What Can A Professional Property Manager Do For You?
Historically, renting your home has been considered a relatively simple and low risk undertaking. However, in recent years, this apparently simple task has become progressively more complex and the risks associated with becoming a landlord far greater. While managing your rental is certainly within the abilities of most property owners, the time and effort involved in management may be greater than the cost of hiring a professional property manager.
The professional property manager is conversant with the applicable statutes and regulations relevant to the management of rental property. In addition, the manager will typically perform the following tasks as part of the management service:
- Advertisement of the rental property
- Screening of potential residents
- Preparation and execution of rental agreements
- Disbursal of funds to the property owner
- Collection of rents
- Monthly and year-end accounting
- Coordination of maintenance and repair work
- Periodic property inspections
- Disbursal of deposits in accordance with state law
- Eviction of residents for breach of the rental agreement
Advertisement of the Rental Property
Until recent years, advertisement of an available rental meant placing a “For Rent” sign in the front yard and possibly placing an ad in the local newspaper. Times have changed. Today, while the old stand-bys are still used, effective advertising also includes extensive use of the internet, making availability of the property known to real estate professionals, and targeted advertising to large employers.
Screening Potential Residents
Once an application for rental is received, it must be determined if the applicant is qualified to rent the property. Has the applicant been evicted from a prior rental? Does the applicant earn sufficient income to pay the rent? These questions, as well as others should be answered prior to approving the applicant.
A professional property manager will typically check four areas when screening an applicant. These are the applicant’s credit report, income, employment, and rental history. It has become almost universal that the applicant’s credit report be checked for late pays, judgments, liens, or bankruptcies. The applicant’s employer is typically contacted to verify income, and the applicant’s prior landlord is contacted to verify rental history. While there are few perfect applicants, the information gleaned through the application review process can greatly reduce the likelihood of renting to an unqualified resident.
Preparation and Execution of Rental Documents
After the applicant is qualified, the necessary rental documents must be prepared and executed. Gone are the days of going to the local stationery store and buying a preprinted, two-page rental agreement. Today, rental agreements are custom drafted to reflect specific state statutes, and sometimes, applicable local ordinances. In addition to the rental agreement, any required addendums are prepared and may include an addendum relating to pets, a no smoking addendum, an addendum relating to pool use, and if the property was built prior to 1978, a lead paint addendum. Further, a move-in inspection is completed and documented for review by the resident at execution of the rental agreement. Ancillary forms relating to transfer of utilities and trash pick-up may also be needed depending on the location of the rental property.
Collection of Rent
Every property owner would agree that timely payment of rent is critical. If the applicant was properly screened prior to acceptance, most poor rental risks will be eliminated. However, circumstance beyond the possibility of screening can adversely affect the resident’s ability to timely pay rent. These circumstances include loss of employment, injury, illness, and changes in marital status. When the resident is unable or unwilling to pay rent, the property manager has the ability to effective move forward with the collection process, or if that fails, terminate the rental agreement and locate a new resident in the minimum amount of time.
Disbursal of Rent to the Property Owner
Typically, the property manager will receive rent on the first day of the month, with disbursal of funds to the property owner between the fifteenth and twenty-fifth of the month. Because the property manager is required to hold all funds in trust, funds must be held until checks clear, which may take as many as ten working days. In addition, time is required for the accounting and statement preparation process.
Monthly and Year-End Accounting
The property manager will provide you with a monthly statement showing all income and expenses associated with your rental property. In addition, you will receive a year-end statement showing all income, and expenses broken out by category.
Coordination of Maintenance and Repairs
If you have ever had a resident at your rental property call you at 2:00 a.m. to tell you that the water heater is leaking and your rental is three inches deep in water, you will appreciate having a professional property manager. Most property managers maintain a twenty-four hour system for receiving emergency repair calls and relationships with a variety of skilled tradesmen capable of handling any emergency. For non-emergency repairs or preventive maintenance, you are contacted in advance to discuss the work and its potential cost to your.
