Archive for September, 2011

Expenditures – Part 2

September, 2011

Expenditures – Part 2

In a recent newsletter (Expenditures – Part 1) we discussed some basic principles regarding expenditures including those that (1) may be deducted in the year made, (2) must be capitalized, (3) must be amortized, and (4) must be added to basis. In this newsletter we continue the discussion of expenditures by considering in more detail some of the specifics related to deductible expenditures.

As stated in Part 1, to be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your industry. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary.

Those expenditures that may be deductible in the year paid include the following:

  • Advertising and other marketing of the rental property
  • Cleaning & maintenance of the property
  • Utilities serving the property
  • Insurance of all types related to the property
  • Taxes of many types related to ownership and operation of the property
  • Rental payments to others for equipment or real estate related to the rental property
  • Employee overhead
  • Interest on loans, whether for the subject property or for equipment used for the property
  • Mortgage Points (although not all)
  • Management fees or leasing commissions paid
  • Tax return preparation fees directly related to the property
  • Travel expenses related to the property or management thereof
  • Auto or other local transportation expenses related to management or maintenance

Some of these items require discussion beyond what was said in Part 1 of this series because they are more likely than others to raise issues in income tax audits.

Repair & Maintenance Expenses

Expenditures for repairs and maintenance, both labor and materials, are deductible in the year paid. Items charged to a credit card can usually be deducted n the year posted to the card account even though paid in the next year or over multiple future years.

Whether an expense is a repair or maintenance is usually immaterial and some events can be considered to be one or both. A repair expense is usually considered an expense incurred in order to restore an item or a system to its previous condition. As examples, replacement of the washer in a leaking faucet or replacement of a relatively small number of shingles would usually be considered to be repairs. A maintenance expense is usually incurred in order to keep a rental property component in good condition. For example, interior and exterior painting expenses are usually deductible in the year paid.

Capitalized Expenditures – Improvements

You must capitalize rather than deduct some expenditures. These costs are a part of your investment in your business and are called “capital expenses.” Capital expenses are considered assets in your business. There are, in general, three types of costs you capitalize.

  1. Business start-up costs
  2. New business assets
  3. Improvements and restorations

For an ongoing rental property, improvements are usually the most common expenditure that must be capitalized. An improvement is work that adds something new to an existing property or makes it better than it was. It is an expense that is incurred to make the property more valuable or to allow for increased rent. Further discussion of improvements and restorations will be included in Part 3.

You cannot deduct the cost of improvements. You must separate the costs of repairs and improvements and keep accurate records of each separately. The cost of an improvement must be capitalized. You recover the cost of improvements by taking depreciation as if the improvement were separate property. You will need to know the cost of improvements when you sell or depreciate your property, as the cost less the portion depreciated prior to sale are added to the basis of the property, reducing the gain from the sale.

Employee Overhead

As you probably expected, not only is the salary or hourly wages of employees who perform management and maintenance work deductible, but all overhead costs associated with those employees are also deductible. Included in such overhead is unemployment insurance, workers’ compensation insurance, the employer one-half of Social Security and Medicare taxes, and health insurance premiums paid by the employer.

However, both wages and overhead associated with improvements would have to be capitalized along with materials and other costs of doing capital improvements just as for capital improvements made by independent contractors.

Interest Expense

You can deduct interest paid on a mortgage or other loan related to your rental property. You cannot deduct interest paid in advance beyond the tax year. If you paid $600 or more of mortgage interest on your rental property to any one person or entity, you should receive from the lender a Form 1098 Mortgage Interest Statement showing the interest you paid for the year.

Expenses Paid to Obtain a Mortgage

Certain expenses you pay to obtain a mortgage on your rental property cannot be deducted as interest. These expenses, which include mortgage commissions, legal fees, abstract fees, title insurance premium, and recording fees, are capital expenditures that you can usually amortize over the life of the mortgage.

Points – The term “points” is often used to describe some of the charges paid by a borrower to take out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest. Points paid when you take out a loan or mortgage result in original issue discount (OID). In general, the points (OID) are deductible as interest unless they must be capitalized. How you figure the amount of points (OID) you can deduct each year depends on whether or not your total OID, including the OID resulting from the points, is “insignificant.” If the OID is not insignificant, you must use the constant-yield method to figure how much you can deduct.

