A client of mine paid $590,000 for a 1,100-square-foot condo in The Woodlands, Texas two and the half years ago, but housing values have fallen so far that she figures such a move would lock in a $200,000 loss.
She has moved back into a home she still owns in the historic Houston Heights and would love to unload the condo.
The good news is that there is a light at the end of the tunnel. A real estate agent recently informed her that the condo can fetch $3,300 a month in rent. That's enough to cover her mortgage and property taxes. She decided to lease out her condo until values rebound.
"It'll be a tax writeoff," she says.
No less a financier (and former do-it-yourself tax preparer) than Treasury Secretary Timothy Geithner is leasing out his Mamaroneck, N.Y. home after failing to get for it a bid he was willing to accept. If you're one of the hoard suffering real estate buyer's remorse, you too may be able to turn a modest profit renting out your albatross of a residence. How can that be? Thank the trove of tax breaks for residential landlords.
The first step in figuring out whether renting makes sense is to find out how much your place is worth. An appraisal is a must, but written statements from a few Realtors will do while they agree on the value and stipulate how much is attributable to land and how much to the building. (The appraisal, as you'll see later, is essential for two separate tax calculations.)
The next step is to see how much the property will fetch in monthly rent and weigh that against the costs and tax consequences. As a landlord, you can't claim mortgage interest as an itemized deduction on Schedule An of your tax return. Instead, you deduct interest costs, plus property taxes, monthly condo fees, insurance and anything you pay to a property manager (most charge 10% of rent) against rental income on Schedule E. You can also expense travel and other costs you incur to look after the property.
The other big tax deduction for landlords is depreciation. The tax code allows you to divide the value of your building (but not the land) by 27.5 and to claim the result as an annual depreciation expense. Here's the first place that the current appraisal comes in. When you convert to a rental, your depreciation is based on the cost of the property plus improvements or its market value at the time of conversion--whichever is less.
She must use the $390,000 fair market value of her condo, not the $590,000 she paid. Assuming that 10% of the $390,000 is attributable to land under her building, the depreciation expense comes to $12,764 annually (and reduces her cost basis by the same amount). Other expenses added and the total is likely to exceed her $39,600 gross annual rental revenue. Almost any residential landlord with a mortgage is going to be in that boat.
The amount by which expenses exceed rent is a tax loss that can be used to shelter up to $25,000 in other income--say, from your salary--if your adjusted gross income is $100,000 or less. (The same cutoff applies to both singles and couples.) Above $100,000 the break is phased out, and it disappears completely at $150,000.
If you happen to be a real estate professional--defined as someone spending at least 750 hours a year, and at least 50% of his working time, in the business--then your career managing property becomes an "active" one and your losses are fully deductible against other income. If you fail the income test or to qualify as a pro, your rental losses don't go entirely to waste. The net loss gets carried forward and deducted if and when you dispose of the loser real estate or you have gains from passive investments. These gains could be from selling the property in question at a capital gain or from owning other passive investments, like oil wells.
Note that "passive" is a term of art in the Internal Revenue Code and does not cover portfolio investing (stocks and bonds). So if you collect $30,000 from stock dividends and have a $30,000 loss on Schedule E, you can't net one against the other. But you can wise up, sell the stocks and use the proceeds to pay off the mortgage. At that point you're probably out of the loss column on the rental and pulling real cash out of the property. A good part of the cash return will be sheltered from taxes by your depreciation deduction.
How are gains taxed when you sell a converted property? A lot depends on timing. If you lived in the property for at least two years and then rented it out for less than three, you may be able to use the provision that excludes $500,000 in gains from the sale of a principal residence, per couple, from tax. (You'll still owe gains tax on the amount claimed as depreciation.) If you sell at a loss, the only deductible portion is the loss occurring after you converted the house from personal to income-producing use. The appraisal is crucial here.
My client is hoping that sales prices will rebound in two years. Assume instead that they slide and she clears only $340,000, or $50,000 less than what her Realtors said her condo was worth when she converted it to a rental. Her tax basis in the property will be $364,500 (the $390,000 minus $25,500 for two years of depreciation). She'd be left with a $24,500 capital loss she can use to shelter taxable gains on other investments. Also, she could then claim any passive losses she couldn't use before.
Renting does present problems. You must either maintain a property yourself or pay someone else to do it. Tax and real estate experts warn against hanging on to real estate if rent falls far short of your pretax, out-of-pocket costs. In other words, look to the tax benefits to sweeten the deal, not drive it. As always don't take my word for it, check with your tax expert or CPA to assist you in your specific situation.
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When the numbers work, this is definitely a strong alternative to consider to be ab le to keep a property untilvalues come back.