Business Organization
Thoughtfully considering how you will own or “take title” for an investment property is worthwhile. There are many second and third order effects to how you organize which can have a material impact on the profitability of your portfolio.
Limited Liability Company. Many times, property is purchased using an LLC to enhance the personal liability protection of the owners; however, there are many good reasons to use LLCs when buying real estate depending on your goals. For instance, LLC debt is not reported on your credit report. This may seem like a small detail, but if revenue from a property is split between you and a partner, but the full mortgage payment for that property is reported on your credit report, the effects can be detrimental. Conversely, selling an LLC is much easier and less costly than selling real estate. Many times recordation and transfer taxes can be avoided when selling an LLC that owns real estate which can add up to many thousands or dollars in savings.
Incorporated Company. Holding real estate in a corporation is similar to holding real estate in an LLC, especially if you’ve made a “sub-chapter S election” to be taxed as an LLC. However, it’s important to note the IRS does not allow corporations to hold real estate if more than 50% of the revenue is generated from rental properties. Additionally, it’s generally not recommended to hold rental properties in a company used as a primary source of income. Comingling active business ownership with rental activities can change the liability risk profile of one, or both companies and subvert the diversity of income each presents as standalone companies.
Personal Name. Taking title under a personal name is the most common way of acquiring rental properties. The upside is nice because mortgage loan terms are generally better, CPA fees are generally less expensive for compiling tax returns, and there is never any ambiguity regarding who owns the property – your name is literally on the title. The downsides usually come into play as you start to accumulate more properties – for example Fannie Mae backed mortgage loans are generally limited to 10 investment properties. And as we discussed above the full debt burden of multiple investment properties can have a negative impact on your personal credit report and skew personal debt ratios if only half of the revenue is recognized on your tax return. IMPORTANT NOTE: Always take title as “tenants in common” if you share an investment property with a business partner. This type of ownership allows your interest in the property to pass to your estate following your death. Ownership taken under “joint tenancy” will automatically reassign ownership to your business partner upon death. Joint tenancy is typically only used with married couples.
Financing
Using debt to finance the acquisition of investment properties is a requirement for most investors. It’s important to understand how financing terms can change and how that impacts the scalability and profitability of real estate investments.
Business or Commercial Financing. This type of financing is exclusive to purchasing real estate using an LLC or Corporation. Usually these products are offered as “portfolio” loans, or loans held for the entire term by the issuing bank or credit union. The terms offered are a diverse as the number of financial institutions that offer them. Important details to pay attention to include:
1) Term (length of time extended to make payments)
2) fixed or variable rate
3) amortization (length of the time used to calculate minimum monthly payments)
4) loan to value requirements (how much is needed in equity)
5) debt service requirements (how much money can they lend you based on the cash flow of the property)
6) seasoning (length of time between acquisition to refinance needed to use appraised value vs. contract price). Seasoning may seem like a small detail – maybe you’ve never even heard the term before – but I can assure you this is a particularly important detail if you’ve ever purchased a property under market and try to rehab and refinance it quickly after the sale.
Conventional Financing. This type of financing can be used to purchase an investment property if you’re taking title in your personal name. Although the rate is generally 1% higher than what you might be able to secure using “owner occupied” financing, the 30 year fix term is usually available which is a huge help to reduce the monthly payment and promotes a better month to month cashflow.
Investment Acquisition
Where is the best place to buy? What about some of the more exotic ways to acquire real estate? I have an old IRA rollover – can I use that money to buy real estate? A work friend told me about his 1031 exchange – could I use that to acquire more rental property? In our opinion holding rental property should always be looked at as a long-term strategy. The costs are high and time required to purchase and rent real estate can be onerous. Using a thoughtful strategy to acquire rental property is necessary for a strong foundation to build your portfolio.
Geographic Focus. Properties close to the DC Metro market (e.g. Montgomery County) typically have a lower return on investment (ROI) as compared to properties in secondary markets (e.g. Frederick and Washington Counties). Conversely, appreciation is typically higher in more populated areas where demand outpaces supply. Your acquisition strategy should be shaped by these basic ROI vs. appreciation tradeoffs and measured against your appetite for risk.
1031 Exchange. 1031 exchange is a reference to the IRS Internal Revenue Code Section 1031 which allows for the sale of real estate and the purchase of like-kind property to avoid capital gains taxes for the owner. 1031 exchanges can be helpful in very specific circumstances to defer the payment of taxes and to instead use that money to purchase another property. From our prospective 1031s are most useful for very wealthy individuals interested in selling fully depreciated assets in large transactions. When executing a 1031 transaction the seller identifies a custodian (usually an attorney specializing in 1031 exchanges) who holds the proceeds from a sale and the seller then directs the custodian to purchase more real estate using the proceeds in a specified period of time. This usually means identifying a new property to purchase in 45 days and purchasing the new property within 180 days from the date of sale. Form our prospective the most important part of real estate investing is patience. Using imposed deadlines to acquire new property may save on taxes, but it also might force bad decisions which can also be costly.
Self-Directed IRAs. Using an individual Retirement Account to acquire rental property can make real estate investing accessible for many people with large retirement accounts, but it is not without risk. Tax advantaged or “qualified” retirement accounts must be handled in a very specific manner by IRS recognized custodians to avoid disqualification. We’ve assisted with the set-up and acquisition of investment properties using self-directed IRAs for multiple investor clients and we can advise on this strategy. Additionally, we’ve built a team from legal counsel, and CPAs to lenders which can help Boomtown clients accomplish their real estate goals using self-directed IRA accounts.