Loan or Mortgage Ends

If your loan or mortgage ends, you may be able to deduct any remaining points (OID) in the tax year in which the loan or mortgage ends as well as any other costs related to financing that were being amortized. A loan or mortgage may end due to a refinancing, prepayment, foreclosure, or similar event. However, if the refinancing is with the same lender, the remaining points (OID) generally are not deductible in the year in which the refinancing occurs, but may be deductible over the term of the new mortgage or loan.

Travel Expenses

You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip was to collect rental income or to manage, conserve, or maintain your rental property. This will usually include educational costs related to investing in and managing income properties. You must properly allocate your expenses between rental and non-rental activities. You cannot deduct the cost of traveling away from home if the primary purpose of the trip was the improvement of your property. The cost of improvements is recovered by taking depreciation.

Local Transportation Expenses

You can deduct your ordinary and necessary local transportation expenses if you incur them to collect rental income or to manage, conserve, or maintain your rental property. Generally, if you use your personal car, pickup truck, or light van for rental activities, you can deduct the expenses using one of two methods: (1) actual expenses allocated to business use according to the percentage of miles driven for business compared to total miles driven for the year or (2) the standard mileage rate for the business miles. For 2010, the standard mileage rate cars, vans, pickups, or panel trucks was 50 cents a mile for all business miles and for 2011, the rate is 51 cents a mile.

To deduct vehicle expenses under either method, you must keep records that follow the rules in chapter 5 of IRS Publication 463. In order to determine the percentage of vehicle expenses or mileage that are business related and support the percentage in an audit, it is important that a log be kept. The log should include beginning and ending odometer mileage for each business related trip.

Payment for Goods & Services

Landlords are required by law to provide 1099 forms for payments totaling $600 or more in a calendar year made to unincorporated businesses for services.

Most landlords often use unlicensed contractors and many of these vendors will not qualify as independent contractors under an audit. Furthermore, many landlords do not utilize 1099s as required by law. While 1099s are required for both licensed and unlicensed non-corporate contractors, failure to use 1099s for unlicensed individuals carries greater risk because licensed contractors are much more likely to possess other characteristics that are considered by the IRS when the issue arises regarding whether a worker is an independent contractor or an employee. Without going into all the details about the potential penalties for improper classification, suffice it to say that all items required for employees – including income tax withholding, social security payments, unemployment insurance, and workers’ compensation insurance – are potentially costly items that can include back payment for those items that would have been required for an employee as well as stiff penalties and interest.

While filing 1099s does not make the worker an independent contractor, the fact that the worker received a 1099 and knows the landlord will file the information with the IRS and the state should increase the odds that he/she will report the income on his/her income tax returns and reduce the chance that the worker might file claims for workers’ compensation or unemployment payments, two of the events by which the possible misclassification of workers becomes an issue.

Can I Ask a Tenant to Move Out (in 30 days)…….

September, 2011

Some Questions & Answers

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Q1

Can I ask a tenant to move out (in 30 days) so that needed work may be done on their unit? No current lease or rental agreement is in effect.

A1

There is always a lease or rental agreement in effect. If there is a written document, it likely has a clause that makes it a month-to-month tenancy upon expiration of the original term. If there was no written document, it is an oral lease agreement, with terms that were agreed by the parties and, if it goes to court, the terms that are best proved by circumstantial evidence or whichever party is the better liar.

However, the above being said, if the lease is currently month-to-month, most states do require a 30-day notice of termination. Some states require a longer notice period under certain circumstances. In most (not all) states, no reason for termination need be provided to the tenant and it is usually best to not provide one that might be turned into a fair housing complaint.

Even if there is no written documentation, you should definitely give a written termination notice and serve it in a manner that provides proof of service. This can be either by delivering it in person or via Certified Mail. In either case, it is best to also mail a copy of the notice via a Certificate of Mailing, a PO service that provides the sender proof of mailing without giving the recipient a chance to reject acceptance of Certified Mail.

