Commercial vs. Residential Mortgages
There is one fundamental difference between commercial and residential mortgages.
With commercial mortgages it is primarily the building and the cash flow it produces that qualifies the mortgage for funding not the borrower.
Commercial lenders originating long term commercial mortgages, as against short term hard money mortgages, are very concerned about the following:
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What is the net operating income of the property (NOI)? |
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What is the debt service coverage? (DSC.) |
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What is the occupancy rate of the property? |
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How long are the leases? |
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Who are the tenants? |
Lets look at each of these in turn.
Net Operating Income (NOI)
This is the income produced by the property excluding interest payments, capital repayments and depreciation.
Debt Service Coverage (DSC)
What is the ratio by which the NOI exceeds the Principal and Interest payment.
If the NOI is $130,000 per year and the P and I is $100,000 per year, the DSC is 1.3 (130,000/100,000).
Lenders look for a DSC usually around 1.25 but it could range from 1.00 to 1.40. The lower number can occur when there is a triple-net leased property to a very financially strong tenant, like a Walgreens, where 100% of the income goes to service the loan.
Occupancy rate
Even if the property is 100% occupied, lenders will allow a notional vacancy factor of 5% or more. Some lenders refuse to lend on properties below a certain occupancy factor, like 70% for instance.
Lease terms
The longer the leases, other things being equal, the more financiable is the property.
The tenants
It doesn't take a genius to figure out why Microsoft or Bank of America is a stronger and more "bankable" tenant than Joe's Pizza Place.
For a quick and dirty calculation of the possible loan amount go our Simplified Underwriting chart.
Tax benefits of real estate investment
You can invest in many types of real estate: rental houses, apartments, vacant land, commercial buildings, industrial, shopping centers or warehouses.
They all offer big tax incentives for investors who understand those benefits.
Many people believe that depreciation is the best real estate tax deduction of all. The IRS REQUIRES real estate investors to depreciate their investment properties.
Depreciation is a "paper loss" required for estimated wear, tear and obsolescence. However, land value is not depreciable. This applies to 100% of the money invested in buying vacant land and that part of the property value apportioned to land on an improved property. (That is, land with a building on it).
Condominiums do not have a land element and the whole value can be depreciated.
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Residential income property is depreciated over 27.5 years on a straight-line basis. |
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Commercial property is depreciated over 39 years, also on a straight-line basis. |
Extra tax benefits of being treated as a "real estate professional".
Time requirement
If you spend at least 750 hours per year, or more than half of your working hours, involved in real estate activities, you probably qualify as a "real estate professional."
There does not appear to be any clear IRS ruling on a semi-retired person with no occupation but real estate and to which they devote say, 200 hours a year.
If you are a "real estate professional" who "materially participates" in managing your investment property, you are allowed almost unlimited income tax-deductions from your investment property.
Full-time real estate brokers, realty sales agents, property managers, builders, contractors and leasing agents are examples of qualified real estate professionals.
However, the tax law excludes real estate attorneys and mortgage brokers from qualifying. Unless, one must assume, they spend more than 50% of their working hours investing in real estate. This would include managing, buying and selling real estate.
If you invest in real estate but do not qualify as a "real estate professional" , you are limited to a maximum annual $25,000 realty investment property loss deduction against their ordinary taxable income. This is called the passive loss restriction. This "loss" includes the paper loss created by depreciation.
However, there is another catch. If your annual adjusted income exceeds $100,000, the $25,000 loss deduction gradually phases out. At the $150,000 adjusted income level, the allowable tax loss deduction goes to zero.
Any undeducted real estate investment tax loss is "suspended" for future use, such as at the time the property is sold at a profit. Then you may subtract the unused suspended tax loss from your capital gain to lower the taxable profit.
Material participation requirement
Participation is key You can still meet the material participation requirement, and claim the unlimited tax deductions as a professional, even if you hire a professional property manager. Day-to-day operating details, such as collecting rents, evicting tenants and unclogging toilets, can be delegated to this manager.
But, you must make the major decisions, such as setting rents, approving major expenses and qualifying new tenants.
Personal property such as appliances
Personal property used in operating the property, such as appliances, is depreciated over shorter periods, typically five to 10 years. Even automobiles and trucks used in the investment operation can be depreciated over their useful lives.
First-year 100% deduction
There is also the new first-year 100 percent deduction for up to $100,000 of business equipment purchased. This would include appliances. Sorry but you can't buy a brand new BMW and deduct 100% of it from your taxes in the first year. There are however special rules for work vehicles, such as trucks. Ask your CPA for more details.
Depreciation is a non-cash deduction
It reduces taxable income from the investment property. But in contrast to property taxes, mortgage interest, utilities, insurance and repairs, it doesn't require any cash outlay . The depreciation expense deduction can turn a positive cash flow property into a loss maker for tax purposes.
Most investment properties go up in value every year, but on paper their value is going down.
Unfortunately, unused tax losses from investment properties cannot be carried back to prior tax years to claim a tax refund.
IRS Notice 88-94 allows use of suspended passive activity tax losses (assuming you do NOT qualify as a professional with material participation) from realty investment assets to offset profits from the sale of the property. The tax result is that you can use suspended property losses on an total basis, rather than property-by-property.
Recapture of depreciation benefits
The maximum capital gains tax rate was reduced to 15 percent in 2003 for assets owned more than 12 months. (If held for less than 12 months gains are taxed as ordinary income.)
However, the IRS requires that you "recapture" the tax saving from your income tax at a special 25 percent depreciation "recapture" tax rate when the property is sold. This apply whether or not you qualify as a "real estate professional."
Example of recapture
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Suppose you bought an investment property for $200,000 and deducted $50,000 of depreciation during your ownership years. |
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That means your book value (also called "adjusted cost basis") declined to $150,000. Then you sold for $350,000. |
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Your capital gain is therefore $200,000 ($350,000 minus $150,000). |
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Of that $200,000 capital gain, the $50,000 depreciation deducted will be "recaptured" and taxed at the 25 percent special federal tax rate. |
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The $150,000 remainder of your capital gain will be taxed at the new 15 percent maximum tax rate. |
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Click here to go to our real estate capitals gains calculator. |
Better Tax Breaks for the Self-Employed for 2003
Health Insurance Deductions for the Self-Employed
Beginning 2003, the self employed can deduct 100% of their payments of medical insurance premiums for themselves, their spouses and their dependants.
Bigger section 179 expensing deductions
Rather than depreciating your office equipment and improvements to your investment real estate you can now expense them and write off 100% in the first year.
The limit has been increased from $25,000 to $100,000 for 2003, 2004 and 2005.
Let's say you buy a new computer for $2,000. A $2,000 write-off reduces your taxes by $500 if you're in the 25% tax bracket.
You can even write off up to $100,000 for the purchase of a new SUV in the year it is purchased so long as the vehicle is used for business purposes and weighs more than 6,000 pounds. How's that for encouraging fuel conservation?
You need to use IRS form 4562, Depreciation and Amortization. Your tax preparer will know what to do.
Pay Your Kids
Pay your kids for helping in your business. You are allowed to pay your kids reasonable wages for doing REAL work.
For 2003 they can earn up to $4,750 without paying taxes. IRS code 3121(b)(3)(A) exempts the wages you pay to a child under 18 from Social Security taxes provided:
- You are a sole proprietor, not a partnership or corporation or
- A husband-wife partnership.
As always, this article is intended to be accurate but is not intended to replace tax advice from a competent professional.
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