Investment Property: Does this make financial sense?

[mikeUrban]

I purchased a property in King West back in 2004 and it's been my primary residence up until now. I'm moving into a new place and debating whether I should sell or rent the King West condo. Here are the details, can someone let me know if it makes financial sense based on my situation?

- Condo was purchased for $160,000, now worth between $280-300,000.

- Outstanding mortgage $45,000.

- Deductible Expenses (maintenance, property taxes, housing insurance, mortgage interest) are about $700/month.

- Can rent for $1500/month

The problem, as I see it, is that my outstanding mortgage is too small which means my deductibles are too low and so that leaves about $800/month exposed to taxation.

Present market conditions aside, does it make sense to rent this property? I can hang-on to it for the long haul, so the present conditions of the market are not too much of a concern.

What I'm looking for is advise about the fundamentals (forget current market conditions) based on my numbers (outstanding mortgage/expenses, etc...)

 

[urbandreamer]

Why do you have to worry about taxes?

 

[mikeUrban]

BTW, the fact that you have a small mortgage and therefore less tax deductible interest is a good thing- I'm surprised that you don't realize that instinctually.

The point I was trying to make is that it's better to have mortgage debt on my investment property (tax deductible) than on my new primary residence (not tax deductible).

Would any reasonable rate of appreciation in the coming years make keeping this place make sense? Let's say (just for fun) that year over year appreciation hovers around 10% (okay, you can stop laughing now)... would it then make sense to keep this place, or should I just sell? I'm off to work, but will try your calculation later tonight. Thanks.

 

[daveto]

Mike,

The question for you is whether you anticipate wanting to sell this in the short-mid term or to hold onto it for the longer term

It has been your principal residence for 4 years, and thus the entire appreciation of $120k is tax free. If you now turn it into an investment 4 years (as an example) and then sell, 50% is tax free and 50% is capital gains.

So what happens if you receive zero appreciation over the next 4 years? Then instead of receiving $120k tax free, instead you receive $60k tax free and $60k capital gains. Plus you also have to pay transaction costs (agents fees)

However if you can hold on to this longer term (indefinately), then I'd suggest taking out a longterm fixed mortgage while rates are historically low and investing the extra cash.

On the flip side, if you try to sell now you may be in for a surprise about your expected sale price (given the direction the RE market seems to be heading)

 

[cabbagetowner]

would be interested if anyone knows or has experience with converting a primary residence into a income property. it makes sense that you should be able to use the capital gains exemption for the increase in value, up until you have another primary residence. Perhaps you can get an property assessment done at the time of conversion.

Depending on the rate you get for the mort's you might want to pull as much equity out of the income propertt and put it into your new primary residence. (that is if you decide to keep the property). I think if you punch in the numbers it's very difficult to have an income property with condos.

 

[mikeUrban]

Mike,

The question for you is whether you anticipate wanting to sell this in the short-mid term or to hold onto it for the longer term

It has been your principal residence for 4 years, and thus the entire appreciation of $120k is tax free. If you now turn it into an investment 4 years (as an example) and then sell, 50% is tax free and 50% is capital gains.

So what happens if you receive zero appreciation over the next 4 years? Then instead of receiving $120k tax free, instead you receive $60k tax free and $60k capital gains. Plus you also have to pay transaction costs (agents fees)

However if you can hold on to this longer term (indefinately), then I'd suggest taking out a longterm fixed mortgage while rates are historically low and investing the extra cash.

On the flip side, if you try to sell now you may be in for a surprise about your expected sale price (given the direction the RE market seems to be heading)

Okay, I think there are a few things wrong with what you are telling me. First of all, when you convert a primary residence into an investment property, you get a property assessment done. So, for example, if the assessment says the place is worth $300,000 at present and I then rent the place out for 5 years and it appreciates to $400,000, I get to keep everything upto $300,000 and only 50% of the gains above that is taxed at my marginal rate. If the place is still worth $300,000 when I sell in 5 years, then I don't pay capital gains, because there wasn't any. To your second point, you can't take out a larger mortgage on an investment property if you are going to use the money towards your primary residence (well, you can -- but the mortgage interest would NOT be tax deductible). I could take out a larger mortgage and use that money to invest in something but NOT for personal use (like a primary residence). If someone knows of a loop-hole they would like to share, I will kiss your feet.

 

[mikeUrban]

Depending on the rate you get for the mort's you might want to pull as much equity out of the income propertt and put it into your new primary residence.

This is the question I've been struggling with for months. I've talked to several accountants and most of them* concluded that you are NOT allowed to do this, if you are planning to deduct the mortgage interest as an expense -- which is really the only reason you'd want to do this, right? Or am I missing something crucial?

*Some will tell you anything you want to hear, doesn't mean you won't get in trouble. From what I understand, the risk of getting caught is pretty low -- but if you are (random audit, for example) your tax returns are going to be scrutinized for the rest of your life ontop of steep financial penalties.

