Buying a House … Residence vs Rental Property

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A common question my clients ask is “Should I buy a house?” A logical extension of the question is “Should I live in the house, or would I be better off renting it out?”

Actually, the question is more often phrased “What are the tax benefits of buying a house?” This can result in a barrage of technical information that doesn’t answer the real question.

THE TAX STUFF

Let’s get the technical tax stuff out of the way:

–  The interest portion of your mortgage payment and your property taxes are tax deductible
–  If you rent out the property, you can also deduct operating expenses like repairs, utilities and management fees
–  If you rent out the property, you can also deduct depreciation. The house itself is depreciated over 27.5 years. Improvements, furnishings and appliances are depreciated at faster rates
–  If you live in the house for more than 2 years, you don’t have to pay tax on the first $250,000 of capital appreciation – the exemption is $500,000 if you’re married and file a joint return
–  If you make under $100,000 you can deduct rental losses on your tax return. But if you make between $100,000 and $150,000, the deduction phases out to zero. The good news is you can deduct the disallowed losses when you sell the house
–  If you rent the property, your gain on sale is taxed at capital gains rates, which are lower than regular rates. Depreciation you deducted is recaptured at regular rates
–  If you pay Alternative Minimum Tax, all bets are off…but if you live in the house, your mortgage interest is a deduction for AMT purposes

There’s the barrage of information. Do you know what you want to do now? I don’t think so.

WHAT YOU”RE TRYING TO ACCOMPLISH

Living in your house accomplishes three main objectives:

– You stop paying rent to somebody else
– Tax deductions for mortgage interest and property taxes make your monthly payments more affordable
– With a relatively small down payment, you get the benefit of the full amount of any gain on sale. It’s not unusual to make a gain as big as your down payment. That’s a 100% return on your investment – and $250,000 or $500,000 of the gain is tax-free

When you rent out your house, the objective is to bring in enough rental income to cover your cash payments for mortgage, property tax and operating expenses. Depreciation doesn’t affect your cash flow, but it can be used to create losses for tax purposes if you are in an income range to benefit from the deduction. I’m sure there are places where you can generate positive cash flow from a rental home, while paying no tax because of the depreciation deduction. A few years ago I worked with a Midwest homebuilder where we marketed houses for exactly that business model, but I now live in Southern California, and positive cash flow is only a dream.

Your income mostly comes from the gain you make when you sell the house. This gain is taxable, but it’s taxed at a lower rate than your regular income.

The downside of renting out your house is that you still have to live somewhere. Any profit you make will be reduced by the rent you pay. If you already own your home, of course, that’s not an issue.

RESIDENCE OR RENTAL – WHICH IS BETTER?

Here’s an example that compares the results of living in your home and renting it out.

I made a number of assumptions as the starting point. I’m sure you can poke holes in some of them, but bear with me.

– You are currently paying rent of $2,500 a month
– You have $150,000 for a down payment
– You buy a house for $600,000 and sell it 5 years later for $700,000
– You take a $450,000 mortgage at 4.0% interest, and pay 2.0% a year for property taxes
– You can rent the house to tenants for $3,600 a month
– Operating costs are $3,600 a year for your residence, and $5,000 for the rental
– Your selling costs are 6% when you sell the house
– Your regular tax rate is 30%

Option 1 – Don’t Buy the House

If you don’t buy the house, you continue to pay $2,500 a month in rent. After 5 years, you have spent $150,000. End of story.

Option 2 – Live in the House

Your mortgage payment is $2,170 a month, and your taxes are another $1,000. You’re now paying for repairs and maintenance, but the tax benefit of the interest and tax deduction means you’re only paying about $200 a month more than when you were renting.

You make $100,000 in profit when you sell the house (less $42,000 in closing costs) but you don’t pay tax on the gain. You also get your down payment back, plus you paid off $43,000 on your mortgage.

Over all, your total cost after 5 years is $63,000. This compares with $150,000 you would have spent on rent. Congratulations – by buying the house you saved $87,000.

