned with chronic vacancy problems. (If you do experience high vacancies, the cause may be the condition of the property.) In markets with higher vacancy rates or seasonal changes in demand for rental housing, you need to carefully plan ahead. In projecting your cash flow through the year, you must determine whether it is feasible to work with more than one property, given the possibility of the vacancy factor. You may be able to get through a month or two with one property vacant, but what about five? Can you afford to continue making mortgage payments with no rental income?

❑ Tenant Problems. Even when your properties are occupied throughout the year, another risk is that your tenants will fall behind in the rent. In the worst situation, a tenant simply does not pay rent at all and you have to begin eviction proceedings. That can be expensive and stressful and takes time as well. Depending on the rules in your state, you would have to expect to lose between one and three months’ rent to complete an eviction. If you select tenants with great care, you can minimize this problem; but it is a very real possibility, and the more properties you own, the higher your exposure.

❑ Unexpected Repairs. There is never a good time to discover that you need to spend money to repair a heating system, a roof, or burst water pipes. Even with the best-maintained property, unexpected repairs are going to arise and cost you money. With a single rental, you may have the financial reserves to get through the experience. With multiple properties, the potential strain on your personal budget could escalate.

❑ Tax Loss Limitations. As discussed previously, you are allowed to deduct up to $25,000 in losses on real estate investments each year, and other limitations may apply as well, depending on your overall income. So from the tax point of view, there is no advantage to owning so many properties that your losses exceed the $25,000 annual level. Because tax

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benefits often make the difference between positive and negative cash flow, your advance planning should also take into account the tax aspects of owning several properties.

❑ Lending Restrictions. The so-called secondary market for real estate financing may impose rules and limits on how many rentals you can finance through conventional lenders, based on your income and credit and down payment requirements. Other restrictions include the level of debt you are allowed to finance. While homeowners are allowed to mortgage up to 90 percent of a home’s value, real estate investors may be limited to 80 percent or even 70 percent, depending on the program. So if you purchase a $100,000 rental property, you might need to be able to make a $20,000 or $30,000 down payment. Of course, the more properties you own, the more cash you need to make these payments.

❑ Time and Effort. Finally, as a practical matter, you need to determine how much time you want to spend managing real estate. When you own stocks or mutual fund shares, you do not have to spend much time at all to manage your holdings. With real estate, you must put in time for a variety of demands; and the more properties you own, the more time you will need to devote. Key Point: With these inhibiting factors in mind, you need to be aware of not only the financial and practical limitations, but also the level of risk involved with purchasing rental properties. If you wish to own multiple houses, the cash flow risk increases proportionately. While a single rental contains an element of cash flow risk, it increases with each additional property that you buy. This doesn’t mean you should avoid investing in more than one property, just that you should carefully evaluate each situation and plan ahead for potential problems.

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Contingency Planning for Cash Flow While our previous example showed that it is possible to experience positive cash flow and a net tax loss at the same time, real-life situations do not always work out that way. There are other factors concerning cash flow that require some contingency planning on your part. Due to the nature of unexpected expenses and costs, vacancies, or tenant problems, it is impossible to build in absolute certainty in your real estate investment program. You can mitigate your risks by doing careful and thorough tenant screening, picking the best locations for your rental properties, diligently monitoring your prop-

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erty, investing only when the economic conditions indicate a strong demand, and limiting your exposure by not overbuying in the market. Even in the best markets and after the most diligent research on your part, there are going to be unknown and unexpected surprises. How do you plan for these? Here are some general guidelines: ❑ Make sure you have an adequate cash reserve. You need to limit your risk exposure by matching up property investments with cash reserves. If your family income is adequate to cover what you consider a realistic level of risk on two properties, then buying three or four properties may be taking excessive risk. You may justify exceeding that level by reasoning that it is unlikely you will face vacancies or unexpected repairs on all of your properties at the same time. That is a reasonable evaluation, as long as you enter the situation with an awareness of the cash flow risks. Your cash flow reserves are literally the amount of money you can afford out of your personal budget to cover unexpected losses, whether they are repairs, vacancies, or other problems. ❑ Take your time in acquiring properties. Do thorough research and don’t allow anyone to pressure you into making a fast decision. Good bargains are plentiful in most markets, and if you lose out on one today, another one will show up tomorrow. Take the time you need to research the prices of properties, vacancy rates, and rental demand trends; to find the best neighborhoods; and to analyze likely after-tax cash flow—all before you commit yourself. ❑ Require inspection of a property as a condition for closing. The worst outcome for any real estate investor is to discover that they have unwittingly bought a “money pit”—a property that demands never-ending maintenance. Never trade your right to require inspections in exchange for other concessions. As a contingency, require that the seller agree to an independent inspection, and reserve the right to cancel the whole deal if that inspection uncovers hidden flaws in the property. You may wish to pay the $200 to $300 fee for the inspection, just to make sure that you get a qualified and independent report. If you ask the seller to pay for the inspection, you lose the right to ensure the independence of the inspector. ❑ Avoid buying properties that don’t quality for conventional financing. Some first-time investors have gotten around the need to qualify for financing by working mainly with sellers who agree to carry a loan for them. As attractive as this might seem, you should ask why they are willing to finance your purchase. Chances are, the house’s condition prevents it from qualifying for conventional financing. If that’s the case, you

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need to know what those conditions are before you buy. If you simply proceed without finding out why the seller is willing to carry a loan, you could be buying someone else’s problems. The day will come when you wish to sell; if the house has a serious deficiency, you won’t be able to move it to a new buyer, who will probably also need financing. Proceed cautiously when a seller offers to carry a loan for you; it could be a red flag. ❑ Perform preventive maintenance regularly. Plan to perform specific tasks as part of your annual cycle. If you own property in northern climates, wrap water pipes and replace heater filters at the beginning of winter; clean out gutters in the fall; maintain septic systems and wells in the spring; and have other expensive systems checked by an expert once a year. The money you spend making sure everything is in working order may prevent more expensive surprises later. ❑ If maintenance is a chronic problem, sell the property. Don’t make the mistake of keeping property that is costing more than it’s worth. Problem houses don’t get better; they tend to continue causing you problems. If you are continually facing unexpected expenses and losing money, cut your losses as soon as possible. Put the property on the market and escape the continuing burden. ❑ Cut losses when necessary. If you overbuy and realize that you are losing money or simply cannot afford to cover the cash flow problems you face, even if temporary, then the smart move is to sell some of your properties. If you own two or three properties and you come to the conclusion that you can only manage one, get rid of the excess. Keep the property that produces the best cash flow and presents the fewest problems. Don’t make the mistake of selling your best-performing assets and keeping the problems. A cash flow difficulty is caused by the very properties you need to sell. Cutting losses is the smart move when you are overextended. ❑ Monitor the market and be prepared to alter your strategy. Nothing remains the same forever. Just as stockholders need to watch for changing fundamentals of companies whose stock they buy, real estate investors have to do the same. Today’s strong demand market can soften next year. Your city may currently have a very low vacancy rate, but any number of factors could change the situation—for example, construction of a large apartment complex, closure of a major employer’s facility, seasonal factors, or a poor local economy. In areas near the Canadian border, changes in international exchange rates may affect the local retail market and, as a result, housing demand. You must continually monitor your local economy, demand for rental housing, and other factors that will affect that demand over time.

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Getting Better Cash Flow You can take some steps to improve cash flow. For example, if you were planning to pay for water and garbage disposal while your tenants will be responsible for electric and gas, you can instead shift all of the utility costs to your tenants in addition to rent. By shopping for more desirable mortgage terms or making a larger down payment, you can reduce the cash flow gap further. If lower rates become available, you can refinance, lowering your interest expense and monthly payment. Even when the local conditions are not ideal for investing in real estate, you can improve your cash flow by picking properties carefully, altering your initial ideas about what types of rentals to buy, and increasing your down payment.

Multiple-Unit Properties Your evaluation of likely cash flow may be interesting when you compare single-family housing to likely outcomes with multi-unit housing. If you can purchase a single-family house for $120,000 and rent it out for $700 a month, you can make positive cash flow, but only marginally. As an alternative, consider looking at multiple-unit investments instead. If you can find a duplex for the same $120,000 investment, you might also discover that each unit can be rented out for $500, increasing your cash flow by $300 per month—without a corresponding increase in expenses or in cash paid out. This is an example only, of course; the specific rent levels and prices of property vary by region. However, the point is that a duplex, triplex, or even a small apartment building may produce far better cash flow than a single-family home without requiring more investment or a higher mortgage payment. A small apartment building is likely to require a greater investment and, perhaps, a higher down payment as well. However, if the cash flow justifies that as an alternative, it could make sense. Buying a five-unit apartment building would probably produce better cash flow than buying five singlefamily houses. It would also be easier and more economical to maintain, insure, and monitor a single property.

Larger Down Payment In determining whether to make a higher down payment as a means for improving cash flow, the obvious limiting factor is availability of cash. However, a second level of analysis should be the use of available capital. If

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you can make cash flow work for a smaller down payment, that leaves more investment capital available for other purposes. The higher your down payment, the lower your cash flow risk, but the more of your capital is tied up.

Improved Tax Benefits As your overall taxable income rises and you move into higher tax brackets, the tax advantages of owning real estate will be correspondingly higher as well. A relatively low overall (federal and state) tax bracket of 20–25 percent is not as advantageous, in terms of tax reduction, as an overall tax bracket of 40–50 percent or more. This, too, will create better cash flow down the road.

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Managing Cash Flow Risk Because you need to make mortgage payments—even if you do not have a paying tenant in the property—there is a greater demand on your personal budget. This means that even if you have positive cash flow, a couple of months of vacancies could be a problem. For many first-time investors, the “cash flow risk” of real estate is invisible. You don’t think about it until you begin managing the property and repairs become necessary, vacancies occur, or your tenant is late with the rent one month. In these situations, the risk becomes all too apparent.

Spreading the Risk One way to manage the cash flow risk is by spreading it. To many investors, this means buying more properties so that a negative situation in one is offset by positive cash flow in another. This may work most of the time, but not all of the time. For example, if an increased vacancy rate is caused by changed local conditions, it is also likely that you will have higher vacancies on all of your properties. In that case, the intended diversification doesn’t achieve its intended result. Another way to spread the risk is by investing in multiple-unit properties instead of single-family homes, as discussed previously. While the singlefamily property is likely to experience the best long-term market appreciation, you need to also consider how your financial life is going to be affected during the years that you own the property. Cash flow, in this respect, is more important than either long-term profits or year-to-year tax benefits. Remember these points:

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1. You must be able to make monthly mortgage payments and pay for upkeep. 2. You need to ensure that you don’t overextend your budget by buying too many rental properties. 3. You need to consider your quality of life if you are managing a larger number of rentals. How much time are you willing to spend and how much of your capital are you willing to tie up in illiquid, long-term investments? These are the important questions that define cash flow risk and, ultimately, determine how many properties you should purchase as investments and whether you want to directly manage those properties. If you believe that it makes sense to own several houses or one multiple-family property, you can also hire a professional management company. This insulates you from the day-to-day tenant contact that so many people find problematical. Watch This: Using a property management company costs money, usually 10 percent of rents collected. For the marginal cash flow situation, such fees can be a big problem.

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Do the Numbers Add Up? Real estate cannot be economically bought and sold like stocks or mutual fund shares, so the market is far less liquid. For this reason, you need to determine the longer-term trends that affect both real estate values and likely long-term supply and demand for rentals. This can be achieved by studying employment statistics and knowing the number of rental units being built, the vacancy rates, and the prices of properties. Collectively, these factors also define whether or not you can make the cash flow work in your favor. If prices are too high, then mortgage payments will be higher, too. It all comes down to a question of whether the numbers work out. As a real estate investor, you accept certain market risks, as you do in any form of investing. As long as you know those risks and can live with them, and the numbers work out to your satisfaction, you will better understand the finite nature of your own financial situation. Success in real estate investing is the result of initial research, a thorough awareness of risk, and the willingness to invest within your limits.


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Picking the Best Investment for You What constitutes “good” rental property? Can you simply pick a house, duplex, or apartment building and depend on supply and demand? Or are there more factors to consider, both financial and market driven? While it might seem that the study of supply and demand would be enough to decide whether the market can support another rental, you need to go beyond the initial study and discover more facts. You must also understand how the attributes of a particular property are going to affect rental value, and what type of tenant the property is likely to draw. A particular property, for example, may attract a specific type of tenant depending on its neighborhood location, the age and condition of the home, the square footage, and the amount of rent you charge. ■

Supply and Demand Cycles in Real Estate The real estate market—like all other investment markets—experiences cycles in which the relative strength of demand varies as the supply grows or shrinks. A basic economic reality is that the cycle is predictable, but its timing cannot be known specifically or in advance. This is the most interesting aspect of real estate economics, but it also creates the greatest uncertainty.

Direct Causes There is no mystery to understanding the direct causes of changes in real estate values. If more people need and want housing than there are properties available, prices rise. The demand causes more building and develop69

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ment activity. As that activity continues, it finally causes overbuilding, which softens prices. The excess demand exceeds supply. This is the nature of the supply and demand market. These forces are obvious and well understood, although the specific forces and the timing of their interaction varies considerably. A cycle may take a year or two, if and when big changes occur within the area. For example, the liberalization of rules for new home construction could lead to higher building activity within a very short period of time. The direct causes of change in supply and demand for real estate—population changes, interest rate fluctuations, availability of money supply for loans to buyers, changes in the tax rules concerning deductions for real estate ownership or investment, and availability of land—can be studied to predict the likely timing of real estate cycles.

Indirect Influences Many forces are at work during the real estate cycle, many of which are not connected directly to real estate values or the market for rentals. Consider the seasonal effect of having a large college or university population in a city. In some areas, college students leave during the summer, but for the rest of the year, they may represent 25 percent or more of the total population. Other influences on real estate values and rental demand include crime, traffic, and employment trends. If a large employer decides to relocate, unemployment is going to rise; in some cases, people will leave the area to look for work elsewhere. The loss of a major employment base has a devastating effect on real estate values, as well as on demand for rental units. By the same argument, when a new employer comes to an area, that creates strong demand for real estate, including rentals.

Example 1: Seattle depends, to a degree, on large employers such as Boeing. In the 1970s, large-scale layoffs created a depression in real estate values. Although Seattle has since recovered and become one of the fastestgrowing real estate markets, its vulnerability continues. The employment base has expanded, but Boeing remains one of the larger employers in the region. Example 2: In the late 1980s, many employers in San Francisco moved out of the city in reaction to a newly passed payroll tax. The surrounding suburbs to the east and the north were better environments for corporations, so a large migration occurred. With the shift of employment base from San Francisco to other areas in the East Bay and North Bay, property values in the suburbs rose dramatically between 1987 and 1989. The changes in value resulted from the sudden increase in demand for both commercial and residential property.

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The Local Market vs. National Averages A lot of time and effort are put into studying national trends in real estate. Industry groups publish detailed statistics and the government tracks trends in prices of homes, inflation, and the average age of people buying their first homes. All of these statistics are interesting and useful, but they do not tell the story of what is going on in your town.

Look Around You The real estate market in your region may be vastly different from the market in the next state or even in the next county. Considering the different economic and demographic factors that affect real estate values, a few miles can make a big difference. For example, if your area is suburban and within an easy commute to a large city, that proximity, when factored in, may translate into a healthy demand for housing. However, if your area is rural and there are few employers within fifty to a hundred miles, property values are less likely to grow as strongly. Those relatively few miles can make a big difference in the strength of your market, for better or for worse. Commuting distance to employment centers is only one of many factors that affect regional real estate values. Traffic rates, crime levels, the weather, and local amenities also influence not only today’s values, but how those values will change in coming months and years. If your property is located in or near a popular seaside resort, for example, that will favorably contribute to property values. But if the property is located in a hurricane zone, it could have the opposite effect. Therefore, a variety of different and potentially conflicting considerations have to be reviewed locally. Where to Get Current Information: To find up-to-date statistics on employment in your area and other important economic and demographic information, check the Bureau of Labor Statistics online at http://stats.bls.gov. This site contains many useful summaries by region and by state. The Web site of the U.S. Census Bureau (www.census.gov) provides highly detailed analysis of housing values, nationally, by region, and even broken down by other demographics, including family composition and size, income, and age of home buyers.

Think Local National statistics may indicate that property values are rising at a desirable rate, consistently from year to year, and above the inflation rate. Real estate

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values may even be beating stock market average returns. Even so, it does not mean that real estate in your area is going to perform in line with national averages. To really discover what is happening locally, you need to go to a local real estate broker, your banker, or a Multiple Listing Service (MLS). You also need to isolate employment statistics and housing trends for the specific area where you are thinking of buying property. This is a fairly complex matter if you live in a built-up region, but far easier if your city is isolated. If you live in the Northeast, for example, your city or town may be part of a larger metropolitan area of a major city. However, in the Midwest and West, cities tend to be more separated, so local and regional statistics are more easily viewed in isolation. A Tale of Three Regions: The corridor between New York City and Philadelphia is built up, and the entire area could be viewed as one massive bedroom community. Anyone living in the New Jersey corridor could reasonably work in Philadelphia, New York, or dozens of smaller cities within a hundred-mile radius. In that situation, how do you focus on housing and rental demand trends in your region? The region itself is so large that it consists of many different subregions. The solution is to study the last year or two in terms of housing prices, demand for rentals, and other related statistics (e.g., population, services, traffic, crime, amenities) and to isolate the area where you would consider investing in real estate. If you live in Austin, Texas, you have an entirely different situation. The region is heavily populated and surrounded by many smaller cities. But compared to the New York and Philadelphia area, Austin is relatively isolated, so a regional market is more clearly defined. The fast-growing suburban communities of Round Rock and Pflugerville on the I-35 corridor to the north are good examples of how communities may grow up close to a larger metropolitan area, though the region is limited in terms of a likely real estate market. A third possibility is that you live in an area such as Casper, Wyoming. This is a relatively small city with considerable distance to the next built-up area. The likely growth in prices and demand for real estate in this region is far different from the New York to Philadelphia corridor or even the Austin region.

Look at Regional Factors The point is that specific regional attributes—both economic and geographic—will affect the long-term growth prospects for real estate. A community located on an interstate and within thirty miles of a major city is going to experience far greater demand and growth than a community

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that’s farther removed from economic activities that will bring population growth to the region. Even when a community is relatively isolated, real estate values may be high and rising because of a single large employer, a nearby recreational feature, or other causes. As a matter of assessing market risk, you must decide how much of the local real estate value exists due to those special circumstances, and what the risk is that the conditions could change.

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Investigating the Local Real Estate Market The real estate market has two components: the prices of property and the demand for rentals. Property values, like all investments, go through predictable supply and demand cycles. Unlike stocks, the cycles for real estate tend to be longer. The phases of the cycles are not affected by day-to-day trading activity like stocks are, so in that respect, the real estate market is more easily understood. The market’s symptoms are easily recognized by studying the current market attributes.

Property Values Statistics kept by real estate brokerages or a local MLS can reveal the current condition of the market. If you approach an experienced real estate agent and ask the right questions, you can easily judge and compare the local market to others. You need to find out the average price of homes, the differences between average asking prices and average selling prices (i.e., the swing), the amount of time property stays on the market before it sells, and the housing stock (i.e., inventory) currently available. The key questions you need to ask to judge the market are summarized in Figure 4-1. Local real estate brokerages can also tell you the direction in which the market is moving. As an astute investor, you will want to time your decision to begin investing in real estate so that demand will be high. That drives up prices and makes the investment value of your property positive—at least from the aspect of market value and potential growth.

Demand for Rentals The second area you need to evaluate is demand for rental housing. This information is also easily discovered by checking with real estate broker-

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Figure 4-1. Questions for judging conditions of the real estate market. Question

What it reveals

What is the average price of housing, both today and one year ago?

If housing values are on the rise, that is a positive sign for investment. Ideally, you want to get into the market at the end of a slow period and just before prices begin to rise. That is difficult to time correctly, so as an alternative, it makes sense to buy into a rising market.

On average, what is the difference between asking prices and selling prices during the past year?

The “swing” is a measurement of how soft the market is right now. If the swing is 5 percent or less, that indicates strong demand. If the swing is higher, it means that demand is on the decline. By comparing the swing during the past month or two to the same period last year, you get a sense of the direction in which the trend is moving.

How long are houses staying on the market, on average?

Are sales taking place within thirty to sixty days? If so, that means demand is very high. But if the time needed to sell is greater, then the signs are not as good. The longer it takes for property to sell, the weaker the demand.

What is the current inventory of homes for sale?

In a high-demand market, houses go up for sale and close very quickly. In a softer market, it takes more time. If your area has an inventory equal to three months’ demand or less, that is a positive sign. If current homes for sale are a full year’s supply, that is a negative indicator.

What level of building activity is under way locally?

Are a lot of homes and housing developments being constructed or planned? Or is current development at a standstill? If activity is high, it means that demand is there, too. But if no one is building homes in your town, that means the market is poor.

ages, your banker, or local property management companies. You need to determine the level of demand as well as the average price you can expect to get for property, by neighborhood. The identification of a specific neighborhood is important because rents may be significantly different in various parts of town. A residential area characterized by single-family, mostly owner-occupied homes will tend to

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carry a higher level of rent, whereas older homes in declining areas will naturally rent for far less per month. The more you understand the character of each neighborhood and the local economic forces at work, the better you will be able to decide where you want to buy rental property. Figure 4-2 lists the important questions you should ask to compare neighborhoods and judge overall demand for rentals in your city or town.

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Determining Whether the Investment Makes Sense In theory, demand is a simple concept. The greater the demand, the higher prices go; and if demand weakens, prices will level out and eventually fall. This economic theory, in practice, is more elusive and harder to identify. As a real estate investor, you have to contend with two primary forms of demand: for properties and for rental units. While they are similar and

Figure 4-2. Questions for judging conditions of the rentals market. Question

What it reveals

What are the latest vacancy rates (overall and by neighborhood)?

Vacancy is the most reliable indicator of market demand and, thus, of investment risk or opportunity. In high-demand markets, expect to see very low vacancies, under 5 percent. Compare annual changes in vacancy, and be aware of seasonal changes.

What is the average rent for each type of rental unit?

This analysis includes size of the property, number of bedrooms, and location. It will vary by whether you’re looking at single-unit houses, duplexes or triplexes, or apartment complexes. The trend is also revealing. Find out how today’s average rent compares to rents for the same type of rental six months and twelve months ago.

What level of construction of new rentals is under way or planned?

If a lot of new rental units are being built in your area, it could change demand—especially if the building trend outpaces demand. If demand is consistently higher than supply and no construction is taking place, then the market is strong—a good sign for you as an investor.

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tend to move together, they are not necessarily the same. You may find that in your region, demand is strong for property but weak for rentals. If your town has more owner-occupied properties than rentals, for example, it is possible to experience strong growth in market value but fairly low rents and rental demand.

The Money Supply A third form of demand involves the money supply. Depending on prevailing interest rates and the supply of money available to lenders, it may be difficult at times to find attractive mortgage rates, or it may be easier at other times, when economic conditions change. These varying conditions will also affect the level of closing costs you will have to pay to obtain a mortgage loan. In a healthy market, it is fairly easy for borrowers with good credit to find lenders for rental properties, even if they already own real estate. In tighter markets, the rules that a lender applies (or that are imposed by the secondary market) may be more difficult to meet. Money, like all commodities, becomes available in cycles. The Federal Reserve controls the money supply by determining how much it will lend to banks and other commercial lenders. It raises or lowers interest rates to control economic growth. These economic factors, while beyond the scope of this book, have a direct impact on all financing of real estate investment. Few people can afford to purchase housing outright, so real estate investing is largely done through borrowed money. This leverage—as it is called among investors—can work both for and against you as an individual.

Interest Rates As the money supply changes, so does the going rate for mortgages. Chances are that as a real estate investor, you will end up financing some of your properties with variable rate mortgages. The interest rate (thus, the monthly payment) on these obligations is adjusted periodically as interest rates rise or fall. The higher the going rate overall, the more your variable rate mortgage payments will climb. Variable rate mortgages are limited in two ways. They contain both an annual and a lifetime “cap,” or maximum. For example, you may agree to a variable rate mortgage and a current rate of 6 percent. The annual cap is set at 2 percent and the lifetime cap on the rate is 14 percent. This means that the lender can never increase your rate more than 2 percent per year, and the loan’s interest rate can never rise above 14 percent, no matter what market rates are doing at the time.

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The prevailing interest rate exists within a range. The better your credit, the shorter the mortgage repayment term, and the higher your down payment, the lower your rate will be. And by the same argument, the worse your credit, the longer your repayment term, and the lower your down payment, the higher your interest rate will be. The range of rates reflects current market interest rate levels, which are adjusted periodically by the Federal Reserve. So, in terms of the “market” for real estate, you need to be aware of the money supply and its influence on the availability of credit. The changes in this market can be seen in varying promotions by lenders. When money is plentiful, lenders compete for your business, offering no closing costs, low points, and fast approval. When money is not available in large quantities, lenders do not seek out mortgage loans and will not encourage you to submit an application. But the money supply is fluid and ever changing. A low point on the economic cycle will soon edge upward and next year’s conditions will look different. Changes may be gradual and take many years, or they can also happen rapidly, within a matter of months. Key Point: The supply of money or the demand for money is not a consistent factor in the market. One of the greatest uncertainties in real estate—given the need for financing—is the changing economics of the money supply.

The Feasibility Question How do you decide whether to proceed when the three types of demand— for properties, rentals, and money—are inconsistent? It comes back to the question of feasibility. What is the monthly payment on a property? This figure has to be based on the price you expect to pay, the amount of down payment you can afford, and the interest rate you will be charged. If you compare this payment to the probable level of rent you expect to receive, you can quickly address the question of feasibility. If you can’t get the numbers to work out, it means that timing is poor. You need to look for investments in a different area, wait for interest rates to fall, or wait for rents to rise due to increased rental unit demand.

Market Conditions That May Change While any one of these factors could make the difference between achieving positive cash flow and falling short, it is likely that two or more factors will change over time. Interest rates may fall and, at the same time, average rent levels may rise. So your monthly payment would be lower and you

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would receive higher income each month. Interest rates are not a small part of this question. The difference of one percent on a thirty-year $100,000 loan is about $68.00 per month. For example, monthly payments on a $100,000 loan at 6.5 percent are $632.07. At 7.5 percent that payment rises to $699.22, an increase of $67.15 per month. If the interest rate then goes up to 8.5 percent, payment grows to $768.92, or an increase of $69.70. Based on the average of about $68 per month, the difference comes out to more than $24,000 in total payments. If you wait out the market and average rates fall by one percent, you would save $68 per month through lower payments. If average rents also rose by $100 per month between now and the time rates change, the total positive difference on cash flow would be $168 per month. That could make the difference for you.

Dealing with Future Risk Just as today’s conditions can improve, a healthy situation can deteriorate. How can you deal with these risks? First, if you are able to finance a real estate investment with a fixed rate mortgage loan, that freezes your payment level over thirty years—and this is a considerable advantage when you also estimate the possible rise in market rents over the same period. The higher average rents move, the better your cash flow. Second, even if you go with a variable rate mortgage, the increase in interest is fixed in two ways. A lender can only raise the variable rate by a limited amount each year (and remember, if rates go down, so will your variable rate). In addition, by contract, the variable rate can only go up so far. The annual cap, along with the lifetime cap, protects you from indefinite increases in the interest rate on a variable rate loan. You can also mitigate risks by ensuring that the elements that contribute to rental demand are not limited. If there is only one major employer in your town, you are at risk. If you buy a rental property and the employer lays off the whole workforce, many people will leave, you will have higher vacancies, and your property value will fall. You should seek out markets with a more varied employment base—not only several employers, but diversified industries as well. Then, even if one employer closes its doors and leaves, it will not have a singular effect on the whole rental and real estate market. Look for factors other than local employment that also contribute to property values. A year-round tourist attraction, for example, tends to keep property values high. Proximity to a large city (meaning easy access and a short commute) may be a strong factor that adds to demand in the market, today and in the future as well. Suburban communities that are within fifty

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miles of major cities are often among the best investment markets. Their housing prices have not grown as rapidly as those within the cities themselves in many cases, but values rise strongly each year. This is the best possible situation in terms of both property value and rental demand. Key Point: In your analysis of where to invest, consider the potential permanent features that are likely to contribute to growing property values and rental demand. For example, a large college creates demand in town.

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Timing Your Decision to the Supply and Demand Cycle Just as the economic concept of demand is easily understood but more difficult to apply, so is the timing of your decision. The supply and demand cycle is fairly simple to grasp, but more difficult to recognize from month to month. In all investments, there is a tendency for false indicators to throw off your estimates. In the stock market, the primary price movement (of a stock or an index) may reverse and appear to head in the opposite direction, only to stop and retreat back the other way. These false starts can occur time and again. A major change in direction is more easily recognized in hindsight, which tends to be perfect. When you are at a specific point in a supply and demand cycle, it is quite difficult to identify the direction or the timing.

Think Long Term Even if you are confident about the position of the cycle, it is far more difficult to know how long it is going to take for the cycle to move in a specific direction. Every cycle sets its own pace and may speed up or slow down without warning. Many factors are at play, including the variable of behavior among sellers and buyers at any given time. You cannot approach real estate in the same way that stock market speculators and day traders do, trying to time decisions to maximize profits and moving in and out of positions frequently. Real estate is far less liquid than stocks, and it also does not trade through auction as stocks do. As a result, real estate has to be treated as a long-term investment. This doesn’t mean it cannot be traded from year to year. However, you cannot depend on fast changes in the market. It happens, but it would not be prudent to invest in real estate when depending on fast changes.

