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Is real estate an investment or a business?
It is both.
Our friends Alex and Taylor moved into their new home in April to accommodate their expanded family. They rented their original home quickly as a corporate relocation, despite the pandemic raging in NJ at the time.*
Just like that, they became landlords -- and small business owners.
Treat your rental property operations as a separate business
Real estate is an investment: we hold our rental property to generate income and potential growth in value. Real estate is also a business: to generate that income, we find and screen tenants, maintain and improve the property, collect rents, and make ongoing decisions. We may do those actions directly or supervise a property manager as our agent.
No matter how you own your rental properties – directly or in a business structure like a Limited Liability Company (LLC) – always treat it operationally like a separate business. That is the only way you will know if your rental property is truly profitable and by how much.
As a side benefit, if you are the kind of person who hunts frantically for receipts the evening of April 14th, treating your rental property like a business will massively simplify tax time.
1. Separate rental property and personal finances
The first thing I tell new landlords is never commingle your personal and rental property finances. Even if you own your real estate directly (not in an LLC or other structure), do not mix your real estate and personal accounts. Mixing rental and personal finances is a recipe for tax or legal problems.
Practically speaking, what does separate financial management look like?
Separate bank accounts – Rental property owners who manage property directly typically keep a general operating account and a separate account for each property’s security deposits. Consider this account structure:
- Operating account – Some rental property owners prefer owning multiple properties in one LLC with one operating account, while others create a separate business structure for each property with an operating account for each property.
- Security deposit account -- Tenants’ security deposits do not belong to you. You are legally required to keep them in reserve to either pay for damages or unpaid rent when the tenant moves out, or to return to the tenant. By keeping them in a separate account, you will not accidentally dip into those funds for expenses.
- Business cash reserves – Some rental property owners like to keep their cash reserves in a separate savings or money market account, linked to their operating account. I’m encouraging clients to keep a year of the property’s expenses in cash reserves to minimize the impact of COVID-19 on their rental property business.
Separate credit and debit cards – Using separate debit and/or credit cards for your rental property business will simplify your business management:
- Tracking expenses for your rentals is easier. No more digging for cash receipts or scouring your personal credit card statement when you are entering expenses into your books.
- It simplifies calculating profitability and comparing budget projections vs. actual expenses.
- Separating your digital expenses will also help you during tax time. Plus, in the event of an audit, you have a clear paper trail.
- For those with an LLC, this helps you maintain your corporate veil of liability protection, by demonstrating that it is a separate business. Without a business credit or debit card, consider submitting expense reports to your LLC for reimbursement.
Separate bookkeeping – Keeping organized books is essential for any rental property business. Organization, structure, and tracking provide real time data on the financial health of your investment. You will be able to track your net income and cashflow and calculate key metrics for both individual properties and the entire portfolio.
Spend time early on in your real estate business to set this up properly. Consider using a property management app such as Cozy, SparkRental, RentecDirect, or Buildium or use an accounting tool like Quickbooks. Whatever tool you use, make sure you can easily create reports for your accountant during tax preparation season.
2. Choose your business structure
Before you buy an investment property, or convert an existing home into a rental, consider the structure where you plan to hold it. This has implications for liability protection, insurance, lending and potentially taxes. Common rental property business structures include:
A sole proprietorship is administratively the simplest way to own rental properties but has some disadvantages. All other factors being equal, mortgages and insurance tend to be easier to obtain and somewhat less expensive. If you are planning to move into the rental property in the future, it will be easier to convert it back into a personal residence for tax purposes.
However, there is no liability protection or privacy with a sole proprietorship. Your home, investments, and future income are at risk from a lawsuit. Landlords who opt to maintain a rental property in their personal name should have an adequate landlord policy and umbrella liability insurance.
A Limited Liability Company (LLC) provides protection from personal liability for business debts. An LLC is a type of business entity, but unlike a traditional corporation does not pay taxes on corporate income. Instead, that income passes through to the members (owners) of the LLC who report income and losses on their personal tax returns.
Properties managed under an LLC add a level of privacy, especially if you are using a professional property manager as your agent. Because an LLC is a separate legal entity, this can the impact the cost and process for both mortgage lending and landlord insurance.
Forming an LLC is easy and inexpensive in most states. You can find the link to your state here.
3. Track your numbers
I encourage you to approach your rental property budget as a data scientist. Create a cashflow budget for your rental property and update your budget vs. actual every month. You manage what you measure.
