Thursday, December 17, 2009

Thank you, Internal Revenue Service

I decided to write this post yesterday after answering a reader's questions about the costs of ownership of a vacation condo. Back in June this year I wrote a post entitled "Positive cash flow. Does it exist?" In that post I explored a hypothetical case detailing expenses, income and other factors related to an investment condo and how they affected the chances of achieving positive cash flow. One factor I did not discuss was the contribution that favorable tax laws make to the overall picture of investment condo ownership. I will use another hypothetical weekly rental condo and explore the effect to overall return that tax deductions will make for an owner. (Disclaimer: I am not an accountant (not even close) and do not claim accuracy nor am I offering tax advice here. This is just a hypothetical case using my understanding of current tax laws. Please consult your accountant and/or tax lawyer before making decisions based on my writings.)

We'll use a $280,000 weekly rental condo in this scenario. We'll assume a 30% down payment (Fannie Mae requirements for 2nd home condos) on a 30 year mortgage at 5.5%. Our fixed monthly costs will be (estimates but close to reality);

property taxes__ 374
condo fees_____ 350
utilities________ 130
insurance_______ 70

Let's project a conservative average of $800 per week for our unit and a conservative 50% occupancy for the year. Management for weekly rental units runs from a low of 10% to a high of 40% in our area. Keeping our example conservative, I'll use the above-average 35% charged by the very efficient team at Cape Winds in Cape Canaveral for our example. That means that our 26 weeks at $800 will net the owner $13,520 after the 35% management fee, a shortfall of $10,912 to our annual expenses. Not looking so good at this point. Those two weeks a year of personal use are going to cost over $5000 each. Ouch! Not so fast. Let's look at the tax benefits. According to IRS publication 527 the following expenses are deductible.
  1. Advertising.

  2. Cleaning and maintenance.

  3. Commissions.

  4. Depreciation.

  5. Insurance.

  6. Interest.

  7. Legal fees.

  8. Local transportation expenses.

  9. Points.

  10. Rental payments.

  11. Repairs.

  12. Tax return preparation fees.

  13. Taxes.

  14. Travel expenses.

  15. Utilities.

[Edited: Thanks to Anonymous CPA for pointing out the math errors] All of our example monthly expenses of $2036 are included in the IRS allowed deductions except the mortgage payment. The interest part of that (average for the year of $892/month) is, however, included. That comes to a total of $21,792 of deductible expenses for owners with active participation. The IRS also allows for depreciation of investment property over a 27.5 year period. That means that for each year of ownership of our $280,000 condo, we will be able to deduct $10,181.82 as depreciation. In this example our investment condo will generate $31,973 of legal tax deductions ( expenses plus depreciation). After offsetting the deductions with the income of $13,520, we are left with $18,453 of net deductions saving the owner $4613 to $5166 in taxes assuming our condo owner is in the 25 to 28% tax bracket. [As pointed out by Anonymous CPA, the limit for deductions is $25,000 per year which would max out the savings for a 28% taxpayer at $7000.] Remember that this is using a conservative 50% occupancy unit with high management costs. In this example our unit does not achieve positive cash flow. I have used management charges at the high end of the scale (35%) and modest 50% occupancy as I prefer to project conservatively so that my surprises are good ones. Good management is available for considerably less than 35% and occupancies of more than 26 weeks a year are common.

But wait, there are other benefits and deductions. A well-informed and law-abiding owner can generate additional deductions including but not limited to some acquisition costs in the year of purchase and travel expenses to manage, conserve or maintain the property. In addition, with higher occupancy and/or lower management expense the numbers can look significantly better. Conclusion; a rental condo at today's prices can come close to paying for itself and, with good management, generate cash flow. Let's also not forget that an owner is allowed to use an investment property for the greater of "14 days or 10% of the total days it is rented to others at a fair rental price". [Edit: I didn't mention possible appreciation or mortgage principle paydown over time nor depreciation recapture taxes upon the sale. The combination of all three could be either a net positive or negative. No way to accurately project without a crystal ball.]

These same rules apply to units rented for longer than weekly periods. The overall numbers are generally less for units that rent for monthly or longer periods but the tax benefits still apply and will make the costs of ownership considerably less than at first glance. As always, do your homework and talk to your trusted expert before making a purchase. Non-American citizens, I have no idea how your tax laws treat your ownership of American investment property.

I hope this was helpful and not too confusing. I also hope my errors are minor. I expect to hear from readers more informed than I. Please contribute your thoughts, observations and experiences to the comments below. And to everyone reading this, I hope you have a happy, safe, rewarding holiday season filled with love and joy.