Periodic Property Inspections
Does the resident have an unauthorized pet? How about six roommates not listed on the rental agreement? These, and other similar problems, can only be found through a physical inspection of the property. Typically, your property manager should have a representative inspect the property one to two times during the term of the rental agreement. Inspections may be conducted either as a scheduled appointment with the resident, or while repairs or scheduled maintenance is performed.
Disbursal of Security Deposits
After the resident moves out of the property, the condition of the property must be assessed and any damages charged to the resident’s security deposit. However, the property owner is not permitted to charge for “normal wear and tear.” What can be charged for that red wine stain on the white carpet? How much for the numerous nail holes in the living room wall? These, and similar questions are addressed by the professional property manager every day.
Further, did you know that if the resident is not provided an itemized statement of deductions from the deposit within thirty days of termination of the rental agreement, the property owner is precluded from making any deduction for damage to the property?
Eviction For Breach of the Rental Agreement
Probably the most difficult part of owning rental property is evicting the resident who has failed to meet their obligations as stated in the rental agreement. Typically, this means that the resident has failed to timely pay rent. The professional property manager can handle the eviction process efficiently, while making the process far less difficult for the property owner.
The professional property manager provides a cost-effective service in the rental and management of investment property. While the above discusses the functions performed by the property manager, it should also be noted that efficiently and competently performing these functions minimizes potential risk to the property owner and in the long term, maximizes returns from the investment property.
are Sometimes Wrong
The Jones went to a lot of trouble to insure that their home was in good repair and was fixed up for sale before placing it on the sales market. The property was attractive and priced to sell. In a short time there was a contract for sale.
When the buyer’s inspector came to perform the general inspection he found that the roof was on its last legs and recommending spending $5,000 for a new roof. The Jones were surprised and upset because the roof should have lasted several more years. They called their roofing contractor who after studying the roof recommended a $500 repair and assured the Jones that the roof would last another three to five more years. Eventually a third roofer recommended by the buyer was consulted who agreed with the Jones contractor. The Jones did the $500 repair and the buyer was satisfied with the opinion of the two roofing contractors.
Inspectors are human and can make mistakes. Do not panic if you get a negative inspection report. Get a second expert opinion and work to resolve the problem.
The solution is not always this easy, especially when contractors can’t agree. Keep in mind that there is an element of subjectivity involved in the inspection process. For example, two contractors might disagree on the remedy for a dry-rotted window: one calling for repair and the other for replacement.
The buyer normally choses the inspector and picks up the cost. If you do not agree with the inspectors report, sometimes finding the right expert to give an opinion on a suspected house problem is the answer.
Your Credit Score
It is important to know your credit status when considering the purchase of a house. Most lenders use a credit score called “FICO”to determine your eligibility for a loan and the interest rate you should be charged. FICO stands for Fair Isaac & Company, and credit scores are reported by each of the three major credit bureaus: TRW (Experian), Equifax, and Trans-Union. The score is computed differently by each bureau since they place a slightly different emphasis on component items. Scores range from 365 to 840.
Lenders started to take a closer look at FICO scores in the early 1990s and this is what they found out. The chart below shows the likelihood of a ninety-day delinquency for a specific FICO score.
|Odds of a
|595||2.25 to 1|
|600||4.5 to 1|
|615||9 to 1|
|630||18 to 1|
|645||36 to 1|
|660||72 to 1|
|680||144 to 1|
|700||288 to 1|
|780||576 to 1|
What affects FICO scores? — How do lenders look at them?
Some of the things that affect your FICO scores are:
- Too many accounts opened within the last twelve months
- Short credit history
- Balances on revolving credit are near the maximum limits
- Public records, such as tax liens, judgments, or bankruptcies
- No recent credit card balances
- Too many recent credit inquiries
- Too few revolving accounts
- Too many revolving accounts
The credit score is actually calculated using a “scorecard”
where you receive points for certain things.
Creditors and lenders who view your credit report
do not get to see the scorecard, so they do not know exactly
how your score was calculated. They just see the final scores.
