Part Three of Financing a Second Property: Passive Activity Loss

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The world of tax deductions for small businesses and second properties is a labyrinth of schedule E vs. schedule C forms, allowable deductions, exceptions and special circumstances. I thought I knew many of the rules because, as a freelancer, I had written a 17,000 word series of video scripts designed to train Realtors in selling vacation homes. But it truly is a complex and overwhelming area of the tax code, and I am learning new things all the time.

Case in Point: The Passive Activity Loss Exception

One of the things I didn’t realize when I purchased the Anchorage and Cabin is I would be able to take advantage of a special tax deduction designed for individuals who experience passive activity loss (PAL) with an investment property. Provided that you are “materially involved” in the management of the property — that is, you take an active role rather than letting a management company handle the details — and provided that you have at least a 10 percent ownership interest in the property, the IRS makes an exception to their general rule that rental losses are passive and can only be offset against other passive income. The upshot is you get to claim a tax deduction up to $25,000 against all income gains, including ordinary income, each year you meet the qualifications.

Okay, this sounds awesome — but of course it’s not that simple. Nothing in the world of small business taxation is even remotely simple; exemptions and exceptions volley back and forth schizophrenically, sometimes in the same document. The problem here? This deduction gets phased out once your modified adjusted gross income (line 38 on your 1040) rises above $100,000 a year, and if your MAGI is over $150,000, you can’t take the deduction at all. In other words, divorcées who don’t usually make squat but decide to cash out their retirement accounts to purchase a historical Maine homestead don’t get to deduct a goddamned thing for that tax year. Goddamn it.

The IRS does allow you to carry the deduction forward into subsequent tax years — at least that’s what I hear from my accountant. What I’m not entirely sure about is if I’ll be able to take the deduction against ordinary income or just against my passive rental losses. If the former, it seems likely that I will be able to recoup about a third of the taxes I’m paying in 2015, though I may have to phase that out over several years.

Beyond that, there are a number of variables:

  • Is it better to manage the property myself or have a company take care of these details for a fee?
  • Would I make more money renting out both houses and using a service or occupying the Cabin and taking a hand’s on approach to renting the Anchorage during the summer season?
  • Should I run the Anchorage as a small business venture, or would it be more advantageous simply to rely on the passive seasonal rental income?

Fortunately, these are questions I don’t have to answer right away.

Nest Egg or Cash Flow

I want to finish this post by touching on a particularly insightful bit of information that one of my freelance clients shared with me. I told him what I was about to do, and rather than try and talk me out of it, he pointed out that the rental revenues I’d have coming in would be equal to the interest on a large nest egg.

I’d never thought about it that way, but it’s true. By the time I retire, annual rental income from the Anchorage will be equal to 4 percent interest on a $500,000 capital sum, and unlike money placed in a safe investment, like a CD, this income stream is tied to inflation.

One of my favorite moments in cinematic history occurs in Albert Brooks’s 1985 comedy, Lost in America, right after the character played by Julie Hagerty gambles away all of the money she and her husband, played by Brooks himself, were going to use to support themselves in their quest to touch Indians and sleep beneath the stars.

“The egg is a protector, like a god,” an irate Brooks rants at her, “And we sit under the nest egg, and we are protected by it. Without it, no protection.”

lost_in_america_1985_685x385The Nest Egg Principal is what most of us emulate as we move toward retirement. The goal is to accumulate a large sum money so that we have enough interest income to supplement what we will receive in the way of social security and pension. Without the “nest egg,” we’ll barely have enough to scrape by.

I’m not knocking this principle. But there’s something to be said for taking a gamble as well.

Part Two of Financing a Second Property: Self-Directed IRAs

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If you cash out your retirement account in one lump sum, you stand to lose far more of your money to the IRS than you would if you took your distribution payments over time. The reason is, by cashing out the entire account, you put yourself in a much higher tax bracket for that single year since distributions from a retirement account are taxed as ordinary income. Instead of being in the 25th percent bracket consistently throughout your retirement years, for instance, you might be in a 33rd percent bracket for one year. While you don’t pay 33 percent on all that money, you may pay that rate on the lion’s share of the distribution.

