So, You Want to Be a Military LandlordRetirement Funding Taxes Managing Your Finances
Being a military landlord can be financially attractive even into retirement where your rental properties can provide another source of income. It can also jump up and bite you if you don’t know what you’re doing. For most of us, we’d rather not get bitten. Let’s see if I can help you out with that.
You May Be in the Military, But You’re Now a Business Owner Too
The first thing you need to do is get your head right. That means you have to start thinking like a business owner. You need to start thinking about dollars and cents and keeping good records. It starts with determining if the house you’re living in will be a good investment when you PCS and turn it into a rental. A couple of formulas might help you with that.
- Net Operating Income (NOI)
- NOI = Estimated Total Income – Estimated Operating Expenses (do not include mortgage payments).
- Calculating NOI allows you to determine if you will generate enough income to pay your mortgage
- Capitalization Rate (Cap Rate)
- Cap Rate = NOI/Value of House (What you paid for it, not your downpayment)
- You can use this to compare your house to other things you could invest your money in.
- Cash Flow
- Cash Flow = Expected Rent – Expected Expenses
- If this number is negative, you’ll need to dip into your other income to cover the rent. This may not be sustainable.
- Cash on Cash Return
- Cash-on-Cash = Before Tax Cash Flow/Total Cash Invested
- Use this to determine if you’re getting your required return on the investment
Once you take a look at these metrics and determined that turning your house into a rental is financially feasible, you have one more important number to figure out. Basis.
You’ll need to depreciate your rental property (We’ll get into what depreciation is in a bit). To depreciate the property, you'll need to calculate basis. To do this you’ll need some key datapoints.
- Purchase price of the structure. You’ll start with the purchase price of the house and add in certain expenses of the purchase (like transfer taxes). You’ll also need to determine the value of the land at purchase. If you’re lucky, the appraisal done when you purchased the house breaks out the value of the land. If it doesn’t, you’ll need to do your best to figure it out. One way to do that is to look at your property tax assessment and determine the ratio of the value of the structure and the value of the land to the total value. Use the ratios to determine the value of the structure and the land when the house was purchased. If neither of these methods will work for you, talk to a realtor and get an idea of the normal ratio of structure and land to total for sales in your area. Do this calculation first and then add the expenses of the purchase to the value of the house.
- Home Improvements. If you made improvements to the house, you add those improvements to your initial basis (purchase price of the home). If what you did increased the value of the house or increased its life expectancy, it is considered an improvement. For example, putting in new windows is an improvement. Fixing a broken window is not. Add your improvements to the purchase price and you’ll get your adjusted basis. If you purchased the house to rent and never lived it, you’re done with basis calculations (for now).
- Basis versus Fair Market Value (FMV). If you lived in the house, you need to compare your adjusted basis with the FMV of the house when you put it up for rent. If the FMV is less than the adjusted basis, you’ll use that number to calculate depreciation. Don’t lose your adjusted basis though, as you’ll need it later. If your adjusted basis is less than FMV (the typical case), you’ll use adjusted basis for the depreciation calculations. You don’t need to keep track of the FMV.
Put the House Up for Rent When You PCS
You’re now ready to rent the property. You may or may not want to hire a property manager. If you’re not going to be living near the property (typical for a military PCS), a property manager may make sense. Also, a property manager can help you determine an appropriate amount to charge for rent.
At this point, you’ll want to set up your “books”. You have a couple of options. You could purchase software like Quicken to track income and expenses. You can also track your income and expenses on an excel spreadsheet. What do you track? Pretty much everything. Or, put another way, “If you’re spending a buck to make a buck, it’s probably deductible.” You’ll also need to track income from all sources. If you need some help with what to track and what categories to use, you might want to take a look at Schedule E to Form 1040. This is the form you’ll use to report your rental activities on your taxes.
Keep in mind that improvements are not deductible in the year paid for. You will depreciate these over their lifespan.
Now you can just count your money as it rolls in (and probably deal with some “issues” as well).
Filing Your Taxes as a Military Landlord
The first year of filing your taxes will be the most difficult. It may be worth it to hire a tax professional. Do your research. Not all preparers working in tax offices are CPAs or Enrolled Agents. Some have minimal training. Be careful with tax software. I’ve seen plenty of errors on rentals on taxpayer prepared tax returns. Here are the main things you’ll need to do.
Watch for a Form 1099-Misc from your property manager (if you have one). The form will include the income you earned from the rental and will be entered on Schedule E.
Pull the year’s expenses from your “books”. These will also be entered on Schedule E
Account for Depreciation on Your Military Rental
This is the big one and the place where people make mistakes. So, let’s start with one major warning. Depreciation is not optional. You must depreciate the property, or you will be operating an unauthorized accounting system. To calculate the depreciation on the property you’ll need the adjusted basis (not including the value of the land) and the date the property was placed in service as a rental. You’ll either enter this information in your software or provide the it to your tax preparer. Depreciation will start on the 15th of the month you placed the rental in service and go for the next 27.5 years. At the end of 27.5 years, you should have “used up” all the adjusted basis of the property. If you make improvements to the property while it is a rental or replace appliances, they will be entered as a separate item to depreciate. This paragraph is important. Read it again.
What Happens if Your Military Rental Shows an Operating Loss?
If the rental operates at a loss, that loss may be deductible against your other income. If your Adjusted Gross Income (AGI) is less than $100,000 and you actively participate in the rental, you can deduct up to $25,000 in losses. If your AGI exceeds $150,000 you receive no deductions in the current tax year. The deduction phases out between $100,000 and $150,000 of AGI. If you can’t deduct the losses in the current year, they’ll carry forward until such time as you have a profit from rental activities or sell the property.