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Q2

I want to evict tenants (Oregon). How do I do it? They are new tenants that have violated the terms of the lease by having more people and by smoking in the unit, both things not allowed.

A2

What you can do depends on clauses in your lease agreement. The fact that they are new tenants would usually be irrelevant. What counts is whether the tenants materially violated one or more unambiguous clauses in the agreement. If they are month-to-month tenants you can simply terminate the lease with 30 days notice without any reason being given. You could also increase the rent with 30 days notice to allow for damages.

Assuming that they did default on the lease agreement, you will first need to properly serve them with a “cure or quit” notice (not necessarily the exact legal name under Oregon landlord-tenant law). I do not think Oregon allows for an “unconditional quit” notice for such violations as you list, so you cannot necessary evict them. A “cure or quit” notice in Oregon must give the tenants 14 days to cure the default and an additional 16 days to vacate (10 days to remove an illegal pet). If the default is not cured within the 14 days and the tenant has not departed within the following 16 days, you can then begin an eviction action.

Practically speaking, the defaults you mention, as I understand your limited description, are such that they may already be no longer in default. Obviously, they could again commit such violations, always curing them before the end of 14 days after notice. Accordingly, you need to always immediately serve the notices upon first knowledge of the violations. If there are a number of repetitive provable occurrences, it is likely that a judge would allow an eviction even though the violations are always cured within 14-day period. This is something that you could ask of an attorney who regularly does evictions in the court of jurisdiction and such an attorney would likely have a good idea of how many such repetitions might be required.

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Q3

On 6/4/11 the City of Chester, Pa notified me that I am delinquent in payment of the 2000 and 2001 Trash Collection Fees for my rental property. This is my only notification from the city. Is there a Statute of Limitation on this bill?

 A3

It is my understanding that there are four categories of debt collections and each has their own statute of limitation under Pennsylvania law. For oral agreements it’s four years, for written agreements it’s six years. For contract notes (such as mortgages) it’s four years, and for open accounts (such as credit cards) it’s six years. After these periods expire, the creditor can still request payment, however, he usually has no potential for punitive action recovery – i.e., via a lawsuit.

I would think that a city trash collection account would have required a written agreement when signing up for service, but such is not always true. However, since 2001 is considerably longer ago than the longest statute of limitations period, the category is likely immaterial.

The fact that this is your first knowledge of the debt may be irrelevant and a judge may believe the city over you if it claims that not to be so – after all, government entities are considered by some to be efficient and truthful.

The above being said, when dealing with a government entity, there may be other issues. For example, the entity might have a lien right against the real estate and such a right might not be subject to statute of limitations periods. It is possible that a government entity is specifically exempted from the statute of limitations laws even if it doesn’t have a lien right.

You do not specifically mention whether the account was in your name or in the name of a tenant, with the city attempting to collect from you even though you did not agree to the account. The latter is allowed in some jurisdictions, but not in others. From the wording of your question, I’m not certain that the alledged delinquency occurred during your period of ownership.

You also do not mention the amount of the city’s claim or whether they are including possible late charges and/or interest for all those years. The first thing you need to do is decide whether the amount the city claims you owe is worth fighting about, particularly if the amount is greater than the maximum small claims amount allowed, which I believe is $8,000 in PA, except for Philadelphia where it is $10,000. If the city’s total claim is for less than this amount – and I certainly hope it is – you could test things in small claims court at relatively little cost, even if you first spend a relatively few dollars for a consultation with a competent attorney experienced in the subject matter. If the claim does not qualify for small claims court, the cost of contesting it will increase substantially. When dealing with government entities it must always be remembered that they have essentially unlimited taxpayer funds (some coming from you) and likely have staff attorneys who may have less than enough to do to justify their salaries. It’s possible that you could even be subject to city legal costs if you lose.

There may be other issues that are material to the problem.

If you have not sat down with the appropriate city trash collection person, preferably someone at the supervisor level, I suggest that you do so in order to determine just what their options are (e.g., do they claim to have lien rights), how aggressive they intend to be, and whether some significantly reduced settlement is possible. After you fully understand the city’s position, you can decide what to do next.