The IRS has made it hard, but not impossible, to recoup some of the losses. I will be able to cushion the blow in two different ways. This post talks about the first, self-directed IRAs.

Self-Directed IRAs: A Quick View

When I told my brand-new accountant what I was about to do, he flipped out. “Do you realize what tax bracket you’ll be in?” he asked me.

He told me I should look into self-directed IRAs. This is a little known investment vehicle that allows you to invest  in “anything you like” rather than sticking to the stocks and bonds that make up most investors’ portfolios. Well, anything except collectibles, S-corp capital stock, and a short list of other prohibited investments.

You can, however, invest in real estate and land, which were the only things of interest to me.

Here’s how it works. The IRA holds the real estate through a company that acts as a custodian of the account. The big investment companies, like Vanguard and Charles Schwab, do not handle self-directed IRAs. You will have to research the companies that do handle these accounts, compare their fee schedules, and check their track records yourself.

The custodian purchases the real estate with rolled over funds from an existing IRA or 401k account after reviewing the purchase sales agreement. They then write checks to pay for ongoing property tax and maintenance and receive rental payments and other revenues on your behalf. It all stays in the IRA. The custodian files the appropriate paperwork with the IRS and charges a variety of fees to maintain your account.

You can theoretically be your own custodian by holding your investment in a so-called “checkbook” IRA as long as you adhere to the rules that govern self-directed IRAs. Checkbook IRAs purport to cut out the middleman — though even these accounts have someone who does the IRS reporting for a small annual fee. However, checkbook IRAs are hanging on to their legal status by the slender thread of one court decision, and the IRS has had its eye on them. I decided not to pursue that course.

Although the IRA shelters your money from taxes, there are a lot of rules that make self-directed IRAs a less than desirable choice for an investment property, especially if you need to pay for a lot of repairs on the property before it generates cash flow:

  • You can’t work on the investment property yourself (there is some disagreement about whether individuals can perform routine maintenance such as mowing the lawn). Thus, sweat equity is out.
  • You can’t live in it or even stay there one night out of the year. Nor can your parents or children live there (siblings are okay).
  • You don’t get any of the tax advantages typically associated with owning an investment property.

How a Self-Directed IRA Worked for Me

Because there is an extensive list of prohibited transactions, I wouldn’t recommend that anyone use this vehicle to purchase a home they plan on living in eventually. Even if you wait until you are old enough to avoid the IRS penalty, you still have to take the entire property as a distribution (and pay taxes at a higher marginal rate). If the property appreciates enough — normally a good thing! — you could conceivably price yourself out of ever buying it from the IRS because you would not be able to afford to pay the taxes.

Because there are two houses on the lot I purchased, and I plan to keep one as a seasonal rental, I toyed with the idea of purchasing the Cabin outright and holding the Anchorage in my IRA. That would have increased my restoration budget for the Anchorage considerably and decreased my tax burden. I already had a good survey of the property, and the surveyor was willing to divide the lot on short notice so that I could make the closing date. The two houses already had separate spring houses, septic systems, electricity accounts, and insurance policies.

But the more I thought about it, the more I realized how difficult it would be to live on one house and keep the other in the IRA. It might raise flags with the IRS. More importantly, I’d never be able to host friends or family at the Anchorage, not even for a few days during the off season. And what’s the point of having a place like this if I can’t use it to host the occasional gathering?

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Fortunately, the family who sold the property had already divided it into two lots; there was a 3-acre field across the street that they listed separately in order to boost interest in the place. The offer I made included both parcels, so I ended up placing the land in a self-directed IRA. Deferring the income tax on that portion of the sale reduced my tax burden considerably, and because it is undeveloped land, there is little that needs to be done in the way of maintenance, so I won’t have to make a lot of future payments into the account.

When I turn 60 I can decide whether to leave it in the IRA for my daughter to inherit or take it as a distribution then.

Financing a Second Property: Part One of a Quick Guide

 

IMG_8874Although most financial experts will advise you not to cash out your retirement funds to purchase real estate, it was the right choice for me. I’m going to walk you through the steps I took to make it happen. There are at least two special circumstances that stacked the deck in my favor, but some of the practical advice I give below is worth considering regardless of what your case may be.

