Jonathan Cunningham, CPA
Residential Rentals: Seven Keys to Success
Rental real estate can be a great individual investment, and I’m often asked for advice by clients. If you have 1 to a dozen rentals here are 7 “Must Have” Steps to Success!
*Additional Compliance Considerations
1. Choose the Right Legal Entity
OWN PROPERTIES DIRECTLY OR THROUGH AN LLC
Direct Ownership –owning properties directly without an LLC or Corporation is a popular way to own residential rentals, single family residences (SFRs) in particular. The main benefits are simplicity and access to conventional and/or FHA mortgages which generally have better terms than available for LLC / Corporate owned real estate. Owning investment real estate directly will cap the size of your portfolio if you are using conventional loans. Up to 10 mortgages are allowed, but in practice the limit is 3 or 4 properties, including your primary residence.
KEY: Consider owning directly when you are the only owner and you have 4 or fewer properties with conventional or FHA financing.
LLC – While a little more expensive and complicated than owning directly, an LLC provides much more flexibility in clarifying the rights and obligations of multiple owners or partners. An LLC offers less formality and complication than a regular Corporation (you do not have to have named corporate officers for example and may not be required to hold period meetings). If your LLC has only one member (owner), it will be disregarded for tax purposes and your real estate income or loss will be reported using 1040 Schedule E with no need to produce K1s or a form 1120.
Generally, it is not advisable for real estate investment LLCs (or any LLC holding appreciating real estate) to take an “S-Corp” election because it means any appreciation on the real estate will be treated as taxable gains upon distribution.
I am often asked if real estate investors should have a separate LLC for each property. Unless you have different owners or different ownership allocations across properties a single LLC is enough. Especially since you will be getting landlord insurance on each property owned by the LLC (see Insurance below).
KEY: Consider an LLC if there are multiple owners if you are seeking financing from lenders who do not require a personal guarantee or if your holdings are growing beyond half a dozen units.
BEFORE moving real estate to a different entity, understand if the move will trigger a property tax reassessment and what those implications are.
2. Buy Right
YOU MAKE ALL YOUR MONEY THE DAY YOU BUY
There is a saying in real estate that you make all your money the day you buy. That doesn't mean you get a satchel of cash when you close escrow (even if that does happen sometimes). It means the price you pay, combined with decisions about which specific property choose has a long lasting, and maybe determinative, impact on the financial performance.
Even in extreme buyers market with a glut of forced sales and desperate sellers it is imperative to do your research and make sure the "deal" you found is a good one. Know the market, and know the physical and legal condition of the property very well.
In seller's markets few or no "good" deals make it to the MLS. Real Estate agents also like to invest, and many have a network of established clients and investors. In many ways, the "best" deals never make it to an actual public listing in a seller's market.
So what do to? Try networking with real estate agents and others in the industry. And most certainly familiarize yourself with the auction market for foreclosed and tax sale homes. A word of caution: many of these sale formats have complex provisions that allow a foreclosed home to be repurchased by the old owner. Or have no warranty and are sold strictly on an "as-is" basis. Almost all require cash. This is not the place to "wing it". Investors acquiring by auctions MUST know the details of what they are doing.
3. Get Insurance
GET LANDLORD POLICIES THAT COVER EACH PROPERTY
Regardless of the form of business, you should obtain landlord insurance covering each property. You should also consider a personal umbrella policy.
Landlord coverage is like a homeowner’s policy and should be obtained for each unit in the portfolio. While an LLC will protect your personal income and assets against liabilities arising from the real estate, it will not compensate you if one or more of the properties are damaged or lost catastrophe or a lawsuit. You need to protect your investments and will be required by almost every lender.
Check if your landlord policy covers loss of rent if the house is damaged or becomes otherwise uninhabitable. You may want to get business interruption coverage if not. Get an umbrella policy to protect your rental real estate from personal liabilities like car accidents or personal negligence. It would be awful to lose your portfolio over a personal mistake. Umbrella policies are affordable. If you own your rentals directly, umbrella policies may also cover claims in excess of the Landlord policy and keep them from affecting the rest of your portfolio and personal assets. The incremental cost of an appropriate umbrella policy would likely be less than $1,000 per year. Such a policy would also protect your rental property business, if, for example, a claim arose from your personal life, possibly via a car accident or other unexpected loss, which is something an LLC formation would not accomplish.
