QUESTION: We are looking to buy a fixer-upper with our son to turn into a rental, with him owning 20 percent. Are there tax complication that we need to know about or do we report the rental as usual and does the tax for ask if we own all or part? Also, we like to offer to him to let his income off of this property come to us as a way of him buying out this property. What tax problems do we run into doing this? Is there a simple way of doing this?
Thanks for your help
ANSWER: This starts out with the Classic: "That all depends".
There are a number of ways that this could be structured, and each has its own possible variables.
1. Were you looking to go into "partnership by default"?
That would bring a whole set of issues, like diversity of liability, it would pass through tax issues, it would allow for him to buy you out of the partnership over time.
2. You could incorporate.
It is more formal, it has possible tax advantages, it has liability advantages.
3. You could file an LLC or some type of Limited Partnership.
Each has unique aspects, none are universally better than another.
4. You could loan him the money.
Then his payments do pay you off, by definition. You would NOT experience any tax advantage from depreciation, or expenses. He might not be able to take advantage of losses. The entire value of the property becomes an asset that he can lose if he is sued. Interest is required, which may increase the total cost of ownership and taxes.
5. You could own it an have him paid to manage it.
You take on all liability personally and all of his income is taxed at Self Employment rates.
6. You could be the borrower/owner.
7. You could cosign for him as the borrower.
Each of these scenarios has worked for someone, and all have failed for others, sometimes catastrophically. If you can narrow it down to which direction you were looking at we start the conversation about the upsides and downsides of what matters.
Each of these is a compromise, taxes, management, liability, ownership, control, cost, and flexibility, are all components of the compromise. Taxes are handled differently in each of these scenarios. The responsibilities and obligations of each of you is different. Keep in mind that if someone is injured on property, there is a risk that the Owner (you, your son, some entity, or EVERYBODY) could be personally responsible for that persons lawsuit.
You want to start out at 80/20, do you have a well defined standard to determine changing it? What if it takes longer?, what if it costs more?, what if it doesn't cash flow?
So we need to look at what you are risking, and what he is risking, what and how much you can commit to this, same for him. What are the expectations for each. And what is the plan if income is less than stellar. Then we can look at each of the options above and critically consider what works best. Then we look at how the taxes play in.
The simple path is rarely the best path.
Our belief is that each business is wholly unique. At the simplest level, there are 3 components.
1. Your product
2. Your market
3. How you bring them together
While many businesses might sell the same product, they will have a different market, or if they claim the same market, they will appeal to that market differently.
Long story short, trying to copy exactly any other model is not a path to success. For instance, two identical houses next door to each other, will not produce the exact same result. Rented for the same number of months per year, same amount of rent, exact same tenant. It is important to differentiate.
As two competitors approach equivalency, they reduce their possibility for profit. Because the only thing they can do to compete, is lower their price. But if one simply has a nicer yard,, a more appealing paint color, or even just a more friendly landlord, then they no longer have to adjust price to win over a tenant, they now appeal to a different market. One appeals to the low price hunter, giving up quality for a lower bill, and the other appeals to aesthetics and comfort.
Which will be more profitable? That depends.
And every market in every city, will have a different outcome. So there is not one path to success. Your obligation as the business owner is to find the most successful path. Is it high end homes, or low end homes? lower dollars per square foot, or nicer square feet? Will improvements net more revenue?
New stainless steel appliances, or old mismatched appliances going to be the better investment?
Choosing the system for your success is no less important than finding the optimum house in which to invest.
I'm not trying to confuse you or scare you. I want to answer your questions and help you to be the most successful, but I'll need a lot more information, so that I can more effectively help you assess what might work. The better you can articulate your unique situation and your plan to address it, the more likely you are to be successful.
---------- FOLLOW-UP ----------
QUESTION: Thanks, hoping it would have been less complicated. Just wanted to do this project with our son. But sounds like the headache would take all the joy out of it.
ANSWER: The headaches always come from lack of preparedness. So preplanning can be a real joy.
Some people are quite successful at RE. They are the ones that can define their market well, describe what makes them unique, and can execute well.
There are lots of ways to enter a market:
Turn key, light fixer-upper, heavy fixer-upper, major construction needed.
Some find a house that is almost good enough to rent (paying a premium in the market for such a turn key opportunity) just a coat of paint and clean the appliances. And hope to charge a low rent that keeps a tenant long term, and gets them paid off in a reasonable time. This works great unless: they didn't realize the water heater was about to fail, and the Air Conditioning wasn't working, and then they got buried and their "low rent" doesn't make for a reasonable return.
Others, just bought the cheapest house they could find, Spent the money to fix it up to rental grade and got a reasonable rent.
I have seen very successful people buy houses that needed a lot of TLC and they invested to bring it up to "Above the Standard", because they knew that their market had people that were willing to pay a premium to rent a nicer home. ($50 a month over 5 years will pay for a carpet upgrade, or some hardwood, or. . .) Their calculations showed upgrading the Turn-key house was going to cost them almost as much to do upgrades they wanted, (new bathrooms, new kitchen, new molding, new doors, whatever, as the "In poor shape home" so they saved money on the buy, since they cut tens of thousands out at that level. They built the value as if it was no longer a rental grade home; changed their market, now they had people looking for a home they could call home, instead of one they just were renting.
This reduced their damage issues, and after the house had been rented for a while and just before it would need a whole new rehab to bring it up to their standard they sell it as a premium home in that neighborhood, getting more than average at sale.
But this plan simply holds different risks. It depends on the neighborhood, the available renters, etc.
It was not my intent to discourage you from going into business, that would be farthest from my goal. I just want you to go into business to win.
---------- FOLLOW-UP ----------
QUESTION: We are already in the business, ie my husband and I. And are doing quite well with it. Taxes are more complicated but manageable with just us two. The complication was in bringing our son into the mix. I'm thinking now of him buying a house in his own name and we just offer to help when needed and him to offer to help when needed on our houses all on a gift of time bases. That way we keep the monies separate.
You are right, it gets geometrically more complicated as you add different players and different assets.
I take it you and your husband own the properties as individuals?
That is NOT normally the best way to run a SUCCESSFUL business. Tax rates, liability and estate issues are not friendly in your case.
It is not normally the best way to run a SUCCESSFUL business, but it is the commonly recommended way. Which is sad, that most people are encouraged to go into business with a model that is designed for failure, and not success.
From where you are right now there are some steps that you can take that would reduce our taxes on the rental income, you could also better manage your deductible expenses. It would actually simplify your taxes some.
Let me know.