Basic guidelines on how to view the FICO scores vary a little from lender to lender. Usually, a score above 680 will require a very basic review of the entire loan package. Scores between 640 and 680 require more thorough underwriting. Once a score gets below 640, an underwriter will look at a loan application with a more cautious approach. Many lenders will not even consider a loan with a FICO score below 600, some as high as 620.
FICO scores and interest rates
Credit scores can affect more than whether your loan gets approved or not. They can also affect how much you pay for your loan, too. Some lenders establish a “base price” and will reduce the points on a loan if the credit score is above a certain level. For example, one major national lender reduces the cost of a loan by a quarter point if the FICO score is greater than 725. If it is between 700 and 724, they will reduce the cost by one-eighth of a point. A point is equal to one percent of the loan amount. There are other lenders who do it in reverse. They establish their base price, but instead of reducing the cost for good FICO scores, they “add on” costs for lower FICO scores. The results from either method would work out to be approximately the same interest rate. It is just that the second way “looks” better when you are quoting interest rates on a rate sheet or in an advertisement.
Factors other than FICO scores affect underwriting decisions. Some examples of compensating factors that will make an underwriter more lenient toward lower FICO scores can be a larger down payment, low debt-to-income ratios, an excellent history of saving money, and others. There also may be a reasonable explanation for items on the credit history that negatively impact your credit score.
They don’t always make sense. Even so, sometimes credit scores do not seem to make any sense at all. One borrower with a completely flawless credit history had a FICO score below 600. One borrower with a foreclosure on her credit report had a FICO above 780.
Portfolio & sub-prime lenders
Finally, there are a few “portfolio” lenders who do not even look at credit scoring, at least on their portfolio loans. A portfolio lender is usually a savings and loan institution who originates some adjustable rate mortgages that they intend to keep in their own portfolio instead of selling them in the secondary mortgage market. They may look at home loans differently. Some concentrate on the value of the home. Some may concentrate more on the savings history of the borrower. There are also “sub-prime” lenders, or “B & C paper” lenders, who will provide a home loan, but at a higher interest rate and cost.
Numerous credit reports can effect your FICO score. Wait until you have a reasonable expectation that you will use a lender before you let them run your credit report. Not only will you have to explain any credit inquiries in the last ninety days, but also numerous inquiries will lower your FICO score by a small amount. This may not matter if your FICO is 780, but it would matter to you if it is 642. Don’t buy a car just before looking for a home!
When people begin to think about the possibility of buying a home, they often think about buying other big-ticket items, such as cars. Quite often when someone asks a lender to pre-qualify them for a home loan there is a brand new car payment on the credit report. Often, they would have qualified in their anticipated price range except that the new car payment has raised their debt-to-income ratio, lowering their maximum purchase price.
Your credit history is important and credit scores are important if you want to get the best interest rate available. Protect your FICO score.
- Do not open new revolving accounts needlessly.
- Do not fill out credit applications needlessly.
- Do not keep your credit cards nearly maxed out.
- Make sure you do use your credit occasionally.
- Always make sure every creditor has their payment in their office no later than 29 days past due.
- Never, ever be more than thirty days late on your mortgage–ever.
Educate Yourself On the Buying Process
Your new home purchase will probably be one of the most important decisions of your life. Before you begin it is important to educate yourself on the real estate market in your area and the buying process. An experienced real estate agent who knows the area can help you with both these issues. Other excellent resources are books on home buying and seminars for the homebuyer.
The ten steps of the buying process discussed in this article are:
- Your Credit Score and “Loan Pre-Approval”
- Select the Best Real Estate Agency
- Search For Properties
- The Offer, Counter Offers and Acceptance
- Disclosure, Disclosure, Disclosure
- The Physical Inspection
- Opening Escrow
- Lender Requirements and the Final Walk Through
- Closing Escrow
- Final Notes
Your “FICO” score provided by each of the three credit reporting agencies is one of the most important factors that lenders consider when providing a good home loan and determining interest rates. Your bank, or a mortgage broker,can interpret the FICO score for you and advise you on the best course for your situation. It is wise to apply for a “Loan Pre-Approval”. This entails a process of complete verification of your loan application, employment, assets, etc. The loan approval step is critical to knowing the interest rate you can expect based on your credit and exactly how much home you can afford. Furthermore, having a “Loan Pre-Approval” in hand will strengthen your offer on any property.
