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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A Part-Time CFO

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At certain stages of growth, many companies find themselves in the awkward situation of needing the services of an experienced CFO, but feel they can’t afford to hire one.

Yes, a good CFO with the depth of knowledge and experience you need can come at a steep price. And – no offense intended – there may not even be enough to keep a good CFO challenged and interested on a full-time basis at this stage of the company’s growth. So what are the options?

The Options

Try to hire a CFO who may or may not find the job satisfying and lucrative enough to stick around for a while.

Hire a slightly stronger accountant at a slightly higher salary, and hope that he or she can rise to the challenge of a job far beyond his or her education and experience level.

Redirect your attention away from running and growing your business to focus on the CFO role yourself.

Ignore the financial needs of the company, and hope for the best.

Divide up the CFO role and ask your other executives to take care of it in their spare time.

OR…

Hire a part-time CFO at a fraction of the cost of a full-time CFO.

What Will a CFO Do for You?

In collaboration with you and your management team, an experienced CFO will quickly assess the company’s finance, accounting and control needs, and lay them out in order of priority. Areas that he or she will be considering include:

Project the future needs of the company based on achievable growth plans – resources, facilities, and the associated costs.

Identify and quantify financing needs to achieve the business plan – both short term and long term.

Develop relationships with financing sources – debt and equity – that are important to the company’s ability to operate and grow today, as well as to support long term growth and development.

Evaluate and make recommendations regarding the strength of the existing accounting staff.

Evaluate and make recommendations on accounting and information systems.

Oversee the preparation of financial statements, ensuring that the best professionals are chosen to provide auditing, tax and other outside services.

Lead the preparation of operating budgets to keep the company on track to achieve its short term goals.

Introduce the management disciplines and internal control structure necessary for the next level of growth.

Advise on the most appropriate methods and rates of growth – including acquisitions.

Conduct due diligence on acquisitions, and satisfy due diligence requirements of investors and lenders.

Lead programs and efforts to contain and reduce costs while still fostering growth.

Strategize on potential exit strategies – sale of the business for example – and help attract investors and buyers.

What to Look For

The more experience a CFO brings to the table, the more widely that experience is likely to vary among the candidates you speak with. All the more reason to have an idea of the qualities that are most important to you and your business. Here are a few thoughts:

Do you feel comfortable talking to the CFO? We all work better with people we like and trust.

Does the CFO seem to find your business interesting? Of course you find it interesting, but you can’t just assume that others do too.

Is a CPA important? Yes, it probably is. It demonstrates a minimum intellectual standard and level of accounting knowledge, and like the top business schools, the top accounting firms tend (with clear exceptions) to attract the best talent.

Does the CFO have a wide variety of experience in which he or she had to show resourcefulness and flexibility, as well as the willingness to learn on the job? How has he or she performed in situations similar to those likely to arise in your company? References come in handy here.

Has the CFO worked with companies similar in size to yours? I can tell you that working for a Fortune 100 company is very different from the environment of an owner-operated entrepreneurial venture. If you are planning to grow rapidly, does the CFO have rapid growth experience?

How about industry experience? Unless you are in a wildly specialized business like banking or insurance, industry experience is probably not critical. CFOs and CPAs are famous for their transferrable skills, and should be expected to learn your business quickly. On the other hand, some businesses like real estate have a steep learning curve, and some prior experience can make a big difference.

Why would a CFO want a part-time position? If this is a temporary move while he or she is looking for a full-time job, it doesn’t have much long-term potential. On the other hand, there are plenty of financial executives who like the flexibility of a part-time situation, and who enjoy working with a variety of interesting clients, each with its own challenges and rewards.

As the company grows in size and complexity, would the CFO potentially be interested in turning a part-time arrangement into a full-time position?

Do you know who to call to discuss hiring a part-time CFO?

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?

How Much Is It Worth? Uh… What? And to Whom?

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Many business owners are thinking it may be time for a change. And everyone has a different set of concerns.

– Do you really want the hassle of doing it all over again through the next business cycle?
– Is there enough cash to retire or move on to the next venture?
– Do you need cash now, or can you take it over time?
– Do you want to get out from under the personal guarantees?
– Continuity of the business.
– Welfare of managers and employees.
– Do you want to have an ongoing management role?

What Are You Selling?

Assets – You can sell off assets, pay off debt, and keep the difference. Selling to an opportunistic buyer would be quicker, but the price will be lower in the amount of their profit.

An Ongoing Business – Solid, predictable cash flows can be multiplied at an appropriate rate to calculate a selling price, and to set a time horizon.

A Business Plan – If it is already under way, you may be able to use projected cash flows to increase the selling price.

Your Wisdom and Expertise – This could justify an ongoing management or consulting role.

Who’s Buying?

Nobody – An orderly shut-down and sale of assets.

Financiers – Maybe, but only if the price is really, really right.

Employees or Family Members – They have a stake in continuing the business. This could take several years to accomplish.

Someone in the Industry – Someone who has an interest in entering or expanding in your market.

Each of these situations will have a very different value and personal outcome for yourself and your family.

Does your CFO have the knowledge and experience to advise you on a business exit strategy?