Buy Income Property Based on Current Income
QUESTION: We want to buy a small apartment building where we will live in the manager’s apartment and rent the remainder of the property to tenants. However, the apartment buildings we have been shown by realtors all have income-expense statements with projected income.
It seems to us we should buy based on the current rather than projected income. But the agents try to get prices based on future income. What do you think?
ANSWER: I think you are right and the agents are wrong. Always buy income property, such as apartments, based on current rather than projected income. The reason is that to attain the projected rents, you will have turn over vacancies which will necessitate repairs to possibly attain the projected rents.
If you are going to incur the renovation costs it is you, not the seller, who should reap the benefits. Make your purchase offer based on current, not projected, net income.
Realty Investment Causes Heavy Loss
Q: Several years ago, I was conned by a real estate agent into buying a warehouse leased to a major discount store chain for 22 years. I thought it would be a great investment. Based on the rental income and the expense payments, I was earning about 10% on my money with a net, net, net lease.
Then the discount chain got mixed up in a leveraged buyout, the company went bankrupt and they moved out of my warehouse. That was almost two years ago. Since then I have hired several realty agents trying to rent my warehouse for enough to cover my expenses, but I’ve learned the discount chain was paying above-market rent. The insurance company that holds the mortgage has started foreclosure. If I sell the warehouse at a loss before the foreclosure sale, can I deduct the loss on my tax returns?
A: Please consult your tax adviser. Losses on the sale of property held for use in a trade or business can be tax-deductible as an ordinary loss.
Although there was nothing inherently wrong with your investment in that warehouse, now you know dependence on one tenant can be very risky, especially if that tenant is paying above-market rent. Triple net leases, where the tenant pays the maintenance, taxes and insurance, can be very advantageous for commercial property owners, unless something goes wrong.
Trading Equity for Like-Kind Exchange
Q: Years ago, I invested in an apartment building. Today I have at least $400,000 equity and profit in it.
I was hoping the capital gains tax law would pass, but those characters in Congress don’t know what’s good for the country, and it looks like they may never enact a capital gains law to encourage investment. Some time ago, you wrote about tax-deferred exchanges. Is there any way I can trade my equity in my apartments for a nice house without having to pay tax?
A: Yes. But to qualify for an Internal Revenue Code 1031 tax-deferred “like kind” exchange, both properties must be held for investment or used in a trade or business. In addition, you must trade up to a larger property without receiving any taxable unlike kind property “boot,” such as cash or net mortgage relief.
Let me illustrate. Suppose your apartments are worth $600,000 with a $200,000 mortgage and $400,000 in equity. You can make a tax-deferred trade for a rental house costing at least $600,000, if it has a mortgage of at least $200,000. However, it must be rented to tenants to qualify as like kind property held for investment or use in a trade or business.
But IRC 1031 does not say how long the house must be rented before you could convert it to your personal residence. No tax would be due upon such conversion. Most tax advisers suggest at least a 6-12-month minimum rental period.
Can Second Mortgage Be Used for Business?
Q: The new tax laws regarding deductibility of home mortgage interest seem very unfair.
My wife and I have a large equity in our home. But my business can use capital for expansion. However, under the new law we can only deduct the interest on a $100,000 home equity loan which we have already obtained. But my lawyer says I can refinance my house and deduct the mortgage interest as a business expense if I put the extra cash into my business. Do you agree?
A: I agree that the new home mortgage interest deduction rules are very unfair, especially for homeowners who had large equities when the law was implemented on Oct. 13, 1987.
Yes, you should be able to deduct the interest on a home loan used for business purposes.
However, be very careful to show the funds were used in your business. As your lawyer advised, although the security for the loan is your home, if the purpose is a business loan, then the interest becomes deductible as a business expense on your business tax return. Ask your tax adviser to explain further.
Life Estate Income Can Be Depreciated
Q: Last year my father died and I inherited a life estate in some income properties he owned. When I die, the properties are to go to my children.
They are free and clear, producing excellent income. Can I depreciate these properties on my income tax returns?
A: Yes. In fact, Uncle Sam says you must depreciate them. Internal Revenue Code 167(h) says a life tenant can depreciate life estate property.
Remove Tenants Before Marketing a House
Q: We have had a house listed for sale since last October. It hasn’t had one offer. The realtor, who I think is doing a good job, says the tenants are discouraging sale of the house. She wants me to evict them. But I hate to lose the rent income and I know the house will then have to be repainted and recarpeted. Do you think I should evict the tenants?
A: Yes. Selling a home with tenants occupying it is extremely difficult. Real estate agents hesitate to show such houses, knowing the tenants will usually emphasize any defects to prospective buyers because the tenants don’t want to see the house sold since they know they will probably have to move out.
What Is Depreciation on Income Property?
Q: You often mention depreciation as an advantage of owning income property. Please clarify exactly what is depreciation and how does it benefit property investors?
A: Depreciation is a non-cash estimated income tax deduction for wear, tear and obsolescence of depreciable property such as apartments, offices, rental houses and warehouses. But land value and personal residences are not depreciable.
To illustrate, suppose you buy a $150,000 rental house to which you allocate $100,000 for the value of the depreciable structure. Using the current 27.5-year straight-line residential rental depreciation useful life, you can deduct $3,680 annually for the next 27.5 years. Commercial buildings are depreciated over 31.5 years. The net result is each year you would shelter $3,680 of otherwise taxable income, such as rent earned by the property, from taxation.
