Category: Real Estate

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Financial Planning Real Estate Taxes

Cost Segregation Studies: A Smart Tax Move… Sometimes

House with a couple thinking about a decision they need to make

Cost Segregation Studies: A Smart Tax Move… Sometimes

If you are a landlord with rental properties, you’ve probably read an article or listened to a podcast where someone recommended, “Do a cost segregation study to reduce your taxes.” This ‘one-size-fits-all’ approach to tax strategy is nearly always flawed, and cost segregation studies are not an exception to the rule. While you might be able to lower your current tax bill by having a cost segregation study done for your property(s), many landlords – especially the families I deal with most often – will not realize a current benefit equal to the time and expense of the study. 

At PIM Tax Services, we work with hundreds of military and veterans families who own rentals. Many became landlords because a PCS move turned their primary residence into a rental. Others are more intentionally building their long-term wealth through real estate. Regardless of how you came to be a landlord, cost segregation can be a powerful tool, but it’s not an automatic win. This article breaks down what a cost segregation study is, why they are suddenly very popular for small-scale rental property owners, and the biggest reason many landlords won’t see an immediate benefit to their income taxes.

What a Cost Segregation Study Actually Is (in Plain English)

A cost segregation (‘seg’) study is a detailed analysis that separates a building into its component parts, grouping those parts according to their depreciation “lives.”

Normally, a residential rental property is placed into service as one entire unit and depreciated over 27.5 years. That’s the default rule for the building (not the land). A cost seg study recognizes that if parts of the building were replaced (like an interior door or the appliances), the replacement parts would be depreciated over shorter periods than 27.5 years.   It separates the building into its component parts and groups them into categories based on their depreciable life:

  • 5-year property (appliances, carpeting, furniture)
  • 7-year property (security system or window treatments)
  • 15-year property (fences, driveways, and certain landscaping features)

Why does that matter? Because once those components are reclassified into shorter lives, they may qualify for accelerated depreciation, including bonus depreciation and sometimes Section 179. The result can be a much larger depreciation deduction early in the service life of the rental property. Instead of spreading it evenly over 27.5 years, you may recover the costs of purchasing the rental property much faster.

That can be fantastic – if you can actually use the deduction on your tax return. (Not everyone can.)

Why Cost Seg Studies Used to Be Only “For the Big Guys”

Ten years ago, cost segregation studies were usually something you saw with:

  • commercial buildings,
  • large apartment complexes,
  • high-dollar multi-unit investments.

That’s because they were expensive. Traditional cost seg studies often cost thousands of dollars. For a single-family home, it was tough to justify that cost unless the numbers were huge. The amount spent on the cost segregation study often exceeded the amount saved in taxes. The value proposition for paying for the cost seg study just wasn’t there for small-scale rental property owners.

Today, the landscape has changed. There are now newer approaches and providers that can produce a cost seg-style breakdown for a fraction of what they used to cost. That shift is exactly why more landlords are asking about it, and why it might be worth considering even for a single-family home. While they are more affordable than they once were, they still do not provide immediate value for everyone.

Most Small-Scale Landlords Already Have Negative Taxable Rental Income

80%+ of the hundreds of landlords we prepare returns for already have negative cash flow on their rental properties. With mortgage interest, property taxes, insurance, repairs, management fees, travel, standard depreciation, etc., many small landlords end up showing losses on their tax return for their rental property(s). Because our tax code characterizes rents as passive income, losses from rental activity are called “passive activity losses” (PAL).

The issue is whether you’re allowed to deduct those passive activity losses on the current year’s tax return.

Passive Activity Losses (PAL) and Suspended PAL (SPAL)

Under the federal tax code, passive losses are subject to limits. In simple terms:

  • If you have passive losses, you can generally only use them to offset passive income. 
  • If you don’t have enough passive income, those losses often get suspended and carried forward.

When that happens, you end up with Suspended Passive Activity Losses (SPAL) that roll forward year after year until you can use them. You can use them when:

  • the rental unit starts producing passive income (rents collected exceed expenses),
  • you have other sources of passive income to absorb them, or
  • you sell/dispose of the property in a fully taxable transaction 

Your ability to use your PAL/SPAL has a significant impact on the current value of a cost segregation study.