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Example: An investor bid on a house in a market where prices had grown quickly. His intention was to rent the house out, even though market rents were not adequate to cover the monthly mortgage payment. In fact, rents fell about $400 short of the mortgage payment. The investor reasoned that prices had been climbing rapidly and were going to continue outpacing the negative cash flow each month. The only problem with this approach was that the market did not continue expanding. In fact, prices leveled off and then fell. While this change in direction was temporary, the slowdown lasted nearly two years. The investor could not afford to keep paying the difference between rental income and mortgage payments each month and had to sell the house at a loss. Don’t Speculate on Rental Real Estate In the previous example, the investor made the mistake of speculating in rental real estate. He was willing to absorb negative cash flow for a few months on the theory that price growth would outpace it and he would be able to sell at a profit a few months later. Speculating in this way makes no sense because you cannot control timing, temporary changes in a supply and demand cycle’s direction, or the prices of property. If you transact too often, profits will be absorbed or even exceeded by closing costs. Real estate is not a viable market for speculation, unless you have an exceptional understanding of the market, a healthy reserve of cash, and the willingness to live with higher-than-average market risk. Short-Term Turnarounds: Rather than attempting to time the supply and demand cycle, you can better use your capital in real estate by buying properties that are depressed in price, fixing them up, and then reselling them. A property needing only cosmetic changes—painting, roofing, and landscaping, for example—may be available for a price far below market value. Some time and effort can quickly turn your investment into a profit. In this situation, you don’t usually have to hold the property for several years to make a profit; you can turn it around in a matter of months.

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Picking the Best Real Estate Rentals Aside from the investigation into the demand for housing, rental rates, and market value, you also should be aware that the “best” value often depends on where the house is located and the type of house itself. As an incomegenerating asset, a specific house will vary in value based on its size and condition, specific neighborhood location, appearance, and age.

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Matching Houses to Tenants Tenants look for houses that match their income (i.e., what they can afford) and can accommodate the size of their family. They are attracted to houses that are near work and fit their specific lifestyle and desires. Each house will appeal to a specific type of tenant. A house in an upscale neighborhood with well-manicured lawns, fresh paint, and modern appliances and design is likely to appeal to a middle-class working couple with children. A small, rustic cabin out in the woods that’s away from traffic patterns will be more appealing to independent-minded, single, younger people, probably without children. Many tenants cannot afford to buy property on their own, but they want a yard where their children can play; they would like to get a dog or a cat, so they want a house rather than an apartment; and if they have several children, they want a larger house with more bedrooms.

Age and Condition A house with a lot of deferred maintenance is going to be more costly to keep in shape. It will also be more difficult to get top rents if the house is outdated; poorly insulated; poorly located; or in need of painting, yard maintenance, new flooring, and other work. One bit of wisdom advises that you should “buy the worst house on a good block.” This means that a poorly maintained house that needs cosmetic improvements is likely to increase in value more rapidly than its neighbors. This assumes that you get a discount in the price due to its condition. In comparison, buying a well-maintained house in a declining neighborhood is a poor investment; it will not hold its value well against other houses if the overall trend in that area is negative. So factors such as local employment, traffic patterns, crime statistics, and demographics will all affect investment value of property.

Conformity Generally speaking, you should invest in properties that are similar to other properties in the same neighborhood. Nonconforming properties tend not to appreciate as well as the typical house. For example, if a neighborhood consists primarily of three-bedroom, two-bath, double-car-garage houses on a quarter acre, that is the standard. The typical house meeting that definition might cost $145,000, for example. If you find a house in such a neighborhood with five bedrooms, four baths, no garage, on one-half acre, and it is selling for $200,000, it is a nonconforming house in every respect

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(lot size, layout, and price). That nonconforming house, even while offering more in the way of features, is likely to be a poor investment. It will not appreciate at the same rate as other, conforming houses, and as a result, it would be a difficult house to resell. It may also be difficult to rent out due to your need to charge higher-than-average rents given the price. Conformity is more than just a concept. It defines investment value in the same way that rental income levels affect appraisal value. The higher the potential income, the higher the property will appraise, based on the income method. However, you would lose points for the nonconformity of a house. Even if an appraiser were to base the estimated value on finding similar houses, a downward adjustment would be made to conforming houses in the same or similar neighborhood, which would make it very difficult to justify a higher purchase price—and, ultimately, the level of selling price you would want to realize later on. Not only is price a problem; nonconforming houses are understandably also more difficult to resell.

Neighborhoods We cannot avoid references to location in a discussion of value. The location of your investment property determines, more than anything else, what today’s value will be and how well that value will grow in the future. Even a difference of one block can significantly affect long-term value. If a house is located on an exceptionally busy street, it is highly visible but will not grow as well in value as an identical house only one block away from the arterial. A house in an older, established neighborhood will be far more valuable than a newer house in a less desirable area. “Less desirable” does not refer to anything as obvious as the neighborhood’s crime statistics, proximity to noise or traffic, or any other tangible characteristics of an area. Desirability of a neighborhood is a reflection of where people want to live. For a variety of reasons (some of which are intangible), a specific neighborhood will have greater status than another. For example, an older section of town where many old-time residents live may be close to a neighborhood coffeehouse, pub, or grocery store. By comparison, more modern neighborhoods may not have the same “feel” to them. In many small towns and small to medium-size cities, this intangible effect can be witnessed time and again. Why is one neighborhood more desirable than another? There are as many answers as there are neighborhoods. As a real estate investor, you can only recognize these variations in desirability by living in the area long enough to be aware of them. You will probably never be able to understand all the reasons for that difference in desirability.

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Cost vs. Rental Value Another way to define what constitutes the “best” investment is through a comparison of cost and rental value. Clearly, the most desirable rental investment is one that costs as little as possible but yields the highest demand among renters. There is a tendency to think that high demand for property and associated growth in property values translates to a strong rental market. An indepth analysis reveals that the two markets are quite independent and may even operate in opposition to one another. It is true that a large transient population (e.g., students or tourism workers) can create a seasonal fluctuation in rental demand. There may be nothing available in the summer months and high vacancies during the winter. From the investment point of view, this is an unhealthy condition. Ideally, there should be a year-round demand for housing to ensure that you can make your cash flow goals. In cities with large college populations, this is possible when the school has courses throughout the year. In cities with a high dependence on tourism, the colder months may be lean economically and across all job sectors. So a robust summer economy might be depressed in the off-season. As an investor, these seemingly subtle differences can spell cash flow disaster if you are not aware of the potential problems beforehand.

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The Advantages of Multiple-Unit Housing When real estate investors face the difficulty of cash flow in single-family housing (the most popular form of investment real estate), one solution may be found by investing in multiple-unit housing instead. This does not limit your choices to detached houses or ten-unit apartment buildings. There is a lot to choose from in between.

Two Can Be Better Than One The duplex—an attached two-unit property—is a far better choice for many markets than the single-family detached home. There are several reasons: ❑ The duplex appeals to many people who want a house. Tenants who seek a detached house often have children. They want to have the sense of living in a house, not an apartment. They may want to grow a garden or enjoy the yard in other ways, such as a playground for their children or for pets. However, many families cannot afford the rent on an entire

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house, so the duplex is an attractive compromise. The duplex or triplex is also popular for student housing; it is nicer than an apartment, but far less expensive than an entire house. The houselike features of the duplex broaden the potential tenant market. This reduces the possibility of vacancies. With two units, even when one is vacant, the other continues to cover part of your mortgage payment, also reducing the vacancy risk.

❑ Many attractive attributes are found in the duplex. The duplex often has many of the attributes found in rental homes—a garage and storage space, a yard, a single-family living space, and more of a family-oriented neighborhood. The duplex, if located in a predominantly single-family area, is far more desirable from the tenant’s point of view than apartment living, but far more affordable than renting a house. Utility costs also tend to be lower. The ability of tenants to attain the sense of being in a house, but at a price closer to that of an apartment, explains why these units are so popular. In many areas, apartment units and houses are plentiful but available duplex units are rare. So, from your point of view, the desirability of the duplex unit makes these safer investments. ❑ Duplex living is a step up from apartment living. Many tenants consider the duplex a significant step up from apartment living. This is especially the case when the duplex is designed to look like a house or is actually a conversion from a onetime single-family residence into two or more self-contained units. It’s important to remember that the majority of tenants want to own a house at some point in the future. Most people with families don’t want to live in an apartment complex any longer than necessary, and a duplex is definitely an improvement over the typical apartment unit. Many tenants who can afford to graduate from an apartment to a duplex see it as a step closer to home ownership. ❑ The maintenance cost of a duplex is virtually the same as that for a house. For you as landlord, the maintenance concerns and costs of a duplex are the same as for a detached house. They include yard work, utilities, systems upkeep, and outside (e.g., roof, siding, paint) maintenance. The efficiency of combined utility costs and yard maintenance makes it easier to meet cash flow. Landlords normally pay for garbage pickup and often for water, while tenants pay the remainder. As far as yard maintenance goes, one potential problem with the duplex is the question of

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which tenant is responsible for it. Expecting two tenants to share the responsibility is asking for trouble; the responsibility has to be specified in the lease for one or the other if you expect to have it done efficiently. As an alternative, you can hire an outside landscaping service and pass on the cost to each tenant. ❑ There are insurance and tax savings. You need to insure your investment property against the possibility of fire and other catastrophic losses. As with utilities, insurance costs for a duplex are going to be lower—as a percentage of rents you collect—than for a house. Insurance rates are based on market value of the property, so a duplex that is about the same market price as a house will cost about the same to insure—even when rental income is far more. The taxes on a duplex are going to be approximately the same as those on a single-family house or perhaps a little more. But if you compare the annual property tax bill as a percentage of annual rents, you will discover that duplex taxes tend to be far lower overall. For example, let’s say that you own a single-family house that you rent out for $700 per month, which is $8,400 per year. Annual property taxes are $900, which is 10.7 percent of annual rents. Or, let’s say you own a duplex and each unit rents out for $450 per month. Your annual income is $10,800. If property taxes on the duplex are $1,000 per year, that represents 9.3 percent of rents. In this comparison, the duplex investment produces a lower tax burden. Because rents are higher, the property taxes are less of a burden. While you’re paying more for taxes on the duplex, taxes are a smaller percentage of rent income. ❑ Potential rental income for the duplex may be considerably higher than for a house. The most appealing point of comparison is in rental income. Even if one unit goes vacant, you continue receiving rent on the other. Rent levels vary by area, of course, but you may discover that the total rent you will receive from a duplex will be far greater than you could receive on a single-family house in the same neighborhood. For example, while a four-bedroom house may rent for $900, you may be able to rent two duplex units, each with two bedrooms, for $600 apiece, for a total of $1,200 per month. If the duplex costs the same as a comparably sized house, your cash flow in the duplex will be much higher. In addition, the lower unit rent of $600 opens your units to a far wider market, reducing the risk of vacancies. Of course, before investing in multi-unit housing, it is wise to compare

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current market rates first, just to make sure that the rents are better. But if your area is typical, you will have better overall cash flow with duplexes in almost every instance. The economy is even more improved with a triplex or four-unit building. ❑ Investment value may be better in duplex units. Single-family houses used as rentals tend to have a resale value about the same as owneroccupied housing. It is likely, in fact, that when you decide to sell your rental house, the buyer will be someone who intends to live in the house and use it as a primary residence. Many first-time home buyers are attracted to the duplex for this very reason. The affordability of home ownership is made easier when the new owner can recoup half of the mortgage cost by renting out the second unit. This also provides tax benefits and partial deductions of insurance and utilities—all advantageous for tax purposes.

Appraising Market Value Multiple-unit rental property may have greater market value, especially in cities or towns with high rental demand and with strong property values. If you own a duplex or triplex, which is clearly rental property as opposed to primary residence property, it may be appraised on the income basis. The higher your rental income per month, the more likely that your duplex property will increase in value. Potential buyers—other landlords—seek properties with positive cash flow, and multiple-unit housing is the most desirable among residential properties.

Appraising Apartment Buildings When you consider buying an apartment building as an investment, you must be aware of how the actual cost of the property compares to rental income. The gross rent multiplier (GRM) is used by appraisers for apartment buildings and is a useful comparative tool. The sales price is divided by monthly rents to arrive at GRM. For example, let’s say you are thinking of buying a property with an asking price of $410,000. Rents for all units add up to $3,000 per month. GRM is calculated as follows: 410,000 ÷ 3,000 = 136.67 Appraisers compute GRM for several similar properties and then calculate the average. From this calculation, they next set market value under the income method. So, if the average GRM in your area were 131.36, the

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appraiser would calculate a thirty-unit building’s market value at $394,800 (131.6 x 3,000). Based on the appraiser’s report, you would conclude that $410,000 is too much to pay, and you could make an offer of $394,800.

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Defining Your Specific Real Estate Market No one formula works in every market. Generalized valuation and demand factors cannot be applied to define the real estate market in your region. We all hear statistics about national housing prices rising or beating inflation, but that is a collective trend representing the net outcome for all regions. Some areas of the country have exceptionally strong real estate markets, whereas other areas are quite depressed. Some areas have seen real estate prices accelerate so quickly that it is difficult to enter the market as a landlord and create positive cash flow. Other areas have very affordable properties but little or no demand for rental units. So it is all a mix. Evaluate all of the conditions in your area. Remember, all real estate is local, and you cannot rely on the national averages to decide whether you are in a good real estate market. It is so local, in fact, that you cannot even depend on statistics from the next town to define real estate values where you live. You need to look at the specific facts where you plan to buy: the prices of property, the demand for rental units, the employment statistics and number of local employers, the typical age of residents (especially if heavily represented by college students or retired people, for example), the different neighborhood characteristics, and the crime levels and trends. Look at Yourself: Finally, before going forward with any rental real estate investment, you should consider your own personal situation—your income level; cash resources; credit rating; and perhaps most important of all, your willingness to spend time caring for your rental property, fixing and repairing it as needed, and dealing with your tenants on a regular basis.

No one approach is going to work for everyone. Every region and city or town has different economic and demand features. Your personal risk tolerance and financial position further affect the type of property you will end up buying. Just as different stockholders will be drawn to one strategy or another in stock selection—varying by risk and growth potential, for example—different people will view real estate properties in varying degrees. The risk factors, added to your financial limitations and commitment level, will determine what properties will work best for you.


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C H A P T E R

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Bookkeeping Basics for Rental Property You must meet special requirements for tracking and reporting rental activity. This is not difficult. It just means that you need to set up your record keeping so that you are able to comply with tax-reporting requirements. A few special considerations make rental property bookkeeping different from most other types of business records. You need to allocate expenses between two or more rental properties and divide expenses when they apply partly to your personal residence and rental investments. In addition, there are some calculations that do not apply to other types of investments (such as depreciation and a breakdown between mortgage principal and interest). This chapter takes you through each area of bookkeeping for real estate and provides suggestions for simplifying the process. ■

Types of Transactions Most investors are aware of record-keeping requirements and tax reporting for capital gains, interest, or dividend income, and of limitations on claiming losses. When you also own real estate, you need to keep track of rental income as well as payments and expenses. Aside from the reporting rules, you also want to track cash flow and anticipate possible future problems. For example, if your rental property is financed with a variable rate loan, an increase in your rate could mean a change from marginally positive cash flow to negative cash flow. Recognizing this problem, you are faced with the choice of raising rents or absorbing the negative number. The same problem can occur when your property taxes or utility bills are increased. Your 89

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rental agreement may provide that increases in property taxes will be automatically passed on to tenants, which will protect your cash flow. If utility expenses rise, you may either raise rents or pass on the utility burden directly to the tenant.

Example: One landlord faced rising utility costs and higher property taxes. However, the rental agreement was month to month rather than a lease, so there was no provision for passing increased costs on to the tenant. As an alternative, the landlord advised the tenant that, effective two months later, he would be responsible for the water and sewer bill. The tenant agreed. In this example, the landlord covered the increased costs by modifying the rental agreement. However, he did not increase the monthly rent. From the tenant’s point of view, the net result is the same, but accepting responsibility for a utility bill may be perceived differently. (Tenants may feel that they have more direct control over utility costs.)

What to Record Record keeping helps you to anticipate changes in cash flow as well as keep track of the required tax records. The transactions you should track include:

✓ Rental Income. You need to record rental income you receive and deposit that income in your bank account.

✓ Mortgage Payments. Your monthly rental property mortgage payment consists of principal and interest and, in many cases, property taxes and insurance as well. The mortgage principal reduces your mortgage debt, but it is not deductible. You need to calculate monthly interest expense. Some lenders break this down each month for you, but others do not. Therefore, you should know how to calculate this cost (see Chapter 2). The impounds you pay each month for property taxes and your insurance payments are rental expenses and should be recorded in the proper account. If you pay property taxes and insurance separately and not as part of your mortgage payment, those payments are recorded as expenses.

✓ Utilities. If you pay utilities yourself, these payments are deductible as rental expenses. If your property is used partly as a rental and partly as your residence, then only the rental portion is deductible. The portion you can deduct is calculated based on usage. For example, if you rent out 30 percent of your floor space, you can deduct 30 percent of the util-

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ities. Or, if you rent out your property for three months of the year, you can deduct 25 percent of utilities paid for the entire year.

✓ Advertising. Payments to advertise a property for rent are deductible. ✓ Legal and Accounting Fees. You may need to consult an attorney regarding contract questions and tenant relations, and you may need help from an accountant or tax adviser to assist with your tax return and tax planning. These are deductible expenses when the consultation relates to your rental properties.

✓ Auto Expenses. If you use a personal car or truck for rental activities, that portion of use is deductible as a rental expense. The most practical method for claiming a deduction for business use of your automobile is on a miles-used basis. Keep good records of mileage and actual use.

✓ Telephone. Like auto expenses, you can deduct business use of your telephone, but you need to keep thorough records to document that business use.

✓ Office Expenses. You need to purchase record-keeping items such as accounting worksheets, binders, folders, and signs (to advertise properties for rent, for example). These expenses are deductible on your tax return as long as they relate specifically to rental property management activities.

✓ Depreciation. The depreciation of properties is a noncash expense, which is calculated annually based on the cost of your property. You cannot depreciate the value of land, but all improvements in the building (e.g., any major additions and repairs) are depreciated annually.

✓ Amortization. If you pay loan fees (also called points) when you finance your rental property, you may not be allowed to deduct that expense in one year. Points often have to be amortized over the life of the loan. For example, if you pay $2,700 in total points and your loan is scheduled to be repaid over thirty years, you are allowed to deduct $90 per year.

Cash Accounting Most individuals report their income and pay taxes on a “cash” basis. That is, you report income and deduct expenses only in the period they are paid. So expenses such as property taxes can be deducted only when you pay them. If you are charged $400 in legal fees toward the end of December, but you do not pay the bill until January, the expense is deductible in the later year when you use the cash-accounting basis.

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With rental properties, there are two exceptions to this rule: 1. Rental income is deducted in the year the rent is earned, even if payment is early or late. So if your tenant pays January’s rent on December 30, it still is assigned to the following year. 2. Interest works in the same way; you are allowed to deduct interest only in the period to which it applies. If you prepay your January mortgage payment hoping to get the additional interest expense into the current year, it will not work. It is deductible in the following year.

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Matching Rental Income and Bank Deposits Keeping track of rental income is a fairly simple process. The easiest way is to ensure that your bank deposits match your income. To keep your records as clear and as simple as possible, follow four rules: 1. Set up an account to be used only for rental income and payments. Because you will have a volume of rental-related income, expenses, and payments, your bookkeeping will be clarified significantly if you set up a special account and use it only for rental activity. Some real estate investors try to track their income and payments through their existing accounts, but that is difficult to do consistently. Even if it costs you money to set up a new account, it is the best way to keep things clear. The bank charges are going to average only $6 per month in most cases, and you may even be able to make arrangements for free checking. 2. Deposit all rental income into the investment account. It is most important that your deposits match your reported rental activity. All income you receive, whether made by check or cash, should be deposited into your investment account. In this way, your record of deposits will match what you report on your tax return. The “source document” for rent is going to be the rental agreement you sign with a tenant, but the real documentation is going to exist in the record you keep of bank transactions. The rental income you deposit in your investment account will be used for mortgage payments and other expenses; use the checking account as a simple way to keep track of all of your rental activity. 3. Identify all nonrental deposits made. If your rental income falls short of your payment obligations, you will need to make additional deposits periodically. Be sure you identify those deposits specifically, in order to be able to explain the source of all deposits. You identify the deposit at

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the time you write it into your checking account. So when you deposit rental income, you identify it as income (and if you have more than one rental property, you should also list the property address). When you transfer money from your personal account, identify it as a transfer. This will simplify your record keeping and reporting. 4. Set up a simple receipts journal and keep it current. Your checking account is an excellent convenience for capturing all of your investmentrelated activity. (Incidentally, you can also use the same account to track investment activity in stocks and mutual funds by expanding the breakdown of deposits and payments. In this manner, all of your investment activity can be reported in a single record, and it is isolated from your personal records. This makes it easier to document what you report on your tax return, including rental income and payments, dividend and interest income, capital gains and losses, and transfers of capital in and out of other investments.) A comprehensive receipts journal that includes space for tracking all of your investment activity is shown in Figure 5-1.

Figure 5-1. Investment receipts journal.

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Note that in this sample journal, rental income is identified by specific property; space has been allowed for up to four properties. You need this breakdown for your federal income tax return. Space is also allowed to document transfers of capital from your personal account and to list other forms of investment income (e.g., interest, dividends, and capital gains) unrelated to real estate. Important: The total column should match your bank deposits without exception. It should also balance with the sum of all other columns, which is an additional procedure for double-checking your figures and keeping your receipts journal in balance.

Good Bookkeeping This procedure—keeping track of rental income through a) your checking account and b) the receipts journal—allows you to fully document all of your investment income throughout the year. The secret to effective bookkeeping is uniformity. If you have income from a number of different investments, you need to consolidate it in some manner. When it comes time to prepare your tax return, you do not want to have to scramble to figure out rental income for each property—and interest, dividends, and capital gains—while also trying to ensure that you don’t count a transfer as income by mistake. The simplified receipts journal ties your deposits to specific sources and makes the record uniform. A double-check is also available from your monthly bank statement. Make sure that the total reported by your bank agrees with the “total” column on your receipts journal. Any differences should be investigated and corrected. So, if you forget to write down a deposit halfway through the month, you’ll be able to find the error and fix it.

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Breaking Down Mortgage Payments Keeping track of income is not a complicated matter. You need to put a little more effort into tracking payments, however. The largest payment you make each month is going to be the mortgage payment. Your monthly payment may consist of up to four different elements: mortgage principal (which reduces your debt balance), interest, and—if impounds are included—additional amounts for property taxes and insurance. It is important to be able to break out these various segments of the mortgage payment in order to track both cash flow and profit and loss. Some lenders provide breakdowns of these payments each month; others do not.

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If your lenders do not provide you with a breakdown of each month’s payment, use a worksheet, such as the one shown in Figure 5-2. This worksheet allows room for not only interest and principal, but also for the impounds you may need to pay each month. As you write each month’s check for your mortgage payment, you should break it down so that your payments record can be kept up-to-date with accurate information.

Figure 5-2. Worksheet for loan payments.

Example: Your loan balance is $96,000 at the beginning of the year and your monthly payment consists of $671.26 (for principal and interest) plus $135.00 for insurance and taxes, for a total of $806.26. The breakdown during the first year is summarized in Table 5-1. Note that the total of twelve months’ payments is $9,675.12. However, because interest and impounds do not reduce the loan balance, only $885.13 of principal is applied to the loan. During this first year, the loan

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Table 5-1. Loan payment breakdown, one year. 30-year amortization, 30-year term Month

Payment

Insurance Taxes

Interest

Principal Balance

1 2 3 4 5 6 7 8 9 10 11 12

806.26 806.26 806.26 806.26 806.26 806.26 806.26 806.26 806.26 806.26 806.26 806.26

36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00

99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00

600.00 599.55 599.11 598.66 598.20 597.75 597.29 596.82 96.36 595.89 595.42 594.94

71.26 71.71 72.15 72.60 73.06 73.51 73.97 74.44 74.90 75.37 75.84 76.32

Total

9,675.12

432.00

1,188.00

7,169.99

885.13

96,000.00 95,928.74 95,857.03 95,784.88 95,712.28 95,639.22 95,565.71 95,491.74 95,417.30 95,342.40 95,267.03 95,191.19 95,114.87

is reduced from $96,000.00 down to $95,114.87. Amortization is very slow during the earlier years of a thirty-year loan and increases over time. In the previous example, a 7.5 percent loan would decrease only about 13 percent over the first ten years. It would take twenty-two years to pay down onehalf of the loan’s balance, with the remainder being paid during the remaining eight years.

Balancing Out Impounds Each month’s loan payment has to be broken down in your books according to the type of transaction involved. Impounds are collected by the lender and paid according to the due dates. For example, you may be required to make two payments a year on your property taxes and quarterly payments on your insurance policy. So the lender collects impounds and then makes timely payments for you. Using the previous example, the collection of impounds and payments may resemble the breakdown in Table 5-2. As long as your impound balances zero out during a single year, the easiest treatment is to simply assign them directly to the appropriate expense category—in this example, insurance and taxes. Two important notes concerning year-end adjustments: First, the impounds are approximations, so you probably need to adjust your year-end expense to reflect the actual total.

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Table 5-2. Impounds accumulated and paid. Impound: Insurance

Month

Payment: Insurance

Impound: Taxes

1 2 3 4 5 6 7 8 9 10 11 12

36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00 36.00

108.00

99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00 99.00

Total

432.00

432.00

1,188.00

108.00

108.00

108.00

Payment: Taxes

594.00

594.00

1,188.00

Second, if your impounds include balances collected but not yet paid out, you need to defer the amounts collected to be applied to the following year.

Example: As of December 31, your lender collected $72.00 in insurance impound and another $297.00 for taxes. However, the actual payments for those expenses were not made and are not due until the following year. You should reduce your insurance and property tax expense by those amounts, since the actual amount being claimed includes impounds not yet due. Breaking Down Each Month’s Payments Actual adjustments such as this should be made at the end of the year to keep monthly entries as simple as possible. As you make each mortgage payment, break it down and classify each portion of the expense based on either the summary your lender provides or your own worksheet. For example, the first month’s mortgage payment of $806.26 would be broken down among the various accounts for the specific property as follows: Insurance Taxes Interest Principal Total Paid

$36.00 99.00 600.00 71.26 $806.26

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Insurance, taxes, and interest paid are all expenses, and principal is a reduction in the mortgage balance. In this example, the effect on cash flow is $806.26 paid out, but the effect on monthly cash expenses is $735.00. This changes slightly each month as interest is reduced and principal payment is increased. Important: The record of mortgage payments has to be further distinguished by property. If you own more than one rental property, you must break down each expense by property, because you are required to summarize in that manner on your income tax return. It is also important to track cash flow for each property, because you may have some positive and some negative cash flow properties.

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Recording Expenses for Rental Properties The complication for rental properties is not only separating payments by type of expense, but the additional requirement that you track expenses for each property. As long as expenses can be identified by the property itself (e.g., interest, taxes, utilities), this is easy to do. However, some expenses (e.g., office supplies, legal and accounting fees, auto and truck expenses, and telephone) cannot be as easily broken down by property. You need to use a formula that makes sense on some basis. (Allocating nonspecific expenses among two or more properties is explained later in this chapter.)

Simplified Record Keeping For those expenses that are easily identified for each property, the recordkeeping rules can be simplified. Remember, you need two forms of distinction: 1) by type of expense and 2) by specific property. It makes sense to set up your records by type of expense and post payments to those expense accounts as they are made. Such a system can be set up within an automated accounting system such as QuickBooks or on a simple Excel worksheet. You need to also track expenses by property, so each expense account has to be subdivided by property address. Figure 5-3 shows a simplified bookkeeping format that allows you to segregate each expense and break it down by rental property. You need to set up expense accounts for: Advertising Auto and Travel

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Figure 5-3. Rental payments journal.

Cleaning and Maintenance Insurance Legal and Professional Fees Management Fees Mortgage Interest Paid to Banks Other Interest Repairs Supplies Taxes Utilities Office Supplies Telephone (Continues)

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Landscaping Bank Charges Miscellaneous

Year-End Summary Each form would be completed for each month. On an automated spreadsheet program, you could set up one “sheet” for each month, with one worksheet for each account, and track entries in that way. The year-end totals could then be transferred into a worksheet such as the one shown in Figure 5-4. This worksheet provides a summary that you can use to complete the expense portion of your federal tax return, Schedule E. (See Chapter 10 for more details.)

Figure 5-4. Year-end worksheet, expense summary.

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Simple Methods for Tracking Cash Payments A chronic problem for anyone operating their own business is the handling of cash transactions. Real estate investors are no exception. A potentially significant dollar amount of deductible expenses may be forgotten each year because the transaction takes place in cash. For example, when doing small repairs on a rental property, you make several trips to the hardware store to buy small tools, hardware, or parts. Each purchase runs $5 or less, and so you pay in cash, losing the receipt along the way. By the end of the job, you may have spent $50, collectively. If you do a repair job like that once a month, you lose track of $600 per year. This example may be only part of a larger problem. If you have several rental properties, it is all too easy to lose track of small expenses, so you need to devise a consistent but simple procedure.

Saving Receipts In more formalized settings, like a business office, you would set up a petty cash fund, placing a set sum of money in a cash box and reimbursing cash expenses for receipts. Considering that the goal is to keep things simple, it should not be necessary to set up a petty cash fund. Instead, you can use a less formal procedure. Since you will normally use your car, van, or truck while out on real estate business, your cash transaction system can be operated out of your vehicle. The following three-point checklist is a suggestion for how the simplified cash system can work: 1. Place a large mailing envelope (e.g., 9 inch x 12 inch in size) in your vehicle. 2. Whenever you buy something related to your real estate investments, place the receipt in the envelope. Write on the receipt the type of expense and the property address or name. 3. Once a month (or more frequently, if the volume is high), gather together the receipts, subtotal each expense classification, and reimburse yourself from your business checking account. In this way, the cash expenses go through your checking account and into your books. This simplified system gets you into the habit of filing receipts in the same place each time you spend money. Remembering to properly label

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each receipt also helps you assign each expense to the correct expense category and for the right property.

Having a Cash Fund If you spend a large amount of cash, you could also place a small cash fund in the envelope. While this increases the chances for petty theft, it also makes it convenient for you to manage cash transactions. Most people find it easier to simply keep more cash in their pocket for such expenses. In general, though, you should work to minimize cash transactions because, even with a simple system like the one proposed, it is cleaner and easier to run as much as possible through your checking account.

Opening an Account To help improve the situation, you can open an account with your local hardware store (the place you are most likely to spend cash) and charge your purchases rather than pay cash. In this way, you pay for your purchases with one monthly check instead of making a higher volume of small purchases throughout the month. As you sign for each purchase, be sure to write down the property address on the voucher so that you will be able to break down your monthly bill by rental property.