It is an advantage to the buyer to have the best professional representation. In most situations the seller of the property pays the real estate commission and the services of a professional real estate agent are free to the buyer. We dedicate our full attention to service and commitment to our clients.
Sometimes you find the home of your dreams immediately and your first offer is accepted. Usually the search takes several weeks and it may not necessarily end with the first home you submit an offer on. For some people the home search process will take months. Be determined to find the perfect home at the best possible price, regardless of whether it takes a day or months.
Our agents use all the latest real estate technology. It is important to your search to be kept abreast of new homes. We monitor the real estate market on a daily basis and notify our buyers of newly listed properties the moment they come to market. We will help you find all the best properties for your consideration.
You have found the right home and you are ready to make an offer. Things included in your offer should be: offer price, terms, conditions and contingencies that must be met in your purchase. It is best to submit offers on the standard form for a residential purchase agreement. A good faith deposit check is normally submitted with the offer. Your real estate agent can carefully explain the purchase agreement to you and fill it out with your complete understanding. You then initial each page and sign the contract.
Once the offer is presented to the seller they may come back with a counter offer. It “stops” your offer when the seller counters with additional terms or conditions. You can accept the sellers offer or make a counter offer of your own. A real estate transaction often will have one or more counter offers before the buyer and seller come to an agreement on price and terms. Your real estate agent will help you with a counter offer and insure that you meet all deadlines and conditions. You have a sales contract once you have reached a successful negotiation with the seller and an offer or counter offer is accepted by one of the parties.
The buyer should request the seller and their agent disclose every material fact known that may effect your buying decision on the property. Sellers normally provide such a disclosure to their agent. It is best to request a copy of this disclosure when making the purchase offer or immediately thereafter.
There is normally a general physical inspection of the property sometime before opening escrow. The inspection process is designed to ensure that you are making an educated buying decision. A licensed inspector is hired to do a general inspection of the major systems that relate to the property. Your realtor can recommend an inspector with whom they have had good experience with in the past.
The inspection usually costs between $250 and $600 depending on the home. In some states the buyer pays for the inspection and in other states the seller. In New Mexico the seller usually pays for the inspection. If defects are found in the inspection the buyer and seller usually determine reasonable repairs to be done by the seller or an adjustment in purchase price. If an agreement is not made on these issues the contract can be mutually cancelled.
Your purchase agreement including any offers and counter offers constitutes your contract and initial instructions to the escrow agent. The escrow agent acts as a third party and insures that all the conditions of the sales contract are met as well as any lenders requirements. They handle all the paperwork and cash. It is important to have a good escrow agent to insure that your transaction closes on time. Your real estate agent can recommend a good escrow agent they have worked with in the past. Escrow normally takes between 30 and 60 days. Now is also a good time to line up your homeowner’s insurance. Recently obtaining homeowners insurance has become more difficult and takes more time than in the past.
Prior to closing your lender usually requires a termite report, title insurance policies, and an appraisal. The seller usually pays for the termite report. There are normally two title policies, an owner’s title insurance policy paid by the seller and a lenders title insurance policy paid for by the buyer. The buyer’s lender will also require that the property be appraised prior to funding. Usually there is not a problem with the appraisal unless you overpay for the property. You can protect yourself by stipulating in your offer that the property must at least appraise for the purchase price.
A few days before closing you will conduct a final walk through to insure that the property is in the same condition as when the physical inspection was preformed and that any negotiated repairs etc. are completed.
Prior to closing the deal, you need to ensure that escrow gets a copy of your new home insurance policy and that any balance of the purchase funds be deposited with escrow. Escrow will also provide you with a “Closing Settlement Statement” which discloses all of your charges (debits) and credits in the transaction. It is imperative that you carefully scrutinize this document to ensure its accuracy. When your loan is fully approved, escrow requests loan documents from your lender and schedules a closing date and time to execute the paperwork.
