Curt's Chalk Talk - Live! Rental Real Estate
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So you've decided to be a military landlord. So we think there's a few things that you might want to know about before you go down this path and today we're going to talk about those. Hi, I'm Curt Sheldon of CL Sheldon and Company, and as mentioned today we want to talk about a few key things that you need to know about if you're going to be a military landlord.
So the first thing we want to talk about is something called depreciation. Now, depreciation is, like I said, one of the things we see a lot of problems with, because it's not intuitive. Now it is maybe if you talk about a car, but with a house it's not. So here's how it works. When you buy a rental property, a property that you're going to rent, that is a business expense. But that property is going to last for several years. And the IRS doesn't allow you to take that full expense in one year. Instead, they require you to depreciate it over the life of that asset. Now, in the case of residential real estate, that asset the IRS has determined is going to last for 27 and a half years. So in essence, you're going to take 127.5 of the value each year as an expense as your building wears out. Now again, it makes more sense with a car. When you buy a car, we know that it becomes worth less value each and every year. That doesn't make as much sense with a house, but it still applies.
But that's going to cause you some problems in the future. When you place that property on the market for rent, we're going to want to depreciate it, again about 3.6% per year. Well, what's the amount that we do depreciate? Well, the amount that you depreciate depends upon the purchase price and the fair market value of when you put it on the market to rent. You're going to take the lower of those two numbers, so the fair market value or the cost plus improvements, and that's going to be the amount that you depreciate. But you want to make sure that you do not include the land in the amount that you depreciate. So let's say you bought a house for a $100,000, $20,000 of that is land value, and the fair market value on the date that you put it up available for rent is $150,000. Well, the lesser of the two is the purchase price, $100,000, we're going to take out the $20,000 worth of land, and you're going to depreciate $80,000 over those 27.5 years.
Now, sometimes people will say, "Ah, I don't want to mess with that. It just sounds like a lot of work." Well, here's the issue. When you sell the property, you are going to owe taxes assuming the property goes up in value, which more often than not real estate does. You're going to owe taxes on the depreciation allowed or allowable. Now, if you don't speak IRS, allowed or allowable means the depreciation you took or should have taken. So if you don't take depreciation, you could be subject to tax on a benefit that you did not take.
Now the good news is there is a way to fix this. You can do what's called a change to accounting method, and you're going to report that on a Form 3115. And I'll be honest here, I said you're going to report that on a 3115. The 3115 is a very complicated form, and more likely than not, you're going to need professional help to get this taken care of. But the idea is since you are operating an unauthorized accounting system, since you are not depreciating the property, you want to account for that and change your accounting system and bring the depreciation that you should have taken onto your tax return. So that is a way that you can fix it if you fail to take depreciation. And you're going to want to, because as I mentioned, you're going to pay tax on the depreciation that you should have taken.
Now, that's going to apply, and we'll come back to this in a second, but that's going to apply whether you qualify for the primary residence exclusion that allows you to exclude up to $250,000 of gains or $500,000 of gains if you're married, 250,000 if you're single. Depreciation recapture is not included in that amount. So we want to make sure that we get this depreciation accounted for and that we pay the tax on it when it's due, whether it qualifies as our primary residence or not.
Now, while you're operating your rental property, you're going to have a couple other things to keep track of when it comes to your property, and that is the idea of an expense versus an improvement. And I'm going to abbreviate that to improve. Okay, so expenses are deductible in the year that they occur. Improvements need to be depreciated over the life of the property. So what's the difference? In general, anything that increases the value of your property or extends the life of the property is going to be considered an improvement. As an example, you put in new high-end windows into your rental property. That would be an improvement because it one, increases the value, and two, it also probably increases the lifespan of the property. And you're going to depreciate those since they're a part of the property over 27 and a half years starting when you put them in. If on the other hand, a baseball goes through your window and you replace the window, that's an expense because it's a repair that you're going to expense in the current year.
So there are some exceptions where you can treat small improvements as expenses, but they're a little bit complicated the rules on that, and we won't go into that today. But just keep in mind, if it increases the value of the property or extends the life, then you're going to depreciate it. If it's bringing it back to its original state, fixing a broken window, then it's a repair and you're going to expense it. Along that line if it's an appliance, you put in a new dishwasher, a new stove, a new refrigerator, those are also capital assets. They'll be depreciated but since they're not part of the structure, they'll have their own lifespan, which is to my recollection, five years for appliances. So you'll depreciate those over five years.
