The Money Commando

For tax reasons you should buy your neighbor’s house (and sell him yours) – part 1

TheMoneyCommando

As a financial planner I see the whole spectrum of attitudes towards taxes. Some people don’t really care about paying taxes – they figure that if they are paying lots of taxes it means they are making lots of money. Some consider it their civic duty to pay taxes and are happy to do so.

At the other extreme I have seen people who will do anything to pay less taxes. They will invest huge amounts of time and effort, to reduce taxes to the bare minimum. If they have to spend 10 hours of planning to reduce their taxes by $1 they will. Some see taxes as theft. Some just think the government is wasteful and they see reducing their taxes as a way to fight government inefficiency.

And of course we’ll always have the people who are willing to anything, no matter how unethical or illegal, to reduce their taxes.

This post is based on an idea for the second group of people – the people who are willing to go to extremes to legally reduce taxes. This idea came to me after reading a post on Gen Y Finance Guy, which was in turn inspired from one of my own posts. So, I guess in a way you could say that I inspired myself.

Personal Deductions

The key to this tax strategy relies on two things:

Let’s talk about the standard deduction first. 

Every taxpayer gets a standard deduction. The standard deduction allows each taxpayer to earn a certain amount of money tax-free. Prior to the 2018 tax year that was $6,300 for an individual and $12,600 for a married couple filing jointly.

 In 2017 the amount was changed. Starting in 2018 the standard deduction has been raised to $12,000 per taxpayer ($24,000 for a married couple filing jointly).

To reiterate, the purpose of the standard deduction is to allow each person to earn up to $12,000 completely tax-free (or $24,000 for a married couple filing jointly).  You only pay taxes on the amount that your income exceed the standard deduction. This is why your actual/effective tax rate is always lower than your marginal tax rate, even if you’re in the lowest tax bracket. 

When it comes time to pay your taxes you can either take the standard deduction or you can itemize your deductions.

Itemizing your deductions means adding up all of the various expenses that the US Congress has decided to allow you to deduct from your income. These include mortgage interest on your personal residence, charitable deductions, some health care costs, property taxes, state taxes, etc.

They key is that you take EITHER the standard deduction OR you itemize your deductions. You don’t take both. If the total of your itemized deductions are higher than your standard deduction then you’d itemize. If the total of your itemized deductions is lower than your standard deduction then you take the standard deduction.

Let’s look at a few examples of when you’d take the standard deduction and when you’d itemize your deductions.

Example 1

You are single, you make $100,000/year, and you recently bought a house for $350,000 (with 20% down). You live in a state with high income taxes (like California). Your personal property taxes are 1.1% of the value of your residence. You have a 30-year mortgage at 4.5% interest, which means your monthly mortgage payment is $1,418.72. For your first payment, that number breaks down to $368.72 in principal and $1,418.72 in interest.

Your itemized deductions are (I’ve rounded these numbers to the nearest $100):

Total itemized deductions = $23,850
Standard deduction = $12,000

Your itemized deduction ($23,850) are higher than your standard deduction ($12,000) so you’d itemize your deductions. Note, however, that the actual value of your itemized deductions are only $11,850, which is the amount that your itemized deductions exceed your standard deduction. After all, you’d get the standard deduction even if you had 0 itemized deductions.

Reread that last paragraph again, as that concept is key. Your itemized deductions are only useful to the extent they exceed the standard deduction.

Example 2

You are single and making $50,000/year. You recently bought a house for $200,000 ($40,000 down, 4.5% interest, $160,000 initial loan balance). Your mortgage payments are $810.70/month, of which $210.70 is principal and $600.00 is interest for your initial payment). You live in a state with no personal income taxes (like Texas). Your personal property taxes are 2.0% of the value of your residence.

Your itemized deductions are:

Total itemized deductions = $11,600
Standard deduction = $12,000

In this case you’d take the standard deduction. Note that in this case you actually get no tax benefit from your charitable deductions, your mortgage interest, or any of your other itemized deductions. If your total itemized deductions don’t exceed the standard deduction then your itemized deductions have no value (at least for tax purposes).

Let’s review our key concept again: Your itemized deductions are only useful to the extent they exceed the standard deduction.

In this case your itemized deductions didn’t exceed your standard deduction, so there was no value in your itemized deductions.

Example 3

You are married and you and your spouse combine to make $250,000/year. You recently bought a house for $750k ($150k down, $600k loan, $3,040.11 monthly mortgage payment, of which $790.11 is principal and $3,040.11 is interest for your first payment). You live in California, which is a state with high income taxes. Your personal property taxes are 1.1% of the value of your residence.

Your itemized deductions are:

In this case, our itemized deductions are limited by the new cap on SALT (State And Local Taxes). That is, our state income taxes + property taxes are capped at $10k. Our total itemized deductions would normally be $17,175 + $8,250 + $26,800 + $2,500 = $54,725, but in this case they are actually $10,000 (max for SALT) + $26,800 + $2,500 = $39,300. The cap on SALT has resulted in a loss of $15,425 in deductions.