Some Background 

When the ex and I split, in 2011, the United States was still recovering from the recession. Although we had more money saved for retirement than the average couple, I had invested everything in equity funds, which were still down considerably, as was the value of our modest house in Austin. The lawyers with whom I consulted about asset division did not believe that I’d be able to remain a homeowner, let alone purchase a second home.

“What will you do? Move in with your parents?” one of them asked.

Among other things, these gloomy speculations made me realize that if I retained an attorney, I could stand to lose a great deal of money, especially if my ex and I got embroiled in a court case. I resolved to employ attorneys on a consultation only basis, hiring one to write up the final divorce paperwork for a flat fee. The whole thing, which included advice from two of the top family lawyers in Austin, cost about $4,000.

In order to keep the house — pretty much the only way I could remain a property owner, given my lack of a stable work history and the stringent mortgage qualifications at the time — I did a cash out refinance while we were still legally married, tapping into our existing equity. My ex got most of that so he could purchase a house for himself; I reserved a small amount as an emergency fund.

This turned out to be a wise move. Austin recovered more quickly from the economic downturn than the rest of the country, and the value of my home rose 26 percent in the next four years. Early last spring, I checked the account balance of the 203b funds I’d been awarded in the form of a Qualified Domestic Relations Order (QDRO). I didn’t log into the account very often; the whole thing reminded me of the difficult days right after the separation. This time, however, I was pleasantly surprised to find that my stocks were up almost 100 thousand dollars as well.

Assessment

I sat down with a pencil and paper and made a complete accounting of my financial situation under various scenarios. I estimated approximately how much I would receive in Social Security and how much the Federal Government would offset the modest pension I’d receive from the community college if I stuck in the plan long enough for it to vest. I also had some Roth and regular IRA funds that were not marital property — not a lot, but not nothing, either.

I realized that I would not be in bad shape even without the QDRO funds. There was not a lot of money, but my needs are modest, and even if I became seriously ill, I was never going to be wealthy enough to afford top-notch assisted care, which these days exceeds even the cost of attending a liberal arts college per year. I would have to be proactive about my health — watch my weight, reduce stress, keep up regular exercise — and hope for the best.

I had been searching MLS listings in coastal Maine for months; now I contacted Realtors and narrowed the field of choice. My best friend and her husband had connections with the Blue Hill Peninsula, so I focused my real estate search there. Good restaurants and a strong artist community were definitely bonuses.

Gathering the Funds

I decided how much money I would need at minimum to afford a house that fit my requirements. Ideally, I wanted a place that would continue to bring in rental income even after I moved up to Maine for good, and properties like that were slightly more expensive. Although QDROs are exempt from the 10 percent penalty that one ordinarily has to pay on an early distribution, I would still be taxed heavily on the retirement funds — more on that in Part Two — so I decided to supplement this amount with another cash out refinance.

For what it’s worth, I love cash out refinances. For an initial $15,000 downpayment on the house in Austin, my ex and I have purchased well over a million dollars worth of real estate. If I had to guess, I’d say we have about $400,000 in equity stemming directly from that initial investment. Subtract the mortgage payments, and that still leaves $150,000. That’s about 17 percent interest over 15 years. Not bad. If we had bought on the west side of town, like our Realtor recommended, we’d be millionaires.

I had my excellent mortgage broker, Jim Loughborough, dig deep to try and get me the maximum amount he could manage out of the refinance. Since I freelance part time and work at the community college part time, the paper chase was excruciating; the lender wanted to know everything about me, and after we ran into problems with the IRS that pushed the closing date back into June, they wanted to know it all over again.

That was nothing, however, compared to my last minute realization that the tax burden from the QDRO distribution would be tens of thousands of dollars more than I initially thought.

Parts Two and Three of this guide discuss some of the ways in which I will be able to cushion the tax blow. I’ll also impart some of the wisdom I learned about the importance of cash flow from one of my freelance clients, a successful Realtor in the Bay area.

Taking Stock and Defining Motives

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Now that the work is finished for the season, I’ve decided to write a series of posts about the steps I took to finance this investment. Given my writerly nature, these posts will probably be pretty discursive. I’ll try to focus a couple of them on topics like using a self-directed IRA to purchase an investment property. Others are just going to ramble from one idea to the next.

