Being a mortgage banker , I’ve done my fair share of researching the impact of the current “Mortgage Meltdown”, but what I haven’t seen publicly written is one very dirty little secret about the way most subprime mortgages were structured. So I’ve come to share. Hats off to Chris Iverson of the Ventoux Real Estate Group, by the way, for doing a superb job on his Mortgage Mania series.

I will never forget the first subprime mortgage solution that I originated. It was about three years ago, the mirror was officially fogged by the client, and the terms looked something like this:

–first mortgage for $400,000 at 80% loan-to-value, 30-year period, fixed for two years at 8.00%, interest-only payments allowed, 2% discount fee, with a three-year prepayment penalty at six months interest

–second mortgage for $100,000 at 20% loan-to-value, 15-year term, fixed for 15 years at 12%, amortized payments, 1% discount fee, no prepayment penalty

What a minute, a mortgage fixed for two years, but the prepayment penalty lasts for three years? Wait another minute, don’t the payments on that first mortgage double in the third year? Yes and yes.

I wasn’t aware that the first mortgage had a prepayment penalty beyond the fixed-rate period until the final loan documents were prepared. As you may imagine, after reading the documents I made an immediate phonecall to the lender that I had brokered the deal to (oh, and yes, that company is BK) and re-negotiated the prepayment penalty to two years without any additional cost.

The truth is, as I further investigated subprime lending, I discoverd that most of those loans were structured that way, and most were not re-negotiated…

So if borrowers were essentially set up for failure, doesn’t that have a domino effect to the lender that issued the paper and the investor that bought that paper? Yes. And that’s why we’re here today. That’s also why we originated as few of these loans as practical.

The reality was that modern subprime lending (modern in that it used to be called “hard money” and the loan-to value requirements were 65%-70% of property value) actually seemed like a win:win in the beginning. Think about it for a moment. To those who were willing to buy, but had serious financial difficulties, subprime lending was a great financing vehicle to own the American Dream or maybe begin investing in real estate . To the investor, it was a low-risk, secured investment that would earn a hefty 11+% yield. Oooops, maybe it wasn’t so obvious a win:win.

We can blame whomever we wish for the current mortgage mess: the rating agencies, Wall Street, big banks, small banks, mortgage banks, mortgage brokers, real estate professionals, borrowers, etc. My feeling is that all of the above share in the blame since it allowed all parties to get greedy. And might we all agree that greed can be a very dangerous motivation?

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Looks like my big idea won’t be unveiled till part 6!

All together now:  I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.  ‘Nuff said.

Let’s take a brief digression into the arcane world of sale-leasebacks of depreciable assets from government entities to private entities.  Financial alchemy at its best!

Here’s how it works…*

A government entity — say, the City of New York — has a very large depreciable asset on its books — say, the subway system.  Depreciable assets, as we’ve seen, are a pretty valuable way of reducing one’s tax bill.  Problem is, the City of New York, as a tax-exempt institution, doesn’t actually have a tax bill that needs reducing!

Across the street is a private entity — say, Goldman Sachs — with a boatload of taxable income, sitting there in public view of the salivating money-grubbers at the IRS.  If Goldman Sachs owned that subway system, now we could take advantage of that depreciation.

Voila!  A perfect opportunity for financial arbitrage, creating a win-win for the City of New York and Goldman Sachs at the expense of the taxpayer.

The City of New York sells the subway system to Goldman Sachs for, say, $10B.  An instant later, the City of New York leases the subway system back from Goldman Sachs — good thing, too, since Goldman Sachs may be good at many things, but running subway systems isn’t one of them!

Goldman Sachs now has a $10B depreciable asset on its books.  I have no idea what the IRS’s depreciation timetable for subway systems looks like, but trust me, depreciating $10B will spit off many, many millions of dollars of tax savings each year.

The relationship between this piece of tax arcana and real estate depreciation?  Stay tuned for episode 7 of my ever-expanding trilogy.

