Tuesday, April 13, 2010

Rent This House - Pay No Tax

In past posts I have tried tried to describe the math behind keeping the house as a rental. Main points:
  • Consider all expenses when calculating whether rental pays. Property tax is a big one!
  • Consider return on equity; if you have equity, you need to earn more than you would by selling and putting the money you get in a bank. (Of course, the banks will give you 0.0001% now, so that may be moot.)
  • Consider high transaction costs - it's just not cheap to buy and sell real-estate. In our case, we considered the market dislocation as driving up transaction costs (in that we'd have to have the house on the market for a while).
Well, it's April and the tax man is upon us.* Here is what I have learend:
  1. Losses on the rental property (there are a lot of up-front expenses; since we rented in October we're definitely in the red against those up-front costs for 2009) do not lower taxes on your regular work-type income. So we just "carry the loss forward" - that is, we can use our loss to pay less taxes next year if/when we make some money on the house.
  2. We have to depreciate the house - that is, we claim for tax purposes that it loses about $3000 of its value as an asset every year. This produces another "loss" for tax purposes.
If we have a good year with the house, we will still make less than $3000 in profit, so it turns out that due to depreciation, we will probably never have to pay taxes on the house.

To explain this second point in more detail: think of your rental house as a business; the business "buys" a house and thus has an asset. The IRS requires you to treat that house as losing value over 30 years. (This is silly because you will almost certainly be able to sell your house for more than $0 in 30 years, but hey, I only work here.) Your business recognizes a "loss" every year of a little bit, and thus you are less profitable to the IRS than you are in real life. (Clearly you didn't lose any real money to depreciation.)

There is a flip side: when we go to sell the house, the price we paid will be lowered by all of that depreciation. We paid $400,000 for the house (plus closing costs), so the odds of us making money on selling the house are approximately zilch. But for tax purposes, the price we bought at will appear lower for every year of depreciation.

(The IRS calls this "recapture" - the idea is that we really did think the house was trending toward $0, so when we actually sold it for more than $0, we were surprised that we made that unexpected money. Again, this strikes me as very silly indeed, but I'm not in charge.)

The final piece of the puzzle: if we have accumulated "losses" with the IRS every year (it's possible, because depreciation will be larger than our profit margins) we do get to use those losses against selling. So when it finally comes time to sell the house, the taxes on any gains (should they, due to some freak accident, exist) will be made larger by depreciation but smaller by losses carried over.

Does this affect the net calculation of whether it pays to rent a house out? I don't think it really matters substantially. It does change all of the numbers a little bit, but the way I see it, there are enough unpredictable factors (how long will you be renting, what will future interest rates be, what will the rental market bear) that the unknowns dwarf the imprecision of calculations done without correct tax treatment.

* You should really not treat anything I say on this blog as professional advice. The best thing to assume is that I am a computer programmer who is woefully under-informed in financial matters, because, well, I am a computer programmer who is woefully under-informed in tax matters.

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