A big hurdle for long-time owners of investment real estate is paying the capital-gains tax – people don’t like writing big checks to the IRS! But if you are thinking of selling a rental property, here’s a reminder that next year it’ll be worse. From latimes.com:
CNBC’s Larry Kudlow on Wednesday tried to get Treasury Secretary Timothy Geithner to clarify where the administration stands regarding the top tax rates on dividend income and long-term capital gains, which are set to rise on Jan. 1 without congressional action. But Geithner’s answer may just have confused matters for CNBC viewers.
“We’re going to make sure that we keep at 20% the existing rates on dividends and capital gains,” Geithner said. “We think that’s good policy.” But the “existing” top rates aren’t 20%, of course. They are 15%. Those were the cuts President George W. Bush pushed through Congress in 2003.
The 15% rate on long-term gains will revert to 20% on Jan. 1 unless Congress acts. Dividend income would return to being taxed at ordinary income tax rates, currently as high as 35% and scheduled to rise to a top rate of 39.6% in 2011.
thoughts for those dividend investors.
Currently REITs are ‘penalized’ vs. typical dividend paying stocks as you must pay ordinary income on the REIT dividend while other stocks get the 15% treatment. This is due to the theory that the income is not taxed at the corporate level first (or the theory of take as much $$$ as you can from whomever you can).
Thus the spread in taxation between a REIT (39%) and ‘other’ dividend stocks (15%) is a whopping 24% EXTRA TAX (160% increase in your dividend tax).
If all dividends go to 39% then the REIT penalty will disappear (REIT taxes stay constant) and you may see a bump in share prices (i.e. reduced yield)as they now become marginally more attractive compared to other dividend stocks.
I would imagine other dividend stocks will consider raising their dividend to counter the effect of higher taxes otherwise investors may flee due to reduced income and relocate to higher income stocks (REITS or other MLP’s etc)
Obviously, many keep high dividend payers such as REITs in IRAs, etc to shelter from the taxes, which is wise.
Well chosen PUBLICLY TRADED REITS are a good way to get exposure w/o the drama of our local market…and they’re liquid too.
Research, Research, Research first.
If someone has not already prepared and planned planned to sell their small investment property (e.g. SFH or condo) this year it may be too late to do so effectively, since the best target buyer would be owner-occupier. For larger investment properties where having existing tenants is positive, you still have some time.
I would expect to see some selling pressure in the second half of this year (more so in equities than property because of the liquidity differences). It is unlikely that legislation would be enacted soon enough to impact rental property owners. However, legislation enacted by November could forestall an end-of-the-year clearance sale on Wall Street.
July 8 (Bloomberg) — Mortgage rates for 30-year U.S. loans fell to the lowest on record for the third straight week, reducing borrowing costs for homebuyers as unemployment and foreclosures weigh on demand.
The average rate declined to 4.57 percent in the week ended today, the lowest since Freddie Mac began compiling the data in 1971, the mortgage-finance company said in a statement.
Clearfund, do you have a favorite REIT at the moment?
On property, considering that many have capital losses in their rental/flipper homes, waiting to sell till next year with higher tax rates is a better move.
Higher tax rates equals a greater post tax loss that you can harvest.
I am in the exact situation where I have sat on my “income” property when I otherwise would have sold. I think that in a perfect world, capital gains tax should not apply in certain situations. For example, I have a house I have lived in for years, I need to move to another city for employment, then I rent out the place at a loss. Now I want to move back to my place, but would like to sell it to upgrade to a better one.
Why should I have to pay capital gains tax on the profit versus the person who also only owns one home but did not have to move for a few years where the jobs were? It is not like this is a profit making investment property or a vacation home.
I think if someone only owns one property and they originally lived in it for a few years it should be exempt from any capital gains just like and owner occupied one. This reflects the reality that these days people are more mobile in general, unemployment is bad so they need to be even more mobile, and the economy is bad so you should not have to buy and sell every time you move to a new city for a year or two (and lose money on the transaction fees new/reset property taxes on the value).
I’m basically proposing that renting out your only property that you used to live in should not put it in the same bucket as an investment property that capital gains tax was meant to cover.
Brett–As far as I know, if you have occupied that home as a primary residence for two of the last five years, then it is already exempt from $250K ($500K if married filing jointly) in capital gains.
Good topic Jim. Folks potentially affected by this tax change should consider this fair warning. Since most of your readers probably have a few bucks in their piggy banks and/or have some assets, it seems to me that next year we will almost certainly have:
higher fed tax rates
higher cap gains rates
higher estate taxes
higher state taxes/fees (of various types)
All with significant decreases in local/state/fed gov’t services to boot. And that doesn’t even include the possible rise of inflation and interest rates.