There is a considerable amount of documents that will require your signature. For this reason, the closing session is characteristically known as a “signing spree”. Almost all the documents are standard forms and not subject to change. One of life’s most exhilarating experiences comes after closing when your agent congratulates you on owning your new home.
Once this session is complete, escrow requests your loan funds from the lender. Normally, the day after the loan funds are received, the deed conveying the title to the Buyer is recorded at the county recorders office.
Plan your move appropriately and make sure to give yourself enough time to adequately pack and unpack. Don’t forget to transfer all utilities into your name including the water if applicable. Remember that utilities and cable TV can require several days’ notice. Be sure to order your new phone service and forward all of your mail at least one week in advance. Get references for yard services, housekeepers, etc. Your agent can assist you in locating the correct utility companies for your new home.
Why Invest in Residential Real Estate?
As an investor, you have the choice of a variety of investments, including real estate. Residential real estate offers advantages unavailable with most other investments, including:
- Leverage of your investment
- Rental income generates cash flow
- Little or no savings to get started
- Tax advantages
Unlike most other investments, an investor can purchase a rental property with a down payment of twenty percent of the purchase price, or in some circumstances even less. Therefore, a relatively modest investment permits the investor to control a valuable rental property. Further, as the value of the investment increases, the investor’s return on his investment increases at a multiple of the increase in the values of the property.
For example, assume that an investor purchases a rental home for $100,000 with a down payment of 20% or $20,000. Five years later, the investor sells the property for $110,000, for a net increase of $10,000. Over the five-year period, the value of the property has increased a modest 10%. However, the investor’s return on his initial investment of $20,000 is 50%; all because the investor was able to leverage the initial investment.
The above example ignores a variety of costs associated with the purchase and ownership of rental property. But, with today’s low interest rates, it is quite realistic to presume that rental income can cover mortgage payments, insurance, taxes and necessary repairs.
While the preceding section addresses leverage, rental property also creates cash flow. Cash flow can be defined as the excess of rental income over expenses. Cash flow from a rental property will be maximized when the property is not leveraged and minimized when the property is highly leveraged.
To go back to the example above, presume that the investor has purchased a rental property for $100,000. The property generates $750 per month in rental income. Taxes, insurance, estimated repairs and maintenance, and estimated vacancy reserve cost $200 per month. Therefore, the property generates a positive cash flow of $550, before payment of principal and interest on the mortgage. The net cash flow generated by the property is dependent of the principal and interest payment; or in other words, how highly the property is leveraged.
If the investor has an $80,000 thirty-year mortgage at 7.00 %, the monthly principal and interest payment is $532 with a net positive cash flow of $18 per month. If the investor has a $60,000 mortgage with the same terms, the monthly payment is $399 and the rental generates a positive cash flow of $151 per month.
No matter what the cash flow generated by the property the first years, it can safely be presumed that the cash flow will increase over time because the principal and interest payment is fixed and rents have historically increased over time. Further, should the investor hold the property until the final mortgage payment is made, the cash flow generated by the investment will greatly increase because the principal and interest payment is by far the largest portion of the expense associated with ownership of the property.
The conventional method of purchasing rental property is to make a down payment of at least 10% of the purchase price and finance the balance with a twenty to thirty year mortgage. There are, however, a variety of other ways to purchase rental property including real estate contracts, seller carry-backs, lease purchases, and lease options. A full discussion of these methods of purchasing rental property is outside the scope of this discussion; however, it can be safely said that it is realistically possible to purchase quality rental property with little of no money down.
All income generated by rental income is taxable and must be reported to the Internal Revenue Service. However, all expenses associated with the property, including depreciation, are deductible. The IRS presumes that the property, excluding the value of the land, has a useful life of 27.5 years and allows the investor to deduct this presumed decrease in value as an expense on the investor’s tax return. Because depreciation is a non-cash expense, it is very possible for a rental property to generate a positive cash flow and a taxable loss at the same time.
Going back to the prior examples, presume that an investor has purchased a rental property for $100,000. The value of the land on which the rental sits is $10,000. Total income generated by the property is $9,000 per year ($750 per month x 12 months). Actual expenses excluding mortgage interest was $2000. Mortgage interest was $6,000.
