Deferring Rental Income - Simple IRA?

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reallyconfused
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Deferring Rental Income - Simple IRA?

Post by reallyconfused » Sun Aug 02, 2009 1:54 pm

My parents have a rental property in California and they get killed every year with the taxes. Would they be able to incorporate the rental property, set themselves up as employees and make simple or sep ira contributions? Thereby deferring the income for years.

KyleAAA
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Post by KyleAAA » Sun Aug 02, 2009 2:51 pm

In short? No, probably not, because the costs of incorporation would outweigh the benefits. Additionally, if they set themselves up as employees they would have to pay self-employment tax, which amounts to about 15% and which they currently completely avoid.

How exactly are they getting killed by taxes? I would think real estate, especially in California, would be fairly tax-sheltered because of the large mortgage deduction and depreciation charges. If they have no mortgage on the property, they might want to consider getting one.

Gill
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Post by Gill » Sun Aug 02, 2009 3:47 pm

KyleAAA wrote: If they have no mortgage on the property, they might want to consider getting one.
How would you suggest this would improve their situation?
Bruce

KyleAAA
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Post by KyleAAA » Sun Aug 02, 2009 3:51 pm

MBMiner wrote: How would you suggest this would improve their situation?
Bruce
Mortgages are good as tax deductions. Whether or not the tax advantages are worth the downsides arising from borrowing is an exercise best left to the reader.

reallyconfused
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Post by reallyconfused » Sun Aug 02, 2009 4:03 pm

KyleAAA wrote: How exactly are they getting killed by taxes? I would think real estate, especially in California, would be fairly tax-sheltered because of the large mortgage deduction and depreciation charges. If they have no mortgage on the property, they might want to consider getting one.
Federal marginal bracket = 33%
California marginal bracket = 10%

So for every dollar of rental income they have to pay 43 cents in taxes. They have no mortgage and for psychological reasons they don't want one. I recall reading somewhere that if you have a mortgage on a rental property it is not deductible anyways. Although I am not sure about that.

KyleAAA
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Post by KyleAAA » Sun Aug 02, 2009 4:06 pm

reallyconfused wrote: So for every dollar of rental income they have to pay 43 cents in taxes. They have no mortgage and for psychological reasons they don't want one. I recall reading somewhere that if you have a mortgage on a rental property it is not deductible anyways. Although I am not sure about that.
Mortgage interest is deductible as a cost of doing business. If they are unwilling to borrow, they have few alternatives. Perhaps a 1031 exchange into a new property would allow them to boost their depreciation deduction, but that's about it. Incorporating isn't the answer, since corporate income taxes are generally higher than individual income taxes.

lucya530
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Post by lucya530 » Sun Aug 02, 2009 4:26 pm

I appreciate your thoughts Kyle.

DSInvestor
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Post by DSInvestor » Sun Aug 02, 2009 4:54 pm

Why take out a mortgage? Why pay $1 in mortgage interest to save 33 cents of taxes? Isn't it better to just pay the 33 cents of taxes and keep the other 67 cents?

Your parents can't be paying 43 cents of taxes on every dollar of rental income because the rental property must have some expenses to offset that income (property tax, maintenance, insurance, depreciation etc). I'm not a landlord, but I would assume that those are types of expenses are deductible for those in the real estate business.

Is the rental income side income on top of income from jobs? If your parents have jobs, are they taking full advantage of work place retirement plans? If both parents work and both are over age 50, they could each contribute 22K to 401k/403b. That could reduce their taxable income by 44K. If under age 50, 401k is limited to 16.5K/yr.

Does the rental income count as self employment income? If it does count as self employment income, they could make some SEP-IRA contributions as sole proprietors if they are not incorporated. If your parents do not have a workplace 401k and the rental income is classifed as self employment income, solo 401k may be better than SEP-IRA as it allows for larger contributions on lower incomes. Best to check with CPA on how rental income is viewed.

Do your parents have investments in taxable accounts? What kind of investments are they? Holding tax efficient investments can make a big difference in your tax liability. Tax inefficient investments (bonds, bond funds, balanced funds, actively managed stock funds) should be placed in tax advantaged accounts. Tax efficient investments (total stock market index, tax exempt bonds) should be used for taxable accounts.

Stocks and stock funds throw off qualified dividend income (QDI) which is taxed at 15% for those in 25% bracket and higher.

Bond, CD, money market income is taxed at marginal tax rates.

If there are stocks or stock funds in taxable accounts, do they have any unrealized losses? They could sell the taxable holdings with losses to harvest tax losses which can be used to reduce capital gains in the future and also provide up to 3K of income reduction for many years.
Last edited by DSInvestor on Sun Aug 02, 2009 5:10 pm, edited 2 times in total.

expat
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Post by expat » Sun Aug 02, 2009 4:57 pm

>> So for every dollar of rental income they have to pay 43 cents in taxes

What about the depreciation deduction?? Not to mention deductible expenses.