Regardless of the form of business, be sure to consult a licensed insurance expert to get the right policies, with matching coverage limits to ensure you are protected.
4. Borrow Smart
FINANCE RENTAL PROPERTY WITH 30% TO 70% DEBT
Traditional finance theory holds that funding businesses with 100% equity is inefficient. And that’s exactly right! Additional business opportunities can be completed by adding a reasonable amount of debt to the picture. For the rental investor, this means you can buy more rentals if you borrow. And, since the interest paid on business debt is tax deductible, the cost of borrowing is significantly offset by the IRS.
That said, DEBT ADDS RISK AND COST. So how much should an investor borrow when financing assets? The answer is enough to increase the number of units in the portfolio, without taking on too much cash flow risk. Of course, the greater the percentage of debt (Loan to Value ratio), the more interest a lender will want to charge. Understand the market for each rental, and the available lending terms are key elements of finding the right amount of leverage for YOUR portfolio.
There are several “portfolio lenders” who lend against rental properties, and some who specialize in single family and duplex properties. These lenders can structure loans against a single property or a bundle of properties.
5. Take Care of Your Investment
PLAN AND PERFORM MAINTENANCE
While real estate is a very durable physical asset it does require maintenance. As your portfolio grows it is important to budget for, and complete maintenance along the way.
Planned maintenance includes things like interior and exterior painting, tuck pointing, new carpets, and new appliances. Some items like water heaters, may be in the planned budget and used until they fail. Other items, like shingle roofs should be replace before they fail. It is difficult to exactly predict maintenance costs each quarter, but maintenance budgets averaged over several years can be very predictable. Preventative maintenance such as termite control, cleaning out the dryer vent, etc should also be scheduled, budgeted and performed. Conduct periodic inspections to evaluate preventative, planned, unplanned and economic maintenance should be budgeted. I you have expertise in this area you can do it yourself, otherwise be sure to hire a qualified property inspector every five to ten years to avoid surprises and update your budget.
In addition to planned physical maintenance, landlords should periodically assess the economic environment. If the neighborhood is changing, or some aspects of the property becoming stylistically dated, economic maintenance may enable higher rents that more than offset the cost of upgrades / remodels. Maybe that old yellow tile countertop is still in good shape but upgrading to granite and some fresh paint may add a couple hundred dollars to what you can get for monthly rent.
Many landlords who “take it as it comes” find that it all comes at once. That is easier with one or two units, but when you have 4 or 6 or 8 it can bite. One day you might find that one unit needing a $10,000 roof, another needing $1,000 for a water heater, $5,000 for painting and a third needing $3,000 in new carpet. OUCH! Do not fall into this trap.
6. Manage Well
MANAGE YOUR PROPERTIES FOR MAXIUMUM SUSTAINABLE CASH
Your rental properties will need to be managed through their lifecycle, including finding and screening prospective tenants, leasing, handling of deposits, collection of rent, maintenance, repairs, turnover and from time to time, evictions. There are significant compliance requirements involved with Property Management that are beyond the scope of this letter.
Property management can be a complex undertaking, that requires skills in marketing properties, finding and screening prospective tenants, setting rent, setting policies, writing leases, and pursing collection and eviction processes. Property managers will need to have or develop a contact list of reliable and competent vendors for things like painting, carpet steam cleaning, carpet replacement, yard work, plumbing, electrical, roofing and so on.
You may wish to consider evaluating historical rents, vacancies and operating costs to develop a forward-looking operating budget. Such a budget should incorporate required repairs, planned maintenance and WDO control. Operating costs such as taxes, property management, unplanned maintenance and loan servicing (if applicable) should be included. Best practice includes a monthly comparison of budget versus actual results.
In other cases, self-managed real estate may suffer from inadequate tenant screening, evictions, damage, and vacancy issues. These costs can quick escalate and devastate the economic performance of your portfolio. I encourage you to carefully consider your requirements and design a simple and effective system to manage these properties. Such a system will certainly involve technology and should have a single bank account (other than as needed for statutory requirements such as a trust account(s) for keeping deposits).
