SMARTERLANDLORDING

ADVICE FROM EXPERIENCE

Income Tax

Choosing An Investment Strategy

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There are essentially three ways to invest in residential real estate.  You can wholesale, retail or buy and hold.  Each has its pros and cons.   Let’s go through each one.

Wholesaling

Wholesaling is acquiring a property for a quick turnaround to another real estate investor.  This strategy is sometime referred to as “flipping.”

Pros

  • You are in and out of the deal quickly.
  • You do not need much capital to get started.  Since the object is to quickly turn the property to another investor, often very little cash is needed, especially if you can just assign your purchase contract to the other investor for a fee.
  • You can earn a quick $1,000, $5,000 or even $10,000 per deal.
  • You do not have to worry about rehabbing the property.  The Rehab is the next investor’s problem.  You may however need to do a little clean up to make the deal work.
  • You do not have to deal with tenants.  Tenants are also the next investor’s problem.

Cons

  • Requires a lot of marketing to both find and sell the properties.  Developing the tools to get sellers calling you and developing a reputable buyers list takes both time and money.
  • Those quick $1,000, $5,000 and $10,000 chunks of cash are considered active income by the IRS and are thus subject to Social Security and Medicare taxes and well as standard income taxes.  So put some aside from every deal you do.

Retailing

Retailing involves acquiring a property to fix up and sell to a retail buyer.  These are generally only single family homes.

Pros

  • The main pro is the big chunks of cash.  The average retailer can shoot for a profit of between $20,000 and $30,000 or more per deal.
  • The pride and satisfaction of fixing up and getting someone setup in a home.

Cons

  • You will need capital to purchase, fix-up and hold the property until you can sell it to a retail buyer.  Holding costs, such as utilities, insurance and property taxes need to be figured into the deal accordingly.
  • You will need contractors to help you rehab the property.
  • Dealing with retail buyers can be tricky.  They can be very finicky and you may have to wait a while for the right one to come along.
  • You will generally need to use a realtor and that adds commissions to the costs.
  • You need to know your retail market backwards and forwards as well as the neighborhoods you are investing in.  Talk to the neighbors and analyze comparable sales as much as possible.
  • Those big chunks of cash are taxed in the same manner as above in wholesaling.  Be sure to set aside some of the profits for Uncle Sam.

Buy and Hold

The buy and hold investor is a landlord.  He or she buys and holds properties to rent for the long term.

Pros

  • This strategy is a huge wealth building machine.  The other strategies provide chunks of cash but this one builds long term wealth.
  • It provides a monthly income from the rents.  You do not have to wait for a buyer to come along to get paid.
  • You are buying a real asset.  You can fix it up and improve the value.  Try that with Exxon stock.
  • Perhaps the best pro is the tax breaks.  Rental income is considered passive income by the IRS.  As such, there are no Social Security or Medicare taxes.  You also get the benefit of depreciation which can significantly reduce active income and thus the tax you pay.  To learn more, pick up this smarter resource.

Cons

  • One word, tenants.  Proper screening can however eliminate many headaches.
  • There are repairs.  Always set aside at least 10% of your gross monthly rental income for future repairs.  Trust me, you will need it.
  • Management is also an issue.  You have to manage your properties in order for them to produce for you.  You need to check on them once in a while and make sure all is ok.  And if you think you can eliminate management with a management company think again.  Now you need to manage the management company.

Which strategy is right for you?  That depends on your personality and what your goals are.  I have done all three but I am generally a buy and hold guy.  I like the monthly income, I can focus on one specific area and I dislike waiting for a retail buyer.

If you are just starting out and need to acquire some cash per haps wholesaling is the right choice for you.  Have cash to invest?  Maybe a couple of houses to hold and rent is the right choice.  Many investors do a little bit with all three.  They like the large chunks of cash, the monthly income and tax breaks from landlording.

Whatever you do, decide to do one of these three strategies today.  You will not regret it.  And if you need to learn more about real estate investing, check out your local REIA group.

 

 

 

 

 

The “Right” Business Structure

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Real estate comes in all shapes and sizes and there are numerous ways to invest in it.  Smarter investors look very closely at how their real estate business is structured because the wrong structure can cost them a lot of time, effort and money, while the proper structure can save and protect their hard earned assets.

