Ever since the housing market bottomed out, real estate has become a great investment. Naturally, income properties should be approached with caution and only by those with decent credit and deep pockets. All-cash deals are easiest to close since banks are too shell-shocked to deal with iffy credit risks.
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Care should also be taken when selecting properties; foreclosures and short sales provide wonderful opportunities, but naïve investors could be bitten on the rump if they don’t know the ins and outs of these transactions.
“Short sales are a lot safer than foreclosures because there are a lot of lawsuits flying around about illegal foreclosures. You may pay for the house but it will turn out you don’t own it after all. And all your money is gone,” says Bodhi Kraus a broker with Priority Lending in Santa Rosa, Calif.
“Banks at first would allow only four financed properties,” Bodhi continues. “Six months ago they extended the number to 10. But if you are an investor with four financed houses, you cannot finance an owner occupied house.
“Gone are the days of 100% financing. Most bankers charge three points with only 20% down and only 1.5 points if you put down 25%.Credit scores must be in the range of 680 plus and interest rates on investment properties run in the high 4s and low 5s,” Kraus states.
All that said; let’s talk about some of the common misconceptions about what is deductible when you purchase, own, and operate a rental property.
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1.You are allowed to write off the down payment. Wrong! This expense is part of the basis of the property and is not deductible on your tax return. You still get the write off, albeit indirectly, via depreciation. Here’s how that works: you buy a property for $100,000. You put down $20,000 and pay $5,000 in closing costs. Your basis in the property is $105,000. After deducting the value of the land, you write off the remainder over 27.5 years for residential property and 39 years for commercial property.
2. Closing costs are deductible. No, they are not. They are added to the basis of the property and are deducted via depreciation over the useful life of the property as described in example 1 above. But take a close look at the closing costs. There may be some expenses listed there that you paid for, e.g. insurance and property taxes which are currently deductible. Always give closing papers to your tax pro, whether it’s for a purchase, refinance, or sale of a rental property or your own personal residence.
3. Points are deductible. Points are only deductible in the year of purchase for your personal residence. For a rental property, points may be deducted ratably over the period of the loan.
4. When you sell an income property, your mortgage balance is deducted from the selling price to determine your taxable gain or loss. No, no, no! Your mortgage balance is not a factor in the equation. The IRS couldn’t care less if you financed or paid cash for a property. The basic formula is: selling price less selling costs and your basis in the property. If you sold the $105,000 rental property purchased in example 1 for $205,000 and paid out $19,000 in closing costs and sales commissions plus $1,000 for a roof repair, your taxable gain would be $80,000 - $205,000 – ($19,000+$1,000).
5. Income received from rentals owned in foreign countries is not taxable. Check with Charles Rangel (D-Harlem) on this one. He was confused about the taxability of rents received on his villa in the Dominican Republic. Why was he confused? “Because,” he says, “I don’t speak Spanish.” This was one of the reasons he was censured by Congress. Don’t get yourself censured. It’s taxable income, OK?
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.