Real estate rental

Understanding your rental property

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

Let’s start by bringing our first city home. It was bought right after we were married with the intention that one day we would live in a bigger house. Because we were so good at saving, we didn’t have to sell the first house to get into the new place. We have made contributions to retirement plans and we have savings outside of retirement plans. The decision has been made to keep this townhouse and convert it into a rental property to begin investing in the alpha edge. It is necessary at this point to understand how a rental property works from its inception, during its operation, and when a decision is made at the end of its existence in the portfolio.

Commissioning of the property

If the property is being converted for personal use, as is the case in this situation, we must take the lower cost or market value to put this property into service as rental. If we originally purchased the home for $ 200,000 and its fair market value is $ 300,000 when we are ready to convert, we will use the original cost of $ 200,000 as our basis. If the fair market value was $ 150,000 at the conversion date, then this would become the basis for the rental property. Putting a property into service in this case means establishing how much will be available for depreciation and how much will be allocated to the land. Suppose $ 200,000 is our base. We will need to map this base to determine what can be depreciated and what should be ground (not depreciated). I like to use the property bill appraisal as it typically divides the property into what is being built and what is land. After reviewing the property’s appraisal, it is determined that 80% of the property’s value is under construction and the remaining 20% ​​represents the value of the land. This means that we will depreciate $ 160,000 over a useful life of 27.5 years, or $ 5,818 per year. If we were to purchase this rental property rather than convert it, our basis would be based on cost plus settlement charges. Remember, every year that we take depreciation, we are reducing our property tax base. This is important to know as we consider the layout of the property.

Rental property operations

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

Disposition of the rental property

We are now considering the disposition of our rental property. At that time, it is believed that we can get $ 400,000 for our investment. Do we have exposure to income taxes due to the gain from this property? Of course you do, don’t be silly. Let’s first calculate what our profit will be. We know our sale price, so we need to calculate our adjusted property. If the property has depreciated over 10 years, our accumulated depreciation will be $ 58,180 ($ 5,818×10 years). This would reduce a depreciable basis from $ 160,000 to $ 101,820. We will add $ 40,000 to this for the non-depreciated land basis, which will increase the adjusted basis to $ 141,820. The exposure to earnings for this property is then calculated at $ 258,180. This gain is the section 1231 gain, which will likely mean it is a long-term capital gain. However, this profit will have two tiers of taxes. Due to the depreciation taken in previous years, the accumulated depreciation of $ 58,180 will have a 25% tax rate application. The balance of the gain, $ 200,000, will be taxed at the long-term capital gains rate of $ 15%. There is the possibility of making a 1031 exchange (of the same type) in this property that would allow the deferral of the gain provided that a property of greater or equal value is acquired. There is also the possibility of offsetting the capital gain of this transaction with the capital losses that could be in the portfolio. Does it make sense to sell directly or do a 1031 exchange? It depends on the facts and circumstances of this particular portfolio. If the alpha edge is well above the 20% mark, and with long-term capital gains of only 15%, it might make sense to simply recognize the gain and pay the taxes (see my article on offsetting gains and losses from capital). If we need to buy another property to keep 20% on the alpha edge, the 1031 exchange might be the right solution. Do you see what I mean when I say that one must understand the basics of owning a real estate property? My way is better.