If You’re Already in the SPAL Group, Cost Seg Usually Doesn’t Help Today

If you already can’t use your rental losses because they’re suspended, adding a cost segregation study will not create an immediate tax benefit.

Instead, what it usually does is:

  • increase depreciation deductions,
  • which increases passive losses,
  • which increases the amount of SPAL you carry forward.

Meaning – you may pay for a cost seg study, and your “benefit” is not a reduced tax bill. Instead, you paid for a more rapid increase of SPAL.

That’s not always useless. Suspended losses can absolutely be valuable later, especially in a year when you sell the rental at a gain, or when your passive income increases. But it’s very different from the cost segregation pitch many people hear, which is essentially “instant tax savings.” (And remember, if you took accelerated depreciation expenses and then sell the property, you may be looking at “accelerated depreciation recapture”!)

A Cost Seg Study After the Property Is Already in Service

If you do a cost segregation study in the same year you place a property into service as a rental, the implementation can be straightforward (still technical, but simpler and cleaner).

But many landlords don’t discover cost segregation until the property has been a rental for a few years. If you implement a cost seg study to accelerate depreciation on a property that is already in service, you may need to correct your depreciation expenses for prior years.

That’s where Form 3115 (Application for Change in Accounting Method) applies. A Form 3115 can allow you to “catch up” missed depreciation (or correct depreciation expenses that should have been different) through a Section 481(a) adjustment. If you are changing to an accelerated depreciation schedule, then the Section 481(a) adjustment produces a large (“catch-up”) deduction in the year of change without amending multiple prior-year returns.

Sounds great, right? Yes… except:

  • Form 3115 is complex.
  • It’s not something most DIY software handles well.
  • It’s not something every professional tax preparer is comfortable preparing. 
  • The math for correcting the depreciation expense is also complex. Properties placed in service in 2023 were limited to 80% special bonus depreciation. Properties placed in service in 2024 were limited to 60% special bonus depreciation. This further complicates the calculation of the Section 481(a) adjustment.

And the cost to prepare a Form 3115 can vary widely. If a cost seg study triggers the need for Form 3115, you’re not just paying for the cost seg study, you’re often paying for professional preparation of Form 3115 to implement the study’s findings. In the market, the cost for preparing Form 3115 can range roughly from $250 on the low end to $2,000 or more. A landlord might see a “$400 cost seg study” advertised and think, “That’s affordable.” But the real out-of-pocket cost may be significantly higher once filing requirements are factored in.

That doesn’t mean “don’t do it.” It means know the full cost before you start.

When Cost Seg Can Make Sense for a Small-Scale Landlord

Even with all the caveats, cost segregation can be valuable for smaller landlords in the right situation. Here are a few patterns where it’s more likely to matter:

1) You can actually use the losses

If you’re not limited by passive loss rules, accelerated depreciation can reduce current-year tax. Just ensure you have passive income that allows you to use the additional depreciation expenses a cost segregation study should generate.

2) You have a high-income year and a strategy to match

Some clients (including military members transitioning to civilian jobs or veterans with changing compensation) have income swings such as bonuses, separation payouts, relocation reimbursements, or a big change in W-2 income. A strategy that creates a larger deduction in a specific year might be useful. But only if the passive activity loss rules don’t prevent you from realizing the extra depreciation expenses.

3) You’re planning a sale and want to model the whole lifecycle

Sometimes a cost seg study increases depreciation now, which can increase depreciation recapture later. Depending on your top marginal income tax rate, the net result may still be favorable for you, but don’t assume anything. Run a model to project the tax implications for the unique facts and circumstances of your situation.

4) The property has substantial eligible components

Not all single-family homes are created equally. A basic older home with minimal improvements might not yield much reclassification. A home with significant renovations, extensive land improvements, or higher-cost components may yield more.

The Bottom Line: This Is a Math Problem, Not a Vibe

Here’s the point I want every landlord to take away:

Whether a cost segregation study is valuable is a math problem.

