Investor · Corpus Christi, TX-Texas · Member since 2015 · 81 posts · 56 votes
Hi Everyone - I have 3 STRs and have gotten very serious with looking at the full financial picture on them now that we have a CPA. We just bought the last two in the last 6 months, but have had our first for almost 5 years now. We were very nonchalant with the numbers on the first one cause we always assumed we were doing well since it was renting great (bad assumption, always know your numbers! very big rookie mistake).
Anyway, signed up for quickbooks and for 2018 we ended up basically breaking even with revenue v. expenses. In my mind, I was thinking well at least we won't owe any income taxes on it, WRONG! Turns out you aren't taxed on profit, you are taxed on net income which doesn't include mortgage payments. Meaning if we broke even with $0 profit but paid $10k in mortgage payments, we are taxed on $10k net income as if the mortgage payments weren't expenses. I know this is a very rookie mistake on our part, but that seems crazy to me!
I made $0 in profit but still owe thousands in taxes. Even if I made $10k in profit and paid $10k in mortgage payments, I would be taxed as if I made $20k profit. It makes the appeal of doing rentals at all not that great.
Let's say I buy a place for $200k and it generates $50k in revenue. Let's assume $20k profit and $20k mortgage payments. I am going to be paying taxes on $40k which will be at least $8k. So with the $20k profit minus $8k in taxes, I'm really only getting $12k cash in my pocket after the tax year. That's only a 6% return on the purchase price. How do you get around this? It's kind of taken the wind out of my sails to be honest... How can you get better numbers??
Meaning if we broke even with $0 profit but paid $10k in mortgage payments, we are taxed on $10k net income as if the mortgage payments weren't expenses
What you're missing is that mortgage payments are two things (four if your insurance and taxes are escrowed). 1) Principal: You're paying back the bank loan and adding equity, 2) Interest: An expense incurred in obtaining the loan, 3) Insurance: An expense incurred in holding a valuable property that you want protected, 4) Taxes: An expense incurred in property ownership.
Remember that the principal payments add to your equity. You'll get that money back someday when you sell it. Therefore, you can't claim it as an expense.
@Jennifer T. "depreciation can be an expense. Depending on what your CPA recommends"....
Ummmmmm.....the IRS assumes depreciation, whether you take it or not. In other words, when you sell, you have to recapture the depreciation, whether you took it or not. If your CPA is not "recommending" you take depreciation, find a new CPA. Now, I'm no CPA, but if you keep your property until death and then pass it down to your heirs, it is also a huge tax advantage.
@Julie McCoy I must have worded something wrong.. Mortgage interest was definitely taken into account! Just still hard coming to terms with showing a $4,500 income when I made $0 profit. Depreciation was also taken into account so this is the best we can do. Had we not made double mortgage payments we may be showing $12k-ish income, but from a yearly basis with the hours spent managing, still doesnt seem worth it.
@Jennifer T. "depreciation can be an expense. Depending on what your CPA recommends"....
Ummmmmm.....the IRS assumes depreciation, whether you take it or not. In other words, when you sell, you have to recapture the depreciation, whether you took it or not. If your CPA is not "recommending" you take depreciation, find a new CPA. Now, I'm no CPA, but if you keep your property until death and then pass it down to your heirs, it is also a huge tax advantage.
Thanks! I was pretty sure that was the case. I definitely take depreciation on my assets, but just didn't feel solid enough in my own tax knowledge to make a blanket statement.
basically what I want to know is what is a highly performing STR from a full financial picture perspective?
Like what should Schedule E look like to know I'm optimizing and it's performing? Showing high net income and then owing more taxes? Or showing no net income?
Making extra mortgage payments has nothing to do with profit or loss. Unless I'm missing something here, it sounds like you simply took your profit and paid down more principal on your mortgage. What you do with said net income is up to you. The goal is to maximize your income/rents, minimize your expenses (while not ignoring repairs, etc), and make sure you take every allowable tax deduction the IRS allows.
Fire the CPA and get one that is more knowledgeable. Likely the only thing you can not deduct from that bank account is the principle portion of the mortgage. Even if you have profit, likely majority will be cancelled by depreciation. My wife is a partner in the CPA firm - this should be basic knowledge for any accountant. If your accountant works in her firm, I am sure person is long gone.
@Anthony Wick yea I think I'm just overreacting. We did get some nice principal pay down so I guess it does cancel the tax out. Just hate paying Uncle Sam!
@Anthony Wick yea I think I'm just overreacting. We did get some nice principal pay down so I guess it does cancel the tax out. Just hate paying Uncle Sam!
Don't you like roads, national defense, medicare, education, and social security? :-)
Jokes aside, tax is just another expense that comes out of profit. So make sure your profit is high enough to cover it, or look for an investment that is.
Great to make pre-tax comparisons. Also, the issue with the ROI analysis here is that you have to either analyze on a cash basis or not.
Cash on cash return here will be determined by whatever profit was over whatever initial payment was made. So if he was all in at say $50,000 (clearly didn’t pay in full if theres that large a mortgage payment looming). $20K profit in a year would be some serious cash on cash return (40%).
If you would rather look at it a different way and ignore the financing to make apples to apples amongst properties, use cap rate of the net income over the purchase price. Which here looks to be $40K over $200K (20%), still solid. Numbers like these seem high as investment returns, partially because STR is more time investment, more risk, and less liquid than alternative non-RE options.
