Why writing off questionable commercial property expenses may hurt you in the long run…

As tax season draws to a close, some people may have given their accountants information to make their investment property look as bad on paper as possible.  By this I mean, some people write off all kinds of questionable expenses against a property to reduce the taxable income on the property, thus reducing the tax liability. 

As I go over the income and expenses of properties for clients getting ready to sell, I generally see some expenses that are not directly related to the property but are still written off as an expense.  I then inevitably have to describe that when buyers, including them, are buying a property, the most reliable source of income and expense data is the tax return.  Obviously, if the property has a higher net operating income it will be worth more. 

Let’s break it down with some real numbers.  Let’s say a property has a rental income of $50,000 per year and $15,000 of expenses written off on the tax return.  This leaves us with $35,000 of net operating income (NOI) – the most important number!  Let’s say investors are requiring approximately a 9% return, and this property sells at a 9% capitalization rate (cap rate = NOI / sale price).  The property would sell for $388,889.  Now let’s imagine the client had $2500 of questionable write-offs in those tax returns.  If we don’t include those expenses on the tax return, so the NOI is actually $37,500, and the property sells at the same cap rate.  The investor would get $416,667 for the same property.  This is an increase in the property value of $27,778 from that $2500 worth of questionable expenses you did not write off!

As I described this phenomenon of questionable write-offs to a client of mine, his response puts it best:

“You may save a couple dollars today, but you more than pay for it when you go to sell.”

Some things in the real estate world will dramatically shape (or reshape) your view on investments.  I recently went through one of these, when I sold an investment property I purchased 6 years ago.  I used to believe investment properties with a return of 6% should only get the delete button, but now a 6% return may not be so bad!  The particular investment property I sold was a good learning lesson in several ways:

• Do not be too motivated to buy a property using a 1031 exchange.  Many times, it is better to just pay the taxes and find a better deal without time constraints.
  
• Falling “in love” with an investment property never ends well.  As they say, “breaking up is hard to do.”  My suggestion is to never start the relationship.
  
• NEVER count on appreciation to make your investment a good one.  ALWAYS use cash flow as your gauge.
  

This particular investment was not too expensive that I could not handle it, but yes, it would have been much nicer to just put the 1031 money under my mattress, paid the taxes, and waited for a better investment to come along...as they often do.  For those that like calculators as much as me,  I have included my yearly cash flows below along with my initial investment indicated as Year 0.   If you calculate the IRR for this investment, what do you get?

     Year                    Total Cash Flow
       0                           ($70,012)
       1                              $577
       2                            ($2432)
       3                            ($4759)
       4                            ($7395)
       5                            ($3543)
       6                            $12934

On this deal, assume the cash flows occur at the end of the year and that there is only 1 payment per year.  Sometimes the best learning experiences come long after college is over!