Before paying for a study (even a “cheap” one), you want someone to run the numbers and answer questions like:

  • Will the accelerated depreciation create a deduction I can use this year, or will it just increase SPAL?
  • If I need Form 3115, what will it cost to prepare and file?
  • How long do I plan to keep the property?
  • What’s my expected taxable income trajectory over the next few years?
  • What happens on sale, especially with depreciation recapture and suspended losses?

A cost seg study can be an excellent tool, but it’s not an automatic win for landlords with one or two single-family rentals. For many small-scale landlords, especially those already sitting on suspended passive losses, the “benefit” may be delayed, not immediate.

A Practical Rule of Thumb

If you want a simple way to think about it:

  • If you’re consistently in SPAL territory and don’t expect that to change soon, a cost seg study will usually not produce current year tax savings.
  • If you can use the losses now (or will soon), or you’re modeling a strategic multi-year plan, a cost seg study might be worth it but only working through the math problem will let you know for sure.

Final Thought (and a Quick Disclaimer)

I am a big fan of smart tax strategies, especially the kind that help military and veteran families build wealth without getting surprised at tax time. Cost segregation studies can absolutely be part of that plan. But it’s not a magic button, and the passive loss rules are often the deciding factor.

If you’re considering a cost seg study for a single-family rental, don’t start by buying the study. Start by running the numbers.  If you are wondering where to even start, a MFAA financial advisor can help you decide, connect you with a tax professional, and incorporate your rentals into your overall financial plan.  

Disclaimer: This article is for general informational purposes and is not tax advice. Tax outcomes depend on your full (and unique) facts and circumstances. Always consult a qualified tax professional before implementing a strategy.

Categories
Financial Planning Real Estate

The Balance Sheet Deception: Understanding the Liabilities of Assets

Old home

Veterans aren’t strangers to the concept of assets and liabilities. One of the first things anyone does when thinking about personal finance is to map out their assets and liabilities into a personal balance sheet. The result is personal net worth.

But how accurate is your balance sheet? What common liabilities are often left off the balance sheet because they aren’t considered financial liabilities? And how can an improved understanding of liabilities give you better understanding of financial risk?

Your Home: Asset or Liability?

Perhaps, you have accomplished one of the milestones of the American Dream: home ownership. Your real estate agent, like many others, probably lauded your new home as an ‘asset,’ even if you have a mortgage. Yes, a home can offer some stability and a place to build memories. It can also appreciate in value as time passes. But, beyond the mortgage, what liabilities does the home create?

Defining Assets and Liabilities

Before we delve deeper, let’s reacquaint ourselves with the definitions:

  • Asset: It’s something you own that has value.
  • Liability: It’s a debt you owe now or in the future, including costs associated with the upkeep of your assets.

The Ongoing Costs of Ownership

Your home sits in the asset column, however, it comes with a list of liabilities when you consider all the ongoing investment and maintenance it demands. Let’s look at a short list of some ongoing costs of the home:

  • Property Insurance
  • Property Tax
  • Lawn Care & Landscaping
  • Appliance Repair
  • Appliance Replacement
  • Termite/Insect Prevention
  • Exterior Repairs (Roof, Siding, Tuck Pointing)

Many of the items on this list aren’t optional. You could cut corners occasionally, but proper home maintenance is necessary to maintain the home’s value. Some or all of those costs are shifted away from you when you rent the home you live in.

The Hidden Liability

Let’s use some numbers to consider the impact of home ownership costs on your balance sheet. Imagine you purchase a $400,000 home using the VA loan benefit to finance the purchase with no down payment. 

Normally, your net worth wouldn’t change. You have a $400,000 asset with a corresponding $400,000 liability. As you pay off the mortgage each month, your net worth increases as the mortgage balance decreases, assuming there are no changes to the market value. 

With that in mind, let’s consider those “hidden” liabilities of home ownership. We could make detailed estimates of all the ownership costs associated with the home over the time of ownership, let’s say 10 years. 

We add up all of those costs and make some adjustments for inflation—for this hypothetical scenario, let’s say the present value of the home ownership costs about $100,000. By the way, financial planning software or a spreadsheet can help with this analysis.

As a result, the moment you signed the title for this new home, you decreased your net worth by $100,000. 