Avoiding the Use of Cash Even though you can devise methods for tracking cash, the fact remains that it is the least desirable method for paying expenses. There is too much inconsistency and there are too many ways to overlook claiming a deduction. Simply forgetting to ask for a receipt means you lose the write-off, and these omissions add up through the year. For example, when you are working on a rental property and making numerous trips to the hardware store, you can easily forget to keep track of what you spend. Receipts get lost. And any time you use cash it requires two steps: First, you have to remember to get a receipt and keep it somewhere safe; second, you have to record the transaction in the books. If you can avoid using cash, you will have a much better system and a cleaner set of books. By using an open account at your local hardware store, you can minimize the use of cash. This does not completely solve the problem, however. As an alternative, you can use credit cards whenever possible to reduce the use of cash. Here are some guidelines for using credit cards:

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❑ Use one card exclusively for investment expenses. If you have two or more credit cards, use only one for your investment-related expenses. When you put gas in your car, purchase landscaping supplies, or shop at the hardware store, use the same card. Don’t use this card for any other purposes, except in emergencies. In this way, your monthly payment on the credit card is consistent and you can easily keep track of business expenses as they occur.

❑ Keep receipts even when using your card, and match all purchases to your monthly statements. Just because you are charging your purchases does not mean you should throw away your receipt, for several reasons. First, you should always check your receipts against what gets charged to your account, to make sure all of those charges are legitimate. Second, the receipt documents what you purchased and is necessary to complete your record keeping. Third, the receipt may be necessary to allocate expenses among properties. For example, you may make a purchase at one store, but the items are allocated to two different properties.

❑ As an alternative, use a debit card on your business account. Some people don’t want to use their credit cards. Perhaps they don’t have an adequate line of credit, or they find it too much trouble to remember which credit card to use. In this case, you can use a debit card associated with your investment expense. The debit card is as convenient as writing a check, and the cash comes out immediately. Remember, though, you still need to keep the receipt to make the record of your transaction complete.

❑ Pay off the balance each month. Don’t let your investment credit card debt get out of control. Pay off the entire balance each month unless an exceptional situation arises (e.g., an unexpected, expensive repair). Having credit available is one way to manage cash flow, but you can only use your card in that way if you keep the balance under control. Paying off the entire balance is the same as if you were writing checks for each and every transaction. Don’t allow your balance to inch upward so that you end up with no credit available when you need it.

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Allocating Expenses Among Properties Certain expenses cannot be identified by property. The larger expenses— interest, property taxes, utilities, and insurance—are easily and specifically tied to the property itself. However, legal and professional fees, office sup-

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plies, auto and truck expenses, and telephone charges are far more difficult to deal with.

Year-End Allocation You are required to break down your rental expense by property, so you need to devise a method that makes sense and is also consistent for allocating nonspecific expenses. The most reliable method is to make allocations at the end of the year based on the level of rents collected. Performing allocations during the year is not advised; this makes more work and confuses the bookkeeping process. Keep it simple and straightforward month to month, and prepare a worksheet at the end of the year, such as the one in Figure 5-5, as part of your tax return, to allocate expenses. Note that insurance is included on this form. The insurance expense that belongs to each property can be easily allocated, of course. The purpose for including insurance on the allocation worksheet is for forms of insurance that cannot be broken down by property, such as insurance on a vehicle that you use only for managing your rentals. The distinction between “supplies” and “office supplies” can be confusing as well. The type of items you would list under supplies includes hardware, drywall compound, paintbrushes, and small tools. Office supplies

Figure 5-5. Year-end worksheet, expense allocations.

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includes the usual paper and pens as well as letterhead, envelopes, stamps, printed checks and deposit slips, and other paper goods.

Computing the Allocation The allocation is not difficult to compute. You just break down each year’s total in each expense classification using the same percentage as rents.

Example: You owned four properties during the most recent year. Rental income was $3,400, $3,785, $6,010 and $1,554. To arrive at a percentage breakdown, divide each rental total by the overall total ($14,749): $3,400 ÷ $14,749 = 23.1% 3,785 ÷ 14,749 = 25.7% 6,010 ÷ 14,749 = 40.7% 1,554 ÷ 14,749 = 10.5% To summarize:

Property # 1 2 3 4 Total

Amount $ 3,400 3,785 6,010 1,554 $14,749

Percent (%) 23.1 25.7 40.7 10.5 100.0

Applying the Allocation To apply these breakdowns for each expense, you would multiply the total by the applicable percentage. For example, if your legal and professional fees totaled $525 for the year, using the breakdown, you would assign the expense to each property as follows: Total

#1

#2

#3

#4

$525

23.1% $121

25.7% $135

40.7% $214

10.5% $55

The allocation method is consistent and easily documented. As with all such calculations, keep the completed worksheet with your tax papers for

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the year so that you will be able to explain how you broke down each expense in the event that you are asked to do so. What if you own a property for only part of the year? The allocation method is still reasonable because it shows a smaller rental total for the property and, as a result, a smaller dollar value as well. However, if you had an unusually large expense in the early part of the year and did not purchase an additional property until later, you could calculate two separate allocations: one for the period you owned three properties, and another for the period of time you owned all four. Because the difference is probably going to be insignificant in most cases, it is a lot of extra work to calculate separate allocations, and it may even confuse rather than clarify the issue. The most reasonable approach is to apply an allocation for the entire year. The overall result will not change, so your tax liability is going to be the same no matter how you break down the allocation.

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Using the Nonallocation Method Another alternative is not to allocate these expenses at all, but rather to show them in a separate column. On the Schedule E used to report rental income, you are asked to show each property’s results in its own column. You could include a column for nonallocated expenses. Using this method, you would report rental income, expenses, and profit or loss for each property, and then a last column, called “unallocated expenses,” would have a total for each expense and a net loss. The columns are added together to summarize the net profit or loss.

Key Point: The unallocated expense method keeps the books simple because no expenses are allocated. However, the process of evaluating cash flow for each property is more difficult. You need to perform your cash flow on all properties, but that is the method you probably use each month anyway. A suggestion: Evaluate cash flow each month based on a worksheet allocation of expenses, which allows you to look at each property objectively. But don’t make allocations within your books. Then at the end of the year when you prepare your taxes, you can consult with your tax adviser as to whether or not to allocate expenses. That allocation can also be done on a worksheet, without complicating your bookkeeping.

Nonallocation is easier than breaking down expenses. You should continue to assign expenses to specific properties as long as you can break them

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down easily. Therefore, utilities, interest, and property taxes should be assigned to their respective properties as payments are being made.

Simplifying Depreciation with Nonallocation The nonallocation method also clarifies the treatment of depreciation for assets that are not unique to a particular property. Under the allocation method, you need to break out a portion of depreciation for each property. Expenses that may be nonspecific to property (e.g., your auto or truck expenses, the costs of landscaping equipment and tools) have to be allocated to each property individually. This complicates the question of depreciation significantly. When you sell a rental property, you are supposed to “recapture” the depreciation expenses you have claimed while you owned it. (This means the amount of depreciation is taxed upon sale of the property.) If you have claimed a portion of depreciation for nonspecific items, it confuses matters. If you have a number of assets that cannot be assigned to each property, using the nonallocation method makes the most sense. Even if this is not a problem today, if you expect to own several properties in the future, you may want to establish a policy now that you will not allocate expenses to each property. This keeps everything much easier to track.

Year-End Tax Reporting One problem with nonallocation is that it does not allow you to show a net profit or loss on your tax return for each property. This does not affect your liability, because the net total of all properties is the profit or loss number that gets transferred to Form 1040 and on which tax is computed. Whether or not you allocate expenses, it is not wise to try to perform the allocation every month. The means for determining the breakdown—usually rental receipts—is likely to change throughout the year, so you would have to continually adjust the breakdown. Allocation should be a year-end calculation, done only once. This also keeps your books simple.

Example: You have three rental properties and you are summarizing your yearend tax reporting. You do not want to allocate certain expenses. A summary of your annual rental income and expenses would look like this:

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Description of Expense

Property #1

Property #2

Property #3

Rental Income $8,515 Interest $6,450 Property Taxes 932 Utilities 117 Depreciation 2,265 Office Supplies Telephone Auto Expenses Landscaping Total $9,764 Net Profit (Loss) $(1,249)

$7,753 $6,601 412 232 2,803

$7,230 $5,559 504 413 2,007

$10,048 $(2,295)

$8,483 $(1,253)

Nonallocated

512 804 240 1,134 106 $2,796 $(2,796)

Total $23,498 18,610 1,848 762 7,587 804 240 1,134 106 $31,091 $(7,593)

In this example, nonallocated expenses were kept separate. While it would be a fairly simple matter to allocate these expenses, this method is clearer and cleaner. Because the net profit or loss on a capital gain is going to be based on the depreciated value of the property, depreciation expenses have to be divided among properties. However, any nonspecific depreciation can be kept in the nonallocated category and treated the same as other nonallocated expenses.

Showing Nonallocated Expenses on Your Tax Form Nonallocation is not a preferred method, because it does not really comply with the columns and format of the tax form. Even so, the net profit or loss continues to be reported, so there is no harm done by nonallocation of certain expenses. And, even though the method does not exactly match the requirements of the tax form, it does comply with the provisions of the tax laws. You are required to report the net profit or loss from the activity and to show a breakdown by property of all revenue and expenses. Because nonallocated expenses cannot be directly assigned, they are treated as though they represent a separate property, but only in the sense that they are given their own special column for reporting purposes. In the previous example, we showed four columns plus a total column. You may notice that the tax form where this information is reported (Schedule E of Form 1040) has only three columns. That doesn’t mean that all of the information has to be forced into three columns. When the information exceeds the capacity of the form, it is summarized on a supplementary schedule, and the totals are reported in the far-right column of the form.

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Getting Help—Finding a Qualified Bookkeeper Even if you are comfortable doing most of your own record-keeping chores, you may find it necessary to hire someone to formalize your books. You may already know how to record transactions and balance the books, but you may be one of the thousands of people who simply don’t enjoy bookkeeping, so it’s a bargain to pay someone else to do it for you. What guidelines should you follow in finding the right bookkeeper? Here are a few ideas:

❑ Check references. Any time you hire someone to work for you, it is essential to check references. Some people are not trustworthy, qualified, or competent, and it is expensive to discover that for yourself, after you have hired them. Ask for professional references, including the two latest jobs, and check them thoroughly. If an applicant is not willing or able to provide references, don’t hire the person. People are not always completely honest in what they tell you when applying for a job, so you must ensure that the person you are interviewing has experience. Ask them questions about bookkeeping: What have they done in the past? Have they worked with accountants in the area? (If so, that gives you more references to check, too.) Are they full-charge bookkeepers? (A fullcharge bookkeeper is supposed to be qualified to do all the bookkeeping entries, including the final entries at the end of each month.)

❑ Find someone with experience in real estate. When it comes to recording transactions, keeping records, and breaking down expenses, the rules for real estate are different from most other types of businesses. You probably need someone with experience in rental bookkeeping. While this is not absolutely essential, it is an advantage. A person who understands how to allocate real estate expenses and why it is so important will have an advantage over someone you will have to train.

❑ Consider using a management company’s services. If you cannot find a qualified bookkeeper in your area, you may want to check with a local real estate management company. These companies handle all of the details of rentals—from bookkeeping to filling vacancies and fielding tenant problems—for landlords who don’t want to deal with these matters themselves or who live far away and cannot. Some of these companies may be willing to quote you a price for keeping your books.

❑ Coordinate the bookkeeping routines with your tax adviser. Your tax adviser should not be someone whom you see only once a year. You may

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also need midterm tax-planning advice, so you should make an appointment to plan ahead. In the course of managing your taxes, you can also ask your tax professional where you can find a qualified bookkeeper. The tax adviser may know someone or, if a member of a large firm, may have an in-house bookkeeping service. This can save you a lot of time and trouble. Your tax adviser won’t have to depend on an outsider’s bookkeeping to determine what is going on; the same adviser can supervise how the books are set up and how month-end and year-end summaries are recorded.

❑ Be aware of employment rules. Make sure the individual you hire understands that the arrangement is not an employment agreement. That means they are responsible for their own insurance and taxes. In some situations, you could get into a lot of trouble if you don’t have a specific agreement and the person complains to the tax authorities that you did not withhold taxes, workers compensation, or unemployment insurance. Therefore, get your agreement in writing, specifying that the individual’s status is as an independent contractor and that the agreement is not an employment contract. If you decide to hire someone as an employee, you should first check into record-keeping and reporting requirements. Having an employee is a complex administrative and bookkeeping problem. You must make periodic deposits for payroll taxes and pay approximately 12 percent of the payroll for federal and state insurance and Social Security. You must also pay workers compensation insurance. For all of these reasons, it is far more efficient and cheaper to hire a bookkeeping service and not an employee.

❑ Hire someone you are comfortable with. No matter how qualified a bookkeeper might be, you should be comfortable with them. You want to be able to talk about your books and ask questions. The bookkeeper, too, must be comfortable working with you. If there is tension in the relationship, you will not enjoy meeting with your bookkeeper. You also will not be able to get the information you need and deserve.

❑ Pay attention to what is being done. One of the greatest mistakes any investor or small business owner can make is letting someone else do the books without paying attention. You should ask questions, review work, and make sure you understand exactly what is going on with your books. You are responsible for keeping records even if you hire someone else, so you need to ensure that the information is being recorded accurately and properly.

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Watch This: Some investors think it is efficient to let their bookkeeper sign checks. This is not a smart idea. You invite trouble when you give someone else unlimited access to your funds. Signing the checks is a good control point, where you can ask questions if you’re unsure about anything—or want to know what is being paid, for example. Not everyone will embezzle just because they have the opportunity, but why invite trouble? Sign your own checks and supervise the entire bookkeeping operation regularly.

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The Rental Agreement In thinking about various types of documentation (e.g., receipts, invoices, statements), we tend to view investment activities in terms of the common tax rules. You need a document to verify the expense. For rental activity, you also need to document the fact that an agreement existed for the period you claim deductions. You can verify expenses to a degree with utility records that show where you and your tenants receive mail. Going beyond this, though, you also need to enter a written agreement with your tenant that defines what you have agreed upon. Your rental contract defines the beginning date of your rental, the amount of rent the tenant is supposed to pay, any deposits given to you and what they are for, which utilities the tenant pays, and other important terms. In addition to being an important legal document, the rental contract is also a form of documentation for tax purposes. It establishes that a contract existed between landlord and tenant.

Conforming to the Law The laws vary from one state to another. The specific terms you put in your rental agreement should be reviewed by a real estate attorney to ensure that your requirements conform with the local laws. For example, some states require twenty days’ notice if you or your tenant want to terminate the agreement; other states require thirty days. You cannot waive the legal requirement. Even if you and your tenant agree to twenty days’ notice, but your state requires thirty days, that is the rule. If one side or the other makes a thirty-day notice, that conforms with the law. A typical rental agreement for a month-to-month rental is shown in Figure 5-6. Remember, though, that the specific rules in your state may require modification to some of the terms listed.

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Figure 5-6. Sample rental agreement. Rental Contract This is a rental agreement for a month-to-month rental between ___________________ ___________________ (tenant) and ______________________________ (landlord), for property located at ___________________________ in the city of __________________ _____________________________. The rental terms begin on _______________ and will continue until one side provides written notice to terminate the agreement. Such notice will be provided no less than ______ days before the intended date of moving. The landlord agrees to refund all deposits due to the tenant as specified below within _____ days after the property has been vacated. The monthly rent is payable on the _________ day of each month in the amount of $_________ per month. The security and cleaning deposit is payable on the date this agreement is signed in the amount of $___________. This deposit will be returned upon completion of this agreement and subject to the tenant’s returning of keys and completion of a walk-through inspection by the landlord and a return of property condition to its original condition. Any cost of cleaning or repair will be deducted from this deposit, explained, and the remaining balance refunded. No portion of this deposit may be applied to rents remaining due upon termination of this agreement. Residents of the property are limited to the following persons: _____________________ _________________________________________________________________________. No additional persons may reside at this address under the terms of this agreement, without written permission from the landlord and renegotiation of a new rental agreement. No pets are allowed at this address unless preapproved by the landlord and subject to an additional pet deposit. The tenant also agrees to the following rules: a. The outside areas will be maintained in current condition, including lawn and yard maintenance. No personal property will be left in the yard or on the porch area. b. The tenant will not paint or perform other repairs or modifications to the property without prior written consent from the landlord. c. The landlord has the right to inspect the property, make repairs, or show the property to prospective buyers in the event a sale is pending, or to new prospective tenants if this agreement is in the process of ending, provided that the landlord will provide ______ days’ notice in advance and make an appointment to have access to the property. d. Rents will be submitted by mail or in person on the due date and at the owner’s address. e. No motor vehicles in excess of ____ vehicles will be kept at the property. All vehicles kept at the property will be currently licensed and registered. No repairs of motor vehicles are allowed at the property. f. The tenant will pay for all repairs for damages caused by the tenants, their children, or guests. If the landlord pays for such repairs, the tenant agrees to reimburse the landlord by payments on a schedule agreed upon by the landlord and tenant.

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g. The tenant will not change locks without prior written permission from the landlord. Upon termination of this agreement, the tenant agrees to provide the landlord with two key sets for the changed locks. h. Other: _______________________________________________________________ Violation of any of the terms of this contract may result in the landlord beginning eviction proceedings. The tenant has read this agreement, understands its terms, and has been given a copy of the agreement. This agreement also represents a deposit receipt according to the terms above. Other agreements that are part of this contract include a Statement of Condition and___________________________________________________. Owner____________________________________________ Date____________________ Owner’s address___________________________________ Telephone _______________ Tenant(s) _________________________________________ Date____________________ __________________________________________________ Date____________________ Tenant’s telephone___________________________________________________________

Some Problems to Watch For The rental agreement is a contract. Of course, it is designed to cover most of the common problems that can arise between landlord and tenant, but it cannot possibly cover everything. Disagreements can and do arise, and some areas of conflict seem to be more common than others—no matter how carefully the rental agreement is worded. These common problem areas include:

❑ Due Date of Rent. Tenants may have a relaxed attitude about the date the rent is actually due. From your point of view, the mortgage payment is usually due on the first, so it would be nice to collect rents on the same day. If you do not specify the due date with the tenant, the payment may slip. If you do not enforce the agreed-upon due date each month, the tenant may fall so far behind that it will be impossible to catch up.

❑ Residents Allowed in the Property. Every house has a limited amount of space. A very small property will be appropriate for a limited number of people, so the rental agreement is designed specifically to limit the number of people who are allowed to live on the premises. Some tenants with large families will initially represent that there are only two people, only to move three or four more people in later. The problem with this is that there will be more wear and tear on the property; in addition, it is not

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fair to you when tenants deceive you about the number of people living in your property. This is why the contract includes space to list everyone. It allows you to enforce the terms later if more people move in to the property. You need to be sure that you don’t violate local laws when limiting the number of people who can live in your property. Some states’ rules forbid discriminating against families with children, for example, so you cannot reject an application solely because your tenant has children. The criteria must include a reasonable argument about the size of the property and the number of people who can live within that space with that many bedrooms and baths.

❑ Responsibility for Yard Maintenance and Provision of Tools. Tenants often want to occupy a house but do not own a lawn mower and other yard tools. As landlord, you probably don’t expect to provide these tools for your tenants, so this is one possible area of conflict. A tenant may actually expect the landlord to buy a lawn mower for them. You need to clarify the fact that the tenant is responsible for yard maintenance, and this invariably includes mowing a lawn, weeding, trimming, and doing other yard routines. Logically, this also means having to buy the needed tools, renting them, or asking a friend for help. Some landlords gladly lend their mower to the tenant or leave a spare mower on the premises. But lacking these, the tenant has to assume responsibility for making arrangements necessary to maintain the yard areas.

❑ Rent Offsets. Some tenants think it is reasonable to barter for some of the rental obligation. This usually means they cannot afford the rent you are asking. If this comes up in the application phase, it is a warning sign. If it comes up later, it may be troubling, but you have to remain firm. The full amount of rent is due. None of that rent can be exchanged for performing work around the property or otherwise working for you. Chances are, you will never have enough work to keep the tenant busy, even if you wanted to. In addition, you already have a specific contract with your tenants; complicating that agreement with a working relationship raises all sorts of potential trouble. What if they injure themselves? Are you liable for providing insurance or withholding taxes? What if you’re unhappy with their work and want to fire them? Any number of serious conflicts can come up, so you are better off keeping the landlordtenant relationship as simple as possible. The two most common areas that come up in the bartering offer are landscaping and painting. Since the tenant is already responsible for

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landscaping, there is no room for negotiation on that count. Most people who have never painted a house think it is an easy job, but they soon find out it is far more work than they think. Landlords should never give permission for tenants to paint inside or out, even if they want to perform the work for free. You need to maintain control over color choices, quality of work, and timing. Tenants may start out working for free, only to later decide they should be paid for their efforts—another potential conflict area worth avoiding.

❑ Automobiles on the Premises. You want to restrict the number of cars that tenants are allowed to have parked on or near your property. This restriction should include a limitation on the number of vehicles, a rule that the vehicles have to be registered, and a ban on working on vehicles on the premises. Without these rules, it is too easy for tenants to make a mess of your property, not only visually but environmentally as well. Your neighbors will not appreciate the problems, and the conditions may also violate local zoning rules. Including vehicle restrictions in your rental contract is important, if only because the problem does arise from time to time.

❑ Application of Security Deposit to Rents. When they want to end their relationship with you, tenants may decide to apply their security deposit to the last month’s rent. This means that if they do not clean the property or if damage has been done, you have no recourse in collecting the costs from the security deposit. However, by the time the tenant has decided not to pay the last month’s rent, it is really too late to prevent this. By the time you would be able to take action to collect unpaid rent, the tenant will be gone and there would be no point in proceeding. If the property is left damaged and there is no security deposit left, you can file a small claims action; but even with a judgment, collection will be a problem. Unless the damage is significant, the effort will not be justified by the amount of money involved. A far more sensible approach is to require tenants to prepay the last month’s rent as well as the security deposit, although this will create a hardship for many tenants. They will need to pay first and last month’s rent plus a security deposit in order to move in. Depending on the condition and age of the property, the neighborhood, and the tenant’s references, you may be willing to forego the last month’s rent requirement. If this rule translates to having longer periods of vacancy (because fewer people can afford to put down that much money), it will not be worthwhile—especially if other landlords are not requiring first and last month’s rent as part of their conditions for moving in.

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❑ Conditions for Return of Security Deposit. The security deposit is intended as a fund to ensure that tenants do not damage your property, fail to return keys, or leave without cleaning. Even so, some tenants will cause considerable damage and fail to clean up and still expect to be given their security deposit. You may need to clarify the intent of the deposit. One solution to this potential problem is to advise the tenant that when they are ready to vacate, you want to do a walk-through inspection with them. At this time, you can check conditions and let the tenant know of any repairs or cleaning that still need to be done. You can also inform the tenant that in order to get their security deposit back, those repairs and cleaning chores need to be completed. This step helps to improve communication and ensures that the tenant knows the terms of vacating the property.

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The Statement of Condition A second form, usually a part of the rental agreement, is the Statement of Condition. This is a listing of any and all defects and other conditions of the property, an inventory of any furniture or appliances included with the property, and other notes agreed to by both tenant and landlord. The form should be completed by the landlord as a walk-through of the property is performed with the tenant. This form could be multi-page and list every possible condition, or it could be fairly simple, with only specific notations made. A sample of the simplified version of the Statement of Condition is shown in Figure 5-7.

Protection for Landlord and Tenant The purpose to the Statement of Condition form is to document the exact condition of the property, to protect both landlord and tenant. If there are any flaws in condition, these should be noted on the form. During the walkthrough, the tenant has a chance to point out flaws that should be written down, such as chipped trim, holes in the walls, worn carpets, or missing and broken tiles. When the tenancy ends, the Statement of Condition can be referred to as the source of information about who is responsible for repairs. The same logic applies to appliances. If appliances are not clean when the tenant first sees them, this should be noted on the Statement of Condition. The landlord should deliver the property in clean condition. It would not be fair to turn over the property in less than clean condition and then expect the tenant to clean up upon vacancy.

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Figure 5-7. Statement of Condition. Statement of Condition Tenant and landlord have completed a walk-through of the property under the rental agreement signed on _____ for the property located at ___________________________. The following summary is agreed upon by both landlord and tenant. The following furniture and appliances are located at the property: Description Condition _________________________________ _______________________________________ _________________________________ _______________________________________ _________________________________ _______________________________________ _________________________________ _______________________________________ _________________________________ _______________________________________ _________________________________ _______________________________________ _________________________________ _______________________________________ Condition of the property is assumed to be without flaws, except as noted below: Inside Paint ___________________________________________________________________________ ___________________________________________________________________________ Floors ___________________________________________________________________________ ___________________________________________________________________________ Walls, Ceilings ___________________________________________________________________________ ___________________________________________________________________________ Fixtures ___________________________________________________________________________ ___________________________________________________________________________ Doors and Windows ___________________________________________________________________________ ___________________________________________________________________________ The property and appliances are in acceptable working order and are clean, and tenant agrees to leave the property in the same condition. Owner____________________________________________ Date____________________ Owner’s Address___________________________________ Telephone _______________ Tenant(s)__________________________________________ Date____________________ __________________________________________________ Date____________________ Tenant’s telephone___________________________________________________________

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The same protection works for the landlord. If the property is spotless and all fixtures are in clean and working order, this has to be noted on the Statement of Condition. If the tenant breaks anything or damages appliances or fixtures, you then have the right to deduct repairs and cleaning from the security deposit. There are some exceptions:

❑ Normal Wear and Tear. You expect carpets to wear out after a few years, and you also expect to need to repaint interior walls. These are examples of normal wear and tear. A tenant who has occupied the premises for many years should not be expected to pay for new carpeting that is several years old. You would expect a tenant to fill holes in the wall where they have hung paintings, but you would not expect them to pay for a new paint job in a room that hasn’t been painted for many years.

❑ Appliance Breakdown. Landlords often put used appliances in their rentals. The cost of new appliances is prohibitive and the number of appliances can be staggering. For example, if the typical house includes a refrigerator, dishwasher, washer, dryer, and range—a total of five appliances—that is a considerable investment. If you own four rental properties, that adds up to twenty appliances. Rather than paying for brand-new units, you will probably purchase used appliances, in which case you have to expect them to break down. A broken appliance is often not worth fixing. More likely, you will place another used unit in the home if your tenant reports a breakdown. It would not be fair to expect the tenant to pay for repairs or replacements, considering that you are providing them with used appliances. You can find used appliances that are in good working order for far less than the prices you’d pay for new ones; but realistically, you also have to expect them to wear out after a while.

❑ Structural and System Flaws. You cannot expect your tenants to take responsibility for flaws in the building itself. Examples include maintenance of heating and air-conditioning systems, roofing and siding, outside paint, and electrical and plumbing systems. All of these are the landlord’s responsibility in most cases. If the tenant were to break something in using systems other than as intended, they would be responsible. For example, if a tenant decides to rewire the house and your electrical system needs to be repaired as a result, that would be the tenant’s responsibility. However, normal problems and periodic maintenance, such as changing filters in your heating system, are your responsibility.

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Keeping Your Records Simple but Effective The legal contracts you need are the beginning of documentation for the terms you and your tenant agree upon. Next, you want to create a method for keeping track of the money that changes hands each month. When you think about the purpose in setting up your books in a particular way, what is the real goal? You want an effective set of books that is easy to maintain, that is easy to track and explain, and that takes as little time as possible to update. Few real estate investors want to spend a lot of time maintaining their bookkeeping system. They would rather be doing other things. If your bookkeeping and taxes are too complex, you may want to pay a bookkeeper to maintain your records and a tax expert to fill out your tax forms each year. However, by applying a few basic rules, you can probably keep your own books—at least when you first begin investing in real estate or own one property. Later on, if you own numerous properties and have many transactions each year, including the sale of properties, you may need to hire expert help.

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Summary of Key Points ✓ Set up a separate bank account, deposit all rental income, and run all payments and expenses through the account. This is the basis of keeping clear and accurate records.

✓ Keep all receipts, filed by type of expense or by vendor. This way, your records are kept in one place and—with relatively little time invested— you can keep the books simple but thorough.

✓ Handle cash expenses consistently, collecting receipts in an envelope you keep in your vehicle, and reimburse yourself periodically by writing a check from your investment account. This helps to keep your books consistent and minimizes the chances that you will overlook a legitimate deduction. If your records are too much to handle, or if you are spending too much time struggling with your bookkeeping, ask for help. Hire a bookkeeping expert, either to do the work for you once a month or to show you how to improve your system so that it is easier to maintain. You are better off paying for help that you need, if you continually struggle with the process. If you understand the process but do not enjoy maintaining the records, con-

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sider automating your books, using an informal system (e.g., a series of Excel worksheets) or a flexible but easy-to-use accounting program like QuickBooks. The next chapter provides more specific ideas for keeping your records neat and clean, and for reducing the common problems that real estate investors face.

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C H A P T E R

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Keeping Track of Real Estate Transactions Many of the bookkeeping standards for rental property are different from those for other businesses. For many first-time real estate investors, the difficulty arises from the mix between personal and investment uses of property. If you begin by converting a home that you use yourself—a vacation home, for example—you need to track personal and investment use carefully. You also need to document how you break down the usage. Probably the most reliable method is to record the number of days the property is assigned to personal use and to investment use. A second problem arises when you convert a property during the year. Some people find themselves in the real estate business when they move from their current house to a new one. Instead of selling their existing primary residence, they convert it to a rental. This decision used to be made to avoid taxes on a sale. However, under current federal rules, you are allowed to sell your primary residence tax free. This rule applies up to $500,000 in profit, as long as you have used the property as a primary residence for at least twenty-four months during the past five years. Even with the ability to escape taxes on the profit from selling your home, you might decide to convert to a rental. For example, the current market may not be strong enough to produce a profit from your current home. Converting it to a rental is one method for delaying the decision to sell until the market price rises. Of course, given the time restriction for avoiding taxes on a profit, you could end up paying capital gains tax on the property later.

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Key Point: Some expenses are both personal and investment related to some degree. These expenses must be broken out and documented properly. The time may come when you will need to explain how you decided to assign a portion of an expense between personal and investment use.

