3 Business Structure Mistakes Real Estate Investors Make

Let’s start with: Why have an LLC?

There are mainly two reasons why you want any kind of business structure:

Pay less tax, and protect your assets.

Before you jump into creating your LLCs for your real estate holdings, there are a few things to consider. Do NOT make these three mistakes.

Mistake #1: Forming the wrong entity and/or in the wrong state.

Sometimes people get confused about their real estate investments and what the IRS considers them to actually be doing.

You could be a real estate dealer, which means you flip or wholesale properties. You could have a real estate business, which means you rent out property for short stays and provide substantial services, like a motel or some types of vacation rentals. You could be a developer which means you buy property and make changes to it before it is sold or put in service. Or, you could be a regular real estate investor and hold property that has long term renters (commercial or residential).

You first need to know what kind of real estate investor you are. You will use different tax strategies and different types of structures depending on the type of investment. For example, if you’re a real estate dealer, you have a business and that means you want an entity that is taxed like an S Corporation or possibly a C Corporation. Flipping houses or flipping burgers…you have a business.

If you have long term rentals, you will most likely want a single or multi-member LLC. If you are investing from Canada, you’ll want an LP (limited partnership).

Bottom-line, know exactly what you’re going to do first and then decide what the right structure is. If you need to close quickly on a property and want an entity right away, your best bet is to use an LLC. An LLC can decide later what type of taxing structure it should have.

The second part of this is setting up the entity in the wrong state. Make no mistake, one way or another you need to have legal authority in the state in which your property is located. If you buy a property in Ohio, you need an OH LLC or you need to authorize your out-of-state LLC to do business in Ohio. (In effect, you’ll pay twice that way – once to the state that has your LLC and once to Ohio.)

If you don’t get your entity set up or authorized in the state of your property, you won’t have any legal standing for possible tenant issues. One way or another, you have to have an entity in that state.

Mistake #2: REP with wrong structure.

The short answer is that if you want to claim real estate professional status (and all the great tax benefits), you have to be a named manager in a manager-managed LLC.

If you tried to do-it-yourself with an online LLC set-up or used someone to set up your LLC who doesn’t understand real estate tax law, you could have a problem.

Mistake #3: Not set-up or maintained properly.

The #1 mistake when setting up an LLC is failure to prepare the Operating Agreement. Most of the online do-it-yourself websites mention it, but don’t give you the tools to do it. Remember the manager-managed LLC is the type of LLC you need for your real estate investments if you ever want to take the “real estate professional” status.

Once the entity is set up, that’s not the end of it. You need to continue to maintain the LLC with proper state and federal filings. Plus you need to give proper notice in your business dealings. Don’t sign contracts with just your name, use your name plus your title (i.e. Manager of ABC LLC).

Are there only 3 possible mistakes? Of course not, but these are the most common.

Easy Tip To Awaken More Refreshed

How much more might you get done today if you’d awakened more refreshed this morning? Do you even remember what being wide awake in the morning feels like? It turns out morning grogginess is common. It’s the number one sleep complaint heard by author Michael Gelb, DDS, MS, clinical professor at NYU College of Dentistry. “People are just exhausted on awakening,” he said. Gelb talked with Nieca Goldberg, MD, host of national SiriusXM radio show “Beyond the Heart” and answered listeners’ calls, explaining how they can breathe better, sleep better, protect their health and reduce snoring with over-the-counter products such as Mute.

“It’s not just that we’re not getting enough hours of sleep, it’s about our quality of sleep. Our airways very often are not open enough and we have some degree of constriction or resistance or narrowing of the airway,” said Gelb, an expert on this subject. “Of course it gets worse when you lay down at night.”

You can blame sleeplessness on evolution, not your flat pillow. Gelb explained that, “Our faces are shrinking. As our brains have gotten bigger, our faces have become more recessed.” He noted that kids’ mouths commonly don’t have room for their wisdom teeth anymore, and our jaws and sinuses are shrinking. “It’s become an endemic problem that a lot people have difficulty with their sinuses, difficulty breathing through their nose. And you see that if you walk into a Walgreens, walk into a Duane Reade, how many of these things are being sold over the counter that open up our airways.”

One solution to improve breathing? Gelb drew a lot of interest from listeners after he advised, “To keep the nose open at night we use Mute nasal stents. That just props the nose open, it improves nasal breathing and it really cuts down on snoring.”

