Tax time always generates interesting questions from my clients as they begin to reexamine their existing structures and converse with their CPAs. Invariably, some will question whether it might be better to “skin their cat” another way. My answer is always the same; you could, but at what cost? I am not using this term in a monetary sense but from a practical investing standpoint. As an active real estate investor who is currently in the process of closing on three properties in Texas, I am reminded that although asset protection is very important, so is practicality.
Looking back at my prior posts regarding asset protection, you know that the best entity to hold rental real estate long term is a Limited Liability Company or “LLC”. The LLC is also great for holding your excess cash that patiently waits on the sidelines for its next shot at a big play. Given you have followed some of these exact structuring techniques, how will it affect your future purchases? Hopefully not at all because simplicity is the heart of your plan and you conduct your business accordingly. Here are some ideas to consider when purchasing real estate when you have existing business entities.
Preparing to Buy – “Everyone Loves Plain Old Vanilla”
My axiom – “less is better when acquiring financing.” I am not referring to the actual investment but your personal preparation. It is never in your best interest to stand out in the crowd when dealing with lenders. Fact is, the majority of underwriters are not sophisticated investors themselves, so do not try to impress them with your knowledge. It will only backfire. At the end of the day your goal is to have your deal funded, so take these early steps to stay out of the way and ensure the process is as smooth as possible.
Here is my short punch list to expedite the financing process:
- Keep your FICO score above 700 As you incur additional debt this has a tendency to negatively affect your FICO score. Credit card debt can be a major contributor in reducing your score. To minimize this effect, open up an account in the name of your entity and transfer your existing balances to the new business card. If you obtain the proper bankcard, this balance will not appear on your credit report, thus improving your personal score.
- Minimize Personal Credit Cards For cards that remain in your name, it is sound practice to keep your overall credit utilization below 50% on each card and limit the number of cards in your personal name.
- Move Money Early If you are like me, your savings is held in a LLC for asset protection. This is ideal in the event of a lawsuit but not so great for obtaining a loan. When applying for a loan, your lender will request 3 months of bank statements to track available funds. If your personal account does not contain enough funds for the purchase because you were planning to transfer money out of your LLC for closing, then “Houston, we have a problem.”
Your underwriter will most likely not understand where this money is coming from and will be apt to assume the worst. Therefore, you will be asked to provide 3 months of bank statements for your savings LLC, plus any tax returns for the LLC. Guess what? My LLC is a disregarded entity and it does not prepare tax returns. This will compound your problems because the underwriter does not understand how a LLC can be active and not file a tax return. (Give him a link to my blog and tell him to get educated) SOLUTION – Move the investment funds out of your LLC into your personal account 3 months in advance of your expected purchase and leave the LLC out of the picture all together. Less is better.
- Find an insurer in the state where you expect to purchase so you can obtain a quote after your offer is accepted. When looking for an insurer you should explain to him that you plan to place your investment into a land trust or LLC after closing. Ask him if this will be a problem with the policy. Also inquire about an umbrella policy for your various investments. Each state has different regulations regarding policy issuance but it is possible to acquire this additional protection. For example, in Washington State, Allstate will allow me to add up to 4 properties under my personal umbrella policy even though the properties are held in separate LLCs.
In my experience, one surefire way to hold up underwriting is by providing too much information either intentionally by talking too much, or unintentionally via your tax return. I can’t help a chatty Kathy but I can help you with your tax reporting.
Eighty percent of the LLCs I create are set up as disregarded entities i.e., the LLC does not file a federal tax return. For the real estate investor who is a member in a disregarded LLC, everything is reported on his or her 1040 Schedule E. To the loan underwriter reviewing such a 1040 return, it will appear as if all of the investor’s rental real estate is held personally and not by a business entity. (Again, keeping everything simple and practical.) However, you might have a CPA in left field who instructs you to change your tax classification from disregarded to a “Partnership Tax Status”. I bring this up because I spoke with 2 clients this week who were inclined to do so after meeting with their CPA.
My clients were told that partnerships have a reduced risk of audit, therefore such a change would be in their best interest. I have a sneaky suspicion that the CPA is interested in creating additional work through the preparation of 1065 partnership returns; however, regardless my opinion on what the IRS is looking at when it comes to audits, I can confirm that a loan underwriter will scrutinize your 1040 with multiple k-1s from partnership returns. Hence, if you adopt this approach you can expect a request for additional documentation on each partnership in which you hold greater than 20% interest.
Here is a classic conflict between people who invest and those who only work with the investor. If you aren’t investing, then making recommendations without regard to their practical implications is like instructing my wife on how to get the kids ready for school. If you aren’t actively involved, you will not understand that the simple things can often pose the greatest hurdles.
The deal is done and the property is in your personal name, so what do you do? If you haven’t done so already, create a land trust and a LLC in the state where the property is located. Deed the property into the land trust, then assign the beneficial interest to your LLC. Contact your insurer and have the trust and/or LLC named as an additional insured. From this point on all rents should be paid to your LLC and accounted for accordingly. (Read about what could happen if you elect otherwise.)