This budget – or “spending plan” -- for your property includes categories for:
- Income: rent, security deposits, pet cleaning fees, application fees. Rental income is somewhat predictable. You set the amount, and tenants pay you – hopefully on time and monthly.
- Expenses: projected vacancies, mortgage, insurance, maintenance, repairs, utilities paid by you, property taxes, management fees, marketing, tenant screening, capital expenses, water and garbage, tree work/landscaping, legal, tax, costs of preparing a vacant unit for rent, etc. Estimating expenses is both an art and a science. You will get better at it over time if you are regularly comparing your budget vs. actual expenses.
Many new landlords think their property will be profitable if the rent covers the mortgage, interest, and taxes, but they do not fully take in account all the other expenses. In your rental business finances, just like your personal finances, there will be unexpected things that happen. Consider adding a contingency of 5-10% of gross rents to your projections initially. With experience, you can refine that number.
You can design the rental property budget in this Zillow tool or DIY it in Excel or Google Sheets.
Of course, putting your budget together is just the beginning. You must follow it! By separating your rental business and personal finances, you will be able to assess in real time whether a new discretionary expense will contribute or detract from profitability. See IRS tips on rental real estate deductions and recordkeeping.
4. Track the time you spend on your rental business
Even though you are treating your rental property operations like a business, the IRS generally treats rental income as passive income. According to the IRS, that means “losses from passive activities that exceed the income from passive activities are disallowed for the current year. You can carry forward disallowed passive losses to the next taxable year.” (See IRS – 925: Passive Activity and At Risk Rules)
While there are fewer deductions available than another type of small business, one big advantage of rental real estate as passive income is that it is not subject to the self-employment tax.
Some rental property investors who earn a profit and work at the rental business “regularly and continuously” may benefit from treating their real estate business as an active business. Rental property owners who are able to treat their real estate income as business income may qualify for the Qualified Business Income Deduction, which is a pass-through income tax deduction of up to 20 percent of net rental income through tax year 2025.
Qualifying for the Qualified Business Income Deduction as a rental property owner
In 2019, the IRS established a safe harbor to allow rental real estate to qualify as a business for purposes of the QBI if the taxpayer or passthrough entity (such as an LLC) meets these requirements:
- Keep separate books and records are maintained for each rental real estate enterprise.
- Perform 250 hours or more in rental services. This includes services performed by employees and agents.
- Maintain contemporaneous records of the services performed.
5. Get professional tax advice
From my point of view as a rental property owner and CERTIFIED FINANCIAL PLANNER™, any rental property owner can benefit from a professional tax advisor, preferably one with real estate expertise – even if you only have a single property.
Taxes can be complicated for rental property owners. Although you may be good at finances and forms, your time may be better spent managing your properties and looking for new deals. A good tax advisor will tell you things you did not know about the U.S. tax code and compliance that will help move your real estate business forward.
Look for a licensed tax professional with a practice who serves many real estate investors. Preferably your tax professional also invests in real estate themselves. A professional tax advisor is an accounting professional who is knowledgeable about the U.S. tax code and works with clients to comply with the tax code and minimize their tax burden:
- A Certified Public Accountant (CPA) is an accounting and financial professional who has passed a four-part examination administered by the AICPA and is licensed at the state level.
- An Enrolled Agent (EA) is a federally licensed tax practitioner who has passed a three-part federal exam or has worked for 5+ years at the IRS in certain positions.
Your business mindset
None of these financial habits takes excessive amounts of time. They all get easier the more you repeat them. By thinking of yourself as a rental property business owner -- and not a passive investor -- you will uncover more opportunities, overcome business obstacles, and build real wealth for yourself and your family.
Have you checked out our new small business financial coaching group? Surround yourself with people who are going to help you figure it out. Join our community as we help each other figure out new and practical ideas to move your business forward. We'll tackle ways to diversify your income and embrace the changes needed to drive new streams of revenue to your business.
* Names have been changed to protect confidentiality. This blog is for general financial education purposes. Information contained in this blog should not be construed as financial, tax, real estate, legal or investment advice. For educational purposes, blog posts may contain links to other websites which are not under the control or and are not maintained by Real Life Planning. Real Life Planning has provided those links for your convenience but does not necessarily endorse all the material on those sites. Please consult your financial, real estate, legal, or tax advisor for advice specific to your situation.