Your Military Rental May Trigger a State Tax Obligation
Oh, and by the way. You may think you don’t have to worry about state taxes since you’re a resident of TX (or FL, or WA, or some other state without an income tax). You’d be wrong. States are authorized to tax the business activities conducted in their state by non-residents. And…the Servicemembers Civil Relief Act (SCRA) only protects your military compensation and your spouse’s wages and/or wage like self-employment income from taxation. If you have a profit, you need to file a state return and potentially pay taxes. You might want to file one if you have a loss too. It’s up to you.
Remember, You're a Military Member and a Business Owner
Businesses are required to file Form 1099-NEC for any person they paid $600 or more, unless that person is an employee. You're also required to file a Form 1099-NEC if you paid a lawyer or law firm any amount of money (tells you what the IRS thinks about lawyers). These forms are due NLT 31 Jan of the year after you paid the individual.
Selling Your Military Rental
At some point you’ll want to sell your property. This more likely than not will result in a tax bill, even if you think you’re not making much money on the sale of the house. Let’s start with the basics.
When you sell the house, you’ll have two types of gains. The first gain is commonly called depreciation recapture. Remember how you were telling the IRS that your house was wearing out and becoming less valuable (depreciation)? If you sell the property for more than what you depreciated it down to, the IRS wants the taxes back that you saved as a result of the depreciation. Remember, you don’t have the option to not depreciate the property and you’ll owe taxes on the depreciation allowed or allowable (in human language that equals the depreciation you took or should have taken). The second gain you’ll be taxed on is the difference between the purchase price plus improvements and the amount you sell it for minus expenses of the sale. These are normal capital gains.
Most likely you’ll pay a 20% tax rate on the depreciation recapture and 15% on the normal capital gains. You might also pay an additional 3.8% Net Investment Income Tax (NIIT) if your AGI exceeds $250,000 if your filing status is Married Filing Jointly (MFJ) or $200,000 if single.
While it doesn’t affect the gain calculation, if you have suspended losses (because your income was too high), they’ll come on to the tax return at this time. The losses will reduce your overall income.
In the rare situation where you used FMV as the basis for depreciation and you sell the house for a price between the FMV of the house and the basis calculated based on the purchase price, you’ll have neither a gain or a loss…I've never seen it.
Enter the Military Primary Residence Exclusion
All married taxpayers can exclude up to $500,000 of capital gains on a primary residence. Single taxpayers can exclude $250,000. The basic requirements for the primary residence exclusion are that you must own and occupy the home for 2 of the 5 years ending on the date of the sale. That might be hard to do if you rented the house due to a PCS. Congress realized that and provided some relief via the tax code.
If you rent the house due to official extended duty (a PCS normally qualifies), you can choose to have the 5-year test suspended for up to 10 years. This means that you only need to live in the house 2 out of 15 years ending on the date of the sale. The suspension ends when you are no longer on official extended duty. Two things to watch for:
- If you move back to the area of the rental, the suspension ends unless you are required to live in government quarters
- The suspension ends when you retire
That doesn’t mean you're in like Flynn. The exclusion does not apply to depreciation recapture. You’re required to pay the tax on the depreciation recapture. Unless…
You Can Defer Depreciation Recapture on Your Military Rental
There is one other option that you have. The 1031 exchange. In a 1031 exchange you exchange your rental property for another rental property and if done correctly, you’ll defer taxes on the depreciation recapture and normal capital gains. Fortunately, you don’t have to literally exchange one property for another (although you can). You can sell your property and buy a replacement using a deferred exchange.
Deferred 1031 exchanges have lots of rules though and you need to follow them or you’ll void the exchange and the tax advantages. First of all, you’ll need to execute the sale of the rental and purchase of the replacement through a Qualified Intermediary (QI). There are companies that provide this service…for a fee. The next hurdle involves dollars and cents. You can’t receive any cash as a result of the exchange and the mortgage on the replacement property must exceed the pay-off of your old mortgage. If you receive cash or if the new mortgage is less than the pay-off of the old mortgage, you’re receiving “boot” and it is taxable. The last major hoop is procedural. You must identify, in writing, up to 3 replacement properties within 45 days of closing on the sale of your rental. You must close on the purchase of the replacement property within 180 days of the closing on the sale of the rental. It’s worth noting the number of properties doesn’t have to be equal. In other words, you can exchange one rental for two rentals. You just need to be careful about boot.
I’ll remind you that you can only defer taxes through a 1031 exchange, you can’t eliminate them (with one notable exception). When you sell the property, all the depreciation will come onto your tax return and if you’ve run out the 2 of 5 (15) primary residence exclusion, you’ll pay taxes on capital gains as well. The notable exception? If you own the rental property until you die, the basis will step up to its Fair Market Value (FMV) as of the date of death. Depreciation recapture and capital gains disappear.
Wrapping it up for a Military Landlord
Rental properties provide tax advantaged cash flow and potential capital gains. Due to the leverage of a mortgage, the rate of return can be impressive. But they’re extremely easy to mess up. You need to have thing figured out and mind your books or you’re going to run into problems and/or expensive bills for someone to fix your mistakes. Make sure you’re ready to take it all on.
Military Finances are Different
The exception to the primary residence exclusion isn’t the only place in the tax code where Active and Retired Senior Military Officers and NCOs are treated differently. There are a lot of other financial opportunities and pitfalls waiting for you too. That’s why we think you should work with a Financial Planner/Advisor that deals with your issues each and every day. If you’d like to find out how we work with clients like you, use the button below to schedule a free initial consultation.
If you found this article useful, you might like the following blog posts:
The Strickland Decision (and IRR 78-161) and You
Get a Bigger Tax Refund than Expected the Year You Retired from the Military?
The Court has Spoken: The Rumor You Heard About Tax Free Military Retirement Pay is Not True