In a recent MarketWatch article, I made the remark that rentals are a business. A reader disagreed. “Rental property is considered ‘investment income,’ and is filed on a Schedule E, not a Schedule C. But I understand your confusion on this matter because many people don’t understand the truth of the matter any more than you do. I know, I’m a real estate investor for 20 years now,” she wrote.
Despite investing her money in real estate, theoretically, to make a profit, this woman passionately believes that rentals are not a business. She’s not alone. Many people are confused because they’ve forgotten that the definition of a business is something that occupies your time, with the intention of making a profit. They’ve also forgotten the history of these taxes.
Shades of 1984
When Congress signed the Tax Reform Act of 1986 (TRA 86) the real estate investment climate was very different – people were chasing lucrative tax benefits, rather than profits. TRA 1986 introduced the concepts of “passive income” and “active participation,” “passive loss limitations,” “material participation” and “real estate professional” and “at-risk rules”.
The IRS urged Congress to include limitations on rental income because, at the time, rental limited partnerships were often designed to be tax shelters for the limited partners. They were sold purely for the tax benefits, not for the potential increase in property value. Not only did these limited partnerships become an abuse of the tax system, they created worthless investments. Those properties were never operated with a profit motive. They often sold the property for less than the purchase price, once the tax benefits were stripped.
Consider a typical California investment of the time. The partnership would buy a property for $2 million with 10% down. Back then, we had ACRS depreciation over 15 years – 19 years for real estate, with accelerated rates of 8% – 10% in the first three years. Mortgage interest rates were around 10% and so were management fees, usually paid to the general partners. A 10% investor would buy in for about $25,000 to cover the down payment and purchase costs.
The properties were bought for about eight times gross rents, so rental income would be $250,000. Deducting the cost of interest would be about $180,000 (10% of $1.8 million), management fees of $25,000 (10% of $250,000 rental income), and property taxes of $25,000. Operating expenses, like maintenance and utilities, would inevitably eat up the rest of the cash flow. However, depreciation would be around $90,000 ($1 million building value times 9%).
Ask any group of college-bound kids what they’re looking forward to this April, and you may expect them to say spring break. Yet a growing number of students could have a different answer this year: their tax refunds.
Fifty-two percent of high-school students have gotten jobs to help shoulder the astronomical costs of tuition, according to a 2011 College Savings Foundation study. The same study indicates that 23% of high-school students saved more than $5,000 for tuition expenses, up from 19% in 2010.
With income comes 1040s. (If you’re a dependent who has earned more than $5,700 as someone’s employee, you have to file. The rules change a bit when it comes to unearned income, or if you’re self-employed.) Since the IRS now requires some of these kids to fulfill the grownup responsibility of filing taxes, they now qualify for the grownup perk of saving for retirement.
“It’s less uncommon than college students think to save for retirement, even at young ages,” says Stuart Ritter, a vice president and certified financial planner at T. Rowe Price.
The best retirement-savings option for a college-age student is a Roth IRA, says Ritter. Unlike traditional IRAs, savers make contributions with after-tax dollars. Yet Roth savers don’t have to pay taxes on the earnings.
If you’re worried about inflation, I Bonds may not be the solution —at least not this year with interest rates so low.
Last year, the Internal Revenue Service rolled out a program that lets you use your tax refund to buy inflation adjusted Series I Savings Bonds.
More than 99,000 bonds were bought using tax returns in 2010, for a total of $11 million, according to the IRS. But that was last tax season, when the rate on I Bonds was above 3%. Today they earn 0.74%.
With the fixed rate on I Bonds currently at zero, analysts say there are more appealing ways to hedge against inflation. “It’s definitely not as exciting and sexy to want to do it,” says Alex Matjanec, co-founder of MyBankTracker.com.
You may be better off sticking with a certificate of deposit, says Matjanec. For instance, a 12-month CD with Ally Bank currently pays 1.29%, he points out.
New cost basis rules will make tax filing season a little easier for investors next year (when filing 2011 taxes) by shifting some reporting responsibilities to financial firms and away from investors.
But, investors aren’t off the hook. To avoid a huge tax headache at the end of this year, investors will need to be proactive by coordinating with their brokers, deciding earlier how they want to report trades and keeping more precise records.
Starting this year, financial institutions and brokers are required to track their customers’ cost basis — or the price they paid when they purchased shares, including commissions — and report that information to the Internal Revenue Service. Investment companies had to start tracking and reporting stocks and some exchange-trade funds this year but reporting requirements for other investments, such as mutual funds, bonds and options are being phased in during 2012 and 2013.
With many institutions setting default methods for how they want to report cost basis, the onus is on investors to check in early if they want to use a particular method when reporting trades—such as whether the oldest shares should be sold first, if an average cost for all the shares should be used or if specific shares should be sold. The default method for reporting stock trades, for instance, is “first in first out,” where the oldest shares are reported as being sold first. That might be bad if your shares have grown substantially in price since you first purchased them.
Now that companies are recording profits again, the question becomes: What should they do with this newfound free cash?
Yes, they could reinvest in the company, but shareholders often push for stock buybacks, which raise the value of the outstanding shares, or higher dividend payments. Companies have increased their offerings of both as the economy’s started to recover: Among members of the S&P 500, repurchases jumped 128% over the past year, and dividend payments rose 9%.
From a tax standpoint, repurchases might appear to be the better news because they’re not taxable to investors. But dividends might actually be the better bet
The Tax Blog brings together a team of award-winning tax journalists from the Dow Jones network and around the web to examine the tax issues, changes and legislation that affect families, investors and small business owners. Our contributors include Tax Report columnist Laura Saunders (WSJ), Tax Guy columnist Bill Bischoff and senior reporter Jilian Mincer (SmartMoney.com), retirement-focused reporter Anne Tergesen (WSJ), wealth management writer Arden Dale (Dow Jones Newswires), TaxWatch columnist Eva Rosenberg and personal finance reporter Andrea Coombes (MarketWatch), and reporter Alyssa Abkowitz (SmartMoney). They’ll provide the latest news and insight, mine the tax code for tips and loopholes, and answer your questions about tricky tax situations. Contact the The Tax Blog with ideas, suggestions or tax questions at email@example.com.