Every year we learn that a client or two has invested in rental real estate when sending us his tax information to prepare his personal tax returns. Rather than consulting with his tax professional about the additional tax preparation services that will be required, and more importantly meeting with his tax consultant to discuss tax planning strategies associated with making the purchase, the buyer has impulsively acted on his emotions which is not prudent. While real estate can be a very important component as part of a diversified portfolio, as with any investment, due diligence should be done.
What are some tax and other considerations that are often ignored?
- Failure to engage a real estate attorney who is well-versed in these transactions before making the purchase.
- Failure to engage an experienced tax professional who is well-versed in these transactions before making the purchase.
- Making the purchase in the owner’s name which may unnecessarily expose the buyer’s other assets to liability claims. Talk to your attorney and tax professional about the pros & cons of using a limited liability company (LLC).
- Making the purchase in a C corporation which may result in double taxation.
- Failure to do a cash flow analysis which may result in the owner having unexpected cash flow problems. Not having adequate financial resources for unexpected catastrophic or major repairs, such as an HVAC system needing to be replaced, flooding, hurricane damage, and structural problems.
- Overpaying for the property which can cripple cash flows currently and in the future. Is the buyer basing the decision to buy on current factors or basing the buy decision by unrealistically improving vacancy rates, decreasing expenses, and increasing rental revenues?
- Failure to have an exit strategy. Are you going to hold onto the property forever? When do you plan to sell it? Have you considered that the real estate market is cyclical and that you could be at risk if prices are depressed when you plan to sell?
- Will the purchase of real estate create a less-diversified portfolio for you when you compare the value of the real estate to your total portfolio’s value?
- Since real estate purchases tend to produce negative cash flows in the early years, will future cash flows and the rate of appreciation result in an overall satisfactory rate of return for your portfolio? How long is that time line? Does it fit within your exit strategy?
- Not understanding the real estate market. More expensive real estate eats up more cash and can result in a larger loan. If property values are increasing faster than rents when you make your purchase, the more expensive properties will return less cash.
- Not considering the financial impact of vacancies, maintenance costs, and careless or destructive tenants.
- Will you manage the property yourself? Are you prepared for those 2 AM phone calls about a leaky toilet? Have you considered how much time will be required of you if you manage the property?
- If you plan to hire a property manager, have you done your due diligence to find the “right” property manager before the purchase is made?
- If your renter turns into a squatter, do you know the real estate law and your rights as a landlord to evict your non-paying tenant?
- If you are purchasing the property thinking that its tax losses will reduce the income taxes you pay, you may be in for some unpleasant surprises. You need to discuss the loss limitation rules and the passive activity loss rules with your tax advisor.
- Are you prepared to deal with zoning rules, housing inspectors, license requirements, and other regulatory authorities?
- Are you adequately insured or are you purchasing the bare minimum to conserve cash?
- How long are you prepared to leave your property vacant until you find the “perfect” tenant?
- Are you aware that as an investor, you will likely pay a higher rate of interest for a loan and higher insurance cost than you may be accustomed to paying for your personal residence? This is especially true if an LLC is used.
- If you purchase the property in a self-directed retirement plan, there are very strict rules imposed by the IRS and the Dept. of Labor that must be followed to avoid self-dealing and prohibited transactions. Read our November 4, 2014 blog which discusses these rules in more detail.
If you want to learn more about investing in real estate, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