KyleAAA
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Post by KyleAAA » Sun Aug 02, 2009 5:00 pm

DSInvestor wrote:Why take out a mortgage? Why pay $1 in mortgage interest to save 33 cents of taxes? Isn't it better to just pay the 33 cents of taxes and keep the other 67 cents?
No, in that the mortgage deduction increases cash-on-cash returns while deferring income taxes on your profits i.e. no need to rely upon appreciation to drive investment returns. At the same time, the cash-out can be reinvested elsewhere into either more income-producing real estate or something more passive and tax-friendly, like an index fund.
[/quote]
Does the rental income count as self employment income?
It does not, so long as active participant rules are followed, which for a small landlord is virtually automatic.

DSInvestor
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Post by DSInvestor » Sun Aug 02, 2009 5:08 pm

KyleAAA wrote:
DSInvestor wrote:Why take out a mortgage? Why pay $1 in mortgage interest to save 33 cents of taxes? Isn't it better to just pay the 33 cents of taxes and keep the other 67 cents?
No, in that the mortgage deduction increases cash-on-cash returns while deferring income taxes on your profits i.e. no need to rely upon appreciation to drive investment returns. At the same time, the cash-out can be reinvested elsewhere into either more income-producing real estate or something more passive and tax-friendly, like an index fund.

It seems the parents don't want a mortgage and the risk associated with it. No mortgage means no risk of bankruptcy. OP did not indicate whether the parents were interested in acquiring additional property. If you owned property free and clear, would you borrow money at 6-7% to invest in index funds? I would not.

KyleAAA
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Post by KyleAAA » Sun Aug 02, 2009 5:12 pm

DSInvestor wrote: Would you borrow money at 6-7% to invest in index funds? I would not.
Absolutely, since that 7% would be fully tax-deductible. It's a relatively safe bet, in my opinion, that a diversified portfolio will beat the nominal after-tax cost of the mortgage of under 5% over 30 years. That is a risk I would definitely be willing to take. Then again, I'm in my 20's.

ResearchMed
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Post by ResearchMed » Sun Aug 02, 2009 5:30 pm

KyleAAA had some helpful info:
Mortgage interest is deductible as a cost of doing business. If they are unwilling to borrow, they have few alternatives. Perhaps a 1031 exchange into a new property would allow them to boost their depreciation deduction, but that's about it. Incorporating isn't the answer, since corporate income taxes are generally higher than individual income taxes.
If the properties are truly "investment properties", and your parents do not stay in any single one of them for more than 14 days per year, then ALL expenses are "deductible", whether it is mortgage payments (and that includes principal, not just interest - unlike for a residential property), taxes, utilities, maintenance (big things like a new roof, small things like repainting a room), lawn care, any local management costs, etc.

AND yes, "depreciation". THIS is where it might "pay" to consider doing a 1031 exchange for some similarly-priced property [regardless of whether the entire market is "up" or "down"] and start that depreciation clock ticking again, in two ways. First, if the depreciation period has ended, well, that's a lost "tax deduction". If it hasn't, AND a new property would cost more, even if similar to the current value of the old property, then my understanding is that the "depreciation" clock not only starts again, but at the new, higher "purchase price".
:!: I am NOT at accountant or a tax attorney, so please make sure they check with the appropriate experts about their own specific information.

As for "corporate taxes", check about incorporating in Delaware (or possibly Nevada).
Note that "incorporating" may be a "non-issue" for a relatively small business such as a few properties owned by a one couple or family.
LLC's or sole-proprietorship/S-corporations MIGHT be more appropriate if you can just have the income (after expenses/depreciation/etc.) "pass through" to your own tax returns.
ONE BIG advantage is to minimize liability exposure should some misfortune befall someone at one of the rental properties.
If they do incorporate (and liability is a valid concern!), then they should also check with their insurance advisors, as they may need "commercial" coverage (they might already need to or already have it), but they might also need a "commercial" umbrella policy that is separate from any "regular" umbrella policy they have along with their homeowner's policy.
Again, check with the same two categories of professionals about their specific situation and both California and their own state tax laws, etc.

ONE possible reason to consider doing something like making one (or both) of them "employees" is if they need a way to increase some payments into the Social Security and Medicare system, for retirement. However, my guess is that it would be better to take that same amount of money and just invest it on their own.

We have just been going through some of this ourselves, but the rental property is not in California.

RM

pshonore
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Post by pshonore » Sun Aug 02, 2009 6:04 pm

ResearchMed wrote: If the properties are truly "investment properties", and your parents do not stay in any single one of them for more than 14 days per year, then ALL expenses are "deductible", whether it is mortgage payments (and that includes principal, not just interest - unlike for a residential property), taxes, utilities, maintenance (big things like a new roof, small things like repainting a room), lawn care, any local management costs, etc.
Principal on a mortgage payment for rental properties or your personal residence is not deductible. Also, major improvements (new furnace , etc) must be depreciated over the useful life

ResearchMed
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Post by ResearchMed » Sun Aug 02, 2009 7:17 pm

pshonore wrote:
ResearchMed wrote: If the properties are truly "investment properties", and your parents do not stay in any single one of them for more than 14 days per year, then ALL expenses are "deductible", whether it is mortgage payments (and that includes principal, not just interest - unlike for a residential property), taxes, utilities, maintenance (big things like a new roof, small things like repainting a room), lawn care, any local management costs, etc.
Principal on a mortgage payment for rental properties or your personal residence is not deductible. Also, major improvements (new furnace , etc) must be depreciated over the useful life
Sorry, pshonore is correct. Thanks!

