Why use an LLC to Own Income Property?

Whether you own one, or many income properties, owning them personally can be a major liability. There is an inherent risk of liability with property ownership. Should an accident occur, you might lose not only the property itself, but all of your other personal assets (including other properties, your home, bank accounts, vehicles, stock, etc). Although insurance can limit your potential exposure, why be exposed at all? 

Many real estate investors create a Limited Liability Company (LLC) to protect their personal assets from possible litigation associated with their income property.  If the property is held in your personal name, a successful claimant will be able to attach your personal assets to satisfy the judgment. By contrast, if the property is held in a California limited liability company, the LLC may be liable. A successful claimant will be limited to only attach the assets of the LLC and your personal assets will remain protected.

Although it may be possible to protect multiple income properties from one another by establishing a separate LLC for each property, LLCs with the same officers and directors may be considered fraudulent. It would be most prudent to discuss your options with a qualified attorney.

A California real estate LLC can also provide significant tax advantages as well as estate planning benefits. For more information on these topics you will need to consult with a tax accountant or tax attorney.

Creating your limited liability company is fairly straight forward. You will register your LLC with the California Secretary of State. There are many attorneys that offer LLC services.

The limited liability company (LLC) has become a favorite vehicle for owners of income-producing real estate seeking to easily and inexpensively establish a level of personal liability protection from claims from tenants and outsiders.

Can you prohibit your tenants from smoking in your rental units?

Effective January 1, 2012, California Civil Code 1947.5 provides that a landlord has the right to prohibit the smoking of tobacco products in all or part of a residential property. This right applies to new tenants who enter into leases after January 1, 2012.  

For existing tenants, a new smoking restriction constitutes a change in terms of tenancy and must be made in compliance with all state and local laws. For specific details read civil code 1947.5

When I purchase a residential income property how much can I raise the rent?

It is not all that uncommon to purchase a residential income property where the current tenants are paying below market value rents. As the new landlord, how much can you legally raise the rent?

Under California Law there is currently no maximum limit for rent increases. However there are regulations that must be followed.

1. If the tenants have leases, the leases carry over to your new ownership. The rent cannot be increased during the terms of the lease unless the lease provides for rent increases
2. If the rent increase or cumulative rent increases are greater than 10% of the lowest rent during the past 12 months, you must give a minimum of a 60 day notice.
3. If the rent increase or cumulative rent increases are 10% or less than the lowest rent during the past 12 months, you must give a minimum of a 30 day notice.

For specific details on advance notice requirements please refer to the California Landlord Tenant Guide which can be found on the California Department of Consumer Affairs web site at www.dca.ca.gov.

Local rent control ordinances may also limit rent increases, or impose additional requirements on landlords. If your investment property is in an area with rent control, check with your local rent control board to find out what additional restrictions apply.

Having tenants that are paying market value rents are a valuable asset when selling a residential income property. It is highly recommended that you renew leases annually and adjust your rents accordingly to maintain tenants that are paying market value rents.

Evaluating Multi Residential Income Properties with GRM and CAP Rate

When evaluating multi residential income properties that are for sale, in order to decide how much to offer or, to compare two unlike properties, among other things, investors will look at two financial numbers, the Gross Rent Multiplier (GRM) and the Capitalization Rate (CAP).  By calculating these two values, it may for example, help you decide how well priced a duplex in a high rent area compares to a fourplex with lower per unit rents.

GRM = Purchase Price/Annual Gross Income

The GRM is the purchase price divided by the annual gross income. The result gives you the number of years it takes for the gross income to make up the purchase price. The nice thing about this calculation is only minimal financial information about the property is needed and it can quickly tell you if the asking price is out of line with other  properties you are considering. It is important to be consistent with what you use for gross income when comparing properties.  I prefer to use my own estimated market value rents as opposed to current tenant rents. You can use the maximum potential rent or make an allowance for some vacancies. I also prefer to include the income from coin-op laundry machines.

