Question about self rental

[PandaBear]

Just paid off 2 houses (1 for my family and 1 for my inlaws to live in as family support), and was thinking about buying a bigger one to live in and turn my current home into a rental, as the one I'm living in is kind of small for our family size. The target would be a 2-2.5M single family home (really nothing to write home about here, 4 bedroom 1960s ranch style or 1990s spanish style of 1800-2000 sqft in a good district). The problem is, I won't be able to afford it and make sense out of it (mortgage, property tax mainly, in today's tax environment without getting into the politics).

So, let's say if I buy that 2.5M house with my parents (I'm an only child), and combine our holding together into a real estate rental business. They currently have some properties that will have enough income after expense to take advantage of the massive 2-2.5M single family home's mortgage and property tax, then if the rental business rent it to me at market rate (say 5k a month), it would still be below the mortgage and property tax combined. I know this doesn't make sense in most business environment but this is how it is in this area's rental market, and why no one buy a property at today's price to rent to you at today's price.

So in the end, let's say we do everything legally and to market value, it would be me and my parents pooling together our holding to form a rental partnership, then after the income and expense I will pay to rent this house at market rate then the profit of this business get lowered due to the weird market rate not being profitable. Will this be legal? If this is legal what is the down side of this? (FYI my parents current rental income is in the much lower tax bracket, say 14% federal, and my current income is in the much higher tax bracket, say 28% federal, for example. In my area I already pay so much in state income tax that even if I itemize deduction i won't be able to deduct the property tax, plus from what I remember only the first 1M of mortgage will be interest deductible). Currently I am doing Federal standard deduction and California itemized deduction.

 

[PandaBear]

Also another question: currently my parents are living in 1 of the N unit of their properties and when they do tax, they use the N-1 portion of the expense to calculate the tax expense base, instead of paying themselves rent and then deduct the whole expense. This in theory should make sense but they also have rent control in the building, so the expense likely accelerate faster than the rent in the future in the long run.

Would it make sense or be illegal if they switch to 100% rental income - 100% rental expense for tax filing, but rent to themselves in the same "rent control market rate" contract?

 

[ABN_CBT_ENGR]

given the unique laws there, you would be best served to consult both a local attorney and CPA because what's allowed in some areas may be radically different that the situation you are in.

 

[Dave Hess]

Sounds like you need to talk to a CPA or lawyer specializing in this field, just my opinion.

I would stay put if I were you and not take on ANY additional debt. Seems too risky especially if there is a job loss, illness of your parent(s) , renter getting laid off, unforeseen problems out your control caused by _____ , etc....

 

[OppositeLocK]

Agree with the others. Pay a CPA to pick his brain for an hour or two.

A lot of people want to be landlords and they don't understand the tax implications.

CPA first, lawyer second depending on the legal structure you want to set up.

 

[Andrew1972]

I would not take a mortgage for a rental. If you do can you manage the risk of non paying renter for a year. Consider recent events and impossible eviction. Would that stress you financially carrying a mortgage for a year + financial costs?

Real estate can be great investment however carries risk. Known three people who went into bankruptcy due to rental over their heads all carried mortgages.

 

[JC1]

I would not take a mortgage for a rental. If you do can you manage the risk of non paying renter for a year. Consider recent events and impossible eviction. Would that stress you financially carrying a mortgage for a year + financial costs?

Real estate can be great investment however carries risk. Known three people who went into bankruptcy due to rental over their heads all carried mortgages.

Given the state of the world today, I would not be doing something like this. A lot of people In the Toronto area were doing this before and plenty lost due to the state of the world and the rental market or Airbnb's collapsing.

Can you handle uncertainty and stress if all goes bad?

 

[Andrew1972]

There is also great reward with mortgages I left out. Age 21 purchased first home in 1996 for 105k 3% down. I sold in 2001 for 250k putting about $3000 in improvements.

I had little to lose then except credit rating, but in situation now I would never do that.

 

[gfh77665]

I would be scared to do it given the state of affairs in CA. Houses and rentals are kind of like stocks, they are forward looking. If they have flown into the stratosphere (like in CA). they are poised for a fall. I see people are fleeing NYC like crazy right now. Rents and property values are plummeting there.

 

[RhondaHonda]

$5k rents on a $2-2.5M property is insane. I wouldn’t do it in this economy/market or any other for that matter.

 

[PandaBear]

So to clear it up, I did some research last night and found that self rental will basically get IRS to throw out your self rental part from your passive income and deduction, and you won't be able to group them together with your other properties to spread the income and deduction. That's basically end of discussion and it won't do you any good. Also if you buy it and use it as your businesses "office" they would likely audit why your office mortgage is a big part of your portfolio expense and why you buy a 2.5M house for an "office".