You bought yourself a $100,000 liability along with your asset.

Other Examples

The scenario with a home isn’t so different than a car, another commonly misunderstood asset. We know a vehicle loses value almost immediately after being driven off the lot. Maintenance, insurance, and depreciation all add up, increasing the actual cost of the car far beyond the original purchase price.

An example that hits close to home with your author is racehorse ownership. In the racing business, yours truly often states that a “racehorse is a liability until it proves itself to be an asset.” For those unfamiliar, training costs for a racehorse tend to run $3,000 to $4,000 per month. That horse is just a cost (from a financial perspective) until it starts winning races.

Making Informed Financial Decisions

The key takeaway is that assets come with liabilities. It’s up to you to understand and quantify these obligations. Then, you can decide whether maintaining or purchasing the asset makes sense.

Ultimately, the question isn’t just whether your assets have liabilities attached—it’s about having a handle on the true financial picture. Here’s where a strategic approach can make all the difference and safeguard the financial health you’ve worked so hard to achieve.

Understanding Your Total Cost

The actual cost of ownership is rarely the sticker price—you need to consider the overall investment, including ongoing maintenance, repairs, and insurance. By mapping out these costs, you’ll have a clearer sense of how your assets impact your liabilities and whether or not you can afford those assets.

The Takeaway

As you navigate the major purchases or financial planning in general, be deliberate about understanding the nuances of what you own and how it impacts your wealth. Your home and your car can indeed be assets, but they also comes with liabilities. By understanding the true cost of ownership and assessing potential appreciation, you’ll move one step closer to financial freedom.

In the grand calculus of your finances, the hidden details of the big decisions can make or break your financial health and financial future. So as you consider the investments in your life, don’t blindly accept assets as such—always question whether they bring you closer to your financial goals. 

Categories
Financial Planning Real Estate

Veterans Affairs (VA) Loan Assumption, Good Deal for Me?

Desk with American Flag patch and house keys on it

Veterans Affairs (VA) Loan Assumption, Good Deal for Me?

Mortgage interest rates have hit a 20-year high with average new mortgage rates over 6%. Higher rates (and payments) can make it hard for new home buyers to stay on budget. Before the spike, many people got new or refinanced mortgages for under 3% interest. For a seller with a low-interest rate, allowing a buyer to assume your VA loan could be a win-win scenario for both of you.

What is VA loan assumption?

A VA loan assumption is when one person takes over an existing VA mortgage loan from another.  The home buyer takes on (assumes) the terms, payments, interest rate, and loan balance from the original borrower as part of the buying process.

All VA mortgages loans are assumable. And anyone is eligible to assume an existing VA mortgage, not just veterans. Buyers must still meet the lender’s creditworthiness, income, and debt-to-income ratio criteria.

I’m a buyer, why consider a VA loan assumption?

Buyer Pros:

Lower interest rates: You could save a lot of money on interest over the long term if the assumable VA loan has a lower rate.

Lower VA loan closing costs: A VA home inspection is not required. You only pay the 0.5% funding fee to assume an existing VA mortgage. There’s no funding fee if you are a veteran with a VA disability, Purple Heart recipient, or surviving spouse receiving Dependency and Indemnity Compensation.

Buyer Cons:

Limited property options: Only shopping for homes with an assumable VA loan will narrow your choices.

Seller’s loan terms: Assuming a VA loan means accepting the existing loan’s terms as is, such as interest rate, loan balance, and repayment period. This may not align with your needs.

Cash on Hand: If the existing VA mortgage is less than the home sale price, you must make up the difference. That means a down payment from savings or taking out a second mortgage. Taking out a second mortgage may be possible but has extra costs and makes the sale more complicated.

Time: Loan assumption is more streamlined than a new VA loan, but assumptions can take longer. Up to 6 months is not unusual. In the meantime, you can’t move in and the seller is waiting to receive money from the sale.

Possible Loss of Entitlement: The buyer may need you to substitute your own VA loan entitlement. This will reduce the amount you could borrow again until you pay off the assumed loan or refinance.

I’m a seller, why consider a VA loan assumption?