* This example is completely ficititious.  As far as I know, Goldman Sachs does not own the New York subway system.  Deals similar to this, however, happen quite frequently between public and private entities.  See, for instance, this (rather dated) report from the Congressional Budget Office.

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This is part four of a three four five-part series on depreciating real estate investments and how it affects your tax bill.

Part 1 talked about the basics of depreciating real estate investments.  In a nutshell, you can depreciate the non-land value of your real estate investments (but not the home you live in) over a 27.5 year period and use this depreciation as a “passive loss” write-off against your regular income.

Part 2 discussed the IRS limitations on the same.  For folks earning $100K per year or less, you can only write off up to $25K of passive losses in a year.  For every dollar you earn above $100K, you lose 50 cents of maximum allowable depreciation write-offs; at or above $150K per year in income, you can no longer deduct passive losses.

Part 3 discussed a Hummer-sized loophole in the IRS limitations having to do with real estate professionals who invest in real estate.  If you qualify as a “real estate professional” in the eyes of the IRS, then you no longer have the $25K limit or the $100K threshold.  You can write off pretty much all your depreciation against your income.

My standard caveat on such matters:  I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.  ‘Nuff said.

Cost segregation, or component-ized depreciation takes the tax benefits of real estate investment depreciation to the next level.   Instead of depreciating the non-land portion of your real estate investment over the 27.5 years the IRS mandates for real property, you segregate or component-ize the investment into smaller chunks of personal property, each of which has a much more aggressive depreciation schedule.

Take our imaginary $500K property from part 1 of this series.  You’ll recall that $225K of that was the land value, leaving $275K to be depreciated over 27.5 years.  What if that $275K could be depreciated much more quickly?  Clearly, you’d end up with more depreciation that you could write off against your income.

Here’s how you accomplish this particular piece of tax alchemy.  You break down your $275K depreciable real asset into numerous smaller depreciable personal assets.  Your $275K property is actually the sum of:

• 14 windows at $500 each = $7000.  The IRS allows you to depreciate windows over, I believe, 7 years.  Instead of depreciating $7000 over 27.5 years (a paltry $250 per year),  you depreciate $7000 over 7 years, giving you $1000 per year in depreciation.  Voila!  Out of thin air, you’ve created an additional $750 in depreciation, which at a 30% tax rate, saves you $225 per year.
• 1 stove = $300.  You can depreciate appliances over 5 years.
• Blinds and drapes = $5000.  5 year depreciation schedule.
• Fence = $10,000.  15 year depreciation schedule.
   
• etc. etc. until you component-ize the whole property.

Your $10,000 per year depreciation now suddenly – magically — goes up several times, with your tax savings doing a similar bit of alchemy.

(For more information on cost segregation, you simply have to read what Jeff Brown has to say about it.)

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Shades of Douglas Adams…While nowhere near as entertaining as his (increasingly inaccurately named) 5-volume Hitchhikers’ Guide to the Galaxy “Trilogy,” this series looks like it may also turn out to be a 5-part “trilogy”.

And again, let’s dispense with the legal disclaimer to keep my attorney happy:

I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.  ‘Nuff said.

Article one of this series introduced the idea of the depreciation tax benefits of real estate investing.

Article two explored the two limitations of these benefits:  First, they cap out at $25K, and secondly, that $25K limit begins to peter out if you earn between $100K and $150K, and they disappear completely above that.

This article and the next will continue to lay the groundwork.  The idea I’m aiming for will (hopefully) be presented in article 5.

We may all bitch and moan about NAR (I know I do!) and the respective state associations.  One thing they’re absolutely great at, however, is making sure that the laws — including the tax laws – in Washington DC and the state capitols are beneficial to those of us in the industry.  (As a sidebar, I’m somewhat torn about these beneficial tax laws.  The real estate professional side of me appreciates them tremendously every April 15th.  The citizen side of me wonders what scheme Uncle Sam will think of to relieve me of those funds in another way.)

Here’s the great little real estate investment secret for those of us in the industry.  It goes something like this:  If you’re classified as a “real estate professional”, then there is no limit to the tax deductibility of depreciation.

