6 Tax and Legal Tips When Investing in Real Estate
Sir Francis Bacon put it best when he said, “knowledge is power”. Not only does he have a great last name but he gives good advice that applies to all facets of life including investing in real estate. Whether you are new to real estate investing, or a seasoned investor, before you rush off to make your first/next real estate investment, consider the following tips all of which are to help you be strategic about investing in real estate the right way for your situation, i.e. knowledge is power. With that in mind, here are six tax and legal tips / questions to ask yourself when investing in real estate:
- Will you invest directly in real estate by yourself / with a small number of business partners OR invest indirectly alongside many other investors in a company that invests in real estate? For example, let’s say you invest $200,000 for 5% ownership of a company that will take your funds and, along with the funds of other investors, probably in the millions of dollars, invest in real estate. In this situation, you typically have very little control or decision-making authority, such that you are basically “parking” your money and somebody else will make decisions regarding the real estate investment such as what to acquire, how to manage it, when to sell, etc. There is nothing wrong with this type of investment, you may actually desire that, but you want to understand this going into the investment and not have false expectations. You should consult with an attorney before signing documents to invest in real estate through a company, particularly one in which you are a minority owner. Contrast that with a situation in which you invest $200,000 along with a friend or business partner to buy an investment property. In this situation, you have a lot more control over the real estate investment, but that comes with more responsibility and potentially more liability. Again, you should consult with an attorney to make sure you are setup properly from a tax and liability perspective and also to make certain you have the appropriate documentation between any business partners you may have in addition to the proper documentation to make your real estate investment. Neither option is better than the other one – they are just different so before making your investment, you should consider which scenario makes more sense for you / which situation you are dealing with.
- Does your real estate investment require financing? There are many benefits that come with investing in real estate with financing/loans, such as minimizing the amount of out-of-pocket cash you have to provide. However, anytime you have a loan, that means you have a lender, and if you have a lender, that means you have to play by their rules. Sometimes having a lender is like dealing with a big gorilla on your back. They have a legitimate interest in the property and want to make sure their interests are properly protected. So by financing a property, you tend to lose a bit of control. You should have an attorney review any loan documents so you understand the rules of the game with that particular lender as it will affect your deal. Without involving a lender in your deal, you get a bit more flexibility and control of the deal but of course this assumes you have all of the cash necessary to complete the investment. Further, if you own properties outright i.e. no financing, that typically means there is a sizeable amount of equity which may require some additional consideration and structuring in terms of asset protection. Again, neither option is better than the other one – they are just different which is why before making your investment, you should consider which scenario makes more sense for you.
- Are you going to invest in real estate inside your retirement account OR outside your retirement account? For the average person, they probably have no idea they have the option to invest in real estate inside their retirement account. But for most of our clients, it is a large part of how they invest in real estate. In fact, many of them invest in real estate inside AND outside their retirement account. Knowing the difference between the two and the impact it has is crucial. If you invest in real estate inside your retirement account, the income is typically either tax-deferred or tax-free. This is probably the biggest benefit to investing in real estate inside your retirement account. However, there are a few more restrictions when investing in real estate INSIDE your retirement account versus outside your retirement account. For example, inside your retirement account, you need to be aware of matters such as “disqualified persons”, “prohibited transactions”, “unrelated business income tax”, and “unrelated debt financed income tax”. Such matters don’t exist when you invest in real estate OUTSIDE your retirement account. Long story short, there is a ton of upside to investing in real estate inside your retirement account, but you should counsel with an attorney before doing so. Yet again, neither option is better than the other one – they are just different so before making your investment, you should consider which scenario makes more sense for you.
- Is your real estate investment a long-term deal OR a short-term deal? This is especially important if you are simply one investor in a company that invests in real estate alongside a number of other investors because if the investment is long-term real estate, such as owning a commercial property, an apartment building, or even a single-family residence, your capital is typically “locked up” for a longer period of time as opposed to a short-term real estate deal such as a 12 month development project for immediate re-sell. Either way, you may be taxed on the income differently with a short-term deal than with a long-term deal, which is why it is important to understand before making your investment how you will be taxed on your income from your real estate investment. Again, neither option is better than the other one but you should consider which scenario makes more sense for you.
- Understand the different ways to acquire investment properties. Besides cash deals and traditional financing deals, there are other ways to acquire investment real estate, such as seller financing, or “subject to” deals. There are pros and cons to some of these less conventional forms of acquiring real estate. One of the biggest benefits is, like traditional financing, it requires relatively little out of pocket cash. However, when acquiring a property via seller financing or subject to existing financing, you should consult with an attorney to make certain the purchase contract properly reflects this type of financing.
- Understand the various ways to sell your real estate investment (Exit Strategy). The more you consider your exit strategy before making your investment, the better situation you will be in. This is similar to #5 above, you might decide to sell via seller financing, or an installment sale, or a 1031 exchange. These are some of the strategies you might consider to defer the capital gain income tax that would otherwise be due when you sell your real estate investment.
In sum, just because you have a friend or a relative who invested in real estate a certain way does not mean you should invest in the same manner. For example, there is a big difference between someone who invests outside their retirement account as an investor in a company alongside a number of other investors in a short-term real estate deal versus someone who is invests inside their retirement account in a two-man partnership on a long-term real estate deal that is financed/has a loan. These are two situations that will have different outcomes from a decision-making perspective during the life of the investment, the liability exposure, and the tax consequences. So before you rush off to invest in real estate, please contact our office. We can properly advise you and also make certain you have the right paperwork, contracts, entities, etc., for your particular real estate investment(s).