Seller Pros:

Increased buyer pool: VA loan assumption benefits may make the property more appealing to buyers. VA loan assumptions are also available to both veterans and non-veterans.

Competitive advantage: Buyers may offer a higher price for a home with a low rate, assumable VA loan.

Lower closing costs: The assuming buyer typically pays the assumption fees and charges.

Seller Cons:

Reduced cash flow: Money from the sale may be delayed until the loan assumption process is complete. You still have to make mortgage payments during that time.

Possible Loss of Entitlement: If the buyer qualifies, they can substitute their VA loan entitlement. Then your entitlement is reinstated. If the buyer doesn’t substitute (or can’t if not a veteran),  entitlement goes with the property. It is tied up until the new buyer pays off the mortgage. This would limit your ability to get another VA loan.

Release of Liability: Anytime you sell a home secured with a VA loan, YOU will still be liable to the government for payment unless:

-Your loan is paid in full.

-The VA releases you in writing from liability on the loan.

-You sell the property to an eligible veteran that assumes your loan AND substitutes their loan entitlement for yours.

Remember: Release from liability and VA entitlement restoration are two separate actions. Contact the VA office that guaranteed your loan and ask for the necessary forms and instructions.

Is VA Loan Assumption a Good Fit for Me?

A VA loan assumption can be a good fit for both buyer and seller when:

  • The existing VA loan interest rate is below the new mortgage interest rates.
  • You both (buyer and seller) can wait to complete a longer closing process.
  • The buyer offers a higher price or concessions in exchange for interest savings.
  • The buyer accepts the terms (years, payments, and interest) of the assumable mortgage.
  • The buyer can pay the difference between the home sale price and the assumable mortgage balance (downpayment).
  • The seller does’t need their VA loan entitlement restored. This allows non-veterans to make offers and assume the loan.

If you think a VA loan assumption might be a good fit for you as a buyer or seller, let your realtor know. They can get the word out and make inquiries for you and help negotiate a sale to benefit you both.

For more information on VA loans, including loan assumption, download the VA Home Loan Guaranty Buyer’s Guide at https://www.benefits.va.gov/HOMELOANS/documents/docs/VA_Buyers_Guide.pdf

If you’ve got questions about VA loans or other military financial topics, MFAA advisors can help.  You can find them here.

Categories
Financial Planning Real Estate

A Military Family’s Guide to Buying a Home

A Military Family’s Guide to Buying a Home

Recently, I’ve had several discussions with clients who are in the middle of a PCS (permanent change of station) or preparing for one. No tears so far, but lots of frustration every time the Federal Reserve raises the benchmark interest rate. Purchasing a home in the current seller’s market presents unique challenges for military families. In this post, I will explore key factors to consider when buying a home, empowering you to make well-informed choices and navigate the complexities of the market.

First of all, should you buy a home? No, really. Should you? We’ve all heard of that family that was able to sell their home in 3 years and make $100,000! Amazing! But that is 100% not the most likely outcome. Being well-informed about the implications of this property turning into a rental is important, as there is a high probability of it becoming one. I recommend you check out this MFAA blog post if you’re on the fence. Go on, I’ll wait. Welcome back! Now that you’ve familiarized yourself with some of the nuances of military real estate investing, you are well-informed and ready to proceed. Huzzah!

You’re moving soon. Where do you start?

  1. Check Your Credit: There are several ways to check your credit score that won’t result in a hard inquiry on your credit. You’ll want to know where you stand before you apply for a loan. I’m a big fan of using annualcreditreport.com, the official website authorized by the Federal Trade Commission, to request your credit reports. Most credit card companies provide their clients with the option to access their credit score at no cost, without it causing a hard inquiry on their credit report.

Did you know that mortgage lenders use a different scoring model when you apply for a loan? The score you receive from your credit card company will probably be different/lower than what your lenders pulls. Ah lovely, another edition of the points are made up and the rules don’t matter.

  1. Do the Math: The full cost of owning a home doesn’t just include the amount that the lender is going to show you. The lender will typically include the principal, interest, property taxes and insurance in their quote. Amounts that they don’t include but that could make a significant difference for you as the buyer include the monthly maintenance, monthly/annual homeowners association fees (up to $1,500/month in some areas!) and improvements you need to make to the home before you move in (that 70s green shag carpet has got to go).