Huh?  Here’s what that means:  If you’re a “real estate professional”, and you earn $175K per year and have $50K in depreciation, all of that is tax deductible.  You simply don’t have to worry about the $150K income limit, or the $25K deductibility limit.

The IRS has some very specific rules about how you qualify as a “real estate professional.”  Many NAR members wouldn’t qualify, while many non-NAR members would.  The rules have to do with, among other things, what your principal line of business is, and how many hours per year you work in a real estate trade.  See this IRS publication for more details.

Let’s run through the same four examples as in my previous article, comparing the tax treatment of “real estate professionals” with “normal” people.

• Let’s say you have depreciation of $10K and your income is $80K. “Normal” person
  Potential tax savings:  $3,000
  Actual tax savings:  $3,000Real estate professional
  Potential tax savings:  $3,000
  Actual tax savings:  $3,000
  
  

  Verdict:  No difference.

• Now let’s say you have depreciation of $40K and income of $80K.“Normal” person
  Potential tax savings:  $12,000 (if there were no $25K limit)
  Actual tax savings:  $7,500
  Lost tax savings:  $4,500Real estate professional
  Potential tax savings:  $12,000
  Actual tax savings:  $12,000 (since all of the $40K depreciation is tax-deductible)
  
  

  Verdict:  Real estate professional ahead by $4,500

• You have depreciation of $20K and an income of $140K.“Normal” person
  Potential tax savings:  $6,000 (if there were no $100K threshold)
  Actual tax savings:  $1,500
  Lost tax savings:  $4,500Real estate professional
  Potential tax savings:  $6,000
  Actual tax savings:  $6,000 (since all of the $20K in depreciation is tax-deductible)

  Verdict:  Real estate professional ahead by $4500

• Finally, suppose your income were $175K and you had $20K of depreciation.“Normal” person
  Potential tax savings:  $6,000 (if there were no $100K threshold)
  Actual tax savings:  $0
  Lost tax savings:  $6,000Real estate professional
  Potential tax savings:  $6,000
  Actual tax savings:  $6,000 (since all of the $20K in depreciation is deductible)
  
  Verdict:  Real estate professional ahead by $6,000

 Overall verdict:  For real estate investors with incomes above $100K and/or depreciation losses above $25K, being classified as a “real estate professional” can have huge tax advantages.

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Same caveat as last time:  I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.

In my first post on this topic, I introduced the basics of the tax treatment of depreciation of real estate investments.  This post and the next one two will continue with the basics, and then I’ll follow up with an idea I have that may — or may not be — a creative use of this stuff.

In their continued infinite social-engineering wisdom, our wise and benevolent leaders have decided that while they want to encourage real estate investing, they don’t want to encourage it too much.  In particular, they really don’t want folks making more than $150,000 a year to gain from the depreciation benefits.

Here’s the rule they’ve set up:  The maximum amount of “passive losses” (which includes depreciation) you can deduct if your income is $100,000 or less is $25,000.  Between $100,000 and $150,000 per year, you lose fifty cents on the dollar of deductibility.  At $150,000 per year and above, you are not allowed to deduct any passive losses.

Four quick examples will illustrate.  Assume in each case that your income is taxed at 30%.

• Let’s say you have depreciation of $10K (under the $25K limit), and your income is $80K (under the $100K threshold).   Your normal tax would be 30% of $80K = $24K.  With the $10K deduction, you’re only taxed on $70K, for a total of $21K.Potential tax savings:  $3,000
  Actual tax savings:  $3,000
  
