I realize rentals are not for everyone. You hear horror stories of trashed properties, non-paying tenants, city citations, “meth-lab rentals”, and the list goes on. But for every such story, there are many stories of those who have built massive wealth through owning rental real estate. Of course, you can invest in real estate through REIT’s, but this article is for those who want direct ownership whether it’s a single-family residence, a duplex, or commercial/retail buildings. If this is you before you take the plunge into owning investment real estate, consider these Seven “Tenets” of Dealing with Tenants:
- Put the Rental Property in an Entity. Whether it’s a $50,000 single family residence or a $5M commercial building, it should be held by an entity that provides protection e.g., an LLC. Be sure to actually transfer title of the rental property into the LLC and in so far as practicable, put everything else associated with the rental in the name of the LLC. Using an entity to hold your rental property(ies) is important. It’s about protecting you and your personal assets from the tenant. If the rental property is encumbered with a loan/mortgage, I nevertheless typically recommend holding the asset in an entity. Also, it’s important to appropriately determine how many properties should you put in the same entity. For more on this topic please checkout Mark’s article and video.
- Get the Appropriate Type and Amount of Insurance for your Rental(s). Putting your rentals into an entity is only PART of a coordinated effort to protect you from tenants. Insurance is the front-line of mitigating risk and shifting liability away from you. This is not a new or cutting edge tip but it’s important to not cut corners here. You need to get the right type and amounts of insurance for your rental property. A good insurance broker can work with your budget to get the policy and coverage that provides the best protection for your situation and your budget. You may also consider an umbrella policy which is a topic on its own. For more on that please checkout Mark’s prior article.
- Use a Landlord-friendly Rental Contract. In addition to entities and insurance, another important way to shift liability away from you and to mitigate risk is to use a strong rental contract that legally puts as much of the responsibility and risks on the tenant. Every state has different landlord-tenant laws so it’s important to get a strong contract that is state specific and landlord-friendly, AND specific to your situation. It’s a much different scenario renting an office suite to a sophisticated business versus renting out a single-family residence to as family as their primary residence versus renting out a property as a vacation rental. Don’t get caught using a boilerplate contract that doesn’t adequately protect you or that doesn’t address items that are specific to YOUR situation.
- Vet the Tenant (and the Property Manager). Although Investors will spend hours and days and weeks meticulously researching the market trying to find the right PROPERTY, many times they give very little thought into finding the right TENANT. You should spend as much time vetting your tenant as you do vetting the property. There are a lot of good resources and companies out there who assist with this process, whether or not you use a property manager, to find out as much about the potential tenant as you can BEFORE they start living in your rental. Likewise, our office has done an entire radio show segment on properly vetting your property manager (“How to manage your property manager”), but it is crucial to have an experienced, honest, and responsive property manager on your side.
- Know the Local Laws. Real estate law varies from state to state and in some situations, county by county and city by city, so becoming a landlord and dealing with tenants means subjecting yourself to certain laws and it’s important to know what they are. For example, in some counties you need to register your investment property with the county assessor and designate it as an investment property. Also, I wrote a prior article on this but some municipalities have rules and regulations about rentals, particularly vacation rentals. It’s important to work with someone who knows these local laws and can apply them to your situation. It’s no secret that typically the margins are better with a vacation rental than a traditional/long-term rental BUT not every investment property can and should be a vacation rental. You’ll need to look at the market, the location of your rental, local law/regulations (see above), and a host of other factors to determine which properties are best to operate as vacation rentals versus long-term/traditional rentals. Knowing the local laws is an important part of that process.
- Maximize the Tax Benefits from your Rental(s). You may have previously read or heard about the four benefits or quadrants of rental real estate: (1) cash flow, (2) appreciation, (3) mortgage pay-down, and (4) taxes. See here for more detail. The first three are fairly self-explanatory (cash flow = rent covers expenses plus some, appreciation = property appreciates/increases in value, and mortgage pay-down = tenant’s rent pays your mortgage and increases equity in your property.) With respect to taking full advantage of the last benefit (taxes), PLEASE make sure you’re tracking all of the expenses associated with your rental. This is where it’s important to have a good bookkeeping system. Hopefully your rentals are cash-flowing, HOWEVER, when it comes to taxes, you MAY be able to report a “loss” and use that loss to offset some of your other income on your tax return! That’s one of the most powerful aspects of rental real estate. Typically most of that “loss” comes from claiming depreciation of the property on your tax return. However, make sure you work with a CPA/accountant who knows rentals that can talk to you about depreciation recapture and the limits of using “passive losses” to offset other income on your tax return. For more articles on passive loss limits, see here and call our office.
- Consider a 1031 exchange. If your situation AND/OR the market dictates it’s time to sell a rental property, AND if you’re going to get “hit” with a sizeable tax on the gain, one option is to sell the property via a 1031 exchange. Our office is available to assist you, but in short, you would want to hire a 1031 exchange accommodator before selling the property so that the sales proceeds can be held by the exchange accommodator while you work to find a replacement property(ies) in compliance with the 1031 exchange rules. As a result, the income tax liability is deferred into your next investment property(ies). For more on 1031 exchanges, see here and here.
In short, each of these tips has a lot of moving parts so whether you own a portfolio of rental properties or you’re just starting out, please call our office.