Option 3 – Rent the House

You rent the house out for $3,600 a month, which is pretty much exactly the amount you pay out for mortgage payments, property taxes and operating costs. You get a tax deduction of $16,000 a year for depreciation, but if you make more than $150,000 it just adds to your deferred loss.

You make the same $100,000 profit when you sell the house. This is taxable at capital gains rates, but the $42,000 closing costs are deductible. As above, you get back your down payment and the $43,000 you paid down on your mortgage.

Your after-tax income from the rental property is $82,000. Nice, really nice. You’ve made a pretax return on investment of 11% a year. Compare that with the return on other investments.

BUT… not so fast.

You still have to live somewhere while you’re renting out the house. Right? Assuming you continue to pay $2,500 a month in rent, that turns your rental profit into a net cash cost of $68,000. The good news is that you’re still miles ahead of where you would have been if you hadn’t bought the house at all, and only about $5,000 behind using the house as your residence.

Do you think you could increase the rent on the house over 5 years? That would make the results of renting vs living in the house about the same, wouldn’t it?

CONCLUSION

Sorry, I’m not giving you a conclusion. This was just one example, and your situation is almost certainly going to be different. My assumptions are just assumptions, and you would have to do a careful analysis of the facts before you move forward.

There are a lot of subjective issues as well. Do you want the headache of being a landlord? And what about unforeseen problems like bad or unreliable tenants? But what about the upside gain if rents keep climbing the way they are in Los Angeles these days?

I would be happy to discuss your specific situation, and run my model with assumptions that apply to you.

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Losing Perspective

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The story is that if you drop a frog into a pot of boiling water, it will jump out immediately. If you put it into a pot of cool water, however, then turn on the heat, the frog won’t notice the temperature change, and will eventually die when it gets too hot. Who knows if it’s true, but it’s a great metaphor, and we see it happening everywhere.

It’s easy to lose perspective.

We Are the Best

I worked on the conversion of a newly-acquired retailer’s systems to those of the acquiring parent company. Although the new system was much more sophisticated and comprehensive, fundamental accounting controls were missing, and it was so difficult to acquire, verify or reconcile certain information that we had lingering doubts over its overall integrity.

The parent company had a unique corporate culture based on the belief that they were the best – had the best stores, the best products, the best people, the best systems, etc. – and there was no room for discussion of improvements. The corporate controller explained to me that the systems were terrible before he joined the company, but they were great now. He listed examples of how bad they used to be, and every one of the deficiencies still existed… but they were the best.

Years later, there was an accounting scandal that hinged, among many other things, on the system’s inability to properly account for cost of goods sold.

They refused to look at their systems with a critical eye, and they lost perspective.

Director’s Cut

A well-known filmmaker invited me to see his new film while it was still a work in progress. He had been editing it for weeks, and was ready to show a rough version of the finished product. It was a demanding film, with dense dialog requiring concentration, and a limited budget for production values, and I was drained by the end of the screening. I looked at my watch several times during the film, so I was very aware of the fact that it was well over 2 hours long.

Called on for comments, I sincerely praised the film for its merits – a respected film critic eventually included it in his annual “Top Ten” list – but I felt the length of the film undermined its overall success. Surprised, the filmmaker responded: “You should have seen it when it was 4 hours long.” I attended the screening of the final film, and still found it much too long.

Art is subjective, of course, but I believe he lost perspective.

Competing Systems

A homebuilder developed an elaborate and advanced construction management system, and its reporting mechanism was tied to an accounting package. For reasons lost in history, they also continued to customize the primary general ledger system that had been in use since the 1970s. The result was that there were two very complex systems, but the reported results were often materially different.

Each member of the management team had his own favorite reports from both systems, and every meeting started with an argument over whose report was correct. One member of senior management knew how to reconcile the results, and he spent more than half his time doing so. By the time the reports were reconciled, the meetings were often over. Important business issues were never addressed, and the managers made their decisions based on different information.

