Landlords and the FairTax
From reader Nathan T:
First let me say congrats on the excellent website. I have been really curious what all the talk is about the fair tax and your site had many of the answers that I was looking for. I do have a question with how landlords are effected by it though. I am new to this concept and admit that I do not fully understand it. So let me get this straight, The landlord does not pay on any of the rents collected until that money is spent for consumption? If this is correct does the renter pay anything on the money used for rent? Also am I to believe that mortgages are not taxed at all? Also under the plan when buying an older property does the purchase get taxed or is that only on new housing? I might have missed something looking around the site and your answers are greatly appreciated. thanks
Have at it, guys.
Nathan, first, let me suggest that if you haven’t already done so, click on the book icon on the right and spend $7.88 for a used paperback copy. Also, scroll down and get on the AFFT site and read the FAQ section as well as the research papers on real estate.
You’ve got it about right– no more tax on your rental income. You will only pay a tax as you spend the money on goods and services for your personal use. The renter will have to pay a 23% tax as part of the total rent, which you will be responsible for collecting and forwarding to your State sales tax agency. In return, you can keep a 1/4 of 1% fee for your troubles. You are going to need a new business plan in order to establish just what the new rent might be. Remember, after registering your business, all business purchases you make, including goods and services, will be tax free, no more income tax on any profits, no more FICA on your employees, no more complicated bookkeeping for income tax purposes, etc. etc. So, you need to figure out how you can send the 23% off to the State, maintain your profit margin, and still be competitive in your local rental market. Not an easy task and the transition period might be a little rocky?
As for the taxation of mortgages, stay tuned for Section 801 which is coming right up as James blogs HR25. There could be taxes on your mortgage depending on the interest rate you pay relative to the Treasury long term rate. Read Section 801 and whatever comes up on this blog.
As for the purchase of rental property, no tax no matter whether the unit is new or old as it would be a business transaction. (Convert the unit to personal use at some later date and there could be a tax depending on when the unit was built.)
A word of caution about your rental business. Your chances of an audit are probably 6-7 times greater, (still fairly remote?) but if you buy a new refridge for your rental units, the auditor better not find it in your own kitchen?! The penalties are pretty severe.
For a quick explanation of mortgages:
The difference between your interest rate and the current Federal rate for any loan represents a premium fee that your bank or other lender is charging. Under the FairTax, that portion of interest gets taxed at the standard rate of 23% inclusive/30% exclusive.
Here is a good example:
A 30 year fixed mortgage today might have an interest rate of 5.79%. The April 2007 Federal Long-Term Rate is 4.70% for a monthly note instrument. The difference between these two items is 1.09%. This 1.09% worth of interest is what gets taxed. 1.09 * 1.3 = 1.417%, an additional 0.327 points of interest.
So your 5.79% interest rate would go up to 6.117%, theoretically.
However, the FairTax should present a great tax savings for banks, meaning interest rates should also fall significantly.
See this link for the fairtax.org line on interest rates:
http://www.fairtax.org/PDF/TheImpactOfTheFairTaxOnInterestRates.pdf
Also a side note about being taxed on property:
There would be no federal tax on any used property at the time of purchase, only new construction after the transition date would be taxed. If you are a registered business you certainly can purchase property tax-free. You would either simply be exempted from tax by the seller of the property, OR you can apply for the credit from tax yourself.
Don’t forget that all land is definitionally used. So there is no tax on the purchase of land period.
“There is no tax on the purchase of land period.”
Does this mean if I purchase a new home, the value of the land is subtracted out before computing the sales tax?
Thanks
Pretty much. You purchase the land lot, tax-free and pay for the tax on the new construction on top of it.
The tax-free aspect of rental property (versus property used for the owner’s personal use) is one of the many reasons I believe the FairTax would be subject to so much fraud and abuse (as well as mind-numbing complexity for honest taxpayers) as to make it unworkable.
In particular, think of vacation homes. Under the FairTax, if you buy a brand new $500,000 vacation home for your own use, you must pay a 30% tax on top of the purchase prices. (e.g. $500,000 + $150,000 = $650,000). On the other hand, if you bought the same home with the intent of renting it out, it would be a “business expense” and not subject to the FairTax. That is, you could get the same property tax free, thus saving yourself $150,000. In addition, all utilities, insurance, furniture, maintenance costs, and travel costs to “inspect” or “work on” the property would also be tax free.