A Tip for Better Rent Collection

September, 2011

A Tip for Better Rent Collection

Never Give the Tenant a Reason Not to Pay Rent

Collection of rents is arguably the most important issue related to property management. Most landlords depend upon the monthly rent to cover mortgage payments, property taxes, and other property expenses. When tenants fail to pay rent, these landlords may find themselves scrambling to cover these expenses.

First and foremost – follow the law. The legal relationship between landlord and tenant is spelled out in state statutes, local ordinances, safety and housing codes, common law, contract law and case law. Each party has obligations to the other that must be fulfilled. Both landlord and tenant have a duty to treat each fairly and to act in good faith.

Of particular importance are two rights given to tenants under law that could affect the landlord’s ability to collect his rent. The implied covenant of quiet enjoyment is basic to all leases. It ensures that the tenant’s possession of the property will not be disturbed by the landlord acting or failing to act in a manner that seriously interferes with or destroys the ability of the tenant to use the rental premises.

The implied warrant of habitability provides the tenant decent and sanitary rental housing at the time of rental and throughout the tenancy. A breach of this warrant violates housing codes and may cause constructive eviction of the tenant, allowing the tenant under statute to withhold rent, repair and deduct damages from the rent, and/or recover other damages.

It is possible for both rights to be violated at the same time. For example, if the landlord causes the rental premises to become uninhabitable, such as allowing unsanitary conditions, waste, or nuisance, the landlord has committed a breach of the lease agreement and may have caused constructive eviction of the tenant. By his breach, the landlord may have given the tenant the right to withhold rent, terminate the lease, or both.

Disputes between landlords and tenants must be resolved by prescribed legal means, not through unilateral actions.

State laws govern most rent issues and the laws vary significantly among the states. There may be statutes regarding the amount of rent that can be charged (in rent control jurisdictions), the amount of deposit that can be required, when and where to pay the rent, grace periods, late rent charges, returned check charges and rent increases. These laws will apply unless the landlord’s lease agreement stipulates different conditions that are not in conflict with the laws. Once the landlord understands what is required by applicable landlord-tenant statutes, he can write his lease agreement to meet or exceed legal requirements in order to better protect his business interests including collection of rents.

A landlord must thoroughly understand his lease agreement and apply the lease terms uniformly and firmly to all tenants who have signed that lease agreement. While the landlord holds the tenant responsible for the terms of the lease agreement, the landlord must hold himself equally accountable under the lease agreement for his duties and responsibilities.

The lease should clearly define all issues related to rent in order to avoid misunderstandings and disputes with the tenant at a later date, perhaps when the payment of rent has already become an issue.

The lease agreement should have clauses that clearly address the issues of:

  • Amount of rent
  • Due date
  • Grace period, if any
  • Type of funds
  • How/where to pay
  • Late charges
  • Returned check charges

Lease agreements must include tools for enforcing timely payment of rents and management of the property. For example, if default provisions aren’t adequate, the landlord may be unable to evict a tenant who defaults on rent payments or other lease obligations.

Communication about rent rules is crucial to getting the rent money. Clearly defined rules help the tenant understand what is required and the consequences of non-performance. Landlords must not be afraid to ask for their money and to follow through with appropriate action if the tenant defaults.

There are some landlords who, as long as they receive the rent within a week or two of the due date, don’t make a big fuss about rent collection. They allow the tenant to develop bad payment habits by not enforcing the landlord’s own rent rules. Lackadaisical behaviors by landlords contribute to unwanted tenant behaviors. If rent collection is not important to the landlord, it will not be important to the tenant. Some tenants take maximum advantage of permissive rent collection. Until rules are enforced by applying consequences to undesired behaviors, the tenant will remain convinced that if he ignores the landlord’s requests the landlord will go away and perhaps even forget about it. Control has passed from the landlord to the tenant. Professional property managers recognize this issue and have standard procedures in place to fairly and consistently enforce the rules for all tenants. Tenants obey the rules because there appear to be serious consequences.