Total itemized deductions = $39,300
Standard deduction = $24,000

This tax payer would obviously itemize deductions, but note that a married couple making $250,000 would be in the 24% income tax bracket, so the loss of $15,425 in deductions (due to the limitation on SALT) has cost them 24% * $15,425 = $3,702 in additional taxes.

Business deductions

Ok, so now that we understand deductions for personal expenses, let’s look at deductions for business expenses. The key difference here is the there is NO standard deduction for business expenses. Business pay taxes on every penny of profit, and this means that ALL business deductions have value (in that you can deduct them from your business income, no matter how small they might be).

For example, let’s say you own a rental property. For tax purposes this counts as a business. Tax law allows you to deduct anything that was reasonably used in the production of income for your rental business. NOTE: that’s not the language of the law, and there are tons of exceptions and exceptions, but that’s the high-level intent of the law.

For a rental property you’re allowed to not just deduct your property taxes and mortgage interest, but you’re also allowed to deduct homeowner’s insurance, repair costs, and depreciation on the property. None of those things are allowed to be deducted for personal expenses. Also, note that there’s no equivalent to the SALT limitation for business expenses.

Let’s go through the same examples that we used for the personal deductions, but let’s say that instead of buying the properties to live in, you bought them and are renting them out.

A few notes – depreciation is a big deduction for rental properties. For residential property you are allowed to deduct 1/27.5th of the value of the STRUCTURE (not the land) per year. The idea is that building wear out and need to eventually be repaired/replaced, but land doesn’t wear out.

For all of these example we are assuming that you bought the property on January 1st, meaning you can use the entire depreciation deduction in the first year (otherwise it’s prorated depending on when you bought the property).

Example 1

You bought a house for $350,000 and are able to rent it out for $2,000/month. Property taxes are 1.1% of the value of the property. The house is worth $200,000 and the land is worth $150,000. 

Income:

12 months @ $2,000/month = $24,000

Deductions:

Since these are BUSINESS expenses rather than personal itemized deductions, we are able to deduct things like insurance, repairs, and depreciation that are not allowable for personal expenses.

Total deductions = $26,622

Cash flow:

The actual cash flow differs from deductible expenses in two ways. First, depreciation is a non-cash expense. That is, you get to deduct it for tax purposes but it doesn’t represent money out of your pocket. Second, your actual cash flow is reduced by the payments on the principal of your mortgage. 

Actual expenses  = $23,850

Business profit

Taxable profit = income – deductions = $24,000 – $26,622 = -$2,623
Cash flow = income – actual expenses  = $24,000 – $23,850 = $150

A few things to note here.

First, depreciation is a non-cash expense. Unlike, say, insurance, which requires you to write a check every year, depreciation does not represent money out of your pocket every year.

The cash flow is the actual amount that goes into your pocket once all expenses are paid. So even though you’re showing a loss for tax purposes of $2,623 for the year, you’re actually making $150.

Second, a taxable loss can be used to reduce your overall taxable income. As long as your earned income is less than or equal to $100k then you can deduct the full loss against your earned income for the year. Your ability to deduct the loss in the current year phases out from $100k – $150k, and above $150k you can no longer deduct the loss in the current year. Instead, you must carry the loss forward into future years and use it against future rental profits.

Finally, for most real estate investors, this can mean years of cash flow without paying any taxes on your rental income. If you have multiple properties you add together all the taxable losses and profits for all properties and only pay taxes if you have a total profit.

The big idea

Ok, so here’s what all of this has been leading up to – if you can change expenses from personal expenses to business expenses then you can “double dip”.

Remember, itemized deductions are only valuable to the extent that they exceed your standard deduction. 

If you are married and filing jointly then your combined standard deduction is $24,000. If you have itemized deductions of $20,000 then those itemized deductions have no value.

But if you could convert those to business expenses, then you can claim ALL of those expenses AND the standard deduction. Instead of being able to use EITHER the $24,000 standard deduction OR the $20,000 in itemized deductions, you’d get to use them both, resulting in $44,000 in total deductions.

How can we do this?

Simple. What if, instead of buying a house to live in, you bought the house and rented it out instead? That would allow you to use the standard deduction against your personal income, plus fully deduct your mortgage interest, property tax, etc. Of course, you’d still need a place to live, so you’d need to rent a house for you to live in.

Theoretically, you’d expect your after-tax income to be the same. After all, if you own a property it shouldn’t really matter financially if you live in it or if you rent it out and rent an identical house for you to live in, right?

Wrong.

Using this technique the amount of money left after paying taxes and housing expenses actually goes DOWN!

In part 2 I’ll go through the math. It’s a bit complicated, so I wanted to put it in a separate post.