@Anthony Wick yea I think I'm just overreacting. We did get some nice principal pay down so I guess it does cancel the tax out. Just hate paying Uncle Sam!
I've been reading through this and I am not sure what you mean by cancelling taxes out. We all hate paying uncle sam. The nice part about investing in real estate is it is considered a passive income, and therefore is not subject to the 15.3% employment tax, unless of course investing is your principle source of income.
What you are experiencing is that uncle sam requires you write-off the capital expense of the property over 27.5 years. So, if your payment structure is not in alignment with 27.5 years, you will either pay more or less than you might think you ought to in any given year. However, it all does come out in the wash eventually.
You mentioned not keeping good books. Bad move. That is going to frustrate you and possibly cost you money.
Every time you buy a new property, you should make an accurate log of the cost. You can, for the most part, include all expenses that you incur obtaining and fixing up the property, right up to the point you place it in service. After you place it in service, certain items must then be deducted on an annual basis only, and others will need a separate depreciation schedule. That gets annoying, but it is what it is. Again, another reason accurate records are a must. I use a simple spreadsheet to track these, backed up with paper receipts. I keep, or print, a paper receipt for everything. Others trust the digital world. The IRS is not going to care if your computer crashed so, keep that in mind when you decide how to handle that.
The first year you own a property, you will need the pre-service total first (up to the point you rent it). That number is your initial cost basis. You will need that number later when you sell. From that number, you will need to subtract the value of the land. That number will be your basis for depreciation. Then add items that were acquired after the property was placed in service that will also be depreciated (and added to your cost basis). Together, with a bit of an adjustment for the timing of it all, will be your first year depreciation deduction. Yes, that is the deduction that represents your mortgage payment, no matter if it is aligned or not. The next year, your depreciation deduction will likely go up a bit, because you will then be claiming the expense for an entire year as opposed to a partial year. You will always need to keep a record of your depreciation from prior years for reference the next year and for reference when you sell. All items you are depreciating, as opposed to taking an annual deduction, count towards your cost basis so, you will need to add those as you go. Then when you sell, you take the total cost basis and subtract all the depreciation expense you took over the years (or, any that you should have, so that's why it's stupid not to) and the difference between that and your sale price (minus the expenses of the sale) will be your capital gain (loss).
That'll be $1000 please. The comment that your new CPA took a different depreciation than the prior CPA is troubling. You may need to file an amended return or, maybe that is simply because the prior year was a partial year.
If you don't understand any of that, then simply keep an accurate and detailed record of every damn penny you spend and what you spent it on, and all the rental income, and expect a whopping bill from the CPA. Keeping and organizing the income and expenses is by far the most time consuming part of doing taxes, and even more so for a CPA who is not going to immediately know what they are looking at when you hand them a shoe box of receipts. Therefore, if you must use a CPA, at least do that much for them.
Have fun and happy April 15th, or March 15th if you have a partner.
@Account Closed really appreciate the detailed response. I just copy/pasted that into Word and will be referencing that for a while. Thanks so much!
Good. I'm glad you read it. Now start reading the material the IRS publishes too!!! Found at irs.gov
I promise what I wrote will be easier to read than what the IRS writes, but in the end the IRS is what matters.
And for full disclosure, what I wrote is simply my interpretation of what the IRS wrote, I am not a CPA, just a guy who can read and interpret so...be warned - lol - I fully reserve the right to be wrong, and when you start reading what the IRS writes and how they write it, will understand why I just said that!!!!!!!!!!!!!!
LOL - Is it still worth a $1000 bucks? But seriously, even if you decide to use a CPA, understanding this stuff for yourself helps. Happy reading - lol.
Best tax advice ever? Never delay doing them. I need to do my personal stuff myself now that I think on it.
I'm not an account, either, but your hotel tax is not gross income, and is also not an expense. It is just money you are tacking on the bill, and holding temporarily for the government. To make your additional mortgage payments make sense in your mind, that would be the same as taking your w2 income and saying it is tax free because I put it in my savings account. You say it isn't worth it for a few grand a year, but you will change your mind when the renters paid off your mortgage. Also, you said 6 percent off of the purchase price, but you haven't purchased it yet. You gave a down payment, and the bank is the largest owner. Your numbers will look better based off of your downpayment.
Would it be so crazy to just keep your mouth shut and not submit anything to uncle sam. Imagine you used a HELOC to purchase a house but just said you used it for renovations and cash the tenants checks and not deposit anything into a bank account
As others have said here, you chose to take a big chunk of your profit and pay down your mortgage instead of putting it in your pocket. That EXTRA $12k (or whatever) you paid on your mortgage isn't an "expense", it's savings. You're just choosing to use use your rental's equity as your savings account. Probably not a good idea. Keep it in something liquid and use it as a downpayment on another property.
@Matt Groth thanks for the response. “I will change my mind when renters pay off my mortgage.” Yea not sure about that. $150k property paid off 30 years from now. I’d be making a whopping total of $5k/year and spending 10-20 hours a month on it. What makes it worth it? Even if I get incredible appreciation and it’s worth $300k, that’s still only $10k/year. If it was a $1M property then yes. I agree, it sounds amazing in theory, but theory doesn’t factor in my time spent managing it.