The process of evicting a tenant for nonpayment of rent is usually among the quickest and most streamlined of all legal proceedings in most states, assuming the legal procedures are properly followed in a timely manner. A common mistake is that the landlord delays taking action against tenants when they default on their lease or cause problems for other tenants. A “pay or quit” notice should usually be served on a tenant the day after the rent is due or after any grace period provided in the lease or by law. If the tenant fails to pay by the end of the notice period required by state law the landlord should immediately begin eviction.

Landlords are justifiably concerned that serving the “pay or quit” notice immediately may alienate the tenant or create unwanted disputes about maintenance or other issues regarding the tenancy. They hope that waiting to serve the notice, on the other hand, may allow the problem to resolve itself because the tenant will eventually pay the late rent.

However, it is best to serve notices as soon as possible. The landlord can always waive the notice if the tenant pays the rent and applicable late charges or cures any other default and can always terminate the eviction process if the problem is resolved only after proceeding to court. Delaying action only increases losses in the case of a tenant who will never again pay the rent and will cause additional financial and/or other problems for many other types of defaults. For example, the longer a tenant is allowed to disturb other tenants, the more likely good tenants will be leaving.

Furthermore, if a landlord doesn’t routinely serve the notice immediately each time a rent is past due, a tenant could claim during the eviction proceedings that the landlord “waived” the right to receive the rent on the first of the month or that you orally “worked a deal” for rent to be paid late. The tenant can even claim that the lease has been permanently modified and that the landlord can no longer demand the rent on the first of the month because he accepted the rent late and did nothing in the past.

When you always serve the “pay or quit” notice promptly you maintain complete control of whether to allow the tenant additional time to pay the rent or not. There should always be a written agreement when giving permission for late payment.

Information on Foreclosures vs. Short Sale for Rental Properties…

September, 2011

Some Questions & Answers

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Q1

Can you provide information on foreclosure vs. short sale for rental properties we own and cannot get the loan modified to rent?

A1

You have asked a question which would require thousands of words to adequately answer because there are several separate primary issues involved and each potentially involves a number of secondary issues. Primary issues include impact on credit record, income tax consequences, and, depending on the state and other factors, the possibility of deficiency judgments from lawsuits against you by the lenders.

I will briefly discuss some of the issues, but for a complete understanding of all the issues using adequate facts related to your particular situation and for your particular state, I strongly advise you to consult with a competent real estate attorney of your state and with a CPA or other competent tax advisor.

Credit Record

Lenders will almost certainly report both foreclosures and short sales to the credit bureaus. In calculating credit scores, every negative on a credit report is assessed by three factors: how recently the negative event occurred; the severity of the negative (how late is the payment); and the frequency of negatives (how many times you’ve been reported delinquent on credit obligations).

A recent bankruptcy does the most damage to your score. If lenders report all of your mortgages as in default, the damage to your credit score would be akin to declaring bankruptcy on all accounts.

Although a short sale, where the lender agrees to take less than owed on the mortgage, will drop your credit score as much as will a foreclosure, there is one advantage to it  when a principal residence is involved. This is that you may be eligible to buy a home with an institutional loan backed by Fannie Mae or Freddie Mac more quickly than you would if it went into foreclosure. Borrowers can be considered for loans after 24 months following a short sale if the sale was caused by extenuating circumstances outside of a borrowers’ control, or after 48 months if it was the result of financial mismanagement by the borrower.

The manner in which title to properties are held could affect the impact on your credit score.

Income Tax

The Mortgage Forgiveness Debt Relief Act of 2007 and the recently passed Emergency Economic Stabilization Act, provides for exclusion of up to $2 million of income ($1 million if married filing separately) from debt that’s discharged through mortgage restructuring, or that’s forgiven in connection with foreclosure, for the years 2007 through 2012. The exclusion must be connected with a decline in the home’s value or the taxpayer’s financial condition, and only applies to a principal residence, not investment properties.

There may be other provisions in the law that can help. For example, some or all of that debt may not be taxable if one is insolvent when the debt is cancelled.

Again, the manner in which title to a property is held could affect income tax consequences.