The downside of the GRM calculation is that ignores operating expenses. So while two properties may appear to be of equal value based on a GRM calculation, you may find one has significantly more operating expenses than the other. For example, with the duplex each tenant pays their own utilities, where in the fourplex you find there are not separate water meters, so water is paid by the landlord. The CAP rate looks at both income and expenses.  Once you can obtain expense information on your potential purchase you can then make this calculation.

CAP% = Annual Net Income/Purchase Price * 100

The CAP rate is the annual net income divided by the purchase price, usually expressed as a percentage. If one ignores the tax advantage of rental income and appreciation of property values, then you can consider the CAP rate as the return on your investment.

The annual net income is the gross income you used in the GRM calculation minus all annual operating expenses. Common operating expenses paid by you, the landlord, may include:

·         Property taxes

·         Insurance

·         Garbage service

·         Landscaping services

·         Water and Sewer

·         Gas and Electric

·         Maintenance and Repairs

·         Property Management fee

·         Vacancy factor (if not included in the gross rent calculation)

If you borrow money to make the purchase you will have a mortgage payment. This expense is not considered an operation expense (it’s the cost of borrowing capital) and not included in the calculation. 

Example: Purchase Price = $900,000 Gross Income = $65,000       Net Income = $45,000

GRM = $900,000/$65,000 = 13.85         CAP% = $45,000/$900,000 * 100 = 5%

When comparing properties, a smaller GRM is better and a larger CAP rate is better. Often these values will be provided to you by the listing broker or on the MLS. However, it is important to understand how these values were derived. I have found that often a vacancy factor was not included, property taxes were based on the seller’s rate and maintenance and repair costs were understated. It is best to get as much information as possible from the seller, and then make your own adjustments and calculations.

Vacancy Rate in Silicon Valley Expected to be Below 3%, a Level not Seen Since the Dot-com Boom

As reported by the San Jose Mercury News on April 17, 2012
http://www.mercurynews.com/business/ci_20410464/bay-area-rent-renters-expensive-squeeze-tight-market

With depreciation, your rental income profit could be tax free!

The objective behind owning residential income property is usually to make a profit. The property itself will typically appreciate over time, providing a nice profit down the road when you decide to sell. In the mean time we are striving for a positive cash flow from the rental income. That is, realizing a profit after all expenses are paid. 

  

Rental income is taxed as ordinary income; however, you will offset much of this income with your expenses related to owning and managing the property. Deductions include your true out-of-pocket expenses such as mortgage interest payments, property taxes, maintenance and repair costs, utilities, advertising for renters and professional property management fees. What’s left is your profit, taxable income.

But wait! There is a phantom expense allowed by the IRS. It’s called depreciation. Like any piece of capital equipment for a business, the IRS recognizes that your property, excluding the land, depreciates as it gets worn out over time. Basically (at the time of this writing) they say take the fair market value of your residential income property (excluding the land value) at the time it became a rental property, divide it by 27.5 and that amount of money can be deducted against your income each year for 27.5 years.

For example, if after deducting the value of the land, your income property is worth $550,000, you divide that by 27.5 and get a $20,000 annual deduction against your rental income. Have you owned your income property more than 27.5 years? Then it’s time to exchange it into a new property using the IRS 1031 Tax Deferred Exchange rules (see my March 19, 2012 post) and keep on going for another 27.5 years.

This is general information regarding residential income property tax advantages. Always check out all tax issues thoroughly with a tax accounting professional before making any real estate investment decision. 

Did you know that conforming loan limits are higher on multi-residential properties?

The Office of Federal Housing Enterprise Oversight (OFHEO) set the criteria on what constitutes a conforming loan limit. Lenders offer the lowest interest rates on conforming loans because they can be later sold to Fannie Mae or Freddie Mac. At the time of this writing the FHA loan limit in California is $625,000 for single family and condominium home. Loans above this amount are referred to as jumbo loans and have a higher interest rate. However, small multi-residential properties have higher limits. The FHA loan limit, at the time of this writing, for duplexes is $800,775, for triplexes is $967,950 and for four-plexes is $1,202,925.

If you are thinking about purchasing a multi-residential income property and would like to discuss loan options, I will be happy to refer you to a knowledgeable and trustworthy mortgage consultant.