Now, earlier I mentioned the ability to exclude gains on a primary residence, and that's technically the Chapter 121 exclusion. Now, generally speaking, that exclusion applies if you have lived out in the property for two out of the last five years. You can sell it and exclude up to $250,000 if you're single, $500,000 if you're married, of capital gains from your income. It never shows up on your tax return. You don't pay taxes on it. Now, there's a special rule for the military, and actually foreign service as well, that if you move out of your residence due to military orders, basically a PCS 50 miles or more away, or you're required to move into government quarters, then you can, and I'll call it suspend the clock, for up to 10 years.
So you have basically, let's say for example, you live in the house for two years, you have to move out due to military orders, the clock stops. And let's say you stay away from that property for 10 more years. So we get to the 12 year point. The clock starts again. You have up to three more years to get two out of five to qualify for this Chapter 121 exclusion. Remember though, even if you qualify for that, you're going to have to pay taxes on the depreciation recapture.
Now, as I mentioned, that exclusion applies if you are required to move for military orders or you're required to live on base. I am of the opinion that when you retire, or if you move back into that area, you're no longer absent due to military orders and the clock starts again. It's not clearly defined in the IRS code. That's the conclusion that I've come to based on the wording. Again, your absence is due to military orders. Once you retire, then you are no longer absent, you have the option to move back, and in my opinion, the clock would start again. If you get stationed back at the same base, now you're no longer absent due to military order. Again, I think the clock would start again.
Now, I saw an article a while ago or a post on Facebook about someone talking about their friends who had several rental properties and they would move back into them for two years and then sell them and they'd get the exclusion every year. There's only one problem with that, and it's not really allowed. It has to do what's called non-qualified use and I'll just write that as non-qual. So what the code says is if you set the property up as a rental, and you rent it for a while, and then you move back in, you have what's called non-qualified use for that time that it was rented. So let's say you're not a military member or you've retired and you live in the house for two years. You move out, you rent it for six years. And then you move back in for two years and you're thinking, "I've lived in it two of the last five years. I can exclude $250,000 worth of gains if I am single, $500,000 of gains if I am married."
Wrong. According to the IRS, that time period of six years that it was rented is considered non-qualified use. So you're going to have to take your gain from the time you purchase it to the time that you sold it, and you're going to have to take six-tenths of it in this case, and that six-tenths worth of profit is not eligible for the 121 exclusion. So you want to be, we're very careful with this about moving back into a house. Now, there is some good news, again for military members, if your absence was due to military orders and you move back in, it does not trigger non-qualified use. But I'd go back to my same position if you're retired and you move back in, I think probably the time from your retirement until the time you move back in is going to be considered non-qualified use. So we want to be careful with that if we're considering moving back into a property. It's not a well-known part of the tax code, but you want to make sure that if it applies to you, you apply it correctly.
Then the last thing I'll hit real quickly is should you even rent at all? So a couple numbers that you might want to think about is the first one is called cap rate. And cap rate equals your net operating income, so I'm just going to abbreviate that net NOI, divided by the value of the property or the value of the house. And that's going to give you some number, some percent. And again, this is not the amount of money that you put down, it's the value of the property when you put it up for rent. And you can use this result to compare it with other investments. So let's say you run this number and it comes back 2%. You look at real estate investment trust because you do want to be invested in real estate, and that comes up to about 4%. Well, maybe the real estate investment trust is a better option than renting your property.
One thing to keep in mind is due to the huge amount of leverage that rental real estate has, it tends to distort our perception of returns because our actual money in is not that high but if you were to put a similar investment into, say, the stock market where you put $2,000 down and you got $10,000 worth of stock, that would magnify your returns as well. By the way, potentially magnify losses, which can actually occur in real estate, although most people think it isn't possible.
Then the other number I'll take a look at and that kind of, again, it helps you to see whether the investment is worth the time or not is called cash on cash. And it is your cash flow, before tax, so how much money, cash in, minus your expenses, divided by your cash that you invested. And that can give you an idea. Again, now we take the leverage of the mortgage out of the equation and gives you a pretty clear, "Okay, I put my cash flow is $2,000 a month, $24,000 a year. I put a $100,000 in on the property. I'm getting a 24% return on my cash." And again, it may be better for comparing one against another than a should I rent or not. But these again, can give you some ideas on what you might earn on your investment before you just kind of follow the water cooler talk that you can't lose money in real estate and that you should invest.
So we're at about our 15 minute point. Those are the things I wanted to cover for today. Give you an idea and a primer on things you need to be thinking about if you're renting real estate. With that, I'll check the chat real quick to see if there are any questions. At present I don't see any and I don't believe I see any raised hands. I may have just raised mine. So I'll give it another second, but if we don't have any questions, I'll wish you a happy Thursday and weekend. You will be getting a recorded version of this webinar. If you have any questions, feel free to reach out to me at curt@clsheldon.com. That's Curt, C-U-R-T, @clsheldon.com. Again, thanks for being here today and we look forward to talking to you in about a month.