Thus, there would be an enormous financial incentive for folks to treat their vacation homes as rental property. All you would need to do is put an ad in the paper or hire a management company to manage your vacation home and you’re in business. Bingo, it’s now tax free. Granted, theoretically at least, if you used your vacation home for your own personal use for some period of time, you would still need to pay some percentage of the FairTax for the personal use of your property. But the calculations involved quickly get incredibly complex.
For example, let’s say the first year you don’t use the vacation home at all for your personal use. Then everything is tax free. But if the next year you use it 50% of the time for your personal use, then you are supposed to go back and then pay the FairTax on a portion of the depreciated value of the house, as well as that of the furniture and any improvements. Then, the next year, you use the home 25% of the time for your personal use. Now you go back and seek a rebate of a portion of the “excess” tax you had paid the year before when you had used it 50% of the time for personal use. Etc., etc. And when you repaint the house or buy new furniture, you must allocate the cost between personal used and business use. How do you make that calculation? Do you see how ridiculously complicated this becomes becomes? As well as a record-keeping nightmare.
And how would the government know how much you actually use the property for your personal use? Are they going to station state troopers around your vacation home on weekends to report whether you (as opposed to a tenant) stay there? And how would they know whether you are working on the house (which would not be a taxable event) versus using the house solely for your personal entertainment (which would be a taxable event)?
The bottom line is that EVERYONE who buys a vacation home will at least try to rent it out some portion of the time in order to save the hundreds of thousands of taxes they would otherwise need to pay if they bought it just for their own personal use. Honest taxpayers who use their vacation homes for personaly use some portion of the time will be incredibly frustrated by the record-keeping and calculations involved each year in trying to calculate just how much taxes they owe for their personal use of the house (including furniture, mainenance, utilities, etc.), all of which will change year after year. Thus, there will be enormous incentive to minimize the personal use of the vacation home that is reported to the tax collection agency and claim everything (or as much as possible) as a business expense. And it will be next to impossible for the tax collection agency to prove differently, particularly since under the FairTax the burden of proof will be on the tax collection agency.
Thus, as I said, this is just one of the many practical problems I have with the FairTax.
I don’t think it’s that hard to use the mixed-use property rules. Many individuals and businesses handle just such types of transactions and have to report income from such rents, etc. and report costs, etc. TODAY.
If they can do it today, they can do it under the FairTax. That’s just my opinion.
There are FAQ’s on the Internet for just this subject: Like this one:
http://www.rentaltaxes.com/mixed-use_property.html
Hayden,
It should also be pointed out that when you eventually sell the ‘rental’ you are selling it as a ‘new’ (ie, never FairTaxed) home and will be taxed then on that sale. So you have to ask yourself: do you want to pay the tax on the home when it’s $500k now, or when you sell it at $1million 10 years from now?
My expectation is that the smart money will try to get the sale taxed at the lowest possible price they can manage: immediately after constrution. I would be *very* surprised to see any building that is not exclusively a commercial use building (ie, multifamily dwellings, shopping malls, etc) jumping through hoops to pay the tax on construction, to insulate itself from having to pay the tax on a higher sales price.
Quadupole –
I would sell my rental to another investor who would buy it tax free. That’s sort of my point, everyone will buy (or claim to buy) real estate, particularly vacation homes, as investment property in order to avoid paying the FairTax.
James — Yes, under today’s Tax Code you can — in some circumstances — deduct costs in connection with a vacation home you rent out. But the rules are very complicated and the record-keeping requirement is very burdensome. Many advocates of the FairTax claim that those record-keeping requirements will be a thing of the past when the FairTax is enacted. I am pointing out that that is not correct. Anyone with rental property or their own business will have just as much (if not more) record-keeping requirements under the FairTax as they do under the current Tax Code in order to justify their tax-free purchases.
My point was simply that your post seemed to infer that the FairTax would somehow introduce more difficulties than already exist, which I think is not true.
I think the nature of such business makes it complex, and no tax system could make not so. I think the paperwork on such a business is roughly the same under today’s system as it would be under the FairTax, because the basic rules of the business are the same, and reporting requirements are the same. There might be new forms replacing old ones, and maybe you’d send them to a different agency, but in the end I think it’s a wash in terms of workability.
The only difference in my opinion is the frequency and size of the deductions/rebate you can get.
