All Forum Posts by: Brian Schmelzlen

Ok, I understand now.

The building's value is NOI/cap rate.

The good news is that the private equity group will not be emotionally attached to the building (it is all just numbers to them). What they should care about is their ROI.

The bad news is that they just recently purchased it and put a decent amount of money into the renovations, which means they would need a good amount of money to hit their ROI. Perhaps even more than what the building is currently worth since it takes time to raise the rents and increase value that way.

Hi @Andrew R. and @Account Closed,

The LLC tax in California is expensive ($800 per year), but an LLC is probably your best choice for owning rental properties. I will give a brief overview of the other options though:

C-corporation: This is a separate legal entity that will file and pay its own taxes.  It offers great liability protection, but it is subject to double taxation (it pays taxes itself, and then you pay taxes when it distributes money to you).  This is generally not a good vehicle for real estate investing.

S-corporation: This is a separate legal entity, but it is also a pass-through entity.  For California, you will pay the greater of 1.5% of net income or $800 to California annually (except for the first year which is just 1.5% of net income).  Because it is a pass-through entity, you do not have the double tax issue.  It also offers great liability protection.  However, it does not have the flexibility that a lot of real estate investors need for rental properties.  If you ever need to take the rental property out of the business, for tax purposes it will be treated as if the S-corporation sold the property to the owners.  Also, all distributions from the business have to be "pro rata" to their ownership interest, which occasionally causes owners issues.

LLC: This is one of the most flexible investment vehicles. It is a pass-through entity, so you do not have to worry about double taxation. It also offers great liability protection as long as you follow the formalities. For California, you will pay an LLC tax of $800 per year, and if your revenue (not profit) is high enough you will also have to pay an LLC fee. Generally, you can put property into and take property out of an LLC without tax consequences. I like this vehicle for rentals, but not for fix and flips.

LLP: This is not available to real estate investing. It is limited to certain types of professional business that are specifically excluded from operating as an LLC, and it requires that the business maintain an insurance policy.

General partnership: I am not going to get into this one too much.  Just don't do it.  It means that you would have liability for the actions of your partners.

Limited partnership: In a limited partnership, there is a general partner who is personally liable for the partnership, and limited partners who are not.  The limited partners are excluded from participating in the management of the business, but they cannot lose anything more than their investment in the business (no personal liability).

Hi Karen,

If you are buying property with someone else, by default you are in a general partnership.  You do not want to be in a general partnership.  You would be totally liable for your friend's actions or liabilities (if your friend gets sued and the other party can tie in the investment at all, you could be sued even though you had nothing to do with it).

An LLC is probably the best best for what you are looking to do. You will want to discuss with a CPA or an attorney what state to establish the LLC in (the state you invest in, NY, or NC).

You can write the operating agreement yourself to save money, but you may end up regretting it. You need a strong operating agreement that covers all contingencies. I am sure that you and your friend can work well together, but one of the advantages of having a strong operating agreement is that it can resolve conflicts before they occur. A good operating agreement will discuss what happens if you both need to contribute more money to the business (what if in 3 years you need a new roof for your investment property, but the LLC does not have enough money in it to cover it); what happens if only one of your is able to contribute money to the LLC for an unexpected situation; what happens if you have a serious disagreement about the direction of your investment (what if one of you wants to sell the rental but the other wants keep it); what happens if one of your expectedly passes and the other is now partnered with the spouse or kids of your friend; etc.

I know you would rather save the money (who wouldn't), but it is a deductible business expense and may save you a lot of headaches later.

Hi Rony,

I am very confused.  How does the private equity group play into this?

The main way you value commercial buildings is on the income method. You will need to know the building's net operating income (NOI) and the average cap rate for similar buildings in the area. The value of the building you are interested in is the NOI divided by the cap rate.

Online banks pay a pretty solid interest rate.  Ally Bank is currently paying 1.6% on savings.

Hi Aaron,

Depending upon the amount of gain you would have on the sale of the land in Oklahoma, if any, I would consider a 1031 exchange into one or more of the properties you are looking to obtain.  It might be unnecessary, but something you should look into prior to selling.

Your plan isn't crazy; it isn't something I would want to do because I wouldn't want to move every 3 months but if that suits your personality then it could work.  One of the more difficult parts would be that you are guaranteeing that you would always be managing your short-term rental business from a distance.  That is fine, but more difficult so you will need to put a lot of systems in place to start and be good at handling issues from a distance.

In terms of where you should start, I think you should look at which market will give you the best return of the 4.  I would start with that one to speed up your savings for #2.

Call the IRS and ask for a 1st time penalty abatement.  Ultimately it was your fault (or your CPA's fault) for not knowing the deadline, but if it is a first time offense occasionally the IRS will waive the penalty.

It doesn't hurt to call and ask for the penalty abatement.

Either there is a misunderstanding or the people offering you advice do not understand California tax laws. Whether an LLC is manager or member managed does not affect whether it is a disregarded entity or not. What controls that is the number of members (owners). If it is a single member LLC, by default it is a disregarded entity in which case it does not file for federal purposes, only state. California does not care if the LLC is disregarded or not for federal purposes. Either way you will be paying the $800 tax if you are considered to be doing business in California. Also, it does not matter what state the LLC is formed under if California discovers it and determines that it is doing business in California. The state has determined that if the managing member (including a single member LLC that is managing another LLC) is a California resident, then the LLC is doing business in California. I hope this helps. I don’t want you to have unexpected tax bills.

Hi @Jonathan James Look,

Unless you are having different partners for each deal, I don't know if you necessarily want a different LLC for every investment. As you may know, California considers you doing business in California if the manager (you it seems like) resides in California. Therefore, you would be paying a minimum of $800 per LLC per year, regardless of what state you actually set the LLC up in. You would also, presumably, be paying a CPA to prepare the tax returns for you.

Of course, there are a lot of times where it makes sense to have a number of LLCs. It makes sense to set up a different LLC for every state you are investing in just to keep things cleaner. This isn't necessary, but I think there are advantages to it. You would want to discuss that with an attorney as well.

It probably makes sense to have different asset classes in different LLCs. For example, it would probably make sense to have a commercial property in a different LLC than a residential property.

It is necessary to create different LLCs if you have different partners on each deal.

For syndication deals, the typical structure I see is a general partner set up as an LLC, and the investment itself set up as a limited partnership. I think this makes a lot of sense, particularly since you would want the investors to be precluded from participating in management activities.

Hi Tim,

Your sibling should be paying market rent.  This still benefits your sibling because it helps keep the value of the building where it should be.  Also, your sibling still effectively gets a discount since 50% of it goes to paying him/herself.

In regards to what should be in the operating agreement, the attorney who drafts it for you would be in the best position to answer that.  My main advice is to not use something like legalzoom.  There is a time and place to use services like that, but I don't think drafting operating agreements is it since it should be personalized to you and your situation.

There are a few things that I think should be in the operating agreement:

1) How do you determine how much to take out in distributions?  Do you both have to agree?

2) How do you determine when more money needs to be put into the real estate business?  What happens if one of you can't/wont pay?

3) What happens if one of you wants to leave the business (or due to a life situation has to leave)?  Can their share be sold to anyone, or does it have to be sold to the other sibling?  If to the other sibling, how do you determine a fair purchase price and payment terms?