• Now let’s say you have depreciation of $40K (above the $25K limit) and in income of $80K (still below the $100K threshold).  Without the $25K limit, your tax savings would be 30% of $40K or a whopping $12K.  Since you’re only allowed to deduct $25K, your actual tax savings would be $7,500.  Still not bad, but of course not as good as the $12K to which you would have been entitled without the limit.  (Note:  I’ll leave it to folks far more expert in this than I to explain the intricacies of what Uncle Sam lets you do with the $15K you couldn’t deduct.)Potential tax savings:  $12,000 (if there were no $25K limit)
  Actual tax savings:  $7,500
  Lost tax savings:  $4,500
• You have depreciation of $20K and an income of $140K (above the $100K threshold).  Since you lose 50 cents of maximum deductibility for ever dollar you earn above $100K, and you’re earning $40K above $100K, you lose $20K out of the maximum deductibility of $25K — in other words, the maximum you can deduct is only $5K.  At a tax rate of 30%, that amounts to $1,500 in savings.Potential tax savings:  $6,000 (if there were no $100K threshold)
  Actual tax savings:  $1,500
  Lost tax savings:  $4,500
  
• Finally, suppose your income were $175K and you had $20K of depreciation.  Since you’re above the $150K income limit, you’re not able to use any of the $20K of depreciation.Potential tax savings:  $6,000 (if there were no $100K threshold)
  Actual tax savings:  $0
  Lost tax savings:  $6,000

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Let’s start with a warning:  I am neither an accountant nor a tax attorney.  More importantly, I am not your accountant or tax attorney.  What follows is simply my layman’s understanding of a particularly obscure part of the tax code.  Before you try any of the below, be sure to consult with the appropriate professional.

‘Nuff said.

[This article is part one of a three four five-part article on a nifty little tax product I've dreamed up.  Part 1 gives an introduction, part 2 will get more advanced, and part 3 is where I'll unveil what I have in mind.  Parts one through four are an introduction.  I'll be particularly curious about what Jeff Brown, the godfather of real estate investment blogging, will have to say about it.]

As part of Uncle Sam’s never-ending tax-law-driven social-engineering crusade to promote certain societal goods — in this case investing in real estate — there are some interesting tax laws on the book having to do with depreciation of real estate investment properties.  Roughly speaking, here’s how it works.

1. You buy an investment property for, say, $500,000.  (Momentary pause to let my Bay Area readers recover from a laughing fit.)  Let’s imagine $225,000 of that is the value of the land itself; the remaining $275,000 – the value of the home itself — is, from the point of view of the IRS, a depreciable asset.  That’s right, depreciable asset — even though, over time, real estate tends to appreciate, not depreciate.  (Keep in mind we’re dealing with tax laws.  They don’t necessarily have a relationship to reality.)
2. From a tax point of view, you’re allowed to depreciate that $275,000 over 27.5 years using straight-line depreciation, which comes out to an even $10,000 per year.  (I picked the above numbers carefully.)  If you’re in, say, the 30% marginal tax bracket, that comes out to a nifty little $3000 in tax savings per year.

To give a very simple example, let’s imagine that you’re taxed 30% on every dollar you earn, and that you have no other deductions, and let’s say you earn $80,000 per year.  Your tax bill would normally be $80,000 X 30% = $24,000.  But because of your investment property, which is spitting out $10,000 per year in depreciation, Uncle Sam is only going to tax you on $80,000 less $10,000 — ie. on $70,000.  30% of that is only $21,000.  Voila!  You just saved $3000 in taxes.

What’s great about depreciation from a tax point of view is that it’s a non-cash expense, a phantom expense, if you will, and yet Uncle Sam treats it as if you had genuinely spent $10,000 out of your own pocket in order to qualify for that $3000 in tax savings.

Let’s do an even more specific example.  Let’s say that your investment property brings in $30,000 per year in rent.  (Another momentary pause for my Bay Area readers.  Yes, there are places in this country that give a 6% return.  Heck, there are probably places that give a 10% return.)  Let’s say that you incurred $25,000 in expenses, netting you a cool $5,000 profit for that year on your investment property.  That’s $5,000 of cold, hard cash you can put in your pocket.

Yes, you have to report that income to Uncle Sam, bringing your total to $85,000, with a resulting tax bill of $25,500.  But your $10,000 depreciation means Uncle Sam only taxes you on $75,000, and you only have to pay $22,500.  Again, a $3000 savings.

For more reading on this, Jeff Brown has an excellent repository of articles on real estate depreciation.

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