http://www.TwinCitiesUSA.com/video/Phil-Kronlage-Discusses-Investing-in-Rental-Property

STEVE:  Hi, this is Steve Westmark.  Thanks for watching my video blog this week.  In the series that I’ve been talking on investment, I’m bringing in different people to help you understand how to invest in real estate.  And today, I’ve brought in Phil Kronlage of Blanski Peter Kronlage & Zoch, and I assume that Kronlage is you.

PHIL:  That’s correct.

STEVE:  So Phil, as a CPA, how do you help the people as they come into your office look at investment property and what are the advantages that they look at both tax-wise, cash flow-wise?  I’ll just leave it open.

PHIL:  The first thing we do is kind of do a forecast of what the client would expect for cash flow.  So we estimate what rental income is going to be each month.  Then we list out the potential expenses that they’re going to have.  And those expenses or cash outlays would include an amount for principal and an amount for interest.  And included with that, the bank is probably going to require that you escrow your real estate taxes and your insurance.  So that’s probably going to be your largest outlay of cash.

Now if you buy a property that’s in an association, you have to take into consideration the association dues, which is something that a lot of people I think seem to forget about when they’re looking at buying the property is that they’ve got to make that association dues payment every month.  So in addition to that, most likely in a single-family residence or in a multifamily area, you’re going to be responsible for the repairs and so forth on that property.  And that’s probably about it for cash outlays.

So you compare that to the rental income coming in and does that exceed, as a rental income, exceed your cash outlay or are your expenses, including your mortgage payment, greater than the cash that you’re receiving from your tenant?  So if it’s greater, the big question is: Where’s the rest of that money going to come from?  And so you need to plan to have that money available on a monthly basis to pay those expenses.  So once we’ve calculated cash flow on this, and if it still looks like a deal that they want to get involved in, then we start talking about the tax ramifications of owning rental property.

And in addition to the expenses that we talked about previously, an additional expense that you can take for tax purposes in determining your taxable income is depreciation.  And that’s basically depreciating the value of the building.  You can’t depreciate the land, so you have to break down the value of the building and land.  And you can only depreciate the building over basically 39 years.  And that gives you an additional deduction and reduces your taxable income.  Once we take a look at the tax ramifications, then we really have a full picture of what your cash flow needs are going to be.

STEVE:  Well, then Phil, after owning the property for quite a few years and having a cash flow with it, which we strongly believe in, there’s usually some type of appreciation.  In fact, over the last 40 years we’ve seen a compounded inflation of about 5%.  What are the tax consequences that a person looks at at that point when you go to sell?

PHIL:  The tax issues that we take a look at at the time of sale is comparing the sale price to what is now your adjusted tax basis.  So your adjusted tax basis is the original cost of purchasing the property, the building and the land, less the depreciation that you’ve been able to expense over the previous years that you’ve owned the property.  And that will give you your cost basis that is deductible for tax purposes.  So you compare that to your sale price and determine whether you have a gain or loss.  If you’re in a gain situation, that gain is going to show up on your tax return as taxable income.

Some of if it recapture of depreciation, which is going to be taxed at a different rate.  And some is going to be potentially capital gain, is what we hope, if there’s appreciation in the property.  So you definitely need to work with your tax accountant to determine what that is going to cost you as far as a gain is concerned, the tax on that gain.  There is an option to defer paying the tax on that gain, and that is getting involved in what’s called a 1031 exchange where you exchange the property that you’re selling for another property that you would want to purchase and start this all over again.

So the property that you are purchasing has to be at least greater or equal to the property that you’re selling to defer the full gain.  So there are ways to not pay any taxes, and if you don’t want to use that 1031 exchange feature, then you will pay capital gains and maybe some recapture of depreciation gains. 

STEVE:  Well, I appreciate you, Phil, being my tax counselor through the years, and I’m sure that you could help many a person whether it be with investment real estate or any type of tax work.

PHIL:  Well, thank you Steve.  I enjoyed the opportunity to meet with you today, and you’re absolutely right.  We work with many, many individuals who invest in real estate through the last 35 years that I’ve been doing it.