Insurance
You, as a landlord, should double-check your insurance policy's fine print to ensure you're covered for common tenancy mishaps. Many landlords have taken out a building policy, often called a 'landlord' product, and assume they're covered, only to find out later the cover is severely limited. Standard building insurance offers some protection for landlords, but often contains clauses excluding malicious damage by a tenant, accidental damage, legal liability and cover for the loss of income. But as the owner of an investment property, these are the very reasons why you would make a claim.
The level of cover and premiums charged for landlord insurance differ from broker to broker. Before signing up for 'landlord insurance', check that it covers the following risk factors:
> Malicious damage by a tenant - This includes everything from holes punched in walls and kicked-in doors to intentional damage to carpets and floors.
> Accidental damage - This covers unintentional damage to a property. Accidental damage also covers the actions of small children, but excludes gradual wear and tear.
> Legal liability - Includes expenses incurred for any lawsuit that arises as a result of a tenant suffering bodily injury or property damage or loss.
> Loss of rental income - In instances where malicious damage has been caused to a property, a loss of rental income may result while the property is repaired or cleaned. Loss of rental income also can result from absconding tenants, defaulting payments, death of a sole tenant, failure to give vacant possession or a court awarding a tenant a release from lease obligations due to hardship
Additionally, if you live on the property, you should obtain mortgage disability insurance as well.
Tax Implications
One of the benefits of investing in real estate is tax savings. Property can be a great way to shelter income from the taxman. However, the value of the tax breaks can vary depending on how much you earn and what you do for a living. The best breaks go to middle-income folks who manage their own properties. But even so-called passive investors and high-income taxpayers can reap some rewards.
For instance, the cost of maintaining and marketing a rental property can be deducted from the income the property generates, without regard to the owner's tax status. These expenses include mortgage interest payments, insurance, utilities, maintenance, repairs, advertising costs and management fees, as well as the non-cash cost of depreciation.
Depreciation is supposed to reflect the diminishing value of a tangible asset over time. If you buy furniture for a rental house, for example, it's likely to wear out over the course of several years. The value of that furniture is depreciated--written off as a deductible expense on your tax return--over a five-year period.
In the case of rental real estate, the value of the home or apartment complex is assumed to go from the price you paid to zero over the course of 27½ years. (There are no depreciation expenses for the land under the building, because land isn't expected to wear out.) In reality, of course, homes and apartment complexes don't necessarily fall in value. In fact, they often become more valuable. So depreciation expenses frequently reflect phantom costs that can be used to shelter otherwise taxable income.
Here's an example: Let's say you buy a four-unit apartment building for $500,000, putting $100,000 down and financing the rest. Your $400,000 mortgage at 7% interest costs about $2,662 per month. Management fees, repairs, insurance and marketing expenses cost an additional $500 per month. The monthly rental income is $1,000 per unit, or $4,000 total. That works out to positive cash flow--income after expenses--of $838 per month, or $10,056 per year. That would normally be taxable income, costing about $3,000 in federal taxes, assuming a 30% marginal tax rate.
But, you are also able to depreciate the building. You divide the cost of the structure--let's assume $425,000 after subtracting the cost of the land from the $500,000 purchase price--over 27½ years. That provides a $15,454 annual depreciation expense, which qualifies as a deduction on your tax return and completely eliminates the tax obligation on the $10,056 in rental income.
What happens to the $5,398 in excess depreciation expenses? Here's where your income and occupation come into play. Most people are restricted from claiming "passive" losses--rental real estate generally is considered a passive investment activity unless you're an industry professional--that exceed their passive-investing income in any given year. Thus, while these losses could offset income from other rental properties, they normally can't be used to offset your wages or income from interest or other investments.
There are two exceptions:
1. If you are a real estate professional who spends more than 750 hours a year buying, selling or renting properties, you can write off an unlimited amount of passive losses.
2. If you are not a real estate professional but are actively involved in renting the apartments--determining the rent and approving the tenants, for example--and your modified adjusted gross income is less than $100,000 annually, you can use as much as $25,000 in passive losses to offset ordinary, non-rental income each year.
From the example, if you qualify for either of those exceptions, you could use the entire $15,454 in depreciation on your rental property to shelter income--whatever its source--thereby saving $4,636 in federal income taxes.
What if you're not a real estate professional, aren't actively involved in the investment or make more than $100,000 a year? Your ability to claim losses in excess of your "passive" income--that's all the income this apartment generates, plus any income you may receive from other rentals--is restricted.
If you earn less than $150,000 in modified adjusted gross income, you will be able to claim a partial deduction for the losses in excess of your passive income. However, if you earn more, you can save these passive losses to use in another tax year when you have more passive income. You still get the deductions, but you might not get them right away.
These deductions can prove highly valuable down the road. The reason: Many people who buy rental real estate keep it for decades--long after the mortgages are paid off and the out-of-pocket cost of owning the property is slim. In the meantime, rents presumably rise along with inflation. So in those later years, you are likely to have lots of income and fewer tangible expenses.
I hope you enjoyed this blog article.
To your financial success,
Peter Wolfing
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