James –
I don’t want to belabor the point too badly and risk puting all of the millions of readers of this blog to sleep, but I do think the record keeping for vacation/rental property under the FairTax will be even more onerous than our current system, because the taxes on the vacation home and related items must be paid (or not paid) at the time of purchase, and then year after year the owner will either need to seek a partial rebate or make a partial tax payment depending how how much the owner does or does not use the property for personal use.
When I first looked for this in the FairTax legislation, I thought I saw something about a 30 year period for rental property. That is, if you converted rental property to personal use (eitehr full-time or part-time) during that 30 year period, you would need to pay some portion of the FairTax. Since you are blogging the FairTax bill, perhaps you know what I am talking about and can cite me to the correct passage. Either that, or I am imagining things, which is also entirely possible.
Thanks.
Hayden
I think you are talking about personal conversion for business property.
The relevant section is Section 103 part C:
`(c) Conversion of Business or Export Property or Services- Property or services purchased for a business purpose in a trade or business or for export (sold untaxed pursuant to section 102(a)) that is subsequently converted to personal use shall be deemed purchased at the time of conversion and shall be subject to the tax imposed by section 101 at the fair market value of the converted property as of the date of conversion. The tax shall be due as if the property had been sold at the fair market value during the month of conversion. The person using or consuming the converted property is liable for and shall remit the tax.’
So basically you would pay the tax on the fair market value of the property at the time you convert it to personal use.
If it became mixed use rather than personal use, then you use the mixed-use property rules in section 705, where you would pay tax on a monthly basis on a ratio of business-to-personal use.
For example if you bought a vacation home for $200,000 as a purely business item and paid no tax on it, then went to mixed property, you would pay tax on your personal use portion, month to month. You divide the gross payments into 360 monthly payments (30 years) and multiply it by your personal use ratio (say 1/3 for this example.) 200,000 / 360 = 555.55 * 1/3 = 185.18 worth of personal use per month. That gets taxed at $55.54 per month, regardless of what your mortgage is.
If after some time you went completely personal use, then you’d probably make up the remainder. The bill is not specific on this scenario, but I would assume that you’d take the full tax on fair market value and subtract any taxes paid for personal use to find out what would remain.
If someone buys a new home in a new subdivision,l how is the land/improvement allocation determined?
The developer paid M dollars for the land, paid N dollars to build the home, for a total cost of (M+N). Then the developer sells it for (M+N)+O.
What’s to stop the parties from colluding to sell the property (now an improved lot) allocating all the profit to the land and none to the improvement?
What I’m getting at above is that while it would be “easy” to divide the profit in proportion of each component’s portion of the total builder cost, I don’t think that would be the right thing to do. I don’t think land by itself becomes more valuable just because you build something on it.
Firstly, I’m a 67 year old retiree. My entire retirement “nestegg” is tied up in five rental houses. Having read both of the FairTax books, and being absolutely convinced that this is the way to go, I went to a FairTax meeting here in Brunswick, GA. Sam, the leader of the small group was very informative, but when I asked him about rental income he told me that under the FairTax as it stands now that the rents I collect would be taxed at 23%. I checked it out on the FairTax.org website and was astounded to find he was right!
With STATE property taxes, mortgages, homeowner association fees, insurance, termite control and general preventive maintenance, (none of which will go away with the FairTax) there is no way a landlord can survive if he or she has to submit 23% of their investment revenue to the federal government.
Left as it now stands, when the FairTax becomes the law of the land, landlords would only have two options. They could increase their rents by 30% (YES, 30%) to maintain their own income to PRE-FairTax levels after paying the 23% FairTax. Their other alternative would be to unload their properties just as soon as the capital gains tax was eliminated. Which would generate a glut of modest to low income homes and apartment buildings on the market creating yet another real estate crisis.
A couple of years ago I sold some properties under the Federal “1031″ exchange program. The documentation referred to the property I sold as “Surrendered Property”, and the new property purchased under the exchange as “Investment Property”. Unless I have a really flawed perception of the FairTax, I understand that an investment is just that, and investment income is not taxed since “Income” is no longer taxable.
My understanding is that only when new products and services are sold to the end consumer are they to be taxed under the FairTax. Rents are not sales, and in the vast majority of cases the properties are not new. It would be my contention that to levy the FairTax on rents would generate a lot of negative publicity from the liberal factions who would rightfully point out that the FairTax unfairly burdens the poor on a major necessity of life. Extending that thought would be the opportunity for the opponents to claim that hundreds of thousands of poor people would become homeless “street people”. A little hysteria along those lines could derail the entire FairTax program.