 

The lender will also show you the closing costs but those are typically not included in your monthly mortgage amount. Closing costs are fees and expenses associated with finalizing the purchase of a property. They usually include charges for services such as appraisals, title searches, loan origination fees, attorney fees, insurance premiums, and government taxes or recording fees. You’ll need to decide if you’re going to add these fees to your home loan or if you’re going to pay for them at closing. I tried to show up at our last closing with a stack of cash like Scrooge McDuck, but my husband said no. So boring.

  1. Explore Your Mortgage Options and Find a Lender: If you’ve already engaged a real estate agent, they likely have a list of reliable lenders they can recommend to you. If you are searching for a lender independently, begin by considering your bank or credit union, as well as local mortgage brokers in the area where you plan to move. Additionally, fellow military members can also serve as a valuable resource for lender recommendations. Online lenders can also be a good option but not all of them are approved to do VA loans. If you’re going to use a loan from the Department of Veterans Affairs (VA loan), then you must make sure the lender is VA approved. Once you’ve made a list of lenders, explore their websites, read reviews, and gather information about their loan products, interest rates, fees, and customer satisfaction ratings.
  2. Get Pre-Qualified or Pre-Approved: What is the difference between getting pre-qualified or getting pre-approved? Think of being pre-qualified like your cousin telling you they can sing “Somewhere Over the Rainbow” just like Judy Garland. But getting pre-approved is having your cousin sing the song and record it to prove that they can do it. (I like to take any opportunity I can to use a theater reference. You’re welcome.)

The lender will likely pre-qualify you quickly (with a phone call or an online form) and this is based on the overall financial picture you share with the lender. To get pre-approved, a borrower will submit an official application along with necessary documentation. The lender will then evaluate your financial situation and history to determine how much mortgage you can reasonably afford. Which one should you do? It depends. Pre-qualification doesn’t generally involve anyone pulling your credit but the advantage of being pre-approved for a mortgage can vary based on your timeline and the specific market you are entering. In a highly competitive market, having pre-approval could provide a significant edge.

  1. Work with a Knowledgeable Real Estate Agent: This is usually where people start but it’s ok if it’s at the bottom of your to-do list. Your agent will be able to do a better job of finding an appropriate home for you if you have a realistic range in mind and you will be less tempted to buy a home that you can’t afford. As financial planners, our interactions with real estate agents are frequent, and I’ve observed that the agents who possess in-depth knowledge of the area and maintain strong connections with fellow agents tend to achieve the highest levels of success. When searching for a real estate agent, don’t hesitate to interview multiple agents. It’s also beneficial to ask for recommendations from friends and colleagues who have had positive experiences with agents.

Additional Tips for Military Families Buying a Home

  • Select a Home in Good School Zone: You may not have children of your own, but it’s important to consider that your future renters will likely have families that will be prioritizing rentals in reputable school districts.
  • Consider Proximity to Military Bases: If you have a home that’s close to a military base, you’ll have a better chance of the home renting quickly.
  • Select a Well-Maintained Property: By prioritizing homes in excellent condition, you increase the likelihood of finding a property that not only saves you money but also requires minimal repairs.
  • Don’t Skip the Home Inspection! Just Don’t. When we bought our home, our realtor knew the seller would want an offer without a home inspection. So, we brought a home inspector with us to the open house. It was a little bit of a Bugs Bunny situation and the seller’s agent was ok with it but that was mega stressful for this rule follower. The market has calmed down some since then so you should be able to arrange for a professional home inspection as part of the offer you make on the home. Home inspections ensure any potential issues are identified and addressed before committing to the property.

Remember to prioritize your long-term goals and maintain flexibility and patience throughout the process. Feeling overwhelmed by all the information on the Internet? Reach out to one of our planners to help you navigate the process and make your next move a smooth transition.