I want to make clear from the onset that I’m not a financial advisor, a tax attorney, or a CPA. I’ve made some miscalculations already; some of them are dumb things I overlooked even after reading dozens of articles online and poring over the pertinent IRS documents.

Still, people think that a venture like this may be out of their reach, so I want to share my experience with you, focusing on both the emotional and economic aspects of it.

This week, I received all but a couple of the bills for work performed on the place this fall. My carpenter’s bill was the biggest; the painter, well driller, and excavator also took sizable chunks. The breakdown looks like this:

  • Clapboard replacement, foundation repair, sill damage to the Anchorage: $10,234.00
  • Painting of replaced clapboards and the other exposed wood: $3,150.00
  • Well, digging and fracking: $6,545.00
  • Consultation with structural engineer:  $291.00
  • Excavation:  $1,410
  • Chimney cleaning and staging:  $866.00
  • Plumbing, including the estimated cost to winterize:  $948.00
  • Lawn maintenance, plus reseeding and fall cleanup: $1,000.00 (estimated)

Total: $24,444.00

Of course, there are property taxes due on both the main lot and the separate parcel of land across the way; and in addition to those expenses, I had to pay the hazard insurance on both buildings, which have different accounts. I won’t count these figures in the tally because my primary interest going forward is how much it costs to repair and restore the buildings.

I have enough of my cash reserve left to fund the next big project — putting a solid foundation under the cabin — but after that I’ll have to save up for each subsequent restoration. There are two big projects that need to be done in the next couple of years: installing a new septic system for the properties, and roofing the main house.

Meanwhile, I’ll be learning how to do this:

Buying a summer house in Maine been a fantasy of mine since I was 12. I would draw elaborate pictures of how I wanted the house to look. I envisioned a drive that meandered slowly through woods richly landscaped in understory ferns and hostas. The house itself, first visible through gaps in the trees, sat overlooking a final parklike slope.

The origin of this fantasy was the cabins my paternal grandparents owned in Pembroke, Maine, a village close to the Canadian border. There were nine white-painted buildings in a row beyond the farmhouse in which my grandparents lived, each kept scrupulously neat and clean. My favorite was a small cabin with bright yellow trim and a weather cock on its peaked roof. Each one was slightly different. That was the charm of the place.

The smell of cut grass and gasoline from the riding mower is what I remember best, that and the sound of sheets churning in the zinc tubs of my grandmother’s old-fashioned washing machine. Sheets and towels, an endless supply, went through that house. I itched and begged to be allowed to feed them through the electric wringer myself, despite my grandmother’s stories about a girl like me “who lost an arm” through carelessness. I never tired of watching the water rush from one end while a flattened curl of towel emerged out of the other. It was like magic.

I was allowed to help my grandmother make and strip beds, hang towels on the line, and do the folding. My grandfather fashioned a cart for the back of his mower, and I rode on that, feeling absurd and semi-important when guests’ children watched me from the swing set at the back of the property. One whole day we spent picking blueberries at the grounds of an abandoned house with “S” shapes cut into the shutters. Saplings as thick as fingers had grown up through the foundation, and in the back was a graveyard that had jars of faded plastic flowers on the tombstones.

Without meaning to, I learned things about the hospitality business. How to prioritize a list of chores. The value of cleanliness. The importance of customer service. My grandfather took pride in what he did, charging modest rates (because he had no swimming pool) and delivering exceptional value. He didn’t just fix things as they broke. He kept a constant vigil, anticipating what might go wrong. When cars arrived, he rushed outside to greet the guests with a show of enthusiasm, often rising from the dinner table to get their keys and show them to their cabin. Sometimes I would excuse myself and run outside, mosquitos stinging my bare legs, to listen shyly to their conversations.

This reminds me of a trip my former boyfriend Paul and I took, driving down the Baja peninsula to see gray whales. Along the way, we drove through the inland desert to the Sea of Cortez and a fishing town called Bahia de Los Angeles. There, a doctor from Mexicali had bought some land for his retirement and came down every weekend to build stone cabins one by one on the beach. Like my grandfather, he didn’t care anything about the money. We paid something like seven dollars a night to camp on his land. Coyotes yipped in the distance. In the morning, a whale breeched the surface of the bay in front of us.