This was one of the first issues I raised when asked for my observations on the company and its operations. The CEO, early in his career, personally directed the customization of the ledger system, and he wouldn’t listen to any criticism. He and his managers had developed the construction system, and were so proud of it that they invited homebuilders from around the country to show it off. There wasn’t going to be any discussion of problems there, either. When I tried to address the gap between the systems, the response was: “It’s great now – up until 6 months ago, all the computer terminals had green screens.” I hadn’t seen a monochrome screen in over 20 years.

The company went bankrupt. They had lost perspective.

Hey, What’re You Gonna Do?

Another retailer was very dependent on its highly complex systems. The nature of the business is that there is a high rate of turnover among line managers, and the corporate training systems placed more emphasis on sales and marketing than on administration. Unfortunately, the systems, while comprehensive, were not user-friendly, and there were constant problems requiring many long telephone calls to explain and resolve issues.

There was constant finger-pointing and redirection. A manager would direct associates to call the technical support hotline, only to be directed to the regional office, who might then send it back to the original manager. Certain employees became known for their ability to resolve certain types of problems, and everyone had a favorite go-to fixer.

Frustration abounded, but there was no feeling at the field level that there was anything fundamentally wrong with the systems. The company had been in existence for a long time. There was no problem with customer service, but the amount of employee time wasted by awkward systems was huge. When I asked why nobody complained up the corporate ladder, they just shrugged and said it wouldn’t do any good.

They had lost perspective.

That’s How it Should Be

In a construction company, it was highly unusual for accounting reports to tie out to the general ledger. It was a constant problem, and drove me crazy, because I could never trust that I was working with reliable information. We were involved in huge projects and equally huge financings, and acting on wrong information could have major consequences.

The CFO and IT director had been with the company for many years, and together had implemented most of the systems in use at the time. They knew them so well that they could tell me how to do elaborate reconciliations of the reports, which would often involve writing special programs. Their default question would typically be: “What do you need that for?” This exercise turned up problems with the original reports often enough that we had the battle many times.

When I pressed the CFO to set up a task force to streamline and clean up the accounting systems, he would argue that the systems were good, and that the reports actually shouldn’t tie out. “That’s how we designed them.”

They had lost perspective.

Does your CFO encourage taking a fresh look at long-established systems and methods?

How Much is Enough?

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How do you decide which projects to invest in? Some companies look at the expected profit as a percentage of expected revenue. This approach, however, does not take into account the size of the investment, how long your money is tied up, or the risk of the investment.

Many companies look at their expected Internal Rate of Return, or IRR. This is a measure of the cash flow of the investment over its expected life, and gives the annual percentage return on the actual cash invested. Some companies informally call this their Return on Investment, although ROI is technically a different measure.

Companies in different industries have their own criteria for a minimum acceptable IRR. Retailers, for example, often look for a 16% return after tax, while homebuilders might look for 18% before tax. The differences are based on the risk involved in the investment. Profit projections are less reliable for a new retail store than for building houses in an established development – under normal circumstances, of course. Retailers also expect their investment to last at least 10 years, while a housing development can often be completed in 2 or 3 years. A lot of things can change in 10 years.

What is the appropriate IRR target for your investments?

Profit Improvement – Simple Communication

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

Communication

Sometimes a simple conversation will solve your problems. This can be a natural process, or the result of an expensive and time-consuming structured organizational review. If you have a problem, talk about it.

A telephone call – The sales department of a homebuilder often selected lots for sale in such a manner that the engineering department had to return to the city with new plans for approval. This caused time delays for sales and frustration in the engineering department, and resulted in increased plan approval fees. A Six Sigma team approached the problem, creating wishbone charts, pareto charts and other analyses to identify the underlying problem, but could find no statistical pattern. Finally, the head of engineering telephoned the head of sales, and the problem was eliminated in five minutes.

A meeting – The buyers at a retail company weren’t getting all the information they needed from the accounting department, so they appointed a full-time administrator to track and report on outstanding orders and merchandise receipts. A meeting between the buyers and the accountants resulted in an automated report that solved all the buyers’ needs, and the administrative position was eliminated.