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Separating Personal and Investment Expenses The solution to the mixed-use problem is documentation. You must contend with this problem in one of three circumstances: 1. When an expense includes both business and personal usage 2. When a property is used only part of the year as an investment 3. When a property is used year-round, partly as your residence and partly as a rental

Business/Personal Mix Some expenses can include both personal and rental portions. Let’s run through some examples. Automobile Expenses. You may use your personal automobile for rental activities. For example, you need transport to examine potential rental properties; to make trips to collect rents; to meet with prospective tenants; to take garbage to the dump; to move appliances or furniture; to keep an eye on the property; and to visit your accountant, attorney, or real estate broker. Any investment use of your automobile is deductible as an investment expense. If you use your personal car or truck in this manner, the most likely method for calculating a deduction is going to be based on the precise number of miles. You are allowed to claim a specific amount per mile as a deduction. You need to keep a log of your automotive expenses, which includes the date, destination, miles traveled, and purpose of each trip. Use an expense log such as the one shown in Figure 6-1. To claim a deduction based on mileage, you must have owned the vehicle and used the mileage method in the first year of ownership (you cannot switch back and forth between mileage and depreciation methods). If you lease your vehicle, you have to use the standard mileage method for the entire lease period.

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Figure 6-1. Automobile log.

The alternative method includes calculating the business portion and then deducting the applicable cost of gas and oil, repairs, insurance, new tires, license and registration fees, and depreciation. This method is more complex but could result in a higher deduction, especially if you use your automobile extensively to manage rental properties. The standard mileage allowance changes from year to year (the IRS releases the new figure in January for the previous year). This mileage allowance does not include parking fees and tolls, which are added separately. Whichever method you use, if it involves more than one vehicle, you have to perform the computations and keep records for each vehicle. If you own several rental properties, it could make sense to buy a truck and use it exclusively for real estate activities.

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Landscaping Equipment. Some rather simple acts can complicate your bookkeeping. For example, let’s say you own a riding mower that cost $1,200 and you use it occasionally to mow the lawn of your rental property. Based on the degree of usage, this equipment is partly a personal asset and partly an investment asset. There is no deduction for personal use, but as an investment asset you are entitled to depreciation expenses. However, you can depreciate the asset only to the degree that it is used as part of your investment activity. If you have only your own lawn and the rental property lawn and you use the mower equally for each, the breakdown is probably fifty-fifty. This is a simple calculation. But the question is complicated if the circumstances are not so straightforward. For example, if your rental property is two acres but your personal property lies on a 50-foot by 100-foot lot, then your investment expense is much higher. You may need to mow 80,000 square feet of lawn at your rental property, versus only 3,000 square feet at your home. In this example, investment expense would be 96 percent of the total (80,000 feet divided by 83,000 feet). This breakdown would be easily documented, especially if you had purchased the riding mower specifically to take care of the rental property. In such a case, it would simplify your bookkeeping to purchase the riding mower as an investment asset and use a smaller, cheaper mower for your residence. This example illustrates that some decisions you need to make in managing your real estate investments can create complexities. You could end up with a considerable investment in landscaping equipment—mowers, garden tools, soil and treatments, and more—especially if you own more than one rental property. Keeping these items separate from your personaluse items helps to keep your books clean and simple. Telephone. If you limit your rental investment activity to your town, it is unlikely that you will have any substantial telephone expense. If you already pay for a telephone line, you may have difficulty justifying a deduction for investment purposes. Even if you use the phone for many local calls, you would have to pay the monthly service fee regardless; so unless you use the telephone for a high volume of calls, you probably are not entitled to a deduction. However, if you can document a substantial number of investment-related phone calls, you could justify deducting a portion of the monthly service charge, taxes, and any long-distance calls. If you claim investment use of your personal telephone, you must maintain a telephone log or make a copy of your monthly bill and mark those calls relating to your investment use. If you make a large number of long-distance calls related to investment activity, you may calculate the deductible portion of your monthly service

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fee. For example, if your investment-related long-distance charges are 35 percent of total long distance, you may claim a deduction of 35 percent of the fixed monthly fee and applicable taxes. This is one method for documenting your telephone use. In cases where you have to make long-distance as well as local calls for your investments, it makes senses to pay for a separate phone line. This simplifies the deduction, since the second line will be dedicated specifically to investment activity. This provides you with an additional benefit: You can connect the second line to a message machine, thus preventing tenants from calling you at all hours with questions, complaints, or requests. That gives you control over contact and ensures privacy. You may wish to deal with tenants during business hours only and not on weekends, during meals, or on holidays. Another way to distinguish between rental-related phone use and personal use is to use a cell phone. The cost is separate from your personal phone use, and you control whether the phone is on or off. You can retrieve messages when you wish, and you can also limit tenant access to the cell phone alone. Office Supplies. The office supply requirements for running your property operation are going to be limited, though your set-up expenses could be considerable. These expenses include paying your bank for printing checks and purchasing a supply of paper, rent receipt forms, accounting worksheets, and other office tools (e.g., tape dispenser, stapler, etc.). These expenses should all be paid for out of your business account and kept separate from the items you use at home. When you buy items you use for operating your investments, you should purchase them separately from other, personal items. While the amount of money involved is probably going to be small, it is a good recordkeeping habit to get into and establish. If you purchase a combination of business and personal items, break the purchases out on your receipt. When information is entered in the books, the portion that goes to personal use should be identified as “draw” and not as an expense (“draw” means money drawn out of the investment funds for personal use). Professional Fees. Everyone needs to use the services of an accountant, a tax expert, or an attorney at some point. You need to break down combined use so that you claim only those expenses that you are allowed to as investment expenses.

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For example, your attorney may advise you on tenant issues, approving the rental application, rental contract, and other forms you use to ensure that they comply with local and state laws. The attorney may also help you if you ever need to evict a tenant or go to court for other disputes. At the same time, your attorney may be advising you on writing your will, buying or selling property, and other issues not related to your rental activity. Therefore, the attorney’s bill must be itemized as well. The nondeductible portion has to be excluded as an expense and identified in your payment as a draw. Or, if the amounts are large enough, you can write two checks to the attorney. The payment from your investment account would pay only for deductible expenses and your personal check would cover everything else. The same rule applies if you use the services of an accountant. However, it gets more complicated because preparing your return includes both personal and investment schedules. You may need to ask your accountant to estimate the breakdown for you, identifying the portion of the fee that applies to real estate activities. That portion can then be paid from your investment account and the balance paid from your personal account. A similar breakdown may be necessary if you meet with your accountant during the year for any tax planning and related discussions. Ask the accountant to estimate the time that applies to real estate activities so that your payment can be applied easily. Home Office Use. Rules for using an office in your home are very specific, and the terms for deducting these expenses are difficult to meet. It is also worth noting that claiming an expense for an office in your home can serve as a red flag. Given the likelihood that the amount will be small, it may not be worth the trouble to claim this deduction. The general rule for qualifying a home office deduction is: You must use a specific space 100 percent of the time and 100 percent for business use. Having a desk in the corner of the dining room doesn’t qualify, because the dining room is used for other purposes. You would have to use a room for no purposes other than keeping track of investment properties. That means you could not use that same room as a guest room, for example. The deduction would be limited as well. If your home office is 400 square feet and the total space in your home is 2,400 square feet, you can deduct one-sixth of home expenses, including utilities, insurance, taxes, mortgage interest, and depreciation. Considering the limitations, the total deduction is going to be quite small and probably not worth the effort or the exposure to possible scrutiny by the IRS. If you decide to deduct the home office, be prepared to carefully and thoroughly document how you arrive at the amount of expense you claim as a deduction.

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Part-Year Rentals If you own a second home or vacation home, you may find it desirable to rent it out for part of the year. This is a sensible way to cover part of your costs and to obtain tax benefits at the same time. You need to divide all expenses on the basis of personal versus investment use. For example, if you always spend three winter months in your second home and rent it out for the rest of the year, you are entitled to a three-quarters deduction of investment expenses. The property has to be available as a rental for the entire period you intend to deduct investment expenses. It is not enough that the house is empty. It has to be advertised and available. So, if you advertise the house for nine months but only rent it out for five of those months, you should still be able to claim three-quarters of the annual expenses as investment related. This relates specifically to property taxes, interest, and insurance. (Property taxes and interest are included as itemized deductions for the period of personal use, but no other expenses are deductible.) For other expenses, such as insurance and utilities, you are allowed to deduct the portion of the total equal to the investment usage. In the case of utilities, you may also deduct the bills for the specific months that the property is rented out. Depreciation—which is an allowance each year—is deducted on a percentage basis. For example, if the property is used 75 percent of the year as a rental, you first calculate the full-year depreciation and then deduct the applicable percentage.

Mix of Residential and Rental Use The division of expenses between personal use and investment use is especially complex when you use a single property in both ways at the same time. If you rent out part of your home, you can deduct a portion of all expenses of the household—property taxes, interest, insurance, utilities, repairs and maintenance, and landscaping, for example. Taxes and interest (the personal portion) are included as itemized deductions, while the rental portion of all other expenses is included as investment expense. If you have a separate building on your property, often called an additional dwelling unit (ADU), the calculation of expenses can be quite simple. If the unit has separate utility meters, for example, division of utilities is made easier. If you know the cost of constructing a separate unit, you also have an exact figure for the improvement, which serves as the basis for depreciation. It is more likely, however, that you will not have separate utility meters or a precise figure for the cost of the rental unit. If you cannot

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easily separate the ADU’s value from the main house, you must divide the basis using another method. The same guideline applies when you rent out part of your house. For example, a section of your house may have its own entrance and contain its own kitchen and bathroom. Even though it is in the same building, it is completely separate from your residential area. Calculating Percentage of Square Footage. The most reliable method in this situation involves calculating square footage. The rental area, as a fraction of total square footage, is converted to a percentage of the total, and that percentage indicates the portion of expenses that can be deducted as investment expenses.

Example: If your total area is 3,000 square feet and 900 square feet is the size of the rental area, you can deduct 30 percent of total household expenses. The division is complicated if you rent out the area for only part of the year. If your house is 3,000 square feet and you rent out 900 square feet, but only for nine months, you have to reduce the allowable portion to three-quarters (nine out of twelve months) as follows: a)

900 ÷ 3,000 = 30%

b)

9/12 of the year x 30% = 22.5%

Figuring Depreciation. When you also claim depreciation for a rental area, you have to apply the same percentages. For example, if you originally bought your house for $180,000 and the land is worth $40,000, that leaves $140,000 that is subject to depreciation (you are not allowed to depreciate land). Based on a period of 27.5 years (the depreciation period for residential real estate) you would calculate depreciation, using the same percentages from the previous example, as follows: a)

$140,000 ÷ 27.5 years = $5,091 (full-year depreciation allowance)

b)

$5,091 x 30% = $1,527 (applied to rental area)

c)

$1,527 x 9/12 = $1,145 (part-year depreciation allowance)

So there are several qualifying restrictions when claiming depreciation in these circumstances. Land cannot be included, you reduce the full-year depreciation to reflect only the portion of the home (the 30 percent) that is rented out, and you further reduce the dollar value when the rental occurs

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for only a portion of the full year (here 9/12, or 75 percent, of the year). Important: In calculating depreciation, you have to base the amount you claim on the original basis in the property. If you bought your home many years ago for $85,000 ($50,000 for the building and $35,000 for the land), you have to base your depreciation on the $50,000 value—even if your property is worth much more in today’s market.

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Tracking Split Expenses Through Your System Great care is required to keep track of any expenses that you split. Keep good records of the assumptions you use when splitting expenses between personal and investment use. A simple worksheet can be used to make your calculations, and this worksheet should be included with your permanent tax records for each year. Do the Breakdown Right Away: Make the adjustments at the time that you enter the expenses into your records. If you are dividing a utility bill between personal and investment use, for example, you should calculate the breakdown when you make the payment. The least desirable method is to go back at the end of the year and calculate all of the divisions of expenses; it makes more sense to do the split as you make each payment.

How to Enter Split Expenses Recalling the advice that you keep a separate checking account for investment activity, how do you make an entry for expenses that are partially investment and partially personal in nature? Since you want to be able to completely document and track all expenses that you claim as deductions, you have three basic choices: 1. Pay the full bill from your personal account and make a “memo” entry in your investment payments record. One simple method is to pay the bill from your personal account and, at the same time, record the investment portion in your rental activity books. Cross-reference the personal check number so that it can be traced back easily to the actual payment. While this method simplifies the transaction, it requires two steps. The key is to remember to record the investment portion. In an effective bookkeeping system, the majority of entries are tied to a cash transaction, a

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deposit, or a check. In this example, you need to enter an expense by making a memo entry, a transaction that is not tied to a cash transaction. The idea works as long as you remember to make the entry; it fails if you overlook that extra step. 2. Pay the full bill from your investment account and exclude a portion. As an alternative, you could pay the entire expense from your investment account and record the personal portion as a nondeductible expense. There are a couple of problems with this method. First, it violates the general guideline of keeping personal and investment expenses separate. Second, it requires you to deposit extra cash into your investment account to cover your mortgage payment, property taxes, insurance, and other expenses. To track cash flow, it is more desirable to keep the investment account strictly dedicated to investment activity, with as few exceptions as possible. 3. Pay the investment portion from the investment account. Another idea is to pay nondeductible expenses from your personal account, and to pay investment expenses from your investment account. You can either transfer funds to your personal account and write a single check, which may be the most practical method, or you can write two checks each month, one for the personal portion and the other for the investment portion. This keeps the division clean and relatively simple, but requires additional work, not to mention writing more than one check for each payment of utilities, insurance, and your mortgage.

Establishing a Formal Procedure Probably the most practical method is to pay all mixed-use expenses from your personal account and to record the investment expense at the end of each month, using the memo method described previously. By formalizing this method, you ensure that you go through a once-a-month procedure to capture all deductible investment expenses. Use a worksheet, such as the one shown in Figure 6-2, to calculate the monthly investment portion of mixed expenses. Each item in the column labeled “rental expense” is the result of multiplying the total by the applicable expense. The total of each expense category should add across and be the same as the total of rental expense. This form can be used to document each month’s assignment of expenses paid from your personal account that relate to investment activity. It serves not only as a means for explaining how the calculation was performed, but also as the document you use to make the entry into your

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Figure 6-2. Worksheet for mixed-use expenses.

books. In the rental payments journal (see Figure 5-3), the total of these entries would be entered just like a check, but the “total paid” number would serve only to balance the entries on the rental payments journal. In comparison, the rest of the entries on the form correspond to an actual payment represented by a check in your investment account.

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Documentation Guidelines Each and every transaction (with few exceptions) needs to be documented by way of receipt, invoice, statement, voucher, letter, contract, or other means. In addition to being able to document all transactions, the properly maintained set of books needs to have an audit trail. That means it has to be possible for anyone to track everything through your records, from original document down to the final entry and, ultimately, on to your tax return. How do you document all of your transactions, without getting into a time-consuming and space-consuming paper war? You need to keep your paperwork, of course. But you also need to be able to control it. You will find that as a real estate investor, you need to keep at least as much paper-

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work as is required by any other business, if not more. You need to keep property tax statements, tax notifications from mortgage companies, monthly statements for utilities, and invoices or statements for insurance, repairs, office supplies, and any other expenses you claim on your income tax return. You may also need to keep detailed logs for use of a personal automobile or truck, and for investment-related use of your telephone. (You may be able to completely document business use of your telephone by marking up a copy of your phone bill, especially if most of your investment use of the phone involves long-distance calls.) The combination of invoices or receipts and specialized logs satisfies the need for documentation. If you spend a lot of money in cash, you can estimate the amount of deductible expenses; however, it is preferable to keep the receipts and record the expenses in your books. The estimate may be reasonable, but you are far more likely to miss expenses to which you are entitled when you do not keep all of your receipts. What to Do: Store your original statements, invoices, and other receipts in a folder dedicated to each year. Unless you have an exceptionally high volume of transactions, you should be able to keep expense documents for one full year in a single folder. Remember the general guideline: You should have a receipt for each expense you claim.

Leaving a Trail In addition to keeping all of your receipts, make it easy for anyone to track payments through your checking account. The easiest way is to mark your check stubs, which provides you with a double benefit. First, it explains how the payment is broken down among two or more rental properties. Second, it helps you to properly distribute a payment among those properties when you make the entry into your bookkeeping system. For example, if you pay your property tax bill for three separate properties, break down the payment, identifying each portion by property address. Use the same system when paying insurance, utilities, and other expenses to a single source when more than one property is involved.

When You Have No Receipt What do you do when you make a payment but you have no receipt? For example, let’s say you spend $75 on hardware for a repair you’re taking care of at your rental property, but the receipt gets lost or thrown away. In that

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case, write out a record of the payment. Write down the date, the store, the approximate or exact amount of cash you spent, the merchandise you bought, and the property address. Put this paper in your system as a replacement for the lost receipt.

Charging Your Purchases If you are spending a lot of money in this way and you keep losing your receipts, one possible solution is to use a resolving account at your hardware store. If, however, you need to buy merchandise from several different stores, then use one credit card only for rental-related expenses and for nothing else. When you charge your purchases, you get an automatic receipt at the point of purchase and you also get a monthly statement from your credit card company. It is desirable to keep the receipt, if only to ensure that you don’t get charged any purchases in error; but if you do lose a few receipts, your record of purchases shows up on each month’s credit card bill. You can achieve the same convenience using a debit card for your investment checking account; but in that case, you also have to remember to write down the purchases you make in your checking account register. If you are prone to lose receipts, you are also likely to forget to write down your debit card purchases.

Being Consistent Most systems succeed because the system itself and all of its facts are consistent. The methods employed are the same throughout, so anyone looking at the books and records can easily find what they need. The uniformity of the system is the key to efficiency. If a system has a series of unrelated methods, or if you do things differently each time you record transactions, it becomes impossible to track the movement of information. Once you decide to do things a certain way, stay with it. If your practice is to pay all water bills with a single check and then break down the payment by property, do it the same way every month. Or if you want to write out separate checks, follow that procedure consistently throughout the year. Record items in the same manner and with the same timing so that monthly expenses show up once per month. The alternative—doubled-up expenses one month and none the next—makes the system difficult to follow and understand.

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Writing File Memos Some circumstances make it difficult to understand your reasoning later. For example, you may enter information a specific way one month and not remember what you were thinking the following month. This is especially true with real estate, when you allocate expenses between properties, pay bills in a particular manner, or assign a payment to a specific property. When you make decisions that might not be clear later on, write a “file memo,” a reminder to yourself about what your reasoning was when you made the decision. The file memo can save a lot of time and trouble later. It can become an important part of your record-keeping system and can aid in clarifying what would otherwise be a confusing or complicated transaction.

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How Long Should You Keep Your Records? As you’ve seen, there are a number of special accounting problems whenever you own rental real estate. In some respects, operating rental property is going to involve more paperwork and more complexity than operating many other businesses. However, you’ll be on safe ground if you make sure to keep all of your documents in a logical manner—while also minimizing the time you spend in bookkeeping chores. Another accounting problem is that you probably need to maintain some of your records for a longer time period than for most types of business. As a general guideline, you should keep records of all deductions you claim for at least three years from the due date of your tax return. For example, your 2003 tax return was due on April 15, 2004. So you should plan to hold onto all of your documentation until April 15, 2007, three years later. If you file for an extension of time to file your tax return, that also extends the retention deadline. For example, if you defer your filing date until August 15, 2004, you need to keep your records until August 15, 2007, three years from the filing deadline. Exception: You need to maintain your records of the property cost and any subsequent improvements until at least three years from the filing deadline for the year in which you sell the property. This means that if you hold onto a rental property for twenty years, you also have to keep records of your purchase and any capital improvements throughout the entire period. This is because you will be claiming depreciation throughout the entire period, based on your original basis (usually the amount you spend) in the asset. If you will be reporting a capital gain or loss upon sale of the property, you must be able to document your original basis.

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Tax-Deferred Exchanges The record-keeping requirement can extend even further back than your purchase. If you acquire rental property through a tax-deferred exchange (see Chapter 9) you also must keep the records for the property you owned before, just to be able to show how you arrived at your basis in the new property.

Example: You bought your first rental property for $100,000 several years ago and held it for five years. During that time, you may have claimed $14,500 in depreciation. When you sold the property last year, you received $130,000. Rather than being taxed on your profit, you deferred that profit in a tax-free exchange—selling one piece of real estate and replacing it with another of equal or greater value. You may have bought a new rental property for $145,000, for example. In this case, your basis in the new property is not $145,000; it is your purchase price minus any deferred gain on the previous property: STEP 1: Calculating the profit on the previous property: Sales price, previous property Minus original cost ($100,000) adjusted for depreciation ($14,500) Net basis in the previous property

$130,000 –85,500 $ 44,500

STEP 2: Calculating the adjusted basis in the new property: Purchase price, new property $145,000 Minus: net basis in the previous property (calculated in Step 1) –44,500 Adjusted basis in the new property $100,500 When you eventually sell the new property, you will be taxed on the difference between your sale price and your adjusted basis of $100,500—unless you subsequently go through yet another deferred-tax transaction. Key Point: The purpose in explaining all of this is to demonstrate why you may need to keep your records of rental real estate for many years beyond the basic three-year requirement. To document a tax-free exchange, you may need to track basis and adjustments back for many years.

As you can see, many special rules and requirements apply to real estate investments that are not experienced elsewhere. The requirements for figuring depreciation, adjusting rental property basis, and even keeping

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expenses separate between rental and nonrental use (or part-year use of property as a rental) all demand special documentation and tracking. Your bookkeeping and record-keeping systems have to accommodate these special demands. If you understand the transactions and the need for such records, it will not be difficult to set up your books to meet all of these requirements. The next chapter goes to the next step: setting up your books so that you can handle all of the special transactions as efficiently as possible.

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C H A P T E R

7

Creating a Timely and Efficient Accounting System Resolving the special problems concerning your bookkeeping requirements is an essential first step in developing an efficient system. As discussed in Chapter 5, these problems include allocating expenses to specific properties; managing expenses that are partially investment related and partially personal in nature; breaking down expenses, based on the use of a property as a rental for part of the year; and allocating expenses in a property that has both personal and investment use. Once you have resolved these problems and identified the most efficient method for dividing up expenses and documenting how that is done, you next need to formalize your bookkeeping so that entries can be made in a timely and efficient manner. It is important to keep your books current; at the same time, you want to spend only the time required to maintain your records.

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Setting Up Your Accounts Every bookkeeping system consists of a series of accounts—records for each specific type of transaction. In your real estate bookkeeping system, you must keep track of several different types of accounts:

✓ Assets. By definition, assets are the value of property you own, including cash, property improvements, and land (adjusted for depreciation), as well as equipment used in your investment activity.

✓ Liabilities. The most obvious and important liability is going to be the mortgage balance you owe on one or more investment properties. This 137

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liability is reduced each month as you make payments. There are current liabilities (the sum of payments due over the next twelve months) and long-term liabilities (the balance owed on each mortgage).

✓ Income. The rents you receive from tenants have to be tracked by property.

✓ Expenses. These accounts are used to record your deductible investment expenses. You need to track expenses both by category and by property.

The Difference Between Assets and Liabilities The difference between assets and liabilities represents your equity in properties. For example, if you buy a $125,000 property with $29,000 down and you finance $96,000, your equity will be $29,000—the difference between the asset value and the liability. In the initial transaction of purchasing a rental property, you must make a series of entries in your books. If you finance your $96,000 loan, your current liability will be the principal portion due over the next twelve months (which changes each year). This can be estimated and updated periodically; absolute accuracy will only become important when you present a summary of assets and liabilities to a lender. You also need to break out the value of land separately, because you are allowed to depreciate improvements but not the land itself. (See Chapter 8 for an explanation of how to determine land and improvement values.) For the purpose of the initial entry, let’s assume that land is worth $40,000 and improvements are worth $85,000. What to Record: In this situation, you need to record a) the asset, broken down between land and depreciable improvements, and b) the liability, broken down between current (what you owe over the next twelve months) and long-term liability.

The entry for the initial transaction would involve setting up account values for all of the components of the purchase: cash paid out, asset accounts, and liability accounts. In the double-entry system, the entry looks like this: Debit Cash Land (Asset) Improvements (Asset) Current Mortgage Payable Long-Term Mortgage Payable

Credit 29,000

40,000 85,000 8,055 87,945

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In this example, the cash down payment is equal to your equity in the property. The sum of land and improvements minus the sum of the mortgage liabilities (current and long-term) equals $29,000, or your equity in the property.

Why Equity Declines Each Year The actual equity as recorded in your books will decline each year as depreciation is recorded. The depreciation expense is offset by a reduction in the “improvements” asset. So depreciation accumulates over the period that you own the property, and the equity your books show in the property declines. This is one of the ironies of accounting. In real terms, your property is probably growing in value over the years, but the accounting rules show it falling. The reporting of assets, liabilities, and equity is unrealistic because it does not show the real current value. It shows the depreciated value of the asset.

Tracking Assets and Liabilities The formal recording of assets and liabilities is only required as part of a double-entry bookkeeping system. However, even if you do not use such a system, you still need to keep track of asset and liability values. For example, if you were to apply for financing on another property, the lender would want to know your liability as well as an estimate of the market value of properties. In an informal bookkeeping system, you need to track rental income and expenses paid, and also asset values and liabilities. That can be done on a card system or simply by recording the breakdowns (between land and improvements, as well as between current and long-term mortgage liabilities). Then annual depreciation is figured out on a predetermined schedule, and the book value of the asset is recorded on the depreciation worksheet. So there are ways to keep track of these items without needing to master double-entry bookkeeping.

Recording Expenses A simple way to record expenses is by using a single-entry method. You track receipts and payments through your checkbook and calculate adjustments for interest and principal at the end of each month, or only a few times per year. A single-entry bookkeeping system is usually enough to track day-to-day expenses, and if you need to formalize your system beyond that, the adjustments can be done separately. If you use a system such as

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Intuit QuickBooks, you do not even need to be concerned with which system you use; you simply enter information into the accounts and the program does the rest for you.

Your Investment Balance Sheet Your accounts are divided into two primary areas. The “balance sheet” accounts include assets you own, liabilities you own, and net worth (the difference between assets and liabilities). The “income” accounts include rents received and expenses paid. When you subtract expenses from rents, you end up with a profit or loss. The assets, liabilities, and equity accounts represent your investment balance sheet. If you were to include information about your real estate investments on a loan application, you would report the balance sheet items as shown in the table on page 138. Separately, you would also show activity in your rentals in terms of income, expense, and net profit or loss. These accounts are collectively referred to as “profit and loss” or, on a loan application, as an “income statement.”

Figure 7-1. Account with subaccounts.

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Rental Income You report rental income, expenses, and profit or loss in a specific sequence on your tax return; you also break down this information by property. Thus, your books have to include not only the breakdown by category, but also a series of subaccounts for each property. If you maintain your books manually, you are likely to maintain subaccounts on one side of each account page, with a summary on the other. Figure 7-1 on the preceding page shows a typical form of account with both subaccount breakdowns (on the left side) and summarized entries (on the right side). Figure 7-2 shows how entries are broken down using an account with subaccounts. In this example, rental income is reported for four different properties. Because income is a credit-balance account, the accumulated rents are shown as a growing credit balance through the year. Why are rents reported as credits? Many people who have not been trained in bookkeeping find such rules confusing. Expenses are reported without parentheses and income is reported with parentheses. This does not mean there is a loss, only that the values are reported as credit-balance

Figure 7-2. Account with subaccounts (filled-in example).

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accounts. This makes sense when you trace a transaction. When you receive rent, it increases your cash balance and, at the same time, it increases your rental income. The cash account reports additions as debits or plus accounts and payments as credits or deductions. A bookkeeper treats these debits and credits in a manner that keeps both sides the same. So every plus (debit) has a corresponding minus (credit) entry. The credit in an income account is not a loss. The accumulation of income is done on the credit side while expenses show up as charges (or debits). Therefore, a typical rentalreceipt entry would involve a debit to cash and a credit to rent income, as follows:

Cash Rental Income

Debit 600.00

Credit 600.00

Single-Entry Bookkeeping Fortunately, you do not need to become an expert in bookkeeping and accounting to keep a simple set of books for your rental activity. However, it helps to understand some of the basic concepts. If you maintain your books on an automated system or spreadsheet, you can simply enter the information in the preset formats. If you keep books by hand, it helps to have a formalized entry system. Double-entry bookkeeping helps avoid errors, but it is not essential. In a single-entry system, you record all cash transactions in a single ledger, showing additions as plus values and payments as minus values. So a single-entry system operates just like your checkbook. The single-entry record can be summarized at the end of each month by tallying the totals for each account. Remember to keep track of all income and expenses by property as well. In a typical single-entry system, a series of entries also tracks what is taking place in your checking account. If you maintain your checking account with adequate detail, you can use it as your primary bookkeeping source, without needing to duplicate information elsewhere. The entries in a single-entry bookkeeping journal would look like the example in Table 7-1. This example can be set up in your checking account record. Because you need to track the type of transaction as well as identify each by property address, it makes sense to use the journal-format checking account, in which checks come three to a page and the running totals are maintained on a ledger sheet.

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Table 7-1. Single-entry bookkeeping journal. Date

Description

1/1 1/1 1/1 1/1 1/1 1/1 1/3 1/6 1/7

Balance forward Rent, Property #1 Rent, Property #4 Mortgage, Property #1 Mortgage, Property #2 Mortgage, Property #3 Mortgage, Property #4 Rent, Property #2 Water bill, Property #3 Electric, Property #1

Cash In

Cash Out

Balance

442.45 496.04 648.07 338.65

2,000.00 2,600.00 3,300.00 2,857.55 2,361.51 1,713.44 1,374.79 1,824.79 1,778.46 1,761.66

600.00 700.00

450.00 46.33 16.80

Key Point: Whether you use the simplified single-entry system or a more elaborate version of double-entry bookkeeping, the goal is to capture all of the information you need as entries occur. Make your bookkeeping as easy as possible; make sure it is complete; and to the extent it is practical, keep the activity separate from your personal records.