 

[rbt]

From what I understand, the risk of getting caught is pretty low -- but if you are (random audit, for example) your tax returns are going to be scrutinized for the rest of your life ontop of steep financial penalties.

If you're being reasonable and playing by the rules as they were meant to be then they won't care. Take what you properly earned and pay the rest. It is the honourable thing to do and if you ever have the opportunity to be in big business honour goes a very long way since other big business folks don't like dealing with cheaters. Audits from the government are minor by comparison.

 

[rbt]

This is the question I've been struggling with for months. I've talked to several accountants and most of them* concluded that you are NOT allowed to do this, if you are planning to deduct the mortgage interest as an expense -- which is really the only reason you'd want to do this, right? Or am I missing something crucial?

You may be overlooking one possibility. You cannot directly write off the interest BUT you can certainly have income from a different property that offsets expenses elsewhere.

I recommend hiring an investment realtor and double checking with your accountant.

Take the equity in your current home and split it three ways:
- Downpayment on a new primary residence. Big new mortgage here.
- Boost mortgage on existing residence to an appropriately leveraged and safe position. Since your change in use will necessitate a sales to yourself (tax wise anyway -- as you described earlier) this can be considered a downpayment
- Is there enough here for a 2nd rental property that will turn a profit?

Write down the interest on both rental properties. Take any monthly profits and pay off the primary residential mortgage faster, reducing the effective (out of pocket) payments.

Your rentals should be profitable on a month to month basis since you can specifically arrange financing to suit the revenue coming in.

In 10 years you should have 3 properties with small mortgages remaining.

 

[Observer Walt]

Mike,

...
It has been your principal residence for 4 years, and thus the entire appreciation of $120k is tax free. If you now turn it into an investment 4 years (as an example) and then sell, 50% is tax free and 50% is capital gains.

So what happens if you receive zero appreciation over the next 4 years? Then instead of receiving $120k tax free, instead you receive $60k tax free and $60k capital gains. ...

I am not an accountant but I think the above is incorrect. Any gain in value while it is your principal residence is free of capital gains tax, period. If you change its use to an investment property, the gain in value from that point to the time of sale is subject to capital gains. Determine the value at the time of the change of use, and use that as your base for capital gains purposes. If there is no increase in value, during the time you hold it as an investment property (unlikely!), there would be no capital gains tax.

 

[mikeUrban]

I am not an accountant but I think the above is incorrect. Any gain in value while it is your principal residence is free of capital gains tax, period. If you change its use to an investment property, the gain in value from that point to the time of sale is subject to capital gains. Determine the value at the time of the change of use, and use that as your base for capital gains purposes. If there is no increase in value, during the time you hold it as an investment property (unlikely!), there would be no capital gains tax.

I knew the answer to this already, but thank you for confirming. When I read misinformation like that, I'm ready to have a panic attack. I find that most people really have no idea what they are talking about when it comes to real estate. For example, many people I talk to think that the capital gains you pay on the sale of your investment property is 50% of the appreciation. When in reality, you are taxed on 50% of the appreciation at your marginal tax rate. BiiiiiiG difference.

 

[mikeUrban]

You may be overlooking one possibility. You cannot directly write off the interest BUT you can certainly have income from a different property that offsets expenses elsewhere.

I recommend hiring an investment realtor and double checking with your accountant.

Take the equity in your current home and split it three ways:
- Downpayment on a new primary residence. Big new mortgage here.
- Boost mortgage on existing residence to an appropriately leveraged and safe position. Since your change in use will necessitate a sales to yourself (tax wise anyway -- as you described earlier) this can be considered a downpayment
- Is there enough here for a 2nd rental property that will turn a profit?

Write down the interest on both rental properties. Take any monthly profits and pay off the primary residential mortgage faster, reducing the effective (out of pocket) payments.

Your rentals should be profitable on a month to month basis since you can specifically arrange financing to suit the revenue coming in.

In 10 years you should have 3 properties with small mortgages remaining.

What you say makes a lot of sense, but I don't know if I'm quite ready to take on multiple investment properties right now. I'm moving into another condo for about 2 years and then plan to make that into an investment property, assuming it makes sense in 2 years...

 

[daveto]

Mike,

I regret that my well intentioned post was not useful (and in fact wrong), but it was classy of you to appreciate my effort. I'm sure that karma will come back to you.

Dave

 

[rbt]

What you say makes a lot of sense, but I don't know if I'm quite ready to take on multiple investment properties right now. I'm moving into another condo for about 2 years and then plan to make that into an investment property, assuming it makes sense in 2 years...

I cannot think of any options other than that for immediate avoidance.

I guess you just optimally mortgage your existing property for maximum profit and perhaps go with a very short term at the new place to minimize the actual interest involved. A $100K mortgage amortized over 10 years (weekly accelerated payments) will have well over 50% of the payments go toward principal without huge payments.