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.”