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Breaking Down Loan Payments for Your Books Each month’s mortgage payment presents special problems for you, if your lender does not show how much goes to interest and principal. Most lenders do not provide you with a monthly breakdown, so you need to estimate the totals yourself. Chapter 5 explained how a typical year’s payments would be broken down between interest and principal. Recalling the formula, the breakdown involves the following five steps: 1. Multiply the balance forward by the annual interest rate. 2. Divide the result in the previous step by twelve (12) to arrive at this month’s interest. 3. Subtract the interest from the total payment you are making. 4. Subtract any impounds that you are required to pay from the total payment. 5. The result (total payment less interest and impounds) is this month’s principal. Subtract this amount from the previous balance to arrive at the new balance forward.

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You may need to apply this formula to each payment on a monthly basis in order to properly break down the various items. This is important because it enables you to track not only your profit and loss, but cash flow as well. These are not the same. Interest payments and impounds affect your profits; however, the entire payment—including principal—affects overall cash flow. In real estate investments, cash flow may be more critical than actual profits. Because most people buy real estate for the long term, future profits may be expected and year-to-year profits may not be as important. For purposes of tax calculations, month-to-month profits do not reflect depreciation expenses, and depreciation itself is a noncash expense. So “profitability” has to be distinguished in two different ways: immediate profits and long-term profits.

Immediate Profits Immediate profits refer to the monthly and annual reported profits. This number affects your federal tax liability. For example, you may have an after-tax positive cash flow while still reporting a net loss for tax purposes. This occurs because depreciation is calculated as an expense, although it does not involve an actual payment. The tax benefits of investing in real estate are one of many features that make it a desirable investment; however, most people are going to be far more concerned with net cash flow from month to month. To demonstrate how you can have the combination of positive cash flow and a tax loss, consider this example: Your rental income is $6,800 for the year and cash expenses come up to a total of $5,700 (interest on your mortgage, utilities, property taxes, and insurance). Depreciation is calculated as a deductible expense, but you don’t pay out cash. In this example, if depreciation is $2,000 per year, you will show a net loss of $900, which is calculated as follows: Rent Receipts Less: Cash Expenses Positive Cash Flow Less: Depreciation Net Loss

$6,800 –5,700 1,100 –2,000 $ –900

This calculation has to be adjusted to allow for the principal portion of your mortgage payment. Although this is not a deductible expense, it is money being paid out, so it affects cash flow. For example, if this year’s

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principal payment came to $600, you would report positive cash flow of $500 ($1,100 pre-depreciation profit minus $500 for mortgage payments). The net loss of $900 remains unaffected. Key Point: In this example, the difference between cash flow and tax-reported loss is significant. It makes our point that you can achieve both and, in fact, that is not uncommon. Depreciation is a major expense and it has “tax savings value” in the sense that the expense reduces your taxes. A $2,000 annual depreciation for someone in the 40 percent effective tax bracket translates to a tax reduction of $800 per year (40 percent of $2,000).

Long-Term Profits Long-term profits from real estate investments refer to the difference between your net purchase and net sales price on each investment. As long as property values rise, you will want to continue holding onto properties. This assumes that a) you are able to create a breakeven or positive cash flow each month and b) you are willing to continue working with tenants. You are able to defer taxes on profits from real estate by selling property and exchanging it for later purchases of equal or greater net value, subject to some limitations (see Chapter 9). You may also avoid taxes by later converting a rental property to your primary residence. As long as you use the property as your primary residence for at least twenty-four months during the five years preceding the sale, profits will be free of tax. The exception: You have to pay taxes on profits equal to the amount of depreciation that was claimed during the period you used the property as a rental.

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Accounting for Prepaid Insurance and Taxes You know that impounds for property taxes and insurance are often added onto your payments. As a general rule, these expenses are payable twice a year; your lender collects the impound each month and then makes timely payments on your behalf. If impounds are included in your monthly payment, it is not necessarily accurate to just assign those deductions to the taxes and interest expense accounts for each property. The applicable period may be different from the timing of impounds.

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Example: Your lender begins taking impounds when your loan is originated in September. However, property taxes are not payable until the following April for the first half of the calendar year. Timing Differences In this example, there are two timing differences. First, the impounds are withheld beginning in September, although the taxes refer to the following year. Second, the actual payment is not due until the following April, even though the expense actually begins to apply from January onward. While this is a confusing problem, it is not difficult to manage in your books. Table 7-2 breaks down the timing differences for you, based on the example of a $1,200 annual property tax bill.

Table 7-2. Timing differences, impound accounts.

Date

Impounds Withheld

Actual Tax Liability

September October November December

100.00 100.00 100.00 100.00

January February March April May June

100.00 100.00 100.00 100.00 100.00 100.00

100.00 100.00 100.00 100.00 100.00 100.00

July August September October November December

100.00 100.00 100.00 100.00 100.00 100.00

100.00 100.00 100.00 100.00 100.00 100.00

Tax Payments Due

600.00

600.00

In this situation—where you have two separate timing problems to track—the easiest solution is to treat impounds as prepayments and to report the actual liability in the correct month. So, as each impound is withheld, the bookkeeping entry is:

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Impound Prepayment Cash

Debit 100.00

147

Credit 100.00

The “cash” credit is actually a part of a larger mortgage payment. So the total payment would include debits to the long-term mortgage note, interest, and the impound account, with the full payment shown as a credit to the cash account.

Special Monthly Entries When the liability is properly reported, the impound account is reduced and the proper expense shown in that account. For example, in each month of the new year, the entry would be made as:

Property Taxes, Property 1 Impound Prepayment

Debit 100.00

Credit 100.00

This entry would need to be made as a noncash transaction. The cash is paid out with each month’s mortgage payment, even though the impound amount is automatically placed into the prepayment account. Under this system, then, you would need to make a special monthly entry to show the adjustment. The overall result of making these entries is shown in Table 7-3.

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Getting the Timing Right This series of entries places the correct expense of $100.00 per month at the right time. The impound account has a perpetual balance of $400.00 because the original series of entries in this example began four months before the end of the year. Mortgage lenders invariably try to collect impounds in advance of the payment due dates. If you begin your mortgage term midway through a payment term such as this, part of your closing costs will include the liability for either taxes or insurance. The whole point about making these adjustments is to make sure that the expense ends up in the correct month. The example of property taxes makes this point; the liability applies equally throughout the year. Impounds do not necessarily correspond to the applicable month. Even if you pay property taxes or insurance directly, some adjustment needs to be made.

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Table 7-3. Impound account entries. Impound Account Credit

Property Tax Expense

Date

Debit

Balance

Debit

Credit

Balance

September October November December

100.00 100.00 100.00 100.00

January February March April May June

100.00 100.00 100.00 100.00 100.00 100.00

100.00 100.00 100.00 100.00 100.00 100.00

400.00 400.00 400.00 400.00 400.00 400.00

100.00 100.00 100.00 100.00 100.00 100.00

100.00 200.00 300.00 400.00 500.00 600.00

July August September October November December

100.00 100.00 100.00 100.00 100.00 100.00

100.00 100.00 100.00 100.00 100.00 100.00

400.00 400.00 400.00 400.00 400.00 400.00

100.00 100.00 100.00 100.00 100.00 100.00

700.00 800.00 900.00 1,000.00 1,100.00 1,200.00

100.00 200.00 300.00 400.00

For example, you would reflect a debit to the expense each month throughout the year and offset that with payments, as follows: Month

Expense

January February March April May June July August September October November December

100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

Payment

600.00

600.00

Difference –100.00 –200.00 –300.00 200.00 100.00 0 –100.00 –200.00 –300.00 200.00 100.00 0

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Making Special Adjustments for Profit and Loss In this case, the expense occurs and applies to each month in advance of the payment date of the taxes that are due in April and October. Thus, the payments represent an effect on cash flow in those two months. However, to accurately report the profit or loss on real estate activity, you need to show one-twelfth of the total expense each month, which is why you need to make special adjustments. A similar situation arises when dealing with insurance. The premium is probably due twice a year or quarterly, but the expense for each property should be shown each month as well. Important: Timing differences can distort both profit and cash flow if not properly adjusted in your system. You need to track cash flow by property and in total so that you can know throughout the year what your actual after-tax net profit is, as compared to your original estimates. To compute the after-tax number, you need to include monthly taxes and insurance, even if you have not paid those bills yet.

Adjusting the Books Monthly Real estate investors who are not well versed in accounting have to struggle with problems such as this unless they can come up with a simple and consistent method for adjusting the books. Reflecting each expense in the proper month helps make monthly and year-to-date profit analysis possible with accuracy. For most people, the problem involves knowing how to make the adjustments. If you want to keep your books simple but still make the adjustments, and if you know the monthly liability for periodically paid or impounded expenses, you can perform the adjustments on a worksheet as follows: 1. Simply write down a summary of income received and expenses paid for the month. 2. Then calculate the estimated adjustments for property taxes and interest expenses. 3. Make an additional adjustment for the allowable depreciation, based on the annual allowance (see Chapter 8). Just apply one-twelfth of the annual depreciation to each month’s profit number to get the true profit or loss. 4. If the results show a loss after adjusting for property taxes, interest, and depreciation, subtract the tax savings to arrive at the after-tax profit or loss.

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5. To calculate federal tax savings, divide your total income tax by the taxable income on your latest year’s tax return. The resulting percentage is your effective tax rate. Multiply your net loss by this rate to arrive at the tax savings. A worksheet for calculating after-tax net loss for both the current month and year-to-date totals is shown in Figure 7-3. State Taxes, Too. You may need to adjust the effective tax rate to also account for state taxes that you pay. As long as you receive a tax benefit from state taxes, that should also be a part of the calculation. When your allowable deductions are figured differently for state tax purposes, the calculation is somewhat more complicated. Since the purpose is to show the savings, simply recalculate what your tax liability would have been if real estate investment losses had been included. The difference in combined federal and state tax liability is the amount you want to include on the worksheet.

Figure 7-3. Worksheet for after-tax profit or loss.

Rental income Less: Expenses paid in cash Less: Liability, property taxes Less: Liability, insurance Net income or (loss) Tax savings (if a loss): Total income tax, latest tax year_________ Taxable income, latest tax year__________ Effective tax rate Tax savings amount After-tax net loss (net loss minus tax savings)

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Documenting Special Rental Situations There are three situations in which you are going to need additional documentation: mixed use of property, allocations between properties, and cash expenses.

Mixed Use of Property When a specific property is a rental for only part of the year, or if you rent out part of the home you use as your primary residence, you must divide expenses between the two types of use. For taxes and interest, the personal portion is reported on Schedule A (itemized deductions) and the investment portion is shown on Schedule E as an investment expense. The calculation between personal and investment use is worth making if your itemized deductions are marginal. For example, reporting a portion of your taxes and interest as rental expense could reduce itemized deductions enough so that you reduce your taxes more by claiming the standard deduction. Key Point: You might discover that you are better off claiming the standard deduction rather than itemizing. This will be true if your itemized deductions add up to a dollar value that is lower than the standard deduction.

For all other expenses—utilities, insurance, and repairs, for example— you are not allowed to claim any personal expenses. However, the portion that applies to rental use is deductible as an investment expense. For example, if you use a property 25 percent as an investment and 75 percent for personal use, your expenses would be broken down as follows: Expense

Total

Personal

Investment

Property Taxes Interest Insurance Utilities Repairs

$ 1,200.00 7,170.00 480.00 1,380.00 935.00

$

$ 300.00 1,792.00 120.00 345.00 234.00

900.00 5,378.00 0 0 0

In this example, the personal portion assigned as itemized deductions is only $6,278. This is less than the allowable standard deduction if your filing status is married filing jointly or head of household. So you would pay less tax by claiming a standard deduction. Whichever way this comes out, you should keep your calculations in order to justify how you break out the expense.

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Breaking Down Personal vs. Investment Use. A part of your worksheet should be the precise calculation between personal and investment use of the property. If the entire property was used as a rental, but for only a portion of the year, the calculation should be based on the number of days or months. For example, if you lived in the house from January 1 through September 30 and then rented it out from October 1 through December 31, the rental period was 25 percent (three months out of twelve). If you permanently rent out part of your property, the breakdown should be based on the square footage of rental space as a portion of total square footage. For example, if your total living space is 3,000 square feet and you rent out 750 feet, then the rental portion is 25 percent.

Allocations Between Properties Some expenses are properly allocated to a specific property. In the case of utilities, insurance, property taxes, and interest, it is easy to make this allocation. In the case of expenses that are not specific to a single property (e.g., legal or accounting fees, office supplies, or telephone), you can allocate a portion to each property or show nonallocated expenses as a separate category on your tax return. Key Point: If you decide to allocate expenses to each property, the most reliable method is to divide nonallocated expenses on the same percentage as total rents you collected. For example, if your total rents for the year were $22,600 and one property’s rents were $7,232, its share of the total would be 32 percent.

Accounting for Cash Expenses The easiest way to get cash expenses into your system is to reimburse yourself based on receipts you save up. Simply write a check to yourself showing the breakdown by type of expense and for each property. If you have lost receipts, write a “memo receipt” noting the date, amount, property, and amount you spent. Try to avoid excessive expenses without proper receipts. The more documentation you keep, the better your bookkeeping system.

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Making Your Accounting System Work Even if you have to make a lot of cash transactions, you can ensure that your system captures all of your legitimate deductions, that every transaction can be proved and traced through your system, and that it does not

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become too time-consuming. Here are some sensible guidelines for making your system work: ❑ Consider the practical over system requirements. No system is going to work for every possible situation. You may simply need to use cash a lot of the time based on the way you work, the kind of expenses you have, and your personal preference. So, even if your “rule” is that you do not use cash when you can write a check or use a credit card, there are going to be times when cash works better for you. This is a practical reality, and you can’t be expected to change your style just because the system would be more efficient, easier, and more consistent. ❑ Remember to balance time against bureaucracy. If you are spending way too much time working on your books, you probably need to streamline your procedures. You want to spend as little time as necessary to get the best possible system. However, it often is the case that—in the interest of making the system thorough—a person who is not experienced in bookkeeping may create a system that is overly complex. Efficiency often means reducing the paperwork as much as possible. Reevaluate your procedures and look for ways to cut back on the time and paperwork requirements. ❑ If you need help, ask for it. Don’t let yourself get buried in the bookkeeping system. If you are overwhelmed and don’t know how to fix it, ask your bookkeeper or accountant to show you a better way. At times, the solution is automation. QuickBooks Pro is an easy-to-use product that makes bookkeeping easier. Your accountant or bookkeeper may have other systems that can be set up to work with Microsoft Excel or other spreadsheet programs. Ask for help if you need it. ❑ If you simply don’t enjoy bookkeeping, pay someone else to do it. There is no absolute rule that you have to do your own books. You may save money by not paying a professional, but that economy is only worthwhile if you are not having fun. To paraphrase the popular bumper sticker: “Friends don’t let their friends keep their own books.” You might enjoy the task and find it easy and fast. Or you may dread it and end up frustrated and buried in complexity.


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C H A P T E R

8

Handling Depreciation for Rental Properties You are allowed to deduct expenses each year that pertain to your real estate investment activity. By definition, deductible expenses include interest, property taxes, utilities, legal and accounting fees, auto expenses, and any other items relating to managing and maintaining your property. As an investor, you also purchase capital assets and are entitled to deduct those costs as well; however, they cannot be deducted in a single year. They have to be depreciated over a specified number of years, called a recovery period. The distinction between expenses and capital assets is an easy one to make. An expense, for the most part, relates specifically to the year in which money is spent. A utility bill is for services for the current month, and interest is calculated on each month’s outstanding mortgage balance. Some exceptions do occur. For example, you may purchase business cards that last several years. The amount of such an expense is small, however, so it does not need to be treated as a capital asset. In comparison to expenses, the cost of capital assets cannot be applied to a single year. They have value over many years, and the period is called the asset’s useful life. You are allowed to claim depreciation each year on a predetermined schedule, to write off a portion of a capital asset over several years.

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Overview: How Depreciation Works The depreciation system is designed to allow businesses and investors to divide capital assets into specific categories and then to claim depreciation as allowed under current federal tax law. The legal definition reads: 155

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“Depreciation is the annual deduction allowed to recover the cost or other basis of business or investment property having a useful life substantially beyond the tax year.”1

Real Estate Depreciation Real estate investments cannot be deducted as an expense in the year you buy property. However, building improvements (e.g., a new roof and siding, fixtures, additions, and repairs of internal systems) are depreciated over many years. You also claim depreciation for an auto or truck and other equipment needed to manage your real estate investments, including computers, office equipment, and landscaping equipment. Depreciation applies to all capital assets, with one exception. You are not allowed to claim depreciation for the value of land. For example, if you buy an investment property for $150,000 and the land is worth $40,000, you can deduct depreciation on the improvements of $110,000. The value of the land portion of your investment property—in this example, $40,000—is carried on your books as an asset and cannot be deducted. Depreciation is always calculated based on your purchase price and never on current market value. Let’s say you bought your primary residence fifteen years ago and paid $85,000 ($15,000 for land and $70,000 for improvements). If you later decide to convert this property to a rental, your depreciation will be based on the $70,000 base value of improvements. Even if values have increased significantly and the property is now worth $200,000, your depreciation has to be based on your purchase price. The calculation is based on the recovery period to be used. Residential real estate is normally depreciated over 27.5 years using the straight-line method (the same amount is depreciated each year). After that many years, the property is fully depreciated and no more depreciation will be allowed. Each year’s depreciation is reported as an expense, and this is where real estate investors have an advantage over most other forms of investment. Depreciation is a legitimate expense even though you do not have to spend the money claimed. It’s calculated based on what you paid for the property, and the expense is deductible on your tax return.

Amortization Closely related to depreciation is amortization. You are allowed to amortize some assets, such as points paid on mortgage loans, the cost of starting a business, and intangible assets (i.e., assets with monetary value but no tangible value).

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For most real estate investors, their amortization expense will be limited to points. The points paid to acquire your mortgage loan cannot be deducted in a single year. Instead, those points are amortized over the number of years of the loan. For example, if your mortgage loan is set up to be repaid over thirty years and you paid $1,500 in points, you are required to amortize it at a rate of $50 per year.

Assets Used Only for Investment Purposes For all assets you use exclusively for investment purposes, calculating depreciation is easy. As long as you have a solid bookkeeping system and records of the date you purchase assets, you can claim depreciation as a legitimate expense. A distinction should be made between when a capital asset is purchased and when it is placed in service. You are allowed to depreciate an investment asset from the date it is placed in service, meaning the date you began using it as part of your investment program. The distinction is further clarified by the IRS: “Depreciation starts when you first use the property in your business or for the production of income.”2

Example: You planned to begin purchasing investment properties last year and you bought a riding lawn mower to be used exclusively in maintaining your properties. However, you did not buy your first property until last month. Even though the lawn mower was purchased last year, it was not placed in service until you bought your first rental property. Under current rules, depreciation is calculated under a set of guidelines called the Modified Accelerated Cost Recovery System (MACRS). As long as you acquired capital assets after 1986, the MACRS guidelines apply. If you purchased any of your property before 1986, you will use the Accelerated Cost Recovery System (ACRS). The rates and recovery periods are somewhat different. These differences are explained in the IRS publication “Instructions for Form 4562.”

Mixed Use of an Asset One difficulty in calculating depreciation arises when you use an asset—a truck, for example—partly for personal and partly for investment use. In that case, you are required to keep records to establish the applicable investment use. The depreciation you claim is reduced to the percentage of investment use, and you are not allowed to claim depreciation above that level.

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Part-time rental of property or renting out a portion of your house also presents special considerations when it comes to depreciation. Calculating depreciation on mixed-use property is discussed in more detail later in this chapter.

Establishing an Office at Home You may also use a portion of your home to conduct business for managing your real estate investments. The rules are strict for claiming a depreciation deduction in this case. You have to be able to establish that you use a specific room 100 percent of the time to conduct business. For example, if you use a room as an office, you cannot also use it to store personal items or as a guest room. It has to be assigned exclusively to investment activity. The amount of depreciation claimed would be a percentage of your home’s total value (excluding land). For example, a 300-square-foot room in a 2,500-square-foot home would be 12 percent of the total. You could claim one-twelfth of the allowable annual depreciation, if you were able to establish the exclusive investment use of that room. Is It Worth It? Most investors find that even if they can establish an exclusive use of one room as an office, the amount of depreciation is so small that it is not worthwhile to claim depreciation. For example, if your home’s value (excluding land) is $125,000, the total annual allowance (based on the 27.5 years you are required to use for depreciation) is $4,545 per year, and one-twelfth of that is $379. Tax advisers have observed that claiming expenses for a home office may act as a red flag and could even trigger an audit. Considering the relatively small benefit to this claim, it is of questionable value.

Claiming Depreciation To report and claim depreciation, you will need IRS Form 4562 and the publication entitled “Instructions for Form 4562.” Detailed explanations for filling out forms are included in Chapter 10. Where to Look: IRS forms and publications can be downloaded online from the Internal Revenue Service’s Web site at www.irs.ustreas.gov.

In submitting your tax return, you are not required to provide detailed information about the assets involved. However, you need to keep permanent records in your files of a) asset purchases and sales, including date and amount; b) methods you use to calculate depreciation each year; and c) cal-

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culations for depreciating assets that apply only partially to investment activity. Because depreciation amounts may change from one year to the next, it is wise to calculate depreciation at the time you begin claiming it—usually when you buy the property—and set up a summary for the entire period involved, keeping that calculation as part of your bookkeeping record. This also helps you to complete your tax return each year and to adjust for new purchases or for the sale of assets during the year. Later in this chapter, there are tables showing the percentages of depreciation allowed under specific recovery periods and using various depreciation methods. Once you identify the correct method to use, you will be able to calculate depreciation for the initial year as well as for all future years for each asset.

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Expensing vs. Depreciation Businesses are allowed to expense capital assets rather than depreciate them over a useful life. This means the assets can be written off in the year they are placed in service, subject to annual limits. If you are familiar with depreciation rules as a business owner, you already know that in some situations, expensing provides an advantageous tax reduction. However, this privilege does not apply to real estate investors. And, even if the rules allowed real estate investors to claim a deduction for expensing, it might exceed annual loss limits. Reason: Under current rules, real estate investors are allowed to claim annual losses up to $25,000 per year as long as their annual income does not exceed $100,000 (above that, the allowance is reduced gradually). So expensing capital assets, even if it were allowed, could put your net loss over the limit. Key Point: If it seems unfair to exclude real estate investors from the expensing rule, remember this fact: You cannot claim more than a $25,000 maximum loss in any one year. Losses above that amount have to be carried over and applied against profits in future years.

Where Expensing Might Apply The expensing rule may apply to you if you have real estate investments and a small business. In that case, you are allowed to expense business assets. This brings up some interesting planning considerations. Suppose you buy a van this year, which you use for your small business and for your real estate investments. You are allowed to claim an expensing write-off in the

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year of purchase under the rules that apply to your small business, but you cannot expense any part of the van to the extent that it is used for your rental activity. With this comparison in mind, you need to plan ahead for your taxes. The more your van is used for small business activity, the higher your expensing allowance will be; and the more the vehicle is used for real estate activities, the less you will be allowed to claim as expensed in the first year.

Keeping the Limit in Mind The limitation of $25,000 in maximum annual deduction of real estate losses is critical to planning how to depreciate assets. (See Chapter 9 for tax rules relating to real estate investing.)

Example 1: Your adjusted gross income (AGI) last year was $85,000. You are entitled to claim up to a full $25,000 loss from real estate activities qualified under current IRS rules. Example 2: Your adjusted gross income last year was $113,000. Your maximum deductible loss from real estate is reduced by 50 cents for each dollar of income above $100,000. Accordingly, your maximum allowable loss deduction is $18,500: Maximum Loss Allowed AGI Income Cap Difference 50 Percent of the Difference Maximum Loss Allowed, Adjusted

$25,000 $113,000 –100,000 $ 13,000 –6,500 $18,500

The deduction for real estate losses is reduced to zero for adjusted gross income of $150,000 or more. The “adjusted gross income” used in the previous calculation is actually a modified version of the number reported; certain expenses have to be added back in (see Chapter 9). Some assets you use in real estate activity can be depreciated using accelerated methods, where more depreciation is claimed in the early years and less later on. You can elect to use the straight-line method for those assets (more about this method later in this chapter). The point to be made here concerning depreciation is an important one: There is no advantage in claiming an accelerated amount of depreciation, even in those instances when it is allowed under the rules (e.g., such as for vehicles, computer and

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office equipment, and landscaping tools), if you will not be allowed to claim a loss. If you have a lot of depreciation expense during the year, it is of no value if the loss is disallowed. This occurs if your reported loss is more than $25,000 or if your modified adjusted gross income is higher than $150,000. In these instances—with your deductible losses limited anyway—it could be worthwhile to elect to claim depreciation over a longer period of time, to reduce the amount claimed each year.

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Calculating Land Values As discussed previously, the one exception to the general rule that you can depreciate capital assets is land. You are not allowed to depreciate land under any circumstances. This raises a question for anyone who purchases investment property: How do you calculate the value of land versus the value of improvements?

Being Consistent You can use any reasonable method to calculate land value. However, once you pick a method, it is a good idea to apply it consistently to all properties. As long as you can justify your calculation on some logical basis, you will be able to claim depreciation for improvements and exclude the value of land. You should select a method that you believe is most advantageous to you and use it for all properties. Because annual loss deductions are limited, “advantageous” could mean using the method with the highest land value. However, if your income is below $100,000 and your real estate expenses are fairly low, you may want maximum depreciation deductions. In that case, select a method that reflects the lowest portion of total value for land.

Three Commonly Used Methods Here are three accepted methods for calculating land value. Notice that each one results in a quite different number: 1. Assessed Value. Your county assesses property for the purpose of calculating annual property taxes. Assessed value may approximate current market value, or it could be far lower than the realistic levels. Calculating land value based on the assessed value is simple; the property tax bill sent to you by your county shows the breakdown.

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Example 1: You purchased a property this year and paid $137,500. Your assessed value, according to your tax bill, is $90,000. This consists of $22,000 (24 percent) for land and $68,000 (76 percent) for improvements. The division is applied to your purchase price of $137,500. You would assign land a value of $33,000 ($137,500 x 0.24), while improvements, subject to annual depreciation, would be valued at $104,500 ($137,500 x 0.76). 2. Appraised Value. At the time you purchase property, it is appraised for financing and also to determine whether the purchase price is reasonable. You can use the breakdown in the appraisal report to divide land from improvements.

Example 2: You purchased a property for $137,500. The appraisal ordered by your lender came in at $140,000 and identified land as being worth $45,000 (32 percent) and the replacement value of your home at $95,000 (68 percent). Using appraisal value to calculate value, you would calculate the value of land as $44,000 ($137,500 x 0.32) and the value of depreciable improvements at $93,500 ($137,500 x 0.68). 3. Insurance Value. You also have values assigned in your real estate insurance policy. Most policies include calculations of dwelling protection plus “other structures” protection (as well as other values). You can use these values as the basis for determining your depreciable base.

Example 3: You purchased a property for $137,500. Based on location, age of the home, and features, your insurance company assigns a value of $80,000 to the dwelling and an additional $8,000 for the storage shed and detached garage. Total depreciable base using this method is $88,000, with the remaining $49,500 assigned to the value of land. You do not pay insurance for land, since its value would remain even if your property were lost in a fire or other damage. Determining Which Method to Use Each method uses a different base, and any one of them can be justified. The appraised value in Example 2 was closest to what was actually paid for the property. This will not always be the case, and it will not always be the most advantageous method to use. If you have only one rental property, low expenses, and income below $100,000 per year, you will probably benefit by claiming as much depreciation as you are allowed, so a calculation that gives less value to land and

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more to improvements is preferable. However, if you have several properties—meaning higher overall reported losses due to more depreciation claimed—you will not be able to claim all of the allowed depreciation, and part of it will be deferred to later years. If your adjusted gross income is more than $100,000, your allowable annual deduction is going to be reduced as well, so claiming more depreciation has no benefit. Key Point: Selecting a method to value land is a matter of planning ahead. It should be based on your personal income, the number of properties you own for investment purposes, and your need for the deduction.

Reporting a Tax Loss For the purpose of argument, let’s assume that you will be reporting a tax loss on your properties. This is more likely when the depreciable portion of your investment property is relatively high. For example, in comparing two investments costing $150,000, depreciation will be higher when the land value is small, and it will decline for a second property whose land value is much higher. If you own a single property and want the highest possible deduction, you will do better (in terms of the deduction and after-tax cash flow) if you select properties with a low portion of land value. However, you may also own several properties, in which case you cannot use a higher deduction. In that case, you may prefer to buy properties whose land value represents a higher portion of the total investment value. In such a situation, the property may gain higher-than-average market value, especially if the land value is high because of its location. So you need to balance the desirability of depreciation deductions (or lack of need for those deductions) against the long-term investment value of the land itself. Depreciation often creates a net loss even in situations where cash flow is positive or breakeven. This occurs because the investment is structured so that rental income covers payments and expenses, but there is little or nothing left over each month. When you then calculate depreciation, it creates a net loss. If you are able to write off $5,000 a year in depreciation on each property, once you reach five rentals, you have arrived at the maximum, so any further deductions will be of no value. Since the annual loss deduction applies, no matter how many properties you own, it makes sense to plan ahead with the loss ceiling in mind. The $25,000 maximum applies to married couples or to single individuals. The law anticipated investors filing separately to increase their maximum loss, so the ceiling is even lower if you are married and filing sepa-

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rately. As long as you live apart from your spouse for the entire year, you are allowed to deduct only $12,500, and the deduction begins to phase out at 50 cents per dollar of income above $50,000. For example, if you are legally separated and living in an apartment by yourself, and your spouse is living in your primary residence for the entire year, then the deduction will be allowed—but the maximum loss and income ceilings are cut by one-half, so real estate investors cannot take advantage of the rules by proceeding as two single persons, each one claiming a $25,000 loss. Thus, if you are married, filing separately but you and your spouse did not live apart for the entire year, the loss on real estate investments is not available at all; no losses are deductible. The restriction is intended to discourage tax planning that uses marriage to create deductions or to avoid a reduction in those losses during the year.