"Unless we make Christmas an occasion to share our blessings, all the snow in Alaska won't make it 'white'."
__________Bing Crosby


  1. An accoutant's response to the 12/17 Post: Well pretty much of what he said is right. His figures don’t add up tho. He was doing really good until he came up with yearly expenses and the totals. I don’t see how you will ever come up with a positive cash flow. I don’t see it, he would have to show me that on paper. Cause the expenses alone come up to 24432 a year. And renting for 26 weeks is only going to net you 20800, and then you have to pay 7280 in management fees. Where is the positive cash flow every going to come into the picture? Not with those figures. And the total loss of deductions you would take is roughly 21,000 not the 39000 he claims. And if the difference he is coming up with is additional expense for you to fly down there ( but remember you have to show that the trip was business. If you go for 14 days, and 6 hours of one of those days is used for taking care of the rental property, you only get to take 1/14 of the trips expenses) and take care of the property….remember to have a deduction you have to spend the money. So if he is claiming another 18000 in expenses (?) he had to have 18000 to spend. Technically he is right. But there is a law limiting investment rental property losses to @25000 per year. And he says nothing about the income tax implications of when you dispose of that property. That 10,181 of depreciation that you’ve taken every year has to be recaptured and you have to pay income tax on it. Let’s say you’ve owned it for 10 years. That’s 101,810 of income to claim, just on depreciation, not to mention the capital gains tax on the gain from the sale. So technically everything you’ve gained in the past is eaten up by the sale and the ordinary income from the depreciation. I’ve never seen rental property purchases and sales every come out good for the owner of the property. Unless you are going to own that property till the day you die, and let your heirs worry about the taxes.

    I think he’s looking thru rose colored glasses. But I’m not a big fan of rental property. So take that into consideration too.

  2. Thanks for pointing out my math error. I added management fees back in to expenses but I had already netted them out. I have edited the post to correct it.

    As to positive cash flow. I suggested it was possible with cheaper management and higher occupancy, both of which are available. I deliberately made my example conservative.

    It's reasonable to expect that some of an owner's travel expense will be deductible as most perform some aspect of managing, conserving or maintaining the property when visiting. It probably won't amount to much but it's imprudent not to take legal deductions.

    About depreciation recapture; I think it's reasonable to expect for owners who hold on to a property for a long period that appreciation and principal paydown will offset recapture and capital gains taxes.

    As always, I could be wrong. Please point out any misinterpretations or errors and thanks for joining the discussion. BTW, If you'll read back through my older posts I think you'll see that my glasses usually tend more towards a dark shade than rose-colored. I'll try to keep my brief bursts of optimism under control.

  3. From another CPA (thanks): A couple of clarifications on your latest post

    1. The $25,000 per year is total, not per property

    2. The $25,000 is only available if your AGI is less than $100k per year, above that the maximum amount currently deductible gets reduced 50 cents on the dollar. (this is the Passive Activity Loss rules)

    3. This assumes you have no passive income (which is gain from another passive activity, not interest dividends, etc.)

    4. Losses disallowed are carried forward indefinitely to use under the $25,000 allowance or against future passive gain.

    5. The depreciation deductions reduce ordinary taxable income but when the property is sold (at least under current law) the depreciation "recapture" is taxed at a maximum rate of 25%

    6. There are special rules for people who work in the real estate industry which could help them deduct more than the $25k per year.

    7. Some portion of the purchase price should be allocated to land which is not depreciable (also if a furnished unit is bought you can depreciate the purchase price allocated to the furnishings over shorter period).

    8. Acquisition costs would be capitalized as part of the cost of the property and depreciated

    9. If the average rental is less than a week, the property would be depreciated over 39 years instead of 27.5 and the special $25k allowance wouldn't be available.

    Bottom line, if you're going to buy a rental, do your planning on a straight cash on cash basis and let any tax benefits be a little bonus you get later on.

  4. Interesting discussion. Rather than getting bogged down on the accounting details, I would like to know a little more about the Management charges for Condo Rentals. You mention a range of 10-40% but is there any correlation between the management percent and the number of weeks rentals can be expected? Also, are the monthly rental rates determined by the owner or the rental management firm? As a prospective buyer, are there records that can be reviewed on rentals associated with a condo being considered for purchase? If a seller says his unit is rented weekly for 80% of the time, how could that be verified?

  5. There is a definite difference in occupancy achieved by the different management companies but it is not directly correlated to their charges. The best management results are often by owners doing their own management. Makes a nice boost to the net as well. It is entirely possible to manage a unit yourself from afar as long as you have a reliable local contact for emergencies and a dependable cleaning person (sometimes it's the same person). I have heard owners claim 45 weeks occupancy doing their own management and I have personally gotten 42 weeks rented in a good year. Best way to confirm previous years' records is to ask for the sales tax records. Expect your results to differ depending on how much personal time you spend in the unit and which style of management you choose. Giving your manager discretion on rates is usually best as long as you can trust them. Cutting the rate can make the difference in getting a last minute renter. If my unit is not booked for next week and I get an inquiry today, I'll cut a deal to get it filled. I'd rather get half price for a week than zero.