All Forum Posts by: Michael Plaks

LLC does not change anything as far as tax treatment of losses. It will still be a passive loss - which this person cannot benefit from, due to high W2 income.

@Stephen Thomas

Don't get too excited with discussions of repairs, depreciation, multifamily etc. All of those things only create more passive losses, and you cannot benefit from passive losses. In short: nothing related to the usual rental properties can offset your W2 income, sorry.

I'm just a messenger.

Now, if your AirBnB unit offers short-term stays, a la hotel, then it is not passive. Then you might be able to generate some losses from that unit, via depreciation and repairs. But we would need to know the details of how you operate the AirBnB. And you can only squeeze some modest savings out of it.

So, I'm intrigued by a strong statement from my colleague @Brandon Hall that "There are ways to drastically offset W-2 income." Wonder what Brandon had in mind by drastically.

@Frank W Lentine

You may be rushing your decision to switch CPAs. I'm not convinced that your CPA did anything wrong.

Whether or not you filed a partnership return or reported it directly on Schedule E - the bottom line would be the same. Your losses are locked up and pushed into the future. They will eventually be unlocked when you sell. (More complicated with the partnership.)

You're hoping to not "make the same mistake" - but there was no mistake.

The only mistake could be filing a separate partnership return, something to look into.

If, on the other hand, your CPA does not give you what you need - like explanations and tax planning, for example - then it may be worth looking elsewhere.

Yes, that sounds like another way to structure self-borrowing, besides a bona fide loan to a controlled entity.

We should not have to play those games though. But I know I'm preaching to the choir.

I'm trying to think logically. Yeah, I realize how ridiculous it sounds when talking tax law. :)

If you borrow money on Day 1 - you have a clear deductibility. But if you temporarily finance with your own cash - it seems to kill the interest deduction. Which sounds - dare I mention the word - unfair?

We can try to work around the problem by formalizing borrowing, as I suggested. I have no idea whether a disregarded entity can work or not. Did not try to research precedents.

I just wish that there was a clean legal way to self-borrow without losing the interest deduction on future refi.

I understand the legislative intent in disallowing interest deduction for equity refi. And when you initially bought with cash, you have 100% equity, so any refi is technically an equity pullout. Yet, I struggle to accept that a short-term cash infusion creates such dramatic tax disadvantage, as opposed to immediate financing (which is often impossible or impractical to obtain.)

This post is meant for my accounting colleagues - an invitation to debate, basically.

Let's consider scenarios.

1. (clear) You buy a rental with a $100k loan. Two years later, you refi into a new $100k loan with better terms. Is the interest on the second loan deductible against this rental? Yes, nothing to debate.

2. (clear) You buy a rental for $100k which needs $20k in repairs. You get a hard money loan for $120k. After rehab, you refi into a permanent $120k loan and start renting it. Is the interest on the permanent loan deductible against this rental? Yes, nothing to debate.

3. (clear) You buy a ready-to-rent rental with a $100k loan. Two years later, you refi into a new $120k loan, pulling out $20k equity in cash. Is the interest on the second loan deductible against this rental? Partially yes, albeit the "partially" thing is an unpleasant surprise to most investors. The interest on $100k of the $120k is deductible. The interest on the remaining $20k is not, unless this $20k is used to rehab this property. 

3a. If the $20k is used to buy another property, it could be deductible against that new property, requiring that you comply with interest tracing rules. Basically, keep this $20k separate from all other money and show that it was specifically applied to the closing or rehab on the new property.

                   And now we start getting into gray area.

4. (almost clear) You borrow $100k from your parents, unsecured, and use it to buy a ready-to-rent rental. 6 months later, you get a mortgage for $100k and pay your parents back. Is the interest on both the unsecured parents loan and the mortgage deductible against this rental? Looks like a yes to me. As far as I can tell, unlike with personal Schedule A mortgage interest, there is no requirement that the loan is secured by the property.

