This is part 2 of an analysis about how to leverage the differing tax treatment of deductions for business vs. personal taxes.
In Part 1 we discussed how the standard deduction makes itemized deductions much less valuable, then talked about how business expenses work.
In Part 2 we are going to explore the math to see how you come out ahead if you buy a house and rent it out vs. buying a house to live in.
Assumptions
Let’s run through an analysis based on the following scenario:
You are married and together you and your spouse make $100,000/year. You recently bought a house for $350,000. You put 20% down ($70,000) and took a 30-year mortgage @ 4.5% interest for the remaining $280,000. Your monthly payments are $1,418.72, which breaks down to $368.72 in principal and $1,050.00 in interest for your first payment.
You live in a state with high income taxes (like California). Your personal property taxes are 1.1% of the value of your residence. The house is worth $200,000 and the land is worth $150,000.
Your itemized deductions are (I’ve rounded these numbers to the nearest $100):
- State income taxes: $6,500
- Property taxes: $3,850
- Mortgage interest: $12,500
- Charitable deduction: $1,000
We are now going to run through the calculation of how much money you have left after paying taxes and housing costs for the scenario where you buy and live in the house vs. buying the house, renting it to somebody, and finding an identical house to rent (and live in).
Rental profit/loss
First, we need to calculate the profit/loss for renting out the house.
We are going to assume that you can rent the house for $2,000/month. That’s a slightly conservative number for a $350,000 house.
Here are the calculations:
In the first scenario (“Live in house”) you have no rental profit/loss because you’re not renting the house to anybody.
In the second scenario (“Rent out house”) you have 2 different sets of expenses – tax deductible expenses and actual expenses. A tax deductible expense means you get to claim it as an expense on your tax return. An actual expense means that you took money out of your pocket to pay the expense.
The difference between the two is that depreciation is a tax deductible expense but not an actual expense, and payments towards the principal on the mortgage is an actual expenses but not a tax deductible expense.
You have a loss of $2,623 for tax purposes but cash flow of $150.
Personal Tax Return
Let’s now do a direct comparison of the total costs involved in both scenarios.
Income
We see the big difference right away – if we are living in the house then our income is unchanged at $100,000/year. However, if we rent out the house we are able to use the taxable loss to reduce our income. If we rent out the house our income (for tax purposes) drops from $100,000 to $97,377.
As we will see later, this is huge, as a lower income means lower federal, state, Social Security, and Medicare taxes.
Itemized Deductions
In the scenario where you are living in the house you have a number of itemized deductions related to your house. These are the property taxes and the interest on your mortgage.
Unfortunately, the total of these ($16,350) are less than the standard deduction for a married couple, so these deductions aren’t useful.
In both scenarios we take the standard deduction of $24,000.
Taxable Income
Taxable income is just your total income minus the greater of your standard deduction or your itemized deduction. In both scenarios we are taking the standard deduction of $24,000 for a married couple.
Tax
This is the big difference between the two scenarios. Because our taxable income has been reduced by our rental loss, we end up paying $725 less in taxes than in the scenario where we live in the house.
Housing
We now have to calculate the actual housing costs in each scenario.
In the scenario where you live in the house the actual costs are the same as what we calculated in the rental profit/loss section above.
In the scenario where you are renting out the house and then renting an identical house to live in we will assume that you’re paying the same rent per month that you’re charging – $2,000/month.
We see that the total difference between the two scenarios is $150. This makes sense, as it matches the profit we calculated in the rental profit/loss section above. Basically, you make $150/year in profit by renting out the house, but you pay $150/year more when you rent the house to live in vs. owning it.
Totals
After considering the cash flow from the rental property, taxes, and your housing cost, you end up having an additional $725 if you buy the house and rent it out vs. buying the house and living in it.
Notes
This calculation doesn’t consider the down payment since it’s identical in either case.
The business deductions are extremely conservative, as we aren’t including any additional business related expenses (office deduction, mileage to/from store to purchase repair supplies, office equipment used to manage the rental, etc.) All of these would further increase the business deductions, which would reduce your taxable income and further reduce taxes.
Conclusion
By moving our real-estate related deductions from our personal tax return to the rental business tax return we were able to reduce our taxable income and reduce our income taxes.
The purpose of this exercise wasn’t to convince you to actually sell your house and trade with your neighbor. Rather, the idea is to show how the increase in the standard deduction has increased the incentive to create your own business(es) to optimize your taxes.
You can reduce your taxes by thoughtfully planning your finances so that you can legally (and ethically) convert personal itemized deductions to business deductions.