Bottlenecks – A land developer was experiencing chronic delays in processing grading permits. Business was booming, so every day represented delayed revenue and additional carrying costs on multi-million dollar developments. A Six Sigma team spent several weeks of process flow-charting and statistical analysis, only to learn that the manager in charge of grading applications was swamped, and had a long backlog. They added a part-time clerk, and the problem was solved. Asking a few simple questions much earlier would have been a lot easier.

Does your CFO encourage your operating team to communicate with each other?

What? … Manage Return on Equity?

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Return on Equity, or ROE, is a widely recognized measure of a company’s performance. Even though some senior executives’ compensation is based on ROE or a similar measure, many regard it as an academic, technical calculation, and wait until year-end for the accountants to give them the result.

ROE tells you how effectively you are using your company’s resources, and it CAN be managed. It is a tool that should be evaluated and refined constantly to ensure your business is headed in the right direction. It can be managed by breaking it down into its separate components:

The calculation of ROE is:

ROE = Profit Margin X Asset Turnover X Financial Leverage

Profit margin is your profit as a percentage of sales. No surprises here. You know your industry, and you know your company, and you know how to improve your margins.

Asset turnover is your sales divided by your total assets. Turnover drops when you carry more standing inventory than you need, or make capital investments before you really need them. Faster collection of accounts receivable will improve your asset turnover… And obviously, increasing sales will improve your turnover.

Financial leverage is your total assets divided by shareholders’ equity. Negotiating longer vendor payment terms can increase financial leverage. So can increasing debt, but that is a complex decision that should be discussed in depth with your CFO.

Does your CFO work with you and your operating teams to improve the components of ROE?

Profit Improvement – Cost Reduction

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Pretty much every company wants to increase its profit, and most managers devote a large portion of their time to trying to increase revenues and margins, or reduce costs. As a financial manager and consultant, I have been involved in many profit improvement initiatives. Here are some examples – they are mostly from construction, retail and land development, but the concepts can be applied to any business.

COST REDUCTION

Reducing costs can be as simple as finding a new supplier, but sometimes a more detailed analysis or a global approach can be effective.

Looking at the details – A retailer’s payroll is typically its largest expense. At one company, the standing order was to maintain payroll at 10% of sales. This worked consistently, but when we started to look at customer traffic patterns, we saw that staffing was not being increased at peak times, or decreased during the slow hours of the morning or evening. A new staff planning system improved customer service and brought payroll under the 10% target.

Statistical analysis – A homebuilder had a problem with windows leaking during rainstorms. Nobody really knew why, but replacement was costly, and it was a serious customer satisfaction problem. We formed a Six Sigma task force to gather and analyze the data. We broke down the data by community, by subcontractor, by supervisor, by manufacturer and installer until a pattern became evident. After a few changes, leaking window problems were reduced by 60%.

Centralization – At another retailer, repairs and maintenance expenses were the responsibility of the local management, and no amount of threats or encouragement could stop costs from increasing. We centralized the function in the corporate office, and made low cost arrangements with regional contractors, reducing costs by over 30%.

Glaring opportunities – A land developer always paid for up-front infrastructure costs – roads, sewer, etc. – on its development projects. This had a huge impact on cash flow and ROI. I learned that most cities are willing to finance these costs with municipal bonds. It wasn’t a secret, but the company never took advantage of the opportunity. I set about becoming something of an expert on the subject, and initiated over $100 million of cost savings that went straight to the bottom line when the developed properties were sold.

Planning – At a homebuilder, we carefully reviewed the cost of every house, and construction (or even purchase of the land) would not be approved until we were certain that projected profits met our investment return guidelines. Marketing would sometimes change design specifications, but the purchasing managers were often the ones who would drop the cost per square foot by changing a material or redesigning a minor architectural detail. This was sometimes a painful process, but the result was a low cost, high value product.

Does your CFO encourage your management team to look at cost reduction in a comprehensive way?