A Real Estate Discussion
I recently had a financial planning discussion with a client and want to share some of the details and considerations with you…
Our client and her two kids had outgrown their current house; it was a little small and the neighborhood was getting a bit busy and overdeveloped.
The current house she lived in has both sentimental value (it was the first house she and her late husband bought and raised their kids in) and the potential to be a good rental property (house is paid off and estimated annual rent is in the 8-9% range for return on equity), so she’d like to keep it.
I typically discourage investors from holding their past primary residence as an investment property if it’s appreciated in value significantly due to the $250,000 capital gains tax exclusion from selling a primary residence you’d lived in for at least 2 of the last 5 years ($500,000 if married).
Example: Let’s say someone bought a house for $200,000 ten years ago and now it’s worth $450,000. If it was their primary residence for at least 2 of the last 5 years then they won’t owe taxes on the growth. They could sell it for $450,000 and pocket $450,000 (not including real estate and title fees, etc.).
If this same person allowed their primary residence to become a rental property and then sold it after 3 years for $450,000, they would owe 15-20% in Federal capital gains tax on the growth (and perhaps some state taxes as well). 20% of $250,000 in appreciation is $50,000 in taxes due — certainly worth their consideration.
Real estate transaction fees can be a concern, but I’ll typically encourage someone to sell their primary residence, pocket the tax-free capital gains, and then go find the rental property they want to own. Don’t just own something because you happened to already own it.
However, in this case, when her husband passed last year she received a stepped up cost basis to reflect the Fair Market Value (FMV) as of the date of her husband’s passing. Thus, the majority of the taxable gains went away. Holding the existing house ended up making sense from both a financial planning and emotional standpoint.
After reviewing her portfolio, income, and objective to keep the current house as a rental, we set a budget accordingly and when the right house popped up in her ideal neighborhood and within her price range, she made an offer (cash).
Offer accepted.
Let’s rewind a little bit… She was able to make a cash offer from her portfolio because we had decided to keep her non-retirement, liquid investments in a high yield money market fund because we knew a possible real estate purchase may have been on the horizon. We desperately wanted to avoid having her portfolio invested in stocks and to have a stock market decline happen at the exact time she may have wanted to buy a house, therefore triggering a sale of investments after a decline. Investments can —and should— fall from time to time. We have to anticipate and limit the forces which could make us sell. Some of these “forces” may include: a financial emergency, the behavioral urge to get out of the market, or a pre-planned expense coming due (like a home purchase or college tuition, etc.).
During a big transaction like this we tend to get a lot of opinions from the bystanders in our lives. For our client, one opinion came from her friend and mortgage lender. The comment from the friend was something like “you should put 20% down and not a penny more.”
I asked my client if this lender knew anything about her current financial situation…she didn’t.
Instead, the lender was giving advice which would have made her a commission of 1-2% of the loan amount had she gone that route (1-2% would have been $6,000-$12,000 in this case). While loans are an important tool for home buying, you should try to avoid borrowing as much as possible when 30 year mortgage rates are at 7%.
On the other hand, my advice was to deplete her portfolio (which also has the effect of reducing our fees we collect to manage her portfolio) and we’ll work to replenish her assets via the rental income she’ll be collecting along with the high savings rate she’ll have due to not carrying a monthly mortgage payment.
As a fiduciary, it’s very rare for me to encourage someone to hold high interest debt when they have the assets available to avoid that debt — even if it means we’re paid less.
So, last month she closed on the new house, paid cash (we wired the funds directly from her portfolio) and found renters for the old house. Seamless.
We’re glad to be available to have these kinds of discussions with our clients.
Oh yea, one more thing:
She asked me "Should I be holding my rental property in an LLC (Limited Liability Corporation)?"
My answer: “Yea, probably.”
I’m not a lawyer, tax advisor, or policymaker, so take this with a grain of salt. However, here’s what I understand to be the pros and cons of putting your rental properties in an LLC.
Pros of an LLC:
#1: Have you heard the horror stories of a tenant slipping and taking the landlord for everything they own? An LLC can minimize this (insurance too). Managing risk is a necessity.
#2: Anonymity (in most states). If you have 10 rental properties in your name, you’re a target for lawyers, scammers, and anyone else trying to strip some of your wealth away from you. One of the best forms of asset protection is to not appear wealthy. (You might be able to accomplish this with a living trust not titled in your name… Like the “Christmas Tree Family Trust” or something like that.)
I often think of this quote from Bill Murray anytime someone wants fame to go along with their money.
Okay, now let’s consider the Cons of an LLC:
#1: Refinancing a loan without first taking the property out of the LLC and waiting a period of time can be challenging. Why? Because a lender knows a lot more about you and your finances than it does your LLC, so giving a loan to an LLC may be difficult.
#2: You may violate the due on sale clause of a conforming mortgage when you deed the property into an LLC (this is rarely enforced and you can deed it back if the loan is called), but it still technically could cause a big headache.
#3: Annual costs can add up in some states. For example, it's $800/yr per LLC in CA. Fortunately it’s $0 in Arizona after you’ve already established your LLC (which does carry formation costs).
#4: An LLC may violate your homeowners insurance. The insurance company may allow the policy to stay in your name and the LLC can be added as an additional party.
#5: Depending on the state, there can be high transfer taxes when you deed the property to the LLC. Or, you may risk property taxes getting reassessed. This can be a costly error.
#6: In some regions, holding in an LLC can impact rent control.
As you can see, whether or not you use an LLC for rental properties is likely going to be contingent on your personal situation. Check with your state’s laws and regulations, review your insurance coverage (especially umbrella liability), and if you have a loan on the property be sure to consider how that may affect your options.
Okay, that’s enough real estate talk for today. As always, feel free to reach out with any questions or if you’d like to review your situation.
All the best,
Adam Harding
CFP | Wealth Advisor | Memorial Day Weekend Barbecue Enthusiast
www.hardingwealth.com
*This is for informational purposes only. Not investment, tax, or legal advice. Consult and attorney and tax advisor before considering these real estate and LLC related items.
