Newsgroups: misc.invest.real-estate misc.legal misc.taxes
Subject: Re: Real Estate Investment Tax Question
From: Deadrat 
Date: Tue, 27 Nov 2007 00:29:17 GMT
Bytes: 4467

mproozee@hotmail.com wrote in news:6c398b03-ea09-44ab-9cf9-9fb80f4ecf98
@s36g2000prg.googlegroups.com:

> I apologize for cross-posting if any of the above newsgroups are
> inapplicable.
> 
> A friend asked me about the legal (tax) implications if he:
> 
> 1) Receives a $1M loan to buy a rental property
> 2) Uses the $1M to purchase a rental property, A
> 3) Uses A as 100%+ collateral for a $750K loan
> 4) Uses the $750K loan to purchase a second rental property, B
> 5) Uses B as 100%+ collateral for a $500K loan
> Wash.  Rinse.  Repeat.
> 
> He then rents out all of the properties for the same monthly payment
> as the loans used to purchase them plus any property taxes.  So the
> rent from A is used to pay off the loan and property taxes on property
> A, the rent from B is used to pay off the loan and property taxes on
> property B, etc.  All of this seems to be legal at this point.
> 
> The plan is to claim no profit and thus pay no tax on the rental
> properties.  He claims that he has nothing to tax until he has a
> capitalization event.  I am neither a real estate expert nor a tax
> attorney but this doesn't make sense to me as the rental income is
> still income and the "loss" due to loan repayment and property tax is
> not the type of "loss" referred to in the tax code.  My assumption is
> that this is tax fraud and that he is responsible for paying income
> tax on all rents received but I haven't been able to find any
> California statute or case law that is sufficiently on point to
> convince him.  This would not be the owner's primary residence or
> anything like that... strictly investment property.

Your friend apparently would have active income from the rents and 
therefore could offset that income by using the investment interest 
deduction (up to the amount of that income).  Assuming that deductible 
expenses for the rental property amounted to at least as much as the 
rental income, then your friend would owe no taxes.  I'm not sure what 
you mean by "loss"; interest and taxes are expenses, and within the 
rules, offset income.  If your friend shows a net loss on his real estate 
business as a whole, then he probably won't owe income taxes from the 
business.

The problem is that in practice, your friend will not be able to find 
properties or lenders to finance his scheme.  Step 2 assumes that he can 
buy a property worth $1.75M for $1M.  Remember that he doesn't really own 
property A outright -- he owes $1M on it, and that $1M is not available 
as collateral for the loan on property B.  Assuming that your friend 
properly discloses everything about his real estate investments -- and it 
constitutes bank fraud to do otherwise -- how is he going to convince a 
bank that he has $750K equity in building A available as collateral for a 
loan?  If the building is really worth $1.75M, how did he convince the 
original owner to let it go for $1M?

> Is there a name for this type of scheme

Yes, the technical name is "pipe dream."  Or maybe in your friend's case 
"California dreamin'."

> and does anyone know what the typical penalty (in California) would be?

Cluelessness is its own penalty.
 
> If anyone has any information, please forward it to my email address:
> mproozee@hotmail.com
> 
> Thanks in advance,
> 
> - Matt