5. (almost clear) You buy a rental for $100k which needs $20k in repairs. You get a private loan for $100k and charge $20k for rehab on your business credit cards. After the rehab, you refi into a permanent $120k loan and start renting it. From the new loan, you pay off the initial loan and the credit cards. Is the interest on the permanent $120k loan deductible against this rental? Looks like a yes to me.

                   Finally - drum roll! - the really grey area.

6. (unclear) You buy a ready-to-rent rental for $100k cash. 6 months later, you get a mortgage for $100k. Is the interest on the loan deductible against this rental?

7. (unclear) You buy a rental for $100k which needs $20k in repairs. You get a private loan for $100k and pay $20k cash for rehab. After the rehab, you refi into a permanent $120k loan and start renting it. Is the interest on the permanent $120k loan deductible against this rental? 

My initial thoughts on #6 and #7.

This is business interest, not home mortgage interest. So we do not really have to consider the acquisition indebtedness concept here, do we? All we have to ensure is that the proceeds are used for business purposes. Refinancing a loan that was initially used for business purposes (purchase/rehab) seems to fit the bill, including private unsecured loans and credit cards. With proper tracing, of course.

Where I'm driving myself crazy is when cash enters the picture. If I have an LLC, and I formally loan my personal cash to my LLC (promissory note and all that) - that seems to work just fine. What if I do not have an LLC and do not have any documented lending?

How can our life be made easier?

• Stop issuing 1099-MISC with box 7 "non-employee compensation" instead of box 1 "rent"
• Stop including refundable deposits in rent income
• Provide annual reports clearly delineated by property
• Learn the difference between maintenance, repairs and improvements and report accordingly
• Report insurance reimbursements separately
• Provide supporting documentation: itemized contractor's invoices, insurance adjusters' reports etc

@Mark Anderson

I think you're risking to drown yourself in technical details before understanding the big picture. I will try to paint that big picture.

1. For tax purposes, you're buying two properties, not one. One is personal (1 unit), and the other is rental (3 units). All costs are allocated 25% / 75% between these two properties.

2. Costs allocated to the personal unit are not deductible, most likely - unless you have a lot of personal itemized deductions. So you will not get any tax benefit for 1/4 of mortgage interest, 1/4 of property taxes, 1/4 of insurance. 1/4 of utilities etc.

3. Costs allocated to the rental units will go against your rental income. If you collected $20,000 rent from the 3 units, and the 3/4 of your mortgage interest, taxes, insurance, repairs and whatnot are also $20,000 - then you have zero taxable income form renting. (Zero cash flow, too)

4. If your rental income is $20,000 and your allocated expenses are $15,000 - then you have $5,000 cash flow that should also be taxable income.

5. However, you can also subtract depreciation, which can kill this $5,000 taxable income and reduce it to zero. You are always allowed to reduce your taxable income to zero.

6. The next question is whether you can reduce it below zero - i.e. generate a tax loss which can be used against your other income, such as from a W2 job. This is where it gets complicated. If your income is under $100k - then you can create a tax loss of up to $25,000. If your income is between $100k and $150k - then the window for the $25k loss gets slowly squeezed out until completely shut at $150k and above. At this point, you can only have deductible losses if you qualify as a RE Pro - which is very difficult to qualify for. Impossible if you have a full-time job.

7. If you do have room for losses - then you may want to play some games trying to maximize the losses. One of those games is to dial up your depreciation by breaking out certain components like appliances, carpets, concrete etc. It is known as cost segregation or asset segregation.

8. If your losses are locked up by high income - then there is no point trying to increase them. All locked up  ("suspended") losses are pushed into the future years and will eventually be unlocked when you sell.

Even this is too long to read. Have anything shorter? :)

Seriously though, thanks @Lance Lvovsky.

@Cole Shawd

We need a context of your CPA's answer.

This is what I assume he meant, which is just a guess until you clarify. If your income (like a job) is over $150k, any paper losses that this property might generate will be locked up tax-wise until some future point: either your income drops, or you have some passive income, or you sell this property.

If your income is below $150k, you are likely to see some tax benefits right away. May or may not be substantial, which is another conversation.