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How to Depreciate Partially Used Assets Many investors employ capital assets that also serve partially as personal property. For example, a car or truck, landscaping equipment, or a computer system may be used for personal reasons as well as for managing your real estate investments. In these situations, you need to keep careful records to establish the exact degree of nonpersonal use. Only by being able to document how assets are used will you be entitled to claim a depreciation deduction. For example:

❑ Automobiles. If you have used your car to monitor properties, meet with prospective tenants, collect rents, meet with your accountant, and other investment-related purposes, that is considered investment use. Keep a log of investment mileage showing the date, purpose of the trip, and total mileage. A sample automobile log is available in Chapter 6 (see Figure 6-1). The investment usage is next divided by total miles. For example, if you drove 3,415 miles to manage your real estate investments, and total mileage for the year was 22,660, investment usage would be 15 percent (3,415 ÷ 22,660). In this example, you would calculate full-year depreciation and then claim 15 percent of the total as an investment expense. (There are special depreciation limits on cars, trucks, and vans, which are explained later in a separate section of this chapter.)

❑ Computers. In the case of computer systems, you would calculate investment usage based on an approximation of the amount of time used on investment-related matters (e.g., for record keeping or online housing

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market research). The actual time spent is the standard for this calculation, and not the time the computer was available for use.

❑ Landscaping Equipment. If you use personal assets such as lawn mowers to care for rental properties, you have to calculate a basis for depreciation. If you maintain the grounds of two properties, you could probably justify deducting two-thirds of the basis as investment expense (the remaining one-third would apply to your own residence and thus would be nondeductible personal use).

❑ Property Converted During the Year. For the purpose of calculating depreciation on property that was converted to an investment property during the year (or an investment property converted to your primary residence), the percentage should be based on the number of months it was used for each purpose. For example, if the property was a rental for three months and your primary residence for nine months, you are entitled to claim 25 percent of the full-year depreciation as an investment expense.

❑ Renting Out Part of Your Home. If you rent out part of your primary residence, the depreciation should be calculated based on a breakdown of square footage. For example, if your house contains 2,200 square feet and you rent out 600 square feet, 27 percent counts as a rental, and you can claim 27 percent of the full-year depreciation. This calculation becomes more complex when it is a room rental and a tenant also has access to the kitchen and common areas of the property. In that situation, you must modify the calculation on a basis that makes sense. For example, if the common areas (e.g., kitchen, living room, and bathroom) constitute approximately 50 percent of the total living space, a portion of that space could be deductible if available to a tenant. So, if four people live in the house, you could justify claiming an additional deduction for a tenant’s access to common areas. Using all of the assumptions in this example, the calculation would be: Total square feet = 2,200 Rental square feet = 27% x 2,200 = 600 Common area in square feet = 1,100 Number of people living in the house = 4 Number of tenants living in the house = 1 = 25% of total Equivalent square footage value for tenant access = 25% x 1,100 = 275 Rental square feet, adjusted = 600 + 275 = 875 Percentage of total = 875 ÷ 2,200 = 40%

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This calculation would allow you to claim 40 percent of the full-year depreciation as rental expense. If the rental is available for only part of the year, the percentage has to be further reduced to the applicable number of months.

Fair Calculation of the Asset’s Use Any asset used partially for investment purposes should be depreciated based on a fair calculation of the portion of use. Each asset has to be calculated in its own manner, since the attributes of each (e.g., automobile, telephone, computer, and lawn mower) are different. There is no one method, so you need to keep good records of how you break down the investment portion and how you calculate depreciation for each asset.

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Depreciation Limits on Cars, Trucks, and Vans The depreciation you claim for passenger automobiles used for investment purposes is limited, even if you use the auto exclusively for business. Passenger automobiles placed in service after the year 2000 are subject to the maximum depreciation limitations shown in Figure 8-1. Note that these are limits for depreciation that you are allowed to claim if the auto is used 100 percent for investment. If you use it only partially for investment, you have to reduce the limits accordingly. For example, on the basis of your auto log, if your total investment use was 15 percent and you placed the automobile into service in late 2003 and the auto has been in use for two years, the maximum allowable would be $4,900. The deductible portion (15 percent) would be $735.

Limits for Trucks and Vans A different set of rules applies for investment use of trucks and vans. Figure 8-2 summarizes the latest information for these limits. The limitations for depreciation on trucks and vans, like those on autos, are reduced to the applicable percentage when the vehicle is used only partially for investment purposes. The rules for depreciating autos, trucks, or vans have been complicated by the imposed annual limitations. Most people can decipher these rules with a review of the instructions; however, if you are not sure about how to apply the rules (or any other calculation), you should consult with your accountant or tax adviser.

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Figure 8-1. Depreciation limits for passenger automobiles.

Important: For current information about the limits for the depreciation deduction for automobiles and trucks or vans placed into service after 2003, refer to the updated edition of the IRS publication “Instructions for Form 4562.”

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Class Lives and Recovery Periods All assets are classified in one of several classifications. Some of these socalled recovery periods are highly specialized, and others are more generalized. The recovery periods that apply to real estate investments are:

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Figure 8-2. Depreciation limits for trucks and vans.

Classification 5-Year Property

27.5-Year Property 39-Year Property

Assets Automobiles and light trucks; office and computer equipment; and appliances, carpets, and furniture used in rentals Residential real property Nonresidential real property

Most capital assets used in your rental activity will fall into the five-year classification; your residential real estate investments belong in the 27.5year recovery period. The calculation of depreciation under each recovery period is determined by the tax rules.

Five-Year Recovery Period The five-year recovery period depreciation is accelerated in the early years and reverts then to straight-line depreciation. The acceleration is at the rate of 200 percent. This means that the initial depreciation allowance is twice the amount that would be allowed using the straight-line method. (Under the straight-line method, the same deduction is allowed each year.) Depreciation in the five-year recovery period, using the General Depreciation System guidelines, is shown in Table 8-1.

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Table 8-1. Depreciation schedule, 5-year recovery period, 200 percent declining balance. Year

Depreciation

1 2 3 4 5 6

20.00% 32.00 19.20 11.52 11.52 5.76

The Half-Year Convention Under the straight-line method, the five-year depreciation term would allow 20 percent per year. Since the 200 percent accelerated depreciation applies, it would seem that the first year’s depreciation should be 40 percent; however, it is only 20 percent. The reason for this disparity is that five-year property is calculated using what is called the half-year convention. Under this convention, all property placed into service during a specific year is treated as though it were placed in service at the midpoint of the year. Thus, only one-half of the applicable depreciation is allowed in the first year. This rule makes it easier to calculate depreciation for all assets in the first year of service. Since the rate of depreciation allowed is 200 percent of the straightline rate, the annual depreciation declines. For example, under the straightline rate, you would claim 20 percent per year for five years. Using 200 percent declining balance, the first year is 40 percent (reduced to 20 percent, due to the half-year convention). Therefore, if the asset were worth $1,000, you would depreciate $200 the first year. That leaves $800. The secondyear calculation would be for 200 percent of a five-year rate: $800 = $160 = 20% x $800 5 Under the 200 percent method, the $160 is doubled, so you would write off $320. This is twice the straight-line rate based on the $800, which works out to 32 percent of the original $1,000 cost of the asset. Applying this same declining calculation to each remaining year’s balance, the depreciation declines rapidly in these first years. The rate reverts to straight line according to the depreciation schedule.

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Exception: If property placed in service during the last quarter of the year is higher than 40 percent of the total of all assets placed in service for the year in that same recovery class, the mid-quarter convention is used in place of the mid-year convention. For example, you purchased a total of $4,000 during the year that is depreciated under the five-year recovery period. But $1,700—more than 40 percent—was purchased in the fourth quarter. So you would use the mid-quarter convention. Under this method, the percentage of depreciation allowed is changed from 50 percent (the half-year standard) to 87.75 percent for assets placed in service during the first quarter, 62.5 percent for the second quarter, 37.5 percent for the third quarter, and 12.5 percent for the fourth quarter.

Most real estate investors will use the half-year convention for assets acquired throughout the year, with calculated depreciation based on the prescribed breakdown in Table 8-1.

Calculating Depreciation for Real Property The rules are different for real property. In calculating first-year depreciation for residential or nonresidential real property, the mid-month convention is used for calculating depreciation during the first year. The first-year percentage varies depending on the month the property is placed in service.

Residential Property For residential property, which is depreciated over 27.5 years under the General Depreciation System, you are required to use the straight-line method, so the value of real property (i.e., purchase less land) is calculated by dividing the total by 27.5. But the actual amount of depreciation you claim each year depends on the month the property is placed in service. Table 8-2 demonstrates that for the first seventeen years, the depreciation expense varies and that from the eighteenth year onward, the depreciation expense reverts to a uniform percentage. That is 3.637 percent, the equivalent annual allowance based on 27.5 years. In the application of the mid-month convention, the calculation varies only during the first year. In the second year through the ninth year, the annual calculation is identical. And the annual deduction increases by only one-half of 1 percent per year after that.

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Table 8-2. Depreciation schedule, 27.5-year recovery period. The month is the first recovery year that property was placed in service:

Year

1

2

3

4

5

6

1

3.485%

3.182%

2.879%

2.576%

2.273%

1.970%

2–9

3.636%

3.636%

3.636%

3.636%

3.636%

3.636%

10, 12, 14, 16, 18

3.637%

3.637%

3.637%

3.637%

3.637%

3.637%

11, 13, 15, 17

3.636%

3.636%

3.636%

3.636%

3.636%

3.636%

The month is the first recovery year that property was placed in service:

Year

7

8

9

10

11

12

1

1.667%

1.364%

1.061%

0.758%

0.455%

0.152%

2–9

3.636%

3.636%

3.636%

3.636%

3.636%

3.636%

10, 12, 14, 16, 18

3.636%

3.636%

3.636%

3.636%

3.636%

3.636%

11, 13, 15, 17

3.637%

3.637%

3.637%

3.637%

3.637%

3.637%

Example: You acquired your residential investment property in August this past year. The value of property (excluding land) is calculated at $125,000. Your depreciation, based on Table 8-2 and using the mid-month convention, will be: Year 1 2–28 29

Percent (%) 1.364 3.636 Remainder

Annual $1,705 4,545 580

According to the mid-month convention table, the yearly depreciation from years 10 through 28 alternate back and forth between 3.636 percent and 3.637 percent. In the example given, this will make a difference of only a dollar per year. In the interest of simplicity, it is practical to continue depreciating $4,545 per year and claim the remaining balance in the twenty-ninth year.

Commercial or Industrial Property The schedule for nonresidential real estate is less complicated. The full term of thirty-nine years is broken down under the mid-month convention as shown in Table 8-3.

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Table 8-3. Depreciation schedule, 39-year recovery period. The month is the first recovery year that property was placed in service:

Year

1

2

3

4

5

6

1

2.461%

2.247%

2.033%

1.819%

1.605%

1.391%

2–39

2.564%

2.564%

2.564%

2.564%

2.564%

2.564%

The month is the first recovery year that property was placed in service:

Year

7

8

9

10

11

12

1

1.177%

0.963%

0.749%

0.535%

0.321%

0.107%

2-39

2.564%

2.564%

2.564%

2.564%

2.564%

2.564%

For example, if the value of a commercial or industrial investment property (excluding land) was calculated at $200,000, and you acquired the property in August (the eighth month of the year), your allowable depreciation deduction each year would be calculated, using Table 8-3 and the mid-month convention, as: Year 1 2–39 40

Percent (%) 0.963 2.564 Remainder

Annual $1,926 5,128 3,210

Key Point: While the special calculations for half-year and mid-month conventions complicate these calculations, they apply for the most part only to the first year. They help to make the depreciation rules fair and consistent. For example, it would not be equitable to allow the same level of depreciation for a $200,000 real property acquired in December as allowed for one acquired in January, nearly a full year earlier.

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Keeping Records of Depreciation Calculations Keeping track of the depreciation you are allowed to deduct each year is not difficult. It makes sense to calculate the depreciation for each year at the beginning (when you put the asset in service) and to then maintain the schedule so that you do not have to recalculate the deduction each year.

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This suggestion is especially useful for the accelerated five-year recovery period, in which the deduction changes each year. You may have a long list of assets in this classification. Beyond your computer and automobile, you could also have dozens of appliances, for example, each acquired in a different year; so keeping track of depreciation allowed for the full term of ownership is a sensible idea.

Example: You have five rental properties. Each one contains a stove, refrigerator, and dishwasher. Four also have washers and dryers. Altogether, you own twenty-three appliances. If these were acquired in different years, calculating depreciation could be complicated. Simplifying the Calculations Set up a schedule like the one shown in Figure 8-3 to track annual depreciation in the five-year recovery period. (You can use the same schedule for your real property; but if the calculated deduction is identical in the second year and onward, it is not necessary to include them on the schedule.) In filling out this schedule, you want to keep track of two separate calculations: the annual depreciation and total to date. This is necessary because, in reporting depreciation on your tax return, you are required to show both prior depreciation and current depreciation. Therefore, allow two lines per asset.

Figure 8-3. Schedule of annual depreciation.

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Example: You acquired a washer/dryer and a refrigerator for Property 1 and a refrigerator for Property 2 during the past year. Using the half-year convention, the form for these acquisitions would be completed as shown in Figure 8-4. Reporting Depreciation for Each Asset This example provides you with the information needed to report depreciation—both current year and prior depreciation—for each asset acquired during the year, through the entire term that depreciation will apply. This type of schedule can be set up using Excel or a similar spreadsheet program and extended indefinitely. Subtotals can also be calculated automatically and entered for each year, for the cost as well as for current-year depreciation and prior depreciation. (In using a spreadsheet program, placing current year and prior year subtotals in separate columns makes the calculation of subtotals easier.)

Tracking Total Annual Depreciation An annual worksheet is also useful for keeping track of each year’s claimed depreciation. This worksheet can be used as part of your permanent records, or it can be attached to your tax return as a supplementary schedule. The worksheet is designed to report all assets, listed and subtotaled by property; the date placed in service; cost; prior years’ depreciation; method and convention; recovery period; rate or percentage; and the depreciation deduction. A worksheet that provides all of this information is shown in Figure 8-5.

Figure 8-4. Schedule of annual depreciation (filled-in example).

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The information gathered in your permanent records and recorded is easily transferred to this worksheet. For example, the details entered in the example shown in Figure 8-4 provide all of the information needed to complete the depreciation portion of your tax return.

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Making Depreciation Elections If you want to calculate depreciation on a different method than the prescribed ones, you can make a tax election. There are two elections you are likely to use, both of which reduce your depreciation expense in the earlier years but increase the expense in later years. If you anticipate reaching the $25,000 maximum deduction this year and you don’t need the extra expense, you may elect to slow down the rate of depreciation. Or, if your adjusted gross income exceeds $100,000, it means your real estate investment losses are limited, so claiming depreciation does not help. Again, you may elect to depreciate under an alternate method. A few points to remember about tax elections:

❑ They are usually irrevocable. Once you elect to use a slower depreciation rate, you cannot simply revert to the prescribed method.

❑ The election has to be made in the first year. You need to decide how to depreciate capital assets during the first year you report the asset as being placed into service.

Figure 8-5. Depreciation worksheet.

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❑ The election usually applies to all assets in the same recovery period. Most elections have to be applied to all assets in the recovery class that are placed into service during the same year.

❑ The election must be made no later than the due date of your tax return. The deadline is the due date for the year the assets were placed in service, including extensions of time to file.

Tax Election #1—150 Percent Declining Balance The first election is to use 150 percent declining balance instead of the 200 percent rate. The calculation of depreciation under the 150 percent schedule is made according to the percentages given in Table 8-4.

Example: You acquired five-year property this year worth $4,000. You are considering making an irrevocable election to use the 150 percent decliningbalance method rather than the 200 percent method, because you believe that you may benefit more from deferring the expense until later. Each of these methods would produce the following annual depreciation expenses: Year 1 2 3 4 5 6

200% 800 1,280 768 461 461 230

150% 600 1,020 714 666 666 334

Table 8-4. Depreciation schedule, 5-year recovery period, 150 percent declining balance. Year 1 2 3 4 5 6

Depreciation 15.00% 25.50 17.85 16.66 16.66 8.33

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Given that the asset value in this example is limited to only $4,000, the difference is not significant. However, the higher the dollar amount of assets placed into service, the greater the effect of deferring part of the depreciation into the later years. This election is made by identifying 150 percent declining balance in the “Rate” column (see Figure 8-5).

Tax Election #2—Straight-Line Depreciation Another election produces straight-line depreciation each year. It is irrevocable and has to be applied to all property in the same recovery period and placed into service during the year. For example, $4,000 of five-year property would be depreciated at the rate of 20 percent per year. Since the halfyear convention still applies, the first and sixth year would see $400 in depreciation expense, and the second through fifth years would have $800 each. This election is allowed under IRC Code Section 168 and is called a Section 168 Election. To make this election, attach a statement to your tax return identifying yourself by name and Social Security number. The statement should explain the election by section reference. For example:

I elect under Section 168(b)(5) to have the provisions of Section 168(b)(3)(D) apply to all property that was placed in service in the tax year ended December 31, 20___, that is included as part of the five-year recovery period. Important: Depreciation is not difficult to calculate, but the rules are revised from time to time. Keeping track of the current rules can be difficult, so you need to refer to the instructions any time you acquire new assets as part of your real estate investments.

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The Recapture of Depreciation Upon Sale When you sell your investment assets, you are required to “recapture” the depreciated value. This means that you will be taxed on the amount of depreciation that you claimed during the period you owned the property.

Example: You purchased a rental residential property five years ago and paid $85,000. The value assigned to the land was $25,000 and the value of the improvements to the property was $60,000. Last year, you sold the property for $135,000 and you had closing costs of $8,000. Your net proceeds were $127,000.

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In this example, your profit on the investment was $42,000 (net sales price of $127,000 less purchase price of $85,000). However, your capital gain will be adjusted to recapture depreciation. You claimed depreciation using the 27.5-year recovery period, which amounted to about $9,800. (This figure will vary depending on the month you purchased the property.) The calculation of your capital gain would be as follows: Sales Price Less: Closing Costs Net Adjusted Sales Price Purchase Price Less: Depreciation Claimed Basis Less Depreciation Net Taxable Capital Gain

$135,000 –8,000 $127,000 $ 85,000 –9,800 $ 75,200 $ 51,800

Keeping Complete Records Considering the complexities of the depreciation rules—as well as rules for calculating net capital gains—many investors require the help of a qualified tax preparer. Your task may be limited to documenting all of your transactions and maintaining records to ensure that you will be able to establish all that you are entitled to claim. A system’s effectiveness can be best judged by how easily someone else can figure out what is taking place. Your accountant or tax preparer will have an easier job to do if you keep good records of purchase dates, dollar amounts, depreciation calculations, and all other transactions. The importance of thorough records becomes clear when you consider the tax rules that cover real estate investing. Depreciation is not the only complex topic. The next chapter explains how the rules apply to your investments.

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Notes 1. IRS Publication, “Instructions for Form 4562.” 2. Ibid.

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C H A P T E R

9

Understanding the Tax Rules for Real Estate Everyone who pays taxes knows that the rules seem to change continually and that forms, record-keeping requirements, and calculations can all be complex. In addition to having to contend with the same tax rules as everyone else, real estate investors have to be aware of some rules that apply just to them. The good news is that most of these special rules are beneficial to real estate investors. For example, sweeping tax reform in 1986 did away with the majority of tax shelters. Before that date, investors could deduct losses without specific limitations and were able to avoid taxes altogether in some instances. The Tax Reform Act of 1986 established new rules. Since that date, any loss on a passive investment—one in which other people manage your investment property for you or make the day-to-day decisions—can no longer be deducted. Such losses have to be carried forward and applied against future passive gains. The one exception to this reform was real estate investing. Unlike other investors with passive losses, real estate investors can deduct passive losses. ■

Passive and Active Income By definition, passive activity is an investment that simply provides income or loss to you. If you do not “materially participate” in running an operation, it is a passive activity. For real estate investors, this distinction is not difficult to make. If you invest by buying units in a limited partnership, it is a passive activity. As a limited partner, you do not participate in selecting

179

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properties, maintaining them, and making decisions from one day to the next. The general partners take care of those activities, and limited partners are provided passive gain or loss for their investment.

Active Participation If you purchase a house and rent it out, selecting tenants yourself, setting rental amounts, performing maintenance work (or hiring someone to do it for you), and deciding which properties to buy or sell, then you are actively participating in the investment. Even if you hire a manager to run the properties, as long as you are involved in tenant selection and maintenance and other decisions, you are actively involved in the property. So, even though real estate investing (by way of direct ownership of properties) is a passive activity, you are allowed to claim a deduction for losses as long as you materially participate in operating the investment properties.

Material Participation To qualify for the “material participation” rule, you have to own at least 10 percent of the property. So, if you buy investments with a family member or friend, you have to be able to demonstrate that you are at least a 10 percent owner and that you materially participated in managing the investments. These rules prevent the creation of tax write-offs for individuals who need the deductions but do not really take part. For example, a parent whose income consists of dividends, interest, and Social Security may not need the deductions from investment properties or has excess levels of losses; and a son or daughter who is earning a salary but has little or no deductions may benefit from a tax loss. In this situation, the ownership and participation have to be bona fide to be allowed. A family cannot simply assign a portion of ownership to a member who needs the deductions.

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Rules on Deductible Losses As mentioned, one of the key tax rules for real estate investors involves deductible losses. These deductions are subject to certain limitations. You can deduct losses up to $25,000 per year on your federal income tax return, as long as your adjusted gross income (AGI) does not exceed $100,000. If your income is higher, you lose 50 cents of deduction for every dollar of income above $100,000.

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Example: If your adjusted gross income was $110,000 last year, your maximum loss deduction on real estate would be reduced by $5,000 (one-half of the excess of $10,000), to $20,000 for the year. If your tax return claim is married, filing separately, you can deduct $12,500 if you and your spouse lived apart for the entire year. However, if you and your spouse lived together for any part of the year, the loss deduction cannot be claimed. The maximum deduction per year is $25,000, under any circumstances. The rules are intended to prevent investors from arranging their affairs to deduct more than that amount during the year.

Excess Loss Any unused excess loss is carried forward and applied to future years; or, when you sell property, the loss is applied against the capital gain. If you have several properties, you can apply the entire passive loss carryover to offset the gain, even though those losses are not specifically incurred on the sold property. If the passive loss carryover exceeds the gain on property, you can deduct the entire loss that applies to that property.

Adjusted Gross Income The definition of adjusted gross income (AGI) has to be modified for this calculation. Normally, adjusted gross is all reported income, minus student loan interest, IRA investments, moving expenses, one-half of self-employment tax, and alimony, for example. In calculating adjusted gross income for computation of maximum real estate deductions, you cannot include IRA contributions, any taxable Social Security benefits, interest on student loans, deduction for one-half of self-employment tax, or tuition and fees deductions. In other words, most of the popular adjustments to adjusted gross income are disallowed.

Example: Your adjusted gross income last year was $87,500. This included deductions for IRA contributions, student loan interest, and tuition deduction totaling $22,000. You also had net losses from real estate investments of $27,000. If the modified adjusted gross income was less than $100,000, you would be allowed to deduct $25,000 in real estate investment losses, and the excess of $2,000 would be carried over and applied to future years. However, your adjusted gross income has to be modified for the $22,000

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in adjustments that are disallowed as well. This alters your AGI for this purpose to $109,500. Your maximum real estate deduction is reduced by onehalf of the excess over $100,000. The computation is as follows: Maximum Real Estate Loss Deduction AGI as Reported Adjustments Not Allowed Modified AGI Maximum Income Allowed Excess One-Half of Excess Maximum Real Estate Loss Deduction Loss as Computed Loss Excess Carried Forward

$25,000 $ 87,500 –22,000 $109,500 –100,000 $ 9,500 –4,750 $20,250 $27,000 $ 6,750

In this example, you would have to carry forward the excess loss of $6,750 ($27,000 minus $20,250) to use in future years. You calculate the maximum deductible losses and carry-forward on Form 8582 (Passive Activity Loss Limitations), which becomes a part of your tax return (see Chapter 10).

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Rules for the Sale of Real Estate When investment real estate is sold, the net proceeds are treated as a capital gain or loss. That means the transaction is reported on Form 4797, where depreciable property is reported. Calculation of the gain itself, and of the taxable portion, involves adjustments to both purchase and sales price.

Long-Term Capital Gains Qualified long-term capital gains are taxed at a special rate below the usual tax rate, so you benefit from favorable tax treatment for property held longer than twelve months. The calculation of taxable gain or loss includes closing costs at the point of purchase and sale; additional capital improvements made while you owned the property; recapture of depreciation; and adjustments in the basis of the property if you deferred a gain on investment property previously. Deferred gain works in this way: If you own a rental property and you sell it, reporting a gain, you can defer that gain if you replace the investment property with a similar property that costs as much or more, within a spec-

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ified period of time. (This exchange rule is explained in more detail later in this chapter.)

Example: You purchased a rental property for $135,000 and, a few years later, sold it for an adjusted price of $160,000. You had a gain of $25,000 and you met the rules for deferring the gain. The profit of $25,000 is carried over, and the basis in the new property is reduced by that amount. You purchased a new property for $175,000 for use as a rental. With the deferred gain from the first property, your adjusted basis is reduced to $150,000. A worksheet for calculating net gain or loss on investment property is shown in Figure 9-1.

Selling Your Primary Residence The rules for selling your primary residence are quite different. A married couple can exclude up to $500,000 of gain from the sale of their house, and a single person can exclude $250,000. You are required to use your home as your primary residence for at least two years during the five years prior to sale, and you cannot claim this exemption more than once during a twoyear period. Beyond that, the exemption of gain can be claimed as many times as possible.

Figure 9-1. Worksheet for calculating profit on sale of real estate.

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As noted, the profit or loss on your real estate investments is separate from the reporting of gain on a primary residence. However, the special exclusion of tax on gain for your residence raises an interesting planning point. You can avoid or defer taxes on capital gains from real estate investing in one of two ways. First, you can execute a “like-kind” exchange, buying a new investment property upon the sale of an older one (see “LikeKind Exchanges,” below). Second, you can convert a rental property to your primary resi-dence.

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Converting a Rental Property When you convert, it simply means that you move into the house you have been using as a rental and live there for at least two years before selling it. If you then have a gain upon sale, the only portion that would be taxed would be depreciation recapture. Of course, this requires considerable advance planning. You have to put in the two-year period as primary residence over a five-year term. For example, let’s say that you have been living in your current house for at least two years. If you convert it to a rental for the next three years and then sell it, you will be able to claim the primary residence exclusion—as long as you did not sell another property within two years and make a similar claim.

Some Tax Rules to Note The depreciation recapture cannot be avoided, even upon conversion from rental to primary residence. You are always required to pay capital gains tax upon sale of any property for which a depreciation expense has been claimed. Similarly, you have to pay taxes on any deferred gain, even if a rental property is later converted to a primary residence. For example, if you bought a rental property for $125,000 and later sold it for $150,000, you could defer the $25,000 profit by going through a like-kind exchange. However, if you later converted the new property to your primary residence and then sold it, you would have to divide the profit into two segments. The first segment is the taxable portion, consisting of the deferred gain and depreciation recapture; the second segment is the remaining profit that is qualified for exclusion under the primary residence rule. (This includes the requirement that you use the property at least two years during the five-year period before the sale, and the limitation that you have not claimed the exemption on another property within the last two years.)

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Importance of Timing This limitation—that you can claim the residential exemption only once in a two-year period—has to be kept in mind when you are timing your decisions to sell property, especially when it is property that is used as a primary residence or that has been converted.

Example: You own two properties. The first one was your primary residence up until thirty months ago, at which time you converted it to a rental. The second is your current primary residence, which you purchased thirty months ago. You have decided to sell your properties and move from the area, so both properties are placed on the market. Which property should you claim? In this example, both properties would qualify for the exemption of gain, because you lived in each as a primary residence for at least two years over the past five years. However, you can claim only one property within a two-year period. So it would be wise to claim the exemption for the property with the higher capital gain, to reduce your tax burden. The only other choice would be to defer selling your current primary residence for two years, so that you would be able to avoid taxes on that property as well. By converting it to a rental and waiting two years, you would still qualify for the two-year/five-year rule and could exempt all gain, except depreciation recapture. You could not make the same move on the property you converted thirty months ago. By waiting the two years, you would no longer meet the requirement that you used it as a primary residence for at least two out of the last five years. You have lived in your present primary residence for thirty months; an additional twenty-four months would take the total up to fifty-four months, during which time the property was not a primary residence. That leaves only six months in the last five years, disqualifying it for the two-year/five-year restriction. Does conversion make practical sense? Converting property from an investment to a primary residence is a wise tax-saving move, as long as it also makes practical sense. However, you may not view a rental property as meeting your requirements for a primary residence, so it may be impractical to move your family into a property that is simply not suitable. You may also be unwilling to wait two full years before selling the property. Investors often need to cash out as soon as possible, which is one of the most common reasons for wanting to sell an investment property. Considering the personal preferences for your primary residence, and your need for cash, it

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may not make sense to convert rental property just to avoid capital gains taxes. How do you establish a primary residence when you convert a property? This is a record-keeping and documentation problem that you must think through. Your mailing address is usually your primary residence, although many people use post office boxes or mail drops instead of receiving mail at their homes. You can establish primary residence by keeping copies of paid utility bills, subscriptions, and other mail showing that you were present at the property. You also use your primary residence address in most cases when you file your income tax return. Your employer also keeps records of your primary residence to mail out tax information forms at the end of the year. Once you begin thinking about it, establishing the location of your primary residence, as well as the dates you lived there, is not difficult.

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Like-Kind Exchanges As a real estate investor, you can defer taxes on gains from property indefinitely, as long as you invest proceeds in properties that are equal or greater in value, and as long as you reinvest within 180 days from the sale date. That means a subsequent purchase has to be closed within that period. The tax deferral of gain from investment property is known as a 1031 exchange (named after IRC Code Section 1031). This election is more commonly called a like-kind exchange, because qualified property has to be of the same type. If you have one rental and you exchange it for another, that is like-kind property. You can trade a house for a duplex or apartment, or switch between residential and commercial, but as long as it remains rental property, the gain can be deferred. You can even exchange improved property for raw land, or vice versa, and have it qualify as a like-kind exchange. The one exception regarding real estate is that both properties in the exchange have to be within the United States. Foreign properties do not qualify.

Where to Look: IRS Publication 544, “Sales and Other Dispositions of Assets,” includes the specific rules for 1031 exchanges. It can be downloaded from the Internal Revenue Service’s Web site at www.irs.ustreas.gov.

