How does cashflow get taxed?

Question

So I just closed on my 1st SFR last week, and am hoping to have a tenant in by June 1st.  A couple questions I have.

I was going to set up my LLC within a couple months as I plan to grow this into a full time business in the next couple years.  I have heard some people on here say that if you deed a property into an LLC it can cause the due-on-sale clause to come into effect.  Is this true?  I was thinking of just doing a $1 million umbrella over all of my assets instead.

Also, how does the cashflow get taxed as I have heard if you do it correctly you should pay almost no tax on your cashflow?

Thanks!

Linda Weygant · Answer

The taxes are going to completely depend on your purchase price and your overall income and expenses.  It is quite common for a rental property to have a positive cash flow, but still show a loss on taxes due to depreciation, which is a non-cash expense.

Let's say you buy a house for $200,000 and rent it for $1500 per month.  Your deductible expenses are $900 per month and the principal amount of the mortgage (which isn't deductible) is $150 per month.  So you've got positive cash flow of $450 per month.

At the end of the year, before depreciation, you report $7200 of profits ($600 x 12) and you've had positive cash flow of $5400 ($450 x 12).

However, you also include depreciation in your expenses.  Residential rental is depreciated over 27.5 years, so your depreciation expense is $7272.

Voila!  You've just wiped out all your profits from a tax standpoint and no tax is due.

Brandon Hall · Answer

@Mohammad Akif this is incorrect on several levels. Cash flow is not taxed. Cash flow very rarely will give a real estate investor any sort of indication about tax liability.

Why?

Depreciation, amortization, and loan principal.

I can have cash flow, in my pocket, of $1,000 per month. But if my depreciation and amortization are $600/mo, then my taxable net income is certainly not $1,000 per month.

Additionally, the loan principal is not a deductible expense but is part of the cash flow calculation (payments reduce cashflow).

Lastly, LLC structure has no effect on tax liability unless you are taxed as an S-Corp or C-Corp.

Kevin Romines · Answer

Don't forget that deprecation is the basis or what you bought the home for minus the cost of the land (this can be subjective, but you can get a feel for what a lot or acreage is going for in the area) divided by 27.5 years. So under the 200K scenario if the lot is worth 50K then it would look like this: 200K minus 50K lot value = 150K / 27.5 years = 5454.54 a year in depreciation. Also remember that depreciation is reducing your basis in the home, so when you go to sell the home, you will have more profit than when you bought it due to the declining basis due to depreciation.

You can avoid the taxes on the profit by doing a 1031 exchange. You will need a quality exchange facilitator for this.

Tom Chen · Answer

Brandon and Mohammad covered most of the tax issues, but I'll add that you may or may not be able to deduct your "excess losses" from your rental property currently depending several other factors such as if you have other sources of passive income, etc.

Justin P. · Answer

Thanks for the LLC clarification, @Brandon Hall.

Great example, @Linda Weygant. I've not seen it explained this clearly before.

Mohammad Akif · Answer

@Brandon Hall I agree with you as I should have mentioned ending cash flow or net cash flow.

Mohammad Akif · Answer

@Dan Shelhamer

In terms of tax, If you ending cash flow is negative then certainly there will be not tax but if your ending cash flow is positive then there will be tax on it. Further, it depends on how do yo have the LLC tax structure setup.

Mohammad Akif, CPA

David Dachtera · Answer

@Dan Shelhamer,

The likelihood of DoS being invoked is very low. Only one institutional lender is known to be a chronic problem: Bank of America.

You might do better to start the LLC now and start building its credit so someday it can get it's own financing and "buy" the property from you. Lenders like to see entities be in business at least a year, preferably two to reduce the chance of them asking for a personal guarantee and have some business credit established.

Until the LLC contains valuable assets, it can be single-member with you being the managing member. Build it's credit, then go multi-member and have it buy the property from you (or ?).

Your attorney can help you structure this.

Your tax accountant can help answer your cash flow question. Thumbnail sketch: you need enough valid expenses to offset your taxable rental income.

David J Dachtera

"Success is not a destination. Failure is not an event. Success is a process, failure is a choice."

- DJ Benedict

How does cashflow get taxed?

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