Depreciation was $3,272 ($90,000 divided by 27.5). The investor’s income statement for the year is:
While the investor’s income statement shows a net loss, the investor actually had a positive cash flow of $1,000 for the year. In addition, the net loss has the effect of decreasing total income taxes due. The investor should, however, consult with a tax professional with regard the tax consequences of any investment.
Rental property has historically increased in value, with values doubling every ten years in many markets. Coupling steadily increasing property values with the cash flow generated from steadily increasing rents provides the investor with an excellent opportunity reap meaningful returns with less risk than other commonly available investments.<
Single Family Homes Always A Popular Investment
The most popular real estate investment for individuals is the single-family homes. The following discussion focuses on why so many individuals chose to invest in single-family homes over other forms of real estate.
It is possible to buy a single family home with 10% or less down payment. This means that you can buy a $100,000 house for only $10,000 down. It is entirely feasible for the average person to save $10,000 to buy their first investment property.
People are familiar with houses. Most people are not comfortable with shopping centers or apartment buildings. They don’t know what the rents are, what repair costs are, etc. On the other hand, most people do understand single-family homes.
More flexibility. Let’s assume that for the same amount of money you could either have 5 houses or 1 apartment building. If you needed money, with the apartment you could either have to sell the whole thing, refinance the whole thing, or bring in a partner on the whole thing. With the 5 houses, you could sell one of them, refinance one, or bring in a partner on just one.
Higher equity build up. There is usually more appreciation in single-family homes than in apartments and other types of real estate. Apartment buildings are valued based on the income approach (how much money they bring in). Single-family homes are valued based on comparable sales. This means that your investment houses are valued according to what the other homes in the neighborhood are selling for.
More control. With an apartment building, all of the tenants know each other, and they will know what they pay in rent. That means it is difficult to charge one tenant higher rent than another. Plus, if one tenant plays the stereo too loud or causes other problems, YOU will get the complaints. With houses, they are generally scattered around the area. You can raise the rents individually; offer lower rents to excellent tenants, etc.
Less risk. With single family homes, you don’t have all your eggs in one basket. The homes are usually scattered around the area. With an apartment building, if the area goes bad for some reason (i.e. a factory or freeway goes in across the street) you are sunk.
Maximizing Profit and Limiting Liability in Real Estate Investing
by Attorney Bill Bronchick
How should I buy and sell real estate? What entity gives the best tax benefits? How can I limit my liability? These are common questions posed by both beginning and experienced real estate investors. The following are answers to common questions about maximizing profit and limiting liability in real estate investing.
How should I take title? The first and biggest mistake you can make as an investor is taking title in your own name. All deeds are public record and free for prying eyes to see. Having property in your own name makes an easy target for tenants, creditors and attorneys. If a liability is created on your property, the owner (you) are liable. Make sure than you have a buffer zone between you and your properties. Keep your ownership private. The simplest, yet most effective device for taking title is the land trust (a.k.a. “Illinois Land Trust”). The land trust is form of revocable, living trust used to take title to real estate. The trust, rather than you, can assume liability for loans. Using a different trust for each property (e.g., “The 2537 Clarkson Street Trust”) allow you to own, manage and transfer property with anonymity.
Keeping a low profile is very important for investors who don’t want the world to see their business. Land trust agreements are not recorded in any public register so the beneficiaries of the trust are not easily discoverable. The beneficiaries of a land trust can be you, a corporation or some other entity (see below). The trust itself is not considered a separate taxable entity from the beneficiaries (see I.R.C. Sec 671-678). Thus, there are no tax consequences of transferring a property into or out of a land trust.
How can a corporation be used to limit liability and maximize tax advantages? A corporation is an effective device for buying and selling real estate on a short term basis (also called “flipping”). A land trust is an effective device for taking title, but it will not protect the beneficiaries from personal liability (since the beneficiary of a land trust reserves the right to direct the actions of the trustee, the beneficiaries can be held liable for mishaps on the property). Thus, if you “buy and flip” property, you should have the beneficiary of the trust be a corporation to limit your liability.
