The tax law is changing. It’s a done (bad) deal. And, one of the ways you can position yourself to take advantage of the changes is to start a business. Because pass-through businesses are going to have special tax preferences.
“What?,” you say. You don’t have any business ideas upon which you can capitalize? How about considering real estate, then.
There are several ways to do so. Some of my clients have set up businesses to take over foreclosed homes. (Yes, I know that was really easy during the Great Recession, as so many homes were taken over by the banks. The changes in the tax laws are going to force a slew more bankruptcies- some in high tax states, others because of the mortgage deduction limits, others still because of the change in income taxes due.) Some folks manage to acquire homes because of the crazy quilt of tax liens that some jurisdictions employ.
The problem with this business strategy is that many of the homes that become available via foreclosure or tax liens are in bad shape. So, besides needing the money acquire the property, we need additional cash to render them habitable- or rentable. The cash needs are true, even if one plans to flip the properties. But, it’s clearly a bigger issue when we are looking for long-term appreciation and enjoying the rent cash-flows.
If we are strictly seeking the cash-flow aspect of rental real estate businesses, then we need to seek out better quality properties. Hopefully, ones that are ready to rent almost as soon as we buy them, providing that desired cash flow.
But, what happens if we live in New York City, Los Angeles, or even DC? The properties that one can buy in these areas have price-tags that may be so steep, the only cash flow we can get from renting them is negative. (That means it costs more of our cash to lease them out than we obtain in rent.)
So, that means- if we really plan to start this business- we should consider looking for properties elsewhere. Where the prices are lower and the rents are reasonable. Which means we can profit from the cash flows we develop from these properties.
That can mean choosing a place that we know, one we’ve used for vacations- or would like to have done so. I have clients who own properties in Florida, South Carolina, Michigan, Pennsylvania, Wyoming, and Texas. Even though they live in the DC metropolitan area, Chicago, Phoenix, or the New York metropolitan area. These clients know the yield they can obtain from the properties (the positive cash flow), as well job growth (and existing jobs) and the population growth for the regions involved. But, owning property in remote locations also means they also need property managers, who will typically appropriate about 8% of the rent for their fees.
For example, it may be beneficial to purchase a property in Detroit. The homes are really cheap now, the area seems to be poised for growth and jobs are returning. (OK. When you have scraped the bottom of the barrel, everywhere one looks things look up.)
Some other folks have purchased properties nearby to the colleges their kids attend. Besides covering the living needs for their child(ren), the house is rented out to other folks, improving the cash flow dramatically. (The owners also have a built-in resident manager- which also means they can compensate their child(ren), who can use these moneys for food, entertainment, maybe even tuition. Oh, look, a way to pay for college with tax-deductible funds!)
To be honest, some 70% of the folks who own and lease the 19 million rental properties across the US have chosen properties within an hour of their home. After all, it’s convenient. Moreover, they know all about the region.
We also have to recognize some other facts. This is a “mom and pop business”- 79% of the owners have just one or two properties in their portfolio. Buying real estate to rent means heftier down payments are required- we should expect to plunk down at least 20% of the purchase price.
On top of that, forget the ‘cheap’ mortgage rates we see advertised. Because mortgages for investment property run about 0.5% to 1% higher.
Those facts are all part of our cost-benefit analysis. How much is that mortgage and real estate tax going to cost us on a monthly basis?
We need to know the going rental rates. But, don’t expect to earn that rent for 12 months a year. Because there are going to be months (especially when we are first starting out) that our property is vacant. I recommend using 11 months for the first few years to ensure we don’t ourselves fall into the foreclosure trap.
The other costs? Insurance, Homeowner’s Association (HOA) dues, the cost for property management, and then throw in maintenance costs. (We should estimate 10% of the rent to cover those maintenance fees. But, that also assumes we know that the dryer, washer, refrigerator, stove, heating system, air conditioner, and especially the roof are all in great shape. Unless, we leave those items as costs for the renter to bear- which also means that it may be harder to find our renter in the first place.)
Given all those costs and fees, we can now determine our yield. If we buy a $ 250K property and rent it for $1500 a month, with $ 1200 in costs, then we can see our profit will be $ 3600 a year. That means our ROI (return on investment) is 1.4%. That’s about what a bank would give us on our money. NOT a good investment. But, if we can rent that property (we MUST do a full analysis and not guestimate what the going rate is) for $ 2000 a month, then we would clear $ 9600 a year- improving the ROI to 3.85%. (Of course, some places in Detroit go for about $ 100K and we can clear almost $6K, providing a 6% yield. Getting a 5% yield or more should be the goal for any purchased property. Unless, you are buying that property to house your kid in college.)
We also should not consider that gross profit as money we can use for anything we choose. No, we should keep an asset-management account, where we put away about 10% of the rent to cover our future maintenance and repairs. (Of course, if we have enough available cash, we can start that account with about 1% of the purchase price and stash away only 3-5% of the rental income each month in the fund.)
And, we need to put the property into an LLC or S corporation. Not only because these are pass-through entities that can let us leverage the changes in the tax laws. No, it also means should anything go wrong, we personally are not at risk. Only the business is. (It also means that each property- if we are going to own multiples- should be in its own business entity.)
Some tips if we are going to purchase property in a remote (more than an hour away) location.
- Retain the services of a local attorney. To make sure our lease is appropriate for the region. To make sure our provisions against pets, sublets, etc. follow the local protocol. To determine what penalties exist for tenants who skip out or don’t pay rent. (You do know that can’t evict someone right away, right?)
- Seek out a local realtor. These folks know the area, know the going rates- and may even be (or know who could be) property managers.
- Check out Roofstock.com or Auction.com. Roofstock helps us find, analyze (including neighborhood analyses), and bid on properties. Their fees are 0.5%- if the property is acquired. Auction.com specializes in foreclosed properties- either in foreclosure or owned by the bank already.
O.K. Let’s get started!