This was the point.

8515743649_7d67e9576f_z   Bahia de Los Angeles,” by Alessandro Valli

Phase One on the Facelift of “a Magical House” Is Complete

Here it is, the tail end of summer, almost time for the plumber to come and winterize my very own historic Maine homestead for the season. Since the closing in mid-July, the workmen have accomplished the following:

  • Dug a well. IMG_0443
  • Removed a chimney stack.
  • Propped the foundation of the Anchorage.
  • Repaired rot and sill damage from failed gutters.
  • Scraped and painted the worst sections of the house.

I have deferred the next big job — putting a proper foundation on the smaller back house, otherwise known as the Cabin — until I get back up there to watch what the contractors are doing.

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Speaking of contractors, Woodstock says that a check is arriving via registered mail for the work he never did. I haven’t seen it yet, but I remain hopeful. I did, however, get my tax bills. One of the siblings of the family that owned the house before me forwarded them to me with a sweet note welcoming me to the house “with open arms and an open heart.” A different sister, the one who arrived to sign papers at the closing, described the Anchorage as “a magical house.”

Some history may be useful here. The property was on the market 12 years, according to its current Realtor. Before the housing market crash in 2007, it had been listed for over twice what I paid. Apparently it was also in better shape. The family made numerous improvements to the back house, including the installation of all new plumbing. But they had given up on the foundation of both structures and let brush grow up around the Cabin. Weather beat down the roofs, and poorly installed gutters introduced rot.

They also disagreed, as siblings will, about whether the house should leave the family at all. Some prospective buyers wanted to tear down the Anchorage and finish off the Cabin. They wanted the place to remain as is.

My daughter and I choose the suite of rooms upstairs as our own apartment for June, before the seasonal rental market heats up and we have to vacate for our paying visitors. This section of the house includes a toilet at the end of a long corridor, a wash basin in the hallway, and two light-filled dormer bedrooms with a distant view of Eggemoggin Reach.Mail Attachment 2 Mail AttachmentThe fact that the water closet has an arched and paneled ceiling speaks volumes about what makes the house so special. It’s a place where nothing is ugly, and most things are whimsical and charming. My room features framed selections from Antoine de Saint-Exupéry’s The Little Prince, for instance. The banisters going up the steep staircase to the second story don’t match; one is black, the other white. This eclectic touch seems random until you realize that their railings mirror the black and white finish on the stairs themselves.

Both houses are full of neat surprises like that. I was immediately smitten. I’d seen a bunch of places that had good individual features, but over the years the owners had put their mark on them in ways that made the design feel incoherent. In one early nineteenth-century house, the original ceilings on the upper floor were less than seven feet high, yet the owners had remodeled a master bedroom on the ground floor to have the prosaic feel of a 1940s bungalow. Another house had a clawfoot tub seated on a platform in the bedroom. I loved the whimsy of that, but the tub was only five feet long — not ideal for soaking my almost six foot body. And though the tub was the focal point of the room, its location beneath the eaves felt cramped and a bit sad.

The Cabin and Anchorage need repair and restoration, and yet they are complete. The Cabin has such rustic charm that from the first time I wandered its circular layout, I  imagined myself, clad in soft winter clothing, walking from the kitchen with a cup of tea and sitting by the fireplace to do some writing. My Realtor remembers how I sank into the red chair pictured below and announced, “I want to buy this place.”

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Meanwhile, another semester at Austin Community College is underway. Teaching sections of literature and composition to reluctant student writers is probably not the most efficient way to fund the restoration of a 200-year-old property, but I get to take six weeks of the summer off to go up and oversee the construction, and, for the time being, it pays my health insurance premiums.

The community college teaching also gives me enough time to supplement my income by writing ebooks and website copy. I began working this patchwork of different jobs after the divorce, so that I could continue picking up my daughter from elementary school and taking her to guitar practice and gymnastics rather than putting her in aftercare. But now I have to admit that I sort of like doing a little bit of everything: grading papers for a few hours, rushing to meet a client deadline, strategizing before administrative meeting at the College, tutoring students at a campus learning lab.

Nevertheless, it will be nice to slow down a bit. Focus on my writing. Get some goats and chickens.