A corporation will limit the problem of IRS “dealer” status. A dealer is one who regularly buys and sells real estate as a business. If an individual is tagged as a “dealer,” the profits on his sale of property are subject to self employment tax (approximately 15%). Corporate dividends, on the other hand, are not subject to self employment tax (although the investor may have to take some salary, subject to self employment tax, to satisfy the aggressive IRS auditor).
What’s the difference between a “C” and “S” corporation?
There are essentially two types of corporations for tax purposes, “C” and “S.” A corporation is a “C” corporation by default; the “S” status must be elected. A “C” corporation files its own tax return and pays taxes on its profits. When the corporation distributes profit to its shareholders (called a “dividend”), the shareholders pay additional tax on their personal income tax returns (called “double taxation”). An “S” corporation is not taxed at the corporate level. Like a partnership, it files an informational return and the shareholders report their share of profit or loss on their personal income tax return.
Which is better for real estate? An “S” corporation is not necessarily better than a “C” corporation, but rather it depends on the investor’s particular tax situation. For example, an investor who has a working spouse may benefit from an “S” corporation, since a loss from the corporation’s operations can be used to offset the working spouse’s income. On the other hand, if an investor has a large profit, she will have income tax on all profits, whether or not they are reinvested or distributed. With a “C” corporation, the individual shareholder is not taxed on profits until they are distributed (the corporation itself pays tax on its income, but the first $50,000 of “C” corporation income is only taxed at the rate of 15%, which is much lower than personal income tax rates).
What is a Limited Liability Company and how is it different from a corporation? The Limited Liability Company or “LLC” is now recognized in all fifty states. People often confuse an LLC with a corporation, but it is much like more a partnership. It’s owners, called “members,” can equally participate in the management of the company without personal liability.
An LLC, if it has two or more members, is treated as a partnership for federal income tax purposes. Thus, like an “S” corporation, the profits and losses “flow through” to its owners. On rental activities, these profits are not subject to self employment tax (an LLC which engages in “buying and flipping” may not be considered “passive” activity and thus subject the members to self employment tax. Thus, a corporation may be better than an LLC for this purpose).
Most states now recognize “single member” LLCs, that is, an LLC with only one owner. The IRS treats a single member LLC as a “non-entity” for tax purposes. That is, the member would report as though the LLC did not exist. Thus, if the investor was reporting his rental activities on schedule “E” of his federal income tax return, a transfer of property from his own name to a single member LLC would not result in any change of reporting. Furthermore, an LLC between husband and wife can still be treated as a “single member” for federal income tax purposes. Thus, one could form an LLC for each property he owns and still file only one tax return!
What is best entity for doing “sandwich” lease options? When you lease with option then sublease with option (called a “sandwich”), you are essentially doing a “buy and flip” (i.e., when your subtenant exercise, you simultaneously exercise from the owner then sell to the subtenant). Thus, a corporation may be better than an LLC in this regard, especially if you do a number of deals and risk being classified as a “dealer.”
So which is better for real estate, a land trust, a corporation, or an LLC? The land trust is simply a title holding device, not an entity apart from its owner. Thus, regardless of who is the beneficiary, the property should always be bough and sold in a land trust. The beneficiary should be a corporation for short term deals and an LLC for long term rentals.
When do I create the land trust? Logistically, I prefer to use my corporation to sign the contract as a buyer. If the contract goes bad, I’d rather the seller sue my corporation than me personally. When it is time to close, I simply create the land trust then assign the contract from my corporation to the trust.
Should I use one land trust for each property? Yes, it is best to have a different trust for each property.
Copyright ©1998 · Bronchick Consulting Group, P.C.
About the author…
William Bronchick, J.D. is an author and attorney who regularly presents workshops and do-it-yourself seminars at real estate and landlord associations around the country. He is the president and co-founder of the Colorado Association of Real Estate Investors. Bill specializes in all forms of asset protection and is the author of several great home study courses.
