Common Tax Mistakes for Real Estate Investors
The American tax code is so complicated that it’s easy for new investors to make mistakes. It’s bound to happen, particularly in the tricky realm of real estate investing. In our blog we’ll cover the most common blunders you can make — and how to avoid them.
What Are Real Estate Tax Mistakes?
Whether you’re a hands-on kind of landlord or you prefer to outsource your management, you’re going to have to file an annual tax return. Mistakes like choosing the wrong business structure for your company or failing to create an operating agreement can cost you plenty. You want to make sound and financially advantageous decisions, right from the beginning. That’s why it’s important to learn how to identify potential pitfalls that will show up on your year-end filings.
Common Mistakes to Avoid
Right now, the real estate market is hot. With properties selling quickly, there is money to be made by investing. Unfortunately, there is also money to be lost, especially to inexperienced investors starting a new business.
- New real estate investors often make several classic mistakes, such as buying an older property or failing to plan for housing market trends.
- Start with a buying strategy that aligns with your long-term goals, whether it’s to earn income by renting or in a lump sum with a flip.
- Do your due diligence, and research the neighborhood where you intend to buy, from schools to employment opportunities.
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Mistake #1: Entity Selection
Selecting the right entity structure for your real estate company is vital to your success. You want to take steps to preserve your personal liability and provide a clear separation of the business from you and other owners. You can choose from several options, from a limited liability company (LLC) to a limited partnership to an S corporation, but which one is the best for tax purposes?
If your goal is to buy and hold your properties, we recommend forming an LLC. It’s the best entity for most real estate investors with capital assets when your goal is to achieve rental income. This business structure allows profit and taxes to pass on to the owners without the potential for double taxation that other entity types might face while protecting members from personal liability. Even if you operate as a single-member LLC, keeping separate financial accounts for the company and not using personal assets for the business will help set you up for success.
For example, if a liability issue arises with a sole proprietorship or a general partnership, your personal assets are at risk. That would be a huge mistake on your part. Instead, ensure you adequately prepare for the potential that your business fails and prevent banks or investors from recovering their losses from any of the owners, including you. An LLC could be all that stands between the court and your personal assets if your entity comes under legal attack.
Mistake #2: Anonymity
Landlords are frequent targets of lawsuits, so it makes sense that a real estate investor would want to remain anonymous. There are many benefits to using anonymity to protect your assets. However, trying to stay incognito when buying properties is a mistake. Most state laws prevent anonymous ownership of tangible assets such as homes and apartment buildings. You shouldn’t be concerned about giving your information to a bank or lending institution as an investor.
On the other side of your business, anonymity might have some value. For example, if you’re flipping or wholesaling real estate, you’ll probably need to sign contracts with builders or other outside parties. On the other hand, if you’re signing as a corporate officer of your business, anonymity might offer some protection.
Mistake #3: Quick Claim Deed
Transferring ownership of your new real estate isn’t always a quick and easy task. It’s tempting to opt for a quick or quit claim deed, but that’s not the best idea. This instrument gives homeowners (the grantor) a way to bypass any interest they have in a property to you (the grantee) without having to jump through the traditional legal hoops. While it might seem like a relatively simple affair, it can be a risky practice.
While a quick claim deed provides the simplest way to transfer ownership of a property, it lacks safeguards, warranties, and oversight. These legal documents offer virtually no guarantees about the ownership, protection from title defects, or validity of the investor’s right to sell the home. They can also be tricky to navigate and expose you to all kinds of legal and tax issues.
Mistake #4: Operating Agreement
An operating agreement is an essential document that the members of every partnership or LLC should consider creating. If you fail to do so, it could be a monumental business blunder. In fact, some states require one to do business. This important legal document details the agreement between your company’s owners, and it’s even valuable for a single-member LLC in that it offers personal liability and tax protection.
Another benefit of an operating agreement for real estate investors is to help prevent disputes between company owners by detailing everyone’s roles and responsibilities. You might also want to stipulate operational meeting rules and clearly state how the entity’s debts and liabilities will be managed. Feel free to include other relevant legal provisions, such as noncompetes, confidentiality agreements, and severability. Here are a few more reasons it would be a mistake to pass on an operating agreement. You can:
- Decide on the business structure.
- Determine each owner’s interest.
- Define everyone’s responsibilities.
- Give one or more partners authority over daily operations.
- Establish liability limits for members.
- Specify dispute resolution procedures.
- Outline steps for entity dissolution and owner exits.
Mistake #5: Warranty Deed
If you’re getting ready to buy your first real estate investment property, you’ll want to know about warranty deeds. It’s a mistake not to get one because this document provides grantors with a high level of protection. In addition, it plays an integral part in the transfer of ownership by indicating a seller owns a piece of real estate that’s free of other ownership claims and has a legal right to transfer its title to you.
A warranty deed also provides new real estate investors like you with security. This document guarantees that your real estate transaction won’t be contested in the future. It also protects you from any title defects that originated before the seller purchased the property and throughout the home’s entire history. You’re still responsible for due diligence, of course.
We suggest you run a title search for any other defects in the title chain and resolve them before closing on the property so they don’t pop up after your purchase it. A process will also uncover any encumbrances, easements, liens, and restrictions. Of course, you’ll still want to invest in title insurance to protect your real estate from any unforeseen defects. Most lenders will want you to take this extra step because of their vested interest in your new asset.
The Bottom Line
if you have questions about real estate investments or tax planning, contact us today. You’ll easily avoid making some of these classic mistakes with our expert guidance. We provide our clients with a personalized strategy that includes a step-by-step approach to protecting your assets and minimizing your taxes.
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