As Gelb explained, “It’s adjustable in size, they come in small, medium and large depending on the size of your nostril. It doesn’t let the first part of the nasal airway collapse as we breathe in and breathe out.”

Gelb recommended starting with the simplest solutions for breathing issues: over-the-counter products, such as Mute. If you want to awaken more refreshed and try Mute tonight, you can find it at most major pharmacies. Use our store locator to find Mute, sleep better and feel better.

The Greatest Real Estate Advantage

Ignoring the fact that stocks, bonds, mutual funds, and other investments are either over-valued or providing negative real returns, real estate has almost always been the best use of capital specifically because of your ability to leverage your investment.

If used properly, leverage will significantly enhance your return on investment. This is easy to do if you invest in income-producing real estate but much more difficult, if not impossible, if you’re investing in stocks or mutual funds.

In our industry we often refer to it as “other people’s money” or “OPM”.

Let’s say you have $100,000 to invest. If you invest it in stocks, bonds, or mutual funds, you can only buy a $100,000 stake as a shareholder. However, if you invest that same amount in rental property – a quality single-family rental, duplex, or in some areas even a four-plex – you can leverage that same $100,000 into a much higher valued asset.

For example, you can purchase $400,000 worth of income-producing rental properties, use only $100,000 of your own money and the bank or lender will lend you the other $300,000 at a fixed interest rate amortized over 25 or 30 years. You now have positive leverage when the interest rate on your mortgage is lower than the overall return on the property. Compare this to investments in the stock market. It doesn’t even compare!

Let me give you an example. When you have $400,000 of rental property generating a net cash flow of $34,400 each year without any debt financing, that’s an 8 percent cash-on-cash return on your investment ($34,400 / $400,000 = .086 or 8.6 percent).

Now say you invest your $100,000 and borrow $300,000 at 5.0 percent interest, amortized over 30 years. The monthly mortgage payment is $1,610.46 per month or $19,325.52 per year, the net cash flow of $34,400 gives you $15,074.48 in net cash flow. That increases your return from 8.6 percent to 15.1 percent ($15,074.48 / $100,000 = .1507 or 15.1 percent).

By using leverage your annual cash-on-cash return increases by over 75 percent (15.1 – 8.6 = 6.5 / 8.6 = .7558 or 75.5 percent). Isn’t that amazing? That’s the magic of leverage!

Today banks and private lenders (via their self-directed IRAs or just private money) consider real estate a relatively safe option. In fact, compared to the stock & bond market real estate is not only safer but actually more profitable.

If your retirement account (IRA, 401k, etc) is not self-directed then you’re missing out on some great opportunities. Look into it, or contact our office to find out more.

There are, however, a few things to keep in mind as you use leverage to invest.

We just came through an era when investors got “OPM happy” and overdosed on cheap leverage for all the wrong reasons. Make sure your properties cash-flow and budget in possible vacancies.

Choose a high quality property in a good neighborhood. If you were investing with cash-only you could choose a more risky “up and coming” kind of property. But if you are using leverage choose an area where, even if rental demand declines, you could sell the property easily. Remember that rental property isn’t as liquid as stocks, bonds or mutual funds. A high quality property makes it easier if an emergency strikes and you are forced to sell.

My most valuable advice is be prepared for the business of owning rentals and keep in mind that it is most certainly a business. Get serious about your education and dedication to the business or hire a good property manager. Finding a good property manager or firm can be the most difficult part of investing.

Finally keep in mind that any investment that produces any reasonable return involves some risk. I believe that real estate isn’t nearly as risky as the current stock and bond markets (negative real rates of return anyone?) but there is always some uncertainty. Be honest with yourself to make wise choices.

Although I am not a financial advisor and cannot give any kind of financial advice, I will tell you that I have moved nearly all of my investments into real estate of some kind.

If the real estate holdings themselves are not your cup of tea you may want to consider being a private lender yourself. Experts will tell you that a balanced portfolio is best. I believe that adding real estate, in some form, to whatever investments you prefer will bring you far greater returns than stocks, bonds, and mutual funds alone could bring. I speak from experience when I say that using a little leverage for income-producing rental real estate can build wealth much faster than other traditional options.

Just remember, it’s “the magic of leverage.”