Categories
Investing Real Estate Savings Taxes

Top 7 FAQs for Military Real Estate Investing

Top 7 FAQs for Military Real Estate

Understanding Real Estate Investing for Military

There are numerous ways to engage in real estate investing. There’s flipping, commercial offices, wholesaling, investing in notes, and the most popular among military families – residential rentals. Becoming a landlord may be the most popular form of real estate investing for military families by default. With steady incomes and incentives to buy houses heaped on service members, many become homeowners. When you own a house and receive military orders to another city your choices are limited. You either sell it, or you turn it into a rental property. Whether by plan or by fate, becoming a landlord is a solution often chosen.

Real estate investing also has a natural appeal to many military folks. Military families are do-it-yourself, ‘bootstrap’ people. There’s an air of self-determination around real estate investing. A sense that you are more in control of your destiny with real estate than you are with traditional investments.

Initiative and hard work seem like they can be turned into profit with a property on Main Street in a way that can not be realized with securities on Wall Street. Financial professionals describe it as inefficiencies in the real estate market that can be profitably exploited. I believe it is true, although more difficult to master than it seems.

The major obstacle to getting started in real estate investing is typically the initial cost. You can get started in TSP for 1% of your paycheck. With an app like Acorns you can open a brokerage account with your spare change.

To get into real estate investing takes capital, often tens of thousands of dollars of capital. It’s a big commitment. 

Big financial commitments generate questions. Access to VA loans and other programs lowers the barriers to entry into real estate investing, but most military families have at least one member with enough sense to know you don’t spew cash at an idea like becoming a landlord without looking a little before you leap. I am asked about it frequently.

Following is a list of the seven most common questions I am asked by people who are contemplating investing in residential real estate rentals. Each of them probably merits its own article, but I’ll try to give you some useful short answers here. 

Is real estate a good investment?

Let me break this news to you gently; it’s not about the real estate, it’s about you. Money can be made in real estate investing, but the path to it isn’t for everyone. In addition to technical know-how, a successful investor must have the ability to avoid frustration and derailment when people disappoint you. Because in residential rental real estate you have to deal with people, and people disappoint.

Sooner or later you will discover some tenants are vandals, some property managers are lazy idiots, and some contractors are thieves. If you believe the hype I see all over the internet about how easy it is to make money in real estate, you should not invest in real estate.

The successful landlords I know are hustling every day for their profits. The rest are trying to get back to even.

What are the tax benefits of real estate investing?

With respect to being a landlord, OWNING rental properties can have many tax benefits. SELLING rental properties usually has significant (and painful) tax consequences. Landlords are business owners. They own and operate residential real estate for the purposes of collecting rents.

The biggest expenditure in such a business is the cost of the property being let to the tenant(s). As a business owner, you can recover the cost of the buildings on your property by deducting them from your taxes over the lifetime of the building. This cost recovery process is known as ‘depreciation’, and its effects can make a tremendous impact to your bottom line while you own the building. However, if you sell the property you will likely owe the IRS for all the depreciation previously claimed on the building.

In addition to depreciation you can deduct all the ordinary and necessary operating expenses of a business. There are numerous ways to take advantage of this situation, but none of them will turn a bad investment into a good investment.

If you are thinking about getting into real estate investing do so because you want to make money from the investments and then take advantage of the tax benefits to maximize your profits. DO NOT get into real estate investing with the primary motive of reducing your taxes.   

Why don’t financial advisors give real estate investing advice?

First – a few of us do. But, I get it. We are so difficult to find as to be indistinguishable from non-existent. Take heart, our numbers are growing! The primary reason there are so few of us is related to how the financial planning field evolved.

Financial planning, so the story goes, was the love child of a few insurance salesmen and stock brokers trying to do the right thing. All the first generation planners came from one of those two fields. You sold insurance and did financial planning or your sold stocks and did financial planning. Nobody sold real estate and did financial planning. The second generation of financial planners were nearly all “investment managers”. They took a piece of the action (a percentage) of all the assets they could gather and manage. Still no real estate.

The third wave is coming. In this wave we take a more holistic approach to financial planning. Some are even calling it ‘life planning’. Some advisors have observed that in life many people invest in real estate, so we are starting to include it in the plans we build with our clients. We are mostly self-taught, though. For example, the inclusion of real assets in a portfolio is not covered in the CFP (R) curriculum. (I am working to get that changed, btw.) 