There are three basic types of business structures, the sole proprietorship, the partnership and the corporation (including limited liability corporations or LLCs).  Each of these structures, like everything else in this world, has pros and cons attached to it.  Let’s look at each one.

Sole Proprietorship

The sole proprietorship is just what it sounds like, you, the individual investor conducting your real estate business.  Usually individuals set up a business name, such as ABC Properties, and then set up their accounts to read as Joe Investor, doing business as (DBA) ABC Properties.

Pros

  • It is easy.  Pick a name and you are in business.
  • It is simple.  Set up a separate DBA bank account and off you go.  Plus the income tax returns are just included with your personal  1040 form.
  • It is easy to end.  Just stop it.

Cons

  • There is no liability shield.  Everything good and bad passes through to you.
  • You are visible as the owner.  There is no anonymity.

 

Partnerships

Partnerships are created when two or more people get together for some sort of business venture.  In real estate investing, partnerships are usually formed because one or more partners have some sort of specialized experience needed for the particular deal.  Or, one or more partners may be bringing their money to the table to fund the deal.

Pros

  • They are easy to set up and start.  No public documentation is generally required.
  • They can be easy to dissolve and can even be specific to a particular deal.
  • Partnerships can bring together people that will make an otherwise unworkable deal workable.  One partner may have money, rehab experience or a list of potential buyers for example.

Cons

  • No liability shield protection.
  • Enhanced level of bookkeeping and federal income tax knowledge needed.  The IRS Partnership Form 1065 is needed for example.
  • Partnerships can get messy.  A partnership operating agreement is a must and it should be reviewed by a qualified attorney.

 

Corporations and LLCs

Corporations and LLCs are legal entities.  They are separate and distinct from you the individual.

Pros

  • Liability shield is in place between you and your investments.
  • They are fairly easy to set up.
  • They can provide you with a more professional image.
  • They can help maintain anonymity.
  • Depending on your business, they can provide various federal tax benefits.
  • Can be a good way to raise funds.

Cons

  • Require paperwork to be filed with the state along with initial and annual filing fees.
  • The laws and rules governing corporations can be complicated.
  • There are annual paperwork, meeting and filing requirements that must be completed.
  • You will often need to pay for professional legal and accounting advice (In Tennessee for example, a corporation or LLC must hire an attorney to represent it in court for example)
  • There are increased bookkeeping and tax reporting requirements.  You must keep all monies separate if you wish to keep that liability shield in place.
  • Banks will not lend to newly formed corporations.  In general, a corporation must be in place for at least three years before a bank will consider lending to the corporation.  So you will not be able to put your investments in the corporate name anyway.

Which one is right for you?  That depends on what you are doing and what your comfort level is.  For those just starting out in real estate investing, I would keep things simple with a sole proprietorship or a partnership.  Don’t over complicate your life when you are just starting out.   If you are worried about getting sued because you do not have a liability shield (and you should be!), just be sure to get a liability insurance policy of at least $1 million to $2 million.

As your real estate business grows and expands, you may want to consider an LLC or corporation, you may even want to consider having several of them.  Why?  Because it is more advantageous tax wise to put long term holds into an LLC and it is more advantageous to use an “S” corporation if you do a lot of retail and wholesale flips.  So if you do both in your business, you may want both types of structures.  Plus as you continue to read this site and become larger and more prosperous, you will become a bigger target and may want the protection a corporate shield offers.  If you own a lot of properties, you may want several different LLCs to “split up” the properties into different entities for asset protection purposes.

Again, it is all up to you and what you want to do and what your comfort level is.  I know investors with layers of corporations and I know investors who have done hundreds of deals and own dozens of properties as sole proprietors.  It just depends on the individual.  In the end, there is no “right” structure.

Whatever you do, don’t just take my word for it.  Do your own research.   Check with and talk to a qualified attorney and accountant in your local area about these issues.  There are local rules and regulations that may make your situation unique.

Until next time, invest smarter!

Podcast – Why Invest in Real Estate

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Check out my latest podcast where I along with Jo Garner and Richard Scarbrough discuss why you should invest in real estate.  Originally aired on AM 600 WREC on 12/3/2011.