Ensure that you do not discriminate against protected classes and are able to demonstrate compliance
Each state has regulations concerning treatment of deposits, including the use of trust accounts, deposit amounts, handling, and deduction of costs and disbursements upon end of tenancy
There are a variety of tools that will help you manage the properties, screen tenants, collect rent and manage and pay vendors. Properly configured, these tools will also enable compliance requirements for state and federal income tax, automate marketing and complete other operational activities. Examples of these packages include Yardi, Stessa, and Cozy.co. Intuit’s quick books and other general accounting packages have real estate capability but for smaller portfolios may be heavy on the accounting and short on the real estate specific functions that will make your life easier.
Many casual investors in real estate fail to develop adequate systems to manage their investments. In many cases this results in overly complex outcomes such as using a proliferation of bank accounts to compensate for inadequate accounting procedures, or worse, a proliferation of legal entities based on false assumptions.
7. Get Taxes Right
RENTAL PROPERTIES ARE TAX FRIENDLY – GET IT RIGHT!
For a long-term investor there are several advantages to real estate over other “passive” investments.
No Self-Employment Taxes – most real estate investors are not subject to self-employment tax on their real property rental income. This is also true for real estate professionals and regardless of if you actively or materially participate in the real estate.
Qualified Business Income (QBI) - As you may know, the Tax Cuts and Jobs Act created significant tax benefits for corporations. To maintain parity and fairness, congress created a deduction for up to 20% of QBI that applies to LLCs and self-employed businesses, subject to certain limitations and requirements. To avail yourself of this significant benefit you must own the real estate directly or through an LLC where you are the only member / owner. In addition, you must make certain elections if the properties will be treated individually or as a group with separate books and record keeping for each property or group of properties. In addition, you must have 250 hours or more per year in work to operate the properties or any group of properties. My recommendation is that you take all 7 of these properties as a single group. The IRS creation of the 250 hours safe harbor rule is very new and not every detail is available. You may want to start tracking time now, and certainly any related expenses will be deductible in the future. Very likely, the 250-hour requirement will be pro-rated for part year ownership.
Depreciation - It is important that your accounting and tax filings take depreciation, even if you are not able to apply it to current income and it exists only as a charge on paper. The reason for this accounting need is that if you sell one of the properties in the future, you may be required to pay recapture tax, which will be based on depreciation that was available to you, regardless of whether it was taken or not. You may want to work with an accountant to establish appropriate depreciation schedules and bookkeeping practices. There are other opportunities to further accelerate depreciation if desired. Determination of the best approach requires a more complete assessment of the properties and your unique financial circumstances.
Capital Spending and Section 179 - Once you have determined initial values and depreciation methods and schedules, you will need to track capital additions. Capital improvements will increase tax basis and ultimately reduce your tax obligations. The TCJA tax reform allows certain capital expenditures (refrigerators and stoves for example) to be deducted in full the year acquired.
Disregarded Entity - if you form a single member LLC it will be disregarded for tax purposes. You will report income (or losses) on Schedule C of your form 1040 individual tax return. This dramatically simplifies tax preparation and filing and means no K1s and no Forms 1065 (or 1120s) need to be prepared.
* Additional Compliance Considerations
State Income Tax – in addition to federal tax your real estate business will be subject to state taxes. You will need to report your rental investments on the state return of the state where you live, and (in most cases) if the property is in a different state, the state where the property is located.
Quarterly Estimated Taxes Required - Unlike wage income with tax withholding for regular paychecks generated from an employer’s payroll, business income, including residential rental business income requires quarterly payment of Estimated Tax. These payments should be calculated and paid to the state and federal (and possibly local) tax authorities every quarter.
1099 Reporting - You will need to collect taxpayer ID and other information for any self-employed contractors/vendors that you hire and pay more than $600 to within a tax year. For each of these vendors you must file 1099-NEC with IRS and provide a copy to the vendor and State tax authorities (depending on the States involved).
Licenses - Determine if your rental requires business license(s) from the county or city in which your properties are located, or if your property is in a jurisdiction that charges property tax differently for rentals vs owner occupied. Most states require that property managers be licensed as such, or as a real estate broker however this requirement is broadly waived for self-managed rentals.
This is a generic overview and may not apply to your specific situation. You should consider obtaining additional legal, accounting and property management / real estate advice specific to your unique circumstances.
Cunningham CPA helps investors get the most from their commercial and residential real estate investments. Call us today for a free consultation.