Should I form an LLC for my rental property?

Many people believe you must have your houses in an LLC to qualify for certain tax benefits. This is not true. There are no tax benefits to placing your rental properties in an LLC. 

Zero. 

None. 

Your rental property business is a business whether it is within an LLC or not. Your ability to deduct business expenses is not impacted by forming an LLC.

There may be legal considerations for forming an LLC in terms of limiting your liability. That is a question for a lawyer. I am licensed to give tax advice. I am not licensed to give legal advice. 

When is the best time to sell my rental property?

In terms of tax strategy – never. As I wrote above, OWNING rental properties can have significant tax benefits. SELLING rental properties frequently turns those significant benefits into significant burdens.

In many cases the most efficient tax strategy for rental properties is probate. When you die owning depreciated property your heirs inherit it with a cost basis reset to current market value. The tax burden is transferred to the government and is no longer a problem for you or your family. 

If you absolutely must get rid of the property, then the second-best time to sell is likely today. The tax burden on the property is most likely going to grow over time, so getting rid of it now is like ripping off the band-aid. Just get it over with.

That said, every case is different. You should have a tax professional knowledgeable in real estate issues evaluate your situation before you act. 

How does the ten-year extension for military people work?

Home sellers can exclude a significant amount of capital gain (frequently all the capital gain) from the sale of their primary residence as long as they meet certain guidelines. The short version of how to qualify for that exclusion is called the ‘2-in-5’ rule. You must live in the house for 2 of the 5 years immediately prior to the sale. There are additional rules, but those are the basics. That means you could move out of your house and turn it into a rental property for up to 3 years, then sell it, and still qualify for the exclusion from capital gains. (Because in the 5 years immediately preceding the sale you lived in the house for at least 2 of them.) 

Military families receive up to an additional 10 years to this ‘2-in-5’ rule if they were moved more than 50 miles from the residence on military orders. This means military families could live in a house for 2 years, take a PCS move to another state, turn the house into a rental property and sell it up to 13 years later AND still qualify for the capital gains exclusion. It’s a pretty nifty benefit!

A related question I frequently get is ‘how long do we have if the military member retires while living at the other duty station?’. The answer is that once the service member retires the extended period stops. Military families receive UP TO 10 years. When you retire your extension stops and you essentially have 3 years from the retirement date to sell the property before you will have to pay capital gains on the sale.

My depreciation is wrong on my prior tax returns, how do I fix it?

The short answer is to hire a professional to do it for you. 

The medium answer is that you can only fix a depreciation issue by amending returns if it was wrong on only one filed return. Once it’s been wrong on two filed tax returns you must submit an application to the IRS to change your method of accounting. This is done on form 3115, and it is a very complicated form. On the last page of the instruction book for form 3115 it estimates that it takes more than 36 hours to learn and prepare form 3115.

Save your time, hire a professional. If you prepared your own tax return and you didn’t get the depreciation right, then it is unlikely you will get form 3115 right.

The outcome of filing the form 3115 depends on how your depreciation was wrong. If you had been under depreciating the property, then you would get an adjustment allowing you to take a one-time additional beneficial depreciation adjustment on your tax return. (You get to claim an additional expense that year.)

If you had been over depreciating the property then you also get to take a depreciation adjustment to your tax return, but you won’t like it as much. The amount of over depreciation gets declared as additional income that year and you must pay tax on it. There are some strategy elements regarding the timing of these adjustments, so you should consult a tax professional knowledgeable in real estate investing before you act.

The Bottom Line

Real estate investing can be financially and emotionally satisfying when done well. At Redeployment Wealth Strategies we have some military families who are profiting nicely with their real estate investments. Unfortunately, we have a larger number of clients who got on that real estate investing highway before they thoroughly researched their situation, and now they’re looking for the off-ramp.

We urge you to carefully consider whether real estate investing is right for you before you make that large capital commitment to participate. Learning the hard way can be very expensive.

As financial advisors, members of the MFAA help people just like you navigate the questions, challenges, and planning opportunities related to investing in real estate. We would love to be of help and have a free consultation.

Find an advisor here!