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Specific Rules for the Exchange The rules to qualify for the exchange are quite specific. When you sell one property, you are required to identify and complete the purchase of another property within 180 days from sale. As part of this timing requirement, you need to identify property you intend to purchase as a like-kind exchange within forty-five days from sale; this is known as the “identification period.” Because of this requirement, it may be necessary to identify more than one potential property, so that if a sale falls through, you will not be precluded from completing a 1031 exchange.

Hiring a Qualified Intermediary You cannot generally execute a like-kind exchange yourself. You need to hire a facilitator, or a “qualified intermediary,” to complete the paperwork and to act as intermediary for both sides of the transaction (you as exchanger and the seller of the new property). Even though you have to pay a facilitator for the services, it is a wise idea. You want to ensure that the like-kind exchange is not disallowed because you didn’t file in time or provide the proper notification. For example, when you make a written offer on a property, you need to include a statement advising the seller that you are purchasing the property as part of a 1031 exchange, and the seller needs to agree to cooperate in that exchange. A facilitator can help in phrasing this notification properly, as well as in making sure all deadlines are met. The facilitator is necessary in the transaction because you, as seller, are not allowed to receive money or property before the transfer has been completed. The facilitator has to actually take legal title to the new property and then transfer it to you, or else the deferral will not be allowed. The intermediary has to enter into a written agreement with you specifying the terms and conditions of the exchange; therefore, the individual cannot be related to you. Furthermore, the intermediary cannot have been an employee, accountant, attorney, or broker working for you for at least two years before the transaction.

When to Elect the 1031 Exchange The 1031 exchange is a useful election when you want to continue investing in real estate and when you want to upgrade from one property to another. For example, if you have one or more single-family houses and you want to exchange them for a single apartment house, a 1031 exchange can be executed so that all of your profits are deferred. Electing the 1031

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exchange does not mean you escape liability for the taxes, only that the tax is put off until you sell the exchanged property. The timing limitation of 180 days can be a problem when you are trying to sell several properties. Unless your local market is very strong, you may have a problem disposing of several properties within that relatively short window. You may require the help of a skilled real estate agent, working in cooperation with your 1031 exchange facilitator, to ensure that you meet your deadlines. If you want to dispose of a rental property but you do not want to invest in another, a 1031 exchange makes no sense, because it keeps you tied into the market. One exception is when you don’t want to sell because you need the money, but you want to defer the taxes. You can exchange a rental property for raw land and qualify for the exchange. Because it will have no tenants, raw land is low maintenance. You must pay property taxes, of course, but you could defer taxes on your profit by trading out of a rental situation. The alternative discussed previously—turning investment property into your primary residence—is easier to execute and also may help you to avoid taxes. Unlike the 1031 exchange, in which taxes are merely deferred, the transfer from investment property to primary residence allows you to sell tax free for the entire profit, except depreciation recapture and any previously deferred gain. Watch This: In any matters involving tax avoidance or deferral, you should consult with an expert tax adviser before making any decisions. An error in timing, filing the wrong form, or not being aware of changes in the rules can all cause expensive tax consequences. Because tax rules change from time to time, you need to make sure that the rules in effect when this book was published continue in effect when you are making decisions about your property.

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Rules for Properties Used Partly as Rentals When your primary residence is partially rented out, you must break down the tax deductions between personal expense and rental expense. This rule applies when a) you rent out a portion of your home or b) when the property is a rental for part of the year and your primary residence for the remainder. When you use your primary residence in this manner, you need to keep good records to document your calculation of the division of expenses. The

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portion assigned to personal use includes mortgage interest and property taxes. The portion assigned to rental use includes deductions for depreciation, utilities, mortgage interest, and property taxes, plus any other rental expense. However, you can deduct only the portion of those expenses that applies to the rental.

Example: You rented out a room in your home for nine months last year. The size of the area rented out was 900 square feet, and the total square footage of your house is 3,100. By this calculation, 29 percent of expenses can be deducted. This includes 29 percent of the full-year depreciation, utilities, property taxes and mortgage interest, and all other expenses that apply to the rental. (If you advertise the rental, for example, you can deduct 100 percent of the cost of advertising, since it applies solely to rental investment and not to personal use.) In this example, 29 percent of property taxes and mortgage interest are listed as rental expense; therefore, the remaining 71 percent would be listed as itemized deductions. If your deductions are marginal between itemizing and claiming a standard deduction, this calculation could result in tax savings. For example, if the standard deduction is higher than the total of your calculated itemized deductions (after deducting the portion applicable to rental), then your taxes will be lower by claiming the standard deduction instead of itemizing your deductions.

Less Than Clear-Cut Division of Use The precise calculation of rental division is relatively easy when you rent out an in-law unit with its own kitchen and bath. However, when you rent out a room and allow a tenant access to your kitchen, living room, bathroom, laundry room, and other areas, you need to arrive at a reasonable calculation of the rental portion of total expenses. Several possible methods of calculation are worth exploring. These include:

❑ Number of People Living in the Home. This calculation assumes that all people residing in the home make about the same degree of use of common areas: kitchen, living room, and bathroom. It has two parts. First, you calculate the rented square feet as a percentage of total square feet; second, you calculate the percentage of people renting (versus total residents) and apply that to the remaining square feet.

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Example: Your home has 3,100 square feet and you rent out a room of 900 square feet. Your family contains four people, so a total of five people live in the home. Your common areas (those areas accessible to all household members) are calculated at 1,050 square feet. The calculation of the percentage that applies to rents is: 1 ÷ 5 = 20% (the percentage of people renting) 1,050 x 20% = 210 (square feet of common areas shared with the renter) 900 + 210 = 1,110 (total square feet assigned to rental) 1,110 ÷ 3,100 = 36% (percentage of shared-space expenses that apply to renter) In this example, you are allowed to deduct 36 percent of interest, property taxes, insurance, utilities, and depreciation as rental expenses; the remaining 64 percent of interest and property taxes are listed as itemized deductions.

❑ Rental Income as a Percentage of Mortgage Payment. An alternative method for making the calculation is to treat rental income as a percentage of your total mortgage payment. In this example, let’s assume that the rental income you receive each month is $400 and your total mortgage payment is $1,314. In this case, 30 percent would be the applicable percentage of expenses you would be allowed to deduct against rental income.

❑ Rent Charged as a Percentage of Overall Market Rent. A third method is to calculate the fair market rent for a house such as yours. For example, in your city, the typical four-bedroom, two-bath home may rent for $1,200 per month. Since you are collecting $400 in rent, it is reasonable to assume that the applicable percentage of deductions is 33 percent, or one-third of the fair market rent you could collect if you rented out the entire house. Where to Look: Check IRS Publication 527 to study rules concerning mixed-use residential rental property. This publication can be downloaded from the IRS’s Web site at www.irs.ustreas.gov.

As long as you apply a method consistently from one year to the next to calculate rental expenses, you can use the one that yields the most advanta-

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geous outcome. In the earlier example, breaking down the square footage provided the most advantage because you can deduct the largest percentage (36 percent) of total expenses as rental expenses. The higher the percentage assigned to rental activity, the higher your deductible expenses. Remember, you cannot deduct anything beyond interest and property taxes as part of your itemized deductions. Therefore, it is advantageous to assign a larger percentage to rental activity, as long as your assumptions are fair and supportable. And if you end up using the standard deduction instead of itemizing as a result of assigning a higher portion of interest and taxes to the rental portion, your taxes will be lower. As far as interest and property taxes are concerned, you are allowed to deduct the entire amount regardless of how much is assigned to personal use and how much to rental investment. The difference in how much you pay in taxes is the result of the percentage of other expenses you can deduct.

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State Tax Liabilities The rules for state income taxes vary considerably. Treatment of real estate income, expenses, depreciation, and deductibility of losses depends on current state law. Even tax rates on the state level are inconsistent. A few states assess no income tax. These states are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Two other states—New Hampshire and Tennessee—tax only interest and dividends. The remaining states impose either a flat rate or a graduating rate. The lowest rate is found in Iowa, whose state income tax begins at 0.36 percent (but rises as high as 8.98 percent). The highest rates are imposed by Montana, which charges as much as 11 percent, and by North Dakota, where some long-form filers pay 12 percent. Each state’s tax requirements are different because of state-level economics and legislative policy. States charging a flat rate (Colorado, Illinois, Indiana, Massachusetts, Michigan, and Pennsylvania) tend to impose the rate at a higher level than those states with a range of rates. This means that depending on whether your overall taxable income is at the high or the low end of the likely range, you may have to pay higher or lower taxes from one state to another. Rhode Island has a simple method. The tax is equal to 25 percent of the federal tax liability. So, if you owe very little in federal taxes, your Rhode Island tax will be small as well; but if your federal taxes are relatively high, you will be hit with additional state taxes as well.

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What to Do: To determine the impact of real estate rental activity on your state income tax rates, check with your state’s tax agency or with your tax adviser. Tax forms for each state can be downloaded on several Web sites, including from the Federation of Tax Administrators (www.taxadmin.org/fta/link/forms.html) and the libraries of Louisiana State University (www.lib.lsu.edu/govdocs/taxes.html).

If a particular state imposes rules that are different from the federal rules for the treatment of losses, you will need to recalculate your deductions and taxable income. Some states further require you to include a copy of your federal tax return with the state return that you file, and to reconcile any differences in reported income and deductions. This extra burden makes the record-keeping rules more difficult for you as a real estate investor. You may also need to recalculate depreciation that you claim on your real estate investments. Not every state has adopted the federal depreciation rules for the purpose of calculating state taxes. Therefore, it may be necessary to keep two different records of depreciation, one each for federal and state calculations. When you eventually sell an investment property, the taxable gain will be different because of these inconsistencies. Key Point: In assessing the tax benefits of real estate investment, the state implications have to be reviewed carefully. Federal rules allow deductions of passive activities and tax-deferred exchanges of investment property (and tax-free sale of primary residence), all as incentives for real estate investors. The states do not automatically provide the same benefits.

The tax rules for real estate are complex and include many special provisions. You will need to consult with a tax adviser for tax planning, especially if you have high income from non–real estate investments, wages, or self-employment. The many questions concerning how to position yourself to reduce taxes legally are complicated when you add in the state tax issues. The state rules do not always conform to the federal rules, so elections you make this year could have an effect on both federal and state liabilities. This is where the help of an expert can be useful; you want to follow all of the rules, reduce your overall taxes within the law, and ensure that you have not missed any potential deductions.

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C H A P T E R

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Tax Reporting for Annual Income and Expense As an investor in real estate, your tax-reporting requirements are more complex than for most other types of investments. For example, if you invest only in stocks and mutual funds, you report interest and dividends on Schedule B and capital gains on Schedule D of Form 1040. Beyond that, there are usually no special schedules to file. For real estate transactions, you must also report the income and expense on Schedule E, and depreciation, passive loss limitations, and likekind exchanges on specialized schedules. This chapter provides blank copies and examples for each of the applicable forms.

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How to Report Real Estate Transactions Using Form 1040 You are familiar with IRS Form 1040, the summary page of every tax return. All schedules and forms that are a part of your tax return are summarized on the 1040. In the case of real estate investments, you have to transfer data from Schedule E, where income, expenses, and profit or loss are summarized. This is the primary schedule for your year-to-year real estate activity. The two pages of Form 1040 are shown in Figures 10-1 and 10-1a. The net profit or loss from real estate is reported on line 17, brought over from the bottom line from Schedule E. If you sold investment real estate during the year, you would also show an entry on line 13a, capital gains and losses, which is brought over from Schedule D.

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Figure 10-1. Form 1040.

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Figure 10-1a. Form 1040 (cont’d).

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Real estate transactions are reported in a manner similar to business income, which would be reported on Schedule C (for sole proprietorships), with additional information provided on other tax schedules or by supplementary schedules. The depreciation form, number 4562, is filled in to supply further information for one line on Schedule E. The net profit or loss reported on Schedule E is then carried over and reported on Form 1040. Figure 10-2 shows the flow of information for typical year-to-year reporting of real estate profit and loss.

Schedule A—Itemized Deductions You also need to use Schedule A if you own your own home. If you rent out a portion of your home, the interest and property tax expenses are split between itemized deductions and rental investment expenses. Figure 10-3 shows an example of Schedule A.

Figure 10-2. Tax reporting for real estate transactions.

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Figure 10-3. Schedule A.

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Itemizing vs. the Standard Deduction The determination of the proper division of interest and taxes raises an interesting strategic point concerning Schedule A. For example, for 2003, a married couple had a choice between itemizing or taking $9,500 as a standard deduction. Your combined interest and taxes (and other deductions) may exceed $9,500; however, if a portion of that total is properly assigned to rental investment expense, your remaining Schedule A deductions could be below the maximum standard deduction level. In that case, it would be advantageous for you to claim the standard deduction, since it would lower your taxable income and the total tax due.

Example: You and your spouse own a home with a separate “in-law unit” that you rented out last year. According to your measurement of the square footage, the rental is 30 percent of the total. You record 30 percent of mortgage interest and property taxes as rental expense on Schedule E and 70 percent as itemized deductions on Schedule A. You have no other itemized deductions to claim. Last year, your total mortgage interest was $9,618 and your property taxes were $705. The sum of these two expenses was clearly above the standard deduction of $9,500 for a married couple in 2003. However, when you record only 70 percent as itemized deductions, you end up with $6,733 interest and $494 in property taxes, or a total of $7,227. In this case, you will reduce your total taxes by claiming the standard deduction of $9,500. Even if your tax rate is only 10 percent overall, claiming the standard deduction based on the previous example will reduce your taxes by more than $200 for the year. Is the proposed 10 percent rate realistic? It is, in fact, because the depreciation and other deductions that real estate investors are allowed to claim reduce taxable income significantly. The 10 percent rate can be achieved for many middle-income range people. In the decision to itemize or use the standard deduction, you need to select the method that provides you with the greatest advantage. In the previous example, it’s to your advantage to take the standard deduction. But you’re better off itemizing if the total of itemized deductions is higher than the amount allowed using the standard deduction. If your itemized deductions exceed the standard deduction even after assigning a portion of your interest and taxes to investment expense, then you would be better off itemizing.

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Planning Point: What if itemized deductions and the standard deduction are very close? If you have numerous itemized deductions for interest and points, gifts to charity, and miscellaneous other deductions, you are entitled to list and claim them. But if the total is within a few hundred dollars of the standard deduction, it could be wise to simply forego itemizing. That reduces your exposure to audit and also simplifies your tax return.

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Schedule E—Income and Expense Schedule E is used to summarize income and expenses for each property. If you carry over unused losses, you can deduct them in future years when you sell a specific property or when you report passive gains. Therefore, keeping accurate records by property is essential. Figures 10-4 and 10-4a show the two pages of Schedule E. (Note: The second page of Schedule E does not relate specifically to real estate investment activities.)

Filling Out Schedule E For a single property, the reporting of income and expenses is straightforward. The items in your checking account, plus any cash expenses and other transactions not shown in your account, are categorized and listed on the form. You need to adjust for interest expenses and impound payments based on the information supplied by your lender. Income. The easiest reporting occurs when you have a single rental property that is rented out full-time and is not used at all as a primary residence. To keep your records as clear as possible, it is desirable to run all rental income through a checking account established specifically for rental activity. In this way, your bank deposits will agree with the total of rental receipts plus any additional funds you transfer from your other accounts. Payments. The record of transactions is also made easier when all of your rental-related payments are made from the same rental-specific checking account. The larger payments will be made for monthly mortgage payments, insurance, and property taxes. The interest portion of your mortgage payments is fully deductible as an expense on Schedule E. Your lender will provide you with a tax form at the end of each year, listing the total interest you paid. Insurance you pay for hazard and mortgage coverage is also fully deductible as long as the property was used exclusively as a rental. Property taxes, if paid directly, are made twice a year to your local county tax authority.

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Figure 10-4. Schedule E.

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Figure 10-4a. Schedule E (cont’d).

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Impounds. If your lender impounds a monthly amount for property taxes and insurance, you need to report the correct amount in these two categories. That is not the total of impounds withheld, but the specific payments made by your lender from the impounds it collected each month. The lender will send you a summary of impound activity each year, which will include identification of insurance and tax payments. Additional Expenses. Other expenses are reported on the applicable line on the first page of Schedule E. Some expenses do not have a specific line and have to be added in via the spaces provided at the end of the printed list. So payments for office supplies and expenses such as telephone and landscaping, for example, will be reported on those lines. Net Income (or Loss). Cash expenses are added up, a subtotal is shown, and below that, the total of depreciation expenses is recorded. The net income or loss for the property is shown on line 22 and is then carried over to be reported on the first page of your tax return, Form 1040, on line 17. As discussed in Chapter 9, you have two limitations in claiming expenses for rental activity: 1. The maximum loss you can claim per year, which is $25,000. 2. The reduction in that loss level when your modified adjusted gross income is higher than $100,000. For every dollar above $100,000, you lose 50 cents in deductible losses; if your adjusted gross income is $150,000 or more, you cannot claim any loss from real estate activity.

Reporting Losses The total of net income or loss reported on Schedule E, line 22, is also shown on Form 1040, line 17, and included in gross income. If the total is a loss, you have two possible restrictions. If the loss exceeds $25,000, the excess has to be carried forward to be used in the future. And if your modified adjusted gross income is greater than $100,000, your deductible loss will be further reduced. In either of these cases, you are required to complete Form 8582, Passive Activity Loss Limitations. This three-page form is shown in Figures 10-5, 10-5a, and 10-5b. Record the amount of loss from real estate activities on line 1b of Form 8582. If you have any prior years’ unused losses, they are recorded on line 1c. The total of 1b and 1c is then entered on line 1d. The total is also recorded on line 4.

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Figure 10-5b. Form 8582 (cont’d).

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Part II of the form is used to calculate reductions in allowed maximum loss deduction when your modified adjusted gross income is greater than $100,000. The total allowed maximum loss is recorded on lines 10 and 16. The second page of Form 8582 contains a series of worksheets that identify overall gain or loss, unallowed losses to be carried forward, and allocation of losses by property. This exercise is not only used as part of your tax return; it also provides a useful record for writing off future unused losses when you sell a specific property. The worksheets continue on page three of the form.

Getting the Most Out of Your Deductions This brings up an interesting planning consideration for those who do rent out a portion of their primary residence. If you will not be able to claim a loss because your income exceeds $150,000 (or if your loss is restricted because your adjusted gross income is between $100,000 and $150,000), you have every incentive to claim as little as possible in rental expense for interest and taxes. In this situation, you want to use a method that provides the smallest rental expense and the largest itemized deduction. You can base the division of expenses on square feet, number of people living on the premises, or percentage of market rent levels, for example. If your deductions for rental expenses cannot be fully claimed, it becomes desirable and economical to assign as much of your interest and property tax expense to Schedule A as possible.

Example: Last year you rented out 30 percent of your primary residence and received $4,800 in rents. You also owned a rental for the entire year and received $14,400. A summary of rental income and expense on each of these properties is shown in Table 10-1. Expenses for cleaning, insurance, mortgage interest, taxes, and utilities for Property A were calculated as 30 percent of the total, with the other 70 percent assigned to your personal use. Mortgage interest and taxes were assigned 30 percent to this schedule and 70 percent to itemized deductions on Schedule A. If you compare Table 10-1 to Figure 10-4, you can see how these details fit into Schedule E. The table includes references to each line on Schedule E. The “total” column corresponds to those columns on the schedule that require a total: rents received, mortgage interest, total expenses and depreciation, and net income or loss.

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Table 10-1. Summary, rental income and expense. Description Rents received

Sch E line 3

Property A

Property B

Total

4,800

14,400

19,200

14,292

211 216

507 410 230 400 11,407 695 115 1,112 682

Auto and travel Cleaning and maintenance Insurance Legal and professional fees Mortgage interest Repairs Supplies Taxes Utilities

6 7 9 10 12 14 15 16 17

Total Depreciation

19 20

3,456 1,337

15,558 3,600

19,014 4,937

Total expenses

21

4,793

19,158

23,951

Income (loss)

22

7

(4,758)

(4,751)

41 73 2,885 30

Depreciation and Amortization In addition to reporting any excess passive losses that are to be carried forward, you need to fill out Form 4562, Depreciation and Amortization. This form summarizes your claimed expense for each year; in addition, you may need to add a supplementary schedule showing the breakdown of depreciation. A sample of Form 4562 (two pages) is shown in Figures 10-6 and 10-6a.

Example: Last year you claimed depreciation for two properties. You depreciated 30 percent of your primary residence based on your calculation of applicable square feet; you also claimed depreciation for a rental property you owned for the entire year. In this example, you owned both properties for the entire year, so all depreciation should be reported on line 17 and also on line 22 of Form 4562. Table 10-2 shows a typical supplementary schedule that would be attached to your tax return to provide more details on claimed depreciation.

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Table 10-2. Supplemental schedule, depreciation expense: straight-line (SL) method (deductible portions in italics). Name ___________________________ Social Security #__________________ Tax Year _________________________ Supplementary Schedule, Depreciation

Property Description

Basis

Date Prior Acquired Depreciation

Current Method/Rate Depreciation

Real Property 133 Bay Street Chicago, IL Less: land Improvements Rental use: 30%

162,500 (40,000) 122,500 36,750

05-02

2,171

SL/27.5 years

1,337

Real Property 1410 Hudson Chicago, IL Less: land Improvements

129,000 (30,000) 99,000

09-01

8,250

SL/27.5 years

3,600

Total

135,750

10,421

4,937

Any amortization claimed is listed on line 43 on the second page of Form 4562. An example would be the cost of points assessed when the loan was arranged for the property. Points are written off over the life of the loan. For example, if you paid $1,500 for points on a thirty-year loan, amortization would be $50 per year. Amortization expense is listed and reported on Schedule E as “other” expenses on line 18.

Documenting Large Expenses Reporting real estate transactions can involve some large numbers, notably for interest and property taxes. How do you document these expenses? Interest Paid. A bank or savings institution is required to send you and the IRS an annual report called Form 1098. It identifies the loan and the total interest you paid during the year. You should ensure that the amount you

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computed and reported on your tax return agrees with the total reported to you on Form 1098. You may also wish to attach a copy of this form to your tax return for each property, to document the expense that you are claiming. If you divide your primary residence interest between Schedule A and Schedule E, you should also attach a summary of your calculation. You may show the calculation right on the copy of Form 1098 that you attach to your return; for example: Total interest = $9,618 Total square feet in the property = 3,400 Total square feet in the rental unit = 1,020 = 30% x 3,400 Interest included on Schedule E = 30% x $9,618 = $2,885 Interest included as itemized deduction = 70% x $9,618 = $6,733 Key Point: If you end up claiming a standard deduction instead of itemizing, it does not matter. This brief summary supports what you have claimed as applicable to rental activity, based on total square footage of your property.

Property Taxes. It may also be desirable to attach documentation of other major expenses, such as property taxes. This is especially worthwhile if you divide the expense between the two schedules. Attach a copy of the bill from your county, with the breakdown clearly shown. For example: Total property taxes = $705 Total square feet in the property = 3,400 Total square feet in the rental unit = 1,020 = 30% x 3,400 Taxes included on Schedule E = 30% x $705 = $211 Taxes included as itemized deduction = 70% x $705 = $494

How Much Documentation to Provide Opinions vary on whether you should attach documentation to your tax return proving expenses or showing your breakdown. One school of thought states that you should not supply any information that is not specifically required. The other school of thought contends that by proving an expense up front, you anticipate and answer questions before they are asked. Both sides make a valid point. The decision should be based on your exposure to a possible audit, and whether it is worthwhile to provide documentation with the idea of preventing an audit from happening.

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Providing documentation along with your tax return may help ward off an audit. If a tax return is selected out for audit and reviewed, having documentation attached will answer the big questions. For example, it may be that your return is pulled because you claim a very high expense for interest and taxes. If the IRS were to audit your return, they may also ask to see receipts for utilities, office expenses, legal fees, cleaning, and other items. However, if the major items have been explained, then auditing the other line items would not be necessary. Key Point: Maintaining complete, accurate records will enable you to successfully handle an audit in most cases. It’s up to you how much documentation to provide along with your return.

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Form 4797 and Schedule D—Sale of Rental Property Beyond the year-to-year reporting of rental income and expense, you also need to fill in special forms to report capital gains on rental property for the year in which you sell. For this, you use Form 4797 and Schedule D. Why two different forms for one transaction? Form 4797 is used to report sales of investment properties. The details are listed on this form, with the single-line profit or loss transferred to Schedule D, which summarizes capital gains or losses. The totals from Schedule D are then transferred to line 13 of Form 1040. The system is set up so that you can report all activity in the right place. For example, if you sell a property and also had capital gain distributions from mutual fund shares and, perhaps, a net loss from selling stock, all of your capital gains and losses end up on Schedule D. A sample of Form 4797 (two pages) is shown in Figures 107 and 10-7a. The flow of reporting information for rental property capital gains is shown in Figure 10-8. The reported gain or loss is transferred from Form 4797 to Schedule D, and then onto Form 1040. This volume of forms is necessary. Schedule D is designed to report all capital gains and losses, including those reported on Form 4797 and those shown only on Schedule D. The need for several specialized forms comes from the need for uniformity.

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Figure 10-8. Tax reporting for capital gains or losses.

Example: You sold a property in 2003 that you bought two years before and realized a gain. The adjusted sales price was $147,366. You had claimed depreciation while you owned the property totaling $5,119; your original net purchase price was $119,417. Your net capital gain of $33,068 would be reported on Form 4797 as: Line 2a 2b 2c 2d 2e 2f 2g 7 and 9

Information Address of property 1-15-01 4-13-03 $147,366 $ 5,119 $119,417 $ 33,068 $ 33,068

This information is transferred to Schedule D—the two-page form shown in Figures 10-9 and 10-9a. The net capital gain of $33,068 is reported on that schedule on lines 11(f), 16(f), and in Part III, line 17a.

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Figure 10-9. Schedule D.

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Figure 10-9a. Schedule D (cont’d).

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Key Point: The distinction between short-term and long-term capital gains is important because they are taxed differently. Taxes on long-term gains (i.e., assets held more than one year) are lower than those on short-term gains, which are taxed at the same rate as other taxable income.

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Reporting Like-Kind Exchanges As a real estate investor, a final form that you may need to complete is Form 8824, for reporting like-kind exchanges. These exchanges, also called 1031 exchanges, allow you to defer taxes to a future sale. A sample of Form 8824 (four pages) is shown in Figures 10-10, 10-10a, 10-10b, and 10-10c.

Following the Specific Rules In a like-kind exchange, you are required to follow very precise rules for the timing of transactions and dollar amounts of replacement property. The purchase of replacement property has to be completed within 180 days of the sale of the original property. In a like-kind exchange, the gain on sale of investment property is deferred until you sell the replacement property, and this is achieved by reducing the basis in new property. For example, instead of reporting the current-year profit of $33,068 on Schedule D (see previous example), you may have been able to execute a like-kind exchange by purchasing another real estate investment.

Example: You sold a rental property last year for $147,366 and replaced it with a like-kind exchange property. You bought the new property for an adjusted purchase price of $161,220 and closed the sale within the 180-day window. In this example, your $33,068 profit reduces your basis in the new property. Although your adjusted purchase price was $161,220, your basis for tax purposes is calculated as: Adjusted Purchase Price Less: Deferred Gain Adjusted Basis

$161,220 –33,068 $128,152

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Figure 10-10b. Form 8824 (cont’d).

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Figure 10-10c. Form 8824 (cont’d).

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Key Point: When you eventually sell this newly acquired property, your gain will be reported not as the difference between purchase price and sale price, but between basis and sale price. This is how gains are deferred in like-kind exchanges.

The rules for reporting real estate transactions can be quite complex. You may need to use the services of a qualified tax adviser, especially in those years when your transactions include capital gains or losses, like-kind exchanges, or adjustments in the passive losses you are allowed to deduct.


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C H A P T E R

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Including Real Estate in Your Portfolio The decision to invest in real estate cannot be made in isolation. You must review real estate’s attributes, both positive and negative, while taking a broader look at your entire portfolio; the limitations of your personal resources; risk factors; and your personal temperament and willingness to be involved with investments requiring your personal touch. Some investors find the idea of investing in rental real estate very appealing. The direct control, tax benefits, potential for positive cash flow, and strong historical record of rising market value make real estate one of the most desirable types of investments. Even when the stock market is weak, people need a place to live. In most regions, real estate prices have performed well even when the overall economy has been poor. This does not mean that every possible market is going to exhibit positive signs; some areas are depressed and will remain so over the long term, so you need to research the market beforehand. Real estate markets are always very local. The national averages have less to do with value than local factors: demand for rentals, market price of rents versus the cost of real estate, the local job market, and other social and cultural trends. You may live in an area with strong rental demand and low real estate prices, the best possible situation. Or you could live in an area where a lot of vacancies have driven down the market rents, but real estate prices remain high. This occurs if rental units have been overbuilt or if the local economy has changed and workers have left the area. It would be a mistake to assume that all markets reflect national averages. It would also be a mistake to make an investment decision without first looking at the real estate market in your town. Beyond that, you also

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need to allow sensible tests to ensure that real estate investing is the right move for you.

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Real Estate and Asset Allocation One underlying premise in financial planning is that your investment assets should be spread among dissimilar markets—so some capital is invested in stocks, some in savings accounts, and some in real estate. This idea—called asset allocation—is a sensible long-term strategy. The idea is often confused with diversification, and in some applications, the two are really the same thing. The difference is an important one, however. A diversified portfolio spreads risks among several different products. For example, a diversified portfolio of stocks includes some blue chips; some small and unknown stocks with good growth potential; and, of course, a division among dissimilar industries. The purpose of diversification is to prevent losses from applying to the entire portfolio. If you own only computer stocks or retail stocks, a single low cycle or bad market season could affect all of the stocks in an undiversified portfolio. Asset allocation achieves a form of diversification, but it goes much further. It is the process of dividing up investment capital among different markets. This serves varying purposes and also helps you to build a base of conservative growth for a portion of your portfolio while pursuing current income or aggressive growth in another. Many investors have allocated their assets unconsciously, as a matter of common sense. They own their own home and are paying the mortgage over many years. They have a savings account and regularly place money in shares of two or three mutual funds. They also own some stocks directly. This is a popular form of asset allocation. Degrees of capital are found in the real estate market, the stock market, and the money market. The money market investment, usually a savings account or money market account, also serves as an emergency reserve fund. If unexpected expenses arise, that cash is available for immediate needs.