Criteria for a Successful Rent Increase
Using rental property as an investment is like any other business; to improve cash flow, you must either reduce expenses or increase income. Increasing income is usually easier to achieve, but unless the residents are on a month-to-month lease, the only times you can increase the rent is when the lease expires, assuming the rental market will allow an increase.
Rent increases in the 4-6% range are usually common, but it is not abnormal to see hikes as small as 2% or as high as 10%. It usually best to increase the rent even if only a minimum amount each time the lease renews. This way the resident is used to expecting an increase. Also the owner avoids having to tack on a large increase when the resident has been in the property for several years at below market rent. A large increase is more likely to cause a resident to move then several smaller increases. It is also recommended to increase the rent when a resident request that they lease the property on a month-to-month basis. A Month-to-Month lease normally an advantage to the renter and a disadvantage to the landlord and residents normally expect to pay a little more.
When considering the amount to increase, figure what your market rent would be. The increase should not be substantially higher than what a comparable house would be renting for. A comparable property would be a house that closely resembles your house in size, age, location, and amenities.
Despite your best efforts, some renters will choose to move away anyway regardless of an increase.
When buying a home it is important to learn about the variety of mortgages options and to determine which mortgage type is the best for your situation. If you qualify for more than one option you would save yourself money in the long run. Your local banker or a mortgage broker are excellent resources for locating the best mortgage at the best rates.
Mortgages fall into four major categories:
- Government Loans such as VA and FHA,
- Fixed-Rate Mortgages,
- Adjustable-Rate Mortgages, and
- Convertible ARM
FHA Loans: The Federal Housing Association offers loans to lower-income Americans. Watch for the FHA approved when looking for homes.
VA Loans: Veterans may qualify for a loan from the Veterans Administration. VA loans have excellent interest rates but there is a limit on the amount you can borrow. This option is used mostly by first time home buyers.
Fixed-Rate Mortgages are the most common. If you want a payment you can count on for a long of a period of time, a fixed rate mortgage works best. With a fixed rate you will have the same payment for the rest of your life. Fixed-Rate Mortgages are very popular when interest rates are very low. Even though the payment is a set amount you can make extra payments to the principal of the loan and pay off the loan sooner. This would save a considerable amount of interest over the life of the loan.
A Fixed-Rate Mortgage works well for people who plan to stay in the home for many years and want to know what their payment will be each month. Fixed rate mortgages are offered in varying lengths and normally range from 15 to 30 year paybacks. Thirty years is the most common choice for first time homebuyers as the payments are the lowest and the mortgage is the easiest to qualify for. Most of the payment in the early years of the mortgage are tax deductible as interest expense.
Adjustable-Rate Mortgages (ARMs)
ARM rate rises and falls depending on the prevailing interest rate. The interest rate is usually lower than a Fixed-Rate and therefore the payment is lower. The lower initial payments will allow you to qualify for a larger loan than if you chose a fixed-rate type. The downside is that your payments can increase if/when the rates go up.
ARM interest rates are tied to a specific financial index (such as Certificate of Deposit index, Treasury or T-Bill rate, Cost of Funds-Indexed Arms or COFi, or LIBOR [London Interbank Offered Rate]) and your payment will be based on the index your lender uses plus a margin (generally two to three points).
Fortunately, the amount an ARM can raise is not unlimited. There are “caps” on how much your lender can increase your rate, both for a period of one year and for the life of the loan. When interest rates are very high adjustable rate mortgages are very popular. They are also recommended when your planned ownership of the property is short-term or if you expect your income will increase to cover any potential rise in the interest rate.
In the long term if interest rates rise the rate as it is adjusted could result in a higher effective rate than the Fixed-Rate Mortgage interest rate available at the time of purchase. Get the formula used by your lender in writing and make sure you understand what it means.
The Convertible ARM combines the initial advantage of an ARM of lower payments and converts to a stated fixed rate after a predetermined number of years. This option is desirable when interest rates are low and the future rate is not guaranteed. In the beginning the Coverable ARM acts like an ARM and once the ARM is converted the loan becomes a fixed rate mortgage with stable payments for the rest of the life of the loan.