I think the bigger question is: what is the tipping point where we can’t take it anymore?
@Local Boy: The key is the “if”. I am moving back after the 5 years. Had I succumb to the dis-incentive to hold on to it and just sell at year 5, I would have sold at the height of the bubble and upgraded. That means now I would be very underwater and tempted to live rent free, contributing even more to the problem.
It speaks to the many unintended consequences that occur when tax policy is put into place to try to modify behavior rather than to simply reflect a proper share of one’s money to contribute to public services.
Jinx – I am prevented from recommending specific stocks by my firm’s policy to keep us out of hot water…
I would look for apartment reits who have low debt (less than 60% of value), and a disproportionate % of units in CA. UDR comes to mind but don’t recommend as its run up huge (yield down to 4%).
There are a couple of Agency mortgage reits we own paying huge dividends above 10%. They only buy guaranteed AGENCY paper so principal/interest is guaranteed….we get in/out to stay liquid and collect dividends.
Also several good REIT mutual funds at Cohen & Steers to choose from.
Lastly, the MLPs, pipelines are solid dividend payers north of 6% these days (some in the 8% range).
Thanks clearfund. 🙂
@BrettinLJ, the situation you are describing is fairly specific and admittedly somewhat unfortunate. But, your idea of any primary residence being forever exempt from cap gains would be subject to a lot of abuse.
Taxes are returning to their pre-Bush (i.e. the last time the country was solvent) levels. It is what it is. Luckily I have enough carry over loss from 2008 to offset many decades of cap gains.
@Dr. Detroit: don’t count on inflation for a couple years. Deflation is still a big possibility.
Local Boy is partly correct on moving back in to avoid capital gains. The law was modified in 2008, so that the entire gain is no longer tax-free if the property was previously used as a rental.
If you have lived in the property 2 of the last 5 years, a portion of any gain will be treated as capital gains. The portion that is taxed is determined by the amount of time it was not owner occupied starting from Jan 1 2009 (grandfather clause).
For example, if you owned since 2000 and rented it out from 2002-2010 and moved back in on Jan 1, 2011 and live in it for two years selling in Jan 2013 you would owe tax on 2/12 of the gain (the 2 years held as a rental after Jan 1 2009 as part of the 12 years of ownership).
For those who held property long before 2009, this is still a good strategy. Prior to the tax law change, you could have held a rental for any period of time, simply moved back in for 2 years and wiped away any capital gains tax liability.
This is not advice nor is it bragging.
I completed the sale of all my income properties in April 2006. Location specific. These days I actively pursue properties that return anything close to positive ROI. I started in late 2008 but still see nothing interesting. My cache does not include JtR’s NorSD area to my loss.
Listen to Jim but keep in mind your tax situation as it might make a huge difference.
Rob Dawg
When are you going to post again? Liked your insight.
I liked the pretty pictures that went with the posts.
Clearfund,
I also highly recommend MLPs for certain investors, although many find the taxation rules very confusing, despite how beneficial they may be, some just want a simple calculation.
That said, the strongest point to be made is that a portion of the distribution is both tax deferred (to when you sell by reducing your cost basis) AND then taxed at the lower long term capital gains (assuming you hold for long enough). It’s a double benefit, but at the cost of some of the distribution (dividend) being taxed at your normal income rate.
As an aside, I have seen many MLPs that pay north of 10%. I think in large part because they are not well understood investments.
I am not an investment advisor, and anything you read on the internet about specific investment vehicles are worth what you paid for them.
However, read this:
http://www.dividenddetective.com/mlp_tax_considerations.htm
Rob Dawg-How many month’s worth of rent would you pay for a property (darn, I forget the acronym here)? That is, if you buy a house for $150k and rent it out for $1,500 a month, for 100 months rent, is that a good deal? Or would you need to find one for less, like 80 months rent? (I’m sure there are other factors to consider, like local vacancy rates, how high HOA fees and taxes are, etc.)
Rob Dawg-How many month’s worth of rent would you pay for a property?
I depends. Olde New England 90x monthly rent. Most of California 110x monthly rent. Greater San Diego and my similar area 120x/130x even.
That is, if you buy a house for $150k and rent it out for $1,500 a month, for 100 months rent, is that a good deal?
In stable California, yes. As long as Prop 13 holds and things don’t get worse.
Or would you need to find one for less, like 80 months rent? (I’m sure there are other factors to consider, like local vacancy rates, how high HOA fees and taxes are, etc.)
80x is not a possibility these days. With all due respect to our host good deals rarely make it to our attention.