Deficiency Judgment

Depending on the state, there may be the possibility of lenders filing lawsuits and obtaining deficiency judgments following foreclosures. There may also be the same possibility for short sales, so it is important that there be an anti-deficiency clause in the short sale agreement. Since lenders generally net more from short sales compared to foreclosures, they are usually willing to agree to no deficiency action. A few states may prohibit deficiency judgments by statute (modified by court cases). For example, Arizona prohibits deficiency judgments for purchase money loans on one- or two-family homes on no more than 2 acres. For Arizona, the law applies to either one’s personal residence or for rental units.

Again, the manner in which title to properties are held could affect deficiency judgment risks.

Other Options

Some states may provide for other options, so, again you need to seek advice from competent professionals. Competent real estate agents who do significant short sale work may be able to provide information about any state benefits.

Depending upon the specific financial numbers related to particular properties, a lender might also be open to accepting a deed in lieu of foreclosure. This will also have potential income tax consequences and may affect your credit record, but it can be the best solution when possible.

Conclusion

As seen from my very brief discussions of a few of the possible issues, it is important that you make decisions based on your particular situation and on the laws of your state. Given the complexity of the subject, do not attempt to deal with this situation on your own.

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Q2

The tenant that signed the lease (WA state) has a girl friend that will be moving in in a month. Should we have her sign the lease and run a check on her also? What are the benefits and the downside?

A2

The basic rule is that every adult (18+ and emancipated minors) who will reside in a unit should have been checked using every screening method used for any applicant – i.e., identity verification, credit report, eviction record search, criminal record search, and inquiry of previous landlords. This applies to both original applicants and those added at a later date. Every adult applicant should be required to sign the lease, both original occupants and those added later.

Identity verification is a primary screening mechanism, as it is of no value to end up with great reports on an identity thief. Also, a credit report alone is not sufficient, as a convicted drug dealer who is successful in his business and would continue in his business while residing in your rental unit can have an excellent credit record and pass all other screening checks.

Screening every potential occupant reduces the chance of ending up with a very bad tenant if/when the only screened one skips, dies, or files for bankruptcy. Requiring every adult occupant to sign the lease provides additional people to go after if there are later problems, as each lease signatory should be jointly and severally liable for the terms of the lease, including for unpaid rent and damages. Also, having adequately screened each lease signatory provides information that can be useful if/when occupants skip.

Screening every occupant and requiring each one to sign the lease has many upsides. I know of no downside. There are likely landlords who purposely do not have all occupants sign the lease because they mistakenly think it will be easier to evict the non-signing occupants if ever necessary. However, such is not the case because they will have to be removed via eviction if they choose to not voluntarily leave when the lease expires or has been terminated for cause by the landlord, just as will the occupants who signed the lease. The cost of screening should not be a reason to avoid it, as most states allow landlords to charge for processing of applications, including screening and, even when in a state that restricts how much can be charged, the cost is relatively negligible. The time and money for adequate screening are both a lot less than the cost of a trashed unit.

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Q3

My tenant painted the exterior wall without my permission. She wants me to pay for the cost, but on rental agreement she signed indicated that tenants shall not paint, wallpaper, add or change, etc. without owner’s prior written consent. What is the best way to refuse her? Please advise.

A3

Assuming that the lease clause you mention is adequately stated, you should not need to even consider reimbursement for the painting. In fact, if the painting is unacceptable to you – due to color chosen, quality of workmanship, or other reason – you could probably require that the tenant pay you for the cost of correcting the work or even returning the wall to its previous condition. Depending on a number of factors you might even be able to terminate her lease if you wished. However, even if you did not provide written permission, anything you had said related to the matter that may have implied permission, even your prior knowledge of intent to perform the work and not actively protesting the work could negate your right to take such actions against her. In deciding how far to push their rights, particularly when the Landlord has not been significantly damaged, Landlords must always consider that judges do not always worry about legal technicalities. That is, the judge may consider oral notice without your protest to be acceptable in spite of the lease’s requirement of written permission.

Assuming that you did not in anyway orally agree, either explicitly or by implication, that she would be reimbursed, you can simply give her a written notice that she has violated the terms of the lease and that you will not be reimbursing her for the painting. If the work is unsatisfactory and you want to attempt to charge her for the cost of correcting it, you could include that information in the same notice.