So the options are now:

1) Stay put, build a she shed in the backyard and use it to "expand" our living area. This will be interesting as wife already complains that we have a small yard and a small house. It is also not comfortable to live in a shed cheaply build or a pita to build it right.

2) Rent a bigger house and rent out our smaller house. We are sort of experienced as landlord already so this is just one extra property to manage, and as long as we screen our tenants ok we should be fine for a few years. The good thing is this house we live in now is not rent controlled and we are likely going to be flexible and can move back when it is time (assuming 1 of the 2 kids would like to move out instead of "staying at home"). Cost would be totally deductible against rent (i.e. $4000 rent - $1000 property tax - $3000 new HELOC will break even in schedule D). The HELOC I take out can be used to pay for future rent of a place I will be living in, or invest for long term capital gain, for example.

Wife shot down the idea because she doesn't want to rent, she wants to "change things around".

3) Rent out the current house and just buy a bigger house. Let's use the above equation to break even, we will be able to get approximately, 900K out of a cash out mortgage for our current house and still make it self sustaining. That 900k will be affordable for down payment of the 2.5M house wife want, then each month we will pay approximately 2600 on property tax and 6800 on mortgage. After other expenses it would probably cost us about 10k a month give or take. This will be a big loss compare to renting for 4500 a month, but if hyper inflation kicks in (that 2.5M house becomes 3M) may not look so bad. On the other hand if a market collapse (i.e. that 2.5M drop to 1.8M or so, unlikely to go much lower) happen I would probably be screwed. Personally I prefer not to think about this, as houses in this price range usually doesn't make sense for investment.

4. I told my wife she can achieve anything she wants if she puts in the effort. She need to quit her low paying job and go learn coding and make 200-300k a year, then we don't need to worry about not able to afford her dream house. Or, she can come to her own conclusion that this does not make sense and she should just be more realistic.

Wife got the hint that I wasn't really trying to force her to make more money, just try to be realistic. This is a good way to end the discussion politely.

5. Move somewhere else. I don't think this is a good option while I am still working and our kids are the reason we need a bigger house. We also have family near by so it would be a chain reaction of a lot of people moving. We also like the weather here so we will be very picky about where to move to (likely no colder than Oregon and no hotter than Southern California). It is not likely a good choice.

6. I move out of the house, so the 3 of them can have the perfect amount of space. They don't feel secure and wife don't want to be dealing with kids all day while I enjoy my life in a man cave.

7. Home expansion, our neighbor did it before. It took them a year and by my ball park figure probably about 200-300k. So consider how much it cost to rent somewhere else (4.5K a month) while this property (1.5M) sit vacant and is worked on, it does not make financial sense. We like the way this house is laid out and we don't want a bad extension to ruin it.

8. Just ignore my wife, this is probably the best option as most of the above options will end up making my wife mad or I mad, and come to an even worse conclusion than this one. I'd pick this any day of the week.

 

[gfh77665]

Consider #5! You would be amazed what 500K would buy you in TX.

Homes and Houses for Sale in Texas

Search real estate properties in Texas.

www.har.com

or

Homes and Houses for Sale in Texas

Search real estate properties in Texas.

www.har.com

or

https://www.har.com/mapsearch/?map_...&bedroom_min=5&square_feet_min=4000#m30774937

There are about 100 more examples in and around Houston alone.

 

[PandaBear]

Thanks for the suggestion, I really do not like the weather in TX. I like the people though.

 

[Dave Hess]

Do what makes your wife happy and you out of the dog house in the backyard.

I’d still talk to a CPA or lawyer. You don’t want any additional tax burdens due to a misunderstanding of IRS rules.

 

[tiger862]

I Louisiana I wouldn't want to be in the rental business. With pandemic you can't be evicted for non payment until things change. They're people 6 months behind which landlord is furious with some threatening bankruptcy. Had one found a way to evict a lady then after court she burned apartment complex causing many to be homeless. I think he used disruptive to describe her to court to get her out as her 5 month of non payment wouldn't even get to court.

 

[JHZR2]

I recall reading somewhere that you can’t rent to yourself for tax and funds shielding purposes. This is definitely a local CPA question.

The good thing is this house we live in now is not rent controlled and we are likely going to be flexible and can move back when it is time (assuming 1 of the 2 kids would like to move out instead of "staying at home"). Cost would be totally deductible against rent (i.e. $4000 rent - $1000 property tax - $3000 new HELOC will break even in schedule D). The HELOC I take out can be used to pay for future rent of a place I will be living in, or invest for long term capital gain, for example.

I suspect all money to be made in RE has been made in your area. And when the economy does a cyclic tank, it will tank there BAD.

If you can rent a desirable $2.5M home for $4000/mo, I don’t see how there’s even a question.

A $2.5M home, with 20% down, 3.5% 30yr mortgage appears to be just under $9k/mo before taxes or insurance.