The schedule K on the mlps are a pain the first time you bumble around learning how to file them. After you’ve done it a few times it’s quite an easy process and not anything to fear. As long as you don’t own 100’s of them it’s well worth the effort.
Recall that you are supposed to depreciate the structure at 3.6 or so percent a year. So when you sell you pay tax on the depreciated basis not the original one, plus any long term improvements. This is actually the dodge that makes RE so attractive in that part of the rental income is tax free until the property is sold. Then you pay cap gains on the depreciation, so that you have converted regular income into cap gains.
Lyle,
One thing that people often forget in the initial calculation is that you only depreciate the structure, not the entire amount.
Add in that structures ACTUALLY depreciate, and you have to put money into them and newbies quickly realize that unless you’ve got the the thing rented nearly 100% of the time (and to do that you have to spend real money, out of pocket), and a poorly maintained rental turns into a money pit quickly.
I have several stories about landlords that have had to pay to fix a water leak, while simultaneously paying for a tenant’s hotel room AND replace their belongings. That’ll put a big hole in the cash flow statement. Besides, when was the last time someone saw a rental investment that even penciled out within an hour’s drive of the coast? It’s been a long time.
Not trying to disparage someone from landlording, but I can find much better ways to invest for my lifestyle. It’s not fun or glamorous, or very profitable when everyone and their cousin is trying to do it too.
Chuck
As a professional tax accountant, I see lots of confusion and misunderstanding in the comments here. Everyone’s situation is different, seek a qualified professional, it’s worth every penny!
Rob Dawg-That’s good information. The reason I picked the $150k/$1,500 a month number is because that is what I paid for my Riverside house (in which I live in) and the minimum amount I believe I could rent it out for. I don’t do so, because I need a place to live and don’t have an extra $150k lying around to buy another place. But if I ever moved out of the area, I would attempt to rent it out instead of selling it. At the very least, gross rent is significantly higher than my monthly payment (including taxes and insurance).
I am convinced that Riverside is a great place to find a rental property. The numbers pencil out, on paper, much better than anywhere closer to the coast (anywhere in San Deigo, Orange, or LA counties). The only downside is vacancy levels and/or level of flaky tenants (unemployment around here is rather high), which I have no way to determine. Maybe Section 8 is actually the way to go out here, for a property in this price range; my understanding is that since the tenants get so much of their rent comped by the government that they go out of their way to keep the place up. Dunno; this is mostly an intellectual exercise for me personally.
Chuck – your comments are spot on. People severely underestimate the financial downside/risk of residential rental operations. At the very least, the operational downside outweighss the operational upside. Pipes can always break and cost lots of $$$, but rent can rarely rise quickly to offset the risk.
I believe that people associate a low probability of an event occuring with low risk…not the same. Ask BP and their insurance companies.
This must be why we gravitated over the years from apartments, to retail, to concrete tilt-up industrial on NNN leases. Operational downside is very limited, and when we replace a tenant we just slap some white/grey paint and hose it out…done! Learned awhile ago that I don’t enjoy the headaches associated with real estate operations as they don’t pay you extra for those.
Aside from their obvious management issues, Residential Rentals at 10 times gross or less, coupled with low interest rates, are FANTASTIC investement vehicles. For first-time Real Estate investors, they can get them into the trade-up position(s) that Clearfund has described. When I bought my first rounds of rentals (mostly 2-4 unit properties), my criteria was if they produced enough revenue to pay for themselves on a 15 year mortgage, then, even if they never go up, we just own them free and clear in 15 years and then clip some coupons. We got lucky with our timing and traded-up as well. Some more posatives–lower down payments and longer, more favorable mortgages!
LB – that’s a good buying strategy. Staying conservative like you described keept you pretty well positioned to ride out issues.
Problem is that most people only focused on the appreciation, overpaid, and didn’t understand operational risk.
Thus we are where we are today.
Chuck you are right its just like owning your own home. Note that a lot of what you suggest is expenses not necessarily capital expenses. Fixing the leak and the nominal provision of interruption of business insurance for the Tennant is a big cash flow hole, but unless it resulted in a major part of the plumbing being replaced would not be capital, so it would be a direct that year expense. But of course just like with a house you have to maintain, new roofs electrical upgrades, and the like.
I was more pointing out depending upon timing you may have fake capital gains to pay taxes on.
It would be interesting if the US took the old UK approach where you got imputed income on your owned home equal to the rent, but then filed a different form as if the house were a rental. What would this model do to the home ownership rate?
Local Boy-The prices on 2-4 unit properties seem to be rather cheap compared to similiar single family houses. But sometimes then you might have to worry about whether or not the second (or 3rd or 4th) unit is property permitted.