Tailoring Asset Allocation to Your Own Situation Asset allocation should be designed with your particular circumstances in mind. No single formula is going to work for everyone, even though some advisers offer ratio breakdowns that everyone should use. To merely suggest that you should invest 40 percent each in stocks and real estate, then keep 20 percent in cash accounts, ignores the reality that you might be better off

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spreading your money differently. In addition, you may have a particular bias for or against the stock market or even real estate, for example. So the general advice to apply a specific formula to achieve asset allocation is hollow. It is a misconception to believe that any one plan will work for everyone.

Spreading Risk The idea of allocating resources is not meant simply to spread money around. It also spreads different types of risks, which is one of the more important aspects to asset allocation. For example, it would be unwise to invest 100 percent in real estate, since it is an illiquid investment. You need to have some cash reserves available, because the only way to get investment capital out of real estate is to either sell or refinance. By the same argument, it would not make sense to place 100 percent of your capital in the money market, where interest rates are low even though the modest profits are constant. That means you lose other opportunities to make your money grow, and the combination of inflation and taxes means the real value of your money market investment will dwindle over time.

Knowing Your Overall Investing Goals Asset allocation helps you to spread your capital among different markets with your overall investing goals in mind. You want to build equity in your home and, possibly, in real estate rentals as well. You also want to minimize your taxes, save for your children’s college and your own retirement, and insure your family against catastrophic losses. Most families have a complex number of financial requirements, some of which are in conflict with one another. For example, you may need life and health insurance, but that means there is not enough cash left over to build an emergency reserve. In such instances you have to make choices. This is where the specific balance of asset allocation becomes essential.

Example: You would like to sell your mutual fund shares and use the cash to make a down payment on a rental property. In evaluating the cash flow situation, you are encouraged to discover that rental rates are strong in your town, that occupancy is high, and that real estate prices have been rising steadily in recent years. However, if you sell off one-half of your mutual fund assets, you will be able to make only a minimal down payment and, as a result, your mortgage payment will be higher than rental income. This negative cash flow presents a problem, and you are aware of the risk: If you were to lose your job, for example, having negative cash flow on your investment real estate could mean

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having to sell at a loss. As an alternative, you could sell all of your mutual fund shares and make a larger down payment. Having a much smaller mortgage would enable you to have positive cash flow as a result.

This example demonstrates the tough choices that have to be made, and why asset allocation has to be reviewed as part of the bigger picture. In the example, the concern was over cash flow, which is always of great importance in real estate investing. Are you better off keeping some mutual fund shares and dealing with negative cash flow? Or should you transfer the entire amount into a down payment and eliminate the cash flow problem? Or should you conclude that perhaps now is not the time to invest in real estate?

Weighing Market and Personal Risk Factors In the previous example, it makes no sense to recommend that you should have a 40-40-20 division of your capital. In fact, with all of the variables at play in the market—prices of property, demand for rental units, and market value trends—you have to make the decision based on an evaluation of the market and of the risks involved. Complicating the problem are the personal risk factors—for example, your family income and whether your spouse also works, your investment reserves and values, your sense of job security—which ultimately determine how the decision is made. Allocating assets should be the result of evaluating personal and market risk factors, and then deciding whether to realign your assets. If you believe the potential in the real estate market is significant and that the likely growth of mutual fund shares is not promising, it could make sense to move assets to real estate investments. But if your family income is barely adequate to meet your obligations today, negative or marginal cash flow could make the risk too high. In that case, a two- or three-month vacancy could destroy your finances, making the prospect of entering the real estate market less desirable. If the market factors are weak as well, it makes sense to wait. Some investors have made the mistake of getting into the market without evaluating their personal circumstances and the market, discovering too late that the timing was bad for such a move. By then, their capital is tied up and the property cannot be sold without losing money. Key Point: If occupancy is erratic or low, market rents weak, and real estate prices flat or falling, or if your personal financial situation is too tenuous, it does not make sense to buy property today. First, review the market factors and your personal circumstances; then, be guided by the principles of asset allocation if the potential for real estate investing is strong and favorable.

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The Leveraged Advantage Asset allocation involves a division of investment capital among markets with different attributes. It also should involve using money in different ways. For example, when you own stocks directly, you make or lose maximum money when the stock moves several points. If you buy shares of a mutual fund you have to pay a management fee, but your money is diversified among many different stocks. You may also own interest in a balanced fund that invests in both stocks and bonds, so the degree of diversification is more extensive. When you put money in a savings account, you are paid a very small rate of return but your money is safe and insured. In all of these examples, you reduce risk by placing capital in many different places, whether stocks, bonds, or cash accounts. In some types of accounts, you are exposed to market risk. With stocks, for example, you face the risk that market value may rise or fall. In other investments, you have more certainty but, at the same time, you know you will earn less. For example, money placed in a savings account or certificate of insurance will yield a predictable but low interest rate, and your funds are insured in case of loss on the part of the savings institution.

A Winning Combination One attribute of real estate that distinguishes it from most other types of investment is the combination of higher-than-average yield, tax benefits, and insurance. Real estate, in comparison to most other investments, is illiquid. This means that you cannot get money out quickly or easily in most cases. However, the combined benefits make real estate a one-of-a-kind investment choice. Consider the fact that an insured property will grow in value as long as it is well cared for. The values of most investments are largely beyond your direct control. When you buy real estate, you insure the value of the property—and a lot of its value is based on how you care for the property. Let’s assume your rental property is located in a neighborhood where property values are growing at a rate of 5 percent per year. As long as your property is kept in good shape (e.g., the lawns are mowed, the paint looks new, the roof is in good repair), you have every reason to expect property value to grow by 5 percent yearly. A house on the next block that is poorly cared for and not well maintained is not going to keep up with other properties in the area. So the owner has considerable control over the investment value of real estate.

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The Magic of Leveraging Another feature of real estate—and one of the most desirable aspects—is the leverage you achieve when you invest. You will probably only make a 10 percent to 20 percent down payment, in most situations, and finance the rest. However, as long as demand is strong for rental units, your tenants pay rent. In a properly planned rental situation, the rent should be high enough to make your mortgage payment and to cover all other expenses for which you are responsible. This includes insurance and taxes and any landlordpaid utilities, as well as the unexpected repairs that seem to come up at the worst possible times. Some financial planners view leverage as the third use of investment capital. The first two are equity and debt. Examples of equity are the direct ownership of stocks, mutual fund shares, savings accounts, or real estate. Examples of debt include putting money in a savings account (which is lending your money to the bank), savings bonds, or income-oriented mutual funds. Leverage, as a third use of capital, has a higher degree of risk but more potential for profit as well. The market exposure has two sides. Potential profit is always accompanied with potential loss, so leverage cannot be thought of without also understanding that risk levels change.

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Growing Value While Your Loan Is Paid Assuming that you have planned well and your rental income covers all of your payments, the value of your real estate investment will grow over time without your having to pay out large sums each month to maintain your mortgage. If property values are growing by 10 percent per year in your city, you will make a much better profit than you would placing capital in a local savings account paying 1.5 percent. In exchange, you accept higher risks. One point of view is that the tenant pays your mortgage for you; however, as a trade-off, you are taking all of the risks by investing in the property. These risks include unexpected major repairs, vacancies, or a decline in real estate market values. Every real estate investor lives with these risks constantly. However, by leveraging your capital, you can control several properties for very little market risk. If you have $100,000 to invest, you could buy a single property for $100,000 and enjoy very healthy cash flow, or you could leverage the money and put 25 percent down on four different properties—spreading your risk.

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Key Point: With leverage, you hope to cover your mortgage with rent income and, ultimately, to be able to sell the properties at a profit. The more you leverage your capital, the more you increase your personal risk.

Your Tolerance for Risk The idea of risk tolerance has to be kept in mind when you consider highly leveraged approaches to real estate. You may be able to locate properties to buy for little or no down payment; you may also discover that some owners are willing to finance your purchase without having to go to an outside lender. In both of these cases, there is probably something about the property that you need to understand before finalizing the deal. A no-downpayment property is available because the seller knows it is the only way to attract a buyer. Seller financing often means that the seller knows a conventional lender would never approve a loan. It may be that the foundation does not meet minimal standards (post and beam instead of full construction, for example), or that some other condition offsets claimed equity in the property. In such cases, offering seller financing might be the only way a seller can get rid of the property without having to spend thousands of dollars to fix a problem. Important: Before accepting an offer for no down payment or seller financing, you should insist on a complete home inspection and make your offer subject to receiving a written report detailing any and all flaws with the property.

Acceptable vs. Too Much Leverage Leverage of capital is an advantage because you can make a finite amount of capital go further. By controlling more properties, you increase your potential overall return. At the same time, the risks rise as well, and this inescapable fact cannot be ignored. Your personal risk tolerance ultimately determines how much leverage you can stand. Most people who buy their own home understand that living with a long-term mortgage is a form of acceptable leverage. But once you begin adding rental properties, the degree of exposure may become daunting. If you want to own several rental properties, it also means having several mortgages and being “at risk” to a greater degree.

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Tax Advantages of Real Estate A review of cash flow has to be performed on an after-tax basis, because the tax advantages to owning rental property are significant. The tax advantages include the deduction of depreciation, a noncash expense that you calculate based on the value of improvements (remember, the land cannot be depreciated). The benefit to deducting real estate losses varies depending on your overall tax situation and rate, and on whether you pay a state income tax as well as federal tax. However, it is quite possible to find yourself in a situation in which you have positive cash flow every month, but you are still able to report a tax loss and reduce your taxes. Those who rent out part of their home or who convert a primary residence to a rental property also gain advantages. As a landlord, you can deduct insurance, utilities, repairs, and other expenses that you cannot deduct on your primary residence. If you own rental property and you sell it at a profit, you can defer the tax on any gain by going through a like-kind exchange. A like-kind exchange allows you to continue investing in properties and upgrading without having to pay any tax until years later. For example, you could sell a single-family house and replace it with a duplex, and then move up to a small apartment complex; you could make a profit on each subsequent sale, but as long as you meet the requirements for a like-kind exchange, you can defer the tax for many years. Tax advantages are substantial for real estate investors, not only in yearto-year deductions but also in the ability to defer taxes for many years. These advantages should be a part of your cash flow analysis, which should always be performed on an after-tax basis. The tax advantages of investment real estate are among the more compelling reasons for individuals to become landlords. As a form of asset allocation, dividing capital between investments producing taxable income and others producing tax advantages is a worthwhile strategy. The higher your tax bracket, the greater the advantage to writing off real estate losses each year.

Example: Your combined federal and state tax rates are 46 percent. Writing off the maximum allowed real estate loss of $25,000 each year produces an overall tax reduction of $11,500, or $958 a month. This savings can make a big difference in your financial picture. You may discover that you have a small pretax negative cash flow but a substantial after-tax positive cash flow.

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Suitability Testing: Is Real Estate Investment for You? With every form of investing, the question of suitability needs to be addressed. Does real estate investment suit you? The need for tax deductions, long-term growth, security, and other attributes are all important in your selection of investments; at the same time, each choice has to be suitable for you individually. Suitability refers to your knowledge as an investor, as well as to considerations of liquidity, financial strength, and personal goals. Tests of suitability can be used, either by an outsider or by yourself, to determine whether a particular investment is the right choice for you.

❑ Knowledge. You are suitable for an investment if and when you understand exactly what risks and rules apply; so if you are a novice, taking high-risk positions in options or commodities would be unsuitable for you. By the same argument, you would not want to enter into a longterm real estate transaction if you did not understand how the market works. If you do not know how to assess supply and demand for both housing and rentals, then you take tremendous risks by simply assuming a real estate investment makes sense. By knowing your facts ahead of time, you can make more informed decisions, and profits will be more likely as well. So as a test of suitability, you should understand the market before you commit money (this applies to all forms of investing, and not just to real estate.)

❑ Liquidity. The need for cash is ever present. It does not mean that you need to have a large sum of cash on hand or in a savings account; it does mean, however, that you need to be able to put your hands on cash on short notice, if the need arises. It makes sense to set up an emergency reserve for unexpected expenses or in case you lose your job, for example. With real estate, you can only get cash out by selling or refinancing. Real estate is not a liquid investment, and illiquid choices are not suitable for you if you may need to get back some of the cash in the future. Even instruments such as certificates of deposit (CDs) tie up your capital for several months; so you should put money into a CD only if you are positive that you will not need those funds before the expiration date. Liquidity also refers to the ability to sell your interests in the market if and when you want to. Stocks are highly liquid because shares can be sold at today’s market price with a telephone call, without any trouble. To sell real estate, you need to list the property, find a buyer, and go

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through a lengthy closing process; it could take months. So, as a second test of suitability, you need to make sure you understand that you cannot get cash out of a real estate investment quickly or easily. Some investments—such as real estate limited partnerships—do not even have a “ready market” for the resale of investment interests. So if you were to purchase units in such a partnership and later try to sell them, you would probably have to take a very substantial discount. Without a ready market, investors have difficulty selling their interests.

❑ Financial Strength. Perhaps the most important test of suitability is financial strength. If your real estate investment is likely to produce negative cash flow that you cannot afford, then it is not a suitable investment for you. If the solution is to offer a higher down payment or to seek markets with better market rents, those are possible solutions; but investing money in a property that produces negative cash flow, or in a weak market where vacancies are possible, could be disastrous to your financial health. Real estate investors need to be able to survive periods of vacancy or to cover unexpected repair expenses that may arise. Therefore, investment real estate is suitable only if you can carry potential cash flow through periods when rents are not coming in, or when expenses exceed the normal monthly budget. Your financial strength is also measured by your credit. If you have an excellent credit rating, you will not have any problems financing real estate investments—assuming that the numbers work. Lenders apply ratios to determine how much you can afford based on your current income and debts, to determine whether you qualify for a loan for investment real estate. This naturally limits the number of properties you will be able to purchase with financing. The higher your income and the more asset value you hold, the easier it will be to finance several investment properties. But if your income is relatively low or you have a high level of personal debt, it is going to be more difficult to gain approval of a loan application.

❑ Personal Goals. Finally, your personal goals have to dictate the decisions you make in managing your overall portfolio. For example, if you want to invest your money so that you don’t have to worry about it, you probably need to pick mutual funds, CDs, and other managed accounts. Real estate demands constant care and attention. Furthermore, to legally claim a deduction of a loss, you have to remain an active participant in managing your properties. So if you plan to invest money and then travel for half the year, real estate will not meet your goals. If you do not

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IN

Y OUR P ORTFOLIO

235

want to deal directly with tenants, you need to consider the potential for a disruption of your lifestyle if you are going to become a landlord. With personal goals in mind, the timing of investments is a secondary test of the suitability question. For example, if you plan to invest in real estate today to fund a child’s college education, how long will you need to keep the properties to make a required profit? How long do you have until those tuition bills will need to be paid? Is it a good match? If you estimate that you will need ten years for real estate values to rise enough (based on recent market trends, for example), that tells you that you need to commit capital for the next decade. However, if your child will be going to college in five years, then real estate is not suitable.

■

Making the Decision to Invest in Real Estate Including real estate in your portfolio is a big step. Most people are content with a fairly standard portfolio—a savings account, an IRA and other retirement savings, mutual fund shares, and perhaps a few individually owned stock. If the typical investor is also buying the family home with a thirtyyear mortgage, this collectively represents a fairly well-diversified portfolio. Why expand beyond this and add investment real estate? One major reason has to do with today’s perceptions of the stock market. The market appears far more risky than it did a few years ago, and many previously dedicated stockholders want to have more direct control over their investment capital. This disillusionment with the traditional markets is transitional, and as the market trend changes, so will attitudes toward placing money at risk in stocks. Even so, there will always be investors who are attracted to the direct control of real estate. Direct control, insurance of your asset, tax benefits, and historical market trends—all these factors, in combination, make real estate one of the best investments available. The tax and record-keeping requirements are complex and you probably will need professional help to make sure you are keeping records correctly. But with that out of the way, you face the potential for strong profits over many years. Real estate is a market worth taking a look at—whether or not you decide that it is for you. If you study the market and understand the risks and rewards before you commit capital, you could become one of thousands of investors who have found an alternative to the less rewarding outcome of mutual funds, the stock market, and the traditional savings account.


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Glossary

accelerated depreciation — A form of depreciation that allows higher deductions in the earlier years, when compared to straight-line depreciation rates. active participant — An investor who spends time managing real estate investments in order to qualify for deducting losses for tax purposes. Active participation involves making management decisions concerning the property, even if a separate manager is hired. adjusted basis — The value of property, for tax purposes, consisting of the purchase price plus improvements and closing costs, adjusted downward for depreciation and further adjusted downward when profits from another investment are deferred through a like-kind exchange. The adjusted basis is subtracted from the adjusted sales price to arrive at taxable capital gain. adjusted gross income (AGI) — The dollar amount on an individual tax return consisting of total taxable income minus adjustments (e.g., student loan interest, contributions to an IRA, and alimony) and before deducting itemized deductions or the standard deduction, or personal exemptions. adjusted sales price — The sales price of investment real estate, consisting of the price minus real estate commission and other costs of sale. The adjusted basis is subtracted from the adjusted sales price to arrive at taxable capital gain. after-tax cash flow — The calculated amount of cash received (positive cash flow) or paid out (negative cash flow) when rental income, expenses, and other payments are adjusted to determine tax benefits of real estate investments. 237

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GLOSSARY

allocation — The process of assigning expenses among properties, used for those expenses not directly tied to any one property. The usual method is to base the allocation on the percentage breakdown of rental income. amortization — An expense calculated to be spread over a number of years, rather than written off in a single year. For example, loan points may be amortized over the term of a loan but cannot be deducted in the year paid. asset allocation — Spreading of investment capital over many dissimilar investments, for the purpose of achieving different financial goals, exposing capital to different forms of market risk and opportunity, and achieving broad diversification. basis — (1) The value of a real estate investment, calculated by adjusting the cost for closing costs, depreciation, and deferred profit from other investments; (2) the dollar value of property that is subject to depreciation, consisting of the cost of all improvements but without including the value of land. buyer’s market — The condition of the real estate market in which buyers have the advantage, usually when an excess inventory of homes is available and prices can be negotiated downward. capital asset — Spending that cannot usually be deducted in the year money is spent, but that has to be depreciated over a recovery period. capital gain (loss) — The gain or loss from real estate investments or business property, subject to rates different from those on ordinary income. cash flow — The amount of cash received and paid each month; rents minus expenses paid and nonexpense payments (e.g., principal on mortgage loans), adjusted further to calculate tax benefits and savings from depreciation expenses. depreciation — An expense calculated to allow deductions of real estate improvements over a period of years. Residential real estate is depreciated over 27.5 years, and assets used to manage investment real estate are depreciated over shortened recovery periods. Depreciation is a noncash expense and is deductible on the investor’s federal tax return. disbursements journal — A specialized record used to record payments, as part of the bookkeeping system. first mortgage — A mortgage on real estate with first priority in the event of default. The first mortgage holder is paid first from proceeds of a foreclosure sale, for example. fixer-upper — A property requiring cosmetic improvements, such as painting, landscaping, and other minor repairs. half-year convention — A calculation of depreciation in the first year as though

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G LOSSARY

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all assets in a particular class were acquired exactly halfway through the year. The half-year convention is used for shorter recovery periods. impounds — Amounts added to monthly mortgage payments, held by the lender, and then paid to third parties. Commonly, impounds include monthly payments toward property taxes and homeowners insurance. leverage — The use of investment capital to control more equity than would be possible through direct ownership. Buying investment real estate is an example. By putting down 20 percent, the investor leverages the remaining 80 percent of the investment through borrowed money. like-kind exchange — The sale of one property and replacement with another, in which the gain is deferred. As a result, that gain is not taxed until the placement property is sold. Also called a 1031 exchange. limited partnership — A form of real estate investment in which the limited partner has no voice in management decisions and in which passive losses cannot be deducted, but must be applied against other passive activity gains. liquidity — (1) The availability of cash in a particular investment, or the investor’s ability to convert an investment to cash; (2) descriptive of a particular market, with the stock market being an example of a highly liquid market and real estate an example of a market with low liquidity. mid-month convention — A method of calculating first-year depreciation for real estate, in which depreciation is based on the assumption that the asset was acquired halfway through the month that the asset was placed in service. modified adjusted gross income — For the purpose of calculating allowable deduction of losses from real estate, modified AGI is the value of adjusted gross income without certain deductions. If modified AGI is above $100,000, deduction limits on real estate losses are reduced. negative cash flow — An undesirable situation in which more money is paid out each month than is being received. Negative cash flow may occur if the property is vacant, or tenants do not pay rent, or mortgage and other payments exceed the level of income that can be reasonably expected from an investment. occupancy or vacancy rate — The calculation of average periods of time a property is either occupied or vacant, usually expressed in the form of a percentage. If a property is occupied eleven out of twelve months, it has a 91.7 percent occupancy rate (or an 8.3 percent vacancy rate). passive activity — An investment activity in which the investor is not involved directly. As such, losses from passive activity cannot be deducted but must be applied against other passive activity gains. An exception to this rule is real

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GLOSSARY

estate, where up to $25,000 per year can be deducted as long as the investor is an active participant and has at least 10 percent ownership of the property. payments journal — Another name for the bookkeeping record or the disbursements journal. positive cash flow — A situation in which total income received exceeds cash expenses and other payments from month to month, on an after-tax basis (after counting tax savings from the activity). primary residence — The residence in which you live. You may have only one primary residence, and for the purpose of exemption from income taxes on the gain from sale of your residence, you must live in the property for no less than two years of the five-year period immediately preceding the sale. receipts journal — A record used to record rent income and other receipts in the bookkeeping system. recovery period — In calculation of depreciation, the period of time that assets are to be depreciated. Most residential real estate is depreciated over 27.5 years, for example. Other assets used as part of the investment activity (e.g., automobiles or computers) belong in the five-year recovery period. second mortgage — A mortgage in second place of priority in the event of default. A first lien holder is paid before the second lien holder in the event of foreclosure. seller financing — Condition in which a seller offers to carry all or part of a loan upon sale of the property. seller’s market — A market condition in which there are more buyers than sellers, which drives up prices for a limited number of properties on the market. straight-line depreciation — A form of depreciation in which the amount deducted is the same each year (with the exception of first and last years). This is the prescribed method that is used for real estate or that can be elected for use in other recovery periods. tax deferral — The delay of tax liability on capital gains until a replacement property has been sold. The gain on one property is deferred by replacing it with another property within the like-kind exchange guidelines. 1031 exchange — A like-kind exchange allowing the deferral of capital gains; named for the Internal Revenue Code (IRC) Section 1031 that provides this benefit for real estate investors.

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Index

documentation, 131-134, 151-152 effective, 119 expense summary, 100 income, 90, 92-94, 141-142 payments, 90 payments journal, 99 practical, 153 prepaid expenses, 145-147 problems, 137 professionals, 109-111, 153 receipts journal, 93-94 records retention, 134-136 simplified, 90-100 single-entry, 142-143 special entries, 147, 149 standards, 121 subaccounts, 140 timing, 147-150 transactions, 89-92 year-end, 107-108 Bureau of Labor Statistics, 71

active income, 179-180 additional dwelling unit (ADU), 46 adjusted basis, 135 adjusted gross income, 181-182 after-tax profit or loss, 150 allocations, expense, 103-106 amortization, 91, 156-157, 207-210 appraisals, 86-87, 162 assessed value, 161-162 asset allocation, 6-7, 226-228 assets, 24, 137, 138-139 automobile expenses, 122-123

balance sheet, 140 bookkeeping accounts, 92, 137-143 adjustments, 149-150 cash payments, 101-103 deposits, 92-93 disbursements journal, 99

241

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242

cash accounting, 91-92 cash flow analysis, 52-53 calculations, 54-57 contingencies, 62-65 features, 8-9 figures, 55-57 improving, 65-66 liquidity, 233-234 management, 19, 66-67 payments, 54 positive, 51 profit and, 58-60 reserve, 63 risks, 15 vacancies, 42-43 worksheet, 55 cash fund, 102 class lives, 167-172 closing costs, 49 commercial property, 25-27 condominiums and co-ops, 38 conformity, 81-82 contingency planning, 62-65 credit status, 11-13, 16-18 declining balance depreciation, 176-177 demand, rental, 41-43 depreciation allocations, 107 automobiles, 167 calculations, 170 claiming, 158-159 class lives, 167-172 commercial, 171-172 declining balance, 176-177 deductions, 207-210 elections, 175-177

INDEX

expense, 91 expensing, 159-160 five-year, 168-169 half-year convention, 169-170 home office, 158 industrial, 171-172 investment assets, 157 land value, 161-164 limits, 160-161, 166-167 mixed use, 157-158 partially used assets, 164-166 real estate, 156 recapture, 177-178 records, 172-175, 178 recovery periods, 167-172 reporting, 174 residential, 170-171 schedule, 173, 174 straight-line, 177 supplementary schedules, 210 system, 155-159 tracking, 174-175 trucks and vans, 166-168 worksheet, 175 direct ownership, 30-32 disbursements journal, 99 diversification, 6-7 down payment, 33, 53, 65-66 expense allocations, 103-106 automobile, 122-123 deductible, 54 documentation, 131-134, 210-212 home office, 126 investment, 122-131 landscaping, 124 mixed-use, 131

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243

I NDEX

nonallocation, 106-108 noncash, 54 office supplies, 125 prepaid, 125-147 professional fees, 125-126 recording, 98-100, 139-140 split, 129-131 telephone, 124-125 worksheet, 100 expensing, 159-161 family income, 23-24 Fannie Mae, 34 financial planning, 22-25 financing, 32-36 five-year recovery period, 168-169 fixer-upper properties, 47-49 forms 1040, 193-196 4562, 208-209 4797, 212-218 8582, 203-205 8824, 219-222 see also schedules Ginnie Mae, 34 goals, 24-25, 227-228, 234-235 gross rent multiplier (GRM), 86 half-year convention, 169-170 home office, 126, 158 impound accounts, 96-97, 146-150 insurance, prepaid, 145-147 insurance value, 162 interest rates, 76-77 Internal Revenue Service (IRS), 158 forms, see forms

schedules, see schedules investment age, 81 cash flow, 42-43 conditions, 75, 77-78, 81 conformity, 81-82 cost, 83 cycles, 69-70 factors, 75-80 feasibility, 77 forms, see forms markets, 73-75, 87 perspective, 13-20 questions, 74 regional, 72-73 selection, 80-83 suitability, 233-235 value, 52, 73, 86, 230-231 itemized deductions, 196 land value, 161-164 landscaping expenses, 124 lender requirements, 11-12, 34, 62 leverage, 9, 229-230, 231 liabilities, 137-139 like-kind exchanges, 186-188, 218-223 lines of credit, 33 liquidity, 233-234 loan origination fees, 35-36 local markets, 71-73 long-term capital gains, 182-183 long-term growth, 7, 39-41 management company, 18, 109 market commercial, 25-27 defining, 87 investigation, 73-75

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244

market (continued) overview, 3-6 regional, 28 research, 19-20 residential, 27-30 value, 15, 18-19 material participation, 180 mixed-use rentals, 127-129, 151-152, 157-158 mobile homes, 38 modified adjusted gross income, 181-182 money supply, 76 month-to-month tenancy, 18 mortgage amortization, 59, 96 breaking down, 94-98, 143-145 conventional, 63-64 costs, 40 down payment, 33, 53, 65-66 equity, 139 financing, 32-36 FNMA and GNMA, 34 impounds, 96-97 interest expense, 36, 40, 57-58 line of credit, 33 loan origination fees, 35-36 payments, 90 preapproved, 34 principal, 57-58 secondary market, 34 unconventional, 33 worksheet, 95 Multiple Listing Service (MLS), 42 multiple-unit housing, 38-39, 83-87 National Association of Realtors, 37 national averages, 71-73 neighborhoods, 29, 74-75, 82

INDEX

noncash expenses, 54 office supplies, 125 150 percent declining balance, 176-177 part-year rentals, 43-46, 127 passive income, 179-180, 203-205 payments journal, 99 preapproved loans, 13 price comparisons, 52-53 primary residence, 34-35, 37 professional fees, 125-126 property selection, 32 qualified intermediary, 187 recapture rule, 177-178 receipts journal, 93-94 recovery periods, 167-172 regional markets, 28 rental agreement, 111-116 rental application, 17 research, market, 19-20 residential property, 27-30 risk cash flow, 57 factors, 228 future, 78-79 lender, 34 management, 66-67 spreading, 227 tolerance, 14-15, 24, 231 schedules A, 196-198 D, 212-218 E, 199-202 secondary market, 34

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245

I NDEX

single-entry bookkeeping, 142-143 single-family homes, 37-38, 65 speculation, 46-50, 80 standard deduction, 198 state tax liability, 191-192 statement of condition, 116-119 straight-line depreciation, 177 supply and demand, 4, 69-70, 73-75, 79-80 tax adjusted basis, 135 advantages, 232 adviser, 109-110 benefits, 8, 66 conversions, 184-186 deductions, 206-208 deferred exchanges, 135-136, 184, 186-188 forms, see forms income, 11, 199-202 itemized deductions, 196 like-kind exchanges, 186-188, 218-233 limitations, 10 long-term gains, 182-183, 215 loss limitations, 61-62, 181 loss reporting, 163-164, 180-182, 202 partial rentals, 188-191 passive losses, 203-205 planning, 10-11 prepaid, 145-147

primary residence, 183-184, 186 reporting, 193-198 sale rules, 182-184 savings, 85 schedules, see schedules standard deduction, 198 state, 191-192 1031 exchanges, 186-188, 218-233 worksheets, 150, 183 telephone expenses, 124-125 1031 exchanges, 186-188, 218-233 tenant agreement, 111-116 credit history, 16-18 issues, 14-15 legal history, 18 matching, 81 month-to-month, 18 problems, 61 references, 16 screening, 15-16 statement of condition, 116-119 warning signs, 18

unconventional financing, 33 U.S. Census Bureau, 71

vacancy rates, 41-42, 61 vacation homes, 43-46 valuation, basis for, 27

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