I often end up in conversations about getting into real estate. Sometimes it is related to a first commercial transaction, other times it is simply buying a first rental home or investment duplex. I’m always happy to talk to new investors about the space and find myself emailing or having lunch with someone on the topic every week.
This week’s episode was rather interesting, I was emailing with a new potential real estate investor along with several other compatriots of mine. One of them sent a response that I thought was insightful and interesting. The question we were approached with in an email was a question about the profitability and decision making guidelines for a particular single family home rental property. The investor was interested in buying their first investment property and was trying to figure out how profitable the property would be every year for them (after taxes and everything).
Here is the response from Steve on the matter that he gave me permission to share because I thought it was great…
I am neither a CPA nor an attorney, and as a landlord, you should probably hire the former and have the latter on retainer. I’m only going to explain where you should look, not what you should do.
You have presented some sample numbers. Have you tried downloading the PDF of Form 1040 Schedule E from irs.gov and filling it out?
You will find that there is a distinct line for pretty much every individual thing you’ve described, except for your mortgage principal payments, which are irrelevant for tax purposes.
- Rent -> line 3
- Mortgage Interest -> line 12
- County taxes -> line 16
- Insurance -> line 9
- Property management
- -> line 11 for answering phone calls about overflowing toilets
- -> line 5 for posting vacancies on their web site
- -> line 8 for actually moving a new tenant in
- Landscaper -> line 7
- Plumber -> line 14
But then when you get to line 22, you’re in for a surprise! You have to jump over to a completely different form, called Form 8582, to determine how much of your operating loss you can actually deduct.
And that’s where the fun begins.
- Form 8582 is where you get to decide whether you are a real-estate professional or not (hint: you’re not).
- Form 8582 is where you get to add up your income from all sources combined, including income from your corporate job.
- Form 8582 is where you get to learn that you make too much at doing real work to deduct all of your real estate losses.
To answer your question ‘how much will I be able to deduct based on these raw real estate numbers?’, there is no way to determine how much you can actually deduct until you add up how much total income you have from all sources (not just real estate) at the end of the year.
It is true that some people can deduct up to $25,000 per year in losses. It is also true that many people cannot deduct anything at all, even if their Schedule E shows an operating loss. Assuming that you can deduct up to $25,000 per year in losses just because your friend who owns a rental house can do it is an invalid assumption.
And, oh by the way, for the 2014 tax year, it gets worse: if your total income from all sources is over $200,000, and you are lucky enough to have a gain (rather than a loss) from your real estate activity, then you get to pay the Obamacare surcharge tax on your rental income.
Definitely some good advice for landlords as well as any investor really. If you want to know what an investment will look like, do the work to run the numbers as if you had already made the investment and see what you learn.