When I wrote that all of the "expenses" were deductible, I did not distinguish between those that need to be depreciated and those that don't. Those that are depreciated fall into different categories, with somewhat different "depreciation schedules" (time periods). Furniture, appliances, new roof, etc. are depreciated over different periods of time. Thus, one might only be able to deduct, say, 1/7th of the cost in taxes each year, for 7 years.

But the other expenses that are not tax-deductible for a residence, such as utilities, lawn care, maintenance, etc., are deductible for an investment property.
Some of the other expenses in a residence that are "improvements" can be added to the cost basis, thus reducing any taxable profit, but "maintenance" and "repair" expenses cannot be.

The purchase price of the rental property itself, if a single family home (I don't know if multi-family is different) was 27.5 years last time I looked (I think). So approximately 4% (1/27.5) of the purchase price would be deducted each year.

This is why doing a 1031 exchange if rental property has appreciated can make sense. If a property costs $X and has appreciated over the years to $2X [obviously, not during the past few years, but going back longer...], then if one sells the old one for about $2X and appropriately buys a new one for about $2X, then the annual depreciation deduction is twice as much. [Depreciation schedules have changed occasionally, so this would need to be factored in, to compare possible "current tax" advantages a 1031 exchange.]

And also sorry about the "principal", where I was also incorrect.
In our case, we financed most of the purchase costs quite recently, so in terms of taxes, most of the "mortgage payments" are still "interest", and the "principal" being repaid is small enough in the early years that I simply forgot it was "there". And for one of the properties, we have a small 2nd for a few renovations, and that is "interest only".
[No lectures please; it is a nice cash cow from the start. Unfortunately, it would be difficult this year to have gotten the "bank leveraging" that made these possible just a year or two ago.]

And I don't think that there is a cap on the amount of mortgage interest that can be deducted, the way there is for a residence, because our rental properties aren't quite in that price point anyway.

RM

pshonore
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Post by pshonore » Sun Aug 02, 2009 7:39 pm

ResearchMed wrote:
When I wrote that all of the "expenses" were deductible, I did not distinguish between those that need to be depreciated and those that don't. Those that are depreciated fall into different categories, with somewhat different "depreciation schedules" (time periods). Furniture, appliances, new roof, etc. are depreciated over different periods of time. Thus, one might only be able to deduct, say, 1/7th of the cost in taxes each year, for 7 years.



But the other expenses that are not tax-deductible for a residence, such as utilities, lawn care, maintenance, etc., are deductible for an investment property.
Some of the other expenses in a residence that are "improvements" can be added to the cost basis, thus reducing any taxable profit, but "maintenance" and "repair" expenses cannot be.

The purchase price of the rental property itself, if a single family home (I don't know if multi-family is different) was 27.5 years last time I looked (I think). So approximately 4% (1/27.5) of the purchase price would be deducted each year.
Minor point; land is not depreciated; you need to allocate purchase price between the land and the dwelling

And sometimes people forget or don't realize that upon sale all depreciation (of the dwelling) is recaptured; in effect any accumulated depreciation is used to reduce your cost basis (and that portion of your gain is typically taxed at 25%; not LTCG rates). Kind of makes the 1031 exchange more attractive but those can be difficult to pull off for residential rental property.

reallyconfused
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Post by reallyconfused » Mon Aug 03, 2009 10:16 pm

DSInvestor wrote: Your parents can't be paying 43 cents of taxes on every dollar of rental income because the rental property must have some expenses to offset that income (property tax, maintenance, insurance, depreciation etc). I'm not a landlord, but I would assume that those are types of expenses are deductible for those in the real estate business.

Is the rental income side income on top of income from jobs? If your parents have jobs, are they taking full advantage of work place retirement plans? If both parents work and both are over age 50, they could each contribute 22K to 401k/403b. That could reduce their taxable income by 44K. If under age 50, 401k is limited to 16.5K/yr.
Your quite right DSInvestor I was exaggerating...they don't pay 43 cents on every dollar but it's fairly close. The 2 rental properties were purchased a number of years ago at relatively low prices so the depreciation and property tax are not all the much. The rental income is on top of their jobs and they work for a small business that does not provide 401ks. They only contribute 12k (6k each) to a T-IRA.

Thanks for your thoughts DSInvestor, pshonore, and especially RM. Very helpful.

RobG
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Post by RobG » Tue Aug 04, 2009 10:20 pm

pshonore wrote: And sometimes people forget or don't realize that upon sale all depreciation (of the dwelling) is recaptured; in effect any accumulated depreciation is used to reduce your cost basis (and that portion of your gain is typically taxed at 25%; not LTCG rates). Kind of makes the 1031 exchange more attractive but those can be difficult to pull off for residential rental property.
What are the issues with a residential rental property 1031 exchange that make it difficult? I've never heard of it being a problem (other than fitting the buy/sell within a window).


rg

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