And you’d pay >$1M In interest.

Even if those numbers are way off, and you’d put 50% down and have a $4500/mo payment, IMO it will just put more capital at risk. Politics aside, the “have nots” greatly outnumber the “haves”, and a $2.5M homeowner is not a pauper anywhere but in the microcosm of the Bay Area.

And not that Covid has shown how few folks need to be in the office, and what folks can get doneaway from the office, while then at area may still be HQ, I suspect many will get smart, and away. And prices will take far worse there.

Not a risk I’d take if I could get a $2.5M home for $4k and turn my existing home into a cash cow.

Even if I misinterpreted the numbers, doesn’t seem like a good place/time to make such a move. Maybe once CA tanks, I’d reconsider.

 

[dareo]

You could get 5 homes in that vintage but double the size in Utah for 2.5 million. One in my area, 4200 sq ft for under 480k. And Utah isn’t even cheap on housing, it’s rather expensive!

 

[dareo]

A more serious comment: if you lived in it for 2+ years and own it outright, you can sell and not pay capital gains on a lot of the profits. I assume cap rates to rent stuff there are terrible, maybe 3% return. I was in a similar but much more normally priced situation and I sold, went to stocks with my equity, and purchased a new home with 5% down. (Wife=VA loan). Let’s say I could have made $1500 a month after expenses renting the old place. Instead I invest in REITs, petroleum MLPs and other stuff that pays nice dividends. Now I can average 10% with just leaving it alone and much much more actively trading them and selling covered call options. Now instead of a single rent check, I get predictable cash flow. Instead of paying part of my new mortgage with a rent check, I pay for it all, and the car loans, and all the utilities too. And I never have to clean it, show it, fix toilets, wonder where the late rent is. Been there, it’s hard money to earn. Stocks are so much easier.

 

[PandaBear]

Not a risk I’d take if I could get a $2.5M home for $4k and turn my existing home into a cash cow.

Even if I misinterpreted the numbers, doesn’t seem like a good place/time to make such a move. Maybe once CA tanks, I’d reconsider.

My thought exactly. Even with hyper inflation it won't get any higher. Around here it seems like any reasonable home (i.e. non VP / CEO of FAANG or drug kingpin) would max out at $3M in prices, even during the crazy days. 2.5M of real money instead of rolling another home's gain into it seems unlikely, and unrealistic. I would prefer not to sell my current home as I like it and my daughter (5 year old) insist that I pass this house down to her instead of her 8 year old sister (I'll need to pass something else down to her instead)....

Regarding to "all the RE money to be made had been made in my area", yes it already happened. The original reason for the cost is the high paying jobs here due to the unicorn start ups and FANG out bid each other, and their workers outbid each other in purchase and rent. Even before the pandemic this has cooled down a lot due to 1) the SALT tax cap since 2018, 2) unsuccessful IPO of many companies like Uber, Lyft, WeWork, Snap, etc, 3) startup funding dried up (sovereign fund based). 2015-2017 is the peak and things have sort of cooled down a bit already, but nowhere close to a crash or mass layoff yet as tech stock and hiring are still doing well, and most buyers are financially well. They know they are overpaying and they know they can afford it "for the family" instead of "it will go up 15% year over year using other people's money" like 08.

 

[PandaBear]

A more serious comment: if you lived in it for 2+ years and own it outright, you can sell and not pay capital gains on a lot of the profits. I assume cap rates to rent stuff there are terrible, maybe 3% return. I was in a similar but much more normally priced situation and I sold, went to stocks with my equity, and purchased a new home with 5% down. (Wife=VA loan). Let’s say I could have made $1500 a month after expenses renting the old place. Instead I invest in REITs, petroleum MLPs and other stuff that pays nice dividends. Now I can average 10% with just leaving it alone and much much more actively trading them and selling covered call options. Now instead of a single rent check, I get predictable cash flow. Instead of paying part of my new mortgage with a rent check, I pay for it all, and the car loans, and all the utilities too. And I never have to clean it, show it, fix toilets, wonder where the late rent is. Been there, it’s hard money to earn. Stocks are so much easier.

I agree. My parents and I (together) only buy in a dip back in 90s and then again in 2012, on the more reasonable priced multi-unit and short sales / foreclosed homes. No way would I buy the 2.5M home for rental income, that's enough to buy at least a duplex if not 3 units here for better cash flow. I also just buy stocks I know and stay the course. In CA dividend stocks doesn't make sense if you have high income, so most of mine is high growth tech stock for long term capital gain, in domain I know about very well. Now that I am mortgage free I am planning to take on more risk not having to worry about the next mortgage payment.

Utah seems like a good deal, but I prefer to stay in the Bay Area due to family and weather reason. When I